Prioritizing Capital Investments
THE CFO TYPICALLY MANAGES a company's process for determining how much funding should be allocated to capital expenditures over a planning period and then prioritizing the potential investments within the company's funding constraints. It is a rare company, indeed, that does not have more proposals than can be funded.
This is another example where the real world deviates from theory. In theory, a company should invest in all the projects whose returns exceed its risk-adjusted cost of capital. However, capital budgeting is usually subject to practical constraints that limit how much can and should be reinvested in the business.
Prioritizing capital investments is one of the most challenging missions in the CFO's playbook, but also one of the best opportunities to preserve and grow shareholder value.
CASH FLOW PROJECTIONS
The process for allocating capital begins with the cash flow projections. Using the company's long-term financial model, the CFO estimates the cash flow from operations over the planning period, with a particular focus on the budget year. Cash flow from operations consists of net income, plus non-cash expenses—such as depreciation of fixed assets, amortization of intangibles, and deferral of taxes—less net working capital requirements for inventories, receivables, prepaid expenses, and payables.
The next step is to measure free cash flow, which is equal to cash flow from operations, less capital expenditures. The CFO ...