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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.
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