Capital Budgeting: a case study analysis of the role of
formal evaluation techniques in the decision making
process
Dr Evan Gilbert
Senior Lecturer
Graduate School of Business
Private Bag
Rondebosch
7701
Telephone :
021-406-1144
Fax :
021-406-1412
Email :
gilberte@gsb.uct.ac.za
Capital Budgeting: a case study analysis of the role of
formal evaluation techniques in the decision making
process
Abstract
This paper furthers the understanding of capital budgeting by reviewing two individual
capital investment decisions taken by manufacturing firms in South Africa. This study
indicates that managers do not base their capital investment decisions on a comparison of
the expected value of potential investment opportunities as recommended by theory.
Rather they follow a multi-stage filtering process and reduce the list of projects by
establishing the alignment with the firm’s strategic goals on a qualitative basis.
Discounted cash flow project evaluation methods (among others) are then used to confirm
that the selected projects are expected to achieve satisfactory levels of financial
performance. This analysis promotes a better understanding of the unexpectedly limited
use of discounted cash flow techniques by managers in capital investment decision
making.
2
INTRODUCTION
Finance theory recommends that managers should undertake capital investment projects
only if they add to the value of the firm. If we assume that managers act so to maximize
the value of the firm, managers should then identify, and undertake, all projects that add
value to the company so as to maximise shareholder value. This theory of capital
investment decision-making implies that managers should establish the expected value
that a project is expected to create. This should be done through the use of value based or
discounted cash flow (DCF) techniques, in particular, the net present value (NPV)
approach.1 Capital investment decisions should then be based on these estimates of value.
Multiple surveys indicate that managers do not always use DCF techniques and that when
they do, they are used in conjunction with other, theoretically deficient, techniques such as
Payback Period (PP). While these surveys highlight the existence of the gap between
prescribed and observed behaviour in this area, they do not suggest why this is the case.
There is, thus, a need for an explicit analysis of the relative role played by formal
evaluation techniques in the capital investment decision making process.
In order to address this gap, case study analysis of two capital investment decisions made
by manufacturing firms in South Africa was undertaken with a particular focus on
identifying the role played by formal evaluation techniques in the decisions taken. This
provides new evidence that allows for an enhanced understanding of the role of these
techniques in capital budgeting decisions.
1
See Copeland and Weston, 1992.
3
The structure of this paper is as follows. A brief discussion of both the value maximising
model of capital investment decision-making and the survey data concerning its
descriptive accuracy is presented in the next section. Details of two investment decisions
are presented, with a particular focus on the role played by DCF evaluation techniques in
the decision-making process. The key differences between the traditional model of capital
investment decision-making and the observed behaviour are summarised and, finally, the
implications of this for further research are discussed.
Use of Formal Evaluation Techniques
A basic tenet of finance theory is that managers act so as to maximize shareholder value.
In the context of capital budgeting, this has been interpreted to mean that managers should
choose all projects that add value to the company. To do so, managers should establish the
estimated value of all projects under consideration2 and select those which add the most
value to the firm (given a capital constraint, if any).
Establishing the expected value of projects involves the estimation of incremental cash
flows over the life of the project discounted at a rate that reflects both the time value of
money and the risk associated with these cash flows.3 If positive, the project adds value
and should be undertaken. In situations of capital rationing, the management should
2
Note that this approach does not say anything about the process whereby the projects being valued are
identified. The case study data presented in this paper suggests that the company’s competitive strategies
directly affect the need for new projects as well as provide the basis for judging the relative attractiveness of
the alternative projects.
3
This approach does not consider the value of real options i.e. the flexibility that firms have when managing
projects in the face of an uncertain future. While these options exist and do add value to capital investment
projects, for the purposes of this paper, the role of the traditional (no-flexibility) investment evaluation
techniques such as the Net Present Value (NPV) or Internal Rate of Return (IRR) will be examined.
4
prioritise the projects in terms of their contribution to the value of the firm and select all
that they can afford.
In terms of process, firms considering investments in new projects should thus estimate
both the incremental cash flows, the appropriate project specific risk adjusted discount
rate and then base their decisions to invest on the results of this DCF analysis. Surveys of
international capital budgeting practices suggest that this is not always the case.
Cross Sectional Studies of Use of Formal Evaluation Techniques
There have been multiple cross sectional studies of the use of formal evaluation
techniques by firms. These have covered the behaviour of both international (see Istvan,
1961, Pullara and Walker, 1965, Meredith, 1965, Christy, 1966, Bavishi, 1981, Moore and
Reichert, 1983, Pike, 1983, Bailes and McNally, 1984, McIntyre and Coulthurst, 1987,
Northcott, 1992, Sangster, 1993, Baddeley, 1996, Harvey and Graham, 2001, and Ryan,
2002) and South African firms (see Andrews and Butler, 1986, Parry and Firer, 1990,
Hall, 2000, and Gilbert, 2003). The following statements summarise the results of these
surveys:
1. Discounted Cash Flow (DCF) techniques are used, but a significant minority of
firms do not do so;
2. Larger firms are more likely to use DCF techniques; and
3. When these techniques are used, they are used in conjunction with other
techniques that are both theoretically deficient and redundant.
