Problem:
To help in this section a PowerPoint presentation “CAPITAL BUDGETING: The Key Building Blocks”, which is an attachment to this email. You can print off this lecture and then run the PowerPoint presentation as you read along. There are 9 building blocks I will be taking you though.
• Investment Opportunity
• Method of Investment
• Capital Sources
• Time Value of Money
• Cost of Capital
• Evaluation Techniques
• Risk Adjustments
• Accounting and Taxes
• The Capital Budgeting Model
Investment Opportunities
a) Cost Reduction
b) Expansion
c) Compliance
Cost Reduction basically something that improves efficiency, speed, or quality. If the new investment saves you money it is a cost reduction opportunity. Usually these types of opportunities involve new equipment or facilities, computers and programs, products, and even technology. But I need to separate this category into something we are already doing and just want to do it more efficiently. I am leaving completely new, never been done here, type of projects for the expansion category.
Expansion projects are those that involve new products, locations, technology, acquisitions, customers, computer applications, new etc. These types of projects have never been done before in our company. We are taking a bigger risk on these types of projects because of inexperience and the unproven assumptions required for success.
Compliance projects involve those mandated by law. These compliance projects may also affect costs and efficiency but normally they are evaluated separately because of the lack of a pure “benefit” motive. Some of these projects may be evaluated based on the avoidance of a fine or tax so I guess you could call this a benefit if the project helped us escape the cost
The second building block concerns the Method of Investment to be used for the new project.
• Purchase
• Make
• Lease
• Rent
These decisions are made about any project. Since most end up as fixed assets on the Balance Sheet, accounting systems track and accumulate costs that are eventually “capitalized” meaning they are added to the fixed assets in the company’s chart of accounts. And yes, these fixed assets can and do include purchased items, the company’s own labor, sub-contract costs, even shipping and instillation.
The third building block are the Capital Sources (money) coming from to make this investment? Basically there are three sources:
• Retained Earnings
• Debt
• New Equity
This decision is made at the top levels of the company as to how much to budget for capital items and where the money is coming from. For our purposes, we will not get into this budgeting process here. We will assume the money is there. What is important to remember however is projects are evaluated on a cost of capital basis which we will discuss in a few moments. Most texts indicate that the source of money is not specifically identified to a particular project. It is pooled and considered part of the company’s overall cost of all capital.
Time Value of Money:
Any capital project is an investment. The two categories are cost reduction and expansion. Both have specific identifiable benefits and costs.
Cost of Capital.
A business plan is based on how great it sounds (of course we have all the legal documents and you are accredited investors) you and I write checks totaling $100,000 for 100% of the shares in the company. In your mind you felt this opportunity could return 20% pretax each year on your investment. The next day I deposit the $100,000 equity in our bank account and borrow another $100,000 from the bank at 10% annual interest. What is our cost of capital now?
You will see that our weighted cost of capital is 15% calculated by adding together 50% equity times 20% and 50% debt times 10%. If we do make 15% pretax we can satisfy the bank and the shareholders.
Evaluation Techniques
These are divided into two basic camps: The “time value of money” evaluation and the plain “give me my money back.” You may read and get the opinion one is better than the other but what ever the method used management still must make some basic and final decisions. The methods don’t do this for you. Typical today in the companies;
• Pay Back Period of less than 3 years
• NPV at risk-adjusted WCC
• IRR and PI to break ties and rationing
With the ever-shorter product life cycle and uncertain economic future today, companies are taking a stronger look at quick pay back. For most mainstream consumer and industrial products a pay back of less than 3 years is the first criteria a project must meet. If not, the project is rejected regardless of the NPV or IRR. The second criteria are the NPV at your weighted cost of capital adjusted for risk. I will talk about risk in a moment. The project must have a zero or grater NPV to be accepted. Finally, the IRR and PI techniques are used where multiple projects compete for limited capital investment funds.
Risk Adjustment is recommended. Companies for the most part use a seat of the pants approach to risk adjustment. So management just uses their best judgment in most cases 1) Risked-adjusted WCC, and 2) Certainty Equivalent (probability). And most companies differentiate between Cost Reduction and Expansion projects feeling Expansion projects are much more risky as we discussed earlier. So naturally these types of projects have a greater risk adjustment. The risk adjustment in any case raises the bar by reducing the potential return or increasing the interest rate or discount factor. This makes the NPV criteria much harder to achieve and thus is a way to compensate for the risk management feels is present.
Discussion Question:
Question 1. Why would a manager use the Weighted Cost of Capital for investment decisions when a specific project may be funded by a particular source of capital, (e.g. debt or equity)?
Question 2. What capital budgeting process and evaluation does your organization (or one you can talk to) use? Specifically what Pay Back Period and NPV discount factor is used and how does the company adjust for risk? You will probably need to ask someone in the financial department on this one.
Question 3. If a company had a ROA percentage lower than its cost of capital for a number of years what problems would you look for in the Capital budgeting process?