How to Ration Capital in an Idea Rich Environment
One of the most critical decisions executive teams make is how to allocate resources. This includes both tangible (physical and financial) and intangible (human and intellectual) resources. In this article we’ll focus on developing the inputs, processes and a tool to help your leadership team in the following ways:
1. Generate a common understanding of the expected outcomes when making significant resource allocation decisions.
2. Develop a common framework to approach the allocation decision.
3. Create a roadmap to help capital requestors know what is expected of them when presenting a new project for approval.
4. Produce a financial model to aid in the approval process.
5. Generate benchmarking and decision improvement capabilities by comparing the financial model to actual results.
In addition, a key responsibility of the Board of Directors is to work with management to develop acceptable investment criteria. Here are some examples of what the Board and Management might agree on:
- Each project undertaken helps achieve our strategic goals
- Each project is safe and legal
- Each project is submitted on an approved corporate form
- Approval levels
- Return Criteria
- Net Present Value: Expected cash flows discounted at the companies weighted average Cost of Capital
- Internal Rate of Return: Investment return rate where NPV = 0
- Payback: Time it takes to recover the cash invested in the project
We’ll use a new capital project to illustrate the steps in the capital allocation process, starting with a project idea.
The first step is to explain what the project is:
- A description of the project
- How it fits into the company’s strategic goals
- The project’s critical risk factors
- A time line including the development/implementation period and expected useful life
The second step is to prepare the financial details:
Capital Needs Calculation (Total Funds Requested):
1. Direct Project Expenditures: These are the capital costs spent on acquiring project assets (land, buildings, equipment, IP and intangibles).
- Asset lives should be assigned to buildings and equipment.
2. Working Capital: This is the incremental capital required to fund the increased activity resulting from the Project.
Expected Improvements from the Investment:
- If the project increases production capacity determine how many more units will be sold each year due to the capital spend. Note: some capital projects save on operating costs or allow for a higher selling price without any change in volume.
2. Gross Margin:
- When the project increases volume the increase in gross margin must be calculated to determine the improved cash flow impact on the business.
- If the project increases per unit prices but not volume, the incremental earnings must be included.
3. Other Income:
- If the project results in other income being earned, that also must be estimated.
4. Other Operating Costs
- Extra volume may result in larger operating costs.
- New plants may require additional operating costs.
- Operating cost savings from the projects should also be included in the analysis.
5. Tax Rate: The company’s marginal tax rate should be used to calculate the net income and cash flow.
The third step is to summarize the financial results from the investment over a foreseeable period of time:
- The capital required
- The expected financial improvements from the project
- Cash flow changes from the investment
- Increased Volume
- Increased Margins
- Other Income Sources
- Additional Operating Expenses
- Reduced Operating Expenses
The fourth step is to determine your Cost of Capital:
This is an important step because capital is not free. Investors (debt or equity) have return expectations that will be imposed on you. Lenders expect to be paid interest and have their principal returned. Equity investors expect stock appreciation and dividends. It’s also important because the cost of capital will be used to discount cash flows and help determine which projects are chosen. Using a cost of capital that is too high could result in good projects being rejected, while using a cost of capital that is too low could result in poor projects being accepted. The cost of capital is expressed as %. When the anticipated project returns exceed the cost of capital the project is expected to be accretive to the company’s value.
Calculating your cost of capital is normally done at the corporate level. It must be consistent across the business to be an effective variable in the decision-making process.
Cost of Capital: The company’s cost of capital is determined by first calculating the cost of equity and the after tax cost of debt. These variables are then weight-averaged to arrive at the Cost of Capital.
The formula is noted below.
[E/(D+E)* CoE ]+[ D/(D+E)* CoD *(1-TR)] = Weighted Average Cost of Capital
- E = Equity
- D = Debt
- CoE = Cost of Equity (expected return on equity)
- CoD = Cost of Debt (average interest rate on debt)
- TR = Effective Tax Rate
Different industries and geographies have different equity return expectations. Expected performance (the market’s, not management’s) will also impact return expectations. Likewise, leverage will affect the cost of debt. The higher leverage the greater you can expect the interest rate to be.
Going through the exercise to determine your Cost of Capital has all kinds of learning experience for the CFO as well as the broader management team. Share the logic and results with the team to prevent unnecessary discourse when projects competing for Capital are reviewed in the future.
Once these steps have been taken you are prepared to use the Capital Investment Analysis Model (see Tools below). This tool was developed to help you realize the 5 goals noted in the first paragraph and to simplify and summarize the key points the project sponsors must cover before the Leadership team and, if necessary, the Board will consider approving the project.
Approved capital investments should be benchmarked annually to the actual project results with the intention to improve the capital allocation process and enhance your investment outcomes.
Please comment freely on the tools functionality and its value as a Capital Planning and Allocation aid for your company.
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