5
A criticism of cross-sectional studies is that they do not explicitly consider the possibility
that new evaluation techniques such as DCF would take time to diffuse across all firms.
This problem is avoided by longitudinal studies of evaluation technique usage.
Longitudinal Studies
Longitudinal studies of the use of evaluation techniques have been conducted by
Klammer, 1972, Klammer and Walker, 1984, and Pike, 1996, for international firms and
by Andrews and Butler, 1986, and Correia et al, 2003 for South African firms. In brief,
these studies indicate that:
1. The use of DCF techniques has grown over time; but
2. Their increase in use is NOT accompanied by a decline in the usage of other nonDCF techniques.
This second point is a strong indication that DCF techniques are not playing the decisive
role in the decision-making process that traditional finance theory suggests it should.
In summary, these surveys indicate that some (generally smaller) firms do not estimate the
expected value of their capital investment projects at all when considering capital
investment decisions. More unexpectedly, the firms that do use DCF techniques also
consistently use other non-value related techniques when evaluating their capital
investments. This suggests that DCF techniques, when used, do not play the decisive role
in the decision making process that is assumed they should (in theory). An analysis of the
role of these evaluation techniques in the decision making process is necessary.
6
Research Methodology
While the survey-based results discussed above indicate the extent of this behaviour they
do not provide any real basis for understanding why this is the case. The case study
approach is a very good way to acquire the data required to better understand the role of
these formal investment evaluation techniques in the capital investment decision making
process. This approach provides rich data on both the context and process of a capital
investment decision which is necessary to identify the relative role(s) of the various
investment evaluation techniques. The limitation of this methodology is that the results
may not be necessarily representative of the population of manufacturing firms. However,
given the current lack of data on this issue, these case studies can provide the insight
required to allow for hypotheses to be developed regarding the unexpected behaviour
reported in the previous section. The validity of these hypotheses should then be tested
across a more representative sample of firms.
Gilbert, 2003, presents the results of a survey of the capital budgeting practices of South
African manufacturing firms conducted in 1997. 318 firms were approached of which 118
responded to the survey. The respondent firms were then invited to participate in
additional case-study based research which aimed to understand the role of DCF
techniques in the decision-making process. Ten firms responded positively. Two firms
were selected on the basis of their different sizes, the importance of the decision for the
firms and (most importantly) the support of the firms in terms of the quantity and quality
of data made available for this research (including the provision of access to the relevant
decision makers). The following case studies were prepared on the basis of a review of all
7
project related documentation and interviews with related managerial staff. The data was
collected over the period of January to September 1998.
FIRM A: RELOCATING A PRODUCTION FACILITY
Firm A produces sisal matting for sale as floor coverings. It has two production facilities one in Johannesburg, Gauteng; and the other in Polokwane, which is approximately 330
kilometres further north. The latter facility is the larger of the two. The focus of this
analysis is the decision to relocate this plant. Figure One below provides an overview of
the decision-making process followed by this firm.
FIGURE ONE: OVERVIEW OF FIRM A’S DECISION-MAKING PROCESS
1. Recognition of the need to move
2. Identify possible locations
3. Identify preferred locations:
1.
Best Inland location (Johannesburg)
2.
Best Coastal location (Durban/Pinetown)
3.
Best Foreign location (Mauritius)
4. Identify optimal location (Mauritius)
5. Final Decision (Set up a pilot plant in Mauritius)
Throughout the decision-making process, the management of Firm A expressed a
commitment to two (sometimes conflicting) strategies4: export promotion and cost
4
There are many competing definitions of strategy, and consequently, how it should be dealt with (see
Mansfield, 1996). In this study the term strategy will refer to the firm’s perception of both the current and
8
minimisation. The first strategy reflected the firm’s belief that the export market
represented a better opportunity for sustained growth than the domestic market. The
current proportion of domestic to international sales was 70:30. The stated commitment
was to reverse this proportion within 10 years. Given the perceived limited potential for
product diversification in the sisal carpeting market, the other strategic commitment was
that of maintaining competitiveness through minimising costs.
Step One: Recognition of the need to move
Management reported three reasons for the consideration of a move from the Polokwane
production facility: the loss of relative cost advantages, the low levels of productivity at
Polokwane and the increasing importance of export sales.
The original decision to locate the factory in Polokwane was in response to government
incentives both direct (e.g. rent) and indirect (production of sisal in the area was
subsidised). These have since been discontinued. The existence of significant negative
productivity differentials between the Polokwane and Johannesburg factories is a
continued management challenge. Finally, export sales, once non-existent, now comprise
thirty percent of the firm’s total sales. As both the raw materials and the finished product
are relatively bulky and raw materials need to be imported and the final product exported
(both by sea) Polokwane’s inland position counts heavily against it. These reasons clearly
reflect the firm’s strategic considerations.
future external environment; and how it sees the optimal role for itself in this environment. A firm’s strategy
thus will reflect its choice of what course of action is most likely to lead to a sustainable profitable outcome,
given the current decision-making environment.
