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Jan Gadella works at the Faculty of Economics at the University of Northampton, United
Kingdom. John Hall works at the Faculty of Economics of the University of Pretoria, South
Africa. Wim Westerman works at the Faculty of Management and Organisation of the
University of Groningen, The Netherlands. The authors are indebted to suggestions and comments of several of their colleagues. Of course the usual disclaimer remains

Abstract
The continuous expansion of the body of knowledge and experience of capital budgeting systems within multinational organisations has led to vast changes. The traditional project management approach begins with assigning tasks to team members, linking authorisations to hierarchical levels. Assembling and processing information, as well as operational risks assessment, lead to specification(s) of the investment. The financial performance of the project is monitored. Behavioural considerations influence the rationality of the decision-making process. In the strategic planning approach, the strategy design must govern the allocation of resources. It is imperative that the range of strategic risks is identified and quantified, including relative competitive positions created by the capital investment. The investment decision-making process may depend heavily upon a suitable financial planning approach. One can examine and analyse the magnitude of the investment expenditure, at the same time addressing the required and available sources of finance. The financial appraisal may utilise both accounting and discounted cash flow methodologies. In addition, the financial analysis may incorporate different types of financial risk assessment, e.g. sensitivity and scenario analyses.
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Section 1. Introduction
The capital budgeting process is an important aspect of financial management.
However, more is involved than just the selection of capital projects. According to
Northcott [1992], capital budgeting includes both selecting long-term investments and planning for their financing. As a part of the management control cycle of a firm, capital budgeting is about the control of capital outlays and corresponding operational cash flows. Multinationals are very complex organisations, because they operate across national borders. The home country headquarters, as a rule, directs the foreign operational units. In most cases these units are structured according to the normal systems of business and/or functional areas. The capital budgeting systems of such firms involve not only financial control of capital investments, but also intense personal relationships management, targeted local strategy development and the building of complex financial information systems. The capital budgeting systems of multinationals are influenced by varying attitudes of external stakeholders
(governments, suppliers, consumers and so on) as well as internal stakeholders
(especially employees, managers and shareholders). While these factors may have a considerable effect at a corporate level, one factor in particular has made a large impact on systems development overall, namely the ever-expanding body of knowledge and experience of capital budgeting. Both managers and scientists have
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been working on new concepts. This article describes the evolution of the developments, present an overarching framework and discusses three case studies.
Despite occasional warnings by renowned scholars such as Pinches [1982] and Ross
[1999], many financial professionals and theorists have attempted to improve financial investment selection techniques, without taking into account issues of organisational behaviour and those relating to strategy adequately. Nevertheless, more pertinent literature has appeared over the last two decades. For example, Myers
[1984] and Wissema [1985] began a theoretical trend when they combined strategic and financial issues. Later Tomkins [1991], Northcott [1992], Oldcorn and Parker
[1996], Grundy [1992; 1998], Slagmulder [1997] and others amalgamated organisational factors, strategy developments and financial elements into one valuebased management concept of capital investment. Interestingly, a number of consultancy firms are in the process of refining this management approach. This more holistic approach to the capital investment decision-making process is deemed to have been accepted as the present day best practice [cf: Lumby & Jones, 2001].
However, Farragher, Kleiman and Sahu [1999] and Verbeeeten [2001] in recent surveys based in the USA and the Netherlands could find conclusive evidence that a higher level of sophistication in the capital budgeting process leads to more substantial corporate performance. Perhaps capital budgeting is not about developing
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a superior decision-making system (“one fits all”), but should it focus on enhancing a contingency review procedure of the organisation in question (“it suits me”).
Goold and Campbell [1987] point out that management control styles should be adapted to the characteristics of the corporate environment and the corporate resources concerned. The control matrix they propose consists of two axes. The horizontal axis, the x-axis, reflects the amount of centralisation in the planning, whereas the vertical axis, the y-axis, delineates the flexibility or tightness of the control. The principal approaches focus on the strategic planning style, the strategic control style and the financial control style. The strategic planning approach stresses centralised strategic planning, and requires limited control of strategic results of capital investments. As a rule, strategic control involves loose planning but tight control procedures. In the context of capital budgeting, strategic checks tend to be of minor importance. However, the concepts of project control should be applied to manage the operation of the investment process. Instead of a financial control approach, this article would suggest the inclusion of a financial planning approach.
