Page 95 - Encyclopedia of Business and Finance

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Capital Investments

next year.) Similarly, if there is risk connected with the product line. Alternatively, management may want to
expected money—the company expects $100, but could combine two plants and eliminate the less efficient one.
get more or less—its value today is less than $95.24. Fur- Such ideas are less likely to come from the plant managers!
thermore, the riskier it is, the lower its value today. This bottom-up process results in ideas percolating
Typically, in order to make fair comparisons, the upward through the organization. At each level, ideas sub-
value of all of the amounts of money expected back from mitted by lower-level managers are screened, and attrac-
capital investments are converted into what are called tive ones are forwarded to the next level. In addition,
present values. The rate of return used to calculate the managers at successively higher levels, who are in a posi-
present value for a capital investment is called the cost of tion to take a broader view of the company’s business, add
capital. The cost of capital is the minimum rate of return ideas that may not be visible, or desirable, to lower-level
the company must earn to be willing to make the invest- managers.
ment. It is the rate of return the company could earn if, At the same time, there is also a top-down process at
rather than making the capital investment, it invested the work in most companies. Strategic planners will generate
money in an alternative, but comparable, investment. The ideas regarding new businesses the company should enter,
cost of capital exactly reflects the riskiness of the money other companies it might acquire, and ways to modify its
expected back from the capital investment. The mathe- existing businesses to achieve greater profitability. Strate-
matical methods used to calculate present values are called gic planning is a critical element in the capital investment
the time value of money and are explained in more detail process. The processes complement one another. The top-
in the books in the bibliography. down process generates ideas of a broader, more strategic
nature, whereas the bottom-up process generates ideas of
Net present value (NPV). A capital investment’s net pres- a more project-specific nature.
ent value (NPV) is the amount of value the company In addition, many companies have a research and
expects the investment to create. The NPV equals the sum development (R&D) group, either within a production
of the present values of all of the money expected back division or as a separate department. An R&D group
from the investment minus the investment’s cost. often provides new ideas for products that can be sent on
to a marketing research department.
MAKING CAPITAL INVESTMENTS
The capital investment process includes the following: Classifying Capital Investments. Analysis costs money.
Therefore, certain types of investments receive only cur-
1. Generating ideas for capital investments sory checks before approval, whereas others are subjected
2. Classifying capital investments to extensive analysis. Generally, less costly and more rou-
tine investments are subjected to less extensive evaluation.
3. Evaluating and choosing proposed capital invest-
ments As a result, companies typically categorize investments
and analyze them at the level judged appropriate to their
category. Potential investments in each category may have
Generating Ideas. The first, and most important, part of
a lot in common and are able to be analyzed similarly. A
the capital investment process is generating new ideas. useful set of investment classifications is:
Ideas for capital investments can originate anywhere in a
company. Often plant managers are responsible for iden- Maintenance projects
tifying potential projects that will enable their plants to
Cost-saving/revenue-enhancement projects
operate on a different scale or on a more efficient basis.
For instance, a plant manager might suggest adding Capacity expansions in current businesses
10,000 square feet of production space to a plant or New products and new businesses
replacing a piece of equipment with a newer, more effi- Projects required by government regulation or com-
cient machine. Ideas for better types of equipment that pany policy
can help the company operate more efficiently may come
from individuals on the plant floor. After screening out Maintenance expenditures: At the most basic level, a
undesirable ideas, managers send the ones that appear to company must make certain investments to continue to
be attractive to the divisional level, with supporting docu- be a healthy, profitable business. Replacing worn-out or
mentation. damaged equipment is necessary to continue in business.
Division management not only reviews such propos- Therefore, the major questions concerning such invest-
als but also adds ideas of its own. For example, division ments are “Should we continue in this business?” and if
management may propose the introduction of a new so, “Should we continue to use the same production

72 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION