Capital Investment Process or Capital Investment Appraisal Theory - Essay Example

Contents Introduction 2 Theoretical Base 2 Capital Investment Process Characteristics 2 ARR 4 Payback 4 NPV 5 IRR 6 Stages of Capital Investment Process 6 Summary 8 Analysis 8 Boston Mayflower Background 8 Stage 1: Searching For Investment Opportunities 9 Stage 2: Initial Screening 10 Stage 3: Project Authorisation 11 Stage 4: Cost Control 12 Stage 5: Post-Completion Audit 12 NPV Perspective 13 Conclusions and Limitations 14 References 15 Bibliography 17 Introduction Capital investment always presents a serious decision for management. The commitment of funds to capital projects gives rise to a management decision problem. Capital investment appraisal theory tries to find the solution of this problem, through the development of techniques allowing to predict the outcome of every investment. As the investment process implies vast expenditures, most of the methods concentrate on the financial aspect of the matter, still recognising the importance of correlation to business strategy of a company. In reality, there are no clear answers made by those techniques as they rely on estimate data. Therefore, it was always implied that despite techniques used to make the future more clear, capital investment decision requires a manager to use intuition. This study of a Boston Mayflower - a residential social landlord with about 5,000 houses - indicates that more accent must be put on qualitative appraisal techniques. The essay begins with building a theoretical base to get the reader familiar with some basic concepts of capital investment appraisal theory. The second part of the essay is devoted to a step-by-step analysis of the investment project of Boston Mayflower. Theoretical Base Capital Investment Process Characteristics This part of the essay is devoted to the description of methods used in the analysis of capital investment. Developed theoretical frameworks include several different techniques of analysis varying mainly in measures of investments. In other words, it is clear that the ultimate goal of every investment is maximisation of owner's wealth; however specific characteristics of every project oblige management to choose carefully and with correspondence to the most vital needs of the business. The most typical example is the choice between long-term investment project with high return value and short-term project but with lesser return. Although the first development plan will lead to better profits in the end, sometimes a company chooses the second one. That means the time factor is more important for owners than greater profits in the illustrated case. Generally, capital investment decisions are always connected to the following list of specific features: a significant outlay of cash; long-term involvement with greater risks and uncertainty because forecasts of the future are less reliable; irreversibility of some projects due to their specialised nature, for example, plant which having been bought with a specific project in mind may have little or no scrap value; a significant time lag between commitment of resources and the receipt of benefits; management's ability is often stretched with some projects demanding an awareness of all relevant diverse factors; limited resources require priorities on capital expenditure; project completion time requires adequate continuous control information as costs can be exceeded by a significant amount. (McGrath, 1998) These characteristics make the managerial decision even more important, as it must be connected with the strategy of a company. Simply, a manager should choose not the most profit-making project, but the most suitable one for the business strategy of his/her company. This statement leads to a careful choice of the evaluation technique used to determine, which investment plan complements best the chosen strategy. There several factors, which should be taken into consideration during evaluation of investment opportunities: initial cost of the project; phasing of the expenditure; estimated life of the investment; amount and timing of the resulting cash flow; effect, if any, on the rest of the undertaking; and working capital required. As the capital investment process is financial in nature, it should be analysed in financial measures. There are four evaluation methods observed in the essay. They are: accounting rate of return, payback or discounted payback, internal rate of return, and discounted cash flow or net present value. Each of them has its own advantages and drawbacks, which are briefly given below. The last technique of capital investment appraisal by net present value (NPV) is described with greater detail as it is applied to Boston Mayflower in the essay. However the description of only one method without the context of other techniques would have been incomplete; therefore a concise description of every method is made. ARR Accounting rate of return deals with