Middle market businesses make project investment decisions every week. It might be to acquire a competitor, expand to a new geography, launch a new product or purchase equipment to increase capacity. Capital budgeting theory provides clear guidance on the methods and financial metrics that business leaders should use to inform these investment decisions. So why do so many businesses not use them? With a little practical guidance from our experts, we’ll unpack the recommended techniques, the common barriers, and how business leaders can use them to make better investment decisions.
What is best practice?
The theory tells us that Discounted Cash Flow (DCF) methods are preferred. This is because they are based on cash flows, consider cash flows across the entire project timeline and consider the time value of money. Payback period and accounting return measures such as Net Profit After Tax (NPAT) are not recommended, for a few reasons. Accounting returns are ineffective because they are profit based, may not accurately capture capital costs, do not consider the time value of money, and focus on single year rather than the term of the project. As for payback, it is equally ineffective as does not consider the time value of money or any cash flows after payback is achieved.
While NPAT margin and other accounting profit measures are not the most effective metrics, it does not mean they are not useful in a project financial analysis. At a minimum, they provide a basis for understanding whether forecast earnings are accurate based on past performance or industry benchmarks. However, because they don’t provide a view of return on investment based on the cost of capital, they should not be the primary informant of investment decisions.
| Measure | Recommended | Definition |
| NPV | Recommended | A project’s net contribution to wealth being the present value of its cashflows including the initial investment. |
| IRR | Recommended | The discount rate at which a project’s NPV equals zero. |
| Payback period | Not recommended | Time until the cumulative project cash flows equal zero. |
| Accounting returns | Not recommended | Traditional accounting profitability measures such as net profit after tax. |
Theory versus practice
So what are businesses doing, if not following best practice? While some of our clients use NPV and IRR methods, and they are better adopted in some sectors (for example, property), they aren’t often used by middle market businesses. Larger firms use Net Present Value (NPV) and Internal Rate of Return (IRR) more often than other measures to inform investment decisions. As firm size decreases, the use of DCF methods does too. Payback period is also still popular despite its known faults.
There are several reasons why firms may be less likely to follow best practice. In my experience these reasons include:
- The requirement for a medium to long term outlook which can be difficult to assess and predict.
- The need for a view of an appropriate discount rate that allows for risk as well as time value of money.
- The fact that DCF methods are more complicated than the alternative measures because they are harder to calculate, more difficult to understand and harder to explain to stakeholders.
Measuring a return over four years (payback) or achieving a certain level of profit expressed as a percentage (NPAT margin) provides a simple, tangible value to measure a project. While it is easy to understand why a business would choose a less complicated measure where possible, ultimately DCF methods can provide more accurate and informative data to help business’ make project investment decisions.
Key considerations when using DCF methods
- Incremental cashflows: it is important to understand how to identify sunk costs and opportunity costs including how the project may affect existing business.
- Alternate case planning: businesses should always consider all options, including the proposed project, any alternates and the ‘do nothing’ case.
- Discounting periods: consider the profile of cashflows and whether annual, quarterly, or monthly discounting is appropriate. Stronger growth profiles and lumpy Capex are key considerations.
- Terminal value: Consider the continuing value, salvage value and any other cash flows at the end of a project term.
Question the underlying financial analysis
To help make informed capital budgeting decisions, businesses should ask some guiding questions to assess project viability and the quality of the underlying financial analysis:
- What financial analysis will be undertaken to assess the project?
- Will cash flows be prepared?
- Will NPV or IRR be calculated?
- Have incremental cash flows been correctly identified?
- Have sunk costs been identified and excluded?
- Have opportunity costs been appropriately considered?
- Has working capital requirement been considered?
- What is the term of the project and how has terminal value been considered?
- Are the cash flows prepared consistent with the discount rate that has been used?
But enough with the theory, what are the real benefits. Those of utilise DCFs for investment decisions benefit from the learnings that come from the process of substantiating cash flows and determining a discount rate as well as the output itself.
If you or your business have any further questions around financial planning and strategic capital budgeting advice, reach out to your local Pitcher Partners expert today.
