Capital planning and investment control are crucial processes for companies to maximize investment returns. By carefully planning capital expenditures and controlling investments through feedback mechanisms, companies can ensure capital is allocated to value-creating projects. This allows them to meet strategic objectives and generate strong returns for shareholders. Here we explore some best practices around capital planning and investment control with real-world examples.
Conduct thorough project appraisal with NPV and IRR
One key aspect of capital planning is conducting rigorous project appraisal to determine expected cash flows and value creation potential. Tools like net present value (NPV) and internal rate of return (IRR) are commonly used to evaluate and rank investment projects. For example, Company A is considering two projects. Project 1 requires an initial investment of $1 million and is expected to generate $150,000 in annual after-tax cash flows over 8 years. Project 2 needs $1.5 million upfront and is forecast to bring in $250,000 per year for 10 years. Assuming a discount rate of 12%, Project 1 has an NPV of $96,452 and an IRR of 16.7%. For Project 2, the NPV is $331,663 with an IRR of 18.2%. Although Project 2 has higher cash outflows, it creates substantially more value. With rigorous NPV and IRR analysis, Company A can objectively quantify project economics rather than relying on gut feel.
Perform sensitivity analysis to assess risk
While evaluating projects, it is also important to run sensitivity analysis to determine how returns change under different scenarios. Continuing the previous example, Company A finds Project 2 still has positive NPV if annual cash flows fall by 20%. However, Project 1’s NPV turns negative if cash flows decrease by just 10%. This shows Project 1 likely carries more risk. By stressing testing with sensitivity analysis, Company A can assess downside risks and potentially mitigate through more conservative projections or staged investment. Scenario analysis also helps determine the impact of factors like cost overruns and project delays.
Use post-completion audits to improve forecasting
Post-investment control via post-completion auditing is vital for improving future capital planning. By comparing projected and actual cash flows, companies can fine-tune models and assumptions. For instance, Company A finds the actual IRR on a recent project was 3 percentage points below projections due to cost overruns. For the next proposal, it adjusts the contingency buffer up by 10% to account for higher execution risk. Company A also revisits sales and margin assumptions which were too optimistic. Feeding these lessons learned back into the capital planning process enhances rigor and prevents repeating mistakes.
Design approval procedures to ensure governance
A structured approval framework is essential for investment governance and control. Company A requires capital projects above $500,000 to be approved by the CFO and projects over $2 million to require Board sign-off. By having layered authorizations, Company A prevents uncontrolled spending. Approval authority is tied to amount and risk level. Other governance best practices include an annual capital plan with required senior management approval, capital rationing to necessitate prioritization, and a Capital Expenditure Committee to ensure objectivity.
In summary, capital planning and investment control enables companies to maximize returns by allocating capital to value-creating projects. Key tools include NPV, IRR, sensitivity analysis, post-completion audits and structured approval procedures. With robust capital planning and disciplined control mechanisms, companies can make optimal investment decisions.