accounting profits and losses. The average annual profit is divided by the average investment cost, resulting in ARR, which shows annual profits as a percentage of the cost of the project. Dealing with average values on the one hand allows seeing the whole picture, but on the other hand minor changes, or 'noise', completely fall out of managers' view (Salmi and Virtanen, 1998). Additionally, operating with profit and loss accounts rather than cash flows can also be seen both as a drawback and advantage. Profits are readily available accounting information, but it detracts from the real nature of investment, which is a cash flow. ARR gives management the ability to clearly see the profitability of every investment project. Payback This technique shows the time needed to cover the investment expenditures. It operates with cash flows, as all the rest methods observed excluding ARR. To convert profits into cash flows one should add the annual depreciation charge to profit/loss for each year of the investment plan. Assuming that cash flows accrue evenly throughout the year, payback method allows not only to determine a whole number of years needed to return investments, but also to find out if a payback period ends somewhere within the year. The simplicity of this method makes it extremely popular: The payback period technique is the single most widely used technique of all of the techniques currently reported to be in use virtually anywhere in the world! It is so widely used for two major reasons: it is the simplest method available [and] it acts as a proxy for risk. (Williamson, 2001) As all capital investment techniques base on and operate with estimate data, the risk of unreliability increases for the long-term forecasts. Payback method minimises that risk providing a manager with an answer to the question "When expenditures will be covered" Nevertheless, payback period method is not without drawbacks. First, it does not show the information on cash flows after payback. Second it does not take into account the time value of money. Still payback method can be used along with other discounted cash flow methods to convert payback into discounted payback. NPV Methods described above do not consider interest rates. It is important to calculate the real present value of funds received in future for more precise forecasting. That is why net present value technique uses the discount factor to calculate present values for cash inflows and outflows, and then compares them. If the present value of outflows is greater than the present value of inflows, than the NPV will be negative meaning a company will lose more funds on investment than it will earn. Positive NPV (the higher the better) means the project will bring profit. This technique has several advantages, such as use of cash flow information, appropriate consideration of time value, and maximisation of shareholder's wealth. The drawback lies within the fact that calculations needed for NPV can be costly and take more time than in other techniques, while this is not always acceptable. "[NPV] holds a high place in the realm of finance and rightfully so it is a powerful tool that allows business managers to assess projects based on their value And yet, like any powerful tool, it can be abused." (Vomvas, 2003) The problem once again lays within the estimate numbers, we always have to deal with when making a forecast. NPV also can misfire, but the danger is that most of the managers place their trust on this method. According to Arnold and Hatzopoulos (2000) out of sample of Times 1000 companies, varying in size, 96 per cent use discount cash flow methods, and NPV is used more frequently than IRR. Typically, the respondents have never used a single technique, but combined several methods. Further on, Akalu finds that "Although theoretically sound, the standard appraisal methods are unable to provide the promised project value to shareholders... Companies' attempt to curb this problem is revealed by their simultaneous use of multiple models." (2002, p.13) Thus, although an NPV method is considered as one of the most reliable, still a careful manager should not rely completely on the numbers. IRR Internal rate of return presents an alternative to NPV. "The IRR is a single rate of return that summarizes the merits of a project. It is 'internal' since it only depends on the cash flows of a particular project, not on rates offered elsewhere." (Firer and Gilbert, 2004, p. 42) Instead of maximising present value, it represents the discount rate used by the company, which gives a zero NPV. This can be made through the interpolation of one negative and one positive NPV with different discount rates. The higher IRR is the better. While being an alternative to NPV IRR is considered to be less reliable, especially when it comes to choosing between several mutually exculsive projects. It presents the results in relative terms, while NPV always shows, which project is the most