The latter approach is especially cognizant of ex-ante financial measures, but treats ex-post checks as a matter of growing importance. The three above approaches have grown in depth and breadth, including more specialised knowledge and experience, whilst incorporating increased areas of interest.
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In this article, firstly the approaches to capital budgeting systems in multinational firms are examined, moving on to the domain of the management control cycle. The development of three capital investment approaches in multinational firms is explored. Secondly, the project control approach is described. Thirdly the strategic planning approach is discussed. Fourthly, the financial planning approach is addressed. Fifthly, a conceptual framework is presented and applied to three case studies. Finally, recommendations are made to both academics and practitioners.
Section 2. Project control approach
Multinational firms usually consist of a (regional) headquarters and local subsidiaries.
Headquarters supervises and assists the subsidiaries. In order to realise particularly corporate scale and scope effects [Funk, 1999], subsidiaries do not perform all management functions all by themselves. That is why intra-firm groupings, for example, of sales subsidiaries vis-à-vis production subsidiaries, may exist. Also, local subsidiaries may cover one or more lines of business. This gives rise to groupings in divisions, business units and so on. Moreover, geographic distance may interfere with intra-firm interaction. This may cause firms to group their subsidiaries per region, be it a continent, a country or even a province. All in all, multiple layers may exist within multinational firms. Capital investment involves the joint effort of many general and specialist corporate officers [Bower, 1970]. Therefore, project teams may
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differ with regards to length of time in operation, number of officers (changing over time), functional composition and personal involvement. Defining individual and group tasks goes along with assigning responsibilities. Authorisation to decide on the use of resources depends on the nature of the unit at hand and the level of management involved. Task control as a part of project control is about checking whether the rules are complied with [Anthony, Dearden & Govindarajan, 1992]. It may enter the scene of the investment project either via personal supervision or via formal information systems.
Information briefings or memoranda serve as focal points in the decision-making process. One of the main tasks of a project team is to assemble and process data on the capital investment. Aspects from various functional areas may have to be taken into account, such as production, marketing, finance and human resources. Readily available internal and external data form the basis of the data gathered. However, these data may be of limited use for investment decisions (for example, historical cost price figures) or may even be wrong (for example, old price lists from suppliers).
Many important data cannot be assembled on a regular basis. They must either be searched for ad hoc, or have to be bought from external providers. Additional information may be informally acquired, for example, from e.g. non-executive board members and suppliers. Nevertheless, lack of information may remain a problem, particularly in (new) product development projects. The same problem may apply
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when there is a severe lack of time, for example, when competitors threaten to capture a market. In the processing of the information assembled, data are created for decision-making. Strategic planning techniques, financial planning tools and professional judgement, among other factors, facilitate information processing (via software). Corporate capital investment manuals, including targeted standard guidelines and forms, may end up guiding the process [Bierman and Smidt, 1993, pp.
504 –521; Segelod, 1997].
The assembly and processing of information goes hand in hand with the identification and handling of operational risks. These may influence capital investments especially in multinational firms. Jahrmann [1991] distinguishes between
1) market risks (e.g. sales markets are falsely or insufficiently targeted);
2)
3) price risks (the danger of price changes, e.g. caused by competitors); credit risks (stemming from partial, late, or from non-payment);
4)
5)
6) delivery risks (suppliers do not comply with delivery terms); transport risks (damage or loss of goods); and currency risks (effects of currency rate fluctuations on transactions).
The non-currency risks may be reduced by avoiding specific markets, as well as by using price clauses in contracts, hedging on commodities exchanges, requiring down payments, asking for credit guarantees (for example using bills of exchange), closing
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transport insurance and changing distribution channels. Exposure to the currency risks on transactions can be hedged by closing forward contracts with banks, using standardized futures contracts and closing currency options contracts [Eiteman,
Stonehill and Moffett, 2001]. Firms may leave operational risks partially open. Risk attitudes tend to be strongly influenced by both financial and strategic considerations.
