Evaluating capital-expenditure, Business Management

Evaluating Capital-Expenditure Proposals at Biotechnique Chemicals

In submitting a project for senior-management approval, the proposers had to identify it as belonging to one of four possible categories: (1) new product or market, (2) product or market extension, (3) engineering efficiency, or (4) safety or environment. The first three categories of proposals were subject to a system of four performance "hurdles", of which at least three had to be met for the proposal to be considered. The Glenlines project would be in the engineering efficiency category. The performance hurdles are:

1. Impact on earnings per share. For engineering-efficiency projects, the contribution to net income from contemplated projects had to be positive. This criterion was calculated as the average annual EPS contribution of the project over its entire economic life, using the number of outstanding shares at the most recent financial year-end used as the basis for the calculation. (At financial year end 1991, Biotechnique Chemicals had 92,891,240 shares outstanding.)

2. Payback. This criterion was defined as the number of years necessary for free cash flow of the project to amortize the initial project outlay completely. For engineering-efficiency projects, the maximum payback period was six years.

3. Discounted cash flow. DCF was defined as the present value of future cash flows of the project (at the discount rate of 13 percent for engineering-efficiency proposals), less the present value of the initial investment outlay. This net present value of free cash flows had to be positive.

4. Internal rate of return. IRR was defined as being that discount rate at which the present value of future free cash flows just equaled the initial outlay (in other words, the rate at which the NPV was 0). The IRR of engineering-efficiency projects had to be greater than 13 percent.

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