What is capital budgeting and what are its key methods?

Introduction

On a drizzly morning in Kolhapur, Sanjana, who runs a small spice processing unit, faced two neat files. One proposed a new grinder that would cut wastage. The other suggested a small packaging line to sell retail packs. Both looked promising, but the firm had funds for only one. Instead of guessing, Sanjana used a simple way to compare the money going out today with the money likely to come in over the next few years. That careful way of choosing big projects is capital budgeting, and it helps even a modest Indian business make a calm, numbers based decision.

What Is Capital Budgeting

Capital budgeting is the process a company uses to decide whether a long term investment is worth doing. These are big, one time choices like buying equipment, opening a branch, installing solar panels or setting up a cold store. The decision affects future profits for many years, so it cannot be made by instinct alone. Capital budgeting puts structure around the choice. It asks what cash will go out, what cash will come in, when those flows will happen and how risky they are. If the value created in the future is higher than the cost today, the project is considered sound.

How Capital Budgeting Works

A practical capital budgeting workflow is straightforward.

• List all real options that can solve the business problem.
  
• Forecast yearly cash flows for each option. Include purchase price, training, maintenance, tax, and any resale value at the end.
  
• Decide the discount rate. Many Indian firms use their borrowing cost plus a small risk buffer.
  
• Evaluate each option using one or more methods, mainly Discounted Cash Flow, Payback and Throughput.
  
• Run simple checks. If raw material price rises by five percent or sales are slower, does the project still work.
  
• Choose the option that adds the most value and fits cash capacity. Review results a few months after the project starts.

To keep things simple, many firms use a small table for each option with expected inflows and outflows year by year. Clear numbers reduce debate and speed up board approvals and loan discussions.

Discounted Cash Flow Analysis

Discounted Cash Flow treats future money as less valuable than today’s money because cash in hand can earn interest elsewhere. The process is to bring all future cash flows back to today’s value using the chosen discount rate and then total them up. This total is called Net Present Value. If NPV is positive, the project is expected to add value.

Consider a community hospital in Indore thinking about an oxygen plant. It costs a substantial amount upfront but would save purchases each month. The team lists expected monthly savings for several years and discounts them back to today. If the total discounted savings exceed the upfront cost, the NPV is positive and the project makes financial sense. DCF is powerful because it respects timing. A rupee saved next year is not treated the same as a rupee saved today.

Payback Analysis

Payback asks one simple question. How many years will it take to recover the original investment from the net cash coming in. A rice mill near Raigarh may buy a moisture control unit that reduces rejection. If the unit costs twelve lakh and generates three lakh of net savings each year, the payback period is four years. Management prefers shorter payback because the money returns faster and risk is lower. The method is easy to explain to owners and lenders. However, it ignores benefits after the payback point and does not adjust for the time value of money. For that reason, many Indian firms use payback as an early screen and confirm the final decision with DCF.

Throughput Analysis

Throughput comes from the idea that every system has one main bottleneck that limits total output. The right project is the one that raises throughput at that bottleneck. Think of a ready to eat millet plant outside Davanagere where the roasting drum is always the slow step. Two proposals arrive. A faster labeller or an additional roasting drum. Even if the labeller is cheaper, the extra drum is likely the smarter choice because it lifts output where the process is constrained, increasing total sales and profit. Throughput analysis protects companies from spending on attractive but non limiting areas.

FAQ

What is capital budgeting and its methods

Capital budgeting is the structured way of choosing long term projects by looking at expected cash outflows and inflows over time. The main methods are Discounted Cash Flow using Net Present Value, Payback period and Throughput focused on the bottleneck. Many firms apply at least two methods to cross check the answer.

What is called capital budgeting

 It is called capital budgeting because it deals with large capital projects rather than daily expenses. The process sets a budget for these projects and tests whether the benefits over future years justify the present cost and the risk.

What are the key steps involved in the capital budgeting process

 Typical steps are option listing, cash flow estimation, selection of a suitable discount rate, evaluation with DCF, Payback and Throughput, sensitivity checks for risk and a final choice followed by a post implementation review. Clear documentation of assumptions helps during audits and bank discussions.

What are the four main types of budgets and budgeting methods

Common budgets in organisations are operating budgets, cash budgets, capital budgets and a master budget that ties everything together. For selecting projects the main methods are DCF with NPV or IRR, Payback period and Throughput analysis. Operating and cash budgets then track the results once the project goes live.

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