It is the belief of most financial experts that the profitability of many firms’ operations is contingent on the successful management of their complex investment decisions. Thus, at the hub of most successful companies is a good and sound investment strategy. The term strategy refers to managers’ ability to effectively plan for their firm’s future. The term capital budgeting explains the whole process through which organisational expenditures is planned together with revenues or returns expected to extend beyond a year. Through effective capital budgeting, companies are able to acquire assets in a timely manner; they are able to enhance the quality of purchased assets. Some finance experts draw our attention to the need for integration of capital budgeting and strategic planning. The reason for this argument is that the future of the company is likely to be adversely impacted by inadequate investments or excessive investments. Excessive investments in tangible assets would result in higher expenses. Investments below the firm’s capacity would result in a loss of market share (customers) to competitors. A company’s ability to recapture lost market share may be challenging and costly, if not impossible. Empirical research findings indicate it takes industries such as the pharmaceutical industry, between ten (10) and fifteen (15) years to research, develop, and finally present a drug on the market for sale. Similarly, companies in the oil and gas industry require huge capital investment in exploration research, heavy equipment, skilled personnel, among others, to ensure successful drilling and production of crude oil in desirable commercial quantities. The costs of funding such ventures are very high and therefore, call for careful and prudent investment decisions to avert economic catastrophes.
Factors Affecting Capital Budgeting Decisions
The underlying objective of capital budgeting decisions is to select investment projects that would maximize the returns of shareowners at the least cost. Arguably, capital budgeting remains the most important decision in financial management. Variations in administrative procedures, commencement, and completion of projects tend to affect investment decisions. Some identified factors influencing capital budgeting decisions of firms include size of a project, impact on risk of a firm, ability to increase revenue and reduce cost (replacement investment, expansion investment, and growth investment), compulsory and other investments, relationship between projects, and administrative processes. Each of these factors is explained in the following section.
- Size of a Firm
There is a correlation between project size and project proposal. That is, a small project size would require a small proposal size; and large project size would require a fairly large proposal size. A project size largely determines the human and financial capital required to ensure its successful completion. To facilitate the decision making process, most companies set investment thresholds (in monetary terms) below which it is not necessary to thoroughly review projects before their commencements. Investments decisions are likely to prolong as firms embark on projects with high magnitudes in relation to size and cost. The definition of large project size varies from one business to another. For instance, Business “A” may define a large size project to include an investment outlay of $5 million, but Business “B” may define a large project size to include an investment outlay of $500,000. It is apparent companies may employ procedures that are standardized when undertaking small projects. However, the companies may require extensive review at various levels for projects with huge investment outlay. For projects that would eventually lead to significant modifications in the firm’s strategy, board of directors’ approval may be required.
2. Impact of Risk on a Firm
One of the important factors that characterise capital budgeting decisions is an analysis of the effects of new projects on the risk associated with the portfolio of a company’s existing activities. We can determine the impact of new projects on the company’s risk by understanding the economic relationship between mergers or acquisitions on one hand; and external investments and internal investments on the other. External investments may be described as a company’s decision to purchase another company. The merits associated with an external investment are limited by its relatively high risk. Variations in perceived risks associated with both internal and external investments may depend on individual judgement. For example, some managers may be comfortable with the pursuit of organisational development and growth from within while others may deem it economically beneficial to explore other markets as a means of coping with the rapidly changing business environment. Companies would be better off, if they are able to emerge from these juxtaposing views with a common view that would maximize their economic value. Internal investments relate to new projects that are initiated within the company. Management’s familiarity with this investment “terrain” helps it to identify and control any related risk. Generally, however, internal investments that relate to the company’s existing activities may limit its opportunity to explore other pertinent areas.
3. Ability to Increase Revenue and Reduce Cost
The decision to invest in a project may be influenced by its ability to contribute to revenue maximization and cost minimization. Replacement investment, expansion investment, and growth investment have been identified by some finance experts as some of the key factors that explain revenue maximization and cost minimization of firms. Each of the foregoing investments is explained in the following section.
Replacement Investments: It is the responsibility of the firm to decide whether to replace its existing property, plant, and equipment (PP&E), or to continue using them. As the firm’s property, plant, and equipment become obsolete, their contribution to the revenue generation process becomes limited, and their contribution to production becomes inefficient and ineffective. Continuous use of obsolete and worn out machines is more likely to contribute to cost than to revenue. This trend could be reversed if the firm purchases new equipment to replace worn out and obsolete ones.
Expansion Investments: a firm may decide to expand its operations by making additions to the capacity in its existing lines of product. For instance, Coca-Cola Company may develop a proposal to add more machines to the types that are now used in the production of Coca-Cola drinks. Additions to the existing machines would help increase the production capacity of the company, more Coca-Cola drinks would be supplied to customers. Another example may be a decision by the management of Target Stores, Unilever or Nestle to open new branches. There is a correlation between the decision to expand and to replace nonproductive machines. For example, a firm may decide to replace aging equipment with a larger and more productive one. The decision to expand is usually affected by a high degree of uncertainty. However, the firm can mitigate this uncertainty by assessing its previous experience from the use of similar machines and stores; and the respective impact of those machines and stores on overall production and sales.
Growth Investments: Investment for growth occurs when a firm decides to invest in new product lines, or to establish branches in other countries. For instance, as part of its strategic growth investment, Target Stores, a United States based company, may decide to open branches in other countries, such as Belgium, Singapore, Morocco, among others. The decision to invest in foreign countries correlates, to a large extent, with management’s familiarity with the foreign terrain. Thus, management may decide to invest in new product lines and in new geographic locations if it has ample knowledge about those potential investment areas. It is argued that decisions related to growth investments are often characterised by vision and judgements that are heroic. It is a widely-held belief that most financial managers lack entrepreneurial spirit, they have reduced themselves to mere bean pushers. That is, they are mostly preoccupied with the manipulation of financial figures. Unfortunately, overconcentration on financial manipulations may result in the implied company’s failure to embrace investment opportunities that are characteristically qualitative in nature. To avert any untoward financial hardships on their organisations, it is paramount for financial managers to focus largely on entrepreneurial activities that would ensure equilibrium in their orientation and concentration on both quantitative and qualitative measures.
Compulsory and Other Investments
Some government regulations obligate firms to engage in nondiscriminatory investment activities. Notable among these regulations are those that focus on companies whose activities pollute our environment. The government, the Environmental Protection Agency (EPA), ensures that adequate measures are put in place by firms to control all forms of pollution in our environment. Environmental protection and preservation are very essential to human survival. For this reason, companies plan and invest in devices that help in pollution control, even though such investments do not generate direct revenue to the companies. Similarly, a firm may construct a parking lot and provide radio and television sets on its premises for employees and customers. Although these facilities do not generate direct revenue to the firm, they serve as a morale booster for employees; they enhance the firm’s chance of retaining existing customers, and attracting new ones.
Ebenezer M. Ashley (PhD)
The Author is a Senior Consultant at Ghana Investment Services Centre and Founder of Eben Consultancy