Chapter 11 The Basics of Capital Budgeting 337executives in marketing, production, and! nance, identi! es the products and mar-
kets in which our company should compete, and the Committee sets long-run
targets for each division. These targets, which are spelled out in the corporation’s
strategic business plan, provide a general guide to the operating executives
who must meet them. The operating executives then seek new products, set expan-
sion plans for existing products, and look for ways to reduce production and dis-
tribution costs. Since bonuses and promotions are based on each unit’s ability to
meet or exceed its targets, these economic incentives encourage our operating ex-
ecutives to seek out pro! table investment opportunities.
While our senior executives are judged and rewarded on the basis of how well
their units perform, people further down the line are given bonuses and stock
options for suggestions that lead to pro! table investments. Additionally, a per-
centage of our corporate pro! t is set aside for distribution to nonexecutive
employees, and we have an Employees’ Stock Ownership Plan (ESOP) to provide
further incentives. Our objective is to encourage employees at all levels to keep an
eye out for good ideas, especially those that lead to capital investments.
Analyzing capital expenditure proposals is not costless—bene! ts can be
gained, but analysis does have a cost. For certain types of projects, an extremely
detailed analysis may be warranted, while for other projects, simpler procedures
are adequate. Accordingly,! rms generally categorize projects and then analyze
them in each category somewhat differently:
- Replacement: needed to continue current operations. One category consists of
expenditures to replace worn-out or damaged equipment required in the
production of pro! table products. The only questions here are should the
operation be continued and if so, should the! rm continue to use the same
production processes? If the answers are yes, the project will be approved
without going through an elaborate decision process. - Replacement: cost reduction. This category includes expenditures to replace ser-
viceable but obsolete equipment and thereby to lower costs. These decisions
are discretionary, and a fairly detailed analysis is generally required. - Expansion of existing products or markets. These are expenditures to increase out-
put of existing products or to expand retail outlets or distribution facilities in
markets now being served. Expansion decisions are more complex because
they require an explicit forecast of growth in demand, so a more detailed analy-
sis is required. The go/no-go decision is generally made at a higher level
within the! rm. - Expansion into new products or markets. These investments relate to new prod-
ucts or geographic areas, and they involve strategic decisions that could
change the fundamental nature of the business. Invariably, a detailed analysis
is required, and the! nal decision is generally made at the top level of
management. - Safety and/or environmental projects. Expenditures necessary to comply with
government orders, labor agreements, or insurance policy terms fall into this
category. How these projects are handled depends on their size, with small
ones being treated much like the Category 1 projects. - Other projects. This catch-all includes items such as of! ce buildings, parking
lots, and executive aircraft. How they are handled varies among companies. - Mergers. In a merger, one! rm buys another one. Buying a whole! rm is differ-
ent from buying an asset such as a machine or investing in a new airplane, but
the same principles are involved. The concepts of capital budgeting underlie
merger analysis.
In general, relatively simple calculations, and only a few supporting documents,
are required for replacement decisions, especially maintenance investments in
Strategic Business Plan
A long-run plan that
outlines in broad terms the
firm’s basic strategy for
the next 5 to 10 years.Strategic Business Plan
A long-run plan that
outlines in broad terms the
firm’s basic strategy for
the next 5 to 10 years.