Successful Capital Investment Decisions

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!

Advertisement

 
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