Capital Budgeting | Definition, Decisions & Techniques
Learn about capital budgeting decisions with examples. See different types of capital budgeting techniques, such
as payback period and internal rate of return.
What Is Capital Budgeting?
In a perfect world, Versace would be a great place to live. Unfortunately, it’s not in the budget.
Corporations, like people, are limited by their budgets. What do you do when you have a limited
budget? You figure out the best ways to spend what you have to get what you need or want. For a
business, that may be new equipment. When corporations figure out ways to get what they need
or want, it’s called capital budgeting. So, corporations conduct financial analysis to determine
whether an investment or project is a good idea to pursue.
Capital Budgeting Decisions
Since the main purpose of a corporation is to make money, it’s important to wisely choose which
opportunities to pursue. There are several factors that a corporation needs to understand in order
to make a capital budgeting decision. They need to understand their cash flow. That is, the amount
of money that goes into and out of a business. How much money do we have?
Corporations also need to understand the financial implications of an investment. How will this
capital expenditure, money spent on projects and investments, affect us now and in the future?
Once they understand the financial implications of an investment, they need to understand
whether it’s a good investment for them. So they need to understand their criteria for making an
investment. What do they hope to gain? How much do they want to spend? What outcome would
make this a good or bad investment for them?
Payback Period
There are several common techniques that corporations use to determine how money is spent.
This lesson will discuss three techniques: payback period, net present value, and internal rate of
return. The payback period is the easiest to calculate.
A business that wanted to buy a new piece of equipment might use this technique to make a
capital budgeting decision. The payback period is the amount of time that it takes for an
investment or project to pay for itself. For instance, the equipment costs $5,000 to purchase and
will potentially earn $1,000 in profits a month. The equipment will pay for itself in five months.
How easy was that? You just need key pieces of information, such as the cost of the machine and
how much profit it could produce over a specific period of time.
Time Value of Money
The downside of using the payback period technique is that it does not account for the time value
of money. That means that money is worth more today than it will be in the future. Money has a
time value for three reasons.
The first reason that money has a time value is that in the future you’ll need more money to buy
the things that you buy now. This is called inflation. Money also has a time value due to
uncertainty. The longer it takes you to recoup the money you have spent, the more uncertain it
becomes that you will get it back. The final reason that money has a time value is due to
opportunity cost. More than likely, there will be alternative opportunities for you to invest in.
Having cash in hand today to invest in another opportunity is more valuable than the cash you will
receive in the future.
Net Present Value
Unlike the payback period technique, the net present value and internal rate of return do factor in
the time value of money. They’re a little bit more complicated than the payback period to calculate,
but they are more accurate.
The net present value compares the outgoing cash associated with a project or investment with
the discounted cash flows expected to be generated by the project or investment. For instance,
assume a business owner is looking into a project requiring a $243,000 initial cash outlay. She
expects the project to generate $50,000 cash every month for 12 months. We use a discount rate of
12% per year. We have a monthly time period, so we have to divide 12% ÷ 12 months = 1% or 0.01
per month. Based on her cost of capital, we can calculate NPV with the following formula:
Rt = net cash flow during a single period
i = discount rate or return for a period
t = number of time periods
Many business calculators and spreadsheets will have the capability to do the summation
calculation, but it can also be done by hand. So, using net present value, the project will earn
$562,754 – $243,000 = $319,754 in profits.
Related to the net present value is the internal rate of return, which is the discount rate at which
the net present value is zero. Once the discount rate is calculated, they can be compared to a
hurdle rate, like 12% in the previous example, to see if the project has a greater percentage return
than what it will cost.
Lesson Summary
Let’s review the main points of this lesson. There are several vocabulary words that you should
remember. Capital budgeting is the financial analysis that corporations conduct to determine if
they should pursue a potential investment or project. Cash flow is the money that goes into and
out of a business. Capital budgeting decisions should be based on three things:
1. How much money do we have?
2. What is the financial impact of the opportunity?
3. What are my criteria for investing in this opportunity?
Three capital budgeting techniques are:
1. Payback period
2. Net present value
3. Internal rate of return
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Financial Risk | Definition, Types & Examples
Instructor
?
Usha Bhakuni
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Expert Contributor
Steven Scalia
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Understand what financial risk is by learning the financial risk definition. Explore various types of financial risk.
Learn what financial risk management is.
