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Justifying Capital Expenditures

Use Payback Period Formula, Calculate IRR, Net Present Value and More

A capital expenditures plan is an important part of your operations plan. Choose a payback period formula, such as calculating internal rate of return or net present value, to make the best investment.

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Capital expenditures planning is as necessary to your business, as business planning is for business growth.

What are capital expenses or expenditures? To be sustainable, businesses need to invest in capital acquisitions and also need to focus on managing the capital investments, such as physical facilities or plants (or additions); equipment; property; and other major improvements.

There are accounting definitions for these type of expenditures and the importance of the definition is in the accounting treatment (depreciation, amortization) of the asset. I am not an accountant. The focus of this page is not on how to treat your investments but how to plan for these type of expenditures and why it's important to do so. Get tax advice from an accountant for the details on how to handle these expenditures (different treatments in different countries).

Capital expenditures need to be part of your business operations plan; as they have an impact on cash flow management and can be a drain on your business unless you plan properly. Therefore make sure that capital expenditures are on your business plan outline checklist (under the Operations Plan).

Usually small businesses do not have enough money to do all the capital projects or buy capital equipment that they might want or need. Therefore capital projects need to be cost/benefit justified. A payback period formula will help you assess the potential investment for viability.

One Way to Assess Capital Expenditures Investment: Use a Payback Period Formula

Note: there are more ways: Some ways to look at cost justification of expenditures are (for the most part, financial ratios are used):

  • A return on investment (ROI) basis, which measures the efficiency or value of the investment (often used to compare investments or expenditures);
  • Payback period formula, which is the length of time the investment takes to payback the cost(shorter is better);
  • Internal rate of return (IRR), (also known as economic rate of return or ERR), which is the internal return rate of an expenditure (net present value of cash flows at zero); the higher the IRR, the better;
  • Discounted cash flow analysis, which is the value of a business in today's terms, based on analyzing or projecting what the business will make in the future (the discounting is the value of cash will be less in the future - due to inflation - than today);
  • And net present value (NPV), which compares the value of today's dollar to the value of that dollar in the future (assuming a specified inflation rate and rate of return). If the NPV of an expenditure or investment is positive, that's a good thing. If it's negative the investment should likely not proceed.

Your expenditures should be focused on achieving your business objectives.

For example, you plan to expand your business by adding a number of new inventory items. Your business will need to add warehouse space. The capital investment project to buy the space next door to expand existing warehouse space and then to build the additional space is in alignment with your business objectives for growth.

It's important to have a little deeper understanding of IRR:

Calculating the Internal Rate of Return

Calculating the internal rate of return (or IRR) of a capital investment is a financial method that businesses use to determine whether the project has enough value to proceed. IRR is the rate at which the project net present value (NPV) equals 0. IRR also calculates the expected return rate of the capital investment (under specified conditions or assumptions).

You can calculate IRR on financial calculators and using MS Excel.

While RRR works well as a capital expenditure decision tool, it does not work as well when used to rate a number of investments against each other.

Providing an acceptable return on investment (this analysis should also look at the payback of adding new inventory items) over a defined period (say two years - of course, one year is better and would be a very good project or investment), and calculating internal rate of return (IRR) of 19%, makes this decision to go ahead on the project easy.

Capital investments can be divided into a number of different categories: discretionary; maintenance; business growth. If you have to pick and chose - maintenance and business growth expenditures should come far ahead of discretionary spending.

However recognize that all expenditures will have a number of drivers (e.g. safety, environmental, what you need to provide good customer service, etc.) and therefore assessment of these investments must also keep those drivers in mind.

Capital expenditure planning needs to be done for 3 to 5 year periods (so that you can plan ahead) and reviewed and updated annually.

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Additional Reading:

Return from Justifying Capital Expenditures to Small Business Plan.

Ensure your Business Financial Plan includes a provision for emergencies.

Your Business Exit Strategy needs to include management succession planning.

Or return to More For Small Business Home Page.

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Implement Your Plan: for Results

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Once you've built your plan, you need to implement it.

Developing your strategy (in the plan) is the first, necessary, step. You need to know the direction you want to go, and you need the strategy and the plan to help you get there.

But once you've built the plan, you must execute it.

There is no value in building a plan that just gathers dust.

When building your business plan, make sure that you include an action plan for the strategies, techniques and tactics.

The actions need to include who's responsible for doing what; measurements for success (such as deadlines and timelines, targets and goals, costs, etc.); and why you need to take the action (in some cases, one action needs to be accomplished before subsequent ones can be launched).

As you work through the plan, make sure that you build reporting periods into the implementation: you need to know what's going on and why something is working, or not.

Make sure to communicate progress, or lack of it, throughout the organization. And re-visit the plan when and where necessary.

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Focus on Your Plan

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Plan for the future: lots of business owners want to get, or keep, moving forward. Planning seems to be more of a passive activity.

However, to ensure that your business goes in the right direction and that it optimizes all its opportunities, and manages its challenges, it is important to plan.

Balance your activities against the plan: make sure that you are investing your time, and money, on the elements of your business that will help you succeed.

Measure what works, and what doesn't work, and keep your focus: use your business plan as a map to guide you in the direction you want to go.