Capital Planning: The Ultimate Guide

1. Financial modeling and analysis

With financial modeling and analysis, you should be able to run different financial scenarios and models and/or look at risk and get a risk score—both qualitative and quantitative. Financial models quantify the impact of capital investments. Compare the numbers against historical performance and provide decision-makers with easy-to-read financial reports of planned versus actuals. Budget planners rely on various finance methods and techniques to make informed decisions, including net present value (NPV), internal rate of return (IRR), and discounted cash flow (DCF).

• Discounted cash flow (DCF): A valuation method that estimates the value of an investment using its expected future cash flows.
  
  DCF = [(cash flow 1) ÷ (1 + r)^1] + [(cash flow 2) ÷ (1 + r)^2] + [(cash flow n) + (1 + r)^n]


• Net present value (NPV): The value of all future cash flows, positive and negative, over the entire life of an investment discounted to the present.
  
  NPV = today’s value of the expected cash flows − today’s value of invested cash


• Internal rate of return (IRR): Used in financial analysis to estimate the profitability of potential investments without accounting for external factors, such as the economy. Organizations often use the IRR function to compare and decide between capital projects.
  
  View the full IRR formula at the Corporate Finance Institute

2. Scenario planning and sensitivity analysis

Capital investment decisions are based on a set of assumptions and inputs. The lack of certainty brings about investment risk.

• Scenario analysis: The process of estimating the expected value of a portfolio after manipulating a number of key variables. This method can be used in both investment strategy and corporate finance.
• Sensitivity analysis: A method to identify how much variations in the input values for a given variable will impact the results for a mathematical model. While there isn’t a single formula for sensitivity analysis, the general approach is to select an input, modify it by a specified amount, and ascertain the impact on the output. Analysts typically vary inputs up and down by a fixed percentage, such as 10%, to assess sensitivity. The simplistic formula is:
  
  New output = base output x (1 + change in input)

3. Risk assessment models

Risk assessments quantify uncertainty in capital planning. A qualitative risk assessment is subjective (a basic score), while a quantitative risk assessment calculates potential outcomes. The goal of any risk simulation is to evaluate the confidence you have in the project plan, which areas of that plan expose the project to the most risk, and what responses you will take to mitigate those risks.

• Monte Carlo simulations: A type of computational algorithm that plays a crucial role in analyzing risks. Monte Carlo simulations are increasingly used in conjunction with AI models. The core concept behind the Monte Carlo simulation is a multiple random sampling from a given set of probability distributions.
• Value at risk (VaR): A statistic used in risk management to predict the greatest possible losses over a specific time frame. Although there are several methods of calculating VaR, the historical method is the simplest:
  
  Value at risk = v_m (v_i / v_{(i - 1)})

4. Portfolio management techniques

Reliable portfolio management enables you to direct and adjust capital planning to help maximize return, whether a project is under consideration, under construction, or nearing closeout and handover. If done well, a data-supported portfolio management strategy helps organizations meet their capital planning goals today and tomorrow.

Investors use both the efficient frontier and the capital allocation line (CAL) to achieve different combinations of risk and return based on what they desire. With CAL, the optimal risk portfolio is found at the point where the line is tangent to the efficient frontier. This asset weight combination gives the best risk-to-reward ratio, as it has the highest slope for CAL. See the image below.

• Capital allocation line (CAL): A line that graphically depicts the risk-and-reward profile of assets that can be used to find the optimal portfolio. The line E(R_c) = R_f + S_pσ(R_c) is the capital allocation line.
• Efficient frontier: It comprises investment portfolios that offer the highest expected return for a specific level of risk and graphically represents portfolios that maximize returns for the risk assumed, showing the benefit of diversification. It helps investors understand the potential risks and returns in their portfolios and analyze how they compare to the optimal set of portfolios considered to be efficient. The efficient frontier rates portfolios (investments) on a scale of return (y axis) versus risk (x axis).

5. Project management and governance tools

These tools are used in the transition between identifying the right projects to do and handoff to a project management execution team. A comprehensive project management application is valuable to manage schedules, contracts, and documents and provide a governance framework for compliance oversight. However, for many project owners the finance capital planning department and project management office use different systems. And that’s not ideal because the execution side is using project management tools to understand the details of what the plan really needs, collecting actuals, and providing forecasts that should go back to and inform the capital planning group on how it’s doing. Furthermore, capital planning can’t wait on slow, spreadsheet-driven processes to evaluate a project’s status. Immediate, data-driven visibility allows that team to quickly and accurately manage the budget.

• Project management software: Automated solution that gives users full control of all workflows. It connects the right people to the right projects, supporting the organization’s goals with a clear view of financial performance across a project portfolio.
• Governance frameworks: Critical to control and standardize the way projects are delivered. Such frameworks also increase efficiency, promote decision-making accountability, and reduce risk through streamlined and standardized processes that provide visibility and support compliance.

6. Performance measurement and KPIs

Ideally, owners measure performance across the entire “plan, build, and operate” lifecycle as assets move from concepts into operations and maintenance. Owners should develop measures and KPIs that reinforce what success looks like and how to achieve the expected result. A good start is to focus on high-level outcomes/targets they care about most—bringing quality assets into production on budget and on schedule while minimizing risk. Measures and KPIs tend to be a mix of quantitative and qualitative outputs. While finance teams may prefer quantitative measures such as ROI, working capital, cash flow, and profit margin, project teams may also include softer measures of team communication, conflict resolution, health and wellness, and team morale.

