March 19th, 2021
As the global market becomes more competitive, businesses become more reliant on quantitative and data-driven analytics to make major decisions. Relying on numbers to give you an informed and objective pathway is more astute than working based on assumptions or the learning-by-trying methodology. This objective approach proves critical for companies looking into new and high-profile ventures, especially in the world of large-scale projects. Enter capital budgeting.
In this article, we’ll walk through what capital budgeting is, why you should be using it, how it works, and more.
What Is Capital Budgeting?
Capital budgeting is a process businesses utilize to assess and determine the feasibility of large-scale ventures, projects, investments, or acquisitions. Capital budgeting quantifies information to give decision makers an objective and data-driven assessment of the proposed investment.
Sometimes referred to as investment appraisal, capital budgeting is a common process for companies looking to expand their business and outreach but want to know if a project will prove profitable enough to justify the company taking it on.
For example, say a chemical company in the U.S. wants to serve the EU market by opening a new production plant in Germany, a country that’s highly regulated and has above average operational costs. Capital budgeting will highlight the feasibility of this venture and give decision makers an absolute yes or no outcome. If the numbers show that investment will have a good ROI, then the company can give it the green light.
Then, project managers can begin what’s called capital planning. Many people conflate capital budgeting and capital planning, but they are distinct phases in a project’s timeline. While capital budgeting details whether or not the new venture will make the company money, capital planning is all about determining where the resources to complete that project will come from. Both intertwine to give you unhindered visibility and an objective perspective over the proposed project, but the benefits don’t end there.
Why Capital Budgeting Matters
Now that we’ve covered the what, we need to talk about the why. Capital budgeting isn’t just key for making decisions backed up by good data. It sets benchmarks for project performance, allowing for constant monitoring and evaluation, course correction, and metric selection. Capital budgeting also creates a high level of accountability for businesses, as stakeholders won’t react kindly to losing profits. Simply put, capital budgeting helps companies ensure profitability to not only survive in the market, but to thrive.
How Capital Budgeting Works
There are a plethora of techniques used in capital budgeting depending on multiple variables such as the project size, cash availability, obtainable data, and more. Here are some of the most common, and most effective, techniques used in capital budgeting.
Payback analysis, also referred to as payback period analysis, is simply calculating how long the project needs to recoup the initial investment through generated profit—i.e., the breakeven point. It’s the ultimate “how long till the project pays for itself” method.
Companies that choose to use the payback analysis method may do so by virtue of its simplicity. Let’s say a company working in renewable energy eyes a new project with an initial investment of $10 million. The goal is to hit their breakeven point by year five. If the project generates a yearly profit (after tax) of $2 million, it’s easy to calculate that the payback period will be five years. Simple and elegant.
The problem with this technique is that it’s sometimes overly simple and doesn’t calculate other variables such as the earning capacity of money (time value of money) — something that could greatly affect ultimate profits. One way to solve for this is to use what’s called a discounted payback analysis, which does take the time value of money.
Let’s go back to the example above, with the renewable energy company wanting a payback period of 5 years. Adjusting the payback analysis to include time value of money through a discount rate, which is essentially an interest rate, of 6%, we get a breakeven point in year six instead.
|Initial Investment||Year 1||Year 2||Year 3||Year 4||Year 5||Year 6|
Since the maximum payback period was five years and the analysis shows the project will break even one year later, the company would elect against undertaking this investment.
Regardless of which variation a company uses, another reason using a payback analysis might be appealing is if a company has limited funds. Since lower cash reserves mean breakeven points are much more important, it makes sense for a cash-strapped organization to run a simple payback analysis instead of dealing with more complex capital budgeting methods.
Internal Rate of Return
The basis for this method starts with what’s known as the cost of capital. Companies typically must borrow money to invest in projects, normally through a mix of equity and debt such as bonds, stock shares or bank credit. The cost of capital is the weighted average of both debt and equity, and it’s the ROI required to justify going forward with a project.
