Budgets often provide road maps for where a company has been or where it is going. Capital budgets are specific tools used to review major upcoming projects a business may undertake. Capital budgeting analysis is the specific review of the number in the budget and a comparison on the potential revenue the company may earn from it. The best tips for capital budgeting analysis include the creation of a budget for each project, use of external funds to pay for it, and a comparison of the project to the company’s internal rate of return. Not all capital budgets are the same as this repeated process might include different inputs and data.
A capital budget is not necessarily a traditional budget at first look. Capital budgeting analysis typically requires information relating to a project’s revenue, costs, and gross profit in addition to available cash for paying project costs and sources of external funds to make up cash shortfalls. With this information, it becomes clear that a separate capital budget is necessary for each project under review. This allows a company to review projects based on the individual information specific to each one. Once the capital budget process is in place, it is usually not too difficult to repeat for new projects under consideration.
The use of external funds is a common part of the capital budget process as new projects are often quite expensive at their initial undertaking. It is a good idea to have a few potential sources of external funds prior to engaging in capital budgeting analysis. This information on external funds adds more data to this activity as a company can determine the cost of capital for each project. Each project under review may not be as lucrative once a company knows how much external money it will take to complete it. Most companies use external funds because operational cash is too precious to use on potentially worthless projects.
Internal rate of return is generally a percentage of financial return a company desires to make on each project. Though this number often takes into consideration some different data in the company, it can also be somewhat arbitrary, such as 15 percent. Capital budgeting analysis allows a company to take information from each project budget and determine if the financial rate of return is higher than the company’s internal rate of return. If projects do not meet this threshold, they are often discarded for ones that do. This addition to capital budgeting analysis allows companies to make even more informed decisions on new projects.