wealth-maximising in absolute terms. Stages of Capital Investment Process Capital investment process has several stages, according to Drury (2004): 1. The search for investment opportunities 2. Initial screening 3. Project authorisation 4. Controlling the capital expenditure during the installation stages 5. Post-completion audit of the cash flows. During the first two stages, a company usually acts under time constraints imposed by competitive bidding situations, market timing desires or the desire to act preemptively on a specific opportunity. Therefore, three types of resources are used during the initial stages of the project: time and concentration of the senior management; analysis team cannot be used on other activities; and expenses of fees to professionals. There is one additional psychological pressure, that is when "'success' is represented by capturing the opportunity. In this case, even more energy can be expended in efforts to 'make it work', despite early indications to the contrary" (Berrends and Clarry, 2002, p. 2). Note that the initial screening stage implies not only financial analysis of the opportunities, but also a strategic analysis of a qualitative nature based on the current business strategy. The purpose of the initial screening is to identify the most compelling opportunities quickly, and eliminate unattractive options as early as possible. Once this is done, and the project is chosen, the project authorisation phase begins. Authorization includes the complete development of an investment plan and all preparations needed for its fulfillment. The main challenge here is to minimize possible planned costs without actually missing them. This stage requires from managers and analysis team to concentrate their efforts on including every single expenditure in the development plan, the results of which quickly become visible on the next stage of implementation - capital expenditure control. On this stage it is important to consider different types of costs. Already incurred costs, or sunk costs, cannot be influenced by rejecting or accepting an investment project. Planned allocated costs, such as project management overheads, require strict control to stay within the planned project budget. Sadly, opportunity costs are often lost in the analysis indicating e.g. the use of previous inventory for the current project. "An opportunity cost is the value of a benefit foregone as a result of choosing a particular course of action." (Irons, 2004) Although it is 'free', this inventory can be sold, therefore it should be taken into account not as its initial cost, but rather its current market value. Finally, discount costs discussed previously should clearly be stated in the development plan. After the project is completed the last stage of post-completion audit takes place. All the cash inflows and outflows are considered to result into a balanced and complete financial view of the project. This last stage is all about looking back on the project to identify and analyse the mistakes made and avoid them in future. Summary Once the theoretical base has been laid out, the analysis of Boston Mayflower Ltd. takes place. We will use both concepts of NPV and staging the capital investment process in order to look on each of the steps from both financial and strategic perspective. Since the access to the information on the investment plan of Boston Mayflower is limited some aspects of capital investment process will be out of sight. The information on the limitations of the analysis is given more explicitly at the end of the essay. Analysis Boston Mayflower Background Boston Mayflower Ltd is a registered social landlord and a company limited by guarantee, which means it has no shareholders. Boston Mayflower is also a charity and therefore it is able to use surpluses to benefit its tenants, since the company is non-profit making. The board of the company consists of unpaid volunteers, "one-third tenants, one-third Council nominees and one-third independent professional people" (Boston Mayflower, 2005). The borrowing capacity of Boston Mayflower is 80m financed by a syndicate of banks and building societies, led by the Royal Bank of Scotland. The primary and core function of Boston Mayflower is to operate for the well-being of their tenants. The mission statements of the company are as follows: to be a pro-active partner, in developing thriving communities; to provide comfortable affordable homes, as a base for people's lives; to empower communities and staff, to work in consultative, inclusive, collaborative ways, to deliver high quality services; to involve tenants in all aspects of the direction and management of the organization. (Boston Mayflower, 2005) The corporate life of Boston Mayflower began in 1999 when the challenge of raising 80m for purchasing and improving almost 5,000 for council homes was overcome. "The improvements to include a modern kitchen, a modern bathroom, PVCu double-glazing, thermal