The Competition for Capital
Need money for a new project? Understanding how your organization makes financial decisions can facilitate a positive outcome.
Determining where to invest its capital is one of the biggest decisions an organization has to make. Ultimately, what’s at stake is shareholder value. A positive return on capital can enhance shareholder value and, clearly, the converse is true.
Since there is typically a limit to how much capital is available in any one year, projects must compete to get the capital they need to go forward.
That is why it is so critical for every manager to understand how capital decisions are made in his or her company – and to have a clear picture of why some projects are approved while others are declined?
For logistics management, this is a particularly valuable knowledge base. Logistics projects are often complex, lengthy and costly. Providing financial decision-makers in your organization with an appropriate business case on your project – in a way that meets their needs – is critical to the success of your proposal.
Some Realities About Capital
Capital is scarce – or is it? Capital is often referred to as a scarce resource. But let’s look at this at little more closely. While capital is not unlimited, it’s not really scarce either. Pension funds and other investors are always on the look out for investments that provide a solid return.
A more accurate statement is the fact that short-term capital in any organization is finite.
Capital markets are efficient and allow for the pricing of a company’s capital fairly easily. The cost of capital starts with a “risk-free cost” which applies to all companies. But this risk-free cost assumes that there is no risk in the investment. Since this is not the case with most investments, the market then provides an assessment of the risk in question and adds a cost associated with that risk to the risk-free rate.
Capital markets are global. Billions of dollars flow into and out of Canada annually. Investors make decisions to move capital around to accommodate a specific business need or to invest in a project that offers a solid return.
The number one goal is shareholder value. A company’s key stakeholders include customers, suppliers, the community, employees and shareholders; but there is little doubt that most companies’ number one stakeholder is the shareholder. When a company works to increase shareholder value and obtain capital from shareholders, it can then effectively address the needs of other stakeholders.
In an effort to provide value, an organization needs to determine the primary goal of its shareholders. This can vary from an income goal where shareholders want regular ongoing income in the form of dividends to a growth objective where shareholders want to see to the share price increase.
Other shareholder goals can include safety where a lower return is acceptable in exchange for low risk investing; liquidity where stock can be sold quickly and investments converted to cash; or tax minimization where investment decisions are made in an effort to minimize tax implications.
Since it is virtually impossible to meet all of these shareholder goals within one organization, most companies will focus on selling their stock to a specific shareholder profile.
Where A Company Gets Its Capital
Simply stated, capital comes in two forms – debt and equity.
Debt capital includes such vehicles as bonds, loans and lines of credit. These are relatively low risk “secured” sources where debt holders receive their money before equity holders in the event the company declares bankruptcy. With this lower risk comes a lower return.
On the other hand, equity capital like common stocks, preferred stocks and a relatively new form of equity called income trusts comes with a high level of risk. If the company declares bankruptcy, the shareholder may receive nothing. In the case of common shares and income trusts, shareholders receive money only when the company makes a profit.
Most companies access both debt and equity sources for their capital requirements. Since debt capital is always cheaper than equity, a company needs to decide what the correct split between debt and equity is for its particular situation. Once that split is determined, a company can calculate its cost of capital. Clearly, if the debt-to-equity-capital ratio changes, so will the cost of capital.
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The Line In The Sand
Cost of capital (see schematic) is one of the most important calculations a company makes. The cost of capital calculation or Weighted Average Cost of Capital (WACC) determines what the minimum required return on any investment has to be in order to pay for the capital.
If you are looking for capital allocation for a new venture, a new project or departmental expansion, it is critical that you understand your organization’s cost of capital. The hard reality is – if your project doesn’t deliver a return that at least covers the company’s cost of capital, it should never get off the ground.
Common arguments departments make when looking for funds are that the investment is “strategic” or that it is “critical to future growth” or it is “too difficult to measure the return.” In the final analysis, however, if you don’t work with the financial people in your organization to measure what the true cost of capital is, including the return on capital for your project, you are doing your company and its shareholders a disservice. Simply, your project should not go forward.
Tools To Support The Capital Investment Decision
Assuming the cost of capital is the starting point for any investment decision, there are a number of different tools that can be used to assess the profitability of a project, or a company for that matter.
Leasing. The lease versus buy decision is one of the more common tools. It looks at a particular asset and assesses whether it is better to tie up your own capital (buy) or use that of the supplier’s (lease).
Present value. This tool looks at a stream of cash inflows and outflows over a period of time and brings that stream to present time using a discount rate to see the value of the project. Present value can also be used for capital budgeting. The discount rate then becomes the “hurdle rate” which determines the cost of capital on the project and whether it creates shareholder value.
Internal rate of return. In evaluating a project’s capital return, this tool uses a present value dollar amount to determine a percentage return. This percentage can then be compared to other projects and a priority list, based on the highest return, can be established. In this way, a company can maximize returns by focusing only on the most profitable projects.
EVA (Economic Value Added). Looking at individual projects (or a company as a whole), this tool determines whether the project is profitable and adding value. It measures the cost of capital employed less the operating profits. If the remaining number is positive, the project is adding value.
Getting To Yes
Given that the amount of capital available at any point in time is finite, getting the go-ahead can still be difficult even when a good return on capital exists. Remember, the overall goal is to maximize shareholder value. Different companies may allocate capital in different ways – by department, by region, by project level – or simply, across the organization as a whole. Whatever the allocation method, only those projects that are profitable should make the short list. From there, selection becomes a relatively simple process of approving projects starting with the most profitable down to the least profitable – until the money runs out.
This can mean a profitable project doesn’t get approved. But the final arbiter should always be maximum return on investment.
Projects that are argued on “soft” costs or emotion don’t even make the short list.
If you want your project to succeed in the “competition for capital,” make it a point to understand your company’s goals and objectives, its approach to finance, what its goals are for delivering shareholder value and what profit means to your organization.
Partnering with the financial group in your company and recognizing the hard reality of return on investment are essential steps if you want to get your next project on the approved list.
Douglas Harrison is President of Acklands-Grainger Inc., the leading distributor in Canada of industrial, fleet and safety supplies, with 200 branches from coast to coast. Mr. Harrison is a graduate and member of C.I.T.T., and a member of the Canadian Professional Logistic Institute. He holds an MBA from Heriot-Watt University in Edinburgh, Scotland.