Consumers and businesses alike have plans for the future. These plans require some form of investment in order to move from a dream to reality. Now, introduce capital budgeting into the picture, and bingo! You’ll be on your way to making decisions that will not only get you closer to your long-term goal or vision but may even exceed them.
Don’t worry, we are not here to teach you Finance 101 and quiz you after reading - but we do encourage you to become familiar with the process of capital budgeting. Allow yourself to leverage the process into your plans and begin making reasonable and profitable investment decisions for your future.
Capital Budgeting Defined
Take a look at your goals for the future, specifically your long-term ones. What do you have on your list? Common goals include owning a home or renovating one, obtaining a higher education, and investing towards early retirement. You may have aspirations, and that’s perfectly fine. Now, to take them off that piece of paper or computer screen and to bring them to life.
Next, consider your cash inflows and outflows. Capital budgeting is a great technique to use. Let’s break down the term.
How to Define “Capital”
Think of physical assets here. Capital refers to an asset that can be liquidated or held towards the purchase of a future expense. Long story short, it is expected to increase in value over time.
Examples of capital assets include:
How to Define “Budgeting”
Budgeting keeps us on track. It’s a tool used by many to plan in the moment, and for the future by laying out your finances and organizing them in a way to control where your money is spent. That is - as long as you follow it.
Set up your budget by taking your income and reducing it by your fixed expenses, then your variable ones. Your fixed expenses are those that do not change month over month, such as a mortgage payment, whereas your variable includes that cup of coffee you get every now and then at the coffee shop.
Now To Put It Together: Defining “Capital Budgeting”
Capital budgeting is a planning process used to measure your investments' value or worth. It’s also termed as “investment appraisal.”
Capital budgeting is heavily associated with business owners, but it can be aligned at home too. The main focus of a business is to earn a profit. Your main focus is to have extra income to turn around and invest—a similar concept. The difference is how the profit is earned.
So while a business is focused on which types of revenue-generating projects it should focus on, you can research which type of long-term investment best fits your style. Investments will vary depending on the person, interest, etc., ranging from stocks, mutual funds, commodities, property, and more.
People want to watch their money grow (if only it grew on trees!), right?
What Is the Time Value of Money?
What if we told you that the money you have in your wallet or in the bank right now is worth more today than the same amount of money would be worth, say five or ten years from now? It’s true, and it all boils down to the anticipated return on investment.
When invested, your money goes to work for you. Different investments chart different courses. Some may work at a snail’s pace but reap the highest growth. Others may give you results in the short term but carry a huge weight of risk.
It depends on where you are comfortable deciding how to invest your money, but why not let it do the leg work for you?
What if you don’t invest your money? Do you think that your $1 will carry the same value next year? Unfortunately, the answer is no, and that has a lot to do with inflation.
The time value of money is a concept that can be used in many instances, not just in savings or investments. It can help you decide when applying for a loan or even when negotiating a salary for a new job. It is often referred to as Net Present Value (NPV) and is one of several types of capital budgeting techniques.
What Is Net Present Value?
The net present value is a calculation that compares the value of money you have today to that of what you may have tomorrow. How do you calculate it? Well, in today’s day and age, grab your phone, a calculator, or the computer. Who does this long-hand anymore?
NPV is a simple formula that takes your cash flow (the projected amount that you plan to have in hand from a project or investment) divided by the discount rate (the rate of return).
Additional Capital Budgeting Techniques
Here are a few additional capital budgeting techniques to use in addition to the net present value.
Let’s say you are looking for another way to bring in earnings, and you decide to purchase the top-of-the-line sewing machine. How long will it take for you to break even or recover from your investment? That is what the payback period is meant to calculate.
The payback period is a simplified technique that is not recommended to be used on its own.
What Is the Accounting Rate of Return?
In this technique, you are taking your average net profit divided by your average investment to get an idea of the average income the asset in mind is expected to generate.
For example, an accounting rate of return (ARR) of 10% translates to earnings of $0.10 for every dollar invested annually.
Setting your ideal rate of return is a good idea. Observe this as you decide where you plan to invest your money. For example, look at the rate of return on gold. According to Statista.com, it nearly reached 25% in 2020.
Defining the Internal Rate of Return
The internal rate of return (IRR) is equivalent to the discount rate required in your net present value calculation to bring your NPV to zero. The downfall of this technique is that it assumes the money is being reinvested at the internal rate of return. Thus, a modified version was created.
What Is the Discounted Payback Period?
How profitable is the project you have drawn out? The discounted payback period can help you determine this. It is similar to that of the Payback Period except that it has been modified to include the time value of money.
When calculating the discounted payback period, ensure it does not become longer than the intended useful life.
What Is the Profitability Index?
This technique considers the present value of your cash inflows, the money you are taking in, the expenses associated versus that of your outflows.
If you have a profitability index that is greater than one, you are in good shape. However, if it is less than one, there is a great risk, and it is best to let that project (or investment) pass by.
Capital Budgeting and Investments: What You Should Consider
Don’t rush into an investment. It may sound fantastic at first until you get into the weeds of the project and realize it may not have been worthwhile. Use capital budgeting to make an informed decision, not one on a whim; back up your decision with the facts.
Here are a few things you should consider:
How does it fit into your strategic plan? Again, think about the long-term. Is it compatible with your future needs?
Will you benefit from the investment? This is where you’ll perform the calculations and scenarios, performing a cost-benefit analysis.
What is the state of the economy? Check the trends. Of course, you can’t predict the future for unexpected events, but it can help you decide whether or not the investment is set up to succeed or fail. Gold maintains its value as a rare precious metal sought after for many purposes.
The Bottom Line
Before you dive in and include capital budgeting in your plan, it’s important to list out your goals.
Include short-term ones, but focus on the long-term goals as these are the ones that the process will help you attain. With those goals in mind, focus on your budget and invest your residual income where you see it has the best chance for growth and where you are comfortable with the associated risk.
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Sources:Gold as an investment: rate of return 2020 | Statista