9
Step Two: Identify possible locations
The first step in the decision-making process was to identify a list of possible alternative
locations. This list was composed in terms of the following criteria:
1. Access to reliable, flexible and cheap transport networks closely linked to a port
(for the imports of sisal and exports of finished goods);
2. Availability of adequate production premises;
3. Presence of supporting infrastructure of sufficient quality, such as engineering
facilities, and access to other vital inputs, for example dyes and latex; and
4. Access to staff (preferably experienced/skilled in manufacturing).
The initial list drawn up included Durban, Pietermaritzburg, Port Elizabeth, the Gauteng
region (Johannesburg and its immediate environs), Polokwane, Reunion, Mauritius,
Maputo (Mozambique).
The list compiled was directly affected by individual bias. Cape Town, for example, had
every attribute required and yet was excluded because the managing director ‘did not like
the people there’. When asked about other areas which apparently fulfilled these criteria
the initial reaction was one of surprise that these options might have been considered
followed by a justification of their exclusion on some (apparently ad hoc) basis, such as
the lack of existing textile production facilities (Bloemfontein, Uitenhage); or the
infrequent stopping of ships at the ports (East London, Richards Bay). No formal analysis
of the cost (or value) implications of these (apparent) deficiencies was deemed necessary.
10
The (assumed) existence of these faults was deemed sufficient for the exclusion of these
alternatives from the rest of the process.
Step Three: Identify preferred locations
The company felt that a complete analysis of the list of possible locations identified was
not cost-effective. The second step in the decision-making process consisted of selecting
three sites from the initial list (the eventual choices made are in brackets):
1. The best domestic inland location (Gauteng/Johannesburg);
2. The best domestic coastal location (Durban/Pinetown); and
3. The best foreign location (Mauritius).
It was felt that these three categories captured the essential strategic choices. An inland
centre would be closer to the existing market (mainly Gauteng) which would be better as
domestic sales remained dominant in the short to medium term. A coastal venue would be
superior in terms of reducing transport costs for the export market – the long-term
strategic goal. Finally it was believed that a foreign location might be even more attractive
in terms of achieving the long-term strategy of increased export promotion. Throughout
the evaluation exercise, it was decided to retain Polokwane as a benchmark case. The
influence of the two strategic goals can be clearly seen at this point.
The destinations on the short list were selected on the basis of a series of comparative,
non-formal analyses concentrating on qualitative differences: two locations were
compared and the lack of a particular factor in one of the two locations, ceteris paribus,
11
was deemed enough to warrant its exclusion. For example, Port Elizabeth was excluded
(when compared to Durban) on the grounds of it being:
•
Further to Johannesburg than Durban. This would lead to higher transport costs;
•
Fewer road transport companies on the route as compared to Durban. There would
be less flexibility in terms of the number of alternatives available and (probably)
higher costs per kilometre; and
•
Shipping lines stopped less often in Port Elizabeth than Durban. This would again
limit the flexibility and increase cost of the transport in, of raw materials, and out,
of finished products.
No formal analysis of these existence or scale of these deficiencies was carried out. Their
perceived existence was sufficient to exclude possible locations.
Step Four: Identify optimal location
For each of the three locations a comparison of estimated direct costs for each location to
current direct costs at Polokwane and an estimated profit/loss statement was completed.
Two scenarios, based on differing assumptions regarding the rates of growth of the
domestic and foreign components of their current demand, were used in these exercises.
The first assumed an annual (compounded) rate of growth (in real terms) of the export
market of 15 percent and the second, a growth in export demand of 7 percent5. In both
cases, demand in the domestic market was assumed to grow by 5 percent (also in real
5
Both of these real growth rates are not sustainable in the long run. This, however, did limit their use in the
evaluation exercise.
12
terms). These rates of growth were identified as being the two most likely scenarios
representing ‘good’ or ‘bad’ future outcomes.
These exercises indicated that the Mauritius option clearly represented a superior choice
to all the domestic alternatives in terms of both relative costs and expected profits. The
quantified benefits of significantly lower wages, the absence of any company taxation,
and significantly reduced internal transport costs outweighed the quantified negatives of
higher rental costs, higher transport costs to the South African market; and the unquantified problems of managing across borders and over such a distance.
The Polokwane region presented the most profitable domestic site due to the significantly
cheaper current rental charge used. Two qualifications to this result were immediately
raised by management. Firstly, the low rental charge used for Polokwane in the
calculations was not likely to last for the period covered by the model. Secondly, the
exercise assumed that the increases in output were to be produced with the existing labour
and capital stocks which would be extremely difficult to achieve in Polokwane.
Consequently the Gauteng/Johannesburg site was considered to be the best domestic
alternative.
