Definition of capital budgeting

Capital budgeting (also known as investment appraisal) is the process by which a company determines whether projects (such as investing in R&D, opening a new branch, replacing a machine) are worth pursuing. A project is worth pursuing if it increases the value of the company.

A project typically adds value to the company if it earns a rate of return that exceeds the cost of capital. The opportunity cost of capital (also known as the hurdle rate) is the expected return that is forgone by investing in the project rather than in comparable financial securities, such as shares, with the same risk as the project under consideration.

While capital budgeting is a fairly straightforward process from a conceptual viewpoint, it can be very challenging in practice. Not only is it difficult to determine the group's appropriate cost of capital, it is often even trickier to accurately forecast the incremental cash flows that result from taking on the project.

**Example**

A construction company has to decide whether to construct a building for a customer. The construction project requires an upfront outlay of £1m now and will generate a revenue of £1.25m in a year’s time when the client pays for the completed building. The expected return on investment is (£1.25m - £1m)/£1 million = 0.25 or 25 per cent a year. The return on the project now has to be compared with the company's cost of capital. Instead of investing in the project, the group could buy, for example, bonds or shares in another construction company. The return that could be achieved from investing in these securities represents the company’s opportunity cost of capital, assuming the return on this portfolio of securities has the same risk profile as the project.

If the opportunity cost of capital is less than 25 per cent, then the company should accept the project, and if it is less, then it should accept. Clearly, if the company could earn 30 per cent in the financial market for a similar risk level, then it makes no sense to invest in a project that only offers 25 per cent.

The net present value added to the company from taking on the project can be found by discounting the project’s incremental cash flows at the opportunity cost of capital. Assuming a cost of capital of 20 per cent, the project’s net present value for the above example is: £1 million + £1.25 million/(1+0.2) = £41667

Note that future cash flows are discounted at a rate of 20 per cent to reflect the time value of money: a pound today is worth more than a pound in a year’s time. [1]