Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Capital Budgeting

What it is:

Capital budgeting is the process of figuring out which projects are financially worth an investment.

How it works (Example):

Let's assume Company XYZ is deciding whether to purchase a piece of factory equipment for $300,000. The equipment would only last three years, but it is expected to generate $150,000 of additional profit per year during those years. Company XYZ also thinks it can sell the equipment for scrap afterward for about $10,000. Using an internal rate of return (IRR) calculation, Company XYZ can determine whether the purchase is a better use of cash than some of Company XYZ's other investment options, which return about 10%.

IRR calculates an investor's break-even rate of return. If an investment's IRR exceeds the investor's required rate of return, the investment is considered acceptable. The investment should be rejected if the IRR is below the investor's required rate of return. Let's say the investment's IRR is 24.31%. From a purely financial standpoint, Company XYZ should purchase the equipment because doing so generates a 24.31% return on Company XYZ's cash -- much higher than the 10% it could get elsewhere.

Accordingly, this project is much more important from a capital budgeting perspective.

Why it Matters:

IRR is not the only capital budgeting method (net present value and discounted cash flow are other methods), it is just an example of why capital budgeting exists. The employees of any company have a fiduciary obligation to act in the best interests of the owners of the company, and evaluating the financial returns on various projects is one way to do that.