This penultimate stage of the decision-making process provides the first application of a
formal evaluation technique. Identification of relative cost differences is consistent (in
part) with the traditional model of decision-making and the choice of the final location
was determined by the results of this technique. However there are some key
shortcomings with the process.
13
Extensive efforts were made by management to establish the extent of these cost
differentials. However, management only focussed on estimating current cost differentials
– there was no systematic attempt to anticipate future changes to production costs in these
alternative locations and so the sustainability of these relative cost advantages was not
explicitly considered.6 Other sources of incremental cash flows were not established.
Inflation and exchange rate movements were ignored which simplifies the analysis, but
has the effect of increasing Mauritius’ relative attractiveness. The lack of any attempt to
formally investigate these variables further highlights the importance of the question of
minimising its current costs – again emphasising the importance of the firm’s cost
management strategy.
By not discounting the projected profits the time value of money was ignored and, more
importantly, the risks of producing in the alternative locations were viewed treated
equally. This is especially important given that Mauritius is situated in an entirely
different economic, political and cultural environment.
The formal evaluation exercise allowed management to identify what the probable relative
production costs would be (in present terms) at the various locations – not the expected
value of the alternative sites. This was sufficient as it dealt with what the decision makers
believed was their key strategic objective – minimising production costs.
Step Five: The final decision
In spite of Mauritius’ overwhelming advantage over the domestic locations in terms of
relative costs and expected profit, the potential risks of doing business in a completely
6
Management’s decision in the final step of the process indicates that they were aware of the shortcomings
14
new cultural and economic environment were perceived to be very large. Consequently,
management decided to keep the production facility in Polokwane running for another
year at least to allow for a pilot plant to be set up in Mauritius to make products for export
to the European market. This deferred the decision to move the entire production facility
from Polokwane for a year. Moreover, the experience of running the pilot plant would
give management the experience to more accurately evaluate the viability of running a
production plant in Mauritius.
The nature of the final decision suggests that that management recognised the limitations
of the formal evaluation exercise. It allowed them to identify Mauritius as their first
choice for a future production facility. However, they decided to limit their exposure by
setting up a pilot plant in Mauritius and deferring the decision to move for a year. While
the results were seen to be directionally correct, they were not sufficiently accurate to
allow management to commit to the choice suggested by the evaluation exercise. This
suggests that the formal evaluation exercise had a limited impact on the eventual decision.
However their to invest in a pilot plant only is entirely consistent with the conclusions of
Real Options theory which recognises that delaying an investment decision until key
uncertainties have been resolved is a valuable source of flexibility7.
In summary, this case study highlights a role for the formal (financial) evaluation exercise
different to that proposed by the traditional model. Rather than being the (decisive) basis
for this entire decision-making process, it can be seen as a mechanism which enabled the
firm to identify the lowest cost alternative site from a pre-selected group. It is an
of this evaluation exercise.
7
I am indebted to an anonymous referee for pointing this out. It does not, however, rescue the decision
making process from the critical analysis presented in this paper.
15
important step in the overall process but the importance of t he strategic factors was far
greater especially in terms of defining the need for the capital investment decision and the
criteria by which alternatives should be chosen for further analysis. They determined
which locations should be (imperfectly) formally evaluated. Moreover, whilst guided by
the results of the formal evaluation exercise the final decision taken was directly affected
by the uncertainty regarding the accuracy of the formal evaluation exercise and thus its
conclusions. Even at this late stage in the decision-making process, the results of the
valuation exercise did not provide the managers of Firm A with a sufficiently strong
foundation for them to commit to their final choice of location as evidenced by the choice
to build a pilot plant).
In terms of process, decision makers seemed to follow a filtering process rather than a
once-off comparison of estimates of value. Initially, a broad ‘mesh’ or filter is applied to
eliminate unwanted choices and then finer and finer filters are applied as the process
continues. The (truncated) value-related estimation exercise was effectively the final mesh
used to identify the optimal location.
FIRM B’S DECISION TO EXPAND ITS CAPACITY
Firm B is a large South African paper manufacturing company and the decision analysed
in this section was taken by the Tissue Paper Division. Capital expenditure proposals are
motivated at the divisional level but permission has to be obtained at the group level if the
amount to be spent is above R1 million. This is formally done through a presentation to
Firm B’s Board of Directors. Figure Two provides an overview of the capital investment
decision-making process followed by the Division.
16
FIGURE 2. AN OVERVIEW OF FIRM B’S CAPITAL EXPENDITURE
DECISION-MAKING PROCESS
1. Recognition of the need for additional capacity
2. Identify First List of options: Option A selected
3. Identify Revised List of options : Option H selected
4. Pre-engineering Study: Option H rejected; Option E selected
5. Board Presentation: Option E accepted
Step One: Recognition of the need for additional capacity
Two reasons were given by the division’s management for the consideration of additional
capacity. Firstly, the rate of growth of market demand was expected to increase; and
secondly, they believed it to be a strategic necessity to continue to maintain sufficient
excess capacity to protect the firm’s dominant market position from potential new
entrants.
