Friday, November 26, 2010

(236)---INVESTMENT DECISIONS AND CORPORATE STRATEGY

Investment Decisions and Corporate Strategy

Recently, a lot of emphasis has been placed on the view that a business firm facing a complex and changing environment will benefit immensely in terms of improved quality of decision making if capital budgeting decisions are taken in the context of its overall corporate strategy. This approach provides the decision maker with a central theme or a big picture to keep in mind at all times as a guideline for effectively allocating corporate financial resources. As argued by a chief financial officer.

Allocating resources to investments without a sound concept of divisional and corporate strategy is a lot like throwing darts in a dark room.

Similarly, an American businessman argues as follows.


“We have erred long by exaggerating the improvement in decision making that might result from the adoption of discounted cash flow (DCF) or other refined evaluation techniques. What is need are approximate answer to the precise problems rather than precise answer to the approximate problems. There is little value in refining an analysis that does not consider the must appropriate alternative and does not utilize sound assumptions. Management should spend its time improving the quality of assumptions and assuring that the all strategic questions. Have been asked, rather than implementing and using more refine evaluation techniques
In fact a close linkage between capital expenditures, at least major ones, and strategic positioning exists which has led some researchers to conclude that the set of problems companies refers as capital budgeting is a task for general management rather than financial analyst. Some recent empirical works amply support the practitioners concern for strategic considerations in capital expenditure planning and control. It is therefore a myopic point of view to ignore strategic dimensions or to assume that they are separable from the problem of efficient resource allocation addressed by capital budgeting theory.


Must companies in Asia consider strategy as an important factor in investment evaluation? What are the specific experiences of the companies in Asia in this required? Examples of six companies showing how they defined their corporate strategy are given as follows:
  • To remain market leader by highest quality and remunerative prices. This company undertook the production of a new range of product (which was marginally profitable) for competitive reasons.
  • To have moderate growth for saving taxes and to set up plants for forward and backward integration.
  • Our strategy is to grow, diversify and expand in related fields of technology only. Any project which is within strategy and satisfied profitability yardsticks is accepted. This company found a low profit chemical production proposal acceptable since it came within its technological capabilities.
  • Strategic involves analysis of the company’s present position, nature of its relationship with the environmental forces; company’s business philosophy and evaluation of company’s strong and weak points.
  • To take up new projects for expansion in the fields, which are closer to present projects or technology? This company rejected a profitable project while it accepted a marginally profitable project since it was very close to its current heat transfer technology.
  • To stay in industrial intermediate and capital goods line and in the process to achieve three fold profits in real terms over five years. This company rejected a highly profitable project since it was a consumer durable and accepted a marginal project.


One more example is that of an Indian subsidiary of a giant multinational that looks for projects in high technology, priority sector. This company even sold one of its profitable non-priority sector division to a sister concern to maintain its high-tech priority sector profile.

Thursday, November 25, 2010

(235)---MANAGEMENT FLEXIBILITY AND COMMITMENT FOR INVESTMENT DECISIONS

Management Flexibility and Commitment for Investment Decisions

Most often we hear managers and investors saying
  • “Our plans and decisions are always clouded by uncertainty”
  • “Investment commitments have tremendous competitive value, although you have to pay a cost”
  • “There is nothing like now never; we become wiser by writing for uncertainty decisions”
  • “Flexibility helps to capture future opportunities”
  • “Relinquishing an on-going project or liquidating a business may be a good opportunity to bail out a firm”


They consider these issues as strategic. In practice, managers and investors consider strategic aspects of investment projects as critical for making the investment decisions. They will always like to have right to expand; right to exit; right to exchange investment since these rights provided flexibility to managers. Because of uncertainty, managers Endeavour to build flexibility into a capital investment. Managers also like to commit doing things in response to competitive, technological, or environmental forces. They like to do things differently from others. These commitments that may be contingent upon certain events taking place provide managers with flexibility, operating freedom and opportunities to proactively gain an advantage over competition. The discounted cash flow method of investment analysis is unable of handling managerial flexibility and commitments and other strategic aspects in investment projects.

