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Home > Balance Sheets Best Practice > Managing Capital Budgets for Small and Medium-Sized Companies

Balance Sheets Best Practice

Managing Capital Budgets for Small and Medium-Sized Companies

by Neil Seitz

Table of contents

Executive Summary

Introduction

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):

  • Create proposals;

  • Select investments;

  • Fund investments;

  • Monitor results.

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.

Create Proposals

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.

Select Investments

General rules for capital investment decisions are the same at global conglomerates and SMEs. Application of the rules is different at a SME, because the CEO is usually not far removed from the person proposing an investment. The CEO is often the originator of a large project, particularly one of strategic importance.

Strategy is the best place to start. Clever wordsmiths can explain why anything and everything is consistent with the company’s strategy. It is the job of top management to make a critical, independent judgment of the strategic importance of the project. To aid in that judgment, Carroll and Mui (2008) stress that “Reviewers should ask for a detailed written description of the strategy—not spreadsheets and slides.”3

The second step in the capital budgeting process is NPV analysis. Project proponents will compute an NPV if asked, and will generally predict positive NPV. Herein lies a subtle danger. If a pet project has a negative NPV, there is a temptation to adjust the sales forecast enough to make it positive. Studies have shown that, on average, proposals overestimate NPV.4

What are best practices for avoiding excess optimism? First, know the people in your company well enough to know who is likely to be overly optimistic. The SME has an advantage in this regard because of its size. Second, seek independent input on critical assumptions for major investments. Third, and this is essential, establish an effective monitoring system, so that managers expect to be accountable for their forecasts.

One reason for starting with strategy rather than NPV is that there are strategic decisions for which accurate NPV estimates are virtually impossible. One example is the Scott Seed Company, which invests in research to maintain its enviable brand recognition for the best lawn grass seed. It would be difficult for Scott to measure the NPV of a particular research project. The project approval process must allow for the funding of critical activities of this type, even though they would lose out if the first hurdle was proven NPV.

Decision speed is another best practice. Many organizations still use an annual budget cycle, in which all proposals for the year are considered together. This might be consistent with the speed of business in another century, but not today. The process must be open to respond to rapidly changing challenges and opportunities. SMEs have a capital investment decision speed advantage, because fewer layers of management are involved.

Risk analysis is different for SMEs compared to large, publicly traded companies, which are typically owned by diversified investors who are concerned about risk to their portfolio. For large companies, sensitivity to overall market conditions is the relevant risk, and risks unique to one company will average out across their portfolio. Owners of SMEs may have most of their wealth in one company, so the welfare of the company is of importance to them. For SMEs, the relevant risk of a particular capital investment is its impact on the overall health of the company.

Stress testing is a best practice for risk assessment. Identify possible problems, such as a recession or loss of a major customer. Prepare pro forma financial statements for the company in these unfortunate scenarios, with and without the proposed capital investment. Although income is important, the critical variable is cash: Will the proposed capital investment push the company into a vulnerable cash position in difficult times?

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Further reading

Books:

  • Martin, John, and Sheridan Titman. Valuation: The Art and Science of Corporate Investment Decisions. Harlow, UK: Addison-Wesley, 2008.
  • Seitz, Neil, and Mitch Ellison. Capital Budgeting and Long-Term Financing Decisions. Cincinnati, OH: Cengage, 2005.

Articles:

  • Laughton, D., R. Guerrero, and D. R. Lessard. “Real asset valuation: A back-to-basics approach.” Journal of Applied Corporate Finance 20:2 (2008): 46–65.
  • Statman, M., and T. Tyebjee. “Optimistic capital budgeting forecasts: An experiment.” Financial Management 14:3 (1985), 27–33.

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