How to Determine Capital Budgeting
Capital budgeting is the practice of allocating funds set aside for investment in the most effective manner. It takes into consideration the risks and possible returns of various potential investments. While various capital budgeting methods exist, they all serve a similar purpose: They help investors maximize earning potential while minimizing risk, giving investors the prudent diversification and powerful investment picks they need to succeed.
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Instructions
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Pick an investment niche. The most effective investors do not look at the entire world market of potential investments. Instead, they focus on particular sectors for which they have a comfortable level of understanding. For instance, one investor may focus on tech startups in the United States, while another may focus on commodities from South America. You may select multiple niches for the sake of diversification, but do not get too broad, as this may limit your ability to identify risks.
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Pick a capital budgeting method. According to Murray State University, some common methods are payback period, net present value (NPV) and internal rate of return (IRR). The payback period method considers the amount of time it will take for you to recover your initial investment. The NPV method takes into account the present value of an investment's benefits minus its present costs. The IRR method considers the rate of return you can expect on a particular investment. View all of your potential investments through the same budgeting method, as you cannot make comparative judgments by using different methods for different investments.
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Identify investment risks. Investment risks fall under two major categories: systematic risks and non-systematic risks. Systematic risks are risks regarding the occurrence of events that affect the entire market or large portions of it all at once, such as inflation, interest rate fluctuations and sociopolitical issues such as civil unrest. Non-systematic risks affect much smaller portions of the market. A particular company's managerial mistakes or financial weakness are non-systematic risks.
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Weigh the potential gains of an investment as defined by payback period, NPV or IRR against the systematic and non-systematic risks. The investments that present high relative levels of return at low levels of risk are the ones toward which you should allocate your capital.
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