What Is the Connection between NPV and Capital Budgeting?

Esther Ejim
Esther Ejim
Man climbing a rope
Man climbing a rope

The term capital expenditure is utilized in conjunction with a sum of money that may have been earmarked by a business entity for the execution of a project that is projected to yield a steady cash flow that will last beyond a stated period, usually a year. Businesses generally have many projects included in their capital expenditure for a financial or business period, and the process of deciding the particular projects to undertake versus the available resources at hand is known as capital budgeting. The relationship between Net Present Value (NPV) and capital budgeting is derived from the importance of using the analysis of NPV to determine the profitability for a potential capital project with the aim of allowing the management in a business entity to decide the best type of capital project in which to channel its resources. This is as a result of the use of NPV to measure the profitability, or otherwise, of a potential project as well as the possibility of such a project earning money in the short or long term. These factors affect the final decision of the company regarding the particular capital project on which to spend money and the type of profit it can reasonably expect to make from such an investment.

As such, the link between NPV and capital budgeting is the use of NPV to decide what projects will produce the most desired benefits to the company. Different companies have their own criteria for deciding the type of project in which to invest, including the selection of projects that will render short-term benefits following the injection of the capital expenditure. Assuming a company is trying to build a new factory, the application of the principles of NPV and capital budgeting will lead to a situation where the expected value of the plant acquisition will be subtracted from the present value of the expected cash inflow from the projected future operations of the plant. This knowledge makes the process of capital budgeting much easier as it allows the company to assess the proposed project in order to arrive at a final decision regarding a potential project that will be favorable to it.

For example, the use of NPV and capital budgeting will enable the company to decide if the proposed factory will generate immediate cash inflow that will quickly offset the capital expenditure, or if the expected cash inflow will come in much later. Where it determines that the cash inflow will not come in quickly enough to satisfy the shareholders, or for other possible reasons, the company might decide to invest in different projects, such as the acquisition of new machinery that might start generating more immediate cash inflow. Also, the application of NPV and capital budgeting will allow the company to pinpoint the approximate time that it can expect the project to start generating cash inflow.

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