Monday, November 22, 2010

(234)---QUALITATIVE FACTORS AND JUDGMENT IN INVESTMENT APPRAISAL

Qualitative Factors and Judgment in Investment Appraisal

In theory, the use of sophisticated techniques is emphasized since they maximize value to shareholders. In practice, however, companies, although tending to shift to the formal methods of evaluation, give considerable importance to qualitative factors. Most companies in Asia are guided, one time or other, by three qualitative factors:
  1. Urgency
  2. Strategy
  3. Environment


All investors think that regency is the most important consideration while a large number thinks that strategy plays a significant role. Some investors also consider intuition, security and social considerations as important qualitative factors. Companies and investors in USA consider qualitative factors like employees’ morals and safety, investor and customer image, or legal matters important in investment analysis.


Due to the significance of qualitative factors, judgment seems to play an important role. Some typical response of companies and investors are:

  • Vision of judgment of the future plays an important role. Factors like market potential, possibility of technology change, trend of government policies etc., which are judgmental, play important role.
  • The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weight age on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgment. Thus, it is inevitable for any management decision.
  • Judgment and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company. For routine matters, liquidity and profits should be preferred over judgment.
  • It (judgment) plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.
    We feel that what businessmen call intuition or (simply) judgment is in fact informed judgment based on experience. A firm growing in a favorable economic environment will be able to identify profitable opportunities without making net present value or internal rate of return computation. Businessmen often act more intelligently than they talk.

Friday, November 12, 2010

(233)---QUALITATIVE FACTORS AND JUDGEMENT IN CAPITAL BUDGETING

Qualitative Factors and Judgment in Capital Budgeting

In theory, the use of sophisticated techniques is emphasized since they maximize value to shareholders. In practice, however, companies, although tending to shift to the formal methods of evaluation, give considerable importance to qualitative factors. Most companies in Asia guided one time or other, by three qualitative factors:
  1. Urgency
  2. Strategy
  3. Environment


All companies think that urgency is the most important consideration while a large number thinks that strategy plays a significant role. Some companies also consider intuition, security and social considerations as important qualitative factors. Companies in USA consider qualitative factors like employees’ morals and safety, investor and customer image, or legal matters important in investment analysis.


Due to the significance of qualitative factors, judgment seems to play an important role. Some typical responses of companies about the role of judgment are:

  • Vision of judgment of the future plays an important role. Factors like market potential, possibility of technology change, trend of government policies, which are judgmental, play importance role.
  • The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weight age on every bit of pros and cons, cost-benefit analysis, are essential elements of judgment. Thus, it is inevitable for any management decision.
  • Judgment and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company.
  • It plays a very important role in determining the reliability of figures with the help of quantitative methods as well as other known financial matters affecting the projects.


We feel that what businessman call intuition or simply judgment is in fact informed judgment based on experience. A firm growing in a favorable economic environment will be able to identify profitable opportunities without making net present value or internal rate return computation. Businessmen often act more intelligently than they talk.

Friday, November 5, 2010

(232)---CAPITAL INVESTMENT CONTROL AND MONITORING

Capital Investment Control and Monitoring

A capital investment reporting system is required to review and monitor the performance of investment projects after complication and during their life. The follow-up comparison of the actual performance with original estimates not only ensures better forecasting but also helps to sharpen the techniques for improving future forecasts. Based on the follow-up feedback, the company may reappraise its projects and take remedial action.

Asian companies practice control of capital expenditure through the use of regular project reports. Some companies require quarterly reporting, others need monthly, half-yearly and yet a few companies require quarterly reporting, others need monthly, half-yearly and yet a few companies require continues reporting. In most of the companies, the evaluation reports include information on expenditure to date, stage of physical complication, and approved and revised total cost.

Most of the companies in reappraising investment proposals consider comparison between actual and forecast capital cost, saving and rate of return. They perceive the following advantages of reappraisal:
  1. Improving in profitability by positioning the projects as per the original plan.
  2. Ascertainment or errors in investment planning which can be avoided in future.
  3. Guidance for future evaluation of projects.
  4. Generation of cost consciousness among the project team.


