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Capital Budgeting Techniques Maximizing Future Profits

2017-07-03 16:12:00.0

| Author: FAS

FAS specializes in small business bookkeeping and tax services. We work closely with small businesses in Katy, Fulshear, Houston and nearby areas. Call us for Free Consultation: 832-437-0385 .






A responsible business decision maximizes the future profit of business and requires that you understand relevant risks and returns involved in your investments with capital budgeting. 

When it involves spending a significant amount of money, you should start with a plan and that means creating a budget. The market is a competitive space and a business without calculated returns and anticipated risks on an investment will have a narrow chance of surviving.
 
Also called, investment appraisal, it is a decision process necessary to determine if a project investment brings long-term profitable benefits. It helps business owners make good investment decisions such as addition, disposition, modification or replacement of fixed assets following a plan that calculates revenue and expenses related to the item or the project investment.

What is capital budgeting?

First, let us understand what is capital budgeting? Charles T. Hrongreen provides a clear definition of the term,
 
“Capital Budgeting is a long-term planning for making and financing proposed capital outlays.”
 
In simple expression, capital refers to a significant amount of expenditure such as purchasing new expensive equipment or technology, funding for research and development, and other fixed assets requiring large cash investments. The amount of money required for these major projects are called capital expenditures.
 
As a business owner, your primary concern is whether the amount you spend will return to you with profit and how much. A small business with limited cash flow should be careful with spending large chunks of money. You should be smart in choosing where to put your cash and capital budgeting gives you a financial peek into the future profit of your project investment. 
 

Four structured steps on appraising investment projects

Step 1. Set long-term business goals. Strategic business goals are important for business growth and capital budgeting aligned with your business goals gives you the ability to design your future success in business taking you one step ahead of competition.

Step 2. Compete to profit. Don’t be afraid of competition and go out to seek new investment projects. Make sure to perform due diligence on evaluating investment projects.
 
Step 3. Cash flow forecasting. Your cash flow is the fuel that runs your business and it is an important step to forecast the amount of cash inflow and cash outflow that determines your investment viability.
 
Step 4. Expenses tracking. You must monitor and control your expenses to keep it within budget. Going out of budget will affect your return of investment and profit.
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What are the basic capital budgeting techniques?

There are different techniques that managers use for capital budgeting. Among the common methods is a comparison of cash inflow and outflow of an investment.
 
Payback Period. This decision technique determines the length of time it takes to return your initial investment. It’s basic and simple calculation of the total cost of the project and divided by the expected amount of yearly cash inflow. The result will give you the payback period. If the payback period is less than your target pay back period, accept the project investment.
 
Formula for Payback Period

Payback Period Formula

Net Present Value (NPV). This decision technique is commonly applied and provides better reliability in project evaluation because of the discounted cash flow analysis that enables you to determine the net present value. To calculate, you will have to get the difference between cash outflows and cash inflows generated by your project investment bookkeeping for the time value of your money.
 
Formula for NPV, where R is the net cash inflow for each period, i is the rate of return required for each period and n is the forecasted periods of project operation generating cash inflows.

Net Present Value Formula

Account Rate of Return (ARR). This technique accounts for the entire economic project cycle that helps ensure net earnings compensate your projected profitability and commonly applied in investment appraisal. But there are two major flaws: 
  1. ignoring the time value of money, and 
  2. dismissing the lifespan of the project or the period of time that a project operates
 
Formula for ARR,
Account Rate of Return Formula
Internal Rate of Return (IRR). This technique applies the discount rate to determine the amount of the return of investment from a project. When you reach the breakeven point, your IRR result should be greater than your investment, which means if your capital is 5%, then your IRR should be greater that makes the project attractive for your business. At IRR, your Net Present Value (NPV) is 0, that is PV of future cash flows less initial investment is equals to 0.
 
Alternate formula is,
Internal Rate of Return Formula
The variables for the formula above are:
  •   r is the internal rate of return
  •   CF1 is the net cash inflow for year one
  •   CF2 is the net cash inflow for year two
  •   CF3 is the net cash inflow for year three
Continue to add the equation based on the length of the project.
 
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Introduction to advanced capital budgeting techniques

Advanced capital budgeting techniques is for those with prior knowledge of the basic capital budgeting techniques. In the video, Mike McKinney discusses the High-Impact Advanced Technique, which is a series of statistical analysis to estimate a project’s profitability including:
  • Monte Carlo Simulation
  • Multivariate Correlation
  • Probability Distributions
  • Expert Opinion
  • Natural Tendency of Capitalism
  • Skewed Distributions
  • Central Tendency Analysis
  • Natural Tendency of Capitalism

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