Tie Your Capital Budget to Your Strategic Plan

Otherwise you will spending money for the wrong projects

Introduction:

§ Some directors who were conscious of their responsibilities as stewards of corporate assets, their responsibilities for internal control, and their responsibilities to the third parties (investors and creditors) hadn’t considered the relationship of capital acquisitions to the strategic plan.

§ Corporate financial professionals need to recognize that capital asset decisions are the most irrevocable long-rang activities because they:

o Involve significant corporate funding

o The least flexible in terms of changing the strategic directions of the business

o Least flexible for conversion into more liquid assets

o May geographically impact the long term raw material supply capabilities of the business

o May geographically impact the business’s long term customer access

o Involve decisions about assets that are unique to the company

Defining Strategic Plan

Strategic Plan must be a living document that:

§ Managers keep on their desk and refer to frequently, perhaps even daily

§ Is updated when events occur, not because time periods expire

§ Requires management explanations when its projections aren’t met

§ Represents management’s philosophy of managing with a planning process.

§ Reflects the corporate leadership’s visions of the company’s future

§ Must be shared with all corporate stakeholders, employees, ad even customers and vendors

§ Supported with individual functional plans developed by the business units

§ Uses a systems approach to show how the functional plans interact with the overall strategic plan

§ Recognize the company financial reporting system as a way to measure the company’s progress in implementing the strategic plan

§ Constrains objectives → Should be accomplished in a given time frame

§ Identifies the strategies

Strategic plan should focus:

§ First, on the customer’s needs

§ Second, on the business’s capabilities

§ In order to meet those needs with its products and services

Building the Plan

§ Begins with a corporate mission statement defining the company’s purpose and where the business wants to be in the future and how to get there

§ Identifies guidelines for targeting the corporate market:

o Customer need in particular market

o Customers’ level of education and income

o Customers’ consumption habits

o Potential mix of products and services

o Customers today and tomorrow

§ Identifies the corporate organizational features:

o Its projected size and potential for growth

o Its resources and capabilities

o An analysis of its physical plant capabilities

o An analysis of its technology development

o Review of the staff support equipment in the planning period

o Use of there resources in achieving corporate goals

Managing the Assets

The stages of assets management are the acquisition, maintenance, and dispositions of plant and equipment

1. Companies acquire new physical assets when operating management determines the plant facilities are inadequate to support corporate needs for growth
2. management usually concerned with just the level of expense and its immediate effect on net income rather than the long-term economic viability of the assets
3. Disposition of assets rarely gets proper attention. → “We already own it, so use it”

Measure the Effectiveness of the Program

§ Periodically review all capital asset acquisition project to make sure you still need them → not valid anymore → Consider about the customer → still purchase or not

§ After compete acquisition, review the project to see the initial projections were on target → if not → need to take steps to improve the process → making future projections

§ Continuously review all capital acquisition expenditures, large and small → make sure all the assets are being acquired → according the strategic plan or not.

The Capital Budget

§ Capital budget is the portion of the strategic plan → selects which assets should acquire and that allocates available resources among the proposed ideas, projects, and product → based on quantitative and qualitative evaluations → determine the best investment for the company’s future

§ Corporate decision-making process and has four interdependent steps:

1. defining and communicating a firm’s long-range and strategic plans and goals

2. developing a system that permits the olderly gathering and ranking of investment proposals

3. determining the accuracy of the estimates that will be used in the estimated rate of return calculations

4. determining and assigning level of risk probabilities to each investment proposals

§ Classical concept company will accepts investment proposals up to that point where marginal cost equal revenues

§ But since you can’t accept all capital investment proposals, need to rank them based on some mathematical standard and keep going until there is no fund left to invest.

Effective Implementations is Key

§ Driving force of any strategic plan is its effective implementation

§ Once you’ve developed the corporate strategic plan assumptions, the next step is to merge this information into the various functional plans, and link all short-terms and long-terms plans

§ The capital budgeting program provides a foundations for the overall strategic operating plan with its view of future economic benefits

§ The decision making factors are:

1. Time Value of money

2. The Cost Of Capital

The Inherent Risk of each projects / proposals

The Capital Budgeting Decisions of Small Business

Introduction:

§ The paper analyzes the capital budgeting practices of small firms

§ Small firms → Employed less than 500 employees

§ In 1997 → Small Business include → agriculture, manufacturing, constructions, transportations, wholesale → industries that require substantial capital investment.

