The capital investment decision combines many aspects of accounting and finance. A number of business factors combine to make business investment perhaps the most important financial management decision. Further, all departments of a firm—production, marketing, logistics, and soon—are vitally affected by the investment decisions; so all executives, no matter what their primary responsibility, must be aware of how capital investment decisions are made and how to interact effectively in the processes.
This post overviews the evaluating corporate investment decisions by discussing the capital investment program. Enjoy!
Investment Analysis
The broad application of investment analysis techniques makes these tools germane to a wide variety of corporate investment decisions. A four-phase approach to investment analysis, along with a successful implementation, characterizes a value increasing Investment program. Each organization also imposes managerial directives designed to balance evaluation and control with analytical appropriateness.
Applications of Investment [Capital Expenditure] Analysis
Capital expenditure analysis represents the traditional capital investment analysis (also referred to by some as capital budgeting). Capital expenditures include investments in equipment and plants. These expenditures may reduce production costs, reduce working capital investment, speed production, expand production capacity, or enhance product quality. Incremental cash flows are used to measure investment results.
Investment analysis can also be applied to business investments that are treated as expenses, such as the investment in an advertising campaign or research and development. Thirty-second commercials in the 2000 Super Bowl cost $2 million each. Individual advertisement campaigns can cost tens of millions of dollars with annual advertising and promotion budgets exceeding $100 million for many large companies. Some companies spend in excess of $1 billion for research and development each year. Although these expenditures are treated as expenses (period costs) and not capitalized (included on the balance sheet), these transactions involve sizable expenditures that ultimately must provide economic returns.
New product introductions also require rigorous analysis. New products require investment in equipment and marketing expenses (advertising and promotions). Before embarking on a new product, an investment analysis captures the projected sales, income, and cash flows and determines the economic viability of that product.
In the “new economy,” many companies invest heavily in information technology. Whether it is technology aimed at the Internet and a changing business model or the implementation of an upgraded enterprisewide solution such as an enterprise resource planning (ERP) system, companies are embracing technology and significantly investing in it. Investors and senior managers demand a return on this investment. The traditional investment analysis techniques provide a useful evaluation framework.
4 Phases of a Successful Capital Investment Program
While nothing can guarantee the success of corporate investments, a four-phase approach increases the likelihood of success. The four phases are:
- Planning
- Project or capital evaluation
- Status reporting
- Post completion reviews Of course, successful implementation is paramount to a successful investment.
Phase-1. Capital Expenditure Planning
The planning phase originates with the strategic financial plan. In a strategic financial plan, capital expenditures are estimated in total with limited supporting details or “major” projects may be specifically identified with minor capital expenditures estimated in total. Capacity reviews augmented with facilities reviews and merged with new product ideas identify future capital investment needs. Advanced identification leads to advanced planning and evaluation.
Capital expenditures are broken into four categories for planning purposes:
- Cost savings
- Capacity expansion
- New products
- Miscellaneous
At the time when the strategic financial plan is prepared, longer-term capital expenditures have not been detailed. Funds are included in the strategic financial plan without all the necessary details in the outer years. The advanced planning leads to a more detailed annual budget.
Good capital planning and budgeting will improve the timing of asset acquisitions and the quality of assets purchased. Since the production of capital goods involves a relatively long work-in-process period, a year or more of waiting may be involved before the additional capital goods are available. Another reason for the importance of capital budgeting is that asset expansion typically involves substantial expenditures. A firm contemplating a major capital expenditure program may need to plan its financing several years in advance to be sure of having the funds required for the expansion.
Phase-2. Capital Evaluation and Authorization
Plan or budget identification of a capital project usually is not authorization to proceed with the project. Authorization (or acceptance) of a project happens during the evaluation phase, which is also called the project approval phase.
While serving a vitally important financial and economic function, a good investment analysis process possesses similar managerial and organizational qualities as a good strategic planning process. Strong investment evaluation and authorization:
- Facilitates communication among the senior executives of an organization
- Sets a business direction
- Prioritizes opportunities and requirements
- Establishes business performance standards and objectives
Significant investment analysis involves many areas within an organization. A new product decision involves research and development, marketing, sales, engineering, production, logistics, finance, human resources, legal, corporate communications, etc. All areas of the organization need to be involved in the decision process, albeit to varying degrees. Even in a simple equipment replacement analysis championed by manufacturing and engineering, marketing and sales must be involved to provide consistent product projections.