Types of Financial Risks
Risk can be defined as the probability of having an unexpected negative outcome. There are many
risks that a business is exposed to. Strategic risks occur because of certain decisions made by
management, such as expansion in new geographies, operating in a particular industry at a
particular time, or the launch of a new product line. Compliance risks are subject to legislative and
bureaucratic rules and regulations. These can include employee protection regulations and
environmental regulations. Reputational risks result from company actions that tarnish its brand
name, such as product failure, lawsuits against the company, or negative publicity due to an event.
Financial risks are risks faced by the business in terms of handling its finances, such as defaulting
on loans, debt load, or delay in delivery of goods. Other risks include external events and
activities, such as natural disasters or disease breakouts leading to employee health issues.
Managing financial risk is a high-priority risk for businesses, irrespective of the industry they
operate in. It can be categorized into the following four categories:
1. Market Risk
2. Credit Risk
3. Liquidity Risk
4. Operational Risk
Market Risk
The first risk, market risk, arises due to movement in prices of financial instruments in the market.
One sub-category of market risk is interest rate risk, which is the risk associated with the
movement of interest rates. This can affect the price of interest-bearing assets, such as bonds or
loans. For example, an increase in interest rates can lead to a loss of value of bonds issued by a
company as the prices of the bonds decrease. To manage interest rate risk, various hedging
instruments are available, such as interest rate swaps and forward rate agreements.
Equity price risk is another sub-category of market risk and is associated with the change in prices
of equity shares of a company. It can be differentiated into two categories: systematic risk and
unsystematic risk.
Systematic risk refers to the risk caused by market factors which affect the entire industry. It
cannot be diversified. When an entire industry is affected by some event, it becomes a systematic
risk. Unsystematic risk refers to risk that is specific to a company, such as management changes
or fraud. This can affect the price of its equity shares. Suppose a company launches a new product.
The market will have uncertainty in terms of response to the product that can lead to fluctuations
in its share price. This risk is borne by the shareholders and is an unsystematic risk.
The most effective method of managing equity price risk is to create a diversified portfolio,
including securities that have low or negative correlation among themselves. In this way, the losses
from one security can be balanced with gains from the other. Derivative contracts to hedge the
portfolio holdings are also a common way to manage this risk.
Another category of market risk is foreign exchange risk, the risk is associated with the
fluctuations in currency values. It happens when a financial transaction is denominated in a
currency other than the base currency of the business. Let’s assume a company that is based in
Hong Kong has clients in the USA and earns the majority of revenue in USD. This company faces a
foreign exchange risk as the revenues need to be converted from USD to HKD, and is exposed to
exchange rate fluctuations between the two currencies.
Foreign exchange risk is usually managed by hedging the exposure in one currency to another so
that the fluctuations in the exchange rate do not impact the transaction. Various instruments, such
as future and forward contracts, forex swaps, money market hedges, and currency swaps are
available for managing foreign exchange risk.
Commodity price risk is another type of market risk and it relates to the change in the price of
input raw materials (production inputs) needed by a business, which can impact the profit margins
of the company. For a company that makes potato chips, potatoes are an important raw material.
Any increase in the prices of potatoes will increase the cost of production for the company. So,
there’s a commodity price risk. Companies generally use long-term supply contracts to manage
commodity price risks. Other measures can include passing the increase in price to the customers,
looking for alternatives of the commodity, or hedging with other financial exposures.
Credit Risk
The second risk, credit risk, happens due to default on loans. When the lenders lend money to
borrowers, there’s always a risk involved that the borrowers might not repay the loan. Suppose a
company has borrowed two million dollars from a bank but is unable to repay because of losses
incurred. This poses a credit default risk for the bank. There are various ways to manage credit risk,
such as credit default swaps that provide protection against credit loss on an underlying reference
entity because of a specific credit event.
Liquidity Risk
The third risk, liquidity risk, is concerned with the short-term financial obligations of a company. It
generally happens when a business that has immediate cash needs holds an asset that it cannot
trade or sell at market value due to a lack of buyers. Suppose a company with one million dollars in
assets, such as land, has no cash available. It runs a liquidity risk in this scenario. Companies
generally take measures to increase their cash on hand to manage liquidity risk.
