CAPITAL BUDGETING

Female Speaker What keeps a business on track? Its well-managed internal systems? Its equipment in top shape. A plan to make sure those things happen. Periodically, usually once a year, business managers sit down together and draft the next year’s spending plan something called a Capital Budget.

A Capital Budget is the formal process in which managers plan out how they will invest resources within their company. By looking at what is important and why, managers are able to make internal investment decisions that benefit the company. Those decisions involve the company’s resources, capital and a formal plan to use them, a budget. Allocating resources through capital budgeting is usually an annual process that involves poring over the previous years accounting data, establishing what worked and what did not, and deciding how the company wants to move forward in the coming year. But, while capital budgets have been around for quite sometime, forward thinking corporations are revolutionizing the process of drawing them up.

One of them, the Navistar International Transportation Corporation has turned away from the common detail-oriented view of capital budgeting in favor of a method that considers shareholder value from the very first step. Focusing on the principle of increasing shareholder value differs from the capital budgeting method used almost exclusively until just a few years ago.

Traditionally, no matter how big the company is, each individual project is reviewed one by one by the company’s financial chain of command. The whole time, the project is in competition with other proposals for company resources. Under the traditional model for capital budgeting, the plant manager, writes up a proposal for the division manager who scrutinizes it, rewrites it and add it to a list of other proposed projects which are then sent along to the company’s comptroller.

Once the comptroller receives the projects, he or she again, scrutinizes them one by one along with proposals from all the company’s other divisions, selects the best, most profitable proposals, and then forwards those to the company’s Chief Executive Officer and Board of Directors. The CEO and board then make the final decisions in the capital budgeting process. At each step along the way, the first plant manager’s proposal has to be rejustified as necessary to the company as a whole.

In the view of many corporate leaders, that blue print for capital budgeting does not offer much flexibility and more and more often, the blue print is being redrawn. J. Steven Keate is the General Manger for Navistar’s heavy trucking division.

Steven Keate In the area of capital budgeting, what we have done is we have incorporated the whole capital budgeting process into the business planning process for the company. So that when we look at capital decisions, we are really looking at them in the context of the overall business. And therefore, approving projects based on how they support the overall business objectives.

Page 1 of 4BUS3062 Capital Budgeting Transcript

7/23/2018http://media.capella.edu/CourseMedia/BUS3062/CapitalBudgeting/CapitalBudget_ts.html

Female Speaker An accountant and former comptroller himself, Keate defends Navistar’s new capital budgeting method as simpler and in the end, potentially more profitable.

Steven Keate We are now spending time thinking of creative ways to make the business more profitable versus spending lots of time analyzing lots of projects, creating lots of detail, and not utilizing our time as efficiently and effectively as we could and are now.

Female Speaker In turning away from the tried and true method, Keate, Navistar and corporations using similar capital budgeting systems had to develop new criteria by which to judge the worth of new project proposals.

For Navistar, that goal became increasing shareholder value. To insure that would take place, Navistar uses something similar to net present value to determine which proposals make the grade and which will be cast by the wayside.

Steven Keate So we went through an exhaustive analysis to understand what the company’s true cost to capital was and established a 15% rate of return requirement as being our hurdle rate. In other words, any project or any business that we have has to earn a rate of return greater than 15%. And in doing that, we should create value for the shareholders.

Female Speaker But the 15% rule only applies division-wide. In other words, each individual project does not have to generate a 15% Return on Investment so long as the average of all the projects reach the 15% mark. That gives Keate the option of undertaking important new projects that he considers necessary for keeping Navistar at the forefront of the trucking industry.

Often, the new projects were the hardest thing to justify using traditional capital budgeting methods. The new method gives managers freedom to pick their own projects, but they still have to take into account outside influences that have historically had an impact on the capital budgeting process. Things like tougher environmental laws, changes in the market, and necessary equipment upgrades.

Most importantly, Keate must consider the corporation’s overall budget, business strategy and direction.

Steven Keate The new approach at Navistar has really helped me focus my efforts. We go through a rigorous planning exercise early in the year to determine how much our capital needs are and whether they support the business objectives. We go through that with the board, the board approves it and from the point forward, I am given the leeway to manage the business and make the decisions within that business plan.

Female Speaker Navistar’s capital budgeting process varies from the traditional model in another way. Instead of rewriting his division’s capital budget every year, Keate is encouraged to think farther ahead.

