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When The Stakes Are High! Build a Proper Business Case

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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money-40603_960_720The Context

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.

The Issues

  • 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.

The Methodology

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.
Many of the concepts discussed in this article are covered in the author’s 101-slide framework presentation on Capital Investment Analysis found here.

About Ganesh Rajagopalan

Ganesh Rajagopalan is an advisor and trainer with expertise in the areas of Strategic Planning, Business Planning, Business Modeling, Financial Planning, Tactical Planning, Industry Analysis, Investment Analysis, Credit Analysis, Financial Systems Planning, Team Building, and Organizational Structuring. Prior to consulting, Ganesh worked with Standard Chartered Bank, Oracle Finance and a niche investment banking firm. He has several business frameworks available on Flevy here.

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