Investment projects are usually not controlled in a scientific manner, as suggested by the standard literature [cf: Meredith and Mantel, 1996]. The desired results of capital investment projects may only be partly defined upfront. Several tasks may have to be performed and they may be unclear. Also, the subdivision and coordination of tasks may be accomplished ad hoc . However, according to Pike and Neale [1993, p. 255],
“the best projects emerge from a tightly controlled process”. The capital investment project control in terms of timing, precedence, outlay and performance may be poor, however. Bounded rational decision-makers who have a limited capacity to process information cannot accomplish optimal results. They replace optimising by
“satisficing”, sequentially searching for solutions on problems, developing repertoires of actions, restricting alternatives and decomposing programmes [March and Simon,
1958]. In addition, organisational learning involves developing decision-making rules
[Cyert and March, 1963]. It may also be explicitly striven for in capital investments
[Butler et al ., 1993]. Decision structures are governed by common rationalisations along chains of reasoning [Weick, 1979]. In order to be able to undertake some
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capital investment projects, mental schemas (representations) need to be broken down in a change process [Tomkins, 1991].
The project control approach focuses on handling capital investments according to standard operating rules. Information management and risk management serve as central devices in rolling out projects. Investment processes are governed by bounded rationality, though. There is little strategic planning or financial planning. The approach may best suit high-tech firms (such as dot-coms), government firms and regulated firms. It may also fit with replacement investments and forced investments.
It may be applicable to small firms and small investments.
Section 3. Strategic planning approach
Although one does not necessarily need to agree with Maccarone [1996] that most of the capital budgeting processes should be looked at in the context of strategic planning, it is indeed true that corporate strategy is often the driving force of capital investments in multinational firms. Firms may focus on designing strategies here [Mintzberg, 1990;
Mintzberg and Lampel, 1999]. Strategy development is done deliberately instead of intuitively or instantly. The chief executive (corporate, business, or local) officer acts as a creative architect. The strategy design is kept simple: strategy development is just about making choices. A well-known strategic design technique for capital budgeting
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processes is the Strength, Weaknesses, Opportunities & Threats (SWOT) analysis
[Aaker, 1998]. An internal analysis unfolds the strengths and weaknesses of the firm or unit itself. An external analysis shows the opportunities and threats stemming from the environment. Key success factors (KSF’s) to be used as an input for capital budgeting may become clear this way. Firms may focus on the synergy between a specific investment and the firm as a whole [Wissema, 1985]. When developing capital investments they may also strive to dig deeper, uncovering core competencies and assigning strategic resources to these [Hamel and Prahalad, 1994]. Finally, balanced scorecard concepts, distinguishing between financial, commercial, internal and learning/growth aspects [Kaplan and Norton, 1996], are increasingly applied.
Multinational firms may also want to model their strategy in terms of a sequence of steps, each consisting of all kinds of checklists and techniques [Mintzberg, 1990;
Minzberg and Lampel, 1999]. Chief Executive Officers (CEO’s) carry the overall responsibility for strategic modelling, whilst lower-level staff tends to actually appraise the investment proposals. Capital budgets contain financial analyses which may be verified in performance reports, thus in a sense linking strategic modelling to financial planning and financial control. The actual financial modelling is often preceded by the practice of benchmarking internal and external best practices [Oldcorn and Parker,
1996]. Strategic gaps between objectives and results can be ascertained and methods to close these gaps may be developed. Firms may subsequently focus on modelling growth
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routes, such as market penetration, market development, product development and diversification [Ansoff, 1965]. Forecasting techniques include brainstorming, scenarioanalysis and decision trees, evolving into figures, tables, graphs and the like, eventually ending in databases, spreadsheets and expert systems. Dynamics from learning may be introduced in the capital budgeting process, using experience, dialogues and careful tests
[Butler et al ., 1993; Piëst, 1995]. Strategic modelling then goes with project planning.
Operating uncertainties may be routinely dealt with when capital investment projects are managed. However, investment planning may incur various strategic uncertainties.
These uncertainties may alternatively possess a positive (chance or option) or a negative
(risk) connotation [Funk, 1995; Luehrmann, 1998-2]. Strategic uncertainties include the following categories:
1) commercial risk (especially as to markets, prices, deliveries and transport);
2) occupational risks (for instance on pollution, natural disasters, claims or
3)
4)
5) operational guarantees); financing risks (such as on credit and loan terms, including financial guarantees supplied); currency risks (exchange rate changes hurting activities and assets); and political risks (e.g. legal licenses, legal structures, subsidies or taxes).
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Commercial risks are discussed as non-currency risks in Section 3, even though a longterm perspective is used here. Organisations can often insure themselves against occupational risks if they are of a standard nature. If the risks are not standard operational and financial instruments may be available to hedge against such risks.
