Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 7 Investment strategy and process 185
Project classification
The information required and method of analysis will vary according to the nature of the
project. A suggested investment proposal classification is given below under the headings
replacement, cost reduction, expansion or improvement, new products, strategic, and
statutory and welfare.
Replacement proposals are justified primarily by the need to replace assets that are
nearly exhausted or have excessively high maintenance costs. Little or no
improvement may be expected from the replacement, but the expenditure is
essential to maintain the existing level of capacity or service (e.g. replacement of
vehicles). Engineering analysis plays an important role in these proposals.
Cost reduction proposals (which may also be replacement proposals) are intended to
reduce costs through addition of new equipment or modification to existing
equipment. Line managers and specialists (such as industrial engineers and
work study groups) should conduct a continuous review of production opera-
tions for profit improvement opportunities.
Expansion or improvement proposals relate to existing products, and are intended to
increase production, service and distribution capacity, to improve product qual-
ity, or to maintain and improve the firm’s competitive position.
New product proposals refer to all capital expenditures pertaining to the development
and implementation of new products.
Strategic proposals are generated at senior management level and involve expendi-
ture in new areas, or where benefits extend beyond the investment itself. A proj-
ect may appear to offer a negative net present value and yet still create further
valuable strategic opportunities. Three examples demonstrate this point:
1 Diversification projects may have the effect of bringing the company into a lower
risk category.
2 A patent may be acquired not for use within the firm, but to prevent its use by
competitors.
3 Where information is difficult to obtain, such as in overseas markets, it may make
sense to set up a small plant at a loss because it places the firm in a good position to
build up information and to be ready for minor investment at the appropriate time.
Statutory and welfare proposals do not usually offer an obvious financial return,
although they may contribute in other ways, such as enhancing the contentment,
and hence productivity, of the labour force. The main consideration is whether
standards are met at minimum cost.
Each proposal should be ranked within each category in terms of its effect on profits,
its degree of urgency, and whether or not it can be postponed.
■ Evaluation and authorisation
Evaluation
The evaluation phase involves appraisal of the project and decision outcome (accept,
reject, request further information, etc.). Project evaluation, in turn, involves the assem-
bly of information (usually in terms of cash flows) and the application of specified
investment criteria. Each firm must decide whether to apply rigorous, sophisticated
evaluation models, or simpler models that are easier to grasp yet capture many of the
important elements in the decision.
The capital appropriation request forms the basis for the final decision to commit
financial and other resources to the project. Typical information included in an appro-
priation request is given below:
1 Purpose of project – why it is proposed, and the fit with corporate strategy and
goals.
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186 Part II Investment decisions and strategies
2 Project classification – e.g. expansion, replacement, improvement, cost saving, strate-
gic, research and development, safety and health, legal requirement.
3 Finance requested – amount and timing, including net working capital, etc.
4 Operating cash flows – amount and timing, together with the main assumptions
influencing the accuracy of the cash flow estimates.
5 Attractiveness of the proposal – expressed by standard appraisal indicators, such as
net present value, DCF rate of return and payback period calculated from after-tax
cash flows.
6 Sensitivity of the assumptions – effect of changes in the main investment inputs. Other
approaches to assessing project risk should also be addressed (e.g. best/worst sce-
narios, estimated range of accuracy of DCF return, discussed in Chapter 8).
7 Review of alternatives – why they were rejected and their economic attractiveness.
8 Implications of not accepting the proposal – some projects with little economic merit
according to the appraisal indicators may be ‘essential’ to the continuance of a prof-
itable part of the business or to achieving agreed strategy.
9 Non-financial considerations – those costs and benefits that cannot be measured.
Following evaluation, larger projects may require consideration at a number of
levels in the organisational hierarchy before they are finally approved or rejected.
The decision outcome is rarely based wholly on the computed signal derived from
financial analysis. Considerable judgement is applied in assessing the reliability of
data underlying the appraisal, fit with corporate strategy, and track record of the
project sponsor. Careful consideration is required regarding the influence on the
investment of such key factors as product markets, the economy, production, finance
and people.
Authorisation
Following evaluation, the proposal is transmitted through the various authorisation
levels of the organisational hierarchy until it is finally approved or rejected. The driv-
ing motive in the decision process is the willingness of the manager to make a com-
mitment to sponsor a proposal. This is based not so much on the grounds of the
proposal itself as on whether or not it will enhance the manager’s reputation and career
prospects. Sometimes those involved in the preliminary investigation and appraisal of
major projects are promoted into head office decision-making positions in time to sup-
port and assist the approval of the same projects!
