Capital budgeting techniques help a company assess a project’s viability and profitability among other things. Not all techniques are the same, just like each project has different factors that affect its future profitability. Common capital budgeting techniques include the creation of a capital budget, present value of future cash flows, and the payback period for a given project. Companies can use each one of these techniques if necessary or select just one. This process is mostly a measurement of financial viability, though nonqualitative reviews may also present information.
A capital budget lists all cash flows from future cash payments and the associated costs with earning these revenues. The difference is usually in the negative as the majority of new projects have costs that greatly exceed the initial revenue projections. Companies then list the available capital for starting the project and determine if outside funds are necessary to offset the start-up costs. In some cases, a new project does not need copious amounts of outside funds, especially if the company has a high available cash balance. Finding inexpensive external funds is a secondary process for capital budgeting techniques.
A more involved process that works itself into the capital budgeting process is the use of a present value formula. This formula discounts the value of future cash payments for several years over the project’s lifetime. A discount factor applies to each of the year’s cash flows in the given time period, eventually bringing all the future dollar values to current value. Capital budgeting techniques that use present cash flow formulas allow for a dollar-to-dollar comparison of dollar values. This process is a bit more involved, though it generally allows for a different and sometimes more accurate review of capital budgets and related projects.
The payback period is a very simple formula that provides basic information on various capital projects. Among the many types of capital budgeting techniques, the payback period is typically the simplest to compute, though it most likely presents the weakest information for making decisions. To compute the payback period, an individual in the company simply adds up the annual cash values for each period in the future and then adds up the start-up costs for the new project. Dividing the total revenue projections by the total start-up costs indicates how long it will take the company to recoup these costs. Again, this does not necessarily indicate the future financial viability of the project.