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The One Year, Thirty Minute Challenge :: Week 35 :: Finance :: Capital Budgeting

It’s that time of year when companies look at their capital budgets for the upcoming year. Capital budgets differ from operating budgets in a couple of important ways. Capital budgets represent a trade – swapping one type of asset for another – $30,000 in cash for a $30,000 delivery truck, $100,000 in cash for a $100,000 enterprise software package. These capital purchases are reflected only on the Balance Sheet. Later, they make their way to the Income Statement and Balance Sheet a chunk at a time using an accounting mechanism called depreciation. Depreciation is driven by the “class life” for each capital purchase. At the time of this writing (August 2020), IRS guidelines set the class life for real property at 39 years, office furniture at 7 years and autos and trucks at 5 years. So, for our $30,000 delivery truck example earlier in the paragraph, we’re spending the physical $30,000 in cash now and reflecting the purchase only on the Balance Sheet – the cash comes off, the truck goes on. Going forward, we’re going to recognize the depreciation on both the Income Statement and the Balance Sheet. Each year, for the first five years we own the truck, we’ll see $6,000 of depreciation expense on the Income Statement and $6,000 removed from the value of the truck on the Balance Sheet (in actuality, it will be accumulated in a single account with all the rest of the depreciation). Conversely, operating budgets are for those expenses that don’t represent a “swap” of assets. Salaries, utilities, and every other non-capital expense happen here. The accounting piece is very simple – reduce cash (on the Balance Sheet) and recognize the expense (on the Income Statement).

The goal of this week’s One Year, Thirty Minute Challenge, is to begin building a capital budgeting process that you can use this year and sharpen in the upcoming years. Keep using it and refining it so it always serves your organization well. Here’s a high-level outline. Your job is to flesh out the steps and fit it to your organization.

Let’s jump in –

Identify Potential Capital Budget Items – The company’s strategic direction and operational necessities should drive this part of the exercise. Typically, there’s no shortage of items clamoring for your capital expense dollars. You might want to enter a new, promising market that requires a new office, new equipment, or new vehicles. You might have to replace worn-out factory machinery or desktop computers to continue existing operations. You might need new equipment to comply with recently mandated government environmental regulations. You might be able to lower manufacturing costs by capitalizing on a new process, but it requires retooling the factory.

Estimate the Financial Impact of the Proposed Capital Budget Items – Using the best information you can gather (from vendors, from your sales, operations, and finance experts) determine the financial effect of the proposed projects on your organization. What will the item(s) cost to obtain? What will the item(s) cost to operate in the first year and all subsequent years? What additional revenue will the item(s) generate in the first year and all subsequent year? If the items are available from multiple vendors, compare item features, benefits, costs, and expected revenues for each option.

Evaluate the Proposed Items and their Financial Impact – Typically, you’ll begin your capital budgeting process with a pool of money you’re ready to devote to capital projects. After you’ve gathered all the information during the previous step, you’re ready to evaluate the proposed projects, hopefully using more science than art. Regulatory compliance gets first dibs since failure to comply could put the ongoing operation of the business in jeopardy. The remainder of the projects should be evaluated by the finance folks using some tried and true capital budgeting metrics that we’ll discuss shortly, but a couple of things first. In many cases, the money to be spent will come from cash on hand. That money isn’t free. If it sat in an interest-bearing investment, it would have a return. For purposes of discussion, let’s say the return on the cash on hand, if left in the investment, is 3%. The return on investment for the proposed capital project needs to be more than 3%. If the money for the capital project is going to be borrowed at an interest rate of 5%, the return on investment for the proposed capital project needs to be more than 5%. You get the idea – the return on the project needs to be more financially beneficial than doing nothing. Clearly, regulatory capital expenses get a mulligan here. There may be no financial benefit to the project. In fact, there might be only financial detriment. But, most likely, the financial detriment is far less than the impact of closing the company. In these cases, the increased costs must be passed along to consumers or be borne by stockholders in the form of lower profits.

Let’s talk about five of the most commonly employed methodologies for evaluating capital projects –

  • Payback Period – How quickly will the cash inflows generated by the investment pay back the initial investment? If the initial investment is $10,000 and the investment generates $5,000 a year in additional cash, the payback period is two years. This method is quick and simple, but it doesn’t take into account the value of cash inflows after the payback period or the time value of money.
  • Net Present Value (NPV) – This methodology compares the present value of all future cash inflows resulting from the project versus the present value of all the current and future outflows required to execute the project.
  • Profitability Index – The present value of all future cash inflows associated with the project divided by the present value of the current and future cash outflows associated with the project.
  • Internal Rate of Return (IRR) – This methodology identifies the rate at which the project breaks even by examining the cash inflows and outflows.
  • Modified Internal Rate of Return (MIRR) – This methodology is similar to the IRR except that it recognizes that cash inflows can be reinvested at a rate that is different than the rate at which they were generated.

Each of the capital projects under consideration must be evaluated in light of these financial metrics (and possibly others). The purpose of this week’s exercise is not to get deeply in the woods, but there are always additional considerations like tax consequence and accounting methodologies. Your finance folks can guide you into a complete discussion.

Most years, you’ll have more potential projects than you have money. The objective measures above will help the projects with the highest return on investment (ROI) bubble to the top.

Occasionally, you’ll be choosing between proposed projects with similar returns – sometimes offering mutually exclusive options. At that point, the “art” kicks in. The projects that most successfully move your strategy forward, the influence of non-financial data (market sizes, trends, patterns), management knowledge and intuition, and more will inform your decision on which projects to pick and which projects to reject or defer.

Implement – After the winning projects are selected, execute like crazy. Depending on the type of project, you might need to create a project team (hope you included that in your capital budget). Create schedules with timelines and milestones, align vendor resources, employ a solid execution framework, and communicate well. You want to implement the project as quickly as possible so it can start generating the cash inflows.

Measure – The capital budgeting tools were forward-looking. After implementation, rigorously track the actual results. Hopefully, the project is performing better than you projected. However, one of the worst mistakes a company can make is succumbing to “sunk cost fallacy”. If a project is seriously underperforming and there’s no remedy in sight, it’s noble to pull the plug. The fact that you’ve already spend $50,000 or $5,000,000 becomes immaterial. Continually investing resources with the hope that the project will magically turn around is a mistake rooted in pride. Track the performance of each project so you have better information for your next round of capital budgeting.

Capital budgeting, many times, represents an opportunity to make a big leap for an organization. A new market, product, process, or system can catapult a company into the national spotlight or into a level of revenue never even dreamed of before. Take this exercise seriously.