Editor’s Note: Ganesh Rajagopalan is a seasoned management consultant and former investment banker. He is also a leading author on Flevy, having published numerous business frameworks on topics such as Strategy Development, Investment Analysis, and Value Chain Analysis. You can view all his materials here.
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Businesses look to grow and be competitive by taking decisions on, new products, new markets, new production facilities, new technology, increase market share etc.
This could involve large investment of funds in, R&D, capacity increase, buying new technology, buying new companies, brands, large advertising expenses etc.
Capital expenditure or ‘Capex’ represents the growing edge of a business and is needed to maintain competitiveness. Future profits & its growth depends upon the return new capital investment generate and is under the constant scrutiny of the market.
- Large outlays are involved initially.
- Returns come by way of cash flows in future.
- These are long term commitments (3, 5, 10, 20 years or more).
- Once committed these could be irreversible – at best the project can be abandoned which can result in major losses as usually the investment amounts are large.
- Also a number of competing opportunities present itself to the business and only the best/optimum ones should qualify. So capital allocation should be optimum as resources a business commands are limited.
Capex projects have a long term impact since the firm commits itself for the future which is not certain. Therefore capex decision can considerably influence the risk complexion of business.
From a financial perspective there is the problem of how to relate the current or ‘investment mode’ cash out-flows with a stream of future in-flows.
Capex need to be evaluated more strategically and using techniques that can take care of the issues mentioned above.
‘Capital Budgeting’ (also termed Capital Investment Analysis) provides a framework for the evaluation of such investment proposals.
- ‘Capital’ refers to the funds that needs to be invested i.e. the assets to be bought/created using the funds, which in turn would contribute to the growth/competitiveness.
- ‘Budgeting’ refers to the estimation of the funds that may be required initially and also the estimation of cash flows that the assets so procured will generate in the future.
The need for a business to earn a sufficient rate of return over and above its cost of funds is well understood. While there are many approaches, the most popular ones take into account that a dollar today in hand is not equal to a dollar to be received in future. This is because
- Future dollar may or may not come – in full and/or on time as expected – also called cash flow risk &
- Purchasing power of dollar in future may not be the same as that of today (inflation).
Then there are
- Strategic considerations involved in long term investment decisions
- Practical aspects of the inputs required to calculate the return on such long term investments.
- The risks associated with long term investments & how to factor-in such risks
- The processes involved in long term investment decisions & its implementation and so on.