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CHAPTER 23

PROJECT REVIEW AND ADMINISTRATIVE ASPECTS

OUTLINE
Control of in-progress projects

Post-completion audits
Abandonment analysis

Administrative aspects of capital budgeting


Agency problem

How sound is the capital budgeting system


Disciplining the capital budgeting process for small ticket items.

Control of In-Progress Projects


Though a lot of effort is expended in selecting capital projects, things often go wrong in the implementation phase. This is evident from the frequent cost and time over-runs witnessed in practice. Hence it is necessary to exercise strict control on in-progress capital projects There
are two aspects of controlling in-progress capital projects.

Establishment of internal control procedures


Use of regular progress reports

Post-Completion Audit

An audit of a project after it has been commissioned is referred to as a post-audit. Most firms do a post-audit for projects above some threshold level Regular post-completion audits of capital projects, provide a documented log of experience that may be valuable in improving decision making, enable the firm in identifying individuals with superior abilities in planning and forecasting, help in discovering systematic biases in judgment, induce healthy caution among project sponsors, and serve as a useful training ground for promising executives

Book ROI
It is a common practice to use book ROI defined as Net income Book value of assets for evaluating existing businesses and projects on a continuing basis. Though widely used, the book ROI has two serious flaws: Even though a project may earn a constant economic rate of return, its book ROI displays wide variation across time. There is an upward bias

in the book ROI of a business which has substantial investment in


intangible assets.

Economic Rate of Return and Book Return on Investment


Cash flow Economic rate of return for a given year Book return on investment for a given year = Present value at the beginning of the year Cash flow + Change in book value = Book value at the beginning of the year + Change in present value

The calculation of these measures may be illustrated with an example. Modern Enterprises Limited is considering an investment of Rs.100 million in a new electronics unit which has an economic life of 7 years. The projected cash flows are as follows: Year 1 2 3 4 5 6 7 Cash flow 14 16 17 29 29 29 29 (Rs. in million) If the opportunity cost of capital is 12 percent, the NPV of the project turns out to be zero. 14 16 17 29 29 NPV = - 100 + + + + + (1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5 29 29 + + = 0 (1.12)6 (1.12)7 The economic rate of return and the book return on investment (assuming a straight line depreciation over the 7- year life) for the electronics project are shown in Exhibits.

Calculation of Economic Rate of Return


(Rs in million) Year 1 2 3 4 5 6 7

1. Cash flow 2. Present value at the beginning of the year, 12 percent discount rate 3. Present value at the end of the year, 12 percent discount rate 4. Change in value during the year (3-2) 5. Economic income (1+4) 6. Economic rate of return(5/2) 7. Economic depreciation

14 100 98

16 98 93.8

17 93.8 88.1

29 88.1 69.7

29 69.7 49.0

29 49.0 25.9

29 25.9 0

-2 -4.2 12 11.8 .12 .12 2 4.2

-5.7 -18.4 -20.7 -23.1 -25.9 11.3 10.6 8.3 5.9 3.1 .12 .12 .12 .12 .12 5.7 18.4 20.7 23.1 25.9

Calculation of Book Return on Investment


(Rs in million) Year 1 2 3 4 5 6 7

1. Cash flow 2. Book value at the beginning of the year, straight line depreciation 3. Book value at the end of the year, straight line depreciation 4. Change in book value during the year (3-2) 5. Book income (1+4) 6. Book return on investment(5/3) 7. Book depreciation

14 100 85.7

16 85.7 71.4

17 71.4 57.1

29 57.1 42.9

29 42.9 28.6

29 28.6 14.3

29 14.3 0

-14.3 -14.3 -14.3 -14.3 -14.3 -14.3 -14.3 -0.3 1.7 2.7 14.7 14.7 14.7 14.7 -0.0003 0.020 0.038 0.257 0.343 0.514 1.028 14.3 14.3 14.3 14.3 14.3 14.3 14.3

Flaw with ROI


The popularity of book ROI, a flawed measure, seems to impair the quality of capital budgeting. As American Accounting Association Committee on Managerial Decision Models observed:
The use of traditional accrual accounting methods for evaluating performance is a critical roadblock to implementation of present value models. Clearly, there is an inconsistency between citing present value models as being superior for capital budgeting decisions and then using entirely different concepts for tallying performance. As long as such practices persist, managers will often be tempted to make decisions which may be non-optimal under the present value criterion but optimal, at least over short or intermediate spans of time, under conventional accounting methods of evaluating operating performance.

