Management And Accounting Web

Cherry, K. 1993. Why aren’t more investments profitable? Journal of Cost Management(Summer): 28-37.

Summary by Linda Bragdon
Master of Accountancy Program
University of South Florida, Fall 2001

Capital Budgeting Main Page | Investment Management Main Page

There are certain investments that give every promise of being profitable, but in fact, end up being just the opposite. There are some things that can be done to improve capital budgeting results.

Executives can also address common problems encountered with capital budgeting using a thirteen-point plan.

Managers must understand that there are two groups of issues that give rise to unwise investment choices. These issues are: those related to objectivity and those related to validity. This must be done before the thirteen-point plan is used.

Objectivity Problems

In a decentralized company, capital expenditures often have to be approved centrally. The selection process of capital investment projects in usually done in descending order. At the top of the list is the capital investment project with the highest positive payback and levels off when the cash outflows for the projects selected reach some “reasonable” level or target amount. A drawback of combining decentralized management structures with fixed availability of capital funds is that overly optimistic projections can be submitted.

Executive management may have extensive personal commitment to the project. They have wishes of rosy prospects, which tend to obscure management’s vision of the future and the very existence of the company may be put in jeopardy.

It is common in the business environment to provide positive feedback while minimizing the negative. This type of information filtering does not provide the ultimate decision makers on an investment with the full story on a proposed project’s risk.

Validity Issues

Insufficient analysis is one of the primary validity issues encountered in capital budgeting. Staff shortages can compromise the reliability of revenue projects. Time constraints can mean that investment costs have not been fully developed to reflect delays, shortages, technology issues, and the learning curve required for new practices and procedures. Limitations in the number of staff analysts, at the corporate level, can restrict verification about the reasonableness or achievability of projections.

The lack of technical expertise is the second primary validity issue. Even the validity of the most well-intentioned capital project plan can be undermined by unfamiliarity with financial analysis techniques.

Thirteen-Point Plan

When it comes to approving capital projects, there should be standard process that ensures fairness and technical accuracy. It should be flexible enough to recognize the unique characteristics of each of the projects.

Step 1: Review strategic direction.

The foundation for the decision making process about capital projects should be the strategic direction and goals of the company. It is important to remember that in choosing projects, capital budgeting techniques ought to work for the whole as well as its parts. When a strategic decision is made, it is intuitive that the decision maker weighs the benefits versus the costs.

Step 2: Select projects for review.

After the strategic dimensions are understood, choose the projects to be reviewed. Identifying projects can be done using several criteria, but first and foremost is to move the company in the desired strategic direction.

Step 3: Review documentation and assumptions.

Careful consideration should be given to the existing research and documentation prepared for a proposed project.

Step 4: Conduct internal interviews.

The perceived concerns, challenges, and problems of management at the project implementation level should be brought to surface.

Step 5: Survey current demand and supply.

Develop a profile for your product by assessing the competition’s current product offerings and the current buying patterns of consumers.

Step 6: Forecast demand and supply.

It is common for forecasts to be overly optimistic or not thorough enough because of a lack of resources to perform adequate market assessments. As a result, penetration assumptions must be rigorously and objectively challenged.

Step 7: Estimate probable costs.

Being as objective as possible is important when estimating costs.

Step 8 and 9: Profile confidence levels and examine past successes and failures of similar projects.

Probability estimates about the likelihood of realizing the revenue and cost projects can be developed using interviews and experience with similar projects. These estimates can then lead to an aggregate “net” probability using decision tree analysis. A measurement that is good at determining the project risk that is involved is the standard deviation of probabilities. Yet another way to determine this risk is to develop a risk matrix. A risk matrix assesses the company’s familiarity with a product on the vertical axis and its familiarity with a particular market on the horizontal axis.

Step 10: Develop project discount rate.

Begin using the capital asset-pricing model to estimate the company’s cost of capital. Next, develop a project-specific discount rate. You will base this on the risk involved and the unique project characteristics.

Step 11: Model the project NPV.

Step 12: Define progress standards.

It should be made known that managers will be measured based on their performance on decisions made.

Step 13: Reevaluate the progress and viability of the project.

This needs to be a continuous process.

Conclusion

The thirteen-point plan is a standard process that allows for the recognition of the unique characteristics of various projects. Yet, there is only one true way that financial managers can know whether the proposed project's benefits exceed the costs. They must conduct aggressive analysis of the project before, during, and after completion.

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