Business Finance

Basic Guide to Capital Budgeting

Written by Clayton Reeves for Gaebler Ventures

Capital budgeting can be one of the most important things your company does. Learn the basics of capital budgeting and why it is important to your small business.

So, you probably hear about budgeting, deficits, surpluses and rates all of the time.

How exactly do they apply to someone intending to create a start up firm? There is no specific answer to that question, but generally speaking it applies to every decision that you make as a business owner. Capital budgeting is the process by which you allocate your resources to produce outputs out of inputs. Thus, capital budgeting is the way you create product and by doing so, increase revenue.

There may be only a few projects that your company can undertake when they first start up. This is why budgeting your money in the most efficient way is so important. If you choose unprofitable or sub-optimal projects, it will be harder to get your company off the ground. However, a few good projects and your cash flows will be streaming. This will also attract investors who see how well you allot your scarce assets.

Allocating your capital in the best way is one of the most important things a company can do. There are a few steps in the capital budgeting process that you need to go through when deciding which projects to undertake.

Identify Opportunities

There may be more than one opportunity for your company to undertake. The first step in capital budgeting is to identify those options and figure out how many realistic ways your company can go. This is one of the most important steps in the process, because if you miss some profitable opportunities it can really hamper your ability to grow. Do not neglect this step.

Evaluate Opportunities

Evaluate the opportunities and decide whether they are realistic, doable, reliable sources of income, in the direction the company wants to proceed, etc. This will give you a better idea of how many of the projects you have available are actually a good fit for your company. Eliminate projects that you feel clash with either the direction or culture of your business.

Identify and Quantify Cash Flows

Identify all inflows and outflows of cash throughout the project. This is one of the more subjective parts of capital budgeting. Once you identify cash flows, assign probabilities to each step and create an expected cash flow that better represents all of the scenarios the project could go through.

Don't select the best case scenario for your cash flows. After this is done, use a process such as NPV to find out how much the project gives to your firm in present value terms. Determining your discount rate is an important step that I will cover in another article.

Select the Optimal Project Mix

Once you know how much each project gives to your company, you can figure out which projects you can undertake. Sometimes, you can only afford one project. This makes the decision easy. However, most of the time you can have a project mix with a few projects running at once.

The rule is to create a project mix that gives your company the maximum net present value. Add up all the NPVs of projects you can undertake, and select the mix that maximizes that number.

Implement and Review

After all of that is done, implement and follow through on your projects. This is more of an operational process, and after it is done, review and audit the projects. Were the cash flows on line? How did the actual NPV turn out? What changes could be made to the decision process? Make sure you actively review your practices so that you can iron out any kinks and become efficient in your capital budgeting procedures.

When he's not playing racquetball or studying for a class, Clayton Reeves enjoys writing articles about entrepreneurship. He is currently an MBA student at the University of Missouri with a concentration in Economics and Finance.

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