Capital budgeting

Capital budgeting often sends financial managers in a swirl before they decide what decision to make of the several investment options at their disposal.

It is best to assess available investments options and select one which will have the highest returns and growth for the organization. By creating capital strategy that increases shareholders value, creating decision makers incentives to focus on value adding and prioritizing investment options that lead to best possible results, a company can have effective planning.

The following are the best practices that are adopted by leading businesses in capital budgeting:

1. Use shareholder value addition as the basis for assessing and ranking capital investments

Over the periods it has come to the awareness of the shareholders the need to invest in a company that adds their value. They will evaluate whether the managers decision adds value or actually destroys it.

The most popular method to evaluate shareholder’s value is SVA (Shareholders Value added). It has been found that SVA highly correlates with stock prices than any other method of calculating shareholders value like; economic profit (EP), and cash flow return on investment (CFROI). SVA is computed using the following formula; Net operating profit - total cost of capital = SVA.

2. Use real option analysis over value potential investments

Real option analysis puts value on management ability to change tact as market conditions change, which value potential investments like net present value (NPV) don’t. Real options reward the upside potential created by uncertainty, it enables companies view full range of possibilities created by each investment.

For instance, real options analysis may convince a company to develop several new products, even though it will manufacture and market only one or two of them.

3. Develop capital allocation strategies that influence capital planning of the competitor

Some world class companies allocate capital in such a way that it influences their competitor to allocate its capital away from the key markets. This if effectively executed makes the competitor loose strength in key markets but the initiating company strengthens its presence in the same markets.

In addition, its best practice to invest in key markets on continuous basis throughout the economic cycles in order to maintain a key position in the market. This is different from some companies that only invest in key areas when the market is favorable.

4. Choose finances as a strategic partner in the capital planning process

To best allocate capital, the personnel in finance and operation must understand the key importance of their inputs in the capital budgeting. They should provide accurate and relevant forecasts and projections to effectively inform capital planning team.

5. Use capital planning process as an opportunity for capacity building

Historically, rarely do capital budgeting achieve the planned projections, however by monitoring, measuring progress and documenting past experiences may give a company unique knowledge that can be used in future. This knowledge can give a company competitive advantage over other market players.

6. Link performance measures with capital investment strategies

Most decisions made on capital investment involve line managers more than the executives. The senior management rely on information collected from the production lines, warehouses, research departments among others.

To achieve good results its best to align employee interests and organization interests by designing a reward system tied to capital investment strategies to promote good ideas.

7. Minimize risk of investing in capital projects.

Many capital projects fail and a company should apply efforts to reduce risks associated with the capital projects. Leading companies reduce risks by developing a rigorous institutionalized analysis of capital projects.

This ensures that the company invests in projects that are thoroughly reviewed have high chances of success and that they will create value and not destroy it.

While doing in capital budgeting it is useful to consider risks involved.