Ever wondered if your next big investment will truly boost your small business? Capital budgeting is your secret weapon, helping you weigh the risks and rewards to ensure every investment propels your growth.
When assessing potential investments into new online projects, new factory, equipment or other ventures, there are few key techniques used.
Net present value (NPV) is by far the most accurate measure of return from investment. It sums all cash inflows and outflows and discounts it into present day value. You can therefore compare two projects even when their timeline doesn't match.
Internal rate of return (IRR) builds on that idea, but goes slightly further. It can compare not only projects with different timeline but of different sizes. Mathematically IRR is a discount rate at which NPV is zero, therefore the maximum rate at which you don't lose money.
Payback period (PP) is a simplistic approach for first - sort of back of the envelope - calculation. It shows only when your investment returns enough profit to pay off the initial investment. However it disregards time value of money.
Profitability index (PI) is a continuation of NPV. It shows a ratio of discounted future cash flows to the initial investment. Or $PI = 1 + \frac{NPV}{Initial investment}$
To truthfully assess the value of your project, you will need to make a financial plan for the whole duration of the project. If the lifespan is longer or indefinite, feel free to assume revenues and expenses growing at the same rate forever.
After modelling possible future projects, you can calculate their financial returns using indicators above. I would recommend using IRR and NPV and choosing the one with higher values. Remember to also consider the size of your needed investment when choosing the right project.
If you are considering new ventures, remember to stay withing your constraints. Financial resources are usually limited, cash flows are often strained and managing it all might push you or your employees to the limit.
Do your due diligence, assess the value the venture brings to your business and choose carefully.