MSG Team's other articles

11379 Step Up Bonds: Pros and Cons

Step-up bonds are special types of fixed income instruments. They help investors partially offset the risks of rising interest rates. This is because when investors invest in a bond, they typically lock in an interest rate. If the interest rate rises beyond that number, then the investors are at a loss because their money has […]

10577 Payment in Kind Bonds – Advantages, Disadvantages and its Types

In the past few articles, we have studied about different types of coupon payments. These coupon payments vary from each other a great deal. However, they all have one thing in common which is the fact that the interest is always paid in cash. However, payment in cash need not always be the case. There […]

10686 Pre Money and Post Money Valuation

Startup valuation is one of the most important issues faced by startup companies in their earlier years. On the one hand, these startup companies are trying to maximize their valuation while giving over a minimum amount of ownership to the investors. Investors on the other hand want to obtain the maximum stock possible. The interests […]

11254 Shadow Banking – Meaning, Functions, Advantages & Disadvantages

Banking is perhaps the most regulated industry on the planet. The movement of funds in and out of the banking system is monitored by governments as well as regulators. However, competitive pressures force banks to undertake more risks and if possible earn a higher rate on their investments. This is what creates a parallel financial […]

11343 The Solicitation Process

The disclosure statement is only the first step in the bankruptcy process. After the solicitation statement has been approved by the court, the ground is set for the negotiations to begin. This is a complicated stage. This is where stakeholders often form groups to connive against the others, and horse-trading takes place. The solicitation process […]

Search with tags

  • No tags available.

The capital budgeting process is at the heart of the financial decision-making which takes place in any organization. However, up until now, the capital budgeting decision has been considered to be a financial decision. As a result, the evaluation of projects and the capital allocation process are based on discounted cash flow analysis.

Many organizations have found this process to be insufficient. This is because the discounted cash flow analysis can be completely decoupled from the strategy formation and implementation process. As a result, the discounted cash flow approach may suggest projects which are not in line with the company’s strategy in the long run.

As a result of this criticism, many organizations are trying to create a linkage between their strategic decision-making and financial decision-making. This is being called strategic capital budgeting. In this article, we will have a closer look at what the strategic capital budgeting process is and how it is different from traditional capital budgeting.

Real Options Analysis: The biggest problem with capital budgeting is that it assumes a static environment. Under the assumptions of the model, the decisions can be undone midway and the financial loss to the organization is limited. However, this is not the case. There are some business models which may be more scalable in the long run. Such business models may have a lower net present value or internal rate of return in the short run. However, they are a more efficient way to increase the value of the firm. This is because they allow the company to conduct a small-scale pilot.

Once the pilot has become successful, resources can be routed to the project and tremendous scale can be achieved within a short period of time. This is the reason that the options provided by a project should also be valued and included in the decision-making process. The venture capitalists of the world are already using this practice. This is the reason why they tend to invest in asset-light high-tech businesses since they require less upfront investment and can be scaled rather quickly. The valuation of these options inbuilt in a project can be done using the approach to value financial options. Many companies have already started integrating the real options approach in their decision-making process.

Value Chain Analysis: Another big problem with the capital budgeting tool is that it does not look at the business in the form of a value chain. As far as the discounted cash flow model is concerned, the business model of any firm can be expressed in the form of net present value. However, this is not true.

A business model is considered to be more stable if the firm has more bargaining power with its suppliers and customers. This is the reason that projects which involve either vertical or horizontal integration are considered to be strategically important. This is because they reduce the dependence on external suppliers.

For instance, a company manufacturing mobile phones can also start manufacturing its own processors in order to reduce the dependence on external suppliers. This is the reason that from a strategic point of view, these projects are considered to be important and are given a higher preference even if the net present value provided by them is lower.

Technology Benchmarking: Capital budgeting also does not take into account the technology which is being used in a project. In the modern world, businesses are only able to survive only if they use advanced technology. It is for this reason that companies should prefer projects which improve the level of technology that they use even if such projects provide a lesser rate of return in the short run.

It is important for companies all over the world to constantly benchmark their technical systems against their competitors. Being able to do so, makes them realize whether they are lagging from a technical point of view. The focus should be on improving the technology in small incremental gains instead of focusing on quantum leaps which may be expensive and inconvenient to implement.

Change Management: The capital budgeting approach does not take into account that there is a culture that has been inbuilt within a company. There are certain ways of doing things and accomplishing goals which people in the organization are familiar with. If these ways are changed suddenly, the organization might have to undertake change management.

Change management can be a challenging, expensive as well as time-consuming process. Hence, it is important to consider this factor while deciding what projects need to be undertaken. The company must strategically decide the type of culture they want to build and must reinforce it at various steps.

Balanced Scorecard Approach: The strategic capital budgeting approach states that it is incorrect to choose a project-based only on financial parameters. Hence, the balanced scorecard approach has been recommended because this approach allows for assigning weights to different criteria and coming up with a composite score. This composite score derived after taking into account financial as well as strategic factors should be the basis for decision making.

The bottom line is that the capital budgeting approach used by finance managers is not enough within itself. There is a need for a more long-term and strategic approach which is provided by strategic capital budgeting.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

Strategic Finance and the Outsourcing Decision

MSG Team

The Strategic Financial Planning Process

MSG Team

What is Strategic Budgeting?

MSG Team