The allocation of capital in small and middle market companies is as important as it is in large enterprises. Given their lack of access to capital markets, capital budgeting is often more important in small and middle market companies because the funds necessary to correct investment mistakes may not be available. Also, large firms allocate capital to numerous projects, so a mistake on one can be offset by success with others. Smaller companies do not have this luxury. Even though capital budgeting is vitally important for small and middle market companies, very few do a good job of it.
Capital budgeting deals with the allocation of financial resources by companies to make investments that are expected to generate long-term returns. This encompasses investments for new or replacement of obsolete equipment or technology, expansion of existing products or markets, expansion into new products or markets, or investments in research and development. The goal of preparing a capital budget is to select those investments the company believes have the best chance of generating returns that exceed the opportunity costs of capital.
Capital budgets compile the expected cash outflows and inflows of project alternatives over a period of years. These cash flows are then discounted back to their “present values” using discount rates equal to the opportunity costs of capital. If a proposed project has a net positive net present value (NPV), then this indicates that the expected cash flow from the project will earn more for the company than the cost of capital to finance it. If there are multiple projects with positive NPVs, then management should select those projects with the highest NPVs.
Other measures used for capital budgeting include payback period and internal rate of return (IRR). The payback period measures the amount of time until the invested capital is recovered. Projects with shorter payback periods would generally be selected, as estimates of longer-term cash flows will be viewed as being more risky. However, a drawback with using payback period to select capital projects is that this method does not focus on cash flows beyond the cost recovery period. The IRR is a measure of the % of financial return on a capital investment. IRR is compared to the company’s opportunity cost of capital and projects with the highest IRR are selected. As IRR is a focus on solely the % return, it is not as useful as a measure of NPV, which focuses on the net present value in dollars.
The single most appealing argument for the use of NPV in capital budgeting is that it gives an explicit measure of the effect the investment will have on the company’s value. If NPV for a project is positive, this project will increase the company’s value.
The cost of capital used to discount cash flows to present value is the company’s “opportunity cost of capital”, or the required rate of return or “hurdle rate”. This rate of return is based on what investors could get elsewhere. There are financial formulas that compute the cost of debt, preferred stock and common stock. Retaining earnings also have a cost associated with them. To simplify this concept, after a company generates earnings, who theoretically owns that money? The shareholders, right? But when earnings are retained, management is investing these funds on behalf of the shareholders back into the company. As such, shareholders will expect some return on the money retained in the company. Their return should be at least the same amount as if they had received the retained earnings in the form of dividends, and then reinvested these funds to purchase more stock in the company.
This is where it gets more complicated. At this point you will need to compute the expected return on the company’s equity capital. One common finance formula computes cost of equity capital based on adding a risk premium to a “risk-free” rate of return (such as a medium to long-term government bond). The risk premium is computed as the excess expected return for the overall equity market over the “risk-free” return multiplied by the volatility (beta) for that specific investment. As beta is not published for privately held firms, utilize beta that is published for a publicly traded stock in a similar industry. With this information you will compute the expected return for a publicly-traded stock. As an investment in a privately-held company is inherently more risky as it is in most cases illiquid, you will then add additional risk premiums to your calculated cost of equity.
For example, your company is a middle market company focused on total water and wastewater solutions for Marcellus and Utica shale unconventional oil and gas exploration and production and you are exploring investments to grow market share. A similar publicly traded company such as Heckmann (HEK) may show a current beta (volatility) of .84. Risk-free intermediate term U.S. debt returns currently return 2.0%. Assume the public equity market is averaging returns of 5%. Additionally Heckmann believes that its specific risk factors given size of company, earnings history and, more importantly, industry risks require an additional 8% expected return. As such, Heckmann’s cost of equity capital is computed as (2.0% + (.84 x (5.0% – 2.0%) +8%) = 12.5%. As a privately held firm, you would add additional risk premiums to this calculated cost of equity that may increase the expected return another 5% or more. As such, your firm’s cost of equity is 18%. This means shareholders of your company expect an 18% return on the money being reinvested for them.
Capital budgeting is a powerful tool that can increase the firm’s probability for successful returns on its use of capital. Capital budgeting will also help a company prevent making mistakes in allocating funds to the wrong projects, such as investing in developing a new service or product that has very few entry barriers, is susceptible to obsolescence, and has increasing price pressures on current suppliers.
For capital budgeting to be an effective tool, cash flow forecasts have to be realistic, which means conservative. The axiom that it is better to error on the side of conservatism is gospel for forecasting longer-term cash flows. This is especially true in today’s business world in which competitors and markets react very quickly. When forecasting cash flows, it is best to develop a “decision tree” in which you analyze what you consider to be potential future results. Assign probabilities to these different scenarios, and through this process management should come to agreement on the projection they feel is most likely.
Harvest CFO Consulting will provide your company with a highly-skilled CFO to assist your company in establishing proper capital budgeting and forecasting techniques to enable your company to increase the probability of long-term success.