In simple terms, the capital budgeting process involves generating ideas, making proposals about several potential projects, and evaluating proposals. Then, we proceed to the capital budget planning stage for the selected project. Finally, we review and monitor performance after the selected project is executed.
Although it looks simple, the complexity can vary greatly between projects. For example, work can be more complex in the acquisition project than in the machine or equipment replacement project. Acquisitions may require us to consult more with external parties. And they join the team to make the acquisition a success.
Generating ideas is the first step in the capital budgeting process before we propose several alternative potential projects. One way to generate ideas is to start by looking back at the Ansoff matrix.
The matrix helps us focus our potential launch projects concerning the company’s growth strategy. It tells us four strategic options for growing a business. Is the company focused on existing products? Or is it necessary to develop a new product? Does the company need to develop new markets? Or is it only focused on the current market?
After mapping the alternative choices, then we develop a growth plan. Is it growing organically or growing inorganically? For example, do we take on a replacement project by replacing machines and equipment with new ones? Or do we need to acquire another company? Compared to the first alternative, the acquisition is considered the most important capital budgeting decision.
The Ansoff Matrix offers four alternatives for growing a business regarding products and markets. They are:
- Market penetration
- Market development
- Product development
Market penetration. We focus on existing products and markets to grow our business. For example, we take an expansion project and expand distribution channels by establishing branch offices in several regions. Or we build an online channel by launching a website to facilitate orders and transactions with customers.
Or, we might take on replacement projects to increase penetration. For example, we buy new machines with more advanced technology to achieve lower costs. Thus, we can sell the product at a lower price, potentially attracting more demand. If successful, sales and market share increase.
Market development. We focus on existing products and sell them to new markets. We take an expansion project by building production facilities abroad, for example, in Vietnam, and selling its products in Southeast Asian countries. Or, we set up a subsidiary to market products in Vietnam and Southeast Asia.
In addition to the organic growing alternatives above, we might take an inorganic growth strategy. For example, we acquire an existing company instead of establishing a new company.
Product development. We focus on new products and market them to the current market. For example, we launch a new product to complement the existing product. The project may require investment in new capital goods, such as buying production machinery or setting up a new factory.
Diversification. We grow our business by launching new products and selling them to new markets. For example, we acquire another company in an unrelated business. Or, it is done by establishing a subsidiary. Diversification is the riskiest growth strategy compared to the other three alternatives. Thus, it requires more careful capital budgeting.
Analyzing project proposals
After the first stage in the capital budgeting process, we come up with several proposals about potential projects for execution. Unfortunately, they may not all be worth it. Thus, we must choose the most profitable and significantly affect the company’s value.
Several methods are available in the capital budgeting process to select viable projects. The two main ones are:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
The above methods require us to gather information to estimate project cash flows as accurately as possible. Inaccuracies in cash flow forecasts can be disastrous. In addition, capital projects consume significant costs. So, when we misevaluate the project, costs can swell.
Net Present Value (NPV)
Net Present Value (NPV) requires us to compare future net cash flows with the initial investment. To get a comparable figure, we discount the future cash inflows. Thus, every dollar we earn in the future is equivalent to a dollar we receive today.
As the time value of money explains, a dollar now is worth more than a dollar in the future. That’s because a dollar today we can invest in generating returns. So, a dollar now can be many times in the future.
Back to NPV again. We calculate that by subtracting the total discounted future cash inflows minus the initial investment. Mathematically, the NPV formula is as follows:
CF represents the cash inflows for each t-th period, say one year. So first, we discount the cash inflows each year to get their present value. Then, we add up the results to get the total discounted cash inflows. Once done, we reduce it by the initial investment to get the NPV.
How do we make decisions using the NPV method in the capital budgeting process?
The project is feasible if the NPV is positive (more than zero). This is because the project generates greater future cash inflows than the initial investment. The larger the NPV, the more profitable the project is because it shows it generates greater cash inflows.
On the other hand, if the NPV is negative, the project is not feasible. This is because the cash inflows generated by the project are smaller than the initial investment. In other words, the money generated from the project cannot cover the money spent on investment. So, long story short, the project is a loss.
So what if the NPV is zero? There is no decision we can make. The project may or may not be feasible. We need other considerations. For example, we might continue a project even if the NPV is zero because the project generates an intangible benefit, such as reputation. We cannot monetize such benefits, so we cannot translate them as cash inflows. They only represent economic benefits, not monetary benefits.
Internal Rate of Return (IRR)
IRR refers to the discount rate at which the NPV is zero. If the discount rate equals the IRR, the total future cash inflows after taxes equal the initial investment. The IRR mathematical formula is as follows:
We see from the above formula that we use the IRR as the discount rate to calculate the present value of future net cash inflows for each period. If we look closely, the IRR in the above calculation is the same as “r” in the NPV calculation.
In NPV, the “r” represents the required rate of return, which is the minimum return on capital we will tolerate for investing money in the project. We may not invest money in a project if alternative investments can generate higher returns.
For example, bonds offer higher returns. So, we are better off investing money in bonds than in projects. Because it offers a higher return, we can make more money by buying bonds than by taking on projects.
Back again to IRR. How to make a decision using the IRR method in the capital budgeting process?
We need to compare the IRR with the required rate of return. If the IRR is higher, the project is feasible. There is no other alternative to make more money than the project.
Conversely, if the IRR is lower, the project is not feasible. As explained earlier, if a project yields a lower return than a bond investment, why take the project?
Then, if we relate the IRR to the NPV, the project is feasible if the IRR is higher than the required rate of return, and that is when the NPV is positive. But conversely, if the IRR is lower, the NPV is negative.
Planning a capital budget
After evaluating each project, we move on to the budget-making process. In addition to cash flow, the selected project must align with the company’s overall strategy.
As described in the first step, we relate project alternatives to the Ansoff matrix, which describes the company’s growth strategy by product and market. Thus, the proposals at the evaluation stage are potential projects by the company’s overall strategy.
At this stage, we develop related budgets, including the timing of cash outflows and inflows. Mapping and allocating resources are also included in this process. For example, does the project need to be financed with internal or external sources? Should the company issue debt securities or shares to raise external capital if internal funds are insufficient? Or, is it better to use an undrawn bank loan facility?
Performance review and monitoring
This is the last stage. We compare actual performance with that estimated in the budget. We also check whether there are deviations from the budget? If there is, we find out the reason behind it and take related steps.
In addition, we also need to monitor projects to improve operations to make them more efficient. If there are obstacles, we take appropriate action to make the project more effective in generating cash inflows and saving resources.
Reading in this series
- Capital Budgeting: Importance, Methods For Assessing Project Feasibility
- What is the Capital Budgeting Process?
- What are the Types of Projects in Capital Budgeting?