Planning and Controlling Capital Expenditure Lecture 10 PDF

Planning and Controlling Capital Expenditure Lecture 10 1 1. Introduction 1. Techniques used in practice 2. How firms plan and control capital expenditure in practice 2 2. Sources of positive NPV Expected cash flows are forecasts: Biased---too optimistic or too pessimistic Unbiased but prone to erro...

Planning and Controlling Capital Expenditure Lecture 10 1 1. Introduction 1. Techniques used in practice 2. How firms plan and control capital expenditure in practice 2 2. Sources of positive NPV Expected cash flows are forecasts: Biased---too optimistic or too pessimistic Unbiased but prone to error Does a positive NPV make sense? NPV  0  supernormal profits  economic rents 1. What is the source of the competitive advantage? How do the rents arise? 2. Has the company market power it can protect? 3. How long are economic rents sustainable? 4. How will competitors react? Negative NPV’s? 3 3. Warning against too high discount rates Example: Assume, 1. the return required on projects with no risk is 12% 2. for the company’s project, the market requires a return of 20% to compensate for its risk 3. the company uses a 30% discount rate for cash flows after year 4 because of what it sees as the extra uncertainity What is the effect? Year (1) rf = 12% (2) r*= 20% (3) r*= 30% 1/1.12t 1/1.2t 1/1.3t PV of £1000? 1 0.893 0.83 2 0.797 0.694 5 0.567 0.402 0.269 10 0.322 0.1615 0.0725 20 0.104 0.026 0.005 4 4. Theory v. practice Pike & Wolfe: 100 large UK firms Investment Practive ’75 ’81 ’86 ‘92 Rarely % % % % % IRR 44 DCF/NPV 32 ARR 51 Payback 73 Formal Risk Analysis 26 Postaudit For major 33 projects 57 39 49 81 38 46 75 68 56 92 86 64 81 9 74 16 50 13 94 5 88 18 72 ’86 Often Mostly Always % % 11 15 15 16 17 13 14 10 24 28 42 23 18 47 22 % 5 Further evidence Arnold & Hatzopoulos (2000) – 300 UK firms surveyed in 1997 Small (%) Medium (%) Large (%) Composite (%) Payback 71 75 66 70 ARR 62 50 55 56 IRR 76 83 84 81 NPV 62 79 97 80 DCF (IRR or NPV) 91 96 100 96 Non Financial Criteria used 32 17 39 31 6 Criticism of UK investment performance 1. payback v. NPV 2. myopic management 3. ARR 4. myopic stock market 5. real investment options 7 5. Preparing cap. budgets in practice 1. search proposals originate in divisions difficult to manage 2. screening formal review body feasibility/consistency check 3. definition 4. evaluation 5. authorisation corporate management approval required for expenditures  £50k (cf. £19.37m budget) 6.monitoring & post-audit 8 1. Search for investment opportunities 2. Screening: Is the project consistent with the strategic plan? Is it feasible? 3. Definition of project and alternatives Assumptions (inflation, markets, GDP) 4. Evaluation 5. Authorisation 6. Monitoring & Post-Audit 9 Other aspects of practice 12-month detailed capital budget + 2/4-year outline plan capital budgeting manual 6. Information and forecasting bias definition stage individual incentives special interests 10 7. Control and evaluation procedures post completion audits 1. improve the quality of existing decisions 2. improve the quality of future decisions 3. enable corrective action on existing projects Problems in implementing postaudits 1. measuring incremental cash flows 2. using accounting measures of performance historical cost accounting depreciation inflation, unrecorded assets, creative accounting 11 Summary 1. you should carefully analyse claims of positive NPV projects 2. risk-adjusted discount rates discount for the risk of every period 3. in practice companies use several investment appraisal criteria 4. capital budgeting in practice involves searching, screening, definition, evaluation, authorisation, monitoring and post-audit 5. forecasted cash flows are susceptible to bias 6. companies control capital expenditure through post-completion audits 12