Back to: Financial Management
Good day, class! I hope you’re all doing well. So far, we’ve been laying the foundation of financial management.
Now, it’s time to get into one of the most important areas in business finance—Capital Budgeting and Investment Decisions.
This is where big, long-term financial choices are made. If a business gets this part wrong, the results can be costly. But when done right, it can lead to growth, profits, and success.
So, what exactly is capital budgeting?
Capital Budgeting and Investment Decisions
Capital budgeting is the process a business uses to decide whether to invest in long-term assets or projects. These could be things like buying new machinery, expanding to a new city, building a factory, or launching a new product line. These decisions usually involve large amounts of money, and the effects last for many years. That’s why they must be made very carefully.
Here’s an example: Imagine a bakery wants to buy a new oven that costs ₦2 million. The oven is expected to last five years and will help the bakery produce more bread, leading to more sales. Before buying the oven, the business must ask: Will this oven bring in more money than it costs? Is it a good investment?
That’s the heart of capital budgeting—comparing the cost of the investment with the expected returns over time.
There are a few popular methods or techniques businesses use to make these decisions:
1. Payback Period
This method asks: How long will it take to recover the money spent on the investment?
Using our oven example, if the new oven helps the bakery make ₦500,000 profit each year, it will take ₦2,000,000 ÷ ₦500,000 = 4 years to recover the cost.
This is simple and easy to understand. However, it does not consider any profits made after the payback period or the time value of money.
2. Net Present Value (NPV)
This method is more detailed. It compares the value of future profits with the cost of the investment, using the time value of money (remember Week 4?).
If the NPV is positive, it means the project is expected to make more money than it costs. If it’s negative, the project may not be worth it.
NPV is highly recommended because it takes into account the real value of future money.
3. Internal Rate of Return (IRR)
IRR is the interest rate at which the investment breaks even. If the IRR is higher than the business’s required return (also called the cost of capital), the project is considered acceptable.
While the calculations can seem technical, the big idea is this: capital budgeting helps businesses choose the most profitable and least risky way to spend their money. A company cannot afford to invest blindly, especially when large sums are involved.
When making these decisions, managers consider a few things: – How much will the project cost upfront?
– How much income will it bring in each year?
– How long will the asset last?
– Are there any risks or uncertainties involved?
To conclude, capital budgeting is the tool that helps businesses plan their future wisely. Whether it’s a small farm in Enugu buying a tractor or a large firm in Lagos expanding its factory, these decisions must be made with care, calculations, and a clear understanding of expected results.
Next class, we’ll take this a step further and talk about Cost of Capital—how much it really costs a business to raise money. Until then, think about any big purchase you’ve seen around you—maybe in school, in your neighbourhood, or on the news. Could you tell whether it was a wise investment?