In larger organisations, the authorisation of major projects is usually a formal
endorsement of commitments already given. Complete rejection of proposals is rare,
but proposals are, on occasions, referred back. The approval stage appears to have a
twofold purpose:
1 A quality control function. As long as the proposals have satisfied the requirements
of all previous stages, there is no reason for their rejection other than on political
grounds. Only where the rest of the investment planning process is inadequate
will the approval stage take on greater significance in determining the destiny of
projects.
2 A motivational function. An investment project and its proposer are inseparable. The
decision-maker, in effect, forms a judgement simultaneously on both the proposal
and the person or team submitting it.
Sometimes the costs associated with rejection of capital projects, in terms of mana-
gerial motivation, far exceed the costs associated with accepting a marginally unprof-
itable project. The degree of commitment, enthusiasm and drive of the management
team implementing the project is a major factor in determining the success or failure
of marginal projects.
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Chapter 7 Investment strategy and process 187
■
Monitoring and control
The capital budgeting control process can be classified in terms of pre-decision and
post-decision controls. Pre-decision controls are mechanisms designed to influence
managerial behaviour at an early stage in the investment process. Examples are setting
authorisation levels and procedures to be followed, and influencing the proposals sub-
mitted by setting goals, hurdle rates and cash limits and identifying strategic areas for
growth. Post-decision controls include monitoring and post-audit procedures.
Major investment projects may justify determining the critical path (i.e. a set of
linked activities) in the delivery and installation schedule. The critical path is defined
as the longest path through a network. Control is established by accounting proce-
dures for recording expenditures. Progress reports usually include actual expenditure;
amounts authorised to date; amounts committed against authorisations; amounts
authorised but not yet spent; and estimates of further cost to completion.
How SmithKline Beecham makes investments
In recent years, with more projects successfully reaching
late-development stage, the demands for funding at
SmithKline Beecham (now merged with Glaxo) were con-
siderable. The pharmaceutical group, which invests more
than half a billion dollars annually, had to create more
value from its investments to help meet its tough earn-
ings targets.
A new decision-making process was introduced,
designed to identify those development projects likely
to create the most value and reflect the complexity
and risk of its investments. Each project team was
asked to develop four alternatives: its current plans, a
‘buy-up’ option and a ‘buy-down’ option (where they
explored the effects of increasing and reducing the
investment outlay) and a minimum plan, where the
project was abandoned at minimum cost. These
alternatives were generated and valued before a
decision was taken.
A variety of decision approaches were taken, focusing
on creating net present value. These included decision
tree analysis, probability analysis, options analysis and
sensitivity analysis (discussed in the following chapters).
However, management soon discovered that equally
important were softer issues such as information quality,
credibility and trust.
It was their initial intention that this new resource allo-
cation process would be useful in cutting the develop-
ment budget. But they now saw investment decisions in a
new light and recognised that the investment portfolio
was worth far more than expected. The net result was an
increase in capital spending by more than 50 per cent.
Source: Based on Sharpe and Keelin, Harvard Business Review, March–April 1998.
MINI CASE
Self-assessment activity 7.3
Read the above article and discuss the impact that a new resource allocation system can
have on capital investment creation, evaluation and decision-making.
The case of the disappearing projects
Ameritech, a major US company operating in the electronics industry, invests over $2 billion a
year, mostly in thousands of relatively small-scale projects. When the company announced
that it proposed to monitor and audit capital projects, that year’s budgets had already been
submitted. But the company told every division to take back their submissions, think about the
Continued
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188 Part II Investment decisions and strategies
7.6 POST-AUDITING
■ Problems with post-auditing
There are many problems with post-audits:
1 The disentanglement problem. It may be difficult to separate out the relevant costs and
benefits specific to a new project from other company activities, especially where facil-
ities are shared and the new project requires an increase in shared overheads. Newly
developed techniques of overhead cost allocation may prove helpful in this respect.
2 Projects may be unique. If there is no prospect of repeating a project in the future,
there may seem little point in post-auditing, since the lessons learned may not be
applicable to any future activity. Nevertheless, useful insights into the capital budg-
eting system as a whole may be obtained.
3 Prohibitive cost. To introduce post-audits may involve interference with present
management information systems in order to generate flows of suitable data. Since
The final stage in the capital budgeting decision-making and control sequence is the
post-completion audit. UK firms have been considerably more hesitant in appreciating
the need to post-audit than their North American counterparts, although there is evi-
dence that this is changing. In a survey conducted in 1985, Neale and Holmes (1988)
found that 48 per cent of large quoted UK companies had adopted post-audits. By
1997, the use of post-audits among large firms had risen to 100 per cent (Arnold and
Hatzopoulos, 2000), although mainly for major projects.