§ Several reasons

o First, small business owners may balance wealth maximization → in making decisions

o Second, Small firms lack personnel resources → may not have the time or expertise to analyze projects

o Finally, some small firms face capital constrains → making project liquidity a prime concerns

§ To document the capital budgeting practice in the small firms → Survey from NFIB → Primary tools used to evaluate project & planning tools & also the owners’ willingness to finance the projects with debt.

§ Result Small firms & Large Firms → different

§ Large firms tend to rely on discounted cash flow

§ Less than 15% small firms use discounted cash flow

§ But Over 30% small firms do NOT estimate cash flows AT ALL

§ Reason → Small business owners surveyed → do not have a college degree

I. Capital Budgeting Theory:

§ Brealey and Myers (2003) → simple capital budgeting decisions → invest in all positive net present value projects and reject those with a negative net present value

§ This decisions → maximizing shareholders wealth → therefore do not need to consider alternative capital budgeting tools, such as payback period or accounting rate of return → Small firms cannot be able to make reliable estimates of future cash flows.

1. Capital Budgeting Assumptions and the Small Firms

o First, shareholders wealth maximization may NOT be the objective of small firms → in each case primary goal of entrepreneur → to maintain the viability of the firm

o Second, small firms have limited management resources → lack expertise in finance and accounting → so may not evaluate projects using discounted cash flows.

o Finally, capital market imperfections → constrains the financing options for small firms. → Ang (1991) notes → access to public capital markets can be expensive for certain small firms and impossible for others.

o Small firms more concern → How quickly a project will generate cash flows? → payback period.

2. Cash Flow Estimation Issues

o Booth (1996) concludes → discounted cash flow analysis is less valuable → when the level of future cash flows is more uncertain

o Discounted cash flow analysis will be less valuable to evaluate venture that are not directly related to current activities

o Discounted cash flows → could be used in the small firms → but because of firm’s size → Cash flow analysis will not be cost effective

o That’s why small firms may not rely exclusively on discounted cash flow analysis

II. Description of data

§ Demographic characteristics of the sample → industry, sales growth, business age, employment, owner education, and owner age

§ 72% of the sample firms are → service 20%, construction / manufacturing 24%, retail / wholesale 48%.

§ High growth category define as → a cumulative increase of 20% or more over the pas 2 years → includes 24% of the sample firms.

§ 24% of the firms also report two year sales declines of 10% or more

§ Therefore → approximately 75% of the sample firms have experienced an average annualized growth rate of 10% or less over the pas two years.

§ Thus many → capital budgeting of small business focused on → maintaining the current level of service and quality → rather than expansion.

§ The mean number of total employees is 4 → only 16% that have only 1 employee and → only 18% have 10 employees or more

§ Over 50% business owners do not have a four year college degree

§ Only 13% have

§ Therefore → many small-business owners may have incomplete or even incorrect understanding of how capital budgeting alternatives should be evaluated

III. Survey Results

1. Investment and Financing Activities

o Identify the firms’ most important type of investment over the previous 12 months → reports the percentage of firms that will delay a potentially profitable investment

o Replacement:

· Firms in service are more likely to this response → but firms in constructions and manufacturing are less likely.

· Firms with high growth rate but age less then 6 years → less likely than the average sample firm

· Finally the replacement activities increases with the business owner over 44 than the business owner is younger than 44

o New product line:

· Firms in service industry → Less likely

· Firms with higher growth rate → More likely than the lower growth rate firms’.

· Oldest firms were → less likely than the average firm to be considering expansion a new product lines

o Wait for Cash:

· Wait for cash → Youngest firms, smallest firms, and owners that have not a college degree

· Almeida, Campello, and Weisbach → Capital constrains will make a firm more likely to save cash.

o Three reasons small firms not follow Capital Budgeting Theory:

· First, it is Not Worthy replacement activities is the most important type of investment for almost half of the sample firms. Maintaining viability of the firms is becoming more concern of the owner rather than maximizing its value.

· Second, the result suggest that many small firms place internal limits on the amount they will borrow → Cannot separate investment and financing decisions → contrary with capital budgeting theory

· Finally, personal financial planning considerations of business owners may affect the investment and financing decisions of small firms.

· These result conflicts with the capital budgeting theory → The transferability of ownership interest allows managers to separate the planning horizon of a business from the planning horizon of its owners.

