Options & Capital Budgeting: Timing, Strategy & Planning

Instructor: Betty Fitte

Betty teaches college business management and finance courses and has senior management business experience.

This lesson explores the timing, strategy and planning for options in the context of business capital budgeting. You will develop a financing budget and plan, as if you were the CFO of a company planning for a million-dollar expansion project.

Introduction

Options: As the baseball great Yogi Berra has said, ''When you come to a fork in the road - take it!'' So, it could be said of options, defined in general as something that may be chosen. In finance, there are many uses and transactions involving ''options''.

  • Stock Markets, like the NY Stock Exchange buy and sell ''options''.
  • An employee may be granted ''options'' in lieu of cash compensation.
  • A CFO may advise the use of ''options'' in raising capital for the building of a new plant.

This lesson explores the timing, strategy and planning for options in the context of business capital budgeting. You will develop a financing budget and plan, as if you were the CFO of a company planning for a million-dollar expansion project.

The Scenario

The CEO (your boss) is driving business expansion and wants to break ground on a new building one-year from today. Current investors comprise the board of directors. The CEO has presented the idea to the board and has received conceptual go-ahead, understanding the following strategy:

  • The new facility will replicate the current successful plant, which is generating $200,000 in contribution margin each year.
  • After paying interest on current debt obligations and agreed upon dividends to shareholders, the company has been able to retain $50,000 per year for the past 4 years.
  • The new location will provide logistics advantages by being near new, key growth customers. The new customers are expected to generate at least as much business as the current location, without adding company overhead cost.
  • A suitable plot of land has been identified for the new location.
  • The new plant is expected to achieve breakeven and profitability within 9 months of operation.

Your Assignment

Your assignment is to develop a capital budget for the project, considering various sources of capital, including the use of stock options. You begin by examining the facts you know, from the information above.

You've met with your operations team, and have determined the following cost estimates and project timing. On July 1st of the current year, you will need to purchase land for the new facility. A suitable plot has been identified for $200,000. The land will need development and along with a contractor's down payment requiring $100,000 by November 1st of the current year.

Upon ground-breaking in January of the new year, you will need to make a ½, $300,000 building contractor payment. By June 30 of the new year, your team expects completion and $400,000 will be needed for remaining building construction payment, facility equipment and furnishings. Additionally, you will need $150,000 to cover operating losses until the new plant reaches breakeven. Total funding needed will be $1,150,000.

You eliminate bank loans for funding as your current debt to equity ratio is high, and you believe there are some motivational benefits to the use of equity in your capital structure. You recap the following timing, strategy, and plan.

Timing: The building project will start 12 months from today so the land purchase must be completed at least 6 months before breaking ground. The cost of the land is estimated to be $200,000 (approximately 20%) of the total project.

Strategy: Your capital investment strategy is to obtain the needed cash for the project from existing shareholders, and key management employees, offering them a combination of stock and stock options. The timing of the stock purchases will be staged to match the cash needs of the planned project. The project is sizable with the potential to double the size of the business, warranting changes to the company's capital structure. Shareholders will be interested in the investment because they have a profitable track record with the company and will want to protect their current investment with a successful capital project.

Key employees will be interested in the investment, because they understand the details and profitable potential of the growth opportunity the expansion project represents. Assuming company valuation would double with the new operation, everyone's stock would increase in value.

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