The increase in the expected rate of growth of market demand (sales) for tissue products
was largely the result of the personal input of the group managing director. In July 1995
he indicated to the Division that they should base their capital expenditure planning on
scenarios: five, ten and fifteen percent annual growth in levels of market demand (sales).
Prior to this the Tissue Division had considered scenarios of five, seven and a half and ten
17
percent. It was estimated that the division’s capacity constraints would be reached in
1998, 1997 and 1996, under the three scenarios respectively. The division thus proceeded
to look for alternative ways to supply the perceived need for an increase in productive
capacity.
Firm B’s Tissue Division held the largest market share of 37 percent. Management viewed
the market as essentially a commodity market with little room for product differentiation.
Consequently they believed that long term profitability could only be achieved through
high operating efficiencies and continued market dominance. This implied that, firstly, the
division must produce at the lowest possible overall cost (i.e. it must not over-capitalise
itself); and secondly, it must maintain a level of excess capacity to block potential
entrants. A key challenge for management was seen to be one of balancing the two
competing aims and this conflict becomes apparent at almost every stage of the process.
Step Two: Identify first list of options
Table One reports the four options which were initially presented to the Division capital
expenditure committee for consideration in August 1995.
Option C was rejected as only offering a short-term solution. It was then argued that that
the lack of in-house technical resources meant that it could only manage one of the
remaining three alternatives at a time. The required level (and timing) of the additional
capacity required was very sensitive to the accuracy of the expectation regarding the rates
of growth in future demand. It was felt that the increase in demand (50 percent or greater)
which would necessitate the consideration of a new plant was not certain enough to take
the risk of over-capitalising the division. Options A and B could provide sufficient
18
breathing space (in terms of additional capacity) to confirm accuracy of these
expectations. The upgrading options (A and B) should thus be considered first as they
would provide incremental tonnage at the lowest cost (and risk). Moreover these options
would allow the Division to correct for the lack of adequate investment in the past which
was constraining its current and future operating efficiency levels.
Table One. The first set of options considered by the Division8
Additional Capacity
Option
Action
(000’s tons p.a.)
A
Rebuilding of paper machine three (PM3) at the Site K factory.
2 000
B
Upgrading of paper machine four (PM4) at the Site B factory.
9 000
C
Renegotiate the supply contract with SAPPI.
4 000
D
Build a new paper machine.
27 000
Further consideration of Option D – building a new paper machine – was effectively
stopped at this stage on the basis that the risk of over-capitalisation was too great due to
both the higher cost of investment in a new machine and the significant additional
capacity it would bring. However, there was no formal analysis of the risk of the rate of
growth in reaching the levels necessary to justify this investment.
The reasons given for the decision taken to focus on options A and B were that it would
allow the Division to use its existing assets more efficiently and avoid overcapitalising the
8
The estimated capital costs of each of these alternatives were not reported at this point – however, as the
reference to overcapitalization in the rejection of Option D shows, this variable was deemed to be of
importance – even on an order of magnitude basis.
19
division. The decision to exclude Options C and D was thus made on their inability to
meet the Division’s strategic goals – not through a comparison of the expected value of
the range of alternatives.
Outside consultants were briefed with the aim of identifying whether options A and B
were feasible and what the potential associated costs might be. This led to the next set of
alternatives considered in November 1995 – these are summarised in Table Two. Options
E to I are mutually exclusive with each other, but not with options One and Two.
Step Three. Identify Revised List of Options
The outside consultants advised that further consideration of option A was not required as
option B provided clearly superior output and cost advantages. Five alternative forms of
option B were presented for consideration (see options E, F, G, H and I in Table Two –
these are mutually exclusive alternatives). At this stage, the technical director, again on
the advice of the consultants, introduced two additional proposals for expenditure on
projects of a replacement/upgrade nature (Options One and Two in Table Two.).
Of these alternatives, Option H, One and Two were selected for further analysis. The total
expected increase in capacity would be approximately 6 000 tons per annum.
The process for deciding between these options is seemingly based on criteria similar to
those proposed by the traditional model. As shown in Table Two, each option was
presented with its expected benefit (additional output added), its relative (estimated)
20
capital costs, and finally, its Internal Rate of Return (IRR) measure. Furthermore, the
option with the highest IRR was the one selected (Option H)9.
Table Two. The second set of options considered by the Division
Option
E
F
G
H
Action
Upgrading PM4’s stock preparation using
latest technology
Two
*
IRR
Payback
Capacity
Cost
(%)
Period
R45 million
23.45
R35 million
28.06
R33 million
28.06
R15 million
46.59
-
-
R8 million
24.05
R10 million
21.55
p.a.
Option E but with essential equipment only
5 300 tons
(risk of negative yield/quality effects)
p.a.
Upgrade and combine PM3 and PM4’s
5 000 tons
stock preparation
p.a.
Utilise existing PM3 stock preparation with
4 000 tons
upgraded PM4 stock preparation
p.a.
