In today’s modern world saturated with corporate giants, medium sized firms, a multitude of small businesses, and accelerating start-ups, survival by strategy has never been so important. Because of this relentless competition, it’s crucial that firms take each necessary steps in ensuring the decisions they make and the money they spend will ultimately increases profitability. To assess the profitability of a business opportunity or asset, such as when entering a new market or buying new machinery-capital budgeting will serve as your most resourceful tool in the decision making process.
Capital budgeting uses several formulas to aid in important decisions about accepting or rejecting a proposed investment opportunity.
With capital budgeting serving as a useful tool in determining a project’s potential risk or return, choosing to ignore a capital budget while embracing a long term investment implies carelessness and inattentiveness to shareholders. Furthermore, a capital budget may assist with securing additional financing from banks or investors when pursuing a new investment project.
Capital Budgeting Process
Here are the 5 steps involved in the capital budgeting process:
- Identify potential opportunities: There are various potential solutions to any existing problem; this step is about identifying which opportunity makes the most logical sense for your overall business strategy.
- Estimate incremental cash flow: Research and gather data on similar projects to estimate expected cash inflows and outflows to determine if the project will be profitable enough.
- Assess risks: Capital investment decisions can bring additional risks that can’t be ignored (in extreme cases-bankruptcy).
- Implement: Create an implementation plan to determine how you’ll monitor the project, pay for it, track progress, and record cash flow.
- Review and audit: Analyze and compare cash flow forecasts with actual results to refine the process of making future capital budgeting decisions.
Time Value of Money (TVM)
Time Value of Money supports the belief that $1000 today will be worth more than $1000 by the following day. How? well, once a dollar is invested, it will be provided the opportunity to begin earning interest-signifying the importance of cash flow timing.
The formula to determine the future value of money is:
Future value = Present value x (1 + rate of interest)
And if you’re trying to figure out the future value in 2+ years:
Future value = Present value x (1 + rate of interest)number of years
For example, let’s use the interest rate of 3% (or .03). How much would $100 be worth in year 3?
- Future value= $100 x (1.03)3
- Future value = $109.27
Capital Budgeting Techniques
There are various capital budgeting formulas and techniques. Some companies may choose to rely on one technique, while another company may use a mixture.
Three key capital budgeting techniques are:
1. Payback Method
With this capital budgeting method, you’re trying to determine the amount of time it’ll take for the capital budgeting project to recover the original investment.
It’s important to note that the payback period method doesn’t consider Time Value of Money.
If the estimated profits are $500 for each of the next 3 years, and your initial investment was $1000, then your projected payback period is 2 years ($1000 / $500).
2. Net Present Value
Net Present Value considers today’s value of a future cash flow-meaning it considers The Value of Money. If the projected profit in the next 3 years is $500 per year, it may seem the answer is simply $500x 3 = $1500.
However, because NPV considers TVM, we have to figure out the discounted cash flow for the cash flow stream. The formula is similar to the TVM formula.
NPV = cash flow for specific period / (1 + discount rate)time period
While the discount rate used will vary from company to company, it’s generally the weighted average cost of capital. The weighted average cost of capital is basically the rate of return needed to pay off a business’ providers of capital.
Finally, to determine the potential return on investment, we add all the present values and subtract the initial cash outlay. An NPV greater than 0 is considered good, and an NPV of 0 or lower is bad.
3. Internal Rate of Return
Interested in finding the potential annual rate of growth for a project? Use this technique. Generally, the potential capital projects with the highest rate of return are the most favorable-where an acceptable standalone rate is higher than the weighted average cost of capital.
To figure out the internal rate of return, we use the same NPV formula. The main difference is that we make NPV= 0 and calculate the discount rate instead. Excel has three main functions to help calculate this (IRR, XIRR, and MIRR function).