All you need to know about Capital Budgeting
The modern CFO knows how to govern the process and the tools that allow him to evaluate economic and financial sustainability. The evaluation of investments is not an exclusively strategic judgment but concerns the entire process of creating corporate economic value. This is a reflection shared by managers, aware that the starting point of the creation of economic value for a company is placed in the allocation of capital between the different investment alternatives. Here’s everything you need to know about capital budgeting.
What is Capital budgeting?
As part of the planning and control process, a capital budget is a central tool with which management establishes the optimal allocation of financial resources. In short, it is a matter of evaluating alternative investment projects to achieve profit levels consistent with the assumed risk profile. It is evident that capital budgeting decisions represent one of the main responsibilities of management, being able, if not taken correctly, to undermine corporate competitiveness. Furthermore, it should be considered that investment analysis is something that does not focus exclusively on industrial projects only, but concerns investment decisions such as the launch of new products, the purchase of shares, shares or securities of different nature or research and advertising projects that impact on the corporate image. Capital budgeting is nothing more than "analysis and evaluation" of the economic returns that could be obtained from the financing of investment projects.
Some classic examples of corporate capital budgeting:
- acquire a new plant that increases business productivity
- finance customers by giving them more credit
- finance a research project
- buy equity securities
- acquire a company
- acquire a corporate brand
For the evaluation of the economic returns of the investments, there are mainly four techniques:
Pay-back period
Evaluate the period of time that elapses between the capital advance and the financial return of the same. For example, I spend 100 thousand dollars for a piece of more technologically advanced machinery, and the new productivity allows me a profit increase of 33 thousand dollars per year. In this case, with a bit of approximation, we can say that the payback period is three years.
Net present value (NPV)
Adds the incoming and outgoing cash flows in the various years of evaluation of the investment and updates its value by applying a discount rate. It is the most used and reliable one of the four methods.
Internal rate of return (IRR) or internal rate of return (TIR)
It derives from the previous method but reasons in reverse. It does not start from a specific discount rate but calculates the discount rate that generates a discounted cash flow zero. The investment is accepted or refused if the discount rate calculated in this way is respectively lower or higher than the degree of risk assigned to the activity to be financed.
Average accounting yield
The average book yield is calculated by dividing the average annual profits by the value of the average annual book investment.
The focus of the investment evaluation
The possible investment analysis profiles concern the following areas of assessment:
1. STRATEGIC, in which consistency with the company competitive profile is verified through the impact on the competitive strength or attractiveness of the business;
2. TECHNIQUE, through which the various technological or commercial options are analyzed in terms of effectiveness and efficiency of operations;
3. ECONOMIC, which verifies the relationship between the resources absorbed (investment) and those released by the project over time (future benefits) through synthetic indicators;
4. FINANCIAL, through which the compatibility of the investment flows with the income and expenses profile is assessed, both from a dimensional and temporal point of view.
The economic-financial evaluation
A great chef, to make a delicacy, must have first quality ingredients and a recipe that distinguishes him. In the same way, the CFO, to carry out an eco-fin effective evaluation, must have the correct "ingredients" and the right "recipe" with which to combine them.
The ingredients represent the elements to make a choice among the investment alternatives. It is necessary to know them thoroughly. On the other hand, the recipes also indicate the operating methods with which to combine the investment alternatives to reach a synthetic parameter of classification of investment opportunities.
The ingredients:
The CFO has five tools that can help him in the choices:
1. the invested capital, broken down into three subcategories:
- The declination of the individual types of investment, in the case of a significant articulation of the project, for example, in the construction of the factories. This is necessary to have a detail of the useful life of the investments in which the project is divided, so as to be able to derive the depreciation
- the temporal distribution of investments
- the secondary costs to be incurred immediately or over the period, so that the investment guarantees its performance during its useful life or within the identified time horizon
2. the duration of the investment (time horizon), which leads us to define:
- The time horizon of the investment analysis, which is affected by the sector in which the company operates the type of investment taken into consideration, the predictability of the results, and the economic life of the project.
- the duration of the periods in which the periodic financial events are to be distributed
3. The metric to be used to evaluate the investment. Taking into account that the economic evaluation of investment has as its object, the analysis of the resources absorbed (investment). The project releases them over time (future benefits), the practice uses cash flows, which in this case are identified by the Cash Flow Operating (Operating Free Cash Flow)
4. The financial value of time: In finance, it is always associated with the concept of interest rate, which is intended as a "reward" for giving up immediate consumption.
5. When evaluating the investments, it must be considered that the cash flows of the project, divided into sub-periods (Fcn), belong to different moments and cannot be added together. Through the discounting process. Therefore, the various amounts will be normalized according to the logic of the financial value of time, thus being able to determine the present value of the profile of future cash flows.
6. The discount rate: The theory and practice refer to the opportunity cost of the project, i.e., the return achievable with an equivalent investment in the amount, in the distribution of flows, and in the risk profile. Cost/opportunity that is based on the concept behind finance: the correlation between risk and return.
From this, we understand how, to determine the value created/destroyed, it is necessary to identify the determinants of the cost of capital, understood as cost/opportunity. Briefly, the key elements through which the cost of corporate capital is determined are:
- the cost of the individual sources of financing, i.e., the cost/opportunity of the shareholders (Ke) and the cost of the interest rate paid to the banks for the credit lines received (Kd)
- the weight of the sources of financing, i.e., the weight as a percentage of the capital contributed by the shareholders (Net Equity / Net Invested Capital) and the weight as a percentage of the capital contributed by the banks (Net Financial Position / Net Invested Capital)
By combining the highlighted elements, we obtain that the cost of capital is determined by the weighted average cost of capital (WACC).
The Capital Budget in a nutshell
In recent times, many companies are implementing capital budget processes with which to select and monitor investment options. Given that the focus of the capital budget is, under the direction of the CFO
, to develop a process of sharing between the management of the rationale for economic-financial sustainability and its feasibility. It is clear that the role of the CFO is to offer its own skills at the service of management.
Author: Vicki Lezama