What is Capital Budgeting? Definition, Benefits, Methods & Examples

What is Capital Budgeting

What is Capital Budgeting? – As a businessman, capital budgeting is one of the essential things in company financial management that you should understand. Especially when you plan to carry out an investment or a large project with a cost that is certainly not small. The reason is, that the accuracy in doing this capital budgeting will determine the success of your business operations.

So, what exactly is capital budgeting? How to apply it? To find out, let’s look at the following discussion, starting from the definition, benefits, and examples of company capital budgeting.

What is Capital Budgeting?

Fundamentally, capital budgeting is a method of financial analysis to determine whether a company project can be carried out or not. In other words, it is the process of evaluating a project from a financial standpoint and aimed at ensuring its success in generating the desired returns.

You could say, capital budgeting is the most important part of other business processes. This is because this activity involves the project owner company and various other stakeholders who play a role in agreeing on the decision making.

Thus, if the budget calculation process does not get an agreement, the cooperation project will not take place. The interests that are considered in capital budgeting are the interests of investors and future profits.

Various Methods of Capital Budgeting Analysis

Calculation of the company’s capital budget is divided into several types of analytical methods. The various methods of capital budgeting are as follows.

1. Internal Rate of Return (IRR)
The first type is the Internal Rate of Return (IRR), which is a calculation method that is known to be more detailed and accurate than others. This is because IRR does not only consider the future value or future potential but also uses the time aspect in its calculations.

2. Net Present Value (NPV)
The next type of capital budgeting is Net Present Value (NPV). Different from the Internal Rate of Return, this calculation method only uses the future value or potential of the company in the future. To say that the project is feasible, the financial manager must at least score above 0 rupiahs in this calculation.

3. Average Rate of Return (ARR)
Another type is the Average Rate of Return (ARR). This is a calculation method based on the company’s average annual income.

4. Payback Period (PP)
The last type of capital budgeting is the Payback Period (PP), which is a calculation method based on the profit return period. The period figures obtained in this calculation generally contradict the feasibility of the project.

That is, the higher the number generated in the PP calculation, the smaller the feasibility of a project to continue.

Also read: What is Refinancing? Definition, Types, Benefits & Examples

Example of a Capital Budgeting Case
In the IRR method, an example of a capital budgeting case is as follows.

Project A is known to be able to get a profit of 30% from funding for 10 years, while Project B earns a profit of 20% for 5 years funding. Both of them received funding of INR 80,000,000. So, the IRR value for each project is:

IRR project A

= [INR 80,000,000 + (30% x INR80,000,000)] / 10 years

= INR 104,000,000 / 10 years = INR 10,400,000

IRR project B

= [INR80,000,000 + (20% x INR 80,000,000)] / 5 years

= INR 96,000,000 / 5 years = INR 19,200,000

Although the percentage of profit generated by project A is greater, from the IRR calculation, project B is much more. Thus, the one that deserves funding is project B.

Meanwhile, with the NPV calculation, an example of capital budgeting is as follows.

PT. Budi Bakti wants to fund INR. 500,000,000 in one of his company’s projects, namely Project X or Y. Project X receives an annual cash flow of INR. 50,000,000 for 10 years with a 5% discount rate. Meanwhile, project Y obtains an annual cash flow of INR 45,000,000 for 15 years at the same discount rate. So:

Project X . NPV

= (INR 50,000,000 x 10 years) – 5%(INR 50,000,000 x 10 years)

= INR500.000.000 – INR25.000.0000 = INR475.000.000

Y . Project NPV

= (INR 45,000,000 x 15 years) – 5%(INR 45,000,000 x 15 years)

= INR675.000.000 – INR33.750.0000 = INR641.250.000

From this calculation, the project that deserves to be funded is project Y because the NPV value is greater.

Benefits of Capital Budgeting for Companies

Then, what are the benefits of calculating capital for the company? In general, the benefits of capital budgeting are as follows.

1. Show Risk
The main benefit of capital budgeting is that it provides an overview of the risks or potential losses of a project or investment if it is carried out. This is certainly an important part that must be considered in depth before the project is agreed upon.

2. Preventing Unscrupulous Fraud
As is known, company projects are often the target of irresponsible people. However, by doing a careful calculation of funding, the company can prevent the possibility of such fraud. Therefore, the funds will be calculated and managed as effectively and efficiently as possible.

3. Help Make Long-Term Plans
Another benefit of capital budgeting is that it helps companies design long-term projects. This is because this calculation will provide several descriptions or possible methods of project implementation, even for the short term.

4. Determining the Types of Projects That Can Be Implemented
Next, the benefit of capital budgeting is that it provides options related to various projects that can generate profits and minimize risk. By doing these calculations, you can determine which plan is more feasible to fund.

5. Showing the Profit Side of the Project to Investors
The last benefit of this funding calculation is to provide an overview to investors regarding the possible profit that will be generated. This is certainly one of the concrete pieces of evidence to build investor confidence in the project.

That’s the discussion about what capital budgeting is, its types, case examples, and its benefits. As already mentioned, capital budgeting is an important thing that should be considered in the process of implementing a project.

The reason is, that this calculation determines the success and ability of the project to generate profit for the company.

 

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