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Capital Budgeting: eight steps

Introduction

Until now, this web site has broken one of the cardinal rules of financial management. This page corrects for that problem and presents now, the first part of the subject of Capital Budgeting.

Many books and chapters and web pages purport to discuss capital budgeting when in reality all they do is discuss CAPITAL INVESTMENT APPRAISAL. There's nothing wrong with a discussion of the CIA methods except that authors have a duty to point out that CIA methods are only one part of a multi stage process: the capital budgeting process.

A discussion of CIA and nothing else means that capital budgeting decisions are being discussed out of context. That is, by ignoring the earlier and later parts of capital budgeting, we are never assess where capital budgeting project come from, how alternatives are found and evaluated, how we really choose which project to choose and then we never review the projects and how they have been implemented.

Definition

Capital budgeting relates to the investment in assets or an organization that is relatively large. That is, a new asset or project will amount in value to a significant proportion of the total assets of the organization.

The International Federation of Accountants, IFAC, defines capital expenditures as

Investments to acquire fixed or long lived assets from which a stream of benefits is expected. Such expenditures represent an organization's commitment to produce and sell future products and engage in other activities. Capital expenditure decisions, therefore, form a foundation for the future profitability of a company.

A Typical Scene?

To try to prove my point here, imagine the scene, you are a senior businessman or an accountant; and you walk into your bank and this happens:

You say: OK, I've done the figure work and this is what I've found. Our Proposal for a new Flange Whackit Product has an NPV of GBP1 billion, on an initial investment of GBP2 million and an annual turnover of GBP500 million. The IRR's great and you won't believe the Payback!

What do you think the banker is going to say? "Hold me back"? ... "Don't go anywhere, let me get my cheque book"?

Hardly! Don't you think it's more likely to hear something like:

"Er, well, that's interesting of course; and if these figures were accurate, we'd certainly want to look into your proposal further. However, we'd like to see your background work first if you don't mind."

THE PROBLEM: what you've just read is what many, many financial management texts and web pages would have us believe is what really happens when a businessman has a good idea ... they just put some numbers together and do a discounted cash flow analysis, a payback analysis and/or an internal rate of return analysis.

Of course, this is exactly what does not happen! CIA is part of capital budgeting, as the following diagram clearly shows.

Capital Budgeting: eight steps

Working down the diagram, we can see eight different steps to the capital budgeting process. If nothing else, this diagram shows that CIA is only one of those eight different steps. Whenever we talk about a project, we might just as well talk about an asset or a group of assets.

In line with our definition of capital budgeting, the term project refers to all investments (resource allocation) of significant size decided and implemented by an enterprise in order to shape its future. All projects are considered to be the result of a capital budgeting decision.

Let's look at each step in turn.

1 Have a good idea

Projects don't just fall out of thin air: someone has to have them. The main point here is that successful, dynamic and growing companies are constantly on the lookout for new projects to consider. In the largest organsiations there are entire departments looking for alternatives and opportunities.

2 Look for suitable projects

Once someone has had the idea to invest, the next step is to look at suitable projects: projects that complement current business, projects that are completely different to current business and so on. Initially, all possibilities will be considered: along the lines of a brainstorming exercise.

As time goes by, and as corporate objectives allow, the initial list of potential projects will be whittled down to a more manageable number.

3 Identify and consider alternatives

Having found a few projects to consider, the organization will investigate any number of different ways of carrying them out. After all, the first idea probably won't either be the last or the best. Creativity is the order of the day here, as organizations attempt to start off on the best footing.

As the diagram suggests, at each of these first three stages, we need to consider whether what we are proposing fits in with corporate objectives. There is no point in thinking of a project that conflicts with, say, the growth objective or the profitability objective or even an environmental objective.

A lot of data will be generated in this stage and this data will be fed into stage four: Capital Investment Appraisal.

4 Capital Investment Appraisal

This is the number crunching stage in which we use some or all of the following methods

  • Payback (PB)
  • Accounting rate of return (ARR)
  • Net present value (NPV)
  • Internal rate of return (IRR)
  • Profitability Index (PI)

    There are other techniques of course; but the technique to be used will depend on a range of things, including the knowledge and sophistication of the management of the organisation, the availability of computers and the size and complexity of the project under review.

    For more information here, go to my page on CIA once you have finished this page.

    5 Analysis of feasibility

    Stage four is the number crunching stage. This stage is where the decision is made as to which project is to be assessed as acceptable. That is, which project is feasible?