Interrelated financing risks and currency risks may be covered by balance sheet and cash flow hedges, leading and lagging cash flows, interest clauses and currency clauses, forward, futures, swap and options contracts, moving financing or activities to other countries and other methods [Eiteman, Stonehill and Moffett, 2001]. Insurance, negotiating a favourable environment or evading certain courses of action may help an organisation to address political risks. Sometimes other operational and financial instruments can be used (see Section 3).
Organisations may focus their strategic planning on the development of market structures by seizing profitable positions in well-distinguished sectors, businesses or countries. In collaboration with personnel from outside the organisation, internal management may occupy an important role, if not the most vital role, as they furnish management with important information for strategic directions. All the stages of the organisation’s product and market life cycles must be explicitly recognised. Portfolio matrices may, for example, uncover problems, strengths and weaknesses. As a result of such analyses these areas in the organisation may be invested in selectively, at various levels of intensity [Grundy, 1992]. Firms may scrutinise barriers to market
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structure changes [Porter, 1980; 1985]. Organisations may also plan to invest selectively in order to optimise their competitive positions, following cost leadership, differentiation, cost focus or differentiation focus strategies. Combinations of these strategies may be justified where firms choose suitable, acceptable and feasible combinations of price and perceived added value [Johnson and Scholes, 1997]. When value drivers are compared with value chains or groups of primary and support activities are evaluated, the financial values of the strategic advantages discerned may be identified [Rappaport, 1986]. A redesign of corporate, business and country portfolios (using core competencies to invest and divest) integrates the above types of strategic planning. Combinations of strategic planning with project control and financial planning are feasible here.
In a strategic planning approach, strategy formation is made explicit. Attention may be focussed on designing properties, modelling outcomes, encountering risks and portfolio formation. Various concepts may be used and an optimal mix chosen specifically for each case. This approach to planning may match the expansion or improvement investment projects, new product development or even mere strategic proposals. The above approach may possess a special appeal for non-traditional production and service firms, as project control and financial planning are less feasible in such firms. It may be especially useful for substantial investment projects in large organisations.
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Section 4. Financial planning approach
Multinational firms that select long-term investments and plan for their financing
[Northcott, 1992] employ a financial planning approach in their capital budgeting system. Capital expenditure refers to the commitment of financial resources [Welsch,
Hilton and Gordon, 1988]. Outlays include fixed assets and related current assets.
Expenses on minor investments can be calculated per unit as undesignated amounts.
Major investments may be budgeted for separately. Both are summed per time period in the capital expenditures budget. Cash budgets include planned cash receipts and cash disbursements. Investment cash flows, operating cash flows and financing cash flows are budgeted directly or indirectly to identify cash excesses and shortages by time period. Both partial and total analyses of the capital investment “problem” can be carried out, eventually including positive or negative synergies between investments [Bouma, 1980]. As long as operational planning issues have been dealt with sufficiently, liquidity and solvency considerations may govern the allocation of capital resources [Olfert, 1992]. Financial markets may be tapped if internal cash flows are insufficient, using a pecking order to evade dilution of control [Myers,
1993]. Internal and/or external capital rationing leads to a need to select investments
[Pike and Neale, 1993]. If investments are selected on a cash flow basis, outlay amounts, operating cash flows, interest coverage and payback periods may be taken into account.
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Firms may base the financial planning of their investments on targeted book profits and asset values. Profits can be broken down into various margins, depending on which costs are ignored. If eventual depreciation values are taken into account, they act upon the asset bases used. Investment selection methods may include [Walsh,
1996; Barker, 2001]:
1)
2) sales volumes, occupancy rates and (direct or indirect) staff numbers; selling prices, various cost prices, profit margins (to sales), operating
3)
4) results (before or after tax deduction) and break even volumes or sales; return on equity, return on assets and return on capital employed; and balance sheet values, profits per share and price-earnings ratios.
These accounting methods are relatively simple, easy to apply and inexpensive to use.
It is easy to create links to both the corporate, business and local management control system and the performance evaluation system. The theoretical deficiencies of the methods may not necessarily be operationally present [O’ Brien, 1997]. If captured in market-grounded rules of thumb, their application may lead to “correct” decisions
[Ross, 1995]. This may also explain why accounting selection methods are still widely applied in multinational capital budgeting [Buckley, 1996].
