LONDON, 27 June 2005 — Saudi companies have witnessed a remarkable growth recently supported by the abundance of liquidity and the availability of banks’ credit facilities. To raise the amount of funds necessary for the perceived expansion plans, companies need to align their liquidity requirements with their stated plans, i.e. adequate capital budgeting.

The responsibility for raising the required funds for a company rests with the finance manager jointly with the treasurer.

The main tool in this effort is the capital budget which sets the plan for future capital expenditures.

Moreover, the composition of the capital budget is determined not only by the physical requirements of the business but by the effects the proposed expenditures will have on financing.

With this rather simplified introduction, we will now attempt to elaborate, in the broadest economic sense, on the design of a capital appropriation system desirable in a modern financial environment.

To start, there are two types of budgeting: Centralized and decentralized. A highly centralized capital budgeting gives senior managers control over strategic direction, but risks avoiding the divisional managers’ specialized knowledge. Decentralized, on the other hand, does reflect divisional expertise but may not take a sufficiently broad view.

The difficulty in designing an effective capital budgeting system is that no one type of system will be universally appropriate. Instead, the system must be tailored to each company’s particular needs and characteristics. Companies can achieve a sensible mix of centralized and de-centralized elements in their capital budgeting system by answering the following crucial questions:

• How much strategic interaction is there among business units?

• To what extent do the company’s investments embody valuable future growth options?

• What are the limits to the company’s ability to absorb growth? and,

• How much uncertainty surrounds division managers’ biases on the quality of their formation.

In general, the theme of the questions centers on two issues: The degree to which separate investment decisions interact, and the relative expertise of the company’s top managers and division heads. The more important these interactions and the greater the operational knowledge of top management, the more useful a budget system tends to be.

Just as independence across divisions favors decentralization, so too does independence over time. Consider, for instance, a routine investment in cost saving machinery. If the technology is well known the investment will not allow the company to gain a competitive advantage through technological or price leadership, nor is the machinery likely to input valuable future investment opportunities.

Such investments are well suited to standard, incremental cash flow analysis and, a decentralized decision making is warranted.

An important feature of a decentralized capital allocation system is that top management has little control over the company’s overall growth rate. Growth is simply the aggregate consequence of investment decisions made the division level.

This situation does not pose a problem for companies with sufficient financial and managerial flexibility, but for the others, unplanned growth can cause strains.

In some cases where growth options are involved, a judicious mix of centralized and decentralized decision making may allow the company to take advantage of division managers specific expertise and headquarters’ broader strategic vision simultaneously.

Another important area deals with the relative degrees of expertise that headquarters and the financial managers can bring to bear on investment decisions. Top management may be in the best position to understand the company’s overall strategic thrust, its future opportunities, and any limits on its growth. To the extent that these are important, a greater degree of centralization is called for.

The more valuable the division managers’ knowledge of costs and markets, and the less this knowledge can be shared with headquarters, the more a decentralized system is called for.

Generally speaking, the design of a mixed capital allocation system should be thought through carefully. Simple rules for dividing decision-making authority between headquarters and the division managers are often effective, but they can lead to serious errors if applied too mechanically. Finally, an analytical framework can help focus management’s attention on the key allocation issues facing the company and on what different allocation systems can and cannot do to confront these issues.

(Habib F. Faris is vice president at Clariden Bank, London.)

(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)