Operational Risk
The fourth risk, operational risk, is mainly a result of internal failures in the operations of a
business. One sub-category of operational risk is fraud risk, which can occur due to internal fraud
deliberately caused by employees or external fraud due to theft or robbery. Financial reporting
poses the biggest fraud risk to companies. To manage fraud risk, companies devise strong policies
for governance, assessment, and prevention of fraud. Regular internal audits and transparent
reporting systems are some of the measures taken to prevent such risks.
Operational risk can also include people risk, which are errors due to human actions, such as
incorrect data entry. Employee training and regular assessment form important tactics to manage
this risk.
Model risk, another type of operational risk, is the risk that the financial model used to capture the
risks or value of a financial instrument does not perform accurately. This can result in mispricing of
assets. Ensuring regular assessment of the models used, proper training of stakeholders, and
maintaining transparent workflow are some of the measures to manage the model risks.
Another sub-category of operational risk is legal risk, which is primarily caused by a defective
transaction, change in law, or a fine imposed for inappropriate actions of the business. The major
sources of legal risk are contracts, regulations, litigations, and structural changes. Legal risk can be
managed with the help of legal advisors who can analyze the contracts and formalities for the
company.
Lesson Summary
Financial risks are risks faced by a business in terms of handling its finances. Managing financial
risk is a high priority for most businesses. Financial risk is classified into four broad categories.
The first, market risk, arises because of movement in prices of financial securities in the market.
The second, credit risk, arises because of non-repayment of loans. The third, liquidity risk, is
concerned with the short-term financial obligations of a company and can occur when a company
in need of immediate capital has valuable assets that have no buyers. The fourth and final,
operational risk, occurs due to internal failures in operations of a business.
Additional Activities
Financial Risk – A Practical Exercise:
The following exercise will allow you to apply your knowledge of Financial Risk by (1) identifying
different types of risk and (2) suggesting ways to manage financial risk.
Exercise:
You are a risk analyst at Boomer Skateboards, a company based out of Illinois that
manufactures skateboards. Boomer has done extremely well in the United States and is
looking to enter the Australian market. Because the Australian market is completely different
than the United States, the company hired some researchers to provide data on the various
risks. You have now received the results of the research (see below) and, while it is accurate, it
is slightly disorganized. You decide that it is best if you organize the various risks into 4
categories (Market Risk, Credit Risk, Liquidity Risk, and Operational Risk) before presenting the
details to management. In addition, you decide to provide a suggestion on how the company
can reduce its credit risk that you identified in the research findings.
List of Risks:
1. The funds required for capital expansion (i.e. building a factory, investing in the supply chain, etc.) will
decrease the company’s cash balance by roughly 85%.
2. The Australian dollar can fluctuate against the US Dollar, leading to unintended gains or losses.
3. There are differences in Contract law between the United States and Australia.
4. Wholesalers in Australia (i.e. your new customers) are not as reliable for paying their accounts as your
wholesalers in the United States.
5. The company’s expansion loan with the bank is at a variable interest rate and thus changes in interest
rates can impact the borrowing cost of the company.
6. The employees in the Australian location may be difficult to train from overseas and can lead to
defects when assembling skateboards.
Solution:
See below.
Risk No. Risk Classification
1
Liquidity Risk
2
Market Risk (Currency)
3
Operational Risk (Legal)
4
Credit Risk
5
Market Risk (Interest Rate)
6
Operational Risk (People)
The company can reduce its credit risk with the following methods:
It can only accept cash payments.
It can tighten the credit terms (i.e. payments are required on shorter notice, penalties can be
imposed for late payments, etc.).
It can offer greater discounts to customers who pay early.
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Operating Budget | Definition & Importance
Learn the operating budget definition and understand how it works. Study the importance of an operating
budget and the three components of an operating budget.
A Look at Budgets
We can all think of something we would love to purchase that costs more money than we have. Or
maybe you have been to a store recently and saw a product you fell in love with but at the time
your money was tied up somewhere else. Part of being an adult is knowing how much money you
have and what that money needs to pay for. This understanding of the quantity of money and what
it is being used for is known as a budget. Thus, when you went to the store and fell in love with
that product but could not purchase it, it was probably because you already had other plans or
obligations for your money, like paying bills and other expenses.
Operating Budgets Defined
Now, a budget is knowing the amount of money you have and planning what you will do with it. An
operating budget is very similar but has a few more components. An operating budget takes into
consideration what expenses a company knows it will have, the costs it expects in the future, as
well as the income it predicts to make over the next year. You see, an operating budget is basically
an estimate of what a company thinks future costs and income will be.
