Where does marketing fit into the capital budgeting equation?

Harrison-Walker, L. Jean ; Perdue, Grady

ABSTRACT

In order for a firm to grow, the firm must often implement various growth-oriented projects. After a number of new project ideas have been generated, the initial list of ideas is screened and those ideas that are inconsistent with the organization's strategy or are otherwise deemed inappropriate are eliminated from consideration. Ideas that survive the initial screening process are then examined for financial feasibility using any or all of the recognized capital budgeting techniques to select which projects should be pursued and funded.

However, financial projections are all too often made on the assumption of "all else being equal." The significance of marketing activities that may determine--or increase--the value of a particular project under consideration by a firm, is seldom directly recognized in finance. This discussion examines the significance of marketing in evaluating the investment potential of a project, which in turn determines whether a given project is--or is not--approved.

INTRODUCTION

In order for a firm to grow over time, the firm must often implement various growth-oriented projects. These projects may include adding a new product line, making an acquisition, building a new plant, or expanding operations internationally. The growth process begins by brainstorming a number of new project ideas. After a number of new project ideas have been generated, the initial list of ideas is screened and those ideas that are inconsistent with the organization's strategy or are otherwise deemed inappropriate are eliminated from consideration. Ideas that survive the initial screening process are then examined for financial feasibility.

There are six commonly recognized capital budgeting techniques that might be utilized by a firm's financial management team to analyze projects in an effort to determine which project (or projects) should be funded. However, financial projections are all too often made on the assumption of 'all else being equal.' Finance tends to take marketing as a 'given' in financial analysis. So the significance of marketing activities that may determine--or increase--the value of a particular project under consideration by a firm, can easily go unrecognized.

Only recently have researchers examined the interrelationship of marketing and finance, including Davidson and Hussey (1999), Zinkhan and Verbrugge (2000), and Loomis, Schlosser,

Sung, Boyle, and Neering (2001). For example Barwise, Marsh and Wensley (1989) tells us "The financial criteria used to decide if a project will be profitable are entirely consistent with the tenets of competitive marketing analysis." Harrison-Walker and Perdue (2004a) point out that marketing and finance share a common goal in the economically viability of the firm, but take different approaches to reach their common goal. "Rather than thinking that one discipline is 'correct,' the more appropriate view is to understand that they constitute different parts of the same team." (Harrison-Walker and Perdue 2004b) The current discussion specifically examines the complementary roles and significance of finance and marketing in evaluating the investment potential of a project, which in turn determines whether a given project is or is not approved.

This paper is presented in four parts. We begin with an overview of capital budgeting and review those aspects of the weighted average cost of capital (WACC) formula that are controllable or otherwise thought to be influenced by finance. Second, we discuss the role of marketing in terms of stabilizing revenues and reducing cash flow volatility, specifically as marketing's role relates to the WACC. Next, we look at the role of marketing in terms of revenue and marketing expenditure projections for a new project. We conclude our discussion of how marketing fits into the capital budgeting equation by examining the various means by which marketing acts to enhance cash flow.

CAPITAL BUDGETING

Capital budgeting is part of the overall strategic management of the firm. Management must set the overall goals for the corporation, and then design a strategic plan for the accomplishment of the goals of the firm. Part of the strategic plan and its implementation is the selection of the projects that will be pursued as part of that plan. Brigham and Ehrhardt (2005) explain that " ... capital budgeting is the whole process of analyzing projects and deciding which ones to include in the ... " set of planned future investments for a company. Capital budgeting involves using analytical tools to help ascertain which of the various acceptable projects will be the most economically viable for the firm. Once that determination is made, then the firm's capital budget (the funds available for new projects) is allocated based on that analysis.

