LM04 Capital Investments

Part 1

1. Introduction

Capital investments are investments with a life of one year or more. Companies make capital investments to generate value for their shareholders.

Capital allocation is the process by which companies make capital investment decisions. Capital allocation is important because it impacts a company’s future.

This reading covers:

• Types of capital investments – going concern, regulatory/compliance, expansion, and other projects
• A typical capital allocation process – steps and principles
• Basic investment decision criteria – NPV and IRR
• Common capital allocation pitfalls
• Corporate use of capital allocation – ROIC
• Real options – timing, sizing, flexibility, and fundamental options

2. Types of Capital Investments

Companies invest for two primary reasons – to maintain their existing business and to grow it.

Projects undertaken by companies to maintain the business include:

• Going concern projects: Projects necessary to continue current operations and maintain existing size of the business or to improve business efficiencies.

Example: machine replacement, infrastructure improvement

• Regulatory/Compliance projects: Projects typically required by a third party, such as the government regulatory body, to meet specified safety and compliance standards.

Example: factory pollution control installation, performance bond posting to guarantee satisfactory project completion

Projects undertaken by companies to expand the business include:

• Expansion projects: Projects that expand business size and typically involve greater degrees of risk and uncertainty than going concern projects.

Example: new product or service development, merger, acquisition

• Other projects: Projects, which include high-risk investments and new growth initiatives, that are outside the company’s conventional business lines.

Example: exploration investment into a new innovation, business model, or idea

(These definitions and examples are taken from Exhibit 1 of the curriculum.)

Business Maintenance

Going Concern Projects

• Projects necessary to continue current operations and maintain existing size of the business or to improve business efficiencies.
• Most common going concern projects are replacing assets that have reached the end of their useful life, and maintaining IT hardware and software.
• Typically, these projects do not increase revenues but they could help a company save costs.
• They are fairly easy to evaluate as compared to the other projects.
• To fund these projects, managers often try to match the financing with the life-span of the asset. For example, issuing a 20-year bond to fund an asset with an expected life of 20-years.
  • If a company finances long-term assets with short-term financing, it faces rollover risk – the short-term financing costs could go up.
  • If a company finances short-term assets with long-term financing, it faces the risk of overpaying in financing costs.
• To estimate the amount of capital spending on going concern projects, analysts often look at the depreciation and amortization expense reported on the income statement.

Regulatory/Compliance Projects

• Projects typically required by a third party, such as the government regulatory body, to meet specified safety and compliance standards.
• These projects are unlikely to increase revenue; in fact, they may increase compliance costs. However, regulatory/compliance costs can act as barriers to entry and protect the industry’s profitability.
• While evaluating these projects, management must determine whether the business will still be profitable after considering the additional compliance costs.
  • In most cases, companies will accept these projects and pass on the additional cost to customers.
  • However, sometimes the cost may be too high and the company may decide that it is better off ceasing operations or shutting down the part of the business that is subject to the new regulation.
  • “Stranded-assets” refers to assets that are at risk of no longer being economically viable due to regulatory changes. For example, carbon-intensive assets such as coal power plants.

Business Growth

Expansion Projects

• Projects that expand business size and typically involve greater degrees of risk and uncertainty than going concern projects.
• Some industries such as pharmaceuticals and oil and gas spend heavily (over 10% of revenues) on expansion projects.
• If internal opportunities for expansion are limited, managers may pursue acquisitions. However, the two main risks in acquisitions are the risk of overpaying and the difficulty in integrating the acquirer’s business operations.

Other Projects

• Projects, which include high-risk investments and new growth initiatives, that are outside the company’s conventional business lines.
• These projects are often observed in privately held companies or public companies under the control of a founding owner/significant shareholder.
• These projects tend to have a venture capital element to them. There will probably be a complete loss of investment, but if successful the project could be highly profitable.

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