The capital budgeting process is defined as an estimation and risk assessment of cash flows, to arrive at a net present value of retained cash flows and .calculate your return on investment (ROI). What does this mean to you? Well when running a business it is important to understand the process of evaluating future projects / contracts that your company wishes to take on and assess if they might be profitable or not. Are they worth your time, money and attention?
Annual Capital Budgeting Process
The capital budgeting process is a significant undertaking and generally keeps a lot of business owners up at night. There is always a level of risk associated with under taking projects. The beta of the project will be higher in comparison to the marketplace beta depending on the level of systematic and business risk your company is willing to undertake.
There is much planning and process implementation, before a company can pull the trigger so to speak, about projects that span 2 to 3 years into the future if not longer. When committed to a new venture, it also takes up a lot of financial resources, such as immediate cash requirements which might be otherwise directed to a different project – this will impact your so called opportunity costs. Needless to say if you are a risk adverse organization who prefers returns from investments with low volatility then perhaps, bonds and money market funds are more your cup of tea. Of course, this would be a preferable course of action, if you would rather avoid the stress.
Preparation of Budgeted Proposals
Sources of the initial idea of a new business proposal for a lot of organizations can come from many sources. These sources include:
- Floor Employees
- Sales Personnel
- Marketing Personnel
- Division Managers
- Senior Level Managers
For an organization to get the best quality ideas rolling, idea generation should not be confined to a restricted set of people within the company. Employee participation no matter at what level within the company, should be very much encouraged and rewarded. This will make employees within the organization engaged, and creates job satisfaction. Generally keeping your staff engaged as part of your business also ensures lower turn-around staff numbers.
A large project will have an extensive scope involving many employees. This can be quite labor intensive and time consuming at all levels within the company and it is a guarantee that the company’s resources will be stretched particularly employees’ time. The following are steps that need to be addressed through analytical work to ensure that the new venture is an appropriate fit for your company:
- Assess market share available based on supply & demand requirements
- Forecast Sales to appropriate market share requirements
- Align Procurement with supply chain requirements
- Follow through with necessary labor overhead
Assess Possible Market Share Increase
If a project is to be taken on then a sales forecast needs to be developed, with sales orders and sale commitments for distribution of the new product being produced. As an example we’ll take a firm that is looking to have additional equipment upgrades to an assembly line to relieve manufacturing line bottlenecks from a possible market share increase. Producing a sales forecast to ensure that the ample supply of new product has increased revenue possibility – economies of scale theory – should be a MUST. If the project still seems to have profit earning and increased market share potential lets move on to the next step
Forecast The Supply Chain And Productivity
This will surely need a schedule of forecasted units of production, a procurement team assuring with suppliers that additional raw material would be available on time, and additional qualified and trained staff to assemble units to take product from raw material all the way to a finished good ready to be sold.
Projects that will survive the so called brainstorming stage and put on paper must now go through the evaluation process. The entire goal of evaluating the proposals that survive the brainstorming stage now need to be assessed for their cash flow estimation. The degree of risk with the possible positive net cash flows must be considered by using a discount rate that gives us a realistic amount of cash taking into consideration a cost of equity (Ke) and a Cost of Debt (Kd). There are different facets of this process, so one must consider the following:
- How is the project being funded through equity or debt?
- If funded through debt is the company leveraging the firm further specifically for the project?
- Have all tax saving opportunities based on interest payments on the debt been recognized?
- What is the tax shield on property, plant and equipment?
- Is there a salvage value on the equipment? – This will result in a reduction in your tax shield (later recovered by the sale of the salvaged equipment)
- Is there net working capital, additional inventory, and payable costs involved which will require more resources from the organization?
In the end all these factors have to be taken into consideration to bring us to a positive net present value (NPV). Therefore, if the amount calculated results in negative cash flows; than the project should not be accepted as it will result in a negative ROI. Stay tuned as I will have a lot more to say on this topic as it is quite extensive and detailed.