Capital budgeting analysis is normally done in purely financial terms, not explicitly considering many of the issues a marketing department will use to judge the worthiness of projects. The capital budgeting techniques known as (1) payback, (2) discounted payback, (3) net present value, (4) internal rate of return, (5) modified internal rate of return, and (6) the profitability index, may be used to examine the expected cash flows of each potential project. Payback is not a discounted cash flow technique. However, the other five techniques listed are discounted cash flow methodologies that are based on the time value of money.

To what extent are these six approaches used in modern business? Bierman (1993) determined from his study of capital budgeting practices among the Fortune 500 firms that most firms use multiple techniques, hoping to derive different types of information from different approaches. He found that 99 percent of the surveyed firms used the internal rate of return, 85 percent used net present value, and 84 percent used payback. He also noted that every firm used some form of discounted cash flow technique in its capital budgeting process. Walker, Burns, and Denson (1993) surveyed capital budgeting of small firms, and found that only 21 percent of these firms used any of the discounted cash flow techniques. Their study indicated that small businesses generally failed to utilize any analytical technique besides payback due to three reasons. The reasons were (1) an overriding concern for liquidity (best measured by payback), (2) not having knowledge of discounted cash flow techniques, and (3) a belief that their projects are so small that any time value of money analysis would not be irrelevant.

The discount rate and WACC

In the five discounted cash flow approaches, the key variable in the analysis is the discount rate. The discount rate is the minimally acceptable rate of return a firm must earn on the capital invested in the corporation. Given that firms know there is a minimally acceptable rate of return on investments, projects undertaken by the firm must contribute towards that purpose. (Allowances are made in many firms for marginally adjusting the discount rate to reflect the riskiness of a particular project. However, all the firm's projects must produce a collective return that equals or exceeds the firm's overall discount rate, or weighted average cost of capital.)

The discount rate normally used by the firm in the capital budgeting process is equal to its weighted average cost of capital (WACC). The WACC is based on the required return for each component of debt and equity in the firm's capital structure. Investors--whether holding debt or equity--have provided capital to the firm, and these investors expect a certain rate of return from the firm in return for providing long-term funding to the company. Assuming a firm with debt, preferred stock and common stock (both of which are forms of equity), the weighted average cost of capital for the firm is given as

WACC = [W.sub.d][K.sub.d](1-T) + [W.sub.p][K.sub.p] + [W.sub.e][K.sub.e]

where [W/sub.d] = the percent of debt in the capital structure, [W.sub.p] = the percent of preferred stock in the capital structure, [W.sub.e] = the percent of common stock in the capital structure, [K.sub.d] = the rate of interest on the firm's bonds, T = the firm's marginal tax rate, [K.sub.p] = the required return on preferred stock, and [K.sub.e] = the required return on common stock.

The first part of the WACC equation describes the debt component. A certain percentage, [W.sub.d], of nearly every major corporation's capital structure is comprised of debt (bonds). These bonds pay a given rate of interest to the bondholders, [K.sub.d]. Interest payments are tax-deductible for a firm, so it is the after-tax cost of the payments that are the actual cost of debt for the firm. Therefore, [K.sub.d] (1-T) becomes the after-tax cost of debt in the capital structure. The component cost of capital that must be paid to holders debt is WdKd(1-T).

The rest of the capital structure is composed of the two forms of equity. Though most firms do not have preferred stock and [W.sub.p] is equal to zero, when it is present the component cost of capital that must be paid to holders of preferred stock is given as [W.sub.p] [K.sub.p]. For many firms the largest component of the capital structure is the common equity. With [K.sub.e] being the minimum required return investors expect to earn, the weighted return for this component of the capital structure is [W.sub.e] [K.sub.e]. There are no tax adjustments for the equity components, as U.S. tax laws do not permit the deductibility of dividend payments.

Financial theory (Brigham and Ernhardt 2005) argues that the firm should move to minimize its weighted average cost of capital. A minimum WACC is attractive to a firm since the total return the firm must pay to its capital structure components is minimized. Also, a minimum WACC (i.e., the smallest possible discount rate) for use in the five time value of money-based capital budgeting techniques, means acceptable projects become more profitable and marginal projects can be found to be more acceptable.

