How do you choose which capital budgeting projects to pursue?

3 Apply the evaluation methods

The third step in capital budgeting is to apply the evaluation methods that help you compare and rank the projects based on their profitability and feasibility. There are several methods that you can use, such as net present value (NPV), internal rate of return (IRR), payback period, profitability index, and modified internal rate of return (MIRR). Each method has its own advantages and disadvantages, and you should use more than one method to get a comprehensive and consistent view of the projects. The evaluation methods help you determine the present value, return, payback, and profitability of each project, and select the ones that meet or exceed your required rate of return and acceptance criteria.

4 Consider the qualitative factors

The fourth step in capital budgeting is to consider the qualitative factors that may affect your decision. Qualitative factors are the non-financial aspects of the project that are not captured by the numerical evaluation methods, such as the social, environmental, ethical, strategic, and operational implications of the project. For example, you may want to consider how the project aligns with your mission and vision, how it affects your stakeholders and reputation, how it enhances your competitive edge and innovation, and how it impacts your operations and resources. Qualitative factors may not be easy to quantify, but they are important to consider, as they may influence your preferences and priorities.

5 Perform the sensitivity analysis

The fifth step in capital budgeting is to perform the sensitivity analysis that helps you assess the robustness and reliability of your results. Sensitivity analysis is the process of changing one or more variables or assumptions in your cash flow estimates and evaluation methods, and observing how they affect the outcome of the project. For example, you may want to test how the project's NPV changes when you increase or decrease the discount rate, the growth rate, the initial investment, or the operating costs. Sensitivity analysis helps you identify the key drivers and risks of the project, and how they affect its profitability and feasibility. It also helps you determine the best-case, worst-case, and most likely scenarios for the project, and how to prepare for them.

6 Make the final decision

The final step in capital budgeting is to make the final decision based on your analysis and judgment. You should weigh the pros and cons of each project, and compare them with your objectives and criteria. You should also consider the availability and sources of funds, the opportunity costs, the synergies and conflicts with other projects, and the feedback and opinions of your stakeholders. You should choose the project that offers the highest value and the lowest risk for your organization, and that fits your strategic vision and goals. You should also monitor and evaluate the project's performance and outcomes over time, and make adjustments if needed.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?