Definition and Examples of Capital

Budgeting
by Sean Mullin, Demand Media
Capital budgeting involves determining the most advantageous investment options for
your small business's liquid assets. Accountants use several complex calculations to
analyze possible investment returns, but many small businesses lack personnel with
awareness of the complexity of capital budgeting. Simply estimating yearly returns in
cash flow doesn't offer your small business an accurate representation of an investment's
real return value.
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Definition
Capital budgeting makes decisions about the long-term investment of a company's capital
into operations. Planning the eventual returns on investments in machinery, real estate
and new technology are all examples of capital budgeting. Managers may adopt one of
several techniques for capital budgeting, but many small businesses rely on the simplest
technique, called "payback period," which simply measures the time needed for the
investment to return its value. Jeryl Nelson, director of the MBA program at Wayne State
College, recommends that small businesses adopt more-sophisticated methods of
calculating investment returns.

Time Value of Money

The payback period computation does not account for the time value of money, which
calculates how much money will be worth in the future based on projected interest rates.
The money spent in capital budgeting is actually worth more in the future because your
business could have invested the money and received interest payments. Small businesses
using payback period computations should account for the time value of money in order
to create a more accurate representation of when investments become profitable.
Related Reading: What Factors Increase the Riskiness of a Capital Budgeting Project?

Inflation
Small businesses must also account for inflation when evaluating investment options
through capital budgeting. When inflation increases, the value of money falls. Projected
returns are not worth as much as they appear if inflation increases, so seemingly
profitable investments may only break even or perhaps lose money when you account for
inflation. As Nelson explains, most small businesses have neither the staff or the
accounting experience to be aware of these factors, so their return projections are less
accurate than larger businesses' projections.

Full Example
Capital budgeting for a dairy farm expansion involves three steps: recording the
investment's cost, projecting the investment's cash flows and comparing the projected

earnings with inflation rates and the time value of the investment. For example, dairy
equipment that costs $10,000 and generates a $4,000 annual return would appear to "pay
back" on the investment in 2.5 years. However, if economists expect inflation to rise 30
percent annually, then the estimated return value at the end of the first year ($14,000) is
actually worth $10,769 when you account for inflation ($14,000 divided by 1.3 equals
$10,769). The investment generates only $769 in real value after the first year.
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References (3)

http://www.fao.org/docrep/W4343E/w4343e07.htm

http://www.google.com/url?
sa=t&source=web&cd=2&ved=0CFEQFjAB&url=http%3A%2F
%2Fwww.sbaer.uca.edu%2Fresearch%2Fsbida%2F1990%2FPDF
%2F03.pdf&rct=j&q=capital%20budgeting%20smal%20business&ei=K-5kTqjIKXr0QGQhIybCg&usg=AFQjCNFuAPwhDJGxbdXn7vlbbty2JUQ64Q&cad=r
ja

http://edis.ifas.ufl.edu/ds138

About the Author

Sean Mullin has been creating online content since 2007. He also worked in an online
writing center for college students. In addition to writing, Sean has a Master of Arts in
classics and teaches Greek and Latin part-time at the college level