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Capital Budgeting Across Business Units

(updated 2021) 

To gain perspective on the choices of a large corporation, their budgeting process, and how (or if) they manage to avoid various measurement pitfalls, an interview was completed with the Facilities Manager of one Strategic Business Unit (SBU) of a Fortune 500 Corporation.

The Interview
His Capital Budgeting responsibility begins with a presentation of the site's needs assessment and a “wish list.” His responsibility terminates with the actual conclusion of the various projects’ execution. At this level, the Capital Budget is split into two categories, Major Capital Projects and Local Capital Budgeting.

Major Capital projects (over .5 million) are decided as a SBU. Individual sites compete with one another for funding of these projects and the decision criteria for funding are 1) business needs and 2) Return on Investment.

For Local Capital Budgeting, each site receives funding for improvements based on a certain percentage of the site’s value. Individual projects are prioritized by the greatest need. These projects are further broken down into two more categories, Infrastructure and Process Improvement. An infrastructure project includes safety, environmental, capital replacements, and energy saving projects while process improvements are primarily cost reductions. Infrastructure projects may take precedence over Process Improvement if it is a question of compliance.

Net Present Value (NPV) analysis is performed, and the Internal Rate of Return (IRR) is also examined.

In analyzing Company X’s methodologies, there are four areas we found of particular interest:
  • The use of a hierarchy in the decision-making for projects over .5 million.
  • The competitive element of the decision-making process.
  • The use of a percentage of site value as a determinant for the Local Capital Budget.
  • The use of the NPV method in conjunction with IRR for judgment of project attractiveness.
The fact that there is a hierarchal decision-making process for projects that cost more than .5 million is of benefit to the company. In this manner the risk of mis-management is reduced. The problems of conflict of interest, empire building, entrenching investment, and risk avoidance are reduced within the organization. Utilizing a competitive element in the process encourages management to put their best foot forward, and further reducing the potential for agency costs.

By utilizing a percentage of site value as a factor for Local Capital Budgeting it would seem that older sites are at a disadvantage, thereby leading to less funding. For infrastructure purposes in particular, an older site may require the most funding. The following clarification was provided:

“The factor that’s used is ERV (estimated replacement value)”. That levels the playing field in that it allows each site to get about the same percentage based on what it would cost to replace the site in total, in today’s dollars, with today’s technology. It’s not a good practical measuring stick as much as it is a good comparison tool. Being a financial tool and not an engineering or construction value measuring tool, the actual value of a site would be much more than what is provided using ERV. Older sites that have not kept up with year-to-year infrastructure needs are at a disadvantage. That’s why from day one of a facility’s existence it is important to plan for and to initiate modernization and renewal activities.”

From this statement it is interesting to note that although the use of ERV fulfills the need to provide an equitable financial measure, from the perspective of the Facilities Manager the tool does not provide an accurate measure of site value.

Like many organizations, Company X recognizes that NPV analysis provides an unbiased way to evaluate projects by taking into account both the time value of money and the opportunity cost of capital. By discounting anticipated cash flows at an appropriate hurdle rate, the site can objectively consider multiple projects side-by-side. This is especially important for mutually exclusive investments where the site must choose between competing projects.

With NPV as the key driver for project acceptability it is a constructive methodology to utilize IRR after NPV analysis. Although IRR can be misleading in the evaluation of mutually exclusive projects, it provides the percentage return on each dollar invested in a project. Employing IRR in this manner, giving it secondary consideration, avoids the associated problems and adds value to the decision- making process.

”Although the statement, “the psychology of financial matters,” will feel like an oxymoron, it’s actually a fairly accurate reflection of reality. At first assumption, finance seems as if it should be an objective and logical science. But, derivatives of mathematics do not necessarily retain all of the same characteristics as the parent. Like most derivatives, the ultimate behavior is inextricably tied to human behaviors.”

- Psychology of Finance

Categorically splitting the Capital Budget and utilizing a hierarchy in the decision-making for Major Capital Projects is a sound method for ensuring reduction in agency costs. The competitive element of the process further enforces diminished agency costs. Utilizing ERV as a determinant for the Local Capital Budget is a useful financial tool that ensures all sites receive equal valuation. However, it is not necessarily an adequate method for deciding actual project implementation. The use of NPV in conjunction with IRR is an appropriate method. NPV allows the site to determine in absolute terms the value in today’s dollars of a given project. By utilizing IRR on a project-by-project basis and not as a comparison tool across projects, common pitfalls are avoided and the greatest benefit is attained.

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