Board oversight of capital expenditures.

Issues for the director to consider in assessing management's intentions for deploying capital.

THE SCENE IS SET. Nine directors sit around an oval-shaped table. The board meeting, which began at 10 a.m., is now well into its fifth hour. One director is beginning to fidget, nervously looking at his wristwatch. He is concerned about his scheduled 5 p.m. departure from LaGuardia. Another begins to contemplate potential traffic congestion during her cab ride to Penn Station.

The chairman, aware of the hour, scans the open agenda items. Only two remain unaddressed: capital expenditure requests and other business. Frustrated, he silently ponders why these blasted meetings always take so long. Perhaps the 30 minutes spent discussing revisions to the major medical plan were excessive.

Then again, the debate about the new advertising campaign was a departure from the agenda. Although the topic is important, did it really warrant the 50 -minute dialogue? Well, in any event, he quickly concludes that the meeting can't be dragged out much longer.

Chairman: "The next item on the agenda is capital expenditure requests. There were four included in your folders. As you know, in accordance with policy, we must approve all requests in excess of $1 million. I assume you have taken the time to review management's descriptions of the projects and the associated financial analysis. Are there any questions?" Pause, "Yes, Jack."

Jack (outside director): "Why are we spending $6 million on new packaging equipment? The returns are paltry and I'm not aware of any serious problems with the existing equipment."

Chairman: "Who from management would like to address this question?"

Bill (VP of operations): "I'll try. Our division president feels that this expenditure is necessary to keep us competitive in the marketplace. Several competitors have already adopted the new technology. If we don't move quickly the equipment manufacturer will be heavily backlogged, and we may have to wait nine months or more for delivery."

Jack: "Yes, but it seems to me that $6 million is a lot of money for...well, I'll let it go."

Chairman: "Okay, any other questions?" Pause. "Well, hearing none, I'll entertain a motion to approve all four requests as a group."

Bill: "So moved."

Tom (LaGuardia-bound director): "I'll second."

Chairman: "Any further discussion?" Silence. "All in favor?"

Board: "Aye."

Chairman: "Opposed?" Silence. "Please let the minutes reflect that the board has approved the four requests which in aggregate total $18,250,000."

Inappropriate prioritization

Been there? Done that? Shame on you; no, shame on us. To some degree we are all probably guilty of negligence when it comes to the allocation of capital. At a board meeting we won't hesitate to spend half an hour discussing a medical plan revision -- an action with a potential financial impact of $200,000 per year. But when it comes to capital expenditures we will make multimillion-dollar commitments at the drop of a hat.

Poorly constructed management descriptions, late receipt of board material, inappropriate board agenda prioritization, and a host of other factors have contributed to our sins of omission and commission. Perhaps it's finally time to pause and revisit the capital expenditure assessment imperative.

Let's quickly recognize and acknowledge that the allocation of capital is not the board's most important responsibility. I believe we would all agree that the selection, motivation, retention, and, if necessary, replacement of the CEO occupies this position of primacy. Indeed, one could argue that capital expenditure decisions fall within the purview of management, not the board.

However, beyond the care and feeding of the CEO, there are few board actions that will influence future organizational success more profoundly than the deployment of financial resources. Can the board truly fulfill its fiduciary responsibility without meaningfully assessing, challenging, and ultimately reconciling with management major capital commitments?

If we agree that oversight of capital spending -- at some reasonable threshold spending level -- is a legitimate area of board oversight, how do we fulfill our responsibility?

The bigger issues

A director's initial review will almost certainly involve financial returns. Boards routinely weigh the cash flow implications associated with capital expenditures. At a minimum, payback -- i.e., length of time required to recover the cost of the investment -- is considered. Most companies also calculate discounted cash flow indicators such as net present value and internal rate of return.

While these represent an appropriate starting point, they fall well short of the concept of due diligence as it applies to the duties of directors. Here are the other issues to consider.

Risk: While it is unreasonable to expect management to precisely quantify the risks associated with a capital expenditure, it is totally appropriate to request a comprehensive and objective qualitative risk assessment. All investments are not created equal, and overzealous managers can disguise important facts.

An investment opportunity with an internal rate of return of 35% is clearly a better alternative than one with a return of 20%, right? Not necessarily. Risk levels vary depending on organizational experience and the nature of the project. Suppose management failed to inform you that the project carrying the 35% IRR is largely untested in its environment or that its impact on product quality is not totally certain. Introducing new products or entering new markets often holds higher levels of risk than projects intended to reduce costs.

Sensitivity Analysis: After a director has concluded that the risks are acceptable given the associated returns, it maybe appropriate to expose the projected financial returns to sensitivity analysis. "What if your savings estimates are overstated by, say, 10%? What effect would this have on the project's IRR?" "What if the projected revenue increases don't fully materialize? How might that affect your projected returns?" Again, these are perfectly appropriate questions for the discerning director to ask management to address.

Hurdle Rates: We have learned that the rate used to calculate discounted cash flows should approximate a company's cost of capital. As a result, the argument goes, projects that carry a positive IRR or NPV will, by the amount of the differential, build value. At a theoretical level, the argument is difficult to attack. But let's remember that all investments do not yield positive cash flows. In reality, a substantial amount of a company's investments are, by necessity, directed toward projects with zero cash flow implications.

Complying with ever-changing legislative requirements or simple maintenance (such as roof replacements) offers no financial gains. If we divide all prior years' expenditures between those with and those without a financial return, what proportions would we observe? If a significant percentage of a company's capital expenditures are committed to zero-return projects, an erosion of the firm's economic value is likely unless the remaining projects carry very healthy returns.

Discipline: Finally, it is the responsibility of the board to impose discipline over the capital-spending process. This can take on several forms. First, do the balance sheet and projected cash flows provide the financial wherewithal to support the expenditures? Even very attractive projects may need to be postponed if approval would place excessive financial strain on the organization.

It is also incumbent on the board to be sure that management holds to the strategic course. Is this expenditure consistent with the mission and strategic plan? It may be inappropriate for a company that is, for example, strategically committed to holding a dominant position in logistics and distribution to commit significant capital to a product-development project (even though otherwise worthwhile) that does not support this objective.

Diligence on deployment

The deployment of capital significantly influences the financial performance of the company over the long term. The board must oversee the capital expenditure process. Merely reviewing management's projected financial returns does not adequately satisfy this obligation. A variety of other factors, such as risk, return sensitivity, financial strength, and strategic thrust, must also be considered.

The factors addressed in this article are in no way intended to be exhaustive. Industry- and company-specific circumstances will ultimately dictate factors of critical importance. Notwithstanding the specifics involved, this is an area of opportunity and responsibility for capable directors to exercise good judgment and diligence.

Dr. James J. Darazsdi, CPA, is the president of RainMakers Management Consultants, Galena, Md. He is also a member of the faculty of Washington College, Chestertown, Md., where he teaches courses in strategic management, accounting, and marketing. He serves on three corporate boards. He formerly served as chairman of the National Association of Corporate Directors.