Capital Investment Decisions – Process

Effective capital investment decisions must allocate constrained resources (cash) to projects that will return a positive cash flow over a time horizon dictated by an owner or by corporate policy.  You might hear the term hurdle rate used by your financial department or banker.  The hurdle rate is the minimum rate that your company expects to earn when investing in a project. The hurdle rate is also referred to as the company’s required rate of return (ROI) or target rate. Typically a project’s internal rate of return must equal or exceed the hurdle rate.  When there are multiple demands for cash for example, a new marketing campaign, geographic expansion plans, a need for additional production capacity, replacement of outdated or high maintenance equipment, each project will be prioritized depending on the cash they generate over a predetermined time frame.  The time frame will play an important role if the company is currently focused on projects that provide prompt returns versus projects which will contribute to future growth.  The factors below will influence capital investment decisions:

  • Management’s outlook (positive or negative)
  • Opportunities due to technological improvements
  • What the competitor is doing
  • Changing customer requirements
  • Cash flow budget
  • Economic forecast
  • Other non-financial factors

You want to avoid reaching a capital investment decision subjectively then apply financial metrics in an attempt to rationalize the decision.  As I referred to in a previous discussion, internal politics can play a role in subjective decisions when individuals or groups have a personal interest in certain projects.  The capital investment process usually involves the following seven steps:

  • Project identification
  • Project definition
  • Analyze the project benefits (financial and non-financial)
  • Approve capital investment
  • Implement the project
  • Project management
  • Audit and report actual benefits versus assumptions

I will dig deeper into each of these steps in my future discussions.  As I discuss each step I will post user friendly templates on our website that can help improve your capital investment decision process.

Capital Investment Decisions

My first job out of school was analyzing and shepherding ‘Authorization For Expenditure’ packages (Capital Equipment Requests) from executive to executive at Daimler.  Each executive depending on which part of the company they were responsible for, looked at these requests differently.  Each required financial justifications that they were comfortable with and each had their own pet peeves.  Organization politics also played a prominent role when individuals or groups had a personal interest in certain projects.  This would sometimes increase the number of obstacles, the amount of information required, and how long it might sit on some ones desk.  This was long before task management software was fashionable so most of my interactions were face to face.

What I learned from these personal interactions was the need to leave nothing to chance when it came to the information I prepared to support of the funding request.  An incomplete submission, or not including information a particular executive was looking for, meant a long walk back to the financial department bullpen for a redo.

I took these lessons with me throughout my career to where I am today, as an owner of a capital equipment manufacturer.  The goal of these posts are to help you develop your own capital spending request whether you own a twenty person machine shop or you are where I was early in my career at a Fortune 500 company.   Future topics will include: capital evaluation techniques, investment plan development, financial modeling, economic analysis guidelines, new versus used equipment, finance methods, and tax strategies.  As I move through these topics I will post user friendly templates on our website and welcome questions that might develop.