2. Planning Activity

o How frequently forms estimate cash flows in making capital budgeting decisions

§ 30% do not estimate the future cash flows

§ Smallest firms → (Three or less employees) → are less likely to make cash floe projections

§ Larger firms → (ten or more employees) → more likely to make and use their estimations

o Whether they have written business plans

§ Only 31% have written their business plan

§ Newer firms → (less than 6 years old) and younger owners → (less than 45 years old) → more likely to use or build the business plan before they run the firm

o Whether they consider tax implications in making capital budgeting decisions

§ 26% do not consider tax implications

3. Project Evaluation Methods

o Gut feel:

§ → Owners without a college degree resort to it most frequently use this rather than → Owners with advance degree

§ Firms with cash flow projections are significantly less likely to rely on guts feel.

§ Difficulties that occur because of the other side of the firms → (Transportations in service industry) → gut feel play there

o Payback Period:

§ Used more often by the wait for the cash firms

§ Firms using the payback period → significantly more likely than other firms to estimate future cash flows

§ Finally → use of the payback period appears to increase with the formal education of the business owner

o Accounting rate of return:

§ → Increases with the firms growth rates significantly higher → than the sample mean for firms entering new lines of business

o Discounted Cash Flows:

§ Primary investment evaluations method of only 12% of the firms

§ Firms use discounted cash flows → use business plans and consider the tax implications of investment

§ Discounted cash flow analysis is useful when evaluating projects with the similar project profiles to current operations

4. Multivariate Analysis

o This techniques appropriate when an unordered response, such as a set of project evaluation tools, ahs more than two outcomes

o Firms using any of the formal investment evaluation tools are more likely to make cash flow projections than firms using gut feel

o Firms using accounting rate of return, discounted cash flow or both → more likely to consider tax implications

o Gut feel → Have less structured planning

IV. Summary

§ Firms with fewer than 250 employees analyze potential investment using much less sophisticated methods

§ Discounted cash flow analysis used → Less frequent than gut feel, payback period, and accounting rate of return

§ Most of the firms in sample are very small → Fewer than 10 employees → Have short operating histories → almost 50% Under 10 years → The owner also not college educated → may have limitations in their bank credit, posing credit constrains.

§ Many investment that small business make → cannot easily evaluated using the discounted cash flow techniques that recommended by capital budgeting theory

§ For these reasons, small firms face capital budgeting challenges that differ from the larger firms. Make it possible → optimal budgeting methods in small and large firm → may differ.

* Investment Decision Making in an Entrepreneurial Firm: An Application

§ Small entrepreneurial firms are typically run by single owners who may lack financial expertise to evaluate investment proposals.

§ They may rely on their personal accountants, tax advisors, and bankers to provide key input in the capital budgeting process.

§ discounted cash flow techniques → NPV, IRR and payback are very popular

§ CAPM → the most popular asset pricing model

§ cross-border adjustments → rarely used

§ corporations tend to disregard firm-related unsystematic risks

§ The smallness of entrepreneurial firms creates unique problems in application of traditional capital budgeting principles.

§ Small firms are also prone to violent changes in profitability → when faced with economic downturns than large firms → which tend to be diversified as well as have access to financial resources

§ This 'small size' effect culminates in a higher discount rate when evaluating capital investment proposals

§ Stein (2002) → found that a decentralized approach to capital budgeting often found in smaller firms works best when information about a project is "soft" → cannot be credibly transmitted within the organization.

§ the analyst tends to agree with his boss' prior beliefs about acceptability or not of a project rather than come up with a totally objective analysis → This problem is particularly crucial in small, entrepreneurial firms where the chain of command between the decision making authority and the analyst is very small

§ state that the choice of a particular decision making process in a firm is a function of the agency problem, quality of information and project risk

§ larger firms are more likely to use the NPV method or the IRR method when evaluating foreign direct investments than smaller firms

The Investment Decision Process:

§ Total risk is more important than unsystematic risk in computation of a small business's cost of equity

§ Bailes at al. (1979) note that smaller firms are less likely to use any risk measurement techniques

§ Discounted cash flow techniques are the most preferred capital budgeting decision criteria used in the industry

§ Danielson & Scott (2005), small business owners are most likely to use relatively unsophisticated project evaluation tools due to their limited educational background, small staff sizes, and liquidity concerns.