Abstract: In this paper are summarized the four main stages in the capital investments
process: identification, development, selection and control. The literature on capital budgeting processes shows that it is a complex, lengthy process of a series of stages through time, in which the earlier activities and choices are crucial. The traditional financial emphasis on the investments selection as the main element is misplaced and the whole capital investment activity is viewed within a wider political context and all activities within the process are interrelated and influenced by structural context, including the formal organization, control procedures, information systems and performance.
Keywords: capital investments, identification, development, selection and control,
budgeting, risk analysis
One way of viewing capital budgeting is to see it as a process with a number of Distinct stages. According to this view, decision-making is an incremental activity, involving many people throughout the organization hierarchy, over an extended period of time. While senior management may retain final approval, actual decision are effectively taken much earlier at a lower level, by a process that is still not entirely clear.
Within a capital budgeting context, various authors have attempted to describe this process. We will employ the four-stage process suggested by Mintzberg, applied to capital budgeting. These are:
- Identification of investment opportunities
- Development of an initial idea into a firm proposal - Selection of projects.
- Control of projects, including post audits. - STAGE ONE : Identification
Economic theory views investment as the interaction of the supply of capital and the flow of investment opportunities. The most important role which top management can play in the capital investment process is to cultivate a corporate
Capital investments - the decision process 99 culture which encourages managers to search for, identify and sponsor investments ideas.
Any manager who has experienced the hurt and frustrations of having an investment proposal dismissed or an accepted proposal fail is likely to develop an in- built resistance to creating further proposals unless the organization culture and rewards are conducive to such activity. There is some evidence that firms employing long-term incentive plans encourage the initiation and implementation of capital investment projects.
For the identification phase of non-routine, strategic capital budgeting decisions to be productive, managers need to conduct environmental scanning, gathering information which is largely externally oriented, much if which is non- financial and ex ante.
STAGE TWO: Development
The second stage in the capital investment decision-making process is the screening of all investment ideas and development of those showing sufficient promise. This is sometimes termed the preliminary project review.
It is neither feasible nor desirable to conduct a full-scale evaluation of each investment idea. The screening process is an important means of filtering out projects not thought worthy of further investigations. Ideas may not fit with strategic thinking, or fall outside business units designated for growth or maintenance.
The investment process usually forms part of a wider strategic process. Capital projects are not normally viewed in isolation, but within the context of the business, its goals and strategic direction. In a recent UK study of strategic investment decision, Marsh et al. found that explicit strategic planning, even at a a divisional level, seemed to have only limited impact on the generation and approval of investment projects.
STAGE THREE: Selection
The selection phase involves evaluation of the project and the decision outcome (accept, reject, request further information). Project evaluation involves the assembly of information in terms of cash flows and the application of specified investment criteria. Each firm must decide whether to apply rigorous, sophisticated evaluation models or simpler models which are easier to grasp yet capture many of the important element in the decision.
The capital budgeting literature distinguishes between “naïve” or simple and sophisticated methods of investment analysis. Simple methods include payback period and accounting rate of return techniques, while “sophisticated” techniques include most, if not all, of the other methods. While sophisticated methods have clearly increased in popularity over the years, the observed increase has not come at the expense of simpler methods. The payback method continues to gain support and is now almost universally employed, approximately one half of the sample using it on every occasion.
Prior studies have also shown it to be highly popular for smaller firms. The obvious conclusion to be drawn is that managers prefer to employ a combination of appraisal methods, sophisticated and naïve.
100 Iloiu, M. Risk analysis
An assessment of the risks involved in making investment decisions is a crucial element of the evaluation process. Although the techniques employed in analysis risk in capital projects vary considerably across firms, all techniques have witnessed considerable increases in usage, The most popular approach involves testing the sensitivity of critical investment inputs and underlying economic assumptions. The high usage of sensitivity analysis and specifying investment outcomes based on best and worst case scenarios suggest a strong movement towards applying multipoint estimates.
A strong movement towards the application of probability analysis is also witnessed, most notably by the larger firms surveyed.
The decision outcome is rarely based wholly on the computed signal derived from financial analysis. Considerable judgement is applied in assessing the reliability of data underlying the appraisal, fit with corporate strategy, and track record of the project sponsor. The selection phase is essentially a political process. Projects put forward at lower levels in the organization need the “impetus” of sponsorship by a higher level manager with a good track record to secure a rapid and safe passage to final approval level. In many organizations relatively few projects are rejected at the final approval stage since to do so would indicate a lack of confidence in the decision- making, judgement of those involved at earlier stages.
STAGE FOUR: Control
The capital budgeting literature frequently assumes that control occurs after the selection phase. In fact, for most projects, relatively little real project control is possible then, the process being more that of monitoring implementation and performance through post-audit and other procedures. These controls do, however, provide useful feedback on how well the capital budgeting process is operating, for example, the realism of assumptions.
The capital budgeting control process may be divided into pre-decision and post-decision controls.
Pre-decision controls are mechanisms designed to influence managerial behaviour. Examples of such controls include the selection and training of subordinates to possess goals and risk attitudes consistent with senior management, setting authorization levels and procedures to be followed and influencing the proposals submitted by setting goals, hurdle rates, cash limits and identifying strategic areas for growth.
Post-decision controls are introduced to help managers implement the project o schedule ant to achieve the planned levels of performance. The most notable increase is the requirement to conduct post completion audits. Such audits seek to compare the actual performance of a project after, say, a year’s operation with the forecast made at the time of approval.
Pike and Neale identify a number of problems with post-auditing which may explain the initial reluctance within firms to introduce such a practice:
Capital investments - the decision process 101 - biased selection - by definition, only accepted projects can be post-audited, and
among these only underperforming ones are singled out by many firms for detailed examination;
- the disentanglement problem – it may be difficult to separate out the relevant costs and benefits specific to a new project from other company activities, especially where facilities are shared and the new project requires an increase in shared overheads;
- prohibitive cost – to introduce post-audits may involve interference with present management information system in order to generate flows of suitable data; since post-auditing every project may be very resource-intensive, firms tend to be selective in their post-audits;
- projects may be unique – if there is no prospect of repeating a project in the future, there may seem little point in post-auditing, since the lessons learned may not be applicable to any future activity;
- lack of co-operation – if the post audit is conducted in too inquisitorial a fashion, project sponsors are likely to offer grudging co-operation to the review team and be reluctant to accept and act upon their findings;
- environmental changes – some projects can be devastated by largely unpredictable swings in market conditions; this can make the post-audit a complex affair as the review team is obliged to adjust analysts’ forecasts to allow for the “moving of the goal-posts” ;
- encourages risk aversion – if analysts’ predictive and analytical abilities are to be thoroughly scrutinized, then they may be inclined to advance only ‘safe’ projects where little can go wrong and where there is less chance of being ‘caught out’ by events.
REFERENCES:
[1]. Butler R., Strategic Investment Decisions, Routledge, London ,1993 [2]. Cooke S., Making Management Decisions, Prentice Hall, 1991
102 Annals of the University of Petroşani, Economics, 2 (2002), 102-105