258 Corporate Finance
which is their opportunity cost (the return they can earn on comparable investments). Theoretically it is correct
to take the investors’ expected return as the cost of equity. An equity investor has many alternatives and can
diversify in a broad range of investments. But a company cannot diversify, at least in the short run, from say,
paper to steel to aircraft. In fact, it might not be possible to diversify at all due to technical reasons. So
Donaldson (1972) argues that the relevant opportunity cost for the company is not that of the shareholder but
that of the company itself. The hurdle rate could be what the company can earn on the company’s alternatives.
It is often argued that if the company cannot find attractive investments it should return cash to stockholders.
But this does not happen in reality. A company in a declining market will not return cash, but will strive to
revitalize product lines and grow. It is useful to classify investments as tactical and strategic. Tactical investment
decisions are concerned with the near future and strategic decisions are concerned with change for a major trans-
formation. He suggests that a tier of hurdle rates be constructed and applied to investments depending on their
nature. For tactical decisions, the appropriate standard could be the performance of the most efficient com-
petitor. For strategic investments, the hurdle rate could be the return a competing division with the best track
record is earning or the return the company can earn on new businesses.
Administrative Process
Success in investment decisions depends not only on techniques but also on people and the process of generating,
evaluating and implementing investments. The starting point for an organization is a long-term plan. The
long-term plan can be exploded into investment ideas. The planning period typically spans five years. The plan
integrates sales and cost projections, operating and capital investment needs. Specific guidelines translate
long-term goals into specific investment proposals. Guidelines provide a frame of reference for everyone in
the organization. They reflect the organization’s policy and strategic thrust, what the firm intends to do in
terms of both internal and external expansion, what product markets it intends to serve, etc. Guidelines should
ensure adherence from all executives. At the same time, it should not discourage unconventional thinking.
Guidelines can be classified as long term and short term. Long-term guidelines deal with growth objectives
whereas short-term guidelines deal with projections regarding sales, input prices, etc.
Preparing Budgets
Executives are typically asked to put their ideas on paper, with specific capital investment plans. The result
is a capital budget. It serves as an initial screening device, and those that pass through the initial screen are
taken up for greater scrutiny. If a time-limit is given for capital expenditure plans, ideas that arrive later in
the budget cycle may be rejected. So a budget should be flexible enough. Project proposals typically go through
several levels before they are accepted. Decentralization reduces the time spent on project approval.
Allocating Funds
Appropriate allocation of funds is essential as it decides the future of the company. So a sound basis for
allocating funds should be evolved. The allocation could be based on mission, product portfolio, geographic
area of operations and competence.^1 Mission is fundamental to any company. It reflects the fundamental
(^1) Tiles, Seymour (1966). ‘Strategies for Allocating Funds’, Harvard Business Review, Jan–Feb.