4 700 tons
mothballed – but concerns on quality,
p.a.
technology exist)
One
Estimated
5 700 tons
Start up of PM3 machine (currently
I
Additional
Implementation of Distributed Control
817 tons p.a.
System
1 170 tons
Fitting of Gas Fired Drying Hood
p.a.
4 yrs 6
months
3 yrs 11
months
3 yrs 11
months*
2 years 6
months
-
4 years 5
months
4 years 10
months
The IRR and Payback Period calculated for options F and G were identical. When questioned about this
highly unlikely outcome the Technical Director for the Division (who prepared the document) said that
these results were correct and any similarity was simply a coincidence.
There are two problems with this conclusion, however. Firstly, the results of the
supposedly redundant payback period (PP) measure were presented for all of the options
considered. When interviewed, management regularly referred to the PP results when
9
This is in spite of the potential problems with using IRR to rank mutually exclusive alternatives. I am
indebted to an anonymous referee for drawing my attention to this point.
21
explaining the relative attractiveness of that alternative. This indicates that decisionmakers do not agree with the theoretical redundancy of the PP measure and do not feel
comfortable with the use of DCF techniques in isolation10. Secondly, while the choice of
Option H is justified (as it had the highest IRR), options One and Two were also selected
for further analysis – even with their very ordinary IRR (and PP) figures. This suggests
that the IRR (or even PP) measures were not the primary basis for the decision at this
point. When asked about this choice, the Divisional Managing Director indicated that
because of his pessimistic outlook regarding future demand, he had wanted the smallest
possible investment of additional assets into the production process. He felt that anything
more would have been unnecessary and would have led to the division over-capitalising
itself. Option H, One and Two offered this combination. The importance of the division’s
strategic aims in this decision-making process re-emphasised at this point as the inclusion
of options One and Two only makes sense as they maximising management’s ability to
implement their strategy of ‘sweating the assets’.
The next stage of the capital expenditure process was a pre-engineering study to determine
a more accurate estimation of the costs of options H, One and Two for budgeting
purposes.
Step Four: Pre-engineering study
The significant results of this study were that the chosen option (H) was discarded on the
advice of the consultants11. Option G was also excluded on the same basis while option I
10
An alternative explanation pointed by an anonymous reviewer is that the PP method is a common proxy
for the risk associated with a project. This could explain it’s ubiquitous presence.
11
It was not possible to cost effectively implement this option given the physical layout of the Site B plant
at the time of this study.
22
was rejected on the basis that it did not present a long term solution.12 The choice was thus
between Options E and F.
Option F, while offering a higher IRR, suffered from the problems of technology
obsolescence in the future which would negatively affect the productivity of all the
associated machinery and lead to lower quality levels. On the other hand, option E would
allow PM4 to run at its designed capacity. It would correct for the original lack of support
processes and thus would increase both levels of output and improve the efficiency of the
existing capital stock. While significantly more expensive (R45 million as compared to
R15 million), its use of new technology would mean that it would require replacement
much later than any other alternative. The importance of these efficiency gains would be
multiplied by their relative longevity13.
In spite of it having a lower IRR (and a longer PP) than option F, option E was selected.
The basis for this decision was that it would supply sufficient additional capacity for the
(downgraded) expected needs of the Division as well as prolong the life of the PM4
machine and improve its operating efficiency measures over this period. This suggests that
either these benefits either not fully reflected in the IRR calculations completed in the
previous stage, or alternatively, that the IRR measures, if accurate, are not important in the
decision-making process. Management indicated that these benefits were not initially
included because they were judged to be unquantifiable and it was only after the preengineering study that this data was available. However it is important to remember that
12
The machinery’s technology was obsolete and the expected quality of the output was deemed to be not be
of a sufficient quality.
13
This strongly indicates that the alternatives under consideration had significantly different economic lives.
This raises further problems with the use of IRR to rank these projects – the reinvestment rate assumption
becomes a problem. I am again indebted to the anonymous referee who brought this to my attention.
23
the choice of focus of the pre-engineering study was option H. Consequently it was
effectively only an accident this data on Option E became available. Furthermore, new
IRR estimates were not estimated and presented in support of this choice.
This stage of the process highlights a significant problem with the implementation of a
model of decision-making based on the comparison of estimates of value. The data
required to accurately estimate the value of the competing alternatives is very expensive
either in terms of management time or consultants’ fees. As a result, managers need to
prioritise options for further consideration and in this case, they did it on qualitative and
strategic grounds (the ability of Option E to minimise additional investment while
leveraging the unused production capacity of the existing assets).
The process of elimination outlined in this step clearly highlights the continued
importance of qualitative variables in the decision-making process in spite of the apparent
use of DCF techniques. Each alternative was carefully evaluated judged in terms of its
alignment with the strategic goals – in spite of there being estimates of the projects’
IRRs14. The estimate of value produced by a DCF evaluation technique depends on the
accuracy of their assumptions regarding the future values of all relevant factors. The
above example suggests that these techniques produce estimates that are not accurate
enough to provide decision makers with an adequate basis for deciding between
alternatives. The DCF evaluation techniques are either somehow incapable of accurately
capturing the value of the alternative’s alignment with these goals, or, alternatively, it may
be that the costs of acquiring information required for the use of the traditional decisionmaking approach are too great to allow for its use in comparing alternative courses of
24
action. The fact that this type of analysis is completed for the presentation to the board
suggests that the latter reason is correct in this case.