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Despite the corresponding effort, cost and uncertainty, firms may also want to take
(the timing of) cash flows and risk attitudes into account when they select their capital investments. Methods to be used include [Walsh, 1996; Barker, 2001]:
1)
2)
3) discounted returns (e.g. discounted payback time and discounted profit); the net present value (NPV) (the sum of discounted net cash flows); and the internal rate of return (IRR) (discount rates make the NPV zero).
To arrive at cash flows, instead of direct calculations, accounting numbers can be used [Rappaport, 1986; Northcott, 1992; Buckley, 1996]. Multinational firms may look at incremental investment outlays, periodical operational cash flows and terminal cash flows. One can also distinguish between three types of investments.
Operational cash flows consist of net receipts from activities. Investment cash flows are concerned with capital outlays and receipts. Financing cash flows stem from equity and debt capital. Applying the Capital Asset Pricing Model leads to discount rates. Market premiums, mitigated by the beta coefficients of the equity or debt instruments used, are added to risk free rates. However, taking shortcuts may yield figures that can be disputed. A value driver analysis may create links to the company’s operational, investment and financing strategies. An Economic Value
Analysis (EVA) of discounted cash flows could also lead to economic profits
[Stewart, 1991]. A performance analysis may then provide project control elements.
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Multinational firms may consider particularly financial risks in the financial modeling of their capital investments [Tomkins, 1991; Oldcorn and Parker, 1996; Buckley, 1996].
Shareholders are usually only interested in risks that they cannot diversify away.
Operational business risks, caused by operational activities, determine the volatility of asset returns. These returns are influenced by business cycle sensitivity and the appropriate cost and revenue structures. Financing with debt exaggerates the returns, because the interest paid is tax deductible. However, the financial risk to residually rewarded equity holders grows as the "financial leverage" increases, because an eventual default will hurt them the most. Firms may want to estimate probabilities and calculate standard deviations to identify the risks they have identified. Sensitivity and scenario analyses may provide information as well. The required financial results, payback periods and accounting rates of return may take financial risk into account. Forecasted cash flows and discount rates may be adjusted to arrive at suited present values. If uncertainties are viewed as opportunities, in addition to present value techniques, real options analysis may be useful. The Black and Scholes formula includes time, intrinsic value, interest rate and volatility elements. Simplification of the formula improves its applicability [Luehrmann, 1998-1]. By taking financial risks and real options into account, strategic values and financial values can be connected.
Financial planning of capital investments may focus on capital expenditures, book profits and asset values, as well as discounted cash flows. Risks may also be
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modelled. The approach may be especially appealing in cost reduction proposals, in expansion or improvement investments and in new product development. The approach may be most suited to traditional production and service firms, as project control and strategic planning can be included here as well. Varying in sophistication, it may be useful for a range of mid-size to large-size investments and large-size firms.
Section 5. Conceptual framework
Three approaches to capital budgeting in multinational firms had been sketched above.
The project control approach stresses organisational behaviour; the strategic planning approach focuses on strategy development; the financial planning approach specifies financial selection. In the above sections, the capital budgeting approaches (and even to a large extent their elements) have been arranged in order of their historical occurrence.
Firms gradually enter the domain of the management control cycle. However, the sequences to be displayed can only be partly discerned at the macro level of multinational firms: project control only precedes strategic planning partly, which in turn goes along with financial planning. Within each approach, sequences can be discerned.
Moreover, the elements of the approaches are interrelated in many ways. Multinational firms are increasingly developing eclectic capital budgeting systems that are specifically targeted towards their own needs. They typically extend, combine and overhaul elements of all three approaches discerned here. An overarching conceptual framework for capital
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budget system development in multinational firms summarises and connects the text thus far (see Figure 1 overleaf). This framework can be applied to two short corporatelevel cases and one long investment-specific case. The cases come from firms with headquarters located in the respective countries of the authors: The Netherlands, South
Africa and Great Britain.
Case study 1: BRM
The first case study focuses on Bollegraaf Recycling Machinery (BRM). This small
Dutch firm has been a producer and supplier of machines for the recycling industry since
1961. It is a leading manufacturer for example, of multifunctional recycling balers. The firm specialises in high quality customer-specified turnkey solutions. The holding has subsidiaries in the Netherlands, Germany, France, England and Spain, as well as a stake in an American importer. Since the mid 1990s, the firm has experienced extensive organic and acquired growth, leading to current sales of € 30 million, balance sheet of
€ 20 million, and employee numbers of 180. This resulted BRM’s having to implement a high level of industrialisation and professionalism. Capital investment in BRM is principally concerned with small to mid-size replacement of plant and machinery, cost reductions, expansion or improvements and new products.
