3 ways to evaluate capital budgeting decisions

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3 ways to evaluate capital budgeting decisions

Many business owners plan to reinvest their tax savings from the Tax Cuts and Jobs Act (TCJA) into their operations. Strategic investments — such as expanding a plant, purchasing a major piece of equipment or introducing a new product line — can add long-term value.

But these investment decisions shouldn’t be made on gut instinct. Instead, it’s important to realistically project future cash flows. Financial experts use projections in conjunction with various financial tools to minimize the guesswork and maximize a business’s potential return.

Getting started

When evaluating strategic investments, the project’s incremental cash flow must be projected. This requires several questions to be answered:

• How much revenue (or cost savings) will the project generate?
• What incremental expenses will the project incur?
• Does the project provide any special tax savings (for example, first-year bonus depreciation or Section 179 deductions)?
• How much incremental working capital and fixed assets will the project require?
• How long will it take to get the project up and running?
• How long will the project generate incremental cash flow?

Financial projections should look beyond the income statement and consider how the project will affect the company’s balance sheet. This helps management evaluate how much cash the project will need each period and whether internal resources will be sufficient to finance the project. Some projects will require the company to tap into the company’s line of credit — or require additional loans or capital contributions.

Using a financial tool kit

Once cash flows have been projected, it’s time to analyze the results and prioritize competing investment alternatives. For example, you might have $200,000 to invest in either a new machine or IT upgrades. Which alternative is better from a financial perspective? Three financial tools that are used to evaluate such decisions include:

1. Accounting payback period. This simple tool tells you how long it will take for a project to recoup its initial investment and start generating positive net cash flow. For example, suppose you’re thinking about buying equipment that costs $200,000 and is expected to generate $50,000 of incremental cash flow annually. Its accounting payback period would be four years ($200,000 divided by $50,000).

Most companies will pursue investments that only meet a predetermined target payback period. The time value of money is a critical consideration when evaluating investments, but it’s ignored by the accounting payback period.

2. Net present value (NPV). NPV is a tool that discounts each period’s projected cash flow into its present value. The sum of the present values for all the periods equals the project’s NPV. If NPV is greater than zero, the project will generate positive cash flow and it’s worth considering. If not, the project may not be worthwhile.

Typically, management uses the company’s cost of capital — or possibly a rate based on the risk of the investment — to discount projected cash flow. For example, launching a new product in the company’s current line of business (or geographic region) may be perceived as less risky (and warrant a lower discount rate) than a product launch in an unknown market.

3. Internal rate of return (IRR). IRR estimates a project’s expected return on investment — essentially, the point at which a project’s NPV equals zero. Management typically has a preset hurdle rate that a project must exceed to be considered. For example, if management sets its hurdle rate at 15%, any project with an IRR below 15% will be on the chopping block.

Unfortunately, these financial tools sometimes conflict with one another. So, it’s important to consider qualitative factors, too. For example, IT upgrades might also protect against cyberattacks and reputational harm, which may be difficult to quantify in financial projections.

Need help?

Some financial professionals are trained in accounting or tax compliance. But a business valuation expert knows how to project and discount future cash flows while taking accounting and tax issues into consideration. Determining how much value an investment project will add over time is a natural extension of a business valuation professional’s expertise.

Sidebar: How much savings will tax reform generate?

Under the Tax Cuts and Jobs Act (TCJA), C corporations will pay a flat 21% federal income tax rate for tax years starting in 2018. Under prior law, C corporations paid a federal income tax rate of up to 35%. The reduced rate also applies to personal service corporations.

In addition, many other entities — including qualifying sole proprietorships, limited liability companies, S corporations and partnerships — will be eligible for a qualified business income (QBI) deduction of up to 20%. Numerous rules and restrictions apply, however.

The TCJA also:

• Expands Section 179 deductions,
• Temporarily provides more generous first-year bonus depreciation deductions, and
• Repeals the corporate alternative minimum tax (AMT).

Not all TCJA provisions are business friendly. But most business owners expect to come out ahead under the new law. The TCJA will affect every business differently — and it could have widespread effects on projected cash flows and the cost of capital that must be factored into strategic investment decisions.