Capital Budgeting Decision Vs. Financing Decision
Capital budgeting evaluates the costs and benefits of long-term assets. The process examines and compares the returns, cash flows and risks associated with acquiring new capital assets or enhancing the existing ones. Financing decisions, meanwhile, concern the availability of funds to meet the budget obligations of your small business. Your financing decisions should be influenced by the cost of different sources of finance, such as debt and equity capital.
The cash flow techniques you employ in capital budgeting facilitate your financing decisions as well. Payback period, net present value and internal rate of return are some of the commonly project appraisal techniques. NPV is the present value of your investment’s future cash flows, while IRR is discount rate that neutralizes the NPV of cash flows to zero. Both NPV and IRR are discounted cash flow techniques -- that is, they reflect the time value of your money when making investment decisions. Payback period is the time it takes to regain the money you commit in an investment, although it does not show the time value of your money.
Decisions to pursue or reject investments depend on their viability and profitability, but also on the capabilities of your small business to raise the initial capital. For example, when an investment yields a positive NPV, it simply means the project is financially viable because it generates returns that exceed the opportunity cost of capital -- that is the benefits you could have earned by directing your funds to alternative investments.
Capital budgeting and financing decisions are dependent on the levels of returns and borrowing costs respectively. Hurdle rate -- that is, the minimum rate of return you can accept to generate from a long-term investment, is commonly used to account for the cost of capital and the underlying risk premium. A risk premium is the extra charge you apply on your hurdle rate to cushion against possible risks of erroneous cash flow projections. Capital budgeting and financing decisions seek to prioritize investments that yield greater returns than your minimum hurdle rate. Aswath Damodaran, a corporate finance and valuation teacher at the Stern School of Business at New York University, suggests that “the hurdle rate should be higher for riskier projects and reflect the financing mix used -- owner’s funds (equity) and borrowed money (debt).” Capital budgeting prescribes higher discount rates for riskier projects to ensure your rate of returns on investments stay above your cost of capital.
Seek a balanced ratio of debt to equity so as to minimize your cost of capital and maximize returns for your small business. There should be equilibrium between your equity capital and debt financing. Unrestricted borrowing reduces your profits because you will spend significant portion of your income on debt repayment. Similarly, excessive equity capital dilutes profits because you will have to distribute the bigger chunk of earnings to shareholders. Choose long-term financing that attracts minimum interest rates to reduce your borrowing costs.
It is not appropriate to invest equity capital in your small business without having a strategic purpose behind it. Investors are driven by the desire to maximize wealth generation and you need to deliver on their expectations by embracing investments that earn maximum profits. The dividend principle holds that you should refund shareholders’ funds in event that your planned investments are not capable of generating sufficient profits.