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Figure 1
Project control
Developing multinational capital budgeting systems
Strategic planning Financial planning
Assigning tasks and responsibilities
Assembling and processing information
Designing allocation of resources
Benchmarking and forecasting
Handling capital expenditures
Calculating profits and values
Handling operational project risks
Strategic risk assessment
Analysing sensitivities and scenarios
Controlling bounded rational behaviour
Assessing competitive positions
Determination present values
Project control process of capital investments is continually updated, and specific tasks and responsibilities in the capital investment decision-making process have been allocated to relevant members of staff. The management of project information has become more structured. Operational risks have been identified and diversified away. In addition, a lot of emphasis has been put on the rationalisation of capital investment behaviour. BRM now attempts to follow a pre-formulated strategic direction in the
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context of capital investments. In addition, the holding's subsidiaries are gradually directing more attention to aspects of benchmarking and forecasting. Strategic risks, relating, for example, to European Union market issues, disasters and other contingencies, in addition to political factors, are now being incorporated in the capital investment decision-making process. The company’s continued growth requires a great deal of attention to its competitive and market environment. Capital expenditures are forecasted in strategic, tactical and operational plans. In this process, the inputs from subsidiaries are gradually gaining importance. At present BRM does not apply a formal financial modelling procedure. Finally, although BRM is aware of present value appraisal techniques, the firm does not intend to apply these methods. In conclusion,
BRM currently has a project control approach on capital budgeting, thereby gradually incorporating strategic planning and financial planning elements (see Figure 2 overleaf).
Case study 2: SABMiller
The second case study is about the capital budgeting system at South African
Breweries Miller plc (SABMiller). This large multinational firm has been a beer brewer in South Africa for over 100 years and has virtually become a monopoly. SAB
Ltd’s flagship brand, Castle Lager, accounts for over 50% of its sales. SAB recently acquired the Miller Brewing Company in the USA. SABMiller is the second largest beer brewer in the world and it aims at business growth and long-term shareholder value. The holding company (currently in the UK) has 111 breweries in 24 countries.
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Figure 2 Capital budgeting system BRM
Strategic planning Financial planning Project control
Tasks and responsibilities are specifically allocated
More structuring in management of project information now
Pre-formulated strategic direction
More attention is paid to benchmarking and forecasting
Capital expenditures forecasted in plans
Financial modelling not formalised, but results estimated
Operational project risks identified and diversified away
Strategic risks are taken into account in decision-making
Tentative analysis of sensitivities and scenarios
Gradual rationalisation investment behaviour is striven for
Attention is paid to competitive and market positions
Present values are not calculated
The organisation employs 38,000 people and had a profit before interest and tax of
US$m704 for the year ending 31 March 2002. Capital budgeting in SABMiller for the 2002 financial year amounted to €258m and covered replacements, cost reductions, expansions (acquiring entire breweries), improvements and new products.
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Project control of capital investments is detailed and is administered by the subsidiary involved. Tasks and responsibilities on capital investments are detailed. Regarding the strategic planning of capital investments, the capital expenditure of each company in the group has to be approved by its board. There are, however, different levels of approval and relatively large expenditures or acquisitions have to be approved by the holding company’s board of directors. Capital expenditure projects are evaluated by means of a detailed cash flow analysis with a statistical scenario analysis of possible deviations (risks concerning currency rate fluctuations as well as political risk are taken into account). Evaluation techniques include NPV, IRR as well as adjusted
(modified) IRR. The discount rate used is calculated by using the weighted average cost of capital, and more specifically, the capital asset pricing model (CAPM) to determine the cost of equity. In conclusion: while SABMiller currently employs all three capital budgeting approaches to a large extent, it emphasises financial planning more than project control and strategic planning (see Figure 3 overleaf).
Case study 3: W H Smith
The last case study discusses a major investment by W H Smith (WHS), a large UKbased stationary and book-retail conglomerate. The capital project to be focused upon here was essentially an investment in a paperback book distribution facility. To incorporate this facility into WHS, a new subsidiary division was formed: Heathcote
Books (HB). The facility is situated on a new development site in Central England.
