Capital Budgeting: evaluation of investments
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.
What is a 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 summary, it is a matter of evaluating alternative investment projects to achieve profit levels consistent with the assumed risk profile. It is clear that capital budgeting decisions represent one of the main responsibilities of management, being able, if not taken correctly, to undermine corporate competitiveness.
Furthermore, it must be considered that the investment analysis is something that does not focus exclusively on industrial projects, 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.
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 investment flows with the income and expenses profile is assessed, both from a dimensional and temporal point of view.
The economic-financial evaluation
To make a delicacy, a great chef must have first quality ingredients and a recipe that distinguishes him. In the same way, the CFO, in order 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 choose among the investment alternatives: it is necessary to know them thoroughly. On the other hand, the recipes indicate the operating methods with which to combine the investment alternatives to reach a synthetic parameter of classification of investment opportunities.
The CFO has five tools that can help him in the choices:
The invested capital, which can be analyzed in three sub-categories:
- 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 structured to be able to derive the depreciation.
- The temporal distribution of investments.
- The additional costs to be incurred immediately or in the long term, for the investment to guarantee its performance during its useful life or the identified time horizon.
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 project's economic life.
- The duration of the periods in which the periodic financial events are to be distributed.
Taking into account that the economic evaluation of investment has as its object the analysis of the resources absorbed (investment) and those released by the project over time, the practice uses cash flows, which in this case are identified by the Cash Flow Operating.
The financial value of time: In finance, the financial value of time is always associated with the concept of interest rate, intended as a "reward" for giving up immediate consumption.
When evaluating the investments, it should be considered that the project's cash flows, divided into subperiods (Fcn), belong to different moments and cannot be added together. Through the discounting process, the various amounts will be normalized according to the logic of the financial value of time, thus determining the present value of the profile of future cash flows.
1. 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 funding sources, 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 evident that the role of the CFO becomes to offer its own skills at the service of management.
Capital budget techniques, for example, importance.
It is the planning process through which a company determines and evaluates possible expenses or investments that are large. These expenses and investments include projects such as building a new plant or investing in a long-term business.
In this process, financial resources are allocated with the company's capitalization structure (debt, capital, or undistributed profits) to large investments or expenses. One of the main objectives of investments in capital balance sheets is to increase the company's value for shareholders. The capital budget provides for the calculation of the future benefit of each project, the cash flow by period, the current value of the cash flows after considering the value of money over time, the number of years in which the cash flow of the project. You need to pay the initial capital investment, evaluate the risk and other factors.
Since the amount of capital available for new projects can be limited, management must use capital budgeting techniques to determine which projects will generate the most profitability over a while.
Capital budgeting techniques include performance analysis, net present value (NPV), internal rate of return (IRR), discounted cash flow (CDF), and recovery of investments.
Three techniques are the most popular in deciding which projects should receive investment funds over other projects. These techniques are performance analysis, CDF analysis, and investment recovery analysis. Capital budget with performance analysis.
Performance is measured as the amount of material that passes through a system. Performance analysis is the most complicated form of budget analysis, but it is also the most accurate to help managers decide which projects to adopt.
According to this technique, the whole company is considered as a single system that generates profits.
The analysis assumes that almost all system costs are operating costs. Likewise, a company must maximize the performance of the entire system to pay for expenses. Finally, the way to maximize profits is to maximize the performance that goes through a bottleneck operation. A bottleneck is the most time-consuming resource in the system. This means that managers should always consider capital budgeting projects that affect and increase performance that goes through the bottleneck.
Capital budget using CDF analysis
The CDF analysis is similar to or equal to the NPV analysis in terms of the initial cash flow needed to finance a project, the combination of incoming cash flows in the form of revenues, and other future outflows in the form of maintenance and other costs.
These costs, with the exception of the initial outflow, are discounted to the current date. The number resulting from the FCD analysis is the VPN. Projects with a higher VPN should be ranked above the others unless some are mutually exclusive—analysis of the recovery of investments.
It is the simplest form of capital budgeting analysis and, therefore, the least accurate. However, this technique is still used because it is fast and can give managers an understanding of the project's effectiveness or group.
This analysis calculates how long it will take to recover the investment of a project. The payback period is identified by dividing the initial investment by the average annual cash income.
Small businesses should take inflation into account when evaluating investment options through the capital balance. When inflation rises, the value of money will decrease. Expected returns are not as good as they seem if inflation was high. Apparently, profitable investments can only stop or perhaps lose money when inflation is taken into account.
The capital budget for the expansion of a dairy involves three steps: recording the investment cost, projecting the cash flows of the investment, and comparing the expected profits with the inflation rates and the time value of the investment.
For example, a dairy production team that costs $ 10,000 and generates an annual return of $ 4000 seems to "pay" for the investment in 2.5 years. However, if economists expect inflation to rise by 30% per year, the return value estimated at the end of the first year ($ 14,000) is actually worth $ 10,769 when inflation is represented ($ 14,000 divided by 1.3 equals $ 10,769). The investment generates only $ 769 in real value after the first year.
The amount of money involved in an investment in fixed assets can be large enough to make a company go bankrupt if the investment goes bankrupt. Consequently, the capital balance must be a mandatory activity for large fixed capital investment proposals. Long-term investments involve risks. Capital investments are long-term investments that involve greater financial risks. That is why adequate planning through capital balance is needed.
Large and irreversible investments
Since investments are huge, but funds are limited, proper planning through capital expenditures is a prerequisite.
Furthermore, capital investment decisions are irreversible; that is, once a fixed asset is purchased, its elimination will lead to losses.
The capital budget reduces costs and makes changes in the company's profitability. It helps prevent excessive or insufficient investments. Proper planning and analysis of projects help in the long run.
Meaning of the capital budget
- The capital balance is an essential tool in financial management.
- The capital budget offers ample room for financial managers to evaluate different projects in terms of profitability to invest in them.
- It helps to expose the risk and uncertainty of the different projects.
- Management has effective control over capital expenditure on projects.
Author: Vicki Lezama