How to use capital budgeting to make investment decisions

Investment is all about identifying the right place to put your money in. Unfortunately, you can’t time travel and learn which ventures succeed. So you’ll never truly know whether an investment decision was right until after you make it and see what happens. That said, you don’t have to shoot in the dark and hope you land a bullseye. Instead, you can make a reasonably informed choice on whether an investment is likely worth it via financial analysis, specifically capital budgeting.?

What is capital budgeting?

Capital is the money invested in a business as equity or debt. It’s a scarce but invaluable resource. So managers carefully choose what activity or sector to invest capital in. Their goal is to maximize business firms and create value for the company.?

Capital budgeting is the process of selecting which areas to invest capital in. Naturally, Capital budgeting is a vital business activity.?

The most useful function of capital budgeting is as an analytical tool. You can apply it to a company’s asset, department, project, or an entire firm. It objectively reveals how well an entity manages their finances.?

Specifically, a capital budget is used to evaluate the quality of a firm’s financial leadership. A financially intelligent firm will invest capital in areas with high returns, while an ineffective one will squander money on useless projects.?

Why is capital budgeting important??

The alternative to capital budgeting is intuition. A manager thinks that investing in a project ‘just feels right' in the absence of statistics or objective information. An intuition-led approach is unreliable and a recipe for disaster.?

A single manager’s intuition may prove accurate in some cases. But without a systematic and data-led approach, a firm will leave their future to chance. Apart from sabotaging their performance, not using capital budgeting will also likely lead to a company losing investment opportunities.?

Investors give you their money because they expect a return. The modern investor is a data-savvy individual who’s extremely concerned with how his money is spent. Naturally, they want to ensure they invest in companies that are least likely to spend their capital on activities with low to no returns.?

Failure to capital budget is a massive red flag. It’s evidence that your company can’t be trusted with money. And so potential investors won’t give it to you, and they’ll be right not to. After all, how can they trust your intuition over solid financial planning??

How does capital budgeting work?

The important concept for capital budgeting is the concept of the time value of money. The time value of money states that money has a time value because it provides a return via interest when invested in a successful enterprise.?

For example, $1.00 in today’s money would be worth $1.10 next year if invested at 10% today. $1.00 is the money’s present value, and $1.10 is its nominal future value.?

But the value of money isn’t constant over time.?

The effect of inflation

Inflation actively decreases money’s value. $1.10 next year may only be worth $1.05 in today’s money. The real value of money is defined by its purchasing power, not its nominal value.

So we need to use a present value/discounted cash flow analysis. This means that we’ll adjust the money in our analysis to a fixed point in time, say today.?

Let’s say inflation hits 5%. So $1.00 next year is worth only $0.95 in today’s money. Going back to our above example. That means at 5%, $1.00 invested today at a 10% interest rate yields a nominal return of $1.10 and a real return of $1.05.?

You’ll use a present value/discounted cash flow analysis to analyze an investment opportunity.?

Investors consider the time value of money when deciding whether to invest in a business. To win over an investor, your company doesn’t just need to give investors more money in the future than they gave you today.?

You have to give investors more money in the future than they gave you today in today’s money.?

The concept of Net Present Value (NPV)

Net Present Value(NPV) is the time value of money calculation used in Capital Budgeting. NPV is the future cash flow expressed in today’s money minus the initial investment in today’s money. It expresses the expected future profit in today’s money.?

A project is profitable when its NPV is greater than 0. A positive NPV means that a project will return more money in the future, in terms of today’s money, than the money needed to invest in the project.?

Conversely, a negative NPV means a project is unprofitable. A negative NPV means that a project will lose value. An NPV below 0 means a project either earned more nominal cash than was invested in it but couldn’t outcompete inflation OR the project earned less nominal, hence less real, income than the investment.?

How do I make a capital budget??

Let’s say we have a company ‘ABC’ that wants to capital budget for a truck they want to buy. ABC’s goal is to buy the truck, use it for 4 years to make deliveries, then sell it.

ABC also assumes that their weighted average cost of capital (WACC) is 16%.?

They’ll follow the following 6-step approach to create a capital budget to decide whether to buy the truck.?

Step 1: Find the total amount of the investment?

Total investment is the money needed for all aspects of a project.?

ABC needs the following investment for their truck:?

Purchase price: $50,000

Sales Tax: $3,500

Vehicle Registration Cost: $1,500

Total Capital Investment: $55,000

Step 2: Determine the net cash flows

Net cash flow refers to the real returns of an asset, NOT its nominal returns. The standard way to approach a net cash flow is with an income statement projection.?

ABC has the following 4-year projection, assuming no taxes.?

Cash Flows

Step 3: Find the residual/terminal value of the asset

There’s a finite number of future cash flows in capital budgeting. Meaning the asset will eventually stop providing cash flows. In ABC’s case, they intend to sell the truck after 5 years. At that point, the truck will stop providing cash flow.?

The residual value of an asset is what the company obtains in exchange for selling that asset. Therefore the residual value of ABC’s truck is what they can sell their truck for after 5 years. The truck’s residual value is $0 if ABC assumes they can’t sell the truck and have to scrap it instead.?

If ABC chose not to sell their truck, their asset will have a terminal value. The terminal value of an asset beyond its projection date. It’s assumed that the asset performs at the same return indefinitely at the level it was in the last year of its projection.?

Put simply, the terminal value of ABC’s truck would be $212,000. That’s the return ABC’s truck is assumed to provide indefinitely.?