A post-audit aims to compare the actual performance of a project after, say, a year’s
operation with the forecast made at the time of approval, and ideally also with the
revised assessment made at the date of commissioning. The aims of the exercise are
twofold: first, post-audits may attempt to encourage more thorough and realistic
appraisals of future investment projects; and second, they may aim to facilitate major
overhauls of ongoing projects, perhaps to alter their strategic focus. These two aims
differ in an important respect. The first concerns the overall capital budgeting system,
seeking to improve its quality and cohesion. The second concerns the control of exist-
ing projects, but with a broader perspective than is normally possible during the reg-
ular monitoring procedure when project adjustments are usually of a ‘fire-fighting’
nature.
post-audit
A re-examination of costs, ben-
efits and forecasts of a project
after implementation (usually
after 1 year)
Self-assessment activity 7.4
What are the main benefits from post-audits?
(Answer in Appendix A at the back of the book)
fact that everyone who worked on the project was going to be ‘tracked’, and then resubmit the
estimates. Seven hundred projects never came back – they just disappeared. Many others had
much lower estimates. We will never know just how many of those 700 projects could have
been investment ‘winners’.
This illustrates just how influential capital budgeting controls can be on managerial invest-
ment behaviour.
Source: Based on Weaver et al. (1989).
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Chapter 7 Investment strategy and process 189
post-auditing every project may be very resource-intensive, firms tend to be selec-
tive in their post-audits.
4 Biased selection. By definition, only accepted projects can be post-audited, and often
only the underperforming ones are singled out for detailed examination. Because of
this biased selection mechanism, the forecasting and evaluation expertise of project
analysts may be cast in an unduly bad light – they might have been spot on in eval-
uating rejected and acceptably performing projects.
5 Lack of cooperation. If the post-audit is conducted in too inquisitorial a fashion, proj-
ect sponsors are likely to offer grudging cooperation to the review team and be
reluctant to accept and act upon their findings. The impartiality of the review team
is paramount – for example, it would be inviting resentment to draw post-auditors
from other parts of the company that may be competitors for scarce capital. Similarly,
there are obvious dangers if reviews are undertaken solely by project sponsors. A
balanced team of investigators needs to be assembled.
6 Encourages risk-aversion. If analysts’ predictive and analytical abilities are to be thor-
oughly scrutinised, they may be inclined to advance only ‘safe’ projects where little
can go awry and where there is less chance of being ‘caught out’ by events.
7 Environmental changes. Some projects can be devastated by largely unpredictable
swings in market conditions. This can make the post-audit a complex affair, as the
review team is obliged to adjust analysts’ forecasts to allow for ‘moving of the
goalposts’.
■ The conventional wisdom
Studies conducted in North America and the UK have generated a conventional wis-
dom about corporate post-auditing practices. Its main elements are as follows:
■ Few firms post-audit every project, and the selection criterion is usually based on
size of outlay.
■ The commonest time for a first post-audit is about a year after project commissioning.
■ The most effective allocation of post-audit responsibility is to share it between cen-
tral audit departments and project initiators to avoid conflicts of interest, while
using relevant expertise.
■ The ‘threat’ of post-audit is likely to spur the forecaster to greater accuracy, but it
can lead to excessive caution, possibly resulting in suppression of potentially
worthwhile ventures.
■ When does post-auditing work best?
What guidelines can we offer to managers who wish to introduce post-audit from
scratch or to overhaul an existing system? Here are some key points:
1 When introducing and operating post-audit, emphasise the learning objectives and
minimise the likelihood of its being viewed as a ‘search for the guilty’.
2 Clearly specify the aims of a post-audit. Is it to be primarily a project control exer-
cise, or does it aim to derive insights into the overall project appraisal system?
3 When introducing post-audits, start the process with a small project to reveal as
economically as possible the difficulties that need to be overcome in a major
post-audit.
4 Include a pre-audit in the project proposal. When the project is submitted for
approval, the sponsors should be required to indicate what information would be
required to undertake a subsequent post-audit.
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190 Part II Investment decisions and strategies
Further reading
We have examined the strategic framework for investment decisions, paying particu-
lar attention to new technology and environmental projects.
The resource allocation process is the main vehicle by which business strategy can
be implemented. Investment decisions are not simply the result of applying some
evaluation criterion. Investment analysis is essentially a search process: a search for
ideas, for information and for decision criteria. The prosperity of a firm depends more
on its ability to create profitable investment opportunities than on its ability to
appraise them.
Key points
■ Investments form part of a wider strategic process and should be assessed both
financially and strategically.
