The search for investment opportunities depends on effective communication of strategy.
Funding decisions must consider cost, control, flexibility, and risk.
Monitoring capital investments is the essential, but frequently neglected, final phase.
Capital budgeting irrevocably shapes the direction of a business, and our collective capital budgeting decisions “determine the kind of society that we and our children will live in—not just this year but many years from now as well.”1 Investment of revenue from their oil industry by Gulf countries is “profoundly reshaping global capitalism.”2 Decisions of such magnitude must be made correctly.
All corporate finance books, including books by the present author, offer the same advice: Choose investments with positive net present values. The NPV rule is important, but it is only one element of best practice. This article highlights best practices in four phases of managing capital budgets for small and medium-sized businesses (SMEs):
The NPV Rule
Net present value (NPV) is the present value of cash inflows minus the present value of cash outflows. A capital investment is desirable if the NPV is positive, and the greater the NPV, the more desirable is the investment. Let us say that a proposed project generates a cash inflow of $1,100 in one year. Suppose that the hurdle rate, the rate investors could earn elsewhere with similar risk, is 10%. The present value—the amount you would have to invest elsewhere at 10% to get $1,100 in one year—is $1,000. The proposed project happens to cost only $950, which is $50 less than the present value; the NPV of the project is $50. The internal rate of return (IRR) is the rate of return actually earned on the investment. For this example, the IRR is 15.8%: $950 invested at 15.8% would grow to $1,100 in one year. If the NPV is positive, the IRR is greater than the hurdle rate, and vice versa.
The results of capital budgeting cannot exceed the set of capital investment proposals. Some large bureaucracies announce a process for submitting proposals—and then wait passively. The shape and direction of a company are determined by capital budgeting decisions, so a passive approach gives the CEO little role in shaping the future of the business.
An active capital budgeting approach is best practice, and it starts with strategy. Strategy creates competitive advantage, and therefore adds value. Without competitive advantage there are no projects with positive NPV. Managers in a position to identify capital investment opportunities must understand the company’s strategy, and how capital investments are a major part of strategy implementation.
A second aspect of the active approach is that many people have vested interests in the status quo. A new strategic direction requires aggressive top management involvement to identify investment opportunities.
An advantage of a SME is that the CEO is generally close to the action. The CEO is well positioned to communicate strategy, spot opportunities, and evaluate investments. A potential weakness of a SME is failure of the CEO to maintain a disciplined, strategic approach, and failure to communicate strategy to other managers. Best practice responsibility in generating proposals in a SME falls heavily on top management. Strategy, communication, and discipline are key elements.
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