Bias in Book ROI


Book ROIs are biased upwards for businesses that make substantial intangible investments in R&D, brand building, and so on, simply because these outlays are not reflected on the balance sheet.

Abandonment Analysis
To decide whether the project should be continued or terminated or divested, the following information is required: Present value of the expected cash flows (PVCF) This is defined as :

PVCF =

m n=1

NCn
(1+r)n

where m is the balance life of the project at the time of review and r is the appropriate discount rate.

Salvage value (SV) This is the value expected to be realised from terminating the project and selling its assets.

Divestiture value (DV) This is the price offered by a third party to buy the project.

Given the values of PVCF, SV, and DV, the following are the decision rules. If PVCF < SV < DV PVCF < DV < SV SV < DV < PVCF SV < PVCF < DV DV < SV < PVCF DV < PVCF < SV Action Divest Terminate Continue Divest Continue Terminate

Illustration
Initial Analysis Year Initial forecast Present Year Analysis in Year 3 Actual cash Forecast Present value

of cash flow
0 1 2 3 4 5 6 7 8 (250) 30 50 80 100 100 80 60 50

value at 12%
(250) 26.8 39.9 60.0 63.6 56.7 40.6 27.1 20.2 1 2 3 4 5

flow
(230) 20 30 65

in year 3

of cash flow at11%

80 90 70 50 40 NPV at the end of year 3 =

72.1 73.1 51.2 33.0 23.7 253.1

Initial NPV = 84.9

Behavioural Issues in Project Abandonment


Do managers follow the logic of net present value calculations in evaluating continuation versus abandonment decisions ? It appears that

they often overlook this logic. They have a tendency to get entrapped
into losing projects and, in their attempts to rescue them, throw good money after bad. Why does this happen ? While there can be several

reasons, it happens mainly because sunk costs, which are irrelevant for
economic accounting,are often not ignored in mental accounting.

Mental Accounting
A person who uses mental accounting does not adapt his asset position to losses and hence is likely to be entrapped in continuing the project. He distinguishes between unrealised paper losses and realised losses and adapts his asset position only after the losses are realised. Since realisation of losses induces regret, he is reluctant to realise them and resorts to procrastination as a way to defer the attendant pain. Of course, he may even deepen his commitment to the project further in the hope of finally emerging as a winner and avoiding the ignominy of failure. In this context, note that commitment has a positive side as well as a negative side. On the positive side, it helps people to work harder, surmount obstacles, and scale great heights. On the negative side, it entraps people into negative NPV projects, induces them to throw good money after bad, and impairs their judgment.

Overcoming Resistance
While the rational internal principal may understand the benefits of terminating a losing project, it may find it difficult to persuade the internal agent to take the desired action because termination means that a mental account has to be closed and the accompanying loss realised. To overcome this tendency the following measures may be used. Follow certain rules Develop proper rewards and penalties Institute relatively independent reviews.

Managing Divestments
Since divestments are becoming commonplace, corporates should approach them systematically. Here are some basic guidelines for managing divestments: Regard divestments as a normal part of business life.
Consider divestment as one of the many responses to a situation.

Approach divestments positively.

Administrative Aspects of Capital Budgeting


Identification of promising investment opportunities Classification of investments Submission of proposals Decision making

Preparation of capital budget and appropriation


Implementation Performance review

Agency Problem
In theory, managers as agents of shareholders are supposed to take actions that maximise the welfare of shareholders (the principals). In practice, managers enjoy substantial autonomy and have a natural inclination to pursue their own goals. This is the agency problem. To prevent from being dislodged from their position, managers may try to achieve some acceptable level of performance as far as shareholder welfare is concerned.

Mitigating Agency Costs


Agency costs can be mitigated by monitoring the actions and behaviour of the managers and by offering them right incentives that motivate them to maximise value

Monitoring helps in checking more visible agency problems, but cannot prevent certain kinds of agency costs. Because monitoring has its imperfections and limitations, suitable compensation plans must be designed to give managers the right incentive.