■ New technology projects are often particularly difficult to evaluate because of the
many non-financial values.
■ The four main stages in the capital budgeting process are:
1 Determine the budget.
2 Search for and develop projects.
3 Evaluation and authorisation.
4 Monitoring and control.
Once a firm commits itself to a particular project, it should regularly and systemat-
ically monitor and control the project through its various stages of implementation.
■ Post-audit reviews, if properly designed, fulfil a useful role in improving the qual-
ity of existing and future investment analysis and provide a means of initiating cor-
rective action for existing projects.
SUMMARY
Further reading on AMT investment evaluation is found in Finnie (1988), Pike et al. (1989) and
Kaplan (1986). Neale and Buckley (1992) consider the practice of post-auditing, while Butler
et al. (1993) examine strategic investment decisions.
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Chapter 7 Investment strategy and process 191
Questions with a coloured number have solutions in Appendix B on page 695.
1 ‘Capital budgeting is simply a matter of selecting the right decision rule.’ How true is this statement?
2 What are the aims of post-audits?
3 AMT plc is increasing the level of automation of a production line dedicated to a single product. The options
available are total automation or partial automation. The company works on a planning horizon of five years
and either option will produce the 10,000 units which can be sold annually.
Total automation will involve a total capital cost of £1 million. Material costs will be £12 per unit and labour
and variable overheads will be £18 per unit with this method.
Partial automation will result in higher material wastage and an average cost of £14 per unit. Labour and
variable overhead are expected to cost £41 per unit. The capital cost of this alternative is £250,000.
The products sell for £75 each, whichever method of production is adopted. The scrap value of the auto-
mated production line, in five years’ time, will be £100,000, while the line which is partially automated will
be worthless. The management uses straight-line depreciation and the required rate of return on capital
investment is 16 per cent p.a. Depreciation is considered to be the only incremental fixed cost.
In analysing investment opportunities of this type the company calculates the average total cost per unit,
annual net profit, the break-even volume per year and the discounted net present value.
Required
(a) Determine the figures which would be circulated to the management of AMT plc in order to assist their
investment analysis.
(b) Comment on the figures produced and make a recommendation with any qualifications you think appro-
priate.
(Certified Diploma)
4 Bowers Holdings plc has recently acquired a controlling interest in Shaldon Engineering plc, which produces
high-quality machine tools for the European market. Following this acquisition, the internal audit department
of Bowers Holdings plc examined the financial management systems of the newly acquired company and pro-
duced a report that was critical of its investment appraisal procedures.
The report summary stated:
Overall, investment appraisal procedures in Shaldon Engineering plc are very weak. Evaluation of capital
projects is not undertaken in a systematic manner and post-decision controls relating to capital projects are
virtually non-existent.
Required
Prepare a report for the directors of Shaldon Engineering plc, stating what you consider to be the major
characteristics of a system for evaluating, monitoring and controlling capital expenditure projects.
(Certified Diploma)
What procedures should a business adopt for approving and reviewing large capital expenditure projects?
QUESTIONS
Read the Harvard Business Review article (Sept.–Oct. 1989) ‘Must finance and strategy clash?’ by Barwise, Marsh
and Wensley. Summarise and comment on their views on the question.
Practical assignment
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The preceding analysis of investment decisions has implied that future returns from investment can
be forecast with certainty. Clearly, this is unlikely in practice. In Part III we examine the impact of
uncertainty on the investment decision, and the various approaches available to decision-makers to
cope with this problem.
In Chapter 8, we discuss a number of methods that may assist the decision-maker when looking at
the risky investment project in isolation. In Chapter 9, we look at how more desirable combinations
of risk and return can be achieved by forming a portfolio of investment activities. In Chapter 10, we
examine the contribution to risk analysis of the Capital Asset Pricing Model, which offers a guide to
setting the premium required for risk. The earlier study of how capital markets behave is particularly
important here. Chapter 10 is highly important because it links the behaviour of individual investors,
buying and selling securities, to the behaviour of the capital investment decision-maker. This focus is
further developed in Chapter 11, which discusses how to alter the discount rate when faced by
projects of degrees of risk that differ from the company’s existing activities. Finally, in Chapter 12,
we look at the contribution to investment appraisal under risk promised by the rapidly developing
field of option analysis.
Chapter 8 Analysing investment risk 195
Chapter 9 Relationships between investments: portfolio theory
219
Chapter 10 Setting the risk premium: the Capital Asset Pricing Model 237
Chapter 11 The required rate of return on investment and shareholder
value analysis
271
Chapter 12 Identifying and valuing options 296
INVESTMENT RISK AND RETURN
Part
III
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