Which is better for your firm? Invest prodigious amounts of capital or scale back on capital investment? Reduce employment to raise the dollar amount of assets at work per employee or elevate employment to meet the demands created by new investments? Questions like these confront all senior managers as they formulate strategic plans and allocate capital. The questions become more compelling as investors demand that corporations consistently deliver shareholder value regardless of their long-term strategy for deploying human and financial capital.
An important factor that distinguishes the winners from the losers in creating shareholder value is the quality of investment decisions, which, in turn, depends on the soundness of a firm’s capital budgeting system. Unfortunately, the history of corporate America is littered with examples of poor investment decisions, ranging from investing too little in positive NPV (net present value) projects and too much in negative NPV projects to investment myopia.1 Such distortions can distract companies from what they do best, causing them to sink millions of dollars in the wrong products and ideas. For instance, Coca-Cola invested in pastas and wines, products for which its rates of return were not only well below those of its core soft-drinks business, but also below its cost of capital. Such errors deplete shareholder value and lead to corporate control contests that result in CEO replacements and hostile takeovers.
Despite the obvious consequences of misallocating capital and human resources, why do companies continue to blunder? We believe it is because they have flawed capital budgeting systems, which they apparently fail to recognize. Some firms sense the weaknesses in their capital budgeting analyses but view them as individual problems rather than systemic deficiencies. They misdirect efforts to redress mistakes and produce greater frustration. As a result, corporate strategy and capital allocation become misaligned and remain so despite disappointing financial performance. Senior management then gets the blame for failing to provide the appropriate leadership and strategic guidance.
Our goal is to present a framework that senior managers can use to allocate capital. The framework explicitly recognizes that capital budgeting cannot be the exclusive domain of financial analysts and accountants but is a multifunctional task that must be integrated with a firm’s overall strategy. Our capital budgeting framework has six key features, each indispensable (see