Testimony for the President's Commission to Study Capital Budgeting
 
Richard M. Swanson, Jr.
Executive Director
Institute of Management Accountants
New York City -- May 8, 1998
 
INTRODUCTION

Good morning ladies and gentlemen: I am pleased to be here this morning to share my thoughts and insights on the subject of capital budgeting as it is practiced in the private sector. I have prepared some brief comments, after which I would be happy to take your questions, or take part in a discussion, as you wish.

To help you put my comments in perspective, I thought I should briefly go over my professional background and qualifications as they may relate to this subject.

I am currently the Executive Director of the Institute of Management Accountants. IMA is the world's largest association devoted exclusively to management accounting and financial management professionals, with approximately 78 thousand members in several hundred chapters and international affiliates. Founded in 1919 as an educational organization, the IMA originally focused on expanding the knowledge and professionalism of people specifically interested in cost accounting. Through the years, IMA has broadened its professional scope, which today covers virtually all aspects of the corporate financial organization. Our members include corporate finance professionals, managers and executives, as well as academicians, government financial professionals and students.

I came to IMA after spending over 20 years in the for-profit corporate sector. During that period, I served in a number of financial professional and executive positions in the US, Latin America and Europe. My experience covers several capital intensive businesses and industries, and includes a number of positions wherein I was directly involved in, and/or responsible for, the capital budgeting process. That involvement ranged from the development of capital budgeting policies and procedures, through the financial and strategic evaluation of individual capital projects as well as merger and acquisition opportunities. I have also been involved in several divestiture situations, which can be thought of as capital expenditures in reverse.

I received my business education at the University of Michigan, where I concentrated in finance and economics.

Finally, I must state that the opinions I offer here today are mine alone, and should not be taken to be necessarily those of the IMA or any of its members.

DEFINITION

Capital budgeting is an element of the strategic planning process in a firm. It is grounded on answers to the fundamental questions: what do we want this company to be and how do we intend to make that happen? My remarks will speak to the process as it picks up after the answers to these questions have been agreed.

The capital budgeting process involves balancing capital spending choices, which I will refer to as "projects", against available funding. By practical necessity, I will discuss the two sides of this balance separately. In reality, however, they are interdependent.

Capital spending projects include, in principal, any expenditure the return on which is expected to occur in future periods; as distinct from operating expenditures the return on which will be essentially current. In practice, the line between these two can be hard to see, in that one can well argue that the vast bulk of expenditures any business makes are, or should be in one way or the other, for the sake of future earnings.

For practicality then, companies establish objective definitions for how to make the split between capital and operating expenditures and budgets, the most popular of which is to follow the rules of generally accepted accounting principles. If an expenditure will be capitalized in the books, it is subject to the capital budgeting process, if not, it is handled through the operating budget. Some of the typical exceptions to that rule can include R&D or major software development expenditures, which must generally be expensed under GAAP, but occasionally are evaluated and budgeted as if they were capital expenditures. Finally, there are what are sometimes called "programs", involving commitments to spend significant funds, typically over an extended period, in pursuit of a particular business strategy. Some or all of these expenditures may be booked as current expenses but the total program itself will nevertheless be evaluated and budgeted as if it were a single capital expenditure decision.

THE RANKING PROCESS - RETURN vs. RISK

The budgeting process is essentially a ranking exercise. Candidate projects are ranked and a cut-off point is determined based on factors such as available funding or financial performance threshold. Relative ranking is based on a mixture of qualitative and quantitative risk and return assessments; the return side being typically the more quantitatively measured of the two.

Finance textbooks contain a number of methodologies for determining financial returns, ranging from relatively simple concepts such as payback and return on investment, to more complex models incorporating the time value of money, shareholder value concepts and explicit quantification of risk. I won't go into details on these now, but would be happy to come back to this area during the question and answer period. Suffice to say that all are used in one company and/or situation or another. My experience is that the corporate world's level of sophistication in terms of the analyses and models used has been growing over recent years, and is particularly high in the case of major projects within large corporations.

Risk is generally evaluated on a somewhat subjective basis, but nevertheless plays a major role in the decision process as to whether or not to fund a particular project, or in determining where a given project fits on the relative ranking scale.

Again, I would be happy to discuss this element more during the Q&A session, but for now let me just touch on some of the factors that impact on the assessment of a project's risk. By risk, I'm referring to variability of return, or as is generally the focus within corporate America, the chance that the project will fall short of satisfactory financial results.

Starting at the low-risk end of the scale are the "necessity" projects; those required to stay in business because of legal, regulatory or safety concerns. The "risk" in these types of projects is the chance that the business turns out to have not been worth remaining in, or that the objective of the expenditure will not be realized due to things like engineering shortcomings or regulatory creep. Basically, in any reasonably healthy business, "necessity" projects don't have any serious problem getting funded.

Next come the process improvement projects. These lower costs and don't require new sales to earn their projected returns.

In general, any time a project's returns are heavily dependent on things the enterprise's management can control or at least heavily influence, the risk will be lower and, all else equal, the project more attractive. Since cost tends to be more controllable than revenues, cost improvement projects are considered less risky.

As we move into project categories wherein new revenues are the source of a project's earnings, the projects become more risky. In increasing order of riskiness then, are projects depending on higher selling prices, increased market share, and penetration into new markets -- product innovation rather than process innovation. Finally, probably the riskiest capital any business ever spends is that which is required to get into whole new businesses or industries. For that reason, such diversification is typically accomplished through acquisition of an existing company or business.

FUNDING

Now I'll make some brief comments on the issue of funding and the limits it may place on capital expenditures.

In theory, the vast and liquid capital markets are such that any project expected to earn at least its cost of capital will find investors willing to fund it. By this theory, no business is capital constrained and is free to invest in any project that is financially attractive. In such a world, there would be no capital "budget" per se, just an analytical effort to determine whether or not a particular project is expected to reach the cost of capital threshold. This is reasonably close to what one sees in the case of emerging high-growth industries and companies. Funding limits are a function of management's credibility in the eyes of the debt and equity markets, based on track record, promising products, or technology; not to say: "hype".

For most of industry, however, management does generally feel that capital is a scarce resource within the firm, and most established corporations prefer to limit themselves to those capital expenditures which can be financed with internally generated funds. Typically, companies have financial policies which include target debt-equity ratios and dividend objectives. These policies, when applied to the specifics of a company's financial performance, produce a determinable amount which will be available for capital expenditures over any given period. Simply stated, earnings plus depreciation minus dividends equals cash flow available for investment.

The significance of this equation is that to maintain a steady state, neither growing or shrinking and disregarding the effects of inflation, a company will make annual capital expenditures equal to its annual depreciation. In this instance, all earnings are available for distribution to shareholders. On the other hand, either inflation or an objective of real growth will require that some level of earnings be retained.

CONCLUSION

In summary the process works as follows: 1) a strategic plan leads to identification of capital projects which will support that plan; 2) the projects are evaluated according to risk and return, and lined up against available funding; 3) those which cannot be justified against the risk return criteria or don't make the cut in terms of available funds are not approved.

If projects necessary to support the strategy are rejected in this process, something has to give: either strategies themselves need to change, the implementation plan needs to be redrawn, or the firm's financial policies need to be modified to allow for the extra funding.

This concludes my prepared remarks. I would be happy to try to answer your questions.


President's Commission to Study Capital Budgeting