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Figure 3
Project control
Detailed tasks and responsibilities allocation
Hierarchically formalised information assembling and processing
Operational project risks handled routinely by BU management
Highly rationalised control of capital investments
Capital budgeting system SABMiller
Strategic planning Financial planning
Group plan allocation of (BU) resources
Forecast outcome deviations with scenario analysis
Currency risk and political risk assessment
Judgment market and competitive positions
Budgets capital expenditures
Cash flows and
(CAPM-based) discount rates
Financial analysis of respective scenarios
NPV, IRR, modified
IRR
HB is a central distribution operation established to offer book distribution services to other parts of the WHS Group and to independent booksellers. It enables booksellers to obtain all their paperback requirements from just one source. The WHS
Group’s paperback sales (including some double counting due to internal trading) exceeded £80million in 1989 when grossed up to retail sales value (RSV).
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The aim of the HB-project was to obtain a facility to stock and distribute paperback books to WHS’s own stores, as well as to operate it as a central corporate warehousing facility and a central distribution centre for small independent bookshops. A new book distribution strategy was proposed with the following objectives: to reduce costs, to increase the intensity of the use of remaining resources, to question the extent of WHS-owned operations, as well as to segregate distribution activities into their components and suggest different approaches for each one. The
UK WHS book marketing activities operate as a series of independent profit centres.
For this reason the WHS Board has agreed that rather than form individual profit centres, more marketing opportunities could be created via one central corporate facility. This might result in an overall group-wide performance increase, by either:
1) utilising the buying power of the enlarged business taken as a whole;
2) inviting publishers to trade their distribution costs for improved retail terms (against which WHS matched their own distribution efficiency
3) through shared costs); or setting up a wholesale operation to serve internally on wholesale terms.
The experience of WHS with a central book distribution facility was based on hardback books only. These represented a different market environment to that of paperbacks. However, the experience with a central stock holding of hardback books had provided WHS with a large number of benefits, including shorter lead times,
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reduced safety stocks, more security of supply and less administrative costs. A central paperback distribution facility was likely to be cost beneficial and conformed to the objectives of the corporate strategy. As a result, the WHS Distribution management asked itself why the company had not previously established a central stockholding for paperback books. However, they were aware that an operation of this kind could further institutionalise infrastructure costs, thus reducing the ability to make costs more flexible in the light of trading fluctuations. The WHS Retail Division's high
'fixed costs' had been the object of corporate criticism for some time and with the above proposal these costs could increase. Many operational advantages could be created, though. These were in themselves valuable, particularly as the sales mix of books inclined towards paperback sales. The problems incurred specifically in the distribution of paperback books involved mainly logistical aspects.
The HB operation was designed to guarantee a 24-hour turnaround service. To be able to supply the full range of titles, a physical distribution operation was required comprising about 12,000 titles. HB was in fact projected to have a stockholding of about 38,000 paperback titles and some hardback ones. In the actual economic investment appraisal, formal management accounting data were introduced. These played only a minor part in the project selection exercise. The Retail Management and the Project Development team had evaluated all the numbers and analysed the assumptions made. They were also satisfied that any organisational, distribution and
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marketing problems had been solved. It was estimated that the financial benefits of
HB ranged from £1m to £2.6m per annum, based on the Development team's perceptions of the risks of the different project alternatives (see above). At that time the financial appraisal of Alternative 1 did not look very promising. However, the project appraisers were of the opinion that the financial forecasts reflected the future market and environmental conditions correctly. The HB distribution project, when fully operational, required a capital outlay of £940,000 and with an IRR of 17% would increase corporate net contribution by £1.3m per annum.
In fact, the actual overall capital investment outlay in HB has been about £950,000, consisting of property, fittings and fixtures, computer equipment etc., but excluding working capital. The working capital requirement for 1988/89 was about
£2.2m. This was considered to be a relatively small expenditure to deal with an annual turnover, at retail value, of about £50m, and about 8,000 to 10,000 titles. In the first year of trading, HB suffered severe computer problems, which prevented orders from being processed and caused a large backlog of book deliveries. As a result, a number of customers switched part or all of their business to other wholesalers. During this period, the auditors were very critical of the possibility of managing and controlling the business as well as the accuracy of the accounts.