To facilitate the investment analysis process, a capital authorization request includes several supporting sections and or schedules:
- Summary cover page
- Decision case cash flow assumptions
- Decision case cash flow amounts
- Decision case net present-value analysis
- Project description
- Sensitivity and/or scenario analysis
- Investment components, potential vendor, and cost basis
- Quarterly expenditure budget
The interesting thing about summary page is that it supports the collaborative nature of capital investment analysis, by providing numerous areas to capture all the appropriate signatures: project originator, project sponsor, analyst/engineer who completes the capital authorization request, and of course management. Not all the signatures are necessary for every project. The form includes administrative header and identification information, an abbreviated project description, budget information, project anticipated expenditure summary, numerous financial indicators, and, of course, the signatures.
The project description includes a full and complete write-up of the project, its rationale, justification of the key assumptions, alternatives considered and rejected, “fit” with strategic objectives, details of budget inclusion, and key technical data, if appropriate. Sensitivity and scenario analysis examine the degree to which changes in key assumptions affect the net present value. A detailed list of equipment components and potential vendors is provided for technical (operational) consideration. The cost basis is provided to understand if the expenditure estimate is a vendor quote (little volatility) or an estimate with maybe significant volatility. Finally for detailed budgeting, including a detailed financing budget, the final schedule of the capital authorization request documents anticipated expenditures by quarter.
Phase-3. Capital Status Reporting
After project evaluation and management approval, a project manager is assigned to implement the project on (or below) budget and on (or before) schedule. Status reporting tracks the project investment. This process reports the total budgeted amounts, project spending, and project commitments (signed contracts that have not been billed by the vendor). By using this report, the project manager can track the project’s initial investment compared to the authorized approval. By using a summary status report that consolidates a number of project status reports, senior management can monitor the implementation progress of all projects.
Phase-4. Post completion Reviews
Post completion reviews are an often-overlooked phase of capital investment. Even companies that conduct post completion reviews often consider this to be their weakest phase of the capital expenditure process. Post completion reviews are conducted any time (1 year, 3 years, or whenever) after the project is completed.
The review compares the project’s original approved cash flows and economic evaluation indicators with the cash flows and indicators based on updated operating performance and information. That is, actual project costs and investment returns are compared to the projected investment estimates when the project was approved. In the case of a 3-year review, 3 years of actual performance are substituted for the first 3 years of projected performance. Finally, the cash flows for the remaining years are re-estimated, given new information and current performance. Based upon this combination of actual investment, current performance, and re-forecasted future performance, the economic evaluation indicators are recalculated and improvement or shortfalls addressed.
Post completion reviews are excellent learning tools for the organization. However, they are time-consuming, provide little immediately “actionable” guidance, and continue to incorporate projections.
Nonetheless, post completion reporting remains a valuable learning tool from which judgments can be made about future capital evaluations, requests, and authorizations.
The next section provides a set of worth considering issues on the capital management process which may enrich your knowledge before going to an implementation. Read on…
Additional Managerial Issues on The Capital Investment Decision
In addition to the four phases of the capital investment process, each corporation must decide on a number of other issues related to capital investment:
Project Categories – Most companies categorize projects by the nature of their expenditures. In this way, management can broadly monitor where its capital is being invested. The categories relate to the underlying rationale of the expenditure. While these are common categories, each company defines its own group of categories. In a separate survey, one company used 26 different categories, including five varieties of new products.
Project Dependence – When evaluating two projects that are mutually exclusive, you can choose one or the other project, but you cannot choose both. Mutually exclusive projects are alternative means of accomplishing the same objective. On the other hand, when you are evaluating independent projects, the acceptance of one project does not diminish the need to invest in the other project. For example, the decision to buy a forklift truck is independent of the decision to add a new packaging machine.
Project Cash Flow Interrelationship – Understanding the distinctions between products that are substitutes or complements is important when determining the project’s cash flows. Kellogg’s introduction of a new, ready-to-eat cereal may cause the sales of existing cereals to decline to some degree. Cash flows from projects with substitution implications must be reduced for the lost revenues, income, and cash flows from the “cannibalized” sales of existing products. Complementary projects enhance the total organization’s cash flows beyond the immediate project. Those additional, complementary cash flows must augment the project’s cash flow. The project’s impact on the organization’s total cash flow must be determined and considered when the project is evaluated.
Budget Identification and Spending – While it is helpful to specifically identify projects within the annual budget process, it is not uncommon that while 100 percent of the budgeted capital expenditures are spent, only one-half is spent on identified projects. The other half is spent on unidentified projects that result from changes in priorities, market conditions, etc.
Budget Authorization – For most companies, the annual capital budget amount is separate from expenditure authorization. Just because a project is identified at budget time, that does not authorize the project. Each project must undergo its own evaluation and authorization.
Project Evaluation Threshold – As previously mentioned, the economic evaluation techniques are appropriate for many, if not all, expenditures. However, if a project analysis were required every time that someone needed a pencil, many person-hours of effort would be wasted. On the other hand, manufacturing should not be given carte blanche for investments in new production facilities costing several hundreds of millions of dollars. A careful balance must be struck, such as all projects over $100,000.
