Generating Capital Investment Project Proposals - Financial Management

Ideas for new capital investments can come from many sources, both inside and outside a firm. Proposals may originate at all levels of the organization —from factory workers up to the board of directors. Most large and medium -size firms allocate the responsibility foridentifying and analyzing capital expenditures to specific staff groups.

These groups can include cost accounting, industrial engineering, marketing research, research and development, and corporate planning. In most firms, systematic procedures are established to assist in the search and analysis steps. For example, many firms provide detailed forms that the originator of a capital expenditure proposal must complete.

These forms normally request information on the project’s initial cost, the revenues it is expected to generate, and how it will affect the firm’s overall operating expenses. These data are then channeled to a reviewer or group of reviewers at a higher level in the firm for analysis and possible acceptance or rejection.

Where a proposal goes for review often depends on how the particular project is classified.

Classifying Investment Projects

As noted earlier, there are several types of capital expenditures. These can be grouped into projects generated by growth opportunities, projects generated by cost reduction opportunities, and projects generated to meet legal requirements and health and safety standards.

Projects Generated by Growth Opportunities

Assume that a firm produces a particular product that is expected to experience increased demand during the upcoming years. If the firm’s existing facilities are inadequate to handle the demand, proposals should be developed for expanding the firm’s capacity such as Ford’s decision to expand Volvo’s manufacturing facilities, discussed in the first section of the chapter. These proposals may come from the corporate planning staff group, from a divisional staff group, or from some other source.

Because most existing products eventually become obsolete, a firm’s growth is also dependent on the development and marketing of new products. This involves the generation of research and development investment proposals, marketing research investments, test marketing investments, and perhaps even investments in new plants, property, and equipment. For example, in order for the mineral extraction industries to keep growing, they must continually make investments in exploration and development. In 2002, ExxonMobil’s capital and exploration expenditures were $14.0 billion.

Similarly, firms in high-technology industries —such as electronics and pharmaceuticals—must undertake continuing programs of research and development to compete successfully. For example, Merck spent over $2.4 billion on research and development in 2002.

Projects Generated by Cost Reduction Opportunities

Just as products become obsolete over time, so do plants, property, equipment, and production processes. Normal use makes older plants more expensive to operate because of the higher cost of maintenance and downtime (idle time). In addition, new technological developments may render existing equipment economically obsolete. These factors create opportunities for cost reduction investments, which include replacing old, obsolete capital equipment with newer, more efficient equipment.

Projects Generated to Meet Legal Requirements and Health and Safety Standards

These projects include investment proposals for such things as pollution control, ventilation, and fire protection equipment. In terms of analysis, this group of projects is best considered as contingent upon other projects.

To illustrate, suppose USX wishes to build a new steel plant in Cleveland, Ohio. The decision will be contingent upon the investment in the amount of pollution abatement equipment required by state and local laws. Thus, the decision to invest in the new plant must be based upon the total cost of the plant, including the pollution abatement equipment, and not just the operating equipment alone. In the case of existing facilities, this type of decision making is sometimes more complex.

For example, suppose a firm is told it must install new pollution abatement equipment in a plant that has been in operation for some time. The firm first needs to determine the lowest cost alternative that will meet these legal requirements. “Lowest cost” is normally measured by the smallest present value of net cash outflows from the project. Then management must decide whether the remaining stream of cash flows from the plant is sufficient to justify the expenditure. If it appears as though it will not be, the firm may consider building a new facility, or it may decide simply to close down the original plant.

Project Size and the Decision-Making Process

The classification of a proposed project influences the capital investment decision-making process. However, there are other factors to consider —in particular, the size of the expenditure required to carry out the project. Most firms decentralize the decision-making function. For example, whereas the approval of the president and the board of directors may be needed for especially large outlays, such as Ford’s $5 to $6 billion investment in Volvo discussed earlier in the chapter, a divisional vice president may be the final decision maker in the case of medium -size outlays.

A plant manager may have responsibility for deciding on smaller outlays, and a department head in a particular plant may be authorized to approve small outlays. For example, at Hershey Foods, a corporate -level review is required for all projects of more than $500,000. Projects below this amount are evaluated at the operating division level only. Hershey is moving toward a system that will require a corporate-level review for all projects of $50,000 or more. This chain of command varies with individual companies. In large firms, however, it is impossible for any one person to make every decision regarding proposed capital expenditures, and a decentralized system is usually employed.

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