PLANNING FOR

C&EN presents the highlights of the Symposium on Capital

Investment and Control, sponsored by the Chemical Management Subdivision

of the ACS Division of Industrial and Engineering Chemistry in New York, Ν. Υ.

The chemical industry faces competi­tive conditions that compel it to adopt an extremely prudent capital invest­ment policy. Because the economic life of its plants can be drastically shortened by advances in technical knowledge, it must be confident that it can obtain a high rate of return be­fore making capital commitments. If it fails to get this return, the industry will have a difficult time financing rapid expansion in the future. Its money, when invested in new plants and equipment, must compete with projects originated by scientists in hundreds of research laboratories throughout the world. Under these challenging conditions, chemical com­panies can only succeed if they have a well organized scheme of capital bud­geting and future planning, extending back into their research laboratories.

Budgeting of capital funds (which pay for such things as new plants and equipment but do not cover operating costs) is especially important to chem­ical companies because their outlays are usually very large and are recov-

NEW FACILITIES. Plant construction is a big element in the chemical industry's capital spending. Here, Celanese em­ployees discuss building of new plant

ered only after long periods of time. Unwise spending can burden a com­pany throughout the entire life of an investment—and may even endanger the company's very existence. When a company does not make wise in­vestments, its growth is restricted and its shareholders fail to benefit from an expanding economy.

Capital budgeting is not merely an accounting technique or an arithmeti­cal summation of the work of an ap­propriations committee. It must ex­press the future plans of the business. For corporations, growth is essential. Capital budgets, based on proper plan­ning, clearly indicate the extent and direction of such growth.

Top management's basic function is to make and carry out long range plans. For this planning to be effective, all outlays for new plants and equipment must be carefully fitted into the com­pany's over-all plans. Spending can­not be hit or miss. Yet, capital bud­gets based on long range plans should never be regarded as fixed; they must be modified as conditions change.

Although they are no more impor­tant than operating budgets, capital budgets are the cornerstone of all bud­gets. Without spending for new pro­ductive facilities, other budgets would rarely be needed. Capital budgets, moreover, must be coordinated with

all other budgets, such as those cover­ing cash flow and operations. In this way, management will have an ad­vance picture of what is likely to hap­pen to the company as a whole.

The capital budget should be pre­pared on an expenditure basis rather than on an authorization basis. It should include all costs that cannot be charged to current operations. These include the costs of new plants and equipment, costs of replacements and improvements, and any deferred costs of research and development. It should cover both authorized projects and projects that may be authorized in a reasonable time. It should also indicate what the corporation's future cash requirements will be, so manage­ment will have enough time to obtain sufficient funds.

All Divisions and Departments

The capital budget should be drawn up by all of the company's divisions and departments, following the in­structions of top management. The detailed work of preparing the budget can be done by departmental person­nel. Particularly when new projects and expansions are costly, their profit­ability and potential obsolescence must be carefully studied.

Before a company installs added ca-

FEB. 2 0, 1961 C & E N 87

133321 feature

HMHMMDM

RAISING FUNDS-Should Company Borrow Money or Sel! Stock?

A simplified example can illustrate some of the factors t h a t affect manage­men t ' s thinking about financing construction projects. Take a company t h a t has about $1 billion in gross plant and working capital, can generate abou t a dollar in sales for every dollar of assets, and is expanding a t a ra te of about 10 % a year.

However, an unexpected reces­sion comes along. The com­pany's sales drop 10 %c, and inventories build up. Cost-cutting programs are put into effect. But the construction program continues at a rel­atively constant rate because of the time needed to modify

During a normal year, plans {usually it is undesirable if its profits are 30% to delay or cancel projects al-of its sales, its income ready under way). So the statement might look like income statement now looks this: like this:

Sales $ 1,000,000,000 $ 900,000,000 Operating costs — 700,000,000 -650,000,000

Operating profit 300,000,000 250,000,000 Depreciation - 100,000,000 -100,000,000

Net before taxes 200,000,000 150,000,000 Taxes - 100,000,000 - 75,000,000

Net income 100,000,000 75,000,000 Dividends - 60,000,000 - 60,000,000

Retained earnings 40,000,000 15,000,000 Depreciation + 100,000,000 +100,000,000

Cash generated 140,000,000 115,000,000 Capital outlays - 100,000,000 -100,000,000

40,000,000 15,000,000 New working capital - 30,000,000* - 60,000,000**

Excess cash $ 10,000,000 Def ic i t $ 45,000,000

in cash

* To take care of the output from new production facilities.

** To take care of the output from new production facilities, as well as the build-up of inventories resulting from lower sales.

