Skip to main content

Capital budgeting

Definition of Capital Budgeting​

Capital budgeting is a process used by companies for evaluating and ranking potential capital expenditures or investments that are significant in amount. A few examples of capital expenditures include:

  • Purchase of new equipment
  • Rebuilding existing equipment
  • Purchasing delivery vehicles
  • Constructing additions to buildings

Examples of Capital Budgeting Calculations​

Capital budgeting usually involves the following calculations for each project:

  • Future accounting profit by period
  • Future cash flows by period
  • Present value of the cash flows by discounting them with an appropriate interest rate
  • The number of years it takes for a project's cash flow to pay back the initial cash investment
  • An assessment of risk along with the urgency of the project

https://www.accountingcoach.com/blog/what-is-capital-budgeting

Hurdle Rate / Minimum Acceptable Rate of Return (MARR)​

Definition of Hurdle Rate​

In capital budgeting, the termhurdle rateis the minimum rate that a company wants to earn when investing in a project. Therefore, the hurdle rate is also referred to as the company'srequired rate of returnortarget rate. For a company to further consider a project, its internal rate of return must equal or exceed the hurdle rate.

The hurdle rate is also used to discount a project's future cash flows to its net present value.

Example of Hurdle Rate​

The absolute minimum hurdle rate should be the company's cost of capital(a blend of the cost of debt and the cost of equity). However, the hurdle rate is usually larger than the cost of capital when the company has many investment opportunities and for projects that have a higher level of risk.

  • Hurdle rates give companies insight into whether they should pursue a specific project.
  • Riskier projects generally have a higher hurdle rate, while those with lower rates come with lower risk.
  • Investors use a hurdle rate in a discounted cash flow analysis to arrive at the net present value of an investment to deem its worth.
  • Companies often use their weighted average cost of capital (WACC) as the hurdle rate.

https://www.accountingcoach.com/blog/what-is-hurdle-rate

https://en.wikipedia.org/wiki/Minimum_acceptable_rate_of_return

https://www.investopedia.com/terms/h/hurdlerate.asp

Weighted Average Cost of Capital (WACC)​

The weighted average cost of capital (WACC) is the average rate that a business pays to finance its assets. It is calculated by averaging the rate of all of the company's sources of capital (both debt and equity), weighted by the proportion of each component.

  • Weighted average cost of capital (WACC) represents a company's cost of capital, with each category of capital (debt and equity) proportionately weighted.
  • WACC can be calculated by multiplying the cost of each capital source by its relevant weight in terms of market value, then adding the results together to determine the total.
  • WACC is commonly used as a hurdle rate against which companies and investors can gauge the desirability of a given project or acquisition.
  • WACC is also used as the discount rate for future cash flows in discounted cash flow analysis.

Weighted Average Cost of Capital (WACC): Definition and Formula

Negative working capital cycle​

When a business collects money at a faster rate than the time required to pay its bills