How Capital Budgeting Deters Innovation—And What To Do About It

When a company fails to stay dominant in key markets, internal systems of resource allocation may be the cause. The decline often begins when financial managers impose strict controls on new capital spending. Operating and R&D managers soon realize that innovative products and processes are failing to clear the capital budgeting hurdles. The company then falls behind in technology and begins to lose market share. Eventually, it may exit from the business or undergo a radical restructuring. A typical large company has between 2000 and 10,000 capital projects to evaluate each year. Top managers need systems to separate good investments from bad, and thus most large companies have developed formal capital budgeting procedures to screen new investment proposals. In a standard capital budgeting system, managers first forecast the project's future cash flows and then discount these by the project's cost of capital(1). The discount rate reflects prevailing interest rates, the riskiness of the project and the corporation's sources of financing. Alternatively, managers may calculate a project's internal rate of return and compare it to the company's cost of capital. They are told (by textbooks and the financial staff) that they should invest in projects that earn more than the cost of capital and reject those that earn less. The great majority of large U.S. companies use net present value or internal rate of return in their formal capital budgeting systems. Most combine them with other financial measures such as payback or ROI(2). However, many operating and R&D managers distrust the results of these financial evaluations. When they criticize the capital budgeting system, they often claim that the cost of capital is too high or that financial markets overemphasize short-term performance(3). The real problem, however, does not lie with the cost of capital nor with the financial markets. The problem is that discounted cash flow measures do not recognize the value of a wide range of competitive commitments. Most importantly, discounted cash flow measures do not value commitments to innovate in advance of the competition. Tracy O'Rourke, CEO of Allen-Bradley, explaining how that company came to invest in computer-integrated-manufacturing, put the case succinctly: "The old financial models have failed manufacturing companies. Return on investment, internal rate of return such--abstractions.give little consideration to strategic opportunities and threats presented by technological advance"(4). The Competitive Impact of Capital Budgeting The inherent conflict between commitments to innovate and systems of capital budgeting is most apparent when a company considers replacing an existing product or process. Whether the decision is to introduce a product or invest in new equipment, financial analysis almost always favors postponement of the investment. However, financial analysis fails to take account of the fact that competitors who anticipate postponement have an incentive to invest in competing products or processes. Thus companies that apply strict financial hurdles to new products and processes will face more competition than those that readily commit to innovate. When a company invests in a new product (or process) that decreases the value of existing products, it is said to be "cannibalizing" its business. Capital budgeting systems are explicitly designed to prevent cannibalization. The main objective of calculating present value or an internal rate of return is to avoid making investments that decrease the company's value to investors. However, if ultimate success depends on deterring competition, cannibalization may be the to long run survival and success. How Innovation Is Deterred It is counterintuitive (particularly to those trained in finance and accounting) to think that value may be increased by making a series of value-decreasing investments. …