Sometime during the recession year, the company will have to find some source of more cash. Assume t h a t its capital account looks like this:

Long term debt N e t worth Tota l capital

$300,000,000 600,000,000

$900,000,000

If management is conservative—wants to sleep well and also eat well and wants to remain in high regard with investors—it may decide to have no more t h a n 4 0 % of its capital in the form of debt . For tunate ly , t he corporation has ample leeway. I t can borrow up to $100 million (or, actually, a little more, since it will be adding some retained earnings to its net worth during the year) and still not exceed the 40 % limit.

Previous long term debt New debt

$300,000,000 100,000,000

Total debt Net worth

$400,000,000 600,000,000

40% 60%

Total capital $1,000,000,000 100%

The company, therefore, is likely to increase its debt ra ther t han sell stock. Growth companies are re luctant to sell stock unless absolutely necessary. The reason is t h a t while they are using the funds from a stock offering to build new plants—and before the new plants are contributing to earnings—the profits from their older operations mus t bear the burden of the dividends paid on the new stock.

Instead, companies prefer to borrow money, so long as they can s tay within a conservative debt rat io. For one thing, interest payments , which can be deducted as a cost from income before figuring taxes, are only about half as expensive to the company as the interest ra te indicates. They may actual ly be less of a drain on cash than dividends paid a t a lower ra te .

pacity for an existing product, it must estimate the likely counteraction of its competitors. All too often, industry has created problems of overcapacity and reduced its earnings when one company expanded its facilities and all of its competitors did likewise to hold their share of the market.

When potentially large amounts of capital are involved, these evaluations should be made by personnel with dif­fering skills and mental outlooks. This is especially important in estimating markets. Projects are frequently over­rated because people are too optimistic or are too inclined to promote rather than appraise. On the other hand, projects can be underrated because of undue pessimism.

Estimating too high a rate of return on an investment is the most frequent hazard. This can result from under­estimating the cost of the plant or overestimating such things as the rate at which it will operate, the price at which the product can be sold, and the amount that can be sold.

Corporate projects usually fall into one of three categories:

• New products and processes.

• Expansion of existing products and processes.

• Cost cutting.

Usually, management expects new products and processes to provide the highest rate of return. It looks to these to upgrade the return on the company's over-all investment and to balance the declining return that often occurs with old line products. On the other hand, companies often carry out expansions and cost cutting projects to maintain their markets, to stay com­petitive, and to protect their existing investments.

Studies of the capital needed for new projects should consider all re­lated factors. These include working capital and the costs of market devel­opment, advertising, plant start-up, and research and development.

Once the project is under way, ade­quate controls must be set up to be sure that field construction is done effi­ciently and within the engineering esti­mate used in authorizing it. During construction, changes in design which change costs need constant attention. So do changes in labor rates or in equipment and material costs. Man­agement must also check to see that the construction work is progressing on schedule.

88 C & E N FEB. 2 0, 1961

33 V»% 66 y , % 100%

Recently, a major oil company with large annual investments in chemical facilities adopted a new method of making up its capital budget. Pre­viously, each division of the company prepared its annual budget by accu­mulating the figures on specific in­dividual projects. It also calculated the expected return on investment for each project. The projects were then reviewed by management, which de­cided which ones were to go into the final budget and which were to be dropped.

Actually, the divisions began pre­paring their budgets nine months or more in advance of the year the budget was to cover. Since it is often difficult or impossible to anticipate chemical re­quirements that far ahead, many chemical projects had to be added to the budget after preparation had started. This made financial planning more difficult.

The company now uses a new ap­proach involving two types of budgets for its chemical investments. In addi­tion to a budget consisting of an ac­cumulation of definite projects, such as had been prepared formerly, it now also sets up a budget in which each project has a probability factor asso­ciated with it. For each proposed in­vestment, it assigns a percentage rang­ing from about 20 to 70%, indicating how strongly it wants to invest in the project. The amount of money re­quired for each project is multiplied by its probability factor to make up a program budget which management can then use in its over-all financial planning.

Small Firms Face Special Problems

The problems of managing capital in small or new companies, although similar to those of large corporations, frequently require more art and der­ring-do. Large, established concerns usually have considerable amounts of capital available. Their basic growth problem lies in selecting the right projects and controlling their outlays. A small company, on the other hand, seldom has enough capital'for even one major project. So, even after a proj­ect is selected, it faces the problem of getting the required funds. With a brand new company, there is no capital to start with, and each dollar it needs comes very hard. Both the small com­pany and the new one, therefore, must get the maximum mileage out of their funds.

SYMPOSIUM ON CAPITAL INVESTMENT AND CONTROL

Chairmen

DONALD B. BENEDICT Vice President Union Carbide Corp. New York, N.Y.

DR. EARL P. STEVENSON Chairman of the Board Arthur D. Little, Inc. Cambridge, Mass.

Speakers

WILLIAM H. BROWN Vice President and Treasurer

American Viscose Corp. Philadelphia, Pa.

DR. ROBERT L PURVIN Executive Vice President Foster Grant Co. Leominster, Mass.