Known Expenses
One component of an operating budget consists of known expenses. These are expenses that a
company knows it will have to pay. For example, electric bills must be paid to turn the lights on and
keep equipment running. insurance, wages, and rent or a mortgage payment must also be paid.
Many known expenses are those that occur every year, and a company expects these expenses
every time it plans a budget.
Future Costs
Unlike known expenses, future costs are those that may change from year to year. They may only
occur once, and may not be something the company expects to pay every time a budget is
planned. For example, if a company has an old machine that looks like it will need to be replaced
within the next year, it would be considered a future cost. Because the machine is not replaced
yearly, and it is not known exactly when the machine will quit working, it is figured into the budget
as a future cost so that the company has enough money in the budget to cover the expense of a
new machine.
Future income
The last main component of an operating budget is future income. This is the part where a
company tries to predict how much money it will make over the next year. For example, if a
company manufactures phones and expects to unveil a new model at some point over the next
year, it might anticipate an increase in profits, which would increase future income. But if a
company makes only one type of phone, and a newer, better device is predicted to be released
over the next year by a competitor, sales might be projected to drop because customers will want
the newer phone. This would result in a lower level of future income predicted.
Example
So what would an operating budget look like? Below you will see an example of Bob’s Appliance
Shop to better understand how the pieces fit together.
Revenue
Sales of Appliances 165,000
Maintenance Calls 105,000
Total Revenue 270,000
Expenses
Cost of Goods Sold 72,000
Wages 44,000
Total Expenses 116,000
Difference 154,000
Keep in mind that this is just a basic example. Actual operating budgets are much more complex
and often have many more places where they gain revenue and many more expenses as well. Each
operating budget is specialized to meet the needs of the business.
Importance of the Operating Budget
So why should a company make an operating budget? Well, for starters, a company needs to know
the best plan for its money. It needs to know if it will be able to cover all of its expenses. Looking at
past years is a good place to start when creating an operating budget, as it can help a company see
where it has spent money in the past. It can also help prepare for future years and understand
where changes need to be made.
Lesson Summary
An operating budget is a way for a company to plan for the coming year by figuring known
expenses, future costs, and future income. Known expenses are those a company already knows it
will have to pay for, like a mortgage payment and utilities. Future costs are those that a company
predicts it will have over the next year, like the replacement of an old machine. Future income is
the amount of money a company expects to make over the next year based on things like sales.
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Health 305 – Assignment 2: Operating Budget
If you have a Study.com College Saver membership and are seeking college credit for this course, you must
submit an assignment and pass the proctored final exam. You must submit your assignment before registering
for the final. Below you will find prompts and instructions for submitting your assignment.
About this Assignment
This course emphasizes healthcare-specific financial policies, analytical frameworks, and economic
considerations vital for financial decision-making, including investment and working capital,
methods of financial management, and insurance coverage. A key focus is on applying economic
and population health models to real-world health service issues.
Prompt
Consider this scenario as part of your assignment. Dr. Emma Thompson, an experienced family
physician, is aspiring to open her own private primary care practice in a suburban neighborhood of
Springfield. After years of working in a large hospital, she wants to establish a more personal and
community-focused healthcare environment. Dr. Thompson has identified a suitable location for
her clinic, which is easily accessible to a diverse population, including young families and elderly
residents. She is keen on offering a range of services from general health check-ups to chronic
disease management. However, Dr. Thompson faces the challenge of efficiently planning the
financial aspects of her practice. She needs to develop a comprehensive operating budget that
includes initial start-up costs, ongoing operational expenses, and revenue projections. The
sustainability and success of her practice hinge on her ability to create a balanced budget that not
only covers costs but also allows for growth and adaptability in the ever-evolving healthcare
landscape.
For your assignment, you are tasked with applying the comprehensive knowledge acquired from
this course to meticulously examine and present the financial intricacies involved in launching a
private primary care medical practice operated by a sole physician.
To effectively demonstrate your understanding and financial analytical and planning skills, you are
required to create an in-depth PowerPoint presentation. This presentation should not only
focus on analyzing best practices for healthcare budgeting but should also be specifically
customized to the nuances of setting up a new medical practice.
