Thursday, July 28, 2011

Making Capital Investments Matter

Too many projects chasing limited capital to invest: Almost all of us are familiar with this scenario. Most large corporations go through the annual rigmarole of creating proposals for capital investments, replete with justifications, projected savings, return on investments, and so on. Asking these two simple questions and plotting it on a simple graph may make this process simpler to make the final choices.

  • Does the proposed investment create any competitive advantage for the company? This question looks like rhetoric, but can be made quite objective. Identify the financial metric that is being targeted through this competitive advantage – it could be reduced cost, increased revenues, lower inventory, lower working capital, better margins, enhanced asset turnover or anything else that the company is trying to achieve as a result of the investment. It can also be an operational metric if that is what is being targeted. For example, if two projects are being targeted to reduce working capital (for example, an inventory optimization system or a bid-optimization system), it is relatively easy to convert their projected benefits to their impact on working capital.
  • How sustainable is the competitive advantage created by the investment in question? Remember, all competitive advantage is bound to disappear as other firms catch-up. Therefore, assessing the sustainability of the advantage is very important. Between two investments with identical returns, the one that creates more sustainable advantage is definitely the winner.
After assessing the two questions, plot the alternatives into the financial-strategic quadrants shown in the figure. Each quadrant represents the sustainability of the competitive advantage and a financial or organizational metric most critical to the firm. The investment proposals in quadrant 4 should be considered for implementation in the short term as these represent advantages with the longest sustainability and highest ROI (assuming ROI is the financial metric along Y-axis). In general, capital proposals in the two right quadrants should be considered favorably, those in quadrant 1 are highly questionable from the point of view of their ability to create any sustained strategic advantage, and those in quadrant 2 should be carefully evaluated to see how the competitive advantages created by them can be made more sustainable with the intention of developing an alternative that can be moved to quadrants 3 or 4, making them more viable and aligned to the business strategy.
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© Vivek Sehgal, 2011, All Rights Reserved.

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