Avoiding Common Pitfalls

No system for allocating capital resources is foolproof. You can, however, cut down on your chances of making a mistake by exploring the following alternatives when planning your capital investment proposal:
● Look for something better. Resist the tendency to assume that the proposals that bubble up from your subordinates are the best available. To strengthen your planning, solicit ideas from the widest possible range of departments.
● Be ready to branch out. Another common failing is the tendency to concentrate on the familiar when seeking fund allocations. Too often, innovative programs are equated with risky pro¬grams, and therefore disregarded. Always be ready to accept change if a sound business case can be made for it.
● Look to the longer term. In many firms, projects with a short payback period get the inside track. Management tends to think in terms of current-year results and overlooks projects that promise only long-term profit opportunities. However, the primary purpose of capital investment is to ensure the long-term profitability of your firm. Thus, while short-term profits are important, always leave room for projects that will pay off over the longer term—and be prepared to argue for them.
● Follow up on your capital program. Once a project has been approved, make an effort to ensure that it meets stated objectives. This will assist you in spotting problems early on and enhance the effectiveness of the program.


Calculating Your True Capital Costs
Before you can make an intelligent decision on a capital investment project, you will need to find out how much the project would cost. Then you must come up with a reasonable idea of the expected rate of return. Knowing these facts will tell you whether you’re in a strong position to request an allocation of your firm’s limited resources.

Assessing the Cost of Debt
Note that the interest rate on loans or bonds used in financing a project is affected by the nature of the firm’s other commitments. If a firm has committed itself to several high-risk projects, it will usually be required to pay a relatively high interest rate on a new undertaking, whether or not this venture is risky in itself. Other factors affecting a firm’s cost of debt include the company’s debt/equity position and the economic outlook for its industry.

For these reasons, it is never safe to assume that the debt costs used to justify one project will be applicable to another. Each time you start to review a new project, take the time to find out your company’s current cost of debt from your firm’s finance department. Because interest expense is a deductible item, the cost of long-term debt should always be expressed as an after-tax figure. Apart from that, figuring your cost of debt is a fairly straightforward process. Merely use the rate of interest that your bank would charge for additional borrowing; apply your current tax rate to obtain the after-tax cost of your debt.
Example: If your company is taxed at 34 percent and your interest rate on a new loan would be 12 percent, your after-tax debt cost comes to 7.9 percent (12 percent x 66 percent = 7.9 percent).

What Are Equity Costs?
Company managers generally view equity capital as cost free. Theoretically, you do not have to pay the capital back, so it’s free, particularly if your company does not intend to pay dividends that year. From a stockholder’s viewpoint, however, the outlook is different. Every dollar of earnings retained in the firm is a dollar denied to the stockholders. In a sense, it is a “hidden” cost for stockholders, almost akin to a new investment in the firm. The reason that stockholders maintain their investment is the promise of future dividends and/or capital appreciation (that is, an increase in share prices). Since both dividends and share price improvement depend on future earnings per share, it is the most important factor in determining your equity costs.