Generating ideas for capital projects

The same general concepts that we developed for security analysis are involved in capital budgeting. However, whereas a set of stocks and bonds exists in the securities market, and investors select from this set, capital budgeting projects are created by the firm. For example, a sales representative may report that customers are asking for a particular product that the company does not now produce. The sales manager then discusses the idea with the marketing research group to determine the size of the market for the proposed product. If it appears likely that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If it appears that the product can be produced and sold at a sufficient profit, the project will be undertaken.

A firm's growth, and even its ability to remain competitive and to survive, depends upon a constant flow of ideas for new products, ways to make existing products better, and ways to produce output at a lower cost. Accordingly, a well-managed firm will go to great lengths to develop good capital budgeting proposals. For example, the executive vice president of one very successful corporation indicated that his company takes the following steps to generate projects:

Our R&D department is constantly searching for new products and also for ways to improve existing products. In addition, our executive committee, which consists of senior executives in marketing, production, and finance, identifies the products and markets in which our company will compete, and the committee sets long-run targets for each division. These targets, which are spelled out in the corporation's strategic business plan, provide a general guide to the operating executives who must meet them. These executives then seek new products, set expansion plans for existing products, and look for ways to reduce production and distribution costs. Since bonuses and promotions are based in large part on each unit's ability to meet or exceed its targets, these economic incentives encourage our operating executives to seek out profitable investment opportunities.

While our senior executives are judged and rewarded on the basis of how well their units perform, people further down the line are given bonuses for specific suggestions, including ideas that lead to profitable investments. Additionally, a percentage of our corporate profit is set aside for distribution to nonexecutive employees, and we have an Employees' Stock Ownership Plan (ESOP) to provide further incentives. Our objective is to encourage employees at all levels to keep on the lookout for good ideas, including those that lead to capital investments.

If a firm has capable and imaginative executives and employees, and if its incentive system is working properly, many ideas for capital investment will be advanced. Since some ideas will be good ones while others will not, procedures must be established for screening projects, our topic in the remainder of the chapter.

Self-Test Question

How does a firm get ideas for capital projects?