GUIDELINES FOR THE INSTALLATION OF CAPITAL BUDGETING SYSTEMS GUIDELINES FOR THE INSTALLATION OF CAPITAL BUDGETING SYSTEMS

by Michael P. Coughlin

Table of Contents

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
THE WORK TO BE DONE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

I. PLANNING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . 3
A. SITUATION ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
B. IDENTIFY ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
C. COMPARE ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
D. CHOOSING ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
E. CRITICAL CHARACTERISTICS OF THE INVESTMENT ANALYSIS TECHNIQUES . . . .10
F . SUPPORT NEEDED (PLANS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12
G . QUANTIFIED PLANS (BUDGET) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

II. ORGANIZING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
A. GOAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13
B. OBJECTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
C. SITUATION ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13
D. COMPARISON AND CHOICE OF ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . .13
E. SUPPORT NEEDED (BUDGET) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

III. STAFFING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
A. GOAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
B. OBJECTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
C. SITUATION ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
D. ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14
E. CHOOSING ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
F. SUPPORT NEEDED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
G. STAFFING BUDGET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

IV. DIRECTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
A. GOAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15
B. OBJECTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
C. SITUATION ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16
D. ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
E. SUPPORT NEEDED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
D. DIRECTING DUGET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

V . CONTROL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
A. GOAL . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
B. OBJECTIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17
C. SITUATION ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
D. IDENTIFY ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19
E. COMPARE ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20
F. CHOICE OF ALTERNATIVES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21
G. SUPPORT NEEDED . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
H. THE CONTROL BUDGET . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
I. EXERCISING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
J. AUDIT REPORTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22
K. REPORT ON THE CONTROL SYSTEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

ACKNOWLEDGEMENTS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

1.

INTRODUCTION

In preparing guidelines for the installation of capital budgeting systems (CBS) the number of variables confronted make it dramatically clear that no one "plan" could be universally applicable. This realization dictated the approach and scope of the paper.

The original goal was to construct a "plan" that would allow one to make operational a capital budgeting system without having to research more than the specific requirements of an individual firm. To accomplish this end a guideline approach seems appropriate. Therefore, the purpose of this paper is to:
  1. outline the work to be done,
  2. raise questions that should be answered,
  3. propose a variety of solutions,
  4. provide concise criteria for choosing a solution to each question.
If the word "concise" was not taken as an overriding constraint, accomplishing this objective would require a series of volumes, rather than a paper. A series of volumes would fail to accomplish the original goal of not "having to research more than the specific requirements of an individual firm."

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THE WORK TO BE DONE

To plan for the complete installation of a capital budgeting system, one must address the entire scope of management and/or administration. The chart below shows the relationship between some of the more popular outlines of the management/administration process. The more popular (traditional) outline will be used as steps for the CBS installation.

Administration/Management
VON STROH TRADITIONAL R. ANTHONY
THINK/PREPARE PLANNING STRATEGIC PLANNING
  ORGANIZING  
DO/IMPLEMENT STAFFING MANAGEMENT CONTROL
  DIRECTING  
CHECK CONTROLLING OPERATIONAL CONTROL

3

I. PLANNING

A. SITUATION ANALYSIS

The time frame of capital budgeting is a function of IRS regulations. Items that are required to be "capitalized" and depreciated usually involve a working life greater than one year. Items that are allowed to be written off in one year as an expense do not fall within the realm of a capital budgeting system.

To further enhance the perspective of capital budgeting, consider the four purposes of Financial Planning proposed by Mockler:

  1. determine the resources required,
  2. project