Step 4: Calculate annual cash flows

ABC will calculate their cash flows by using the values obtained in steps 1 to 3. The cash outflows will be negative values, while the inflows are positive values.?

ABC will calculate their annual cash flow by summing the cash flow value of each period. Notice that the $0 residual value shows that ABC expects to scrap their truck at the end of 4 years.?

Step 5: Calculate the Net present value (NPV)

NPV is the sum of each year’s cash flow in present value. They’ll calculate it with the following formula:?

Net Present Value = $14,667

Since the NPV is positive, ABC concludes they probably should invest in the truck. The $14,667 NPV means the company will earn the equivalent of $14,667 in today’s money in 4 years. Hence, the truck is a good investment.?

Step 6: Perform a sensitivity analysis

A positive NPV doesn't guarantee a company should invest in a project. Remember, NPV is calculated using projections, not real values. It's impossible to know the future real value of a truck. We can only estimate it. The truck's positive NPV value only holds true if the projections are accurate.?

There are many ways their projections might be wrong. For example, what if the truck actually costs more than $55,000 because of an increase in taxes? What if the truck costs more to operate than expected? And what if the truck breaks down and has to be scrapped before the expected 4 years??

All these scenarios are possible. And each one dramatically alters the truck's NPV. Businesses have to test their projections for these possibilities. They achieve that with a sensitivity analysis.?

A sensitivity analysis involves systematically changing all the variables in a calculation, like operating expenses, capital investment, and discount rate, to see how that impacts the truck's NPV.?

The following table shows an example sensitivity analysis in which ABC assumes a higher capital investment cost with all other variables held constant.?

Notice that the truck’s NPV remains positive until a 120% base projection. This means that ABC shouldn’t invest in the truck if its capital investment needs more than $66,000. Similarly, ABC will systematically alter the other variables to determine how safe the investment is if their projections prove wrong.?

Analyzing these scenarios helps ABC’s executives better define the risk of buying the truck. They’ll likely invest in the truck if their calculations reveal a consistently positive NPV in the different scenarios. They may decide it’s a bad investment if the truck’s NPV decreases too drastically under different scenarios.?

NPV limitations?

NPV only determines whether a project provides enough return to repay its capital cost. It does not provide the return on the investment, which is the internal rate on return(IRR).?

ABC’s truck’s IRR is the accounting return they directly receive from their truck.?

What are the applications of capital budgeting?

You can use capital budgeting to analyze any investment from buying a truck to mortgaging a house and starting a new business.?

Here are two other examples of capital budgeting in action:?

1. Acquiring a Portfolio of Assets?

Let's say John wants to acquire a portfolio of assets consisting of existing commercial real estate from a lender. He could calculate the portfolio's NPV using the portfolio's cash flow and return rate.?

He could also apply sensitive training to further clarify his investment's risk and establish whether it's justified. This information lets him better understand whether the investment is worth it.?

He could also better negotiate with the lender using this information.?

2. Starting a new business?

Let's say Sarah is an entrepreneur who wants to know whether she should open a new Caribbean restaurant in her city. Food tastes aside, she can use capital budgeting to estimate her returns.?

The following is her capital budgeting analysis. Since she expects the business to operate after the 4-year projection, she uses a terminal value in her analysis.?

Discount rate = 20%

Net Present Value = $758,102

Further applying a sensitivity analysis would reveal that her restaurant’s NPV is positive until her capital investment exceeds $2.75 with all other factors held constant.?

Meaning, she should open this business unless the capital costs exceed $2.75 million.?

How can I make an accurate capital budget??

Capital budgeting can be complicated. The analysis makes a lot of assumptions about future values that could be totally off the mark. Even the world's financial experts can't produce 100% accurate capital budgets. You should follow the following rules and conventions to improve the accuracy of your capital budget.??

1. Understand the importance of accuracy

An accurate projected cash flow is the most important part of capital budgeting. For accuracy, you want to account for all cash flow sources, like changes in working capital, accounts receivables, and inventory. Your residual or terminal values should also be meaningful.?

You want a seasoned financial professional to use accurate and detailed information to prepare a capital budget for you. Even getting just one variable wrong could drastically alter the accuracy of your capital budgeting. The result is a potentially disastrous business decision.?

2. Use detailed information?

By far, the most common reason for inaccurate capital budgets is not using detailed information. Let's say a company, A, wants to purchase another company, B. They make a capital budget to evaluate whether to buy company B.?

But company A only uses company B's target projected income statement as their only operating cash flows. And company A uses company B's net income, Not their cash value. Lastly, company A ignores how changes in working capital impact company B's cash flows.?

Lastly, they don't create a meaningful residual value. The result is that company A seriously undervalued company B. Company B is still valued enough that they want it. So company A makes an offer far below company B's value and is rejected.?

3. Don’t overestimate the residual or terminal values

Imagine that an entrepreneur, Sam, is capital budgeting for his new business. He mistakenly attributes a high residual value to his company by assuming his company's value would markedly rise after going public.?

His incorrect residual value provides him a positive NPV, suggesting he should start this business. In reality, a realistic residual value would provide him with a negative NPV.?

Since he’s assumed an inaccurately high residual value, which has led to a positive NPV, Sam opens a business that he probably shouldn’t.

Final Thoughts

To recap, capital budgeting is a financial analytical tool. It’s used for everything from deciding whether a company should buy a new truck to whether you should start a new business. The idea behind capital budgeting is to predict whether a business activity will generate more value in the future, in today’s money, than it costs today.