insulation and central heating." (Boston Mayflower, 2005). All the improvements were planned to be implemented within a five-year period. In October 2005, Boston Mayflower has announced the completion of a five-year major improvement programme involving 27m in investment. "This has included 13,000 individual improvements These works have all been achieved within our Business Plan forecasts and within our timetables." (Boston Mayflower, 2005). The report of Audit Commission indicates that the results achieved by Boston Mayflower are very encouraging: "To date in excess of 99 per cent of the properties have been dealt with within 365 days of the previous annual gas servicing and safety check." (Audit Commission, 2005). Let us look in detail on the story of Boston Mayflower to find out about factors that drove the company to success. Stage 1: Searching For Investment Opportunities Being a non-for-profit organization Boston Mayflower acts irrationally from the theoretical perspective. However, capital investment appraisal theory tries to explain only the behaviour of firms, final goal of which is making money. That is why one cannot blame the theory for failing to explain the case of Boston Mayflower. Unlike commercial organizations expecting to maximise the shareholders' wealth and searching for investment opportunities, Boston Mayflower was searching for opportunities to improve life of its tenants, because the final goal of the company is fulfilling its mission: "Nonprofits do not exist simply in order to provide their employees with jobs. Their purpose, in most cases, is to change the world." (Hayes and La Piana, 2005). In 1999 over 3,100 of Boston Mayflower properties relied on natural gas for space heating and hot water (Audit Commission, 2005). The company was responsible for ensuring that gas servicing and annual safety checks were undertaken. The opportunity found by Boston Mayflower to invest into improvement of gas servicing inventory in order to make servicing procedures more effective and efficient. Additionally the company expected to achieve better performance through greater tenant awareness of gas safety, and encouragement of tenant cooperation. Stage 2: Initial Screening Since the opportunities of improving the equipment and increasing cooperation with tenants were not mutually exclusive (total capital expenditures of both projects together were about 27m - Boston Mayflower's budget was able to carry out these funds for investment) it was decided by the Board to combine these activities into a single project of improving quality of communal services provided by the company. With the help of Boston Borough Council the board has checked the availability of funding their improvement project. Royal Bank of Scotland has agreed to cooperate with Boston Mayflower and to provide a borrowing facility of 80m for housing improvements and new developments. It was decided that Boston Mayflower will be able to complete its improvement plan in 5 years; that is the end of 2005 was marked as the end of this project. While proprietary organisations often use a payback technique to determine the time period needed to return investments, this technique was inapplicable to Boston Mayflower. During the initial screening the main efficiency indicator was considered not return value or payback time, as in case of profit-making organisation, but a customer satisfaction - a qualitative measure, which is not easy to evaluate. Monthly reports to senior management, progress meetings with the contractor, regular QA inspections undertaken by the client, contractor and a third-party determined by Boston Mayflower, with a minimum of 5 per cent being completed by each party - these are the arrangements to control the quality and tenants' satisfaction. The objective was to complete 13,000 individual inventory improvements by the end of 2005. Stage 3: Project Authorisation After the initial screening phase was completed the detailed development plan was prepared by management. For cost accounting, an activity-based costing system was used. It should be noted that managements' great commitment on this stage has greatly improved the effectiveness of the whole project, which was more than once stated in theoretical findings: "interaction and participation of senior functional managers in group decision-making generally lead to greater commitment and, as a result, increased effectiveness." (Lefley and Ryan, 2005, p. 19) In addition to inventory improvements and regular quality checks the plan included other sources of expenditures, such as: a detailed flowchart indicating key stages of the process and key parties; supporting text to provide further clarification of the process described in the flowchart; special posters, articles and photograph in tenant newsletters raising the profile of gas safety and increasing tenant awareness; introduction of customer satisfaction surveys with prize draws. "Forms returned from addresses where