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However, during the next nine months, service improved and lost sales were recovered. A fast order turnaround and a high order fulfilment rate were regularly achieved, and trade customers started to return. Improvements in service came from better warehouse methods. The HB warehouse costs were, at 8% of sales, relatively high. This was related to the wide range, 40,000 titles, which overburdened the operational and space elements of the warehouse, and the computer system could not cope with the large number of book titles. After a review, management implemented a lower cost, more service/user-oriented information system. Also, a staff incentive scheme was introduced which improved productivity to cope with the increased number of orders. Finally, efforts were made to improve the external sales of both traditional and non-traditional business. The costs for these so-called Development
Sales efforts were budgeted for at £350K per year for the next three years. In addition, in response to the efforts of its management, HB received growing support from publishers who recognised an opportunity to reduce their own distribution costs.
Based on an average 5% growth in turnover over the past 12 years, paperback book sales at the end of 2002 reached approximately £144m. The total, WHS (UK alone)
Retail Division turnover, at the end of 2002, had increased to £1,501m. (The Retail
Division’s worldwide turnover had increased to £1,855m). HB management envisaged extensive growth in the normal wholesale sector in 1989, to the possible detriment of sales to their existing bookselling accounts. The ultimate corporate
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strategy of WHS was to improve its market share position of the HB part of the wholesale market from 5.3% to 25.8%. The capital investment in HB has greatly contributed to WHS's objectives. We conclude that the investment appraisal, although in the end it included all three capital budgeting approaches distinguished here, was ultimately driven by a refined strategic planning approach (see Figure 4 overleaf).
Figure 4
Project control
Capital budgeting system WHS
Strategic planning Financial planning
Retail Management +
Project Development
Team set up new BU
Much assembling and processing of various operational information
Operational risks mainly handled in project phase
Many control efforts to improve performance
Redefining strategy, three alternatives for corporate facility
Capital investment is benchmarked against other central facility
Strategic risks mainly include flexibility loss
Reflection market and environment condition
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Capital outlay fore- cast along operational specifications
Focus financial modelling: contri- bution, cash flows
Three alternatives are appraised
Net contribution and
IRR calculation

Section 6. Conclusions and recommendations
We have presented three approaches to capital budgeting: a project control approach, a strategic planning approach and a financial planning approach. In line with common corporate practice, we thus focused more on planning than on control. Our approach was quite eclectic, as we explicitly included risk assessment, for example. We combined the selected approaches in a conceptual framework. Multinational firms may first focus on project control, then pay attention to strategic planning and finally to financial planning.
They may thus gradually enter into the domain of the management control cycle. We mentioned four variables that may influence actual capital budgeting systems: the actual business case, the type of investment, the size of the firm and the size of the investment.
We also feel that average project periods, knowledge and experience, time pressures felt, formality and hierarchy, outsourcing levels, the level of involvement of consultants and cultural differences may influence systems designs. Firms have to take specific circumstances into account and should therefore not apply our framework too rigorously.
It may, for example, be more important to budget capital expenditures accurately
(financial planning) than to assess difficulty of the project or to assess competitive positions precisely (strategic planning), when a firm is rapidly leading sales or procurement changing markets. Moreover, capital budgeting systems can never be regarded as complete, but should, instead, always be ‘under construction’.
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Many studies on capital budgeting systems have focused on one or two of the following topics: project management, strategic management, management control, corporate finance or international management. We have tried to combine all of these views in this paper, thereby of course losing detail, but on the other hand gaining broader insight. Instead of giving an account of in-depth case research or reporting on a written survey, we have provided an eclectic overview of today’s corporate practice in multinational firms. We hope that our qualitative approach will not only trigger related theoretical but also empirical research. Case research may reveal additions to and limits of our framework. Also, timely developments in multinational firms may be signalled this way. Oral or written surveys may uncover details of typical current capital budgeting systems. It is beyond the scope of this paper to answer the empirical question of how capital budgeting systems development is beneficial to multinationals. Further empirical research might be very interesting, though. It would be interesting to learn whether multinationals that have more sophisticated capital budgeting systems do indeed outperform comparable firms that have less sophisticated systems in terms of value. Our analysis not only suggests that adding capital budgeting approaches creates firm value, but also that digging deeper into a specific approach may be a source of value. Researchers could therefore also try to measure the amount of sophistication of capital budgeting systems and study its impact on share prices. Thus, empirical research on capital budgeting is by no means unnecessary, as long as actual systems of multinational firms are ‘on the move’.
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