Capital projects require a look into the future and often involve the introducti
ID: 2766517 • Letter: C
Question
Capital projects require a look into the future and often involve the introduction of new, unproven machinery whose benefits are based on best information available assumptions vs. past experience. They often require the assignment of financial benefits to subjective issues like improvements in quality and customer satisfaction. How much will they improve and what is that worth? Often they involve cost savings through the elimination of headcount which means lay-offs or reassignment of employees. Does the savings in wages/benefits offset the soft costs of lost skills / experience, lower morale, etc.?
Explanation / Answer
Capital projects are long term projects. You have to employ a lump sum amount at the begining of the project. Then project will generate cash flows/revenues throughout its life. Introduction of a machine is a capital project. Initially you are investing money to get it. Then goods will be produced and sold to earn revenues/cash flows.
Decision of investment insuch projects are normally based on the informations of expected cash flows/revenues of its lifetime. If these basic data are reliable, then decisions taken on this machine will be accurate. If the machine is an old one and has already reliable data availale, then decisions taken are mostly correct. But uncertainty develops when machine is a new one. No past history is available. In those cases decisions are taken on the basis of claims made by its manufacturer. Also many subjective factors are taken into consideration. Its manufacturer may claim that this machine will reduce wastage and will generate products of better quality in comparison with other existing available model. If the actual results justifies such subjective factors, then the problems will be over.
But in these cases actual results may be found deviating a lot from the expected one. As a result investment in capital project may result into a loss. But company cannot revert its decision, as already money has been spent. In those situations firm has to rectify the situation as far as possible so that at least cost of capital (minimum required rate of return) is recovered.
In an effort to do so company may have to take some hard decisions. It can reduce number of employees. Also it can lay off existing highly skilled employees and replace them by new employees who are less effecient and can work with low cost. While taking such decisions, company has to consider the incremental cost and incremental benefits side by side. If benefits appears to be more than costs, then only the hurse decisions are taken for betterment.