A few companies abandon the project if it becomes uneconomical. The power of review is generally invested with the top executives of the companies in Asia.

Thursday, November 4, 2010

(231)---CAPITAL INVESTMENT PLANNING AND CONTROL

Capital Investments Planning and Control

Capital Rationing

Asian companies, by and large, do not have to reject profitable investment opportunities for lack of funds, despite the capital markets not being so well developed. This may be due to the existence of the government –owned financial system, which is always ready to finance profitable projects. Asian companies do not use any mathematical technique to allocate resources under capital shortage which may sometimes arise on account of internally imposed restrictions or management’s reluctance to raise capital outside. Priorities for allocating resources and determined by management, based on the strategic need for and profitability of projects.

Authorization

It may not be feasible in practice to specify standard administrative procedures for approving investment proposals. Screening and section procedures may differ from one company to another. When large sums of capital expenditures are involved, the authority for the final approval may rest with top management. The approval authority may be delegated for certain types of investments projects. Delegation may be effected subject to the amount of outlay, prescribing the section criteria and holding the authorized person accountable for results.
Funds are appropriated for capital expenditures after the final selection of investment proposals. The formal plan for the appropriation of funds is called the capital budget. Generally, the senior management tightly controls the capital expenditures. Budgetary controls may be rigidly exercised, particularly when a company is facing liquidity problem. The expected expenditure should become a part of the annual capital budget, integrated with the overall budgetary system.


Top management should ensure that funds are spent in accordance with appropriations made in the capital budget. Funds for the purpose of project implementations made in the capital budget. Funds for the purpose of projects implementation should be spent only after seeking formal permission from the financial manager or any other authorized person.

In Asian, as in UK, the power to commit a company to specific capital expenditure and to examine proposals is limited to a few top corporate officials. However, the duties of processing the examination and evaluation of a proposal are somewhat spread throughout the corporate management staff in case of a few companies.

Senior management tightly controls capital spending. Budgetary control is also exercised rigidly. The expected capital expenditure proposals invariably become a part of the annual capital budget in all company. Some companies also have formal long range plans covering a period of 3 to 5 years. Some companies feel that long range plans have a significant influence on the evaluation and funding of capital expenditure proposals.

Monday, November 1, 2010

(230)---RECOGNITION OF RISK IN PROJECT EVALUATION

Recognition of Risk in Project Evaluation

The assessment of risk is an important aspect of an investment evaluation. In theory, a number of techniques are suggested to handle risk. Some of them, such as the computer simulation technique are not only quite involved but are also expensive to use. How do companies handle risk in practice?

Companies in Asian countries consider the following as the four important contributors of investment risk
  1. Selling price
  2. Product demand
  3. Technological changes
  4. Government policies


Asian countries are fast changing from sellers’ market to buyers’ market as competition is intensifying in a large number of products; hence uncertainty of selling price and product demand are being realized as important risk factors. Uncertainty government policies, of course, are a continuous source of investment risk in developing countries in Asia.


Sensitivity analysis and conservative forecasts are two equally important and widely used methods of handling investment risk in Asian countries. Each of these techniques is used by a number of Asian companies with other methods while many other companies use either sensitivity analysis or conservative forecasts with other methods. Some companies also use shorter payback and inflated discount rates (risk-adjusted discount rates).


In USA, risk adjusted discount rate is more popular than the use of payback and sensitivity analysis. The contrasts in risk evaluation practices in Asian countries, on the other hand, and USA and UK, on the other, are sharp and significant. Given the complex nature of risk factors in developing countries, risk evaluation cannot be handling through a single number such as the net present value (NPV) calculation based on conservative forecasts or risk-adjusted discount rate. Managers must know the impact on project profitability of the full range of critical variables. An American businessmen states: “the appear to be more corporations using sensitivity analysis than surveys indicate. In some cases firms may not know that what they are undertaking is called ‘sensitivity analysis’ , and it probably is not in the sophisticated, computer oriented sense...Typically, analysts or middle level managers eliminate the alternative assumptions and solutions in order to simplify the decision making process for higher management.