The final stage of the decision-making process was to present the results to the Capital
Expenditure Committee of the Group’s Board of Directors in August 1996.
Step Five: Board presentation
The proposal to upgrade PM4 consisted of the Division’s request for permission to carry
out their planned course of action (Options E, One and Two). The upgrading of PM4 was
presented as a viable short-term alternative until the installation of a new machine could
be seen to be ‘strategically appropriate’. The division’s management clearly
communicated this choice as an opportunity to improve the efficiency of its capital stock
and reduce the need for additional future non-productive investment expenditure. This
alternative allowed it revitalised the capital stock of its existing production facility and
avoided the gradual decline in its long term capacity. The board approved the application
and the changes to PM4 took place.
Some formal evaluations of the proposed alternatives (IRR; PP) were included but these
results were not used to justify the course of action selected by indicating how these were
the best results available. The only other course of action mentioned in this presentation
was to bring the installation of a new paper machine forward. No analysis of the expected
value of this alternative was presented15. This suggests that the only role of the formal
14
The validity of the use of these IRRs to rank alternatives is doubtful given the mutually exclusive nature
of the alternatives and the variation in the alternative projects’ lives.
15
This option had been effectively discarded at the first opportunity (see the discussion of Step Two above).
25
evaluation included in this presentation was to confirm the viability of the proposed plan
of action to the board rather than its necessary superiority over competing alternatives.
In summary, the decision that Firm B took was initially prompted by a change of
expectations, modified by the division’s existing competitive strategies and then justified
by the formal analysis of a limited number of alternative solutions. The key choices
throughout the process were made with the aim of balancing the competing strategic aims.
These choices made were justified on the grounds of qualitative, and not quantitative,
criteria. When used, the DCF techniques (combined with the PP method) provided support
for the decision taken on other grounds.
KEY DIFFERENCES TO THE TRADITIONAL MODEL
The review of these decisions suggests that the recognition of the need for additional
investment is affected by their strategic choices. The final choice made is a result of the
application of a multi-staged filtering approach to a range of potential alternative
solutions. Qualitative factors are applied over a series of steps in this filtering process to
reduce the list of alternatives which are further evaluated. Of these, the degree of
alignment of the alternatives with the company’s strategic goals is usually the most
important factor. Estimates of project value are not the key basis for management’s choice
between alternative capital investment opportunities. This data suggests that capital
investment behaviour can be better understood within the context of the competitive
environment of the firm and its choice of strategic responses. In particular, this model
deviates from the traditional model of decision-making in the following key areas:
26
1) The traditional model does not consider the genesis of the projects being evaluated.
This study suggests that capital investment decision-making processes are triggered by
a change in expectations regarding future investment needs. These changes in
expectations are normally closely related to the management’s strategic focus. For
example, Firm A would not have considered the need to change its plant’s location if
it had not decided to try and increase its export sales;
2) Unlike the traditional model which implicitly assumes a one stage process, the
observed decision-making process consists of several stages. At each stage a filter is
applied and a smaller list of alternatives is identified for further analysis;
3) At each stage of this process the choice of the alternatives for further analysis is done
primarily on the basis of a series of qualitative factors. Alignment with strategic goals
is the most common rationale used for these choices. Estimates of the value of
alternative courses of action are not calculated or used in these early stages. If
anything, management seem more focused on establishing the expected relative costs
of alternative options;
4) Formal evaluations of projects (when conducted) are used to justify the viability of the
preferred course of action, not as a basis for the choice between alternative projects.
While it is an important discipline imposed on the outcome of the choice process, it
does not provide the key input upon which the final choice is made.
By focusing attention on (correctly) estimating the value of the alternatives, the traditional
model implicitly assumes that all sources of potential value can be measured and
incorporated into the estimation of the incremental cash flows. However while costs can
27
be established with some degree of accuracy (and are usually vital to the companies’
competitive strategy choices), other factors which affect the expected value associated
with the project are hard to identify.
Another key barrier to the usefulness of DCF techniques is the significant investments to
obtain data necessary to complete these estimations with confidence. It is not usually cost
effective to complete it for all alternatives.
IMPLICATIONS FOR FUTURE RESEARCH
There is a need for a survey to establish how the behaviour observed is representative for
other South African firms.
The importance of competitive strategy in the triggering and filtering of capital investment
decisions suggests that the structure of the industry in which the firm operates could have
an impact on firms’ capital investment decisions.
Alternative forms of competition (e.g. through product differentiation or service offerings)
could lead to different capital investment responses to similar changes in the environment.
Both the firms examined in this paper viewed the products they produced as commodities
which lead to their focus on capital investment decisions which minimised costs – but this
is not necessarily the case for all firms.
