Tie Your Capital Budget to Your Strategic Plan

The article is talking about:

· Defining Strategic Plan

· Building the Plan

· Managing the Assets

· Some Common Evaluation Techniques

· Capital Budget

As corporate financial professionals, they need to recognize that capital asset decisions are the most irrevocable long-range activities because they:

· involve significant corporate funding;

· are the least flexible in terms of changing the strategic direction of the business;

· are the least flexible for conversion into more liquid assets;

· may geographically impact the long-term raw material supply capabilities of the business (for example, newer manufacturing facilities are located near deep-water ports to accept raw materials arriving from around the world);

· may geographically impact the business's long-term customer access (for example, a company would place a new plant near existing product delivery points or concentrations of potential customers); and

· involve decisions about assets that are unique to the company.

Since the unique features of capital assets represent the source of a company's product individuality and position in the marketplace, capital decisions must support the company's strategic plans

DEFINING THE STRATEGIC PLAN

The strategic plan must be a living document that:

· managers keep on their desks 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. Everyone has to understand any significant variations from the planned activities so adjustments can be made to the plan.

· represents management's philosophy of managing with a planning process. Here it's both a product and a process. The product is the plan-the written document. The process is the interaction that takes place among the employees and management to develop the plan.

· reflects the corporate leadership's visions of the company's future.

· must be shared with all corporate stakeholders, employees, and even customers and vendors so they can embrace it as their own.

· is supported with individual functional plans developed by the corporate units. It uses marketing's sales projections, manufacturing's production projections, human resources' training objectives, and similar plans from the rest of the divisions.

· uses a systems approach to show how the functional plans interact with the overall strategic plan. It considers how each corporate function influences the other organizational activities, recognizing that all parts (subsystems) of a company must operate together toward a common purpose as stated in the corporate mission statement.

· is recognized in the company's financial reporting system as a way to measure the company's progress in implementing the strategic plan. (The financial reporting system is a universally recognized measurement mechanism.)

· contains objectives-specific measurable results that outline exactly what should be accomplished in a given time frame.

· identifies the strategies-the how, where, and when of resource commitment to achieve objectives.

The strategic plan should focus first on the customers' needs, then on the business's capabilities to meet those needs with its products and services.

BUILDING THE PLAN

The strategic plan begins with a corporate mission statement defining the company's purpose and where the business wants to be in the future, including how it plans to get there. It identifies guidelines for targeting the corporate market, such as:

· customer needs in that market,

· customers' level of education and income,

· customers' consumption habits,

· potential mix of products and services, and

· customers of today and tomorrow.

It also identifies the corporate organizational features, such as:

· its projected size and potential for growth,

· its resources and capabilities,

· an analysis of its physical plant capabilities,

· an analysis of its technology developments,

· a review of the staff support requirements in the planning period, and

· use of these resources in achieving corporate goals.

SOME COMMON EVALUATION TECHNIQUES

· Payback (Payout) Method-This technique subtracts the cash inflows from the project's initial cash outflows until the outflows have been recovered. The time required to recover the cash outflow is the payout period.

· Average Annual Return on Investment-This evaluation procedure takes the total income over the life of the project divided by the years of the project and develops an average annual income value. The average annual income is then divided by the investment amount to determine a rate of return.

· Present Value Method-This method takes a predetermined interest rate, usually the company's cost of capital, and discounts the cash flows by that value. The result shows the present value of that cash flow at the predetermined Interest rate for the project under review.

· Discounted Cash Flow Method-This procedure takes the cash flows of the project over the life of the project and determines the project's present value and internal interest rate. Any rate above the company's cost of capital will enhance the overall corporate picture. It allows the maximization of corporate profits by selecting projects with the highest internal interest rates.

· Purchase vs. lease-A lease may be an alternative to a capital expenditure, but It's a financing consideration for the acquisition and not a part of the investment decision itself. Under today's "substance over form" financial and tax rules, leases involving substantially all of an asset's economic life and value must be treated as an acquired asset. Therefore a lease is no longer an economic ranking consideration as it may have been before the 1970s.

MANAGING THE ASSETS

The stages of asset management are the acquisition, maintenance, and disposition 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 or corporate citizenship, such as environmental concerns and safety. Acquisitions include:

· equipment replacement expenditures

· expansion investments that enlarge

· investments to support strategic improvements in existing products and the addition of new products that offset or replace deteriorating markets and protect the company's revenue position; and

· combinations of the above.

2. Maintenance

· If a strategic view says the facilities have a long-term value, delaying asset replacement programs unnecessarily drains the company's resources. This is the wrong way to save money or improve profits.

· If a strategic view says the facilities have no longterm value, then get rid of the assets. There's no advantage to maintaining nonviable assets.

3. Disposition of assets rarely gets proper attention.

The goal here is to ensure the assets will be fully utilized and support management's strategic vision.

IS THE PROGRAM EFFECTIVE?

Once you've defined your asset management program, identify the key measurements that will keep the program viable and effective:

· Periodically review all capital asset acquisition projects to make sure you still need them.

· After you've completed an acquisition, review the project to see if the initial planning projections were on target

· Continuously review all capital acquisition expenditures, large and small, to make sure that all assets are being acquired according to the strategic plan rather than in a piecemeal fashion.

THE CAPITAL BUDGET

Capital budget is the portion of the strategic plan that selects which assets you should acquire and that allocates available resources among the proposed ideas, projects, and products based on quantitative and qualitative evaluations to determine the best investment for the company's future. It's the most dynamic aspect of the 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 orderly gathering and ranking of investment proposals;

3. Determining the accuracy of the estimates that will be used in the estimated rate of return calculations; and

4. Determining and assigning levels of risk probabilities to each investment proposal.

Only after considering all these steps as an integrated whole can you make a valid "go" or "no go" capital budgeting decision.

Since capital expenditures are long-term commitments, you should consider only strategically defined, thoroughly thought-out, qualitative and quantitative capital budgeting proposals. The classical concept of capital budgeting decisions says a company will accept investment proposals up to that point where marginal costs equal revenues. But since you can't accept all capital investment proposals, you need to rank them based on some mathematical standard and keep going until you reach the point where funds aren't available or the project's return falls below the company's hurdle rate. You'll make these choices after you accept the mandatory and nonfinancial operating necessity proposals, such as pollution devices, safety programs, or employee benefits.

EFFECTIVE IMPLEMENTATION IS KEY

The driving force of any strategic plan is its effective implementation-allocating scarce corporate resources in a way that ensures you'll continuously achieve corporate long-term objectives. 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-term and long-term plans. After the functional plans for marketing, production, human resources, finance, and other support units are developed, the data is consolidated into the corporate plan.

The capital budgeting program provides a foundation for the overall strategic operating plan with its view of future economic benefits. The prime decision-making factors of the capital program should be:

· the time value of money,

· the cost of capital, and

· the inherent risk of each project/proposal.

Fixed assets are long-term present-dollar commitments that will be used over a long period of time in the normal course of business. Capital budgeting decisions are more than far-reaching-they are future-defining. Every capital budget expenditure must provide assets that have the highest priority in the strategic plan.