How Firms Organize the Investment Process

1. The Capital Budget

Senior management needs some forewarning of future investment outlays. So for most large firms, the investment process starts with the preparation of an annual capital budget, which is a list of investment projects planned for the coming year. Smaller investments are not item­ized separately in the budget. For example, they may be grouped into the broad category of “machine replacement.” Larger investments that significantly affect the company’s future will receive greater attention.

Many of the investment proposals that are included in the budget bubble up from the bot­tom of the organization. But ideas are also likely to come from higher up. For example, the managers of plants A and B cannot be expected to see the potential benefits of closing their plants and consolidating production at a new plant C. We expect divisional managers to pro­pose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own data processing operations to a large central computer. That proposal would come from senior management.

Inconsistent assumptions can creep into these expenditure plans. For example, suppose the manager of your furniture division is bullish on housing starts, but the manager of your appliance division is bearish. The furniture division may push for a major investment in new facilities, while the appliance division may propose a plan for retrenchment. It would be better if both managers could agree on a common estimate of housing starts and base their invest­ment proposals on it. Therefore, many firms begin the capital budgeting process by estab­lishing consensus forecasts of economic indicators, such as inflation and growth in national income, as well as forecasts of particular items that are important to the firm’s business, such as housing starts or the prices of raw materials. These forecasts are then used as the basis for the capital budget.

Preparation of the capital budget is not a rigid, bureaucratic exercise. There is plenty of give-and-take and back-and-forth. Divisional managers negotiate with plant managers and fine-tune the division’s list of projects. The budget is then reviewed and pruned by senior management and staff that specialize in planning and financial analysis. Usually, there are negotiations between senior management and divisional management, and there may also be special analyses of major outlays or ventures into new areas.

The final capital budget needs to reflect the corporation’s strategic plans. These plans take a top-down view of the company. They attempt to identify businesses where the company has a competitive advantage. They also seek to identify businesses that should be sold or allowed to run down. A firm’s capital investment choices should reflect both bottom-up and top-down views of the business. Plant and division managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may have a mistaken view of the forest because they do not look at the trees one by one.

2. Project Authorizations—and the Problem of Biased Forecasts

Once the budget has been approved, it generally remains the basis for planning over the ensu­ing year. However, it is not the final sign-off for specific projects. Most companies require appropriation requests for each proposal. Before each investment gets the final go-ahead, it will need to be supported by a more detailed analysis setting out particulars of the project, cash-flow forecasts, and present value calculations.

Many investment projects carry a high price tag and may determine the shape of the firm’s business 10 or 20 years in the future. Hence, final approval of appropriation requests tends to be reserved for top management. Companies set ceilings on the size of projects that divisional managers can authorize. Often these ceilings are surprisingly low. For example, a large com­pany, investing $400 million per year, might require top management to approve all projects over $500,000.

The result is that the head office may receive several hundred investment proposals each year. As each proposal travels up the organization, alliances are formed. Thus, once a division has screened its own plants’ proposals, the plants in that division unite in competing against outsiders. The final proposal may be silent on the questions and doubts that were raised dur­ing the project’s travel up the organization.

Project sponsors are liable to be both overconfident and overoptimistic about their pet proj­ects, and these two traits make it particularly difficult for others to judge the merits of a pro­posal. Most people tend to be overconfident when they forecast. Events they think are almost certain to occur may actually happen only 80% of the time, and events they believe are impos­sible may happen 20% of the time.¹ Therefore. project risks are understated.

Furthermore, anyone who is keen to get a project accepted is likely to look on the bright side when forecasting the project’s cash flows. Such overoptimism seems to be a common feature in financial forecasts. Overoptimism afflicts governments too, probably more than private businesses. How often have you heard of a new dam, highway, or military aircraft that actually cost less than was originally forecasted?

Overoptimism is not altogether bad. Psychologists stress that optimism and confidence are likely to increase effort, commitment, and persistence. The problem is that hundreds of appro­priation requests may reach senior management each year—all essentially sales documents presented by united fronts and designed to persuade. Alternative schemes have been filtered out at earlier stages. The forecasts have been doctored to ensure that NPV appears positive. One response of senior managers to this problem of biased information is to impose rigid expenditure limits on individual plants or divisions. These limits force the subunits to choose among projects. The firm ends up using capital rationing not because capital is unobtainable, but as a way of decentralizing decisions.

It is probably impossible to eliminate bias completely, but senior managers should take care not to encourage it. For example, if divisional managers believe that success depends on having the largest division rather than the most profitable one, they will propose large expan­sion projects that they do not truly believe have positive NPVs. Or if new plant managers are pushed to generate increased earnings right away, they will be tempted to propose quick- payback projects even when NPV is sacrificed.

Sometimes senior managers try to offset overoptimism by increasing the hurdle rate for capital expenditure. Suppose the true cost of capital is 10%, but the CFO is frustrated by the large fraction of projects that don’t subsequently earn 10%. She therefore directs project spon­sors to use a 15% discount rate. In other words, she adds a 5% fudge factor in an attempt to offset forecast bias. But it doesn’t work; it never works. Brealey, Myers, and Allen’s Second Law² explains why. The law states: The proportion of proposed projects having positive NPVs at the corporate hurdle rate is independent of the hurdle rate.

The law is not a facetious conjecture. It was tested in a large oil company where staff kept careful statistics on capital investment projects. About 85% of projects had positive NPVs. (The remaining 15% were proposed for other reasons—for example, to meet environmen­tal standards.) One year, after several quarters of disappointing earnings, top management decided that more financial discipline was called for and increased the corporate hurdle rate by several percentage points. But in the following year, the fraction of projects with posi­tive NPVs stayed rock-steady at 85%. If you’re worried about bias in forecasted cash flows, the only remedy is careful analysis of the forecasts. Do not add fudge factors to the cost of capital.^{3 [1]}

2. Postaudits

Most firms keep a check on the progress of large projects by conducting postaudits shortly after the projects have begun to operate. Postaudits identify problems that need fixing, check the accuracy of forecasts, and suggest questions that should have been asked before the proj­ect was undertaken. Postaudits pay off mainly by helping managers do a better job when it comes to the next round of investments. After a postaudit, the controller may say, “We should have anticipated the extra training required for production workers.” When the next proposal arrives, training will get the attention it deserves.

Postaudits may not be able to measure all of a project’s costs and benefits. It is often impos­sible to split the project away from the rest of the business. Suppose that you have just taken over a trucking firm that operates a delivery service for local stores. You decide to improve service by installing custom software to keep track of packages and to schedule trucks. You also construct a dispatching center and buy five new diesel trucks. A year later, you try a post­audit of the investment in software. You verify that it is working properly and check actual costs of purchase, installation, and operation against projections. But how do you identify the incremental cash inflows? No one has kept records of the extra diesel fuel that would have been used or the extra shipments that would have been lost absent the software. You may be able to verify that service is better, but how much of the improvement comes from the new trucks, how much from the dispatching center, and how much from the software? The only meaningful measures of success are for the delivery business as a whole.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.