Measures and KPIs should also be relatable to the audiences that review them. Project teams tend to track performance at a finer level of detail than is generally shared with executives or public stakeholders.

• Return on investment (ROI): A simple and intuitive metric of the profitability of an investment. ROI is a key metric used by business analysts to evaluate and rank investment alternatives. There are several versions of the ROI formula. The two most commonly used are:
  
  ROI = net income/cost of investment
  or
  ROI = investment gain/investment base


• Economic value added (EVA): A way to measure the economic profit of a company or project. EVA is calculated by taking net operating profit minus a finance charge. The finance charge captures the required rate of return on capital invested by the company.
  
  The EVA formula can be expressed as:
  
  EVA = NOPAT – (WACC invested capital)
  
  Where NOPAT = net operating profit after tax; WACC = weighted average cost of capital; invested capital = shareholders’ equity + net debt at the beginning of the period. (Alternatively, invested capital can be calculated by taking total assets minus cash minus non-interest-bearing liabilities.)

7. Advanced analytics and big data

Data from past construction projects is valuable in helping organizations understand how to build out new projects more efficiently. For example, an energy company has built numerous refineries, and there’s general knowledge of what it will take to build the next one. Advanced analytics can help that company analyze mountains of data from the last 20 refinery projects to make better-informed decisions on the right projects to take on, how to allocate available funds for a given project, and how to spread the money across projects.

• Predictive analytics: The use of statistics and modeling techniques to forecast future outcomes. Predictive analytics determines a likely outcome based on an examination of current and historical data. There are three common techniques used in predictive analytics: decision trees, neural networks, and regression.
• Big data analysis: The process of collecting, examining, and analyzing large amounts of data to discover market trends, insights, and patterns that can help companies make better business decisions.

1. Align capital planning with strategic goals

Capital planners are uniquely challenged with ensuring that all projects which receive funding are properly aligned to an owner’s strategic goals and objectives. The importance of this formal alignment can’t be understated. Planners must consider the external and internal factors that could affect an organization's ability to pursue strategic goals without fear or favor, estimate the capital needed for each project, and evaluate and rank the projects that will receive funding.

2. Implement a rigorous project evaluation process

A standardized process in which each project is evaluated, scored, and prioritized helps eliminate pet projects and favoritism. Projects can be ranked according to urgency, feasibility, risk, and strategic alignment. The projects with the highest positive impact and the lowest opportunity cost generally get the nod.

3. Establish a strong governance framework

A strong governance framework provides proof over time that you’re getting what you paid for—timelines are being met and risks are being managed and mitigated. A clear connection between finance, which releases capital budgets, and the PMO, which receives those budgets and provides monthly forecasts back to finance, keeps each department in constant alignment should reauthorizations be required. A strong governance framework should include the policies and procedures that each group is responsible for, a reference system architecture that outlines both when and how specific data and information crosses departmental boundaries, and the frequency interval of stakeholder decision-making and reporting.

4. Foster cross-functional collaboration

It’s important to foster cross-functional collaboration between key departments, especially between capital planning/finance and the project management office execution group. They will share information at specific intervals and times, ideally at least every month.

But such collaboration may not just be internal. Owners often hire delivery teams (contractors/suppliers) as part of the execution process. Ensuring that these delivery teams can both access and share critical project documents, schedules, risk, and cost information with the PMO is vital. No engineering or construction project happens in a vacuum, and all must contribute to and collaborate on a shared and unified plan.

5. Embrace flexibility and adaptability

Yes, owners want predictability from their capital planning strategies to ensure that deadlines are met and costs remain under control, but it’s important to be flexible. Planners must build flexibility into capital budgets to adapt to ever-changing conditions, such as when the price of materials suddenly skyrockets or there’s a freak weather event.

6. Leverage technology and data analytics

The technologies you choose should start with the end in mind. Are the technologies making project information readily available to those who need it? Do they make it easy to keep decision-makers and stakeholders at all levels informed?

Capital planning technologies should ideally help planners evaluate, prioritize, and select the projects that align to the organization’s strategic goals and objectives. They should also be interoperable with the project management technologies of the PMO and delivery teams who provide the necessary forecasts planners need to make adjustments across their project portfolio.

Once all projects in the portfolio can be seen together, you can easily find new opportunities to unlock and surface insights. Data analytics dashboards built into integrated portfolio capital planning and project management technologies give planners and PMO/delivery teams the insights they need to make the most informed decisions.

7. Prioritize risk management

Project risk occurs in two phases: during the proposal, prioritization, and selection phase and during the project execution phase. Capital planners focus on the former, operations/delivery teams on the latter. Putting a risk management framework in place across both phases is crucial.

8. Ensure transparency and accountability

As capital projects become increasingly complex, it’s critical to create clear service-level agreements and provide all stakeholders with regular updates at every stage to help ensure transparency and accountability. Those stakeholders include not only owners, planners, and delivery teams, but also regulators.

9. Emphasize continuous improvement

Continuous improvement involves refining ongoing processes based on lessons learned from past project errors and failures. It also involves constantly adjusting existing project processes to meet changing demands.