Tie Your Capital Budget to Your Strategic Plan

A. Introduction
§ Upgrade the equipment to support a product that was in the mature stage → possibly approaching a point where it would be phased out
§ Capital assets decisions → the most irrevocable long-range activities because:
i. Involve significant corporate funding
ii. The least flexible in terms of changing the strategic direction of the business
iii. The least flexible for conversion into more liquid assets
iv. May geographically impact the long-term raw material supply capabilities of the business
v. May geographically impact the business’s long-term customer access
vi. Involve decisions about assets that are unique to the company
§ Unique features of capital assets → represent the source of a company’s product individuality and position in the market place

B. Defining the Strategic Plan
§ Strategic plan must be a living document that:
i. Managers keep it
ii. Easily updated → depend on events
iii. Requires management explanation when the projection aren’t met → can be adjusted
iv. Represent management’s philosophy of managing with a planning process →the product is the plan; the process is the interaction → employees and management → that takes to develop the plan
v. Reflect the corporate leadership’s visions of the company’s future
vi. Supported with individual functional plans
vii. Contains objectives → specific measurable results that outline exactly what should be accomplished in a given time frame
viii. Identifies the strategies → How, where, and when of resource commitment to achieve objectives
§ Strategic plan → focus on customers needs then business capabilities to meet those needs with its products and services

C. Building the Plan
The strategic plans contains
§ Corporate mission → company purpose
§ Where the business wants to be in the future
§ How it plans to get there
§ It identifies guidelines for targeting the corporate market
§ It identifies the corporate organizational features

D. Managing the Assets
§ Develop the strategic plans → need to look at the fixed assets
§ Stages of asset management:
i. Companies acquire new physical assets → operating management determines the plant facilities are inadequate → for growth or corporate citizenship → acquisition include:
a. Equipment replacement expenditures
b. Expansion investment
c. Investment to support strategic improvements → existing or new product
ii. Maintenance → management should be concerned about the potential for piecemeal maintenance programs for older facilities
iii. Disposition of assets → get rid of assets when it still has value → both company (acquired or sell) can get benefit
a. The goal → to ensure the assets will fully utilized and support management’s strategic vision

E. Some Common Evaluation Techniques
§ Payback period
i. Its strengths
a. Simplicity
b. Identifying the time required to return the money
ii. Its weakness
a. It ignores the time value of money
b. The cash outflows after the payback period
§ Average Annual Rate on Investment
i. Its advantages
a. The consideration of the full income of the project
b. The ease of locating comparable data later in the accounting records
ii. Its Disadvantages
a. Failure to consider time value of money
b. Influence of inflation
§ Present Value method
i. Its Disadvantages
a. Difficult to compute
b. Management must select the discount rate
c. Result may be misleading when comparing projects
§ Discounted Cash Flow method
i. Its advantages
a. Consideration of time value of money
b. Consideration of all project’s cash flow
c. Results are easily understood
d. Compensates of unequal lives and cash flow
ii. Its Disadvantages
a. Difficult to compute
b. Implication that the cash can be reinvested at the internal rate of interest
§ Purchase vs. Lease

F. Is the Program Effective?
Key measurements that will keep the program viable and effective
§ Periodically review all capital asset acquisition project to make sure you still need them
§ Review the project to see if the initial planning projections were on target
§ Continuously review all capital acquisition expenditures to make sure that all assets are being acquired according to the strategic plan

G. The Capital Budget
§ Capital budget → portion of strategic plan; select which assets you should acquire; allocates available resources; based on quantitative and qualitative evaluation; determine the best investment
§ Corporate decision-making process:
i. Defining and communicating a firm’s long-range and strategic plans and goals
ii. Developing a system → permits gathering and ranking of company proposals
iii. Determining the accuracy of the estimates that will be used in the estimation of rate of return calculation
iv. Determine and assign levels of risk probabilities to each investment proposals

H. Effective Implementation is Key
§ Driving force of any strategic plan is its effective implementation
§ Develop the corporate strategic plan assumption → next step is to merge this information to the various functional plans and link all short-term and long-term plans
§ The prime decision-making factors of the capital program should be
i. The time value of money
ii. The cost of capital
iii. The inherent risk of each project/proposal
§ Fixed assets → long-term present-dollar commitments that will be used over a long period of time in the normal course of business