Clearly among the things that management can influence is the particular capital structure selected for the company. While the rate of return on each asset class is at least partially determined by the market, management has great discretion in choosing the particular mix of debt and equity that comprises the firm's capital structure. Finance textbooks in universities commonly discuss the ability of management to vary the proportional use ([W.sub.d], [W.sub.p], and [W.sub.e])) of the sources of capital, and influence the firm's WACC.

More important for this discussion, management also has the ability to specifically influence the common equity component of the WACC. By taking actions that raise or lower [K.sub.e] (the required return on common stock), WACC is ultimately raised or lowered. Within the context of the Capital Asset Pricing Model (CAPM), financial theory argues that the cost of common equity capital, [K.sub.e], is derived as

[K.sub.e] = [K.sub.rf] + ([K.sub.m] - [K.sub.rf]) [[beta].sub.i]

where [K.sub.rf] = the risk-free interest rate, [K.sub.m] = the required return of the market, and [[beta].sub.i] = the beta of the individual company.

The first two variables lie completely outside the control of management. The risk-free rate (along with level of all interest rates in the market) and the required return on the market are both exogenous variables. Beta, on the other hand, can be at least partially determined by management.

Financial theory indicates that management can influence beta in a variety of ways. For example, changing the capital structure will itself change beta. The use of less financial leverage (debt) in the capital structure should result in a reduced volatility of earnings that will lower beta. Beta can also be lowered by management choosing future investment projects that reduce the level of risk for the firm's overall capital budget, which reduces the overall volatility of the firm's earnings. All other things being equal, the lower the beta for a firm then the lower will be its [K.sub.e]. This implies a lowered WACC (and discount rate).

What is not normally addressed in conventional financial analysis is the role of marketing in determining the firm's beta. Financial analysis normally treats marketing as a given. A certain level of marketing is taken as a given for the firm, and there is usually no acknowledgement within financial analysis that marketing might be able to play a role in the capital budgeting process. However, if through marketing the firm can reduce the volatility of its earnings (and its beta) that will lead to the firm to having a lower cost of equity capital ([K.sub.e]). The reduced cost of [K.sub.e] implicitly would result in a reduced WACC. Since the WACC is the discount rate used in the firm's capital budgeting analysis, the discounted cash flow tools would all recognize each project as being more profitable. Acceptable projects would become even more attractive, and previously rejected marginal projects could even become acceptable.

MARKETING AND REVENUE STABILIZATION

Marketing can contribute to reducing the firm's beta, just as proper financial management can. However, while finance seeks to reduce volatility (or beta) by either lowering the use of debt in the corporation's capital structure or by investing in lower risk projects, marketing seeks to reduce volatility by the direct stabilization of revenues. The volatility of revenue and earnings can be lowered when retention, customer satisfaction, and loyalty are increased (Srivastava, Shervani, and Fahey 1998). "When the firm has a satisfied and loyal base of customers, the cash flow from these customers is less susceptible to competitive activity" (Srivastava, Shervani, and Fahey 1998, p.12).

A number of marketing activities are designed in such a way as to promote satisfaction, loyalty, and retention. As an example, relationship-marketing programs are intended to enhance customer loyalty to the company and the brand, while increasing switching costs. Switching costs are the psychological, social, and economic costs a customer incurs when changing a supplier (Gruca 1994; Sengupta, Krapfel, and Pusateri 1997). For example, Verizon communications charges customers a fee of $5.00 to change long distance providers. This serves to discourage customers from switching providers. When companies serving business customers offer special services free of charge to their customers that are not available from competitors, there is an economic cost associated with switching suppliers. Revenues are more stable to the extent that customers can be maintained and discouraged from switching to other providers.

