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Capital Expenditure Management – Challenges

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What should be the ideal size of the capital expenditure budget for a company? This question has also been at the top of the mind for many who have found that many corporate like Reliance, Infosys, Coal India, ONGC,  to name a few, have been sitting on tens of thousands of Crores!

The challenge associated with growth driven by capital expenditure is bound to be high, be it organic growth or inorganic growth, through acquisitions. Challenges associated with organic growth can vary depending on the nature of the expansion viz., Greenfield or Brownfield i.e. expansion of capacity in the same place. Greenfield expansion which means building a new facility will be greater challenge as it could entail significant increase in manpower including managerial. Management bandwidth will always be tested and in the case of inorganic growth the pains associated with integration, predominantly soft issues, tends to be an additional one.

Financial

The discussion is not on the manner of funding projects but on the implications! Most financial analysts reviewing the financial performance of companies look at a couple of key ratios, amongst a host of others. These are Return on Capital Employed (ROCE), Capital Turnover ratio and Free Cash Flow.

ROCE is an efficient indicator of the returns that the company is in position to secure by sweating its assets. Since it is computed as a percentage of total assets i.e., fixed and net working capital any sudden increase in the base without a commensurate increase in profitability will prove to be drag.

The Capital Turnover ratio would indicate the number of times a company is in a position to turn its capital employed in terms of sales. If the gestation period of investments is long or in case of capital intensive projects any significant change would cause a drop in this ratio.

Free cash flow has of late shot into prominence. "Profit is an opinion; cash is a reality” so the famous quote goes. Given the fact that organizations are required to account for incomes on accrual which can get vitiated by aggressive sales practices, this measure is a good indicator of realized profits! This will help in the determination of not only the capital expenditure that a company can incur out of own funds but also the extent to which it could probably borrow. The ratio of Free Cash Flow to capital expenditure would definitely help the process.  The greater the number the better it would be.

Thus from a financial perspective there is no single yardstick but it would be appropriate to conclude that all the three ratios need to reflect a higher number with a positive upward trend.

Management Bandwidth

One of the biggest challenges, India in particular, has been the quality of project management. It is sometimes rare to see projects being completed without time or cost overruns, both of which can have serious financial implications. It is has also been observed that key operating personnel being transferred to new projects exposing current operations under the risk of time overrun. Delays in execution of projects coupled with problems in existing projects could be a double whammy.  In the case of inorganic growth challenges associated with cultural integration will be another crucial aspect.

Our project management capabilities can be evaluated by a comparative study of China’s landmark rail link between Beijing and Shanghai that was launched a year ahead of schedule! The Beijing–Shanghai High-Speed Railway is a 1,318 Km long high-speed railway that connects Beijing and Shanghai. The construction began on April 18, 2008 and commercial service was put into commercial service on June 20, 2011. More than the fact that it was completed in 3 years, what is even more important is that it was completed one year ahead of schedule. The train services are expected to carry about 2.20 lakh passengers every day!  The estimated revenue generation by advancing the project alone is about Rs.48000 crores for a year assuming the charge 700 Yaun per trip! Compare this with the Bandra Worli sea link project of 5.6 km that was to have been completed in 5 years at a cost of Rs.300 Crores. The project actually took 10 years and was completed at a estimated cost of Rs.1400 Crores. This is only a small example of the fate of similar other projects both minor and major! It would be inappropriate to assume that these delays happen only in public projects.  They are very much part of the system, in the private ones too probably the magnitude of the problem is lesser. It is not uncommon to hear of cases where the viability of the project has jeopardized due to delays.

Maximum Capital Expenditure

In the ultimate analysis there can be no single yard stick to determine the maximum capital expenditure that can be undertaken by a company. It has to function of both existing financials, especially the ratios referred and the management bandwidth to manage the successful project roll out.  Current situation of the economy need not necessarily be the only determinant as capital expenditure is always incurred with a long term perspective and in that context this may about the best time to incur the same as there is potential save substantially!

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