Your PowerPoint should be analytical, covering essential topics such as:
Startup costs, including premises, equipment, and initial staffing needs
Market analysis impact on healthcare budgeting
Revenue optimization strategies from various sources like Medicare, Medicaid, and private insurance
Effective cost management in healthcare settings
Financial risks in healthcare operations
Suitable financial management methods for healthcare practices
Recommendations for financial planning and decision-making in healthcare
Potential revenue sources like patient fees, insurance reimbursements, and any other viable income
streams
Ongoing operational costs, including staff salaries, utilities, medical supplies, and maintenance
Potential financial risks and challenges associated with the medical practice and mitigation strategies
In your presentation, ensure that each slide is clear and concise, providing insightful analysis and
realistic projections. Visual aids like charts and graphs to illustrate key financial concepts are highly
encouraged. Additionally, every claim or strategy you propose should be backed by credible
sources and industry standards.
Related Lessons
The following lessons from the course may help you with this assignment.
What Is an Operating Budget? – Definition & Examples
What Is Capital Budgeting? – Techniques, Analysis & Examples
Financial Risk: Types, Examples & Management Methods
Formatting & Sources
As part of your research, you may refer to the course material for supporting evidence, but you
must also use at least three credible, outside sources and cite them using APA format as well.
Please include a mix of both primary and secondary sources, with at least one source from a
scholarly peer-reviewed journal. If you use any Study.com lessons as sources, please also cite them
in APA (including the lesson title and instructor’s name).
Primary sources are first-hand accounts such as interviews, advertisements, speeches, company
documents, statements, and press releases published by the company in question.
Secondary sources come from peer-reviewed scholarly journals, such as the Journal of Management.
You may use sources like JSTOR, Google Scholar, and Social Science Research Network to find articles from
these journals. Secondary sources may also come from reputable websites with .gov, .edu, or .org in the
domain. (Wikipedia is not a reputable source, though the sources listed in Wikipedia articles may be
acceptable.)
If you’re unsure about how to use APA format for your paper and sources, please see the following
lessons:
What is APA Format? Definition & Style
How To Format APA Citations
Grading Rubric
Your PowerPoint will be evaluated based on the following criteria:
Category
Unacceptable (01)
Inaccurate or
missing
Content
information on
Accuracy (x2) healthcare
budgeting
strategies.
Needs
Good (4)
Improvement (2-3)
Excellent (5)
Total
Possible
Points
Basic information
provided but lacks
depth or accuracy.
Accurate content
with good coverage
of healthcare
budgeting
strategies.
Highly accurate and
detailed
presentation of
sophisticated
10
budgeting
strategies in
healthcare.
In-depth and
insightful analysis
of financial aspects
in healthcare
settings.
Analytical
Depth (x2)
No analysis of
financial aspects.
Basic analysis
present but lacks
depth or insight.
Good level of
analysis,
demonstrating
understanding of
financial concepts.
Source
Utilization
No sources or
inappropriate
sources used.
Less than three
relevant sources
used.
Good use of at least
three relevant
sources are used,
enhancing content
quality.
Excellent use of
three or more highquality, relevant
5
sources that greatly
enrich the content.
Presentation
Quality
Poorly organized,
unclear, or
unprofessional
presentation.
Somewhat
organized but lacks
clarity or
professionalism.
Well-organized and
clear presentation,
professional in
appearance.
Exceptionally
organized, highly
clear, and
professional
presentation.
Total Points
10
5
30
Before You Submit
When you complete your assignment, we suggest taking some time to check for any errors or to
add any finishing touches. We also suggest that you use online plagiarism checkers such as
PlagScan or DupliChecker to make sure that your assignment is not too similar to any existing
materials. Plagiarized submissions will NOT be graded.
How to Submit Your Assignment
When you are ready to submit your assignment, please fill out the submission form and attach
your assignment in Word doc, Excel file, PDF, or text file. After turning in your assignment, you may
go ahead and take the proctored final exam. You do not need to wait for your written response to
be graded. You should receive your assignment grade within one week.
If you are not satisfied with the score you receive on your assignment, you may revise or rewrite it,
and resubmit them for grading using the same submission form above. Keep in mind that the
grade you receive on your assignment is only a portion of your overall grade for the course, and
you are free to retake the proctored final exam as well if you choose. Please see the course
syllabus for a more detailed breakdown of the grading policy.
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