the work has been completed on the first mutually agreed appointment are entered into a series of draws to win one of 20 50 gift vouchers of the tenant's choice." (Audit Commission, 2005) The survey gave tenants the ability to assess contractor's performance and suggest ways of quality improvement. Additionally, a shared drive on Boston Mayflower IT system slowed every party to monitor the performance. Once every aspect of the development was planned, and costs allocated the work on the project has begun. Stage 4: Cost Control Systems devised on the previous stage have allowed Boston Mayflower board to monitor performance and control costs easily. Activity-based costing system used by the company to attach expenditures to activities helped to execute two functions on this stage: providing economic feedback to managers to manage costs and improve the efficiency and effectiveness of existing operations; and roviding relevant information to manage the cost and mix of future activities (Drury and Tayles, 2003). Along with cost, a constant quality control was also maintained. At the end of 2004 it was clear that the project requires not gradually incremental but a rapid rise of performance to complete the project in time. The new procedure developed in the end of 2004 has proved to be extremely successful, and the developed approach is used by Boston Mayflower even after the completion. Close cooperation with tenants and high commitment of managers were the keys to the success of the company. Prize draw arrangements implemented by Boston Mayflower have also played a great role in prompting tenants to cooperate. Stage 5: Post-Completion Audit The audit check made by the Audit Commission after the project was completed has found that the performance of Boston Mayflower was satisfactory. "Limited additional resources have been required to deliver the new approach. However, significant gains in performance have been made and a substantial reduction in abortive calls achieved." (Audit Commission 2005) The following successful initiatives were pointed out: successful system of cooperation encouragement; high commitment of senior management to project activities; high level of cooperation between all the participants of the project; increase of quality standards in housing services; a well-developed cost and quality control systems. Eventually, there were some weak points in investment planning indicated in the post-completion audit report. The initial screening stage was rather weak leading to time delay at the end of 2004. The reason was inaccurate forecasting that has led to additional expenditures. Finally, the initial level of performance on early stages of the project was not high enough to compete the project within the estimated time period. After the completion of improving gas servicing Boston Mayflower has announced a new funding deal of 85m for 35 years. "The Company is now in a strong position to achieve the Government's Decent Home Standard for all its properties by the target date of 2010." (Boston Mayflower 2005b). Re-financing will provide opportunities for further property investment in the future of the company. NPV Perspective Looking on the case of Boston Mayflower from a NPV perspective does not make much sense as there are no shareholders, which wealth could be maximised. Nevertheless an NPV concept can be adapted from quantitative financial terms to qualitative strategic. Continuing the analogy of financial profit for profit-making organisations and mission fulfillment for non-profit once, we can assume that tenants of Boston Mayflower play the similar role to shareholders in business organisations. This makes sense, as like with shareholders, the company serves to improve life of tenants and strives to induce them into internal operation of the company. Therefore, the measure of 'wealth' in this adapted NPV scheme is played by the satisfaction of tenants. Looking from an NPV perspective on the improving gas service project of Boston Mayflower gives us the notion of investing material capital (funds) into immaterial one (satisfaction), which returns to the company once again in the material re-financing, as Boston Mayflower indicates strong performance in fulfilling its mission. Additionally it is important to note that there are indications in academic literature for the need of new capital investment appraisal method, which will combine both quantitative financial analysis with qualitative strategic assessment of investment (Mercken and Milis, 2004; Drury and Tayles, 2003). The case of Boston Mayflower falling out of perspective of traditional concepts only supports that conclusion. Conclusions and Limitations Due to the lack of developed theoretical frameworks describing a capital investment appraisal theory in not in financial but strategic terms, the presented case of Boston Mayflower falls out of traditional capital investment theory. However the development of a new qualitative method is