Question

1. How important is the Capital Expenditure request process to Stryker

2. What financial calculations might you perform to complete the economic value justification?

Answer 1

Answer 1.

Problem Diagnosis

            The main focus of this case is the capital budgeting process and the capital investment approval process that is taking place at Stryker Corporation. It sets out all the detailed procedures, rules, policies, authorization limits for different types of capital spending which normally include the working capital requirements for the existing business, machinery, buildings, licensing agreements, joint ventures, acquisitions and mergers. The track record of the company had been impressive and the profitability of the company along with the growth in the share prices of the company had boosted significantly over the past years.

It was in 2007, when significant modifications had been made to the Capital expenditure requests approval system and these modifications were made so that the spending thresholds for the Group and the Division levels could be increased. However, it was in the same year that problems started to arise despite the fact that the modifications that had been made to the system were intended to support the long term sustainability and growth of the company. The stipulated time for the review of the CERs and its submission was not being met.

Furthermore, the Committee was not available whenever the divisions needed them. There was no formal way through which the complaints were being handled by the Committee and no formal meetings were conducted by them. Some of the managers thought that the new modifications were unnecessary and as a result of them recently some of the CERs had been rejected. Overall, everything was clashing with the decentralized structure and culture of the company, which was increasing the issues for everyone.

Situation Analysis

            The mission of the capital budgeting process at Stryker Corporation and the main purpose of CERs is that a formalized and a standardized capital budgeting process should be formulated at the organization. This set of procedures and policies had been designed at the company so that a formal process so set up for requesting for the capital budgeting investments and formal approval is required before a capital spending is made. The growth benchmark of Stryker is 20% and the capital budgeting process in place at Stryker was developed to support this growth and also sustain the long term profitability of the company.

            A simple capital expenditure approval process is shown in the diagram below:

Use of Corporate Financial Theory

            There are many types of submissions for the capital spending at Stryker Corporation and formal approval is required for all of them. The most important capital budgeting requests include the requests for licensing agreements, equipment’s, buildings, mergers and acquisitions etc. All the approval forms and the submissions that are made for the capital budgeting requests contain detailed financial and operating analysis, sensitivity analysis, and what-if analysis to support the request for the particular capital expenditure. In order to perform the detailed financial analysis there are many concepts of corporate financial theory. The following points highlight these facts:

• All the submissions that are provided show all the key financial indicators such as the internal rate of returns, modified internal rate of returns, payback period, net present values and sensitivity analysis.
• All the outgoing cash flows and the incoming cash flows from the projects are highlighted.
• The impact of the project’s inflows and outflows on the net earnings of the company is also evaluated and analyzed.
• The specific risks facing the projects are also described and how they can affect the project returns in case those risks materialize.
• Economic justification is provided and proved for all the operational CERs.
• For all the merger and acquisition CERs, the base case, worst case and the best case computations are incorporated so that the magnitude of the risks inherent in the projects could be evaluated.
• All the project completion dates and the milestones are also mentioned so that the project remains on track.

Impact of Industry, History and Culture on CERs

Industry: As the baby boomer population is growing and the medical industry on the other hand is also growing. Therefore, as a result of this Stryker is also going to experience growth in the company’s CERs and capital investments. However, in order to sustain the current and achieve the future growth for the company, its management needs to have strong capital budgeting procedures and CER evaluation methods in place. Through these setups the company would only be able to make the best financing decisions and touch the future growth targets for the company.

2.

Economic Value Added (EVA) or Economic Profit is a measure based on the Residual Income technique that serves as an indicator of the profitability of projects undertaken. Its underlying premise consists of the idea that real profitability occurs when additional wealth is created for shareholders and that projects should create returns above their cost of capital.

EVA adopts almost the same form as residual income and can be expressed as follows:

EVA = NOPAT – (WACC * capital invested)           

Where NOPAT = Net Operating Profits After Tax

WACC = Weighted Average Cost of Capital

Capital invested = Equity + long-term debt at the beginning of the period

and (WACC* capital invested) is also known as finance charge

Calculating Net Operating Profits After Tax (NOPAT)

One key consideration for this item is the adjustment of the cost of interest. The cost of interest is included in the finance charge (WACC*capital) that is deducted from NOPAT in the EVA calculation and can be approached in two ways:

1. Starting with operating profit, then deducting the adjusted tax charge (because tax charge includes the tax benefit of interest). Therefore, we should multiply the interest by the tax rate and add this to the tax charge; or
2. Start with profit after tax and adding back the net cost of interest. Therefore, we should multiply the interest charge by (1-tax rate).

Accounting Adjustments

Three main adjustments should be made. Among the most common and important are:

• Expenditures on R&D, promotion, and employee training should be capitalized.
• Depreciation charge is added back to profit and instead, a charge for economic depreciation is made. This reflects the true change in the value of assets during the period, unlike accounting depreciation.
• Accounts such as provisions, allowances for doubtful debts, deferred tax provisions, and allowances for inventory should be added back to capital implied.
• Non-cash expenses should be added back to profits and to capital employed.
• Operating leases should be capitalized and added back to capital employed.
• Tax charge will be based on cash taxes, rather than the accruals-based methods used in financial reporting and will be calculated as follows:

Tax charge per income statement – increase (or + if reduction) in deferred tax provision + tax benefit of interest = Cash taxes

Calculating the Finance Charge

Finance Charge = Capital invested * WACC

and WACC = Ke*E/ (E+D) + Kd (1-t)*D/ (E+D), where Ke = required return on equity and Kd (1-t) = after tax return on debt

Thus, given the adjusted taxes, we can write the economic value-added formula as follows:

EVA = NOPAT – (WACC * capital invested)