Three Questions to Consider Before Undertaking a Capital Project

FAQ

From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.

What are the most important qualitative factors to consider when evaluating a proposed capital project?

Net present value analysis, internal rate of return, and other quantitative analyses are important tools for evaluating capital projects.  While family business directors should be acquainted with these tools and generally understand how they work, it is just as important that directors understand the limitations of these tools.

Quantitative capital budgeting tools cannot answer this question: should we undertake the proposed capital project?

Specifically, these capital budgeting tools are ideal for answering this question: Is the proposed capital project financially feasible?  Too often, however, we see these tools being used to answer what seems to be a related question, but one that the tools are simply not designed to answer: Should we undertake the proposed capital project?  The first question opens the door to the second, but the tools of capital budgeting – no matter how sophisticated or quantitatively precise – cannot answer the second.  To answer the second question, you and your fellow directors need to consider three qualitative factors, each of which can be framed in the form of a corresponding question.

1. Market Opportunity

The market opportunity question is simply this:  Why does the proposed capital project make sense?  Management must be able to provide a simple, straightforward, and compelling answer to this question.  The components of an acceptable answer to this question should focus on the customer need being addressed by the project and how the project is an improvement over how the market is currently meeting the identified customer need.  Under no circumstances should the answer to this question reference a net present value or internal rate of return.  If the minimum conditions of financial feasibility have not been met, the proposed project should not be in front of the board.

2. Strategic Fit

Once the market opportunity has been demonstrated and vetted by the board, the next question is this:  Why does the proposed capital project make sense for us?  In other words, how does the proposed capital project relate to the family business’s existing strategy?  Does the proposed project represent an extension of the existing strategy, or does it deviate from the strategy?

One temptation that family businesses can succumb to is modifying an existing strategy for the express purpose of justifying a proposed capital project that a key constituency really wants to do, which is inadvisable.  Instead, the board should understand why a change in the company’s existing strategy is warranted and why the proposed change to the strategy is an improvement given current market and regulatory conditions, competitive dynamics, and opportunities.  If the board determines that the proposed change in strategy is appropriate, then the discussion can move to whether the proposed capital project should be approved.  If strategy is the driving factor, the proposed capital project may not necessarily be the best way to execute on the new strategy.

Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.

This discussion presupposes, of course, that the family business has a strategy that has been clearly communicated to management, employees, and shareholders.  Absent a guiding strategy, capital budgeting can devolve into what one of our clients sagely referred to as “a race to the table.”  If there’s no guiding strategy, the first manager to arrive at the board meeting with a financially feasible project is likely to receive approval, even if the project does not promote the long-term health and sustainability of the family business.

Your family business’s strategy should be driving capital budgeting; letting capital budgeting drive strategy eventually results in a mess.

3. Constraints

The final question is this:  Can the proposed capital project be done by us?  Management’s time and attention, infrastructure and systems, and human resources are limited.  Will undertaking the proposed capital project divert scarce resources away from other areas of the business?  In our experience, managers proposing capital projects tend to underestimate the impact a project will have on the rest of the business.  While it is certainly true that some expenses are fixed in the short term, all expenses are variable in the long-run.  Resource constraints can be overcome, but directors should be certain that the full cost of doing so has been contemplated and reflected in the capital budgeting analysis.

Does your family business have a robust capital budgeting process that determines whether a proposed capital project is financially feasible?  If it does, that’s great.  But the approval process cannot end with a green light on the financial side.  Family business directors need to be diligent to answer the qualitative questions identified in this post.