Capital Budgetting

Capital Budgetting is the process of deciding amongs possible investments. The idea is for a given price, how much future cash flow would I require, and when, to earn my cutoff cost of capital

For example, if my capital is worth 15%, I will require the net present value of future cash flow to exceed the price I must pay to get into the deal.

Some important thoughts

Taxes matter.

If you are investing after tax capital be sure the cash flows you expect are also after taxes. Similarly the discount rate should be tax sensitive. Be sure you understand accelerated depreciation.

Ignore equal things

You need not consider any factor that is the same under more than one option. For example if I buy a building, or if I lease it under a net lease, the municipal taxes will be identical. I need not clutter up my calculations when I assess my choice.

Understand sunk costs

All of your life and all of your future decisions will play out in the future. What has gone before is irrelevant. Suppose you can buy a new machine so much more effciient than the one you bought last month that it produces product with a cost advantage great enough to justify spending $1,000,000 to buy it. The fact that you bought a similar, but less efficient machine, eight months ago also for $1,000,000, should have no affect on your decision. Except for the resale value of the old machine, your first million is a sunk cost. The money is gone and you should manage your business based on what the future has to offer.

Lease or buy

If the lease interest factor is less than your cost of capital you might choose lease. Be a little wary though, as your debt structure increases so does your cost of capital. One thing to consider is whether there is any value in ownership over leasing. The question is, “Do I want to own it or just use it.” This is especially important for businesses with high return options in a narrow area. The money used to buy inventory, advertise, or invest in research may produce higher returns than the saving to own a machine.

Opportunity cost.

Every yes creates at least one no. Make decisions with what you know. You can’t do everything and should not worry about missing out when you discover it later.

Organize Your Capital

Money is a scarce resource. Be sure you allocate it to optiomize your results. Quick returns are btter than long returns because that minimizes the risk of osolence and new competitors. Do not overinvest in low return assets.

Discuss your ideal capital structure with lenders. Your own money is the most expensive capital you have because the amount of cheap loans depends on how much capital you can invest. Be sure you are using cheap borrowings to maximum advantage. Maintain a healthy risk aversion though. There are more costs to boirrowing than interest.

I help business owners, and professionals understand and manage risk and other financial issues. To help them achieve their goals, I use tax efficiencies and design advantages to acquire more efficient income and larger, more liquid estates.

Please be in touch if I can help you. 705-927-4770

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