A framework for integrating capital budgeting analysis with strategy.

Introduction

Financial theory for selecting capital budgeting projects is well established |40~. Many articles advance the argument that discounted cash flow (DCF) models capture the true economic value of long-term investments. Surveys of current practice demonstrate that DCF models are,

in fact, the primary decision models used for both conventional capital budgeting decisions |18~ and for high technology investments |41~. Surveys of practicing managers, however, also indicate that many decision makers are not satisfied with the implementation of these time value approaches; much of the apparent dissatisfaction relates to the lack of a formal linkage between capital budgeting decisions and organizational strategy |36~. What is needed, therefore, is a framework to help guide or structure the decision process to ensure a formal linkage between capital budgeting decisions and firm strategy.

This paper has three objectives: one, to review implementation issues concerning the use of time-value capital budgeting models; two, to propose a framework that can link capital budgeting decisions to strategy; and three, to illustrate how this framework could be developed and applied in a real world environment using the Analytic Hierarchy Process (AHP). While others have suggested the use of the AHP in a capital budgeting context (see, for example, |4~|11~|17~|34~|35~|38~), little attention in the literature has been devoted to the fundamental problem of structuring the decision hierarchy appropriately. This paper focuses on that question.

Review of Current Research and Practice

In a review of existing surveys on capital budgeting practices in this country, Mukherjee and Henderson |23~ summarized four limitations of DCF models for analysis of capital investments: (1) an inability to capture the role of organizational structure and behavior in corporate decision making; (2) a failure to incorporate management behavior toward risk; (3) difficulties in application due especially to unrealistic assumptions about data availability; and (4) inability to incorporate strategic considerations in decisions made by the firm.

For these reasons, Bennett et al. |3~, Bromwich & Bhirani |5~, Canada |6~, Kaplan |16~, McNair et al. |20~, Mensah & Miranti |21~, Noble |26~, Polakoff |29~, and Shank and Govindarajan |33~ question the exclusive use of DCF analysis in justifying capital investments, especially those involving automated technology. Thus, these authors believe a new decision approach may be needed that: (1) identifies relevant attributes (both qualitative as well a quantitative) representing important benefits of capital investments; (2) relates the importance of these attributes to achieving the firm's long-term strategy; and (3) formalizes the decision process with a systematic approach that links the firm's strategy to the ultimate investment decision.(1)