101: Capital Budgeting

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How do you as an entrepreneur decide whether or not to make big financial investments such as expanding your operations or upgrading your infrastructure? Do you rely on your business acumen and gut instincts, or perhaps consult with a trusted mentor? While these strategies may work if you’ve really got the Midas touch, you’ll probably do yourself—and your investors—a great service by understanding and employing some simple capital budgeting techniques.

Capital budgeting is the preferred means of making long-term investment decisions at large companies the world over, and fortunately it is pretty easy for even a solo entrepreneur to grasp the concept and employ some of the same techniques used in finance departments at multi-national companies.

We’re going to look at two methods for capital budgeting: net present value (NPV) and internal rate of return (IRR). Both of these techniques are what are known as discountedcash flow methods. That means that they account for the fact that while the cash outflow associated with an investment in your business must take place in the present, the inflows associated with that investment will not be realized until the future, and that the value of those inflows must be discountedback to the present day.

Both NPV and IRR are really easy to compute by using an online calculator, a financial calculator, or an Excel spreadsheet, so rather than get bogged down in the math just use one of those tools to follow along with our examples.

Let’s start with NPV. Say you have the opportunity to make a $100,000 investment in your business that it is estimated to result in an additional $40,000 in income a year for the next four years, and that your firm’s cost of capital (sometimes called the discount rate) is 8%. Should you make the investment?

If we input these figures into our handy online tool we see that this investment has a NPV of $32,485. When an investment’s NPV is positive (as in this case), that means that it more than pays for itself. In fact, the additional NPV actually increases the value of the firm, so by all means we should make the investment.

Now if we plug the same set of cash flows into our calculator and have it compute the internal rate of return, we see that this investment has an IRR of 21.86%. So according to this metric, should we make the investment?

The answer once again is “yes”, because the IRR of 21.86% is greater than our 8% cost of capital. Whenever an investment’s IRR exceeds the firm’s cost of capital, it adds value to the firm and is thus worth making.

IRR & NPV analysis can be particularly helpful when evaluating two mutually exclusive long-term investments in order to determine which one is the better choice for your business. You’ll want to compute both the IRR and the NPV for each and then compare the results. Oftentimes both metrics will be higher for one of the options and that will make it the obvious choice.

But for mathematical reasons that we won’t get into here, it is possible that one investment has a higher NPV and the other has a higher IRR. If you find yourself in this situation then the prudent decision to make is to go with the investment with the higher NPV, as NPV is based upon more conservative assumptions concerning how cash flows will be reinvested.

So hopefully you now have a basic understanding of what capital budgeting is and how to use it to evaluate investments in your business. What we’ve just gone through is an overview and not an exhaustive explanation, so if you’ve got additional questions before making real-world investments, make sure to consult with an accounting or investment professional.

More By Gregg Schoenberg
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