Capital Project Management, Volume II

Capital Project Finance

Robert N. McGrath

• Publisher: Business Expert Press
• Year: 2019
• Print ISBN: 9781949991864
• eBook ISBN: 9781949991871
• Topic: Business
• Subtopic: Project Management
• Index: Business

This book is companion to Volumes I and III in the series. Volume I covers managing strategy through capital project portfolios; Volume III is a complete case study. This volume describes the strategic challenge of adding real economic value, properly and rigorously defined. The author explains how this is accomplished through the capital budgeting process; discusses the importance of free cash flow and finally, capital projects, as financial options, are discussed, as a way to manage risk while enhancing the likelihood of project approval.

The author is a retired business professor; his research interest has been the management of technology and innovation. For this book, he double-checked none of the 1, 250 media items collected, accepting their overall veracity at face value. This approach advocates no one person, no one company, no one technology, and no portion of the global automobile industry. Analysis and practical application came foremost.

CHAPTER 1

Corporate Strategy and Capital Finance

Introduction

Volume I in this series addresses the comprehensive problem of corporate strategy using a project management approach, especially toward the development of a portfolio of capabilities. This chapter in this volume completes that theme toward addressing the capital project finance problem specifically. The pursuit of profitability cannot be correctly understood without discussing the corporate strategy and then, afterward, how that affects capital project planning and management. To begin, consider carefully the italicized terms in the following:

(Niu May 18, 2017).

… Can Tesla be both overvalued and undervalued? … Tesla is absurdly overvalued if based on the past, but that’s irrelevant. A stock price represents risk-adjusted future cash flows … Tesla can be overvalued in the short term but undervalued in the long term ...

It‘s all interrelated, though … Executing in the long term may subsequently drive the market cap higher, although Tesla will still need to address its short-term challenges.

By early 2017, Tesla had made the stunning achievement of exceeding the market capitalization of any other U.S. auto manufacturer, but was still far from demonstrating profitability. Was this feat just an investment bubble as they say, the irrational exuberance of a recovering global economy, animal spirits gone over the top? After all, the market cap went back down before long, though for many reasons and not all the fault of Tesla or Elon Musk. The dynamics of these things are complex and sophisticated, and obviously, outcomes depend on how executives manage the external situation from all points of view.

Words like capital, capitalization, and capital projects are used frequently. Connotations and opinions aside, in a capitalist economy, like those who characterize most of the industrialized world, financial and investment pressures are never irrelevant, invariant, or confined to Wall Street. One way or the other, all humans are invested in this story, and it does well to have insight into what is going on. Grasping the concept of capital itself helps explain why people on Wall Street think the way they do, and why the news media often speaks the way it does in the terms it uses.

After studying this chapter, the reader will be able to

Provide a simple explanation of capitalism as an economics theory that is focused on the productivity of accumulated investment or owner capital.

Explain the difference between economic profit and accounting profit, how each is measured, and where to find these numbers in required corporate financial statements.

Define opportunity cost and explain its importance to understanding the cost of capital.

Define capital structure and the weighted average cost of capital (WACC).

State the relevance of the WACC to the capital project hurdle rate.

What Is Capital-ism?

Capitalism is the economics theory that cannot be properly understood unless the word capital, not liberty or freedom per se, stands at its center.

Part of the confusion lies in the fact that the word capital can be inferred to mean different things, but they all come down to one. Think of capital as anything that can be used as a resource in a production process. That is close enough to the economic definition, which is a little more complicated. Hopefully, the production process in mind is the one that somehow, adds value to the monetary cost of any capital resource, allowing a price above cost that is justified at least by that added value. Here, cost of the resource means the cost of parts, labor, equipment, land, and the cost of money itself.

It was discovered early in the Industrial Revolution (i.e., in the late 1700s and especially the early 1800s) that any one person could become only so productive at the added value part, without getting a boost from some kind of production technology, for example, in those days, the steam engine, the reaper, the cotton gin. Let us say that 100 people all making (or growing) the same thing but all separately, added up their total production and calculated its value; the latter basically, the average price across all 100 individual producers, times their overall unit volume. Now, let us say that all 100 business owners agreed to pool their resources so that en masse, they could jointly buy and own some newfangled invention that processed their resources and produced the product. Assume that no one person could afford the technology, but together they could buy and own it.

Ownership of private property is a key to it all, then and today.

Today, people buy stock and own a company collectively; in those days, they bought livestock and owned a herd collectively, which is at the etymology of the idea. The economic principle is the same. Now, corporate bonds that are sold and used to finance a firm are also called capital, but represent debt and not ownership, and the economic principle is a bit different. The distinction is important and will resurface later when discussions become more specific.

As they hoped, the total production went up, and also, the unit cost (hence the average price they could offer) went down.

Next, assume they formed an organization, called it a corporation in order to separate ownership from management for good legal reasons, and thereby hired several people called managers whose prime duty—their fiduciary duty—was to properly oversee their property and maximize its economic potential, unless otherwise directed by said owners.

To help monitor this duty, they created a committee called the board of directors. First and foremost, the board worked for the true owners, not the managers. In fact, its prime job was to make sure the managers best represented the interest of the owners and investors of the capital.

The investors of capital had property rights, real property rights, while the managers “just worked there.”

Assume that the economic gains to this productivity phenomenon were returned to the 100 original owners in proportion to their personal investments. One period to the next. It was the productivity improvements that really mattered, so soon they expanded by borrowing from others and buying more land, more equipment, and hiring more people. All investors owned the company in proportion to their investments and made proportionate returns.

The owners of capital made more economic gain by pooling it and entrusting it to managers, than by keeping it fragmented and personally controlled.

In this light, consider:

(Lovelace May 14, 2018).

Buy and hold billionaire Ron Baron on Monday defended his investment in Tesla, saying he doesn’t care that he hasn’t made very much money from the electric-car maker yet.

“I think we’re going to make 20 times our money because the opportunity is so enormous,” [he said,] “people say, ‘gee, they’re spending a lot of cash.’ of course, they’re spending a lot of cash. They’re building factories.”

If an investor waits until something is successful then, “it’s too late. Then you’re going to pay a high price,” said Baron … “what we try to do is buy when that development is taking place.”

The economic value of a firm, then, is said to be, in today’s terms, the value of the firm that can be rationally predicted of its future. When the hypothetical capitalists of ...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Abstract
• Contents
• Preface
• 01_Chapter 1
• 02_Chapter 2
• 03_Chapter 3
• 04_Chapter 4
• 05_Conclusion
• 06_Media Articles
• 07_References
• 08_ATA
• 09_Index