Transcript Lecture 30.ppt

Last Study Topics
• The capital investment process
• Project Authorization
Topics Covered
• Off Budget Expenditure
• Decision Makers and Information
Off Budget Expenditures
Information Technology
Research and Development
Marketing
Training and Development
Information Technology
• IT projects have costs well over $1 billion.
• Much of this expenditure goes to intangibles
such as system design, testing, or training.
– Such outlays often bypass capital expenditure
controls, particularly if the outlays are made
piecemeal rather than as large, discrete
commitments.
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• Investments in IT may not appear in the
capital budget, but for financial institutions
they are much more important than outlays
for plant and equipment.
• An efficient information system is a valuable
asset for any company, especially if it allows
the company to offer a special product or
service to its customers.
Research and Development
• For many companies, the most important
asset is technology.
• The technology is generated by investment in
research and development (R&D).
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• R&D budgets for major pharmaceutical
companies routinely exceed $1 billion.
• Glaxo Smith Kline, one of the largest
pharmaceutical companies, spent nearly
$4billion on R&D in 2000.
– How does this information relates with the
analysis part!
Marketing
• In 1998 Gillette launched the Mach3 safety
razor.
• It had invested $750 million in new, custom
machinery and renovated production facilities.
• It planned to spend $300 million on the initial
marketing program.
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• Its goal was to make the Mach3 a long-lived,
brand-name.
– This marketing outlay was clearly a capital
investment, because it was cash spent to generate
future cash inflows.
Training and Development
• Training and development is another
expenditure which doesn't includes in the
capital budgeting costing.
• For example –
– By launch of the Mach3, Gillette had hired 160
new workers and paid for 30,000 hours of training.
Small Investment
• How can the financial manager assure that
small investments are made for the right
reasons?
• Financial staff can’t second-guess every
operating decision.
– They can’t demand a discounted-cash-flow
analysis of a cappuccino machine.
Important Point
• The financial manager has to consider all
investments, regardless of whether they
appear in the formal capital budget.
– The financial manager has to decide which
investments are most important to the success of
the company and where financial analysis is most
likely to pay off.
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• The financial manager in a pharmaceutical
company should be deeply involved in
decisions about R&D.
• In a consumer goods company, the financial
manager should play a key role in marketing
decisions to develop and launch new
products.
Postaudits
• Most firms keep a check on the progress of
large projects by conducting postaudits
shortly after the projects have begun to
operate.
• Postaudits pay off mainly by helping managers
to do a better job when it comes to the next
round of investments.
Information Problems
The correct
information
is …
1. Consistent Forecasts
2. Reducing Forecast Bias
3. Getting Senior Management
Needed Information
4. Eliminating Conflicts of
Interest
Establishing Consistent Forecasts
• Inconsistent assumptions often creep into
investment proposals.
• Suppose the manager of your furniture
division is bullish on housing starts but the
manager of your appliance division is bearish.
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• What happen then!
• The inconsistency makes the furniture
division’s projects look better than the
appliance division’s.
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• Senior management ought to negotiate a
consensus estimate and make sure that all
NPVs are recomputed using that joint
estimate.
– Then projects can be evaluated consistently.
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• This is why many firms begin the capital
budgeting process by establishing forecasts of
economic indicators;
• Such as inflation and growth in gross national
product,
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• Forecasts of particular items that are
important to the firm’s business;
• Such as housing starts or the price of raw
materials.
Reducing Forecast Bias
• Anyone who is keen to get a project accepted
is likely to look on the bright side when
forecasting the project’s cash flows.
– How often have you heard of a new dam, highway,
or military aircraft that actually cost less than was
originally forecasted?
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• You will probably never be able to eliminate
bias completely, but if you are aware of why
bias occurs, you are at least part of the way
there.
– For example, if they 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.
Getting Senior Management
Needed Information
• Valuing capital investment opportunities is
hard enough when you can do the entire job
yourself.
– In real life it is a cooperative effort.
• Although cooperation brings more knowledge
to bear, it has its own problems.
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• Many of the problems stem from sponsors’
eagerness to obtain approval for their favorite
projects.
– As a proposal travels up the organization, alliances
are formed.
– Preparation of the request inevitably involves
compromises.
– The plants unite in competing against outsiders.
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• Should we announce a definite opportunity
cost of capital for computing the NPV of
projects in our furniture division?
– The answer in theory is a clear yes, providing that
the projects of the division are all in the same risk
class.
• What going to happen in the real context?
Brealey & Myers Second Law
“The proportion of proposed
projects having a positive NPV
at the official corporate hurdle
rate is independent of the hurdle
rate.”
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• A firm that accepts poor information at the
top faces two consequences.
• First, senior management cannot evaluate
individual projects.
– For example -In a study by Bower of a large
multidivisional company, projects that had the
approval of a division general manager were
seldom turned down by his or her group of
divisions.
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• Second, since managers have limited control
over project-by-project decisions, capital
investment decisions are effectively
decentralized regardless of what formal
procedures specify.
– The firm ends up using capital rationing not
because capital is truly unobtainable but as a way
of decentralizing decisions.
Summary
• Off Budget Expenditure
• Decision Makers and Information