Cross-selling multiple services and products--and thereby increasing the number of bonds between a company and its customers--can also promote customer loyalty and increased switching costs (Srivastava, Shervani, and Fahey 1998). Customers appreciate the efficiencies associated with one-stop shopping. Activities designed to reduce cognitive dissonance (post-purchase anxiety), such as letters thanking customers for their purchase and letting them know they are important to the business, help the company cement long-term relationships with its customers (Lamb, Hair, and McDaniel 2000).

Other activities that help to reduce the uncertainty of business-to-business cash flows include developing partnerships with suppliers and channel members, leading to greater sharing of information, automatic ordering and replenishment, and lower inventories (Srivastava, Shervani, and Fahey 1998). These activities, along with just-in-time inventory programs and electronic supply chain linkages, tie companies together structurally. Marketers have recently begun to recognize the effect that their activities have on the level of volatility in their businesses and increasingly are looking at how to reduce the volatility of market share and sales volume, rather than simply focusing on sales volume.

THE ROLE OF MARKETING IN PROJECTING REVENUES

A separate question from the ability of marketing to reduce the volatility of cash flows for potential capital budgeting projects is whether marketing has the ability to enhance (make larger) the cash flows associated with a particular project. Brigham and Ehrhardt (2005, p. 399-400) hint at a belief within the finance discipline that marketing has such a role. In considering scenario analysis within their discussion of cash flow estimation in capital budgeting, they offer the following:

In a scenario analysis, the financial analyst begins with the base case, or most likely set of values for input variables. Then, he or she asks marketing, engineering, and other operating managers to specify a worst-case scenario ... and a best-case scenario.

Presumably, the best and worst-case scenarios are a function of external factors. In other words, the level of revenues from a particular project may vary as a result of various exogenous reasons, such as the state of the economy, etc. Brigham and Ehrhardt (2005) appear to be asking for a best guess at low and high revenue potentials associated with a project at a fixed level of marketing effort. In other words, an assumption of 'all else being equal' is made. However, in addition to the influence of exogenous factors, various levels of marketing activity (endogenous, or controllable by the firm) associated with a project should also produce different levels of revenues from the project. Thus, finance really has not only the original three scenarios (base, best and worst) based on exogenous factors to consider, but also cases with various levels of marketing effort. The three initial scenarios can therefore turn into six, nine, or many more, depending upon how many levels of marketing activity are considered. This should raise the question within capital budgeting of whether or not marketers should provide finance with projections based on a single level of marketing effort, or multiple levels of marketing activity. Capital budgeting should consider on what basis is that single level of marketing effort was selected.

Budgeting marketing activities

There are essentially four budgeting techniques in use by businesses today: (1) percentage of anticipated sales, (2) availability of funds (whatever the company can afford at the time), 3) competitive parity (based on what the competition spends) and (4) objective and task (whatever it takes to achieve the company's objectives). The primary weakness of the percentage of sales approach is that the company budgets more for marketing activities when sales are high and less for marketing activities when sales are low. Interestingly, various studies of actual business practices find that more companies use the percentage of anticipated sales technique than any other technique (Ramaseshan 1990; Synodinos, Keown, and Jacobs 1989). The second technique suffers from a total lack of planning. The third technique assumes that the company has comparable resources to its competitors and that the competition has done a better job of determining an appropriate marketing expenditure. Each of the first three techniques focuses on coming up with a budget first, and allocation of funds to specific marketing activities later. In contrast the objective and task technique focuses first on the company's objectives and how best to meet them, and then determines the budget that is required to support the necessary marketing activities. A more reliable revenue projection can be made to the extent that marketing activities are specifically identified and tied to objectives. However, the objectives may vary depending upon the exogenous conditions present at the time.

According to Buzzell and Wiersema (1981), increased outlays for marketing expenses tend to accompany successful market share building strategies, and therefore profitability. As marketing expenditures fluctuate, so does potential revenue. The numbers used for projecting revenues for new projects are highly dependent upon the specific level of marketing activities planned to initiate and maintain the new project. Marketing's role in generating revenues becomes immediately apparent and it becomes important to understand just how marketing activities affect revenue generation.

