Project Appraisal Capital Allocation Frame Work

Capital Asset Pricing Model (CAPM) Normally the company’s cost of capital is used to discount the forecasted cash flows of the new project. Many companies estimate the rate of return required by investors in their securities. Towards this purpose the company’s cost of capital is used to discount cash flows in all new projects. This is not an accurate method since the risk of existing assets of a company may differ from the risk of new project assets. Since investors require a higher rate of return from a very risky company, such a company will have a higher discount rate for its new investment opportunities. The cost of capital or required rate of return on the project would be the same as the one on company’s existing assets if the risk is the same. The company’s cost of capital is the correct discount rate for projects that have the risk as the company’s existing business. If the project risk differs from the risk on existing assets, the project has to be evaluated at its own opportunity cost of capital.

The true cost of capital depends on the use to which it is put. 2. The CAPM can be used for estimating the company’s cost of capital. Each project should be evaluated at its own opportunity cost of capital. Capital asset pricing policy theory tells us to invest in any project offering a return that more than compensates for the project’s beta. Beta is a measurement of the amount that investors expect the stock price to change for each one percent additional change in the market risk. The discount rate increases as project beta increases. 3. However, firms require different rate of return from different categories of investment. The higher the beta risk associated with an investment, the higher the expected rate of return must be to compensate investors for assuming risk. 4. The CAPM holds that there is a minimum required rate of return even if there are no risks, plus a premium for all non-diversifiable risks associated with investment.

Projects should be evaluated as portfolio and there is a reduction of risk when they are so combined. 5. For calculating the company’s cost of capital, the beta of its assets has to be ascertained. But the beta cannot be plugged into the capital asset pricing model (CAPM) to find the company’s cost of capital because the stock reflects both business and financial risk. The beta has to be adjusted to remove the effect of financial risk since borrowing increases the beta (and expected return) of its stock. 6. The expected rate of return calculated from the capital asset pricing mode r = r f + β ( rm - r f ) (where r is discount rate, rf is interest rate on risk free asset like treasury bill and rm is expected return) can be plugged into standard discounted cash flow formula as under:

T

t

T

t

PV Σ C / ( 1+ r) = Σ C t / [ 1 + rf + β ( rm – rf ) ] t=1

t=1

The capital asset pricing model values only cash flow for the first period (C1). Projects, however, yield cash flows for several years. If the risk adjusted rate r is used to discount the cash flow, we assume that cumulative risk increases at a constant rate. The assumption will hold when the project’s beta is constant or risk per period is constant. 2. Capital Allocation Framework(CAF) Capital budgeting is not the exclusive domain of financial analysis and accountants. It is multifunctional task linked to a firm’s overall strategy. Capital is scarce and hence must be allocated across competing claims very judiciously. The identification, evaluation, and selection of individual investment proposals is usually guided by a capital allocation framework, defined explicitly or implicitly by top management.

The CAF of a firm spells out the kinds of businesses the firm wants to be in, the strategy of the firm, the types of investments that make sense for the firm, the approach of the firm towards conglomerate diversification, so on and so forth. CAF is divided into seven sections as follows:  Key criteria  Elementary investment options  Portfolio planning models  Strategic position and action evaluation  Diversification debate  Investment in capabilities  Strategic planning and capital budgeting 2.1 Key Criteria The objectives of maximizing the wealth of shareholders is reflected, at the operational level, in three criteria: profitability, risk, and growth.

• Profitability is defined as: Profit after tax Net worth • Risk: It reflects variability. How much do individual outcomes deviates from the expected value? A simple measurement of variability is the range of possible outcomes i.e. the difference between highest and lowest outcomes. • Growth: It is manifested in the increase of revenues, assets, net worth, profits, dividends, and so on. To reflect the growth of a variable, the measure commonly employed is the compounded rate of growth. 2.2 Elementary Investment Options The building block of the corporate resource allocation strategy are the following elementary investment options:  Replacement and modernization  Capacity expansion  Vertical integration  Concentric diversification  Conglomerate diversification

Investment Options Investment Principal Likely Outcomes Strategy Motivators Profitability Growth Replacement -Quality improvement High Moderate &modernization - Cost reduction - Maintenance Capacity -Ability to serve High Moderate Expansion growing market - Cost leadership Vertical -Greater stability for High Moderate Integration existing and proposed operations - Greater market power Concentric - Improves utilization High Moderate Diversification of resources Conglomerate - Limited scope in the Moderate High Diversification present business Divestment - Inadequate profit High Low - Poor strategy

Risk Low Moderate Moderate

Moderate Low Low

Elementary Investment Strategies, Principal Motivations, and likely Outcomes

2.3 Portfolio Planning Models To guide the process of strategic planning and resource allocation two tools have been quite relevant. They are o BCG Product Portfolio Matrix o General Electric’s Stoplight Matrix Boston Consulting Group (BCG) matrix analyses products on the basis of (a) relative market share and (b) industry growth. BCG Product Portfolio Matrix Relative Market Share Industry Growth high Low Rate High Stars Question marks Low Cash Dogs cows  Stars: Products enjoying a high market share and a high growth rate are referred to as stars

 Question marks: Products with high growth potential but low present market share are called question marks  Cash cows: Products which enjoy a relatively high market share but low growth potential are called cash cows.  Dogs: Products with low market share and limited growth potential are referred to as dogs. It is clear that cash cows generate funds and dogs, if divested release funds. GE’s Stoplight Matrix: It is for the sophistication, maturity, and quality of its planning systems.There are two key issues: (a) Business strength - How strong is the firm against competitors? (b) Industry attractiveness – What is the attractiveness or potential of the industry? As shown in the following exhibit, products which are favorably placed justify substantial commitment of funds and those unfavorably placed call for divestment.

