In the life of every business, there are costs and profits. Hopefully, the latter exceeds the former.
The financial side of business can be like a foreign language for many of us. It just doesn’t make sense (beyond the basics). If you fall into this group, ensure you have a great accountant or financial whiz in your corner sooner rather than later. You need someone to make sense of the symbols and numbers.
One such area that needs the attention of an expert is your capital budgeting, which refers to the evaluation and planning of your capital expenditures for the year. This includes spending for your fixed assets (purchasing and improving assets like machinery, equipment, and facilities) and other investment spending. You need to evaluate these proposed expenditures in order to determine their likely success or failure (is there ultimately more or less money in your pocket). There are several capital budgeting techniques you could use during this process. Some of them are more detailed and precise than others, but all will at least give you some insight into a proposal's validity.
The Payback Period Technique
This one is relatively simple and straightforward. The payback period technique will determine the length of time, in years, that it will take to recover a cash investment. The basic formula is Cost of Investment/Annual Net Cash Flow.
Let’s say your company is looking at making $200,000 worth of improvements in its production machinery. The company takes in $300,000 per year (cash inflow) with expenses of $225,000 per year (cash outflow). That leaves you with an annual net cash flow of $75,000.
$200,000 (investment cost) / $75,000 (annual net cash flow) = 2.67
This example has a payback period of 2.67 years. So...what does that mean?
Companies use different criteria and requirements when utilizing the payback technique. Some might have a maximum period (3 years, for example), over which and a proposed investment would be rejected. Others might use the “useful life” of the investment as a guideline. The useful life is how long the investment should last (how long the new equipment could reasonably be expected to function without issue for the company, for example). If the new machinery in our example had a useful life of 5 years, and the payback period was 2.67 years, the proposal would be approved (it’s less than the useful life).
If the annual net cash flow varied from year to year, the formula would use the cumulative value (adding it up each year until it reached the investment amount) to determine the payback period.
The Net Present Value Technique
The Net Present Value technique can be very simple, or much more complicated. If the only cash outflow is the initial investment cost, the formula is very, very simple:
Present Value of Cash Inflow (x number of years of project useful life) - Present Value of Initial Investment
As a simple example, if your company is looking at spending $175,000 in production facility improvements, with a useful life of six years, and cash inflow of $25,000, it would look like this:
$150,000 ($25,000 x 6 years) - $175,000 (initial investment) = -$25,000
This proposed investment would be rejected. Any negative sum indicates a poor return. A positive sum would indicate a good investment, and a sum of zero could go either way.
Obviously, this is simplified, and rarely (if ever) is your only cash outflow going to be the initial investment cost. Running a business takes money. Lots of it. And the Net Value Technique can be much more complicated.
The present value requires yet another equation, and is necessary for most (if not all) capital budgeting techniques. Use it to determine the worth of "future" money today. It utilizes time and interest rate in the calculation. At its simplest, the formula is PV = FV / (1 + r)
- PV = Present Value
- FV = Future Value
- r is the interest rate expressed as a decimal
- n is the number of years
So, for example, $37,000 three years from now with an interest rate of 12% would have a present value of $26,428.57. [37,000 / (1+0.12) = 26,428.57]. $37,000 in three years is worth nearly $26,500 today.
The net value technique requires that you know the cash inflow, cash outflow, useful life, and rate of return/interest. Let’s say you’re evaluating a proposal to invest $2000 in a new digital printer with a useful life of 4 years. Your cash inflow each year is $800, and your outflow is $150, for a total cash flow of $650 per year, with a desired interest rate of 10%.
PV = -$2000 (initial investment today)
PV Year 1 = $650 / 1.10 = $590.91
PV Year 2 = $650 / 1.10 = $537.19
PV Year 3 = $650 / 1.10 = $488.35
PV Year 4 = $650 / 1.10 = $443.96
Adding those values gives your NPV (net present value)…-$2000 (initial cost) + $590.91 + $537.19 + $488.35 + $443.96 = $60.41.
In this example, the NPV is a positive $60.41, so it does return enough to cover the costs of the investment. A NPV below zero should be avoided, as it falls short.
Changing the interest rate, or length of project/useful life, will obviously affect the NPV. Experiment with the numbers.
The interest rate that gives an NPV of zero is known as the internal rate of return.
The Profitability Index
This final technique is the ratio of return to cost, found with the following formula:
PI = PV for Cash Flows (sum of years of useful life) / Initial Investment
- PI = Profitability Index
- PV = Present Value (using the Present Value formula)
A PI of 1 indicates breakeven, while a PI>1 indicates an attractive return (the greater the value of the PI over 1, the better it is). A PI<1 should be rejected as unprofitable or unsustainable.
There are other capital budgeting techniques out there, but these three offer a good, basic introduction. Proper planning and budgeting are the difference between making and losing money, so it’s definitely worth your time to learn a few different ways to evaluate (or hire someone who really knows what they’re doing).
This introduction to the techniques should not be a replacement for proper financial training, planning, budgeting, and accounting.
Photo by Cellular Immunity
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