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Capital budgeting
An important step in raising capital is estimating your capital requirements. Some of the capital you raise will likely be used to increase your working capital. However, a substantial part will be used for capital investments.
Capital budgeting is the process of identifying and ranking which of these capital investments add the most value to your business. Your capital budgeting decisions are not unlike the personal budgeting decisions we make every day. Consider these common features:
- Constraints. The amount of capital you can raise is limited, imposing a constraint on your choices. As you increase your firm's debt, its debt-equity ratio and debt-servicing requirements increase, making it harder to raise additional debt. Equity investors also want to earn a return on their investment. To safeguard their return, equity investors are likely to make a limited investment.
Similarly, you face constraints with your personal budget, at least in the short run. Since you only earn so much income, it's important to allocate it among your different uses: living expenses, debt repayment, and contributions to a savings plan.
- Project ranking. How you choose to allocate the investment capital you manage to raise depends on the set of investment opportunities. Project ranking is a means of allocating your investment capital to those projects that contribute the most value to your business.
In a similar fashion, personal budgeting relies on allocating your limited resources to their best use. You can rank your debts, with those bearing the highest after-tax interest rate at the top of the list. We tend to pay off debts with the higher interest rates first, or invest if we can earn a higher return than the interest rate owed on our debt. To help identify our best-performing investments, we can rank them, with those earning the highest after-tax return at the top of the list.
- Measurement. There is a variety of methods available for measuring your firm's return on an investment project. Three major methods useful in measuring a project's value are the payback, net present value, and IRR methods.
The following table summarizes the major pros and cons of the three project-ranking techniques identified:
Method
|
Advantages
|
Disadvantages
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| Payback |
Simplest method to use. |
Ignores subsequent
cash outflows. Does not use DCF analysis. |
| IRR |
Ranks projects by rate of return. Can compare to hurdle rate to make accept-reject decision. |
Projects can have more than one IRR. Need to measure your hurdle rate. |
| Net present value |
Uses DCF analysis. Ranks projects by net present value. |
Negligible. |
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You may decide to undertake projects to either expand your business or to replace worn-out equipment. As a start-up business or one in the early stages of growth, you are most likely concerned with the first kind of project.
In either case, you want to estimate your cash flows over the number of years you expect to either incur or receive them from the project. Keep in mind that an expansion project is intended to add sales; as a result, you want to add those incremental sales to your estimate of cash inflows. For example, if you expect to receive $250,000 a year in additional sales from a new project, those sales represent your cash inflows.
Cash flows are the proverbial "bird in the hand." Cash can be used to pay bills or vendors, make additional capital investments, or earn interest income if invested in safe short-term investments. Because of a preference to think in terms of cash flows, the IRR and net present value methods are superior to the payback method.
Hurdle rate is an important part of using either the IRR or net present value method. The hurdle rate is the most appropriate interest rate to use when evaluating investments. Often times, the hurdle rate is the opportunity cost of investment capital, the rate of return that can be earned on the next-best alternative investment.
The predictability, or certainty, of receiving a certain amount of cash flows also influences the hurdle rate: if cash flows are less certain, you may want to discount by a slightly higher interest rate. If cash flows are relatively certain, you may want to discount by a slightly lower rate. For example, you may consider adding 0.50% to a hurdle rate of 8% to adjust for less-predictable cash flows.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
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