constrained with uncertainty. First of all, qualitative measures will not provide such unambiguity about the investment decisions as financial terms do. It can be assumed, that the outcome of using such method, if developed will be more like recommendations, than like a certain answer. Still, if the strict answer provided by the traditional techniques were satisfactory, then of course this new approach would not be in demand. Apart from the advocating non-profit nature of some investment processes, this study has provided findings related to the key points in success of investment process. There were three factors, that drove Boston Mayflower to success: management commitment, highly detailed reporting system, and a strong cooperation with contractors and tenants. Additional difficulties for the study were caused by the lack of financial information on the Boston Mayflower project. Due to this it was not possible to check the data about the size of investment presented in press releases with traditional capital investment appraisal methods. That is why the analysis was limited mostly to strategic aspect of the project, and rightfully so, since the non-for-profit nature of Boston Mayflower. References Akalu, M.M. (2002). Evaluating the Capacity of Standard Investment Appraisal Methods: Evidence from the Practice. Discussion paper, Tinbergen Institute, Netherlands. Retrieved February 2, 2006 from http://www.tinbergen.nl/discussionpapers/02082.pdf Arnold, G.C. and Hazopoulos, P.D. (2000). The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom. Journal of Finance and Accounting, Vol. 27, Iss. 5, pp. 603-626 Audit Commission. (2005). Housing Efficiency Report: Boston Mayflower Ltd. Retrieved February 2, 2006 from http://www.audit-commission.gov.uk/housingefficiency/showcase_boston_mayflower_ltd.asptitle=Boston_Mayflower_Ltd Berrends, W. and Clarry, D. (2002). Evaluating Investment Opportunities - Making the Right Decisions. Retrieved February 2, 2006 from http://www.hatch.ca/Light_Metals/Articles/evaluating_investment_Opportunities.pdf Boston Mayflower (2005). About Us. Retrieved February 2, 2006 from http://www.bostonmayflower.org.uk/aboutus.php4 Boston Mayflower (2005b). Press Release: 85m Investment for Lincolnshire Housing. Retrieved February 2, 2006 from http://www.bostonmayflower.org.uk/news/32.php4 Drury, C. (2004). Management and Cost Accounting. 6th edition, Thomson Learning, London. Drury, C. and Tayles, M. (2003). Profiting from Profitability Ananlysis in UK Companies Working paper series. Retrieved February 2, 2006 from http://www.brad.ac.uk/acad/management/external/pdf/workingpapers/2003/Booklet_03=18.pdf Firer, C. and Gilbert, E. (2004). Investment Basics XLVIII. Common Challenges in Capital Budgeting. Investment Analysis Journal, No. 59, pp. 41-45. Hayes, M. and La Piana, D. (2005). Are You an Effective Competitor Published by The Foundation Center on March 30. Retrieved February 2, 2006 from http://www.fdncenter.org/pnd/tsn/tsn.jhtmlid=102200001 Irons, A. (2004). Capital Investment Appraisal. Student Accountant Online. Published on March 3. Retrieved February 2, 2006 from http://www.accaglobal.com/publications/studentaccountant/1105038 Lefley, F. and Ryan, B. (2005). Financial Appraisal Profile Model. Palgrave Macmillan, Ney York. McGrath, G. (1998). Evaluation Techniques for Capital Budgeting. Student Accountant Online. Published on November 1. Retrieved February 2, 2006 from http://www.accaglobal.com/publications/studentaccountant/39709 Mercken, R. and Milis, K. (2004). The Use of the Balanced Scorecard for the Evaluation of Information and Communication Technology Project. International Journal of Project Management, No. 22, pp. 87-97. Salmi, T. Virtanen, I. (1998). Internal Rate of Return Estimation Methods vs. Accountant's Rate of Return Revisited, A Simulation Approach. Proceeding paper of 16th European Conference on Operational Research, Brussels, July 12-25. Retrieved February 2, 2006 from http://www.uwasa.fi/itv/publicat/EUROXVI.pdf Vomvas, A. (2003). The Pitfalls of Net Present Value Analysis. Financial Manager, June-July 2003. Retrieved February 2, 2006 from http://www.bcfm.com/financial_manager/JuneJuly2003/PitfallsofNPV.pdf Williamson, D. (2001). Capital Budgeting: The Key Numerical Techniques. Published by Duncanwill.co.uk on October 12, 2001 revised on May 8, 2003. Retrieved February 2, 2006 from http://www.duncanwil.co.uk/invapp.html Bibliography Burn, P. and Dewhurst, J. (1993). Small Business Management. 3rd edition, Palrave Macmillan, Houndmills. Drury, C. (2004). Management and Cost Accounting. 6th edition, Thomson Learning, London. Fink, R.L., Margavio, G.W. and Margavio, T.M. (1994). Evaluating Capital Investments in Quality Improvement. Journal of Cost Management, Spring, pp. 57-62. Hirst, I. (2000). Investment Appraisal for Shareholder Value. 2nd edition, Pearson Education, London. Williamson, D. (1996). Cost and Management Accounting. 1st edition, Prentice Hall. Read More