Importance of Capital Budgeting and Planning
Capital budgeting refers to identifying and evaluating large projects that provide cash flows over a period longer than a year. This covers many different things, whether it be growth expansions or acquisitions.
It is one of the most important things you need to keep in mind as an entrepreneur or a finance professional. The cost of getting this wrong will set your company back a substantial amount.
When you invest in a project, you are spending money on long-term assets that may not provide cash flows you want to receive. Through financial analysis and careful decision-making frameworks, you can select the best alternative in order to create the most value for your company.
Similar to personal finance, a budget for your company is a key part of ensuring its survival. Staying out of bankruptcy, and spending money efficiently is why budgets are created in the first place. On top of just surviving, budgets are used to help you and your company thrive.
Net Present Value: Sum of the present values of all incremental cash flows. For a simple project that costs $100 to build, and earns $10/year after-tax for 5 years, and assuming a 10% discount rate, the NPV would be calculated as follows:
With these numbers, the NPV is negative and would show that your project is a bad investment. On the other hand, if you increase the cash flows to $30/year, the NPV is $14 and would be a positive NPV project.
Next looking at the same project but with a lower discount rate, the discount rate increases significantly.
For more technical professionals, here is the process put into a mathematical formula below:
Internal Rate of Return: Similar to the Net Present Value, but this is the discount rate that makes the present value of the after-tax cash flows equal to the initial cost of the project. In other words, the IRR is the discount rate at which the NPV is 0. Using the latest example from above, the IRR of the project is 15%.
If the IRR is greater than the required rate of return, accept the project.
If the IRR is less than the required rate of return, reject the project.
In this case, 15% is a solid IRR, and generally higher than most equity returns.
You can also create an NPV profile that shows a project’s NPV for different discount rates. NPV on the y-axis and the cost of capital on the x-axis. If you plot two projects on the same chart, a crossover rate is the discount rate at which the NPV for the two projects is equal. Any time the lines cross the x-axis represents the IRR of each project.
Payback Period: Number of years it will take your project’s cash flows to recover your initial investment. This concept is very intuitive because you’ve been doing it subconsciously your whole life. With your first business, as an example, a lemonade stand. Everyone would ask themselves, if I had to spend $100 to start the lemonade stand and I made $10 a day, how many days would it take for me to get all of my money back and break-even?
Note that the time value of money is not taken into consideration here, so the payback period is useless as a measure of profitability. It is only a general estimate as to how long it would take to recover your initial cost of investment.
Strategic decisions in business should be done in a sequential series, without neglecting any of the steps.
1. List Alternatives
In order to make a decision, you need to brainstorm different ideas. If a project comes up out of the blue, it may be good to take a step back and analyze what other things you can do. If a project requires millions of investment, there are many different things you can do with that amount. Go through the capital allocation things you can do (INSERT LINK HERE) and see what specific projects are available.
2. Analyze Alternatives
Financial models, payback periods and NPV analysis should be done for each project. Similar to the above, it’s important you have a thorough understanding of what you need in order to make the right returns.
Types of Projects
Maintenance projects: These projects are required to maintain your business and capital assets. Things like cleaning certain machinery, or fixing up rental units to ensure your tenants are satisfied.
These new projects help to relieve the cost burden on your company currently. Although it may be pricey in the beginning, the goal of these projects is to reduce costs eventually.
Different times in the economy call for different strategies. If your business notices a trend, growth projects help expand your current offerings to try and capture that trend as well. Unlike maintenance projects and efficiency projects, these projects may be riskier as you are sailing into uncharted territory. Think of these projects of being projects focused on vertical/horizontal integration.
Similar to growth projects, you may also be thinking about new product offerings for your business.
The projects above are not regarded as compulsory, because you can choose between them freely. Although one may be the better choice, there is no obligation. Compulsory projects may exist when you receive a government grant, or funding from a specific financing firm, who provides the grant with an obligation.
3. Prioritize and Select
You should base all of your decisions in finance with cash flows, not accounting/GAAP income. All cash flows for your new projects should be in terms of incremental cash flows. These types of cash flows are incremental because they only occur if the project occurs.
Some traps to avoid are sunk costs, which are costs that already occurred so it cannot be avoided. It’s best to get a professional financial manager or investment banker to help with this step as there are many technical aspects to it.
Overall, the concept behind it is we are trying to value the project, and compared the value among the alternatives. To value the project, there are many finance concepts to consider, or else the projects would not be fair comparisons.
Going back to the importance of time value of money, projecting the cash flows is important too. Keeping in track opportunity costs is important too. Opportunity costs are cash flows that would have been available if the company didn’t go through with the project. Tax considerations are important because if you do your analysis on a pre-tax basis, you are greatly overstating your total amount of cash flows available for the project.
Some firms have a large financing pool to choose from, but other firms have to be very thrifty with choosing the projects. It’s rare that a company will have the resources required to go through with all of their positive NPV projects. In this case, picking the highest NPV project and descending thereafter.
4. Track Decision and Adjust
A big issue with many companies is their commitment to a new project. New projects are exciting, but once they’ve been around for a while, people start to care less about them. Keeping track of your new project, by analyzing key performance indicators is crucial in seeing whether or not your project turned out well.
When going through your project, if you think it was a bad project, try to figure out what went wrong. On the other hand, it may be a good idea to apply what went well to other projects too.
Tracking and reflecting capital budgeting decisions allow you to prevent mistakes in the future, and iterate in order to find the optimal process which works for your company.
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