MARKETING AND REVENUE ENHANCEMENT

According to Srivastava, Shervani, and Fahey (1998, p.11), marketing activities serve to increase the level of cash flows or generate cash flows that are higher than otherwise. More specifically, "cash flows can be enhanced by (1) generating higher revenues, (2) lowering costs, (3) lowering working capital requirements, and (4) lowering fixed capital requirements." Satisfied customers buy more of a particular product or service from a given supplier (see Bolton 1998; Bolton, Kannan and Bramlett 2000; and Verhoef, Franses and Hoekstra 2001), buy additional products or services (Reichheld and Sasser 1996), make recommendations to others, (Anderson, Fornell, and Mazvancheryl 1998), and exhibit increased price tolerance (Anderson 1996; Narayandas 1998). From a managerial perspective, well-established and differentiated brands can earn a price premium and, at the same time, require less in terms of promotional expenses to maintain the product or to launch brand extensions. Closer relationships with suppliers have enabled channel partners to achieve greater efficiencies by linking their supply chains (Srivastava, Shervani, and Fahey 1998). Cooperative ventures, such as cobranding and comarketing alliances, also enable firms to enhance cash flows (Bucklin and Sengupta 1993). Cooperation that involves sharing brands and customer relationships enables firms to (1) lower the cost of doing business by leveraging others' already existing resources, (2) increase revenues by reaching new markets or making available others' products, and (3) avoid the fixed investment of creating a new brand altogether or of establishing or extending the customer base (Srivastava, Shervani, and Fahey 1998). Cost savings may also be realized as a result of imitating competitive offerings, as opposed to the firm conducting its own innovative research and development (Mizik and Jacobson 2003).

Spin-off opportunities

Marketing recognizes that some strategic investments go beyond the exploitation of a particular opportunity (Barwise, Marsh and Wensley 1989). Strategic investments may open up options that extend even further into the future than the original project (Barwise, Marsh and Wensley 1989). Examples include options stemming from investments in R&D, know-how, brand names, test markets, and channel developments that create options for subsequent products that complement or are based on existing ones (Barwise, Marsh and Wensley 1989). Such investments have value beyond the initial investment (Barwise, Marsh and Wensley 1989). As noted by Hayes and Garvin (1982), few investments are intended as 'doomsday projects' for which there is no successor. Focusing on the net present value of initial projects can lead to a series of absurd decisions that are not in the long-term best interests of the company. Capital budgeting decisions need to take into account the spin-off opportunities that may enhance the revenues associated with a particular project.

CONCLUSION

The success of a new project "depends, in large measure, on marketing's ability to gain the support of the financial managers" of their company (Lamons 2002).

 The CEO's most trusted advisor these days is the CFO. If the CFO
 doesn't see the need, it doesn't get done, and that includes brand
 image development, e-commerce initiatives, customer relationship
 management programs, Six Sigma, and anything else with a big price
 tag attached (Lamons 2002, p.5).

All too often areas within a firm often operate in isolation, and yet a business as a whole functions as a system. Logically, all actions within a firm must be interdependent. As demonstrated in this article, making the 'all else being equal' assumption in capital budgeting analysis may be myopic. As demonstrated in this paper, the value of a project may be greatly impacted by the marketing activities of a firm. All too often capital budgeting techniques focus on the results of a calculation, rather than on the important underlying assumptions on which the calculation is based (Tilles 1966). This would include (among other things) the interaction between exogenous variables and the level of marketing activity needed to achieve particular strategic objectives. A significant contribution of this paper is to describe the mechanism by which marketing impacts the valuation of a project and the necessity for finance to explicitly consider the level of marketing activity in its evaluation of new projects.

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L. Jean Harrison-Walker, University of Houston-Clear Lake Grady Perdue, University of Houston-Clear Lake