A Follow-up Note on Capital Budgeting 261Sound financial analysis ties the details of strategy to financial implications. It is hard to convince executives
from non-financial backgrounds that it is possible to capture the value of any strategy in rupee terms and that
it is nothing qualitative. Capital budgeting in many companies is simply an exercise in finding an input value
that gives the required output.^2 Strategic investments usually open up options that extend beyond the original
projects. Options stemming from investment in R&D, brand names have value beyond the initial investment
period as they open up opportunities to create subsequent products that complement existing ones. The usual
DCF methodology breaks down when applied to multi-stage options on real assets.In fact, the option pricing
formula doesn’t resemble DCF formula in any way. This explains why strategic investments, most of the
time, fail to pass the DCF test leading to conflict between marketing and finance.
Capital Budgeting in Japanese firms^3
It is interesting to note that most Japanese manufacturers including large sophisticated firms make little or
no use of NPV or IRR in evaluating investments. Apparently, they are more willing to undertake risky, long
term investments. Instead of the standard DCF procedures, a vast majority of Japanese firms use a one-year
ROI calculation. The project’s accounting income for a typical year is calculated and then divided by the
initial investment. Many firms calculate payback period. These calculations are relatively crude. The reason
for the simplified approach might be the emphasis on consensus decision-making in Japan. The process
involves discussions among executives from different areas and levels within the firm. The process helps in
identifying questionable assumptions, different project structures and strategies. Since the managers who
actually run the project are involved in the investment analysis, they tend to be aware of the critical factors
for success. Many Japanese firms use a relatively low discount rate. The prime rate or the before-tax cost of
borrowing is commonly used as discount rate. There is no use of risk-adjusted discount rates.
Capital Budgeting in US firms^4
Managers in the US use multiple evaluation techniques. For instance, ROI may be supplemented with DCF
procedure. Analyses are done using nominal discount rates. Using risk adjusted discount rates for projects
with different risk characteristics is also quite popular. It is common practice for hurdle rates to be specified on
a divisional or company wide basis using a current cost of capital. Unlike Japanese managers, US firms do
not subscribe to the consensus decision-making practice. The detailed project analysis is typically done by a
small group of executives who then forward results and recommendation to top management. In many firms
there is relatively less outside inputs for project evaluation. Many firms apply a discount rate of 30 percent
for long-term projects.
(^2) Barwise, Patrick, Paul R Marsh, and Robin Wensley (1989). ‘Must Finance and Strategy Clash?’, Harvard Business
Review, Sep–Oct.
(^3) Hodder, James E (1986). ‘Evaluation of Manufacturing Investments: A Comparison of US and Japanese Practices’,
Financial Management.
(^4) Survey results of practices in America could be found in: Oblak, D J and R J Helm (1980). ‘Survey and Analysis of
Capital Budgeting Methods used by Multinationals’, Financial Management, Winter; Schall, L D, G L Sundem, and
W R Geijsbeek Jr (1978). ‘Survey and Analysis of Capital Budgeting Methods’, Journal of Finance, March.