The capital investment process requires a series of actions and decisions by management. These are likely to include:
1. Determination of the budget
2. Identification of possible projects
3. Preliminary screening
4. Project evaluation
5. Authorization of projects
6. Management and monitoring
7. Post completion audit
Determination of the Budget
It is known that capital budgeting decisions require large sums of money. The starting point therefore is how much money is available? In theory, all projects that are sufficiently profitable could be put to the capital market for funding. In practice, multi-divisional organizations operate an internal capital market in which senior management is better informed than the external capital market to assess capital proposals and allocate scarce resources.
Identification of Possible Projects
Conventional economic theory views investment as the interaction of the supply of capital and the flow of investment opportunities. It would be quite wrong, however, to assume that there is a continuous flow of investment ideas. In general, the earlier an investment opportunity is identified, the greater is the scope for reward.
Possibly the most important role which top management can play in the capital investment process is to cultivate a corporate culture that encourages managers to search for, identify and sponsor investment ideas.
Generating investment ideas involves considerable effort, time and personal risk on the part of the proposer. Any manager who has experienced the frustration of having an investment proposal dismissed or an accepted proposal fail is likely to develop an inbuilt resistance to creating further proposals unless the organization culture and rewards are conducive to such activity.
At this early stage, a preliminary screening of all investment ideas is usually conducted. 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 investigation. Idea may not for example, fit with strategic thinking.
The evaluation phase involves appraisal of the project and outcome (accept, reject, request further information etc.). Project evaluation, in turn, involves the assembly of information (usually in terms of cash flows) and the application of specified investment criteria. Typical information included in an appropriation request is:
• Purpose of project – why it is proposed and the fit with corporate strategy and goals
• Project classification- e.g. replacements, expansion, growth, others, etc.
• Finance requested – amount and timing, including net working capital.
• Operating cash flows- around and timing, together with the main assumptions influencing the accuracy of the cash flow estimates.
• Attractiveness of the proposal – expressed by standard appraisal indicators, such as net present value, internal rate of return, payback period, etc.
• Sensitivity of the assumptions – effect of changes in the main investment inputs.
• Review of alternatives – why they were rejected and their economic attractiveness.
• Implications of not accepting the proposal – some projects with little economic merit according to the appraisal indicators may be ‘essential’ to the continuance of a profitable part of the business or to achieving agreed strategy.
• Non-financial considerations – those costs and benefits that cannot be measured.
Authorization of Projects
The decision to accept a particular capital investment proposal should be made by a pre-agreed decision-making mechanism (in the case of very large projects, this will probably require ratification by the Board of Directors). The decision makers will need to be satisfied that the proposal is expected to meet the required profitability. They also need to ensure that adequate sources of finance have been planned for and that the project does not create excessive risk for the organization.
Management and Monitoring
The approval of a project will necessitate the appointment of a project manager with the appropriate resources and agreed targets to be achieved. The project manager must be charged with the task of keeping his or her superiors informed of project progress. Periodic progress reports may be required, identifying actual and potential deviations from budget, both financial and non-financial terms, so that corrective action can be instigated. Good project management techniques and skills will be vital during this stage.
Post Completion Audit
The final stage in the capital budgeting making and control sequence is the post-completion audit (PCA). A PCA aims to compare the actual performance or a project after, say, a year’s operation with the forecast made at the time of approval. ne aims of the exercise are twofold. First, post-audits may attempt to encourage more thorough and realistic appraisals of future investment projects and secondly, they may aim to facilitate major overhauls of ongoing projects perhaps to alter their strategic focus.
These two aims differ in an important respect. The first concerns the overall capital budgeting system. seeking to improve its quality and cohesion. The second concerns the control of existing projects, but with a broader perspective than is normally possible during the regular monitoring procedure when project adjustments are usually of a ‘fire-fighting’ nature.