Now, on a five to 10-year planning cycle, Keate presents Navistar with a business plan incorporating projected revenue, cost and resource elements, and reviews the plan each year only to determine if and where changes need to be made. The only expectation placed on him is that the 15% return on assets must be met.

Page 2 of 4BUS3062 Capital Budgeting Transcript

7/23/2018http://media.capella.edu/CourseMedia/BUS3062/CapitalBudgeting/CapitalBudget_ts.html

Steven Keate The way we set this up is that as long as we continue to operate within the strategy that we have defined and the major activities and initiatives that we have defined, there is nothing more than a communication or a more informal update given to the executive management of the board to demonstrate that we are on track. And that as long as we are implementing that plan and delivering the results, we are left to run the business.

Female Speaker In addition to making final capital budget decisions easier for Navistar’s CEO and Board of Directors, presenting his spending plan in broad strokes allows Keate the freedom to decide when major project proposals should be dropped, because they will not be profitable.

Steven Keate Sometimes we start projects that look good at the moment, but events unfold that would say that that project no longer will contribute to shareholder value. And those are the tough instances where you have to have the courage and the conviction to say no and to stop a certain project that you may have fallen in love with and that you may have embarked on, but that no longer makes sense for the shareholder and therefore, for the business.

Female Speaker That was the case in a recent situation involving Navistar’s heavy trucking division and the United Auto Workers. At stake for Navistar was production of a next generation heavy truck. Expected to cost $400 million over four years, the project carried a lot of momentum in the capital budgeting process. Despite the importance of the project within the company, the need for definitive shareholder value won out as the deciding factor.

Steven Keate We, unfortunately, were unable to reach an agreement with the UAW that would have given us the flexibility to introduce that new product in a cost effective way. And therefore, after a lot of soul searching and a lot of gnashing of teeth, it was decided, as difficult as the decision was, to stop the development of the program.

Female Speaker Not only would the union demands have driven up the cost of the project, they would have driven down the profits of Keate’s entire division because the proposed project was so big.

Steven Keate So we worked hard over the course of the next nine months working with the leadership of the UAW to communicate more effectively with them in terms of how important the project was and why these changes needed to occur to make us all successful. And thankfully, at the end of that time, we were able to negotiate a change to the Collective Bargaining Agreement that provided the flexibility that we needed to introduce the new product and we are looking forward to the year 2001 when that new product hits the market.

Female Speaker Keate credits Navistar’s more recent view of capital budgeting for simplifying the decision to hold off on the project. By establishing shareholder value as a corporation wide goal, Navistar’s new capital budgeting system is an improvement over the way the corporation had carried out their traditional model.

Page 3 of 4BUS3062 Capital Budgeting Transcript

7/23/2018http://media.capella.edu/CourseMedia/BUS3062/CapitalBudgeting/CapitalBudget_ts.html

Not only is the new system more efficient for cutting down on paperwork, but it also creates more of a team effort by reducing conflicting goals within and between departments. But as with any major change in a business, there is a flip side to shortening the capital budgeting chain of command.

Steven Keate If there is a downside to the approach that we have undertaken, it is maybe a perception that we have backed off too far. That under this kind of an approach, bad projects make it through somehow and be approved. I do not think that is the case. I mean we have to watch it and really become more and more confident with this new approach that we have taken. While there are probably is no perfect system. This was the right system for us and we are going to make it a success.

Female Speaker At the bottom line, the purpose of capital budgeting is to determine how a company will spend its resources over a given time period. Necessary, because it combines the company’s business plan with its plan for internal investments, capital budgets are company’s financial road map for arriving at its business goals.

Common to all capital budgeting processes is an attention to what the company hopes to accomplish through investing its resources, while at the same time, keeping an eye on the cost that will always pop up in the course of doing business, whether it is industry regulations, emergency cost or material upgrades.

Through capital budgeting, company managers stay as close as possible to the projects they feel will provide the most Return on Investment while remaining within the confines of the company’s mission. And that keeps companies on track, in line and moving ahead.

L ic ensed under a Crea t iv e Commons At t r i but i on 3 .0 L ic ense .

Page 4 of 4BUS3062 Capital Budgeting Transcript

7/23/2018http://media.capella.edu/CourseMedia/BUS3062/CapitalBudgeting/CapitalBudget_ts.html