How to Efficiently Prepare Your Capital Budget

According to Investopedia, capital budgeting is “the process that a company performs to evaluate potential projects or investments”. In other words, when preparing its capital budget, a company is predicting whether it will have the money to pay for its projects and investments in the long term and if these will give them the expected return.

This is important because every business must plan for the expenses and benefits that can be derived from an investment before making it to ensure that it doesn’t harm the organization’s normal operations. For example, before deciding to open a new branch, it is necessary to measure whether this investment will leave the company indebted in the short or medium-term and whether it will be worth it in the long term.

There are several methods to efficiently budget your capital. In today’s article, we present what they are and the importance of doing an analysis of each new major project and the entire investment portfolio.

Capital Budget: What is it and Why is it Important?

Capital budgeting is the process that allows you to assess the relationship between the costs and benefits of various projects so that the company can prioritize those that will give the best returns.

For example, imagine that an organization wants to expand its logistical warehouse, upgrade its servers, or adopt new ERP software. However, they do not have the capital to invest in all of them simultaneously – before choosing which path to take, a financial assessment needs to be carried out. This assessment is what we call a capital budget.

The capital budget is used to evaluate so-called capital projects. These are projects aimed at the company’s capital goods, that is, those assets that the company has improved, such as the organization’s building, IT servers, or industrial machinery.

Capital goods have a “useful life” period, at the end of which they may stop providing the expected return for your business, requiring an upgrade. A capital project, therefore, also takes care of this upgrade, making the asset more efficient or productive. However, in general, these projects consume large amounts of money.

Before spending large amounts of money, making a capital budget allows clarity to make decisions based on the benefits each project will bring. It helps to answer, for example, what will be the increase in efficiency and how long will the useful life of that good be extended. As a result, it is also possible to reduce the risks involved in making a big investment.

How to Prepare the Capital Budget: Step-by-Step

There are a few steps to take to establish your capital budget:

1. Identification of Investment Opportunities

An organization first needs to identify an investment opportunity. This can be anything from a new line of business to expanding the product and purchasing a new asset. However, identifying opportunities is easier in theory than in practice. To begin, this process must involve all areas or department of a company to be effective — this includes even business units far from the headquarters.

In addition, the survey of ideas and opportunities involves a careful assessment of a business’ differentials, its weaknesses, and bottlenecks. Then, together with all the proposed areas that can be resolved, the identified problems are raised.

Manually, this process can take weeks or even months and can change the ideas raised as obsolete. Therefore, having a solution in the cloud that allows the involvement of different business areas and collaboration between people in the process of capturing investment opportunities is essential.

2. Evaluation of Investment Proposals

Once an investment opportunity is recognized, an organization needs to assess its investment options; that is, how the proposals are put into practice.

There are several methods commonly used to value fixed assets. The most important are:

  • Analysis of the Net Present Value (NPV). In this method, the net change in cash flows associated with the purchase of a fixed asset is identified and then this change is discounted from the current cash flow value. If the company is evaluating a portfolio of projects, it should choose those projects that had the highest net present values.
  • Internal Rate of Return (IRR). Here, you divide the average profit after tax by the average investment after depreciation. This method allows the company to select projects whose results are higher than a minimum rate defined by the company.
  • Return Period (Payback Period). This determines how long it takes to generate enough cash flow from a project to pay the initial investment in it. The focus here is on the period of time the investment is at risk of not being returned to the company.
  • Discounted Cash Flow. Discounted cash flow methods consider present and future income streams. These methods take into account the concept that a real gain today is worth more than a real gain tomorrow. This means that they take into account profitability and the time value of money.

3. Selection of the Investment Portfolio

Once investment opportunities are identified and all proposals are evaluated, you need to decide which investment will generate the best return and select it. The organization must classify projects according to pre-established criteria and select the portfolio that generates the greatest contribution to the business objectives.

An extremely important factor in the portfolio selection and prioritization process is the projects’ alignment to the company’s strategy. For this reason, parameters must be established that allow the assessment of how much the selected projects contribute to achieving the strategic objectives. Often, a project that generates greater financial return may be passed over for another because of other criteria that are more important to the company’s strategy, as the financial return.

Let’s take a real example of a mining company in Brazil, where sustainability issues make up its main strategic objectives, so a project with a greater financial return and large environmental impact should score worse than projects with a better balance between return and sustainability.

4. Project Financing

Once the project is selected, an organization needs to fund it. To finance the project, it is necessary to identify the sources of funds and allocate them accordingly. The sources of these resources can be reserves, investments, loans, or any other available channel.

5. Performance Evaluation

The last step in the capital budgeting process is the investment review. Initially, the organization selected a particular investment for an anticipated return. So now they must compare the expected performance of the investments with the actual performance, during and after project implementation.

Capital investment portfolio management is an essential part of executing a company’s strategy, and as such, it is necessary that you have the right tools to make forecasts more accurate. This allows you to prove to the board of directors that the investments are aligned with the organization’s business objectives.

With the right tools, a project management team can quickly start working on the real numbers in planning each project, not just guesswork or manual selection. This leads to higher overall performance, higher profits, and lower long-term risk for the organization as a whole.

Watch the Capex Optimization Webinar, featuring two Teams Ideas clients, and learn a little more about how a Capital Project Planning and Management solution can help automate your company’s investment portfolio selection and prioritization process.