Custom Search

How Firms Organize the Investment Process

It helps to use discounted cash-flow techniques to value new projects but good investment decisions also require good data. Therefore, we start this material by thinking about how firms organize the capital budgeting operation to get the kind of information they need. In addition, we look at how they try to ensure that everyone involved works together toward a common goal.

Project evaluation should never be a mechanical exercise in which the financial manager takes a set of cash-flow forecasts and cranks out a net present value. Cash-flow estimates are just that ¤estimates. Financial managers need to look behind the forecasts to try to understand what makes the project tick and what could go wrong with it. A number of techniques have been developed to help managers identify the key assumptions in their analysis. These techniques involve asking a number of ¬what-if ­ questions.

What if your market share turns out to be higher or lower than you forecast? What if interest rates rise during the life of the project? In the second part of this material we show how managers use the techniques of sensitivity analysis, scenario analysis, and break-even analysis to help answer these what-if questions.

Books about capital budgeting sometimes create the impression that once the manager has made an investment decision, there is nothing to do but sit back and watch the cash flows develop. But since cash flows rarely proceed as anticipated, companies constantly need to modify their operations. If cash flows are better than anticipated, the project may be expanded; if they are worse, it may be scaled back or abandoned altogether. In the third section of this material we describe how good managers take account of these options when they analyze a project and why they are willing to pay money today to build in future flexibility.

After studying this material you should be able to

_ Appreciate the practical problems of capital budgeting in large corporations.

_ Use sensitivity, scenario, and break-even analysis to see how project profitability would be affected by an error in your forecasts and understand why an overestimate of sales is more serious for projects with high operating leverage.

_ Recognize the importance of managerial flexibility in capital budgeting.

For most sizable firms, investments are evaluated in two separate stages.

STAGE 1: THE CAPITAL BUDGET

Once a year, the head office generally asks each of its divisions and plants to provide a list of the investments that they would like to make.1 These are gathered together into a proposed capital budget.

This budget is then reviewed and pruned by senior management and staff specializing in planning and financial analysis. Usually there are negotiations between the firm`s senior management and its divisional management, and there may also be special analyses of major outlays or ventures into new areas. Once the budget has been approved, it generally remains the basis for planning over the ensuing year.

Many investment proposals bubble up from the bottom of the organization. But sometimes the ideas are likely to come from higher up. For example, the managers of plants A and B cannot be expected to see the potential benefits of closing their plants and consolidating production at a new plant C. We expect divisional management to propose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own data processing operations to a large central computer. That proposal would come from senior management.

Senior management`s concern is to see that the capital budget matches the firm`s strategic plans. It needs to ensure that the firm is concentrating its efforts in areas where it has a real competitive advantage. As part of this effort, management must also identify declining businesses that should be sold or allowed to run down. The firm`s capital investment choices should reflect both ¬bottom-up ­ and ¬topdown ­ processes ¤capital budgeting and strategic planning, respectively. The two processes should complement each other. Plant and division managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may have a mistaken view of the forest because they do not look at the trees.

STAGE 2: PROJECT AUTHORIZATIONS

The annual budget is important because it allows everybody to exchange ideas before attitudes have hardened and personal commitments have been made. However, the fact that your pet project has been included in the annual budget doesn`t mean you have permission to go ahead with it. At a later stage you will need to draw up a detailed proposal describing particulars of the project, engineering analyses, cash-flow forecasts, and present value calculations. If your project is large, this proposal may have to pass a number of hurdles before it is finally approved.

The type of backup information that you need to provide depends on the project category. For example, some firms use a fourfold breakdown:

1. Outlays required by law or company policy, for example, for pollution control equipment. These outlays do not need to be justified on financial grounds. The main issue is whether requirements are satisfied at the lowest possible cost. The decision is therefore likely to hinge on engineering analyses of alternative technologies.

2. Maintenance or cost reduction, such as machine replacement. Engineering analysis is also important in machine replacement, but new machines have to pay their own way.

3. Capacity expansion in existing businesses. Projects in this category are less straight-forward; these decisions may hinge on forecasts of demand, possible shifts in technology, and the reactions of competitors.

4. Investment for new products. Projects in this category are most likely to depend on strategic decisions. The first projects in a new area may not have positive NPVs if considered in isolation, but they may give the firm a valuable option to undertake follow-up projects. More about this later.

ACAPITAL BUDGET List of planned investment projects.