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Capital budgeting is perhaps the most important task faced by financial managers and
their staffs. First, a firm’s capital budgeting decisions define its strategic direction, because
moves into new products, services, or markets must be preceded by capital expenditures.
Second, the results of capital budgeting decisions continue for many
years, reducing flexibility. Third, poor capital budgeting can have serious financial
consequences. If the firm invests too much, it will incur unnecessarily high depreciation
and other expenses. On the other hand, if it does not invest enough, its equipment
and computer software may not be sufficiently modern to enable it to produce
competitively. Also, if it has inadequate capacity, it may lose market share to rival
firms, and regaining lost customers requires heavy selling expenses, price reductions,
or product improvements, all of which are costly.
The same general concepts that are used in security valuation are also involved in
capital budgeting. However, whereas a set of stocks and bonds exists in the securities
market, and investors select from this set, capital budgeting projects are created by the
firm. For example, a sales representative may report that customers are asking for a
particular product that the company does not now produce. The sales manager then
discusses the idea with the marketing research group to determine the size of the
market for the proposed product. If it appears that a significant market does exist, cost
accountants and engineers will be asked to estimate production costs. If they conclude
that the product can be produced and sold at a sufficient profit, the project will
be undertaken.
A firm’s growth, and even its ability to remain competitive and to survive, depends
on a constant flow of ideas for new products, for ways to make existing products better,
and for ways to operate at a lower cost. Accordingly, a well-managed firm will go
to great lengths to encourage good capital budgeting proposals from its employees. If
a firm has capable and imaginative executives and employees, and if its incentive system
is working properly, many ideas for capital investment will be advanced. Some
ideas will be good ones, but others will not. Therefore, companies must screen projects
for those that add value
Project Classifications
Analyzing capital expenditure proposals is not a costless operation—benefits can be
gained, but analysis does have a cost. For certain types of projects, a relatively detailed
analysis may be warranted; for others, simpler procedures should be used. Accordingly,
firms generally categorize projects and then analyze those in each category
somewhat differently:
1. Replacement: maintenance of business. Replacement of worn-out or damaged
equipment is necessary if the firm is to continue in business. The only issues here
are (a) should this operation be continued and (b) should we continue to use the
same production processes? If the answers are yes, maintenance decisions are normally
made without an elaborate decision process.
2. Replacement: cost reduction. These projects lower the costs of labor, materials,
and other inputs such as electricity by replacing serviceable but less efficient equipment.
These decisions are discretionary, and require a detailed analysis.
3. Expansion of existing products or markets. Expenditures to increase output of
existing products, or to expand retail outlets or distribution facilities in markets
now being served, are included here. These decisions are more complex because
they require an explicit forecast of growth in demand, so a more detailed analysis is
required. Also, the final decision is generally made at a higher level within the firm.
4. Expansion into new products or markets. These projects involve strategic decisions
that could change the fundamental nature of the business, and they normally
require the expenditure of large sums with delayed paybacks. Invariably, a detailed
analysis is required, and the final decision is generally made at the very top—by the
board of directors as a part of the firm’s strategic plan.
5. Safety and/or environmental projects. Expenditures necessary to comply with
government orders, labor agreements, or insurance policy terms are called mandatory
investments, and they often involve nonrevenue-producing projects. How they are
handled depends on their size, with small ones being treated much like the Category
1 projects described above.
6. Research and development. The expected cash flows from R & D are often too uncertain
to warrant a standard discounted cash flow (DCF) analysis. Instead, decision
tree analysis and the real options approach are often used.
7. Long-term contracts. Companies often make long-term contractual arrangements
to provide products or services to specific customers. For example, IBM has
signed agreements to handle computer services for other companies for periods of
5 to 10 years. There may or may not be much up-front investment, but costs and
revenues will accrue over multiple years, and a DCF analysis should be performed
before the contract is signed.
In general, relatively simple calculations and only a few supporting documents are
required for replacement decisions, especially maintenance-type investments in profitable
plants. A more detailed analysis is required for cost-reduction replacements, for
expansion of existing product lines, and especially for investments in new products or
areas. Also, within each category projects are classified by their dollar costs: Larger investments
require increasingly detailed analysis and approval at a higher level within
the firm. Thus, a plant manager may be authorized to approve maintenance expenditures
up to $10,000 on the basis of a relatively unsophisticated analysis, but the full
board of directors may have to approve decisions that involve either amounts over $1
million or expansions into new products or markets.
Note that the term “assets” encompasses more than buildings and equipment.
Computer software that a firm develops to help it buy supplies and materials more efficiently,
or to communicate with customers, is also an asset, as is a customer base like
the one AOL developed by sending out millions of free CDs to potential customers.
All of these are “intangible” as opposed to “tangible” assets, but decisions to invest in
them are analyzed in the same way as decisions related to tangible assets. |
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