When it comes to capital budgeting, the stakes couldn’t be higher. Capital budgeting is a management process used to make decisions about long term investments. The dollar values are high. The consumption of organizational resources is large. The implications of the investment drive corporate strategy for years to come. These aren’t the sort of decision that should be made lightly, yet often in practice, they are.
Capital budgeting decision should be evaluated from both a financial and strategic perspective. The financial perspective requires detailed due diligence to quantify expected returns. Discounted cash flow analysis is commonly used for significant investment decisions. Simple payback analysis is fine for small investments that are likely to pay back within a few years.
So what gets missed? Let’s look at three things.
1. Opportunity costs
How many capital budget presentations, meetings, and decisions are made around just one opportunity? My hunch is more than just a few.
A CEO or a business developer comes up with an idea and an organization often puts together a project team to flush it out. Instantly, you have introduced bias into the process by tasking a group of people to study the merits of one particular opportunity. Instead, every capital budgeting decision should also address the question – by pursuing this opportunity, what am I not doing instead?
Really strong companies will maintain a portfolio of opportunities across a broad landscape. Opportunities could include acquisitions, new organic expansions, and even buying back your own shares if the expected return is greater than any other opportunity out there (and of course you are a publicly listed company).
One German study found that decision making was six times more effective when alternatives were presented and discussed.
2. Risk management
The business case shows a positive net present value – thank goodness!
That sort of thinking clears the way for superficial thinking to drive the decision. However, the only thing certain about your business case is it’s wrong. Once you get past this fixation on trying to predict the future with any degree of accuracy, you can now focus on better understanding the range of possible outcomes.
The business case is premised on a series of assumptions about demand, selling price, operating costs, capital requirements, working capital, etc. There are often dozens of these sorts of assumptions underpinning the calculation of net present value. Some of these assumptions are highly uncertain (say demand). Others will have less uncertainty (say the tax rate).
You can broadly use the theories of statistical analysis to roughly create a range of possible outcomes for each assumption. Using simulation analysis, you can pretend to make this decision over and over again using different assumptions to create a risk adjusted perspective of NPV. Your base case might show a positive NPV, but if the probability of achieving it is only 60%, do you still invest the money?
3. Working capital investment
This is a simple one, or rather I say should be simple. Yet, it’s often forgotten. If you plan on opening a new plant – you need raw materials on day one to begin production, your customers won’t be paying you immediately either, you’ll need to fill your warehouses with finished goods. This investment in working capital can be substantial.
The other thing that is often missed is that starting up a new operation rarely goes according to plan. You will almost always begin commercial operations later than planned, spend more money on start up costs, and suffer higher inefficiencies in the beginning. This too will require incremental financing to get going and should be explicitly considered in the business case.
Want to learn more about capital budgeting? We’ve got a course in that too.
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