The internal rate of return is the profit margin that’s needed to clear the hurdle of the cost of capital. Take this example: you get a bank loan with a 13% interest rate to start your own business. In order for your business to survive, you need a profit margin higher than 13% to cover your weighted average of cost of capital and make money.
Companies use the internal rate of return, because it’s a great way to set a benchmark of success for projects. It’s also used to compare ventures, helping companies decide on undertaking new projects or expanding existing ones. However, this proves difficult for mutually exclusive projects, or projects that directly compete with each other for the same resources. That’s because the internal rate of return just highlights if a project will be profitable and thus beneficial to a company or not. It can’t decisively show how two mutually exclusive projects would impact cash flow.
The internal rate of return methodology also falls short when assessing projects with chaotic or hectic rates of return that fluctuate drastically from one period to another. It’s better to use the internal rate of return method when assessing projects that boast stable return figures. Another headache is considering how many periods to calculate. Although businesses usually calculate roughly three to five years as a rule of thumb, it differs depending on the nature of the project itself.
Let’s take another example to further highlight the internal rate of return. Let’s say an oil and gas company was planning a project in a developing country and had a cost of capital of 14%. The company invested $25 million at the start of the project, and set a rate of return at $9 million per year. Calculating for the first four years, we would get an internal rate of return of 16%. In this case the company would accept the project.
So if the internal rate of return was higher than the cost of capital, the project would be accepted. If it was lower, however, a company would reject the project.
Net Present Value
Net present value is the most refined and comprehensive approach to capital budgeting. It calculates the time value of money through incremental cash flows against the cost of capital.
Simply put, net present value is the difference between a project’s current profits after tax and the initial investment (cost) of the project.
Net present value is the most detailed capital budgeting technique, as it leaves no stone unturned and allows you to compare multiple mutually exclusive projects at the same time—something that both payback analysis and internal rate of return methods can’t do.
To calculate the net present value of a project, you calculate the difference between the initial cost and the sum of all periods’ profits, then divide by the sum of the period and discount rate, or interest rate. The great thing about net present value is that it gives you a quantitative measure of the added profitability a project will achieve.
Let’s take an example of a chemical plant comparing three different projects as shown in the table below:
|Project A (discount rate 10%)||Project B (discount rate 9%)||Project C (discount rate 14%)|
Project A and B have positive net present values, and companies will go forth with those projects. Project C, however, has a negative net present value and will not be picked up by the company.
Throughput analysis is an extremely comprehensive and accurate capital budgeting technique. By treating the entire company as one project and focusing on raising profit margins and cutting costs in bottleneck operations, it highlights the proposals that will best serve the company’s bottom line. Specifically, throughput analysis hinges on the fact that if you can maximize the work passing through operational bottlenecks, you can increase the throughput of the entire company.
Priority will be given to proposals that directly affect the bottleneck operations, and focus will be on throughput rather than cost reduction. If a proposal directly impacts the bottleneck positively, then the company will pick it up. If a proposal affects another set of operations, it will probably be discarded.
Take a chemical manufacturer that is experiencing a bottleneck in production. If a proposal impacts production positively, the company will undertake it. If proposals come in that affect sales, distribution, or warehousing, the company will discard them in favor of one that improves the bottleneck.
Find the Right Capital Budgeting Tools for Your Projects
Clearly, capital budgeting can provide you with an essential roadmap for growth. No matter which method works for your business, quantifying information and relying on good, solid data to back up your decision-making is critical to building your business’s success.
But it’s impossible to carry out capital budgeting efficiently and at scale without the right tools. EcoSys offers an out-of-the-box project portfolio management solution that’s flexible enough to fit your portfolio and your existing processes. From capital budgeting and planning to risk management and more, EcoSys can help you manage your projects from start to finish.
To learn more, check out our website today.
One thought on “Capital Budgeting: Definition, Benefits, and Process”
Very formative and educative