Demystifying the Capital Budgeting Process: A 7-Step Guide

Demystifying the Capital Budgeting Process: A 7-Step Guide


Making new investment decisions as a small business owner can be exhilarating, but it can also be somewhat intimidating. After all, you have limited access to equity and debt, so it’s important to feel confident that any new project will create value for the company.

How do you know which projects to take on, and which ones just aren’t worth it? It all comes down to capital budgeting.

What Is the Capital Budgeting Process?

Capital budgeting is the process of analyzing the costs and returns of investing in long-term assets. This analysis reveals whether or not a specific investment has enough return to justify committing the funds and taking the risk.

Capital budgeting is based on analyzing the cash flow — not profits — of a project, and it comes down to the time value of money. The idea is that money on hand today is worth more than money that will be received in the future. Future cash flows are discounted at a projected cost of capital to find the value in today’s dollars.

For example, if you invested $100 today at an interest rate of 5%, it would be worth $105 one year from now. Conversely, $105 received a year from now and discounted at 5% would be worth $100 today. This is the concept of net present value (NPV), used to evaluate the viability of investments in long-term assets. If the NPV of all cash inflows versus outflows is positive, then the investment would be justified.

Since the capital budgeting process is based on the analysis of cash flow, loan payments are included in the analysis, but non-cash accounting entries, such as depreciation, are not.

Next time you face an investment decision, walk through these seven steps of capital budgeting.

1. Identify Potential Opportunities

The capital budgeting process begins with identifying the investment ideas and making sure they fit with your current strategy. For example, a trucking company owner may be thinking about buying a new truck to focus on making local, short-haul deliveries.

First, does this purchase fit with the business mission? Is the company’s strategy to focus on local deliveries, or is there more potential in long-haul trips? Should the purchase be made now, or should it be postponed?

Ask yourself these questions to make sure your investment fits with your growth strategy and makes sense in the current economic environment.

2. Project Operating Costs

Next, estimate all the costs it will take to complete the project. This task may involve research, getting quotes, and exploring the alternatives. For example, should you lease the equipment instead of purchasing it?

Projected revenues and cost estimates must be as accurate as possible. In our example, the truck’s cost would be its initial purchase price plus taxes and registration fees. The operating costs will consist of drivers’ wages, fuel, maintenance and licenses.

Do not use a best-case scenario; base your revenue and expense estimates on what you think will be realistic. Generally, revenues will be less than expected, and costs will usually be higher.

Two semi trucks are approved through capital budget process

3. Estimate Cash Flow

Prepare cash-flow estimates that start with projected revenues and deduct operating expenses, including loan payments. Non-cash accounting deductions, such as depreciation, are not included in these calculations.

Ask yourself — how confident are you about the cash-flow stream? Is there a high probability that the cash flow will be realized?

4. Analyze the Project

Use the NPV method to determine if future revenues less expenses, when discounted to the present, will exceed the initial investment outlay. That will be the decision point for a viable project, when NPV is greater than zero.

Suppose, in our example, the trucking company owner decides to pay cash for the truck, which will cost a total of $75,000. Then, the initial outlay in year zero would be $75,000.

For cash inflows, the owner estimates the new truck will generate net income (revenues less expenses) of $31,000, $34,000, $37,000, and $40,000 over the next four years. If we use a discount rate of 15%, this NPV Calculator finds that the NPV for the truck purchase will be around $25,000. Since this NPV is positive, it makes sense to buy the truck.

If you are comparing several investment possibilities, the next step is to calculate the internal rate of return (IRR) for each project to find the one with the highest return. Investopedia defines IRR as the discount rate at which the NPV of cash flow equals zero. In our example, the IRR for the truck purchase is 30%.

5. Assess Risks

How much money could the company lose if the project fails? What if the revenues are less than expected? Or what if expenses are higher than projected? Will the purchase of a new truck still make sense?

Prepare several “what-if” projections to find the effects on cash flow if the actual results are less than needed to justify the investment.

6. Implement the Plan

Approved projects will need a plan for implementation. This means getting quotes for purchases and finding a way to pay for the project. You should also introduce employees to the project and define their roles.

In our example, the sales staff will need to solicit new customers to keep the truck busy. The owner may need to hire a new driver, and accounting will need instructions on how to set up revenue and expense accounts.

7. Monitor the Results

Set up procedures to track project costs and revenues. Reporting of results should be done on a monthly or quarterly basis to make sure revenues and expenses stay in line with your projections. This will help you identify any deviations from the expected results and take timely corrective actions to get back on course.

This step-by-step approach to capital budgeting can be used by all types of businesses to analyze the viability of a long-term investment. It could be used by a landscaper, for example, who is considering the purchase of additional mowers and trimmers to take on more clients. Or it could be used by a farmer who is thinking about leasing more acres and will need to purchase a harvester and cultivator to handle the additional workload.

The capital budgeting process is more than just making a quick calculation on the back of an envelope for the years it takes to pay back the investment. In today’s competitive environment, a more refined analysis is required, so you can make the best decisions for your business.