Authorization Levels – Each company must decide how deeply into the organization capital authorization should be allowed and at what dollar level. For example, should a senior engineer be allowed to authorize capital expenditures?
The Investment Process
The investment process begins by projecting operating cash flows for a potential investment. The projected cash flows are the basis upon which capital investment techniques are applied and the investment efficacy determined. The major capital investment evaluation techniques include:
- Payback period (PBP)
- Net present value (NPV)
- Internal rate of return (IRR)
- Terminal rate of return (TRR) or modified internal rate of return (MIRR)
Additional techniques include:
- Discounted payback period (DPBP)
- Profitability index (PI)
Financial performance metrics are viable metrics used to set objectives and performance standards, benchmark against other organizations, and manage the business, but they are inappropriate measures for investment decision making. Accounting-based performance measures (including accounting based rates of return) differ greatly from economic rates of return.
While accounting metrics can result from future financial statement projections, the nature of the accounting returns differs from that of the economic returns.
The major differences are summarized:
- Accounting returns are determined for discrete, single time periods (month, quarter, year, etc.) while economic returns consider a continuous time frame over multiple periods. Accounting returns are based on income (accrual) while economic returns center on cash flows.
- Accounting returns can vary widely over the life of an asset as the asset depreciates, since accounting returns use historical book values.
The following sections describe the common economic performance metrics used to evaluate investment decisions:
Accounting Returns Economic Returns
Single time periods Multiple time periods
Discrete time Continuous time
Accrual income–based Cash flow–based
Historical book values Market values
Major Investment Evaluation Techniques
The point of capital budgeting—indeed, the point of all financial analysis—is to make decisions that will maximize the value of the firm.
The capital budgeting process is designed to answer two questions:
- Which among mutually exclusive investments should be selected?
- How many projects, in total, should be accepted?
When one is comparing various capital budgeting criteria, it is useful to establish some guidelines. The optimal decision rule will have four characteristics:
- It will appropriately consider all cash flows.
- It will discount the cash flows at the appropriate market-determined opportunity cost of capital.
- It will select from a group of mutually exclusive projects the one that maximizes shareholders’ wealth.
- It will allow managers to consider each project independently of all others. This has come to be known as the value additivity principle.
Capital investment decisions, which involve commitments for large outlays whose benefits (or drawbacks) extend well into the future, are of the greatest significance to a firm. Decisions in these areas, therefore, have a major impact on the future well-being of the firm. This post focused on how capital investment decisions can be made more effective in contributing to the health and growth of a firm and enhance shareholder value. The discussion stressed the development of systematic procedures and rules throughout all four phases of capital investment.
Four commonly used procedures for ranking investment proposals: payback, net present value, internal rate of return, and terminal rate of return:
Payback is defined as the number of years required to return the original investment. Although the payback method is used frequently as a simple rule of thumb, it has serious conceptual weaknesses, because it ignores the facts that (1) some receipts come in beyond the payback period and (2) a dollar received today is more valuable than a dollar received in the future.
Net present value [NPV] is defined as the present value of future returns, discounted at the cost of capital, minus the cost of the investment. The NPV method overcomes the conceptual flaws noted in the use of the payback method.
Internal rate of return [IRR] is defined as the interest rate that equates the present value of future returns to the investment outlay. The IRR method, like the NPV method, discounts cash flows. However, the internal rate of return method assumes reinvestment at the IRR.
Terminal rate of return (or modified internal rate of return) is the interest rate that equates the cost of the investment with the accumulated future value of the intermediate cash flows that are assumed to be reinvested at an appropriate risk-adjusted cost of capital. The TRR explicitly incorporates an opportunity cost of capital as a reinvestment rate.
In most cases, the three discounted cash flow methods give identical answers to these questions:
- Which of two mutually exclusive projects should be selected?
- How large should the total capital budget be?
However, under certain circumstances, conflicts may arise. Such conflicts are caused primarily by the fact that the IRR method makes different assumptions about the rate at which cash flows may be reinvested, or the opportunity cost of cash flows. The assumption of the NPV and TRR methods (that the opportunity cost is the cost of capital) is the correct one. While the terminal rate of return is an improvement on the internal rate of return, it may lead to an incorrect choice of mutually exclusive projects if the sizes of the investments are significantly different. Accordingly, my personal recommendation is to use the NPV method to make capital investment decisions.
Relevant, nominal, incremental, after-tax cash flow development is the backbone for financial investment analysis. However, just as a strong strategic planning process has strong financial considerations, which also enable managerial processes, so does a strong capital investment process and its evaluation and authorization phase.
A strong evaluation and authorization phase:
- Facilitates communication among the senior executives of an organization
- Sets a business direction
- Prioritizes opportunities and requirements
- Establishes business performance standards and objectives
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