Financial Planning: Capital Budgeting Involves Forecasting

Even a two-income household can find choosing between investment opportunities a challenge. It becomes even more important to make wise investment decisions when working with limited assets. Capital budgeting is a financial planning tool used to evaluate prospective investment ideas. It can help couples make sounder decisions when comparing the potential returns of two or more investment projects.

Timescales

The capital budget is typically developed for long-term investment planning. It has primarily been used as a business budgeting technique for large capital investments where prospective projects might have a life span of a year or more. For example, these are investments that might require significant capital expenditures in machinery, supplies and labor. As a household budgeting tool, capital budgeting is best compared to investment and wealth management strategies.

The Capital Budgeting Process

The capital budgeting process includes a number of steps, according to Diana R. Harrington, finance professor and author of the book Corporate Financial Analysis. The first step in capital budgeting is to gather potential investment ideas. Next, the costs and benefits of each investment idea should be assessed. This requires forecasting costs and prospective returns. To make a cost-benefit assessment, forecasts for each potential investment should be compared with all alternative investment options.

Choosing Between Investment Options

After a cost-benefit analysis is performed for each investment idea, each prospect must be ranked relative to its potential for long-term profit. There are a number of specific capital budgeting techniques which can be adapted to household long-term budgeting. This includes the payback period, the internal rate of return and profitability index methods.

Budget Variances

Ultimately, the chosen long-term investment option is awarded with capital, but capital budgets are not abandoned once investments are made. These budgets are always a work in progress. For example, comparing budget variances with actual costs and returns at milestone points provides data for investment return forecasts. While long-term monitoring of investments is generally necessary, budget variance analysis can serve as an early warning to reign in an investment or to take a closer look at underlying operations.