The perceived usefulness of DCF techniques is directly related to both the confidence that
the decision makers have in accuracy of the assumptions used in these techniques and/or
the ease with which these assumptions can be confidently made. Firms should use DCF
28
techniques more often if the economic environment is stable; and/or they are operating in
less concentrated industries.
CONCLUSION
The challenge facing managers making capital investment decisions is significant. Formal
evaluation techniques promise an objective, value maximising solution to this problem.
However, as managers have a limited awareness of opportunities and time to evaluate
them, their observed responses involve the use of shortcuts and approximations.
Understanding companies’ competitive environments and strategic reactions to these
environments are vital to understanding their capital investment decision-making
behaviour. While DCF techniques can, and do, play an important role in capital
investment decision-making, the costs (and sometimes impossibility) of completing them
properly means that their use is always going to be limited. If an analysis of capital
budgeting focuses only on the use of these measures, it will be similarly limited.
29
References
Andrews, G.S. and Butler, F. 1986. Criteria for major investment decisions. The
Investment Analysts Journal. (27): 31-37.
Baddeley, M. 1996. Rationality, Expectations and Investment: the Theory of Keynes vs.
Neo-Classical Theory. University of Cambridge: unpublished Ph.D. dissertation.
Bailes, J. C., and McNally, G. M. 1984. Cost and Management Accounting Practices in
New Zealand. International Journal of Accounting Education and Research. (19)Spring:
9-71.
Bavishi, V. B. 1981. Capital Budgeting Practice at Multinationals. Management
Accounting. (August): 32-35.
Christy, G. A. 1966. Capital Budgeting - Current Practices and Their Efficiency. Eugene:
University of Oregon Press.
Correia, C., Flynn, D. Uliana, E. and Wormald, M. 2003. Financial Management, 5th ed.,
Johannesburg: Juta & Co.
Copeland, T. E., and Weston. J. F. 1992. Financial Theory and Corporate Policy. New
York: Addison-Wesley Publishing Company, Inc.
Gilbert, E. 1999. An Investigation into Uncertainty and the Capital Investment Decisions
of Manufacturing Firms in South Africa. University of Cambridge: unpublished PhD
thesis.
30
Gilbert, E. 2003. Do managers of South African manufacturing firms make optimal capital
investment decisions? South African Journal of Business Management. (34)2: 11-17.
Hall, J.H. 2000. Investigating aspects of the capital budgeting process used in the
evaluation of investment projects. South African Journal of Economic and Management
Studies. (3)3: 354-368.
Harvey, C. and Graham, J. 2001. The theory and practice of corporate finance: evidence
from the field. Journal of Financial Economics. (60)2/3: 187-235.
Istvan, D. F. 1961. The Economic Evaluation of Capital Expenditure. Journal of Business.
(34)January: 45-51.
Klammer, T. 1972. Empirical Evidence of the Adoption of Sophisticated Capital
Budgeting Techniques. The Journal of Business. (July): 387-97.
Klammer, T. P., and Walker, M. C. 1984. The Continuing Increase in the Use of
Sophisticated Capital Budgeting Techniques. California Management Review. (XXVII)
Fall: 137-48.
Mansfield, R. 1996. Strategy, Concept of. in International Encyclopedia of Business and
Management. M. Warner (ed.), London: Routledge: 597-607.
McIntyre, A., and Coulthurst, N. 1987. Planning and Control of Capital Investment in
Medium-Sized UK Companies. Management Accounting UK. (March): 39-40.
Meredith, G. G. 1965. Capital Rationing and the Determination of the Firm's Performance
Standards for Capital Investment Analysis. University of Queensland Papers. (1)4: 85114.
31
Moore, J. S., and Reichert, A. K. 1983. An Analysis of the Financial Management
Techniques Currently Employed by Large U.S. Corporations. Journal of Business Finance
and Accounting. (10)4: 623-45.
Northcott, D. 1992. Capital Investment Decision-Making. London: Academic Press.
Parry, H.M.A. and Firer, C. 1990. Capital budgeting under uncertainty: an empirical
study. South African Journal of Business Management. (21)3: 52-58.
Pike, R. H. 1983. A Review of Recent Trends in Formal Capital Budgeting Processes.
Accounting and Business Research. (51)Summer: 201-08.
Pike, R.H. 1996. A longitudinal survey on capital budgeting practices. Journal of
Business, Finance and Accounting. (23)1: 79-92.
Pullara, S. J., and Walker, L. R. 1965. The Evaluation of Capital Expenditure Proposals:
A Survey of Firms in the Chemical Industry. The Journal of Business. (38)4: 403-08.
Ryan, P.A. (2002) Capital budgeting practices of the Fortune 1000: how have things
changed? Journal of Business and Management, (8)4 Winter:
Sangster, A. 1993. Capital Investment Appraisal Techniques: A Survey of Current Usage.
Journal of Business, Finance and Accounting. (20)3: 307-32.
32