Funding is an essential part of the decision for a large capital investment. The major considerations in funding are cost, control, flexibility, and risk. Debt is often seen as less expensive than equity, partly because the cost of debt is tax-deductible. Sale of new equity is often seen as undesirable, because it dilutes ownership and weakens management control. The trade-offs are in flexibility and risk. Heavy debt levels reduce financing alternatives and may force the company to abandon its strategy in difficult financial markets. An often ignored best practice is always to maintain some unused borrowing ability so you can respond to changing circumstances.
The risk associated with debt is determined primarily by the cash flow needed to service the debt, not the amount of debt. Risk analysis using pro forma financial statements highlights the combined impacts of the proposed investment and its funding on the risk of running out of cash. A project funded with intermediate-term debt may raise the risk of a cash crisis to an unacceptable level, though the same project funded with long-term debt or equity would not be excessively risky.
The most common deviation from best practice is a failure to monitor capital investments after the decision is made. First, the expectation of monitoring helps control excess optimism about costs and benefits. Second, deviations are more likely to be correctable if detected early. Third, monitoring is a learning tool for improving the capital budgeting process.
The first stage of monitoring occurs as the capital investment is being acquired and made operational. Are costs and timing consistent with the proposal? If there are deviations, can they be corrected? The second stage is monitoring the investment once it is operational. Are results what we expected, can we make improvements, and what can we learn from the experience?
Bass Family Electric
Bass Family Electric (the name has been changed for confidentiality) was an electronic contractor with a 20-year history of success in small commercial building projects. The founder made a strategic decision to leapfrog into much larger projects, increasing debt to fund the needed capital investment. Small projects typically lasted a few weeks, but big projects stretched over a couple of years. The sad result of expansion was a series of losses and looming bankruptcy.
The problem was failure to fully implement the strategic decision. The company continued to prepare bids as it had done for small projects, ignoring the fact that long-term projects were capital investments. One capital investment that was not made was a monitoring system for long-term projects. A brief study of past projects made clear which types of projects and conditions were leading to losses.
The prescription was to avoid the types of projects that created losses temporarily, modify the bid process to recognize large projects as capital investments, and institute monitoring that allowed a rapid response to deviations. Bass was then positioned to expand its range of business, including the types of projects that had previously contributed to losses.
Capital budgeting is the implementation of strategy, and it commits the firm to directions that are not easily changed. Best practice requires that strategy determines capital investments, not the other way round. Best practice requires a disciplined process, with the involvement of the CEO and CFO, and clear communication from proposal development through capital budgeting, funding, and monitoring.
Making It Happen
Determine who will be responsible for managing the capital budgeting process (typically the CFO). In addition to managing the process, the CFO will recommend financing.
Communicate business strategy clearly to everyone involved.
Establish and publish hurdle rates.
Create standards with regard to what must be in capital investment proposals, including general description, strategic impact, NPV, and risk analysis.
Establish responsibility for capital investment decisions. Managers at various levels may be given authority to decide on smaller investments, while large, strategic investments are decided by top management. A capital investment committee is frequently used, with membership including the CEO, CFO, and other senior managers.
Establish a time schedule and process for monitoring. The monitoring process may be done as often as once a week during implementation, and may be part of the annual review thereafter.
1 Report of the President’s Commission to Study Capital Budgeting. Washington, DC. February 1999. Online at: clinton3.nara.gov/pcscb/report_pcscb.html
2 Abdelal, Rawi, Ayesha Khan, and Tarun Khanna. “Where the oil-rich nations are placing their bets.” Harvard Business Review (September 2008): 119.
3 Carroll, Paul B., and Chunka Mui. “7 ways to fail big.” Harvard Business Review (September 2008): 82–91.
4 Malmendier, Ulrike, and G. Tate. “CEO overconfidence and corporate investment.” Journal of Finance 60 (2005): 2661–2700; Statman, Meir, and Tyzoon Tyebjee. “Optimistic capital budgeting forecasts: An experiment.” Financial Management 14:3 (1985): 27–33.
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