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How To Use Capital Budgeting To Make Investment Decisions - LinkedIn
How To Use Capital Budgeting To Make Investment Decisions - LinkedIn
How To Use Capital Budgeting To Make Investment Decisions - LinkedIn
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Investment is all about identifying the right place to put your money in.
Unfortunately, you can’t time travel and learn which ventures succeed.
So you’ll never truly know whether an investment decision was right
until after you make it and see what happens. That said, you don’t have
to shoot in the dark and hope you land a bullseye. Instead, you can
make a reasonably informed choice on whether an investment is likely
worth it via financial analysis, specifically capital budgeting.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Investors give you their money because they expect a return. The
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Failure to capital budget is a massive red flag. It’s evidence that your
company can’t be trusted with money. And so potential investors won’t
give it to you, and they’ll be right not to. After all, how can they trust
your intuition over solid financial planning?
The important concept for capital budgeting is the concept of the time
value of money. The time value of money states that money has a time
value because it provides a return via interest when invested in a
successful enterprise.
For example, $1.00 in today’s money would be worth $1.10 next year if
invested at 10% today. $1.00 is the money’s present value, and $1.10 is
its nominal future value.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Inflation actively decreases money’s value. $1.10 next year may only
be worth $1.05 in today’s money. The real value of money is defined by
its purchasing power, not its nominal value.
Let’s say inflation hits 5%. So $1.00 next year is worth only $0.95 in
today’s money. Going back to our above example. That means at 5%,
$1.00 invested today at a 10% interest rate yields a nominal return of
$1.10 and a real return of $1.05.
You have to give investors more money in the future than they gave
you today in today’s money.
Let’s say we have a company ‘ABC’ that wants to capital budget for a
truck they want to buy. ABC’s goal is to buy the truck, use it for 4 years
to make deliveries, then sell it.
ABC also assumes that their weighted average cost of capital (WACC)
is 16%.
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Net cash flow refers to the real returns of an asset, NOT its nominal
returns. The standard way to approach a net cash flow is with an
income statement projection.
Cash Flows
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
If ABC chose not to sell their truck, their asset will have a terminal
value. The terminal value of an asset beyond its projection date. It’s
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
assumed that the asset performs at the same return indefinitely at the
level it was in the last year of its projection.
ABC will calculate their cash flows by using the values obtained in
steps 1 to 3. The cash outflows will be negative values, while the
inflows are positive values.
ABC will calculate their annual cash flow by summing the cash flow
value of each period. Notice that the $0 residual value shows that ABC
expects to scrap their truck at the end of 4 years.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
NPV is the sum of each year’s cash flow in present value. They’ll
calculate it with the following formula:
Since the NPV is positive, ABC concludes they probably should invest
in the truck. The $14,667 NPV means the company will earn the
equivalent of $14,667 in today’s money in 4 years. Hence, the truck is a
good investment.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
There are many ways their projections might be wrong. For example,
what if the truck actually costs more than $55,000 because of an
increase in taxes? What if the truck costs more to operate than
expected? And what if the truck breaks down and has to be scrapped
before the expected 4 years?
All these scenarios are possible. And each one dramatically alters the
truck's NPV. Businesses have to test their projections for these
possibilities. They achieve that with a sensitivity analysis.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Notice that the truck’s NPV remains positive until a 120% base
projection. This means that ABC shouldn’t invest in the truck if its
capital investment needs more than $66,000. Similarly, ABC will
systematically alter the other variables to determine how safe the
investment is if their projections prove wrong.
Analyzing these scenarios helps ABC’s executives better define the risk
of buying the truck. They’ll likely invest in the truck if their
calculations reveal a consistently positive NPV in the different
scenarios. They may decide it’s a bad investment if the truck’s NPV
decreases too drastically under different scenarios.
NPV limitations
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
ABC’s truck’s IRR is the accounting return they directly receive from
their truck.
You can use capital budgeting to analyze any investment from buying a
truck to mortgaging a house and starting a new business.
He could also better negotiate with the lender using this information.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
The following is her capital budgeting analysis. Since she expects the
business to operate after the 4-year projection, she uses a terminal value
in her analysis.
Meaning, she should open this business unless the capital costs exceed
$2.75 million.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
By far, the most common reason for inaccurate capital budgets is not
using detailed information. Let's say a company, A, wants to purchase
another company, B. They make a capital budget to evaluate whether to
buy company B.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Lastly, they don't create a meaningful residual value. The result is that
company A seriously undervalued company B. Company B is still
valued enough that they want it. So company A makes an offer far
below company B's value and is rejected.
Since he’s assumed an inaccurately high residual value, which has led
to a positive NPV, Sam opens a business that he probably shouldn’t.
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(1) How to use capital budgeting to make investment decisions | LinkedIn 26/10/2022, 3:40 PM
Final Thoughts
Published by
Ramish Kamal Syed 28 articles
SEO Content Writer
Published • 22h
This is my detailed guide on how to use capital budgeting to get new assets, start new
businesses, or evaluate whether you should make any other capital-intensive investment.
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Messaging
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