    In order to choose the project, management needs some hurdles:

  • what must the payback be
  • what rate of ARR is acceptable
  • what is the NPV cut off
  • what IRR is the least that we can accept
  • what PI is the least that we can accept

    and so on.

    Some projects will be discarded as a result of this stage. For example, if the PB cut off is, say, 2 years, and a project has a PB of 3 years, it will be rejected. The same is true of the ARR, NPV, IRR and PI.

    Capital rationing might be a problem here, too, if the organization has general cash flow problems.

    Capital Budgeting Policy Manual

    Let's pause at this point to make the point that what we have just said about cut off rates and so on come from formal procedures and documents. One such formal document is the Capital Budgeting Policy Manual, in which formal procedures and rules are established to assure that all proposals are reviewed fairly and consistently. The manual helps to ensure that managers and supervisors who make proposals need to know what the organization expects the proposals to contain, and on what basis their proposed projects will be judged.

    The managers who have the authority to approve specific projects need to exercise that responsibility in the context of an overall organizational capital expenditure policy.

    In outline, the policy manual should include specifications for:

    1. an annually updated forecast of capital expenditures
    2. the appropriation steps
    3. the appraisal method(s) to be used to evaluate proposals
    4. the minimum acceptable rate(s) of return on projects of various risk
    5. the limits of authority
    6. the control of capital expenditures
    7. the procedure to be followed when accepted projects will be subject to an actual performance review after implementation
    (See IFAC document The Capital Expenditure Decision October 1989 for full details of the manual)

    6 Choose the project

    Once we have determined the feasible/acceptable projects, we then have to make a decision of which to accept.

    If we have capital rationing problems, we might be restricted to one project only. If we have no cash problems, we might choose two or more.

    Whatever the cash position, we would like to invest in all projects that have a positive NPV, whose IRR is greater than our cut off rate and so on.

    7 Monitor the project

    As with any part of the organization, the project must be monitored as it progresses. If the project can be kept as a separate part of the business, it might be classed as its own department or division and it might have its own performance reports prepared for it. If it's to be absorbed within one or more parts of the organization then it could be difficult to monitor it separately: this is something that management has to decide as they implement their new projects.

    8 Post completion audit

    The final stage: once the project has been up and running for six months or a year or so, there must be a post completion audit or a post audit. A post audit looks at the project from start to finish: stages 1 - 7 and looks at how it was thought of, analysed, chosen, implemented, monitored and so on.

    The purpose of the post audit is to test whether capital budgeting procedures have been fully and fairly applied to the project under review.

    Of course, any weaknesses that might be found during the post audit might be specific to one project or they might relate to capital budgeting systems for the organization as a whole. In the latter case, the auditor will report back to his superiors and to management that systems need to be overhauled as a result of what has been found.

    Conclusions

    In brief, this page has demonstrated that capital budgeting involves a lot more than just carrying out a few calculations for payback, ARR and so on.

    The capital budgeting process involves expenditures and investments that are relatively large and that must then be undertaken and controlled in a serious, professional way.

    References

    The International Federation of Accountants (IFAC) has a number of very useful guides for anyone considering capital budgeting in practice.

    Three very useful guides, with an outline of their contents are:

    The Capital Expenditure Decision, October 1989

    Each of the following sections is very comprehensive and the guide is 81 pages long.

    section 1 - quantitative estimates
    section 2 - decision models
    section 3 - administration of the capital expenditure decision
    exhibit 1 - the appropriation request (cover page)

    post completion review, april 1994

    a reading of this document shows that IFAC is trying to make us into practical users of post completion audits, not just theoretical admirers! about 60 pages of useful information.

    executive summary
    introduction
    section 1-scope and purpose of post completion reviews
    section 2-the post completion review decision
    section 3-the post completion review committee
    section 4-the methodology of post completion review
    appendix 1-factors related to documentation supporting a post completion review
    appendix 2-example of a post completion review checklist
    appendix 3-a case illustration (acme corporation)
    attachment 1-p & l estimate 1991-1995
    attachment 2-cash flow analysis 1991-1995

    management control of projects, october 1991

    a 97 page guide.
    section 1 - nature of projects
    section 2 - the control environment
    section 3 - project planning
    section 4 - project execution
    section 5 - project evaluation
    section 6 - implementation

    Duncan Williamson
    17 February 2002 revised August 2003

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