The Hindu Business Line : Capital budgeting needs vision

"WHAT business are you in?" a CEO of Ponds was once asked. "We sell hope," he said. (A wide definition of business indeed.) The same question was posed to Akio Morita, the founder of Sony. He said, "We are in entertainment." And when a truck-fleet owner was asked the same question, he said, "We are into truck and transportation business." (A very narrow definition of business.)

The first two answers were from two successful business heads, whose vision and definition of business were crystal clear from the very beginning. Whereas in the transporter's case, it is unlikely his company would ever achieve the heights of a Ponds or Sony.

A crucial aspect in the success of the two companies would no doubt be capital budgeting (CB).

Capital budgeting is based on identifying the opportunities, threats and internal weaknesses, setting long-term goals, formulating action plans and strategies, and monitoring them on a continuous basis.

These decisions have to fulfil the criteria of creating net positive present value for the organisation. Thus an organisation should grab and hold on to every opportunity (both external and internal) that creates positive net present value (NPV) for its shareholders. And in a competitive environment, every organisation has to attract, reward and retain its shareholders and potential investors.

Whenever businesses take capital budgeting decisions they add value (that is, of course, if the decisions do not fail), which gets reflected in shareholder earnings, the price-earning ratio, the share price, market capitalisation and dividends.

Capital budgeting

The investment decisions of any business are of two types: long term (where funds are usually invested for more than three years) and short term (where investments are for a year or less).

Long-term investment decisions are called capital budgeting/capital expenditure decisions — launching a new product, improvisation, modernisation, expansion, replacement of fixed assets, research and development, purchasing new fixed assets, acquisition, takeover, merger, alliances, and so on.

Characteristics of CB decisions

The benefits/losses associated with such decisions arise in the future owing to the high set-up/initial costs and long gestation periods. And owing to the high costs, in case of loss, firms face serious long-term consequences.

Initial investments are large. The funds are required to purchase fixed asset, for branch expansion, replacement, acquisition, and so on.

Usually, CB decisions are irreversible. This is because: i) the resale value of any purchases made as a part of any CB decision is very low; and

ii) the initial setting up costs cannot be recovered if the project runs into losses. As the timeframe in setting up and implementing a project is long, the money value is bound to change. In case of low/nil profits, project costs would increase manifold with time.

Capital investment of any form reveals its growth potential: Long-term investments are made to generate future revenues/profits which add to the value of the firm. Thus, investments grow with time if profitable investment plans are implemented.

The growth of any company is measured by the expected return multiplied by the amount of funds invested by the firm, that is, g = b x r — where `g' is growth of firm; `b', the funds retained by the firm only for investment purpose; `r', the required/expected rate of return; and r {gt} k (the cost of capital).

When `b' is high — that is, funds invested by the firm are large — then `g' will also be large even if `r' remains constant. Hence, once the company decides to go for profitable investment the company will grow, provided r {gt} k (cost of capital).

(Edited extracts from Financial Management. Book courtesy: Pragati Prakashan. www.pragatiprakashan.com)

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