KENNETH H. HANNAN Executive Vice President Union Carbide Corp. New York, N.Y.

JOHN E.WOOD III President Enjay Chemical Co. Division of Humble Oil & Refining Co. New York, N.Y.

A small growth company may re­quire capital for three purposes:

• Replacement.

• Expansion and improvement.

• New projects.

The small company can usually gen­erate enough capital from its opera­tions to pay for replacing equipment and expanding and improving its op­erations. But with rising costs, sel­dom is much money left over for new projects. Long term borrowing can provide some expansion money. How­ever, in a small, growing company, the increasing needs for working capital to handle increasing sales may use up much of its borrowing power. So in working out its capital budget, the company may find that the most prom­ising projects are much too rich for its corporate blood.

What can it do then? It can com­promise, or it can drop the project. Frequently, it compromises.

First, the company can determine whether it can build something less than the "ultimate plant." If it can put up a bare minimum of plant, it will gain certain benefits—even though the plant does not meet textbook stand­

ards of service and capacity. Possibly, construction can be stretched out, so that the plant is completed while al­ready operating. Installation of such conveniences as locker facilities, shops, warehouses, and plant offices may be delayed, as may be paving, painting, buying of spare equipment and parts, and many other items that can add up to a sizable investment.

Tougher and riskier compromises must be made when even these meas­ures fall short of solving the capital problem. The company must then try to reduce the size of its proposed plant, perhaps to only 25 to 30% of the ac­cepted minimum economic size. Such a plant won't fare as well as a bigger one, either in terms of total profits or profit margins. In fact, the plant may do little better than break even. But it can be used to prove the company's ability to make and market the prod­uct. At the same time, it can develop the company's technical proficiency in processing. And if this compromise works, the company can expand, step by step, as additional capital becomes available.

Such an approach may require more than the usual amount of capital to

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reach the ultimate plant. However, capacity is added only as needed. The operation of large plants well below capacity, with high operating costs and higher fixed costs and carrying charges, can actually be harder on finances than spending a little more total capital as earned.

A willingness and ability to com­promise does not mean that other sound business principles are unim­portant. Engineers, accountants, law­yers, marketing specialists, and chem­ists should still go ahead and plan the perfect plant, the ideal organization, the complete distribution system. But their recommendations can only serve as benchmarks—points at which to ap­ply the technique of compromise. Small companies don't "throw away the book/' But they must write their own answers.

The small company must recognize all the possible deviations from the "best way"—with all their advantages and disadvantages. If its capital prob­lems can be handled with reasonable understanding of the compromises that have been made and of the resulting limitations, management can arrive at an intelligent decision.

How to Set Up a New Company

New companies face all the prob­lems of the small company and many more. All such ventures involve some­thing new and different, yet they must use well known or reasonably proved principles. They must have easily available raw materials, a relatively well defined market, and, above all, must be highly profitable.

Promoting a new company is similar in many ways to promoting a new proj­ect in an established firm—with one big difference. The promotion of a new company is presented to strangers and generally to people who have only a limited background in the field. Convincing them is more difficult.

Bankers and investors look at a new venture from a completely independent point of view. Of course, they have every right to be critical and skeptical. To be successful, the promoter must offer them a precisely calculated risk and a sizable incentive. And he must assure them that the amount of money being invested is really adequate.

The attractiveness of a new com­pany to investors will usually depend on the promoter's ability to gain the greatest leverage—by borrowing the maximum amount of capital at the

lowest interest rate and by issuing a minimum of stock. The real trick is to sell bankers on the inherent safety of their investment.

Guarantees—of plant performance, sales, raw material supply, manage­ment availability—increase safety. But a venture can lose a large measure of flexibility and, therefore, potential profit by trying to lock up the entire project to reduce the risks involved. A good balance is essential. The key is the ability of the promoter to sell his ideas with a minimum of guarantees and a maximum of calculated com­promise.

The promoter must generally keep the capital investment low, even though, as a result, the new7 plant may have higher operating costs and fewer than the usual number of service facili­ties (which may not be too bad if the omitted facilities can be added later at no great extra cost). Expenses may also be reduced by cutting down on equipment and spare parts. The new company can make many other com­promises, such as buying instead of producing electrical power, or leasing instead of building warehouse and terminal facilities. Problems involv­ing recovery of waste streams or the upgrading of by-products are more difficult to resolve. But, even when profitable, such refinements can be de­layed as part of the compromise.

As time goes on, the job of obtain­ing needed capital through com­promise can become increasingly diffi­cult. When responsibilities spread with the growth of a company and when the chief "questioner" can no longer follow everything, the willing­ness to compromise slips away. In fact, the spread of responsibilities in a company almost always encourages more conservative thinking.

Ingenuity is essential in the art of capital management, which is, of course, the all-important ingredient in the development of new ideas and growth companies.

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90 C & E N FEB. 2 0, 1961

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