Capital budgeting is a business term used to describe the process of determining how to best use the capital the company has on hand. Should they expand? Should they reinvest in a new factory to increase capacity? Is it profitable to acquire another business for expansion? In other words, capital budgeting is the process of deciding “what should we do with all of our cash?”
Most Businesses Skip Capital Budgeting
In the real world, the vast majority of business owners and managers base their decisions on intuition. They see an opportunity for improvement and then they just plow ahead. These plans use up precious company resources to further the agenda. Sometimes, their gut feeling is totally misguided. When that happens, businesses end up being punished financially for the decisions.
Even if a project makes money, there’s a case to be made that the initiative was still a failure. This is because the same capital could have been spent more prudently elsewhere. Determining which areas to spend on in a huge part of capital budgeting.
Projects Can A Failure (Even When They Succeed)
In a previous life, I worked at a technology manufacturer that sold electronics to retailers. The company was doing quite well. The owner had an opportunity to expand into Latin America. His gut told him it was the right move. He plowed quite a bit of money (aka capital) into hiring staff, setting up offices, and all the other details of opening new locations.
Five years into the expansion, while the company’s operations and revenue overall kept growing exponentially, the Latin America division was still bleeding money and resources. However, the owner kept at it. Eventually, he ended up turning some profit from that investment to expand. However, a more robust capital budgeting process would have probably revealed a few better opportunities use his capital to grow his business without the painful losses.
How To Budget Your Capital
Someone asked recently which bank offered the highest yield on a business savings account. He wanted to earn some interest with his operating cash flow. That decision was relatively easy. After all, every bank that’s FDIC insured is basically the same. So he just picked the highest interest rate offered and he was done.
Most other capital allocation decisions aren’t as easy. That’s because different projects require different amounts of initial investment. The potential future payoff is also different. In order to figure out which project is worth more to the company, you need to be able to make an apples to apples comparison.
The Time Value of Money
One way to make a fair comparison is to bring all future investments and profits into the present. Future dollars are worth less than present dollars, because any present day dollar can be invested to be worth more tomorrow. This means that once the decision maker determines an interest rate the company can earn, it can be used to properly discount future investment and returns. (A good gauge is to use what the capital of the company has been earning historically.)
For example, let’s say business is good. A company is selling everything it produces, hand over fist. The owner wants to expand capacity by opening additional production lines in the factory. She works with the contractors and determines that retooling the factory would cost $400,000. Now let’s assume that the new lines can produce $100,000 in additional profit for the company immediately and be able to scale up to $180,000 in profits after five years. Unfortunately, the owner further determines that the good times won’t last forever. After year five, she projects the additional capacity would likely go idle because of lack of demand.
The schedule of profits is as follows.
- After One Year: $100,000
- Two Years: $120,000
- Three Years: $140,000
- Four Years: $160,000
- Five Years: $180,000
Is the investment worth it?
The Math is Easy Once You Have All the Numbers
In order to answer that question, the owner needs to figure out what all the numbers are worth in today’s dollars. We know that the company has historically made 10% on its capital. So $400,000 is worth $440,000 after one year, and $484,000 in year two, etc. Similarly, a $100,000 profit after year one is worth $90,909.09 today. Year two profits are worth even less today. That’s because the company has demonstrated historically that it can allocate $90,909.09 and get $100,000 in profits after one year.
Applying the time value of money, the two investments are worth the following to the company:
Additional Profits in Today’s Dollars:
- First Year Profits: $90,909.09
- Second Year: $99,173.55
- Third Year: $105,184.07
- Fourth Year: $109,282.15
- Fifth Year: $111,765.84
Total after five years: $516,314.70
The project is clearly worth the cost. That’s because owner is paying $400,000 to expand and getting $516,314.70 of profits, all measured in today’s dollars.
Payback Period vs. Discounted Payback Period
Management may want to calculate the payback period to find out how long it’ll take to recoup its investment. In our example, the payback period is roughly three years and three months. The initial investment was $400,000. The yearly profits are $100,000, $120,000, and $140,000 from the first three years, and then $40,000 from the first quarter of year four.
However, this method doesn’t take into account the time value of money. Remember how we said that $1 is worth less in the future, since that same $1 today can be used to grow itself through investments? To account for investment growth, a discounted payback period is used. In our example, we would simply use the profits all in today’s dollars. This makes a more accurate payback period of three years and 11.5 months ($90,909.09 in year one, $99,173.55 in year two, $105,184.07 in year three, and $104,733.29 in year four).
A Note About Terminal Value
You might notice I purposefully made the example a little simpler by saying that the owner expects demand to go back to normal after five years. That means the additional profits generated by the investment is eventually zero.
In reality, that’s rarely the case. In order to add this complexity into the capital budgeting analysis, the owner needs to determine the value of all the expected future cash flow. This is an entirely different subject, in and of itself. However, she needs to calculate the terminal value of this project. In other words, she needs to provide an estimated value of the future cash flow beyond the initial five-year forecast period.
Don’t Forget About Cost of Capital
We simplified our examples by having the owner pay for everything in cash. In reality, though, many companies will finance these purchases. This is true even if the company has lots of cash on hand — especially in the modern era of ultra low interest rates. Apple, for instance, has hundreds of billions of dollars on hand. Even with that large pile of cold, hard cash, they regularly borrow billions on the public markets.
To account for the true cost of capital, you would need to subtract any interest expenses against the projected profits. Of course, cost of capital will also affect the company’s historical return on capital.
In some cases, capital budgeting can clearly point out whether an opportunity is worth pursuing. Just like the example I gave about expanding, the decision maker can easily see whether it’s worth the effort to change up the factory — even when demand is expected to go back to normal after five years.
So why do most decision makers keep using their intuition instead of having a formal capital budgeting process in place? There are a few reasons.
Benefits May Be Limited to Large Corporations
First, capital budgeting only works if the numbers being used as comparison are accurate and dependable. This means that the people preparing the statements and schedules need to be competent. In the real world, only big corporations have the ability to attract dedicated and talented employees for this process. Many smaller, independent businesses just can’t afford to employ a team of accountants or economists.
In a similar light, the process itself adds costs and complexity. When a Fortune 500 company is contemplating a billion-dollar deal, then it’s easy to justify the added cost of these experts. For pretty much everybody else, the cost alone may exceed any real gains.
No One Has a Crystal Ball
Even if you can justify the cost of having the best and brightest minds analyzing your numbers, the real world is unpredictable. No one has a crystal ball. Imagine being the CEO of Apple and being offered to buy out Tesla a good number of years ago. They definitely would have ran the numbers back in the day, but decided against it. No amount of good projections could have predicted the electric car maker would thrive and become the powerhouse it is today.
Furthermore, who’s to say that Tesla would have continued to innovate and thrive if it was merely a division of Apple? When one thing changes, everything else can change too. That’s what makes life interesting.
The Bottom Line
Capital budgeting is extremely useful in certain situations. In reality though, it’s a process that typically only huge corporations go through. For one, management often has to justify their decision to stakeholders with hard numbers. I mean, would you trust a CEO who says something like “We’re expanding into this industry because my gut say we should?”
Instead, it’s far more convincing to have spreadsheet after spreadsheet of factual data. That gives the impression that the decision is rooted in hard facts, instead of random feelings.
For the little guy, a full-blown capital budgeting process is almost impossible to execute properly. You would have to deal with the cost of doing the analysis itself. Far more importantly, however, the accuracy of the any statements produced is heavily depended on an unpredictable future. It’s little wonder that you never really see anybody go through a capital budgeting process for their personal or small business budgets.