Business Strength Strong

Average

Weak

High Invest Invest Hold Industry Medium Invest Hold Divest Attractiveness Low Hold Divest Divest Products which are placed in between qualify for divestment.

2.4 Strategic Position and Evaluation (SPACE) SPACE is an approach to hammer out an appropriate strategic posture for a firm and its individual businesses. It involves a consideration of four dimensions:  Company’s competitive advantage  Company’s financial strength  Industry growth  Environment stability In order to apply SPACE approach to a firm, the following procedure may be followed:

1. Numerically assess the firm on the factors which have a bearing on four dimensions. The scale of assessment for the factors relating to the dimensions of company’s financial strength and industry strength may be 0 to 7, with 0 reflecting most unfavorable assessment and 7 the most favorable. However, the scale of assessment for environment stability and competitive advantage may be o to –7, with 0 reflecting the most favorable and –7 the most unfavorable assessment. 2. Plot the scores for four dimensions on the axis of the SPACE chart. 3. Connect the scores so plotted to get a polygon, reflecting the size and direction of the assessment. (Refer the chart) Strategic Postures : A. Aggressive B. Competitive C. Conservative D. Defensive

A. Aggressive posture FS 7 -7 CA

7 IS

ES –7 C. Conservative Posture FS 7 -7 CA

7 IS ES –7

B. Competitive Posture FS 7 -7 CA

7 IS

ES –7 D. Defensive Posture FS 7 -7 CA

7 IS ES -7

Generic Strategies and Key Options Status Quo

Concentric Diversification

FS

Conglomerate Diversification

Concentration FOCUS

Diversification

COST LEADERSHIP

Conservative

Vertical Integration

Aggressive

CA Divestment

Defensive

Competitive

Liquidation

GAMESMANSHIP

DIFFERENTIATION

IS Concentric Merger Conglomerate Merger

ES Retrenchment

Turnaround

2.5 Diversification Debate Conglomerate diversification, which is involves diversification into unrelated areas, is very common in India. Despite its popularity, it is considered to be a highly controversial investment strategy. 1. Most of the businesses are characterized by cyclicality. It is desirable that there are at least two to three distinct lines of business in a firm’s portfolio. It helps a company in reducing its overall risk exposure. 2. It expands opportunities for growth. When the existing business reaches saturation it is natural to look at other businesses where growth opportunities exist. While the prospects of succeeding in the new line of business are often uncertain, the immense potential acts as an irresistible bait. 3. Though a good device for reducing risk exposure and widening growth possibilities, conglomerate diversification more often than not tends to dampen average profitability.

Guidelines for Conglomerate Diversification Conglomerate diversification, in general, dampens profitability and in some cases jeopardizes the existence of the firm.There are some practical guidelines in this respect: 1. If you lack financial sinews to sustain the new project during the ‘learning period’, avoid grandiose diversification projects. 2. Realistically examine whether you have the critical skills and resources to succeed in the new line of business. 3. Ensure that the diversification project has a good fit in terms of technology and market with the existing business. 4. Try to be the first or a very early entrant in the field you are diversifying into. This will protect you from serious competitive threat in the initial years. 5. Where possible, adopt the following sequence: marketing-sub – contracting – full manufacturing.

6.

Seek partnership of other firms in areas where you are vulnerable or competitively weak. 7. If the failure of the new project can threaten the company’s existence, float a separate company to handle the new project. 8. Remember that meaningful conglomerate diversification represents the greatest challenge to corporate vision and leadership. 9. Guard against bandwagon mentality and empirebuilding tendencies. 2.6 Investment in Capabilities Empirical evidence suggests that companies that perform well have organizational capabilities that enable them to exploit opportunities. Organizational capabilities are combinations of human skills, organizational procedures and routines, physical assets, and the systems of information and incentives that improve performance along particular dimensions. Such capabilities are indeed

organizational assets. There are five specific capabilities:  External Integration Capability  Internal Integration Capability  Flexibility  The capacity to Experiment  The capacity to Cannibalize Allocating Resources to Build Capabilities:  Identify the capabilities that the firm should develop and ensure that there is a firm organizational commitment to them.  Develop a capital budget for capabilities and a proper system of authorization and accounting for expenditures relating to capabilities.  Translate the desired capabilities into appropriate goals and rewards that are clearly understood and used by people throughout the organization.  Link compensation of managers to improvements in speed, quality, and flexibility.

2.7 Strategic Planning and Capital Budgeting Capital expenditures, particularly the major ones, are supposed to sub-serve the strategy of the firm. Hence, the relationship between strategic planning and capital budgeting must be properly recognized. The following exhibit presents a way of defining this relationship. As emphasized in the exhibit, capital budgeting should be squarely related to corporate strategy. The challenge for a company lies in developing a capital allocation system which accommodates investment in capabilities without sacrificing the benefits of a formal financial analysis.

Environmental Assessment

Managerial Vision, Values & Attitudes

Corporate Appraisal

Strategic Plan

Capital Budgeting

Product Strategy, Market Strategy, Production Strategy and so on