Capital Budgeting
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Some industries are de-integrated such that the design of products and technologies occurs across the boundaries of firms and other legally separate entities. There are important consequences for capital budgeting. Write an essay explaining how capital budgeting practices may be affected when investments need to be coordinated and integrated at inter-firm and inter-organizational levels. Take care to illustrate your answer by reference to relevant case studies and readings.
Capital expense is a cash outlay for projects or investments that are expected to produce a cash inflow or benefits over a period of time usually exceeding one year. Examples of projects include investments in property, plant, and equipment, research and development projects, large advertising campaigns, or any other project that requires a capital expenditure and generates an expected cash flow. They are potentially large and irreversible outlays. As capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project selection, which is so called capital budgeting. Potentially, there is a wide range of criteria for selecting projects and implementing them. Some shareholders may wish the firm to choose projects that will show immediate increase in cash inflows, and some may want to emphasise long-term growth with little importance on short termism. It would be quite difficult to satisfy the differing interests of all the shareholders. Therefore, the ultimate goal is to maximise present value of the firm and it is the reason for firms always carry out discounted cash flow (DCF) and net present vale (NPV) to convince investors.
Traditionally, firms have operated under mass production within its own enterprise, producing products and services at its lowest costs possible. By achieving it, firms aimed at expanding itself to become larger and larger in order to take advantage on the economies of scales. Everything has been operated under restrictive procedures, according to Max Weber, this was known as bureaucratic organisations and it was crucial to any organisation. However, firms, under this system, were usually not responsive enough to the changing of environment or its customersÐŽ¦ tastes, as the production was operating and flowing through assembly lines, where the operations were set into the programs in advanced. If firm wanted to make a minor changes in their production line to satisfy individual customer, this was unlikely to happen unless all the assembly lines had stopped in order to make the adjustment on the programs. This weakness has forced firms to make fundamental changes later on when people become demanding more than ever and if firms want to be more efficient to tackle the rapid change of environment. Under bureaucratic policy, the capital budgeting practices were highly centralised. Investment decisions were appraised and evaluated by the top management after all departments have done the thorough research and analysis on the feasibility of investments. Usually, it took a long time before the final agreement was met.
In the 1980s and 1990s, firms have shifted to synchronous flow systems from mass production due to the inefficiency, inflexibility and low quality of production. Those weaknesses have definitely dampened firmsÐŽ¦ capability on reaping profits, especially when people become more aware of quality and costs. Coincidently, the emergence of information technology occurred. Therefore, a fundamental and crucial change took place. As a result of the help from Internet, communication technologies, firms can de-integrate its production within firms and across boundaries of firms by using methodologies like supply chain management and collaborative commerce. This can help firms to improve their competitiveness and eliminate the difficulties on low velocity of material flow, inflexible technologies and high cost of quality, which they have been suffering from under the mass production since 1980s. Therefore, firms can produce products or services according to specific customersÐŽ¦ needs.
De-integrated firms are those who divide all its stages of production into smaller units or tasks and empower their employees, suppliers in different departments to be responsible for the specific tasks by those who have comparative advantages among others. Using technology like Internet, it enables firms setting up network systems with their internal and external parties, in order to coordinate and communicate with each other more efficiently and responsively and also improve its operational effectiveness. Hence, firms can change from demand-driven to customer-driven as being more responsive to customer orders. For instance, Intel has been one of the largest companies followed this change. Intel has decentralized nearly all of its production to the outside parties, apart from the core systems which is an important process within its product line which cannot be outsourced to other companies. At the end, Intel outperformed their competitors and further increased their market shares.
Synchronous flow production system is a flexible system which enables firms to produce detail-tailored products to meet customer demands, in which it is one of the approaches under de-integrated firms. There are intra-firm synchronous flow production systems and inter-firm synchronous flow production systems. The former one is all about within single company itself, like Catepillar, whereas the latter is about coordinating with other firms to complement each other to achieve success and it is closely related to de-integrated firms, like Intel. Daimler Chrysler is another example, who has contracted with thousands of suppliers to produce their products flexibly.
However, those changes have created difficulties on capital budgeting practices and the impact on both intra- and inter- synchronous flow production systems. The old method was not workable and suitable with the new operation system to appraising and making decisions on investments anymore. According to the intra-firm case of Catepillar Corporation, the old capital budgeting methods used in the firm were not flexible enough to manage their PWAF (Plant With A Future) program, which was the official name for their new implementation. It was too rigid as requiring board approval for every purchase and not incorporating with the benefits and costs of integrating diverse assets. Therefore, a new practice was developed. Furthermore, Milgrom and Roberts (1990; 1995) argued that ÐŽ§without coordinated capital investments, firms may lose the competitive advantage of a system of manufacture whose ÐŽÒfundamental logicÐŽ¦ involves integrating activities across subunits and across stagesÐŽÐ , also ÐŽ§Discounted cash flow(DCF) analysis applied to incremental