Guidelines for Designing the Incentive

Compensation Plan
Integrate the incentive plan into the total compensation architecture
Set the right set of performance measures
Use objective criteria Reward relative performance Lengthen the decision making horizon of executives

Evaluating the Capital Budgeting System of an Organisation


Results Techniques Communication Decentralisation

Intelligibility
Flexibility Control

Review

Disciplining the Capital Budgeting Process for Small Ticket Items


Senior managers can bring discipline to the capital budgeting process for small ticket items by asking the following questions:
1. Is this your investment to make?

2.
3. 4. 5. 6. 7.

Does it really have to be new?


How are our competitors meeting compliance needs? Is the left hand duplicating investments already made by the right? Are the tradeoffs between profits and capital spending well understood? Are there signs of budget massage? Are we using shared assets fully?

SUMMARY

It is necessary to exercise strict control on in-progress projects. There are two aspects of controlling in-progress capital projects: (a) establishment of internal control procedures and (b) use of regular progress reports. An audit of a project after it has been commissioned is referred to as post-audit or postcompletion audit. It is a useful feedback and review tool. Performance evaluation may be done in terms of economic rate of return or book return on investment (ROI) : Cash flow + Change in present value Economic rate of return for a given year = Present value at the beginning of the year

Cash flow + Change in book value


Book ROI for a given year

= Book value at the beginning of the year

It is common practice to use book ROI (net income) / book value of assets) for evaluating existing business and projects on a continuing basis.

Although widely used, the book ROI has two serious flaws : (a) Even though a project may earn a constant economic rate of return, its book ROI displays wide variation across time. (b) There is an upward bias in the book ROI of a business which has substantial investment in intangible assets. A capital investment cannot be regarded as a commitment till the end of the project life. Hence it has to be periodically reappraised to determine whether it should be continued or terminated or divested. The techniques used to analyse a new project can also be used to analyse whether an existing project should be continued or not. To decide whether a project should be continued or terminated or divested, calculate PVCF (present value of expected cash flows), SV (salvage value), and divestiture value (DV). Choose the option that has the highest value. It appears that managers often overlook the logic of net present value in evaluating continuation versus abandonment decisions and have a tendency to get entrapped into losing projects. To overcome this tendency, the following measures may be used : (i) follow certain rules, (ii) develop proper rewards and penalties, and (iii) institute relatively independent reviews. For identifying promising investment opportunities, the relationship between the firm and its environment should be regularly analysed, corporate plans and perspectives must be widely shared, and the creativity and imagination of the employees must be tapped.

Investment proposals may be classified in many ways. The following scheme of classification can with minor modification be adopted for most manufacturing enterprises : (i) replacement investments, (ii) modernisation and rationalisation investments, (iii) expansion investments, (iv) new product investments, (v) research and development investments, and (vi) obligatory and welfare investments. To ensure that all relevant information for proposals is gathered systematically, a standardised proposal form may be used by all the sponsors of investment projects. Some decentralisation of capital budgeting is required to facilitate quick decisions, develop executives, and conserve top management time for important matters. That is why most companies empower executives at different levels to take investment decisions involving outlays up to certain limits. While the capital expenditure budget is usually drawn up for one to two years, it is desirable to have a perspective plan ranging from 3 to 5 years. In some cases it may even be of a longer duration. The coordination of the capital expenditure budget should preferably be done by a financial officer of the firm. For timely implementation of projects within reasonable costs, the following are helpful : adequate formulation of projects; use of the principle of responsibility accounting; use of network techniques; and exercise of proper control.

Despite, its importance, performance review tends to be one of the most neglected aspects of capital budgeting. Managers enjoy substantial autonomy and have a natural inclination to pursue their own goals. This is the agency problem. Agency costs can be mitigated by monitoring the actions and behaviour of the managers and by offering them right incentives that motivate them to maximise value.

The soundness of the capital budgeting system of an orgnisation may be evaluated in terms of the following criteria: results, techniques, communication, decentralisation, intelligibility, flexibility, control, and review.
Tom Copeland argues that a company can reduce its capital expenditure and create sustainable value by conducting a rigorous evaluation of small-ticket items that are often unnecessary and wasteful.