Capital budgeting processes and investment decision frameworks

Capital Budgeting

The company is considering expanding production capacity for its flagship product. There are opportunities in overseas markets that the company can take advantage of if it moves quickly. Thus, the capital project is an expansion to the existing production facility, to double it capacity.

There are a number of issues that need to be overcome in order to get approval for this project. The first is that the company needs to determine the cash flow estimates from the project. There are a number of assumptions that must go into this, including sales and profit figures, as well as the initial cost of the project. Once the cash flows have been estimated, the discount rate must be set. This is typically the company's cost of capital. If the company does not know its cost of capital, it must estimate this.

If the project has a positive net present value, in other words if internal rate of return is above the hurdle rate, then the next set of steps for gaining approval for the project involve evaluation against competing investment alternatives. A wide range of criteria goes into this step of the process. Because most firms have limited amounts of capital available, the capital budgeting decision process will need to determine the best use of company funds. The factory expansion to meet a move overseas will need to prove not only the best decision in terms of net present value or IRR but will also need to meet the firm's soft criteria as well. These soft criteria can include the firm's overall strategy, the expected payback period for the project and the maximization of shareholder value. In addition, there may be political considerations within the firm, or concerns about non-financial resources that need to be addressed.

Internal politics can play a significant role in the project approval process. This soft dynamic can sometimes be overcome with hard facts and information, but for the most part project approval will require some degree of political capital with the approvals committee or senior management.

The risk of the project is another key consideration. The net present value calculation is based on a set of assumptions about the future cash flows. However, the sensitivity of these cash flows to external or internal events may vary from project to project. Managers and shareholders are often risk averse in nature, therefore the relative risk level of the plant expansion will be taken into consideration prior to project approval. As sensitivity analysis can be used to demonstrate the degree to which certain assumptions are important to the final cash flow projections.

Another potential hurdle to overcome is that of the public image for the project. In this case, there is little potential for public relations disaster, unless the plant expansion will result in environmental catastrophe. However, the company is likely to guard its image carefully so the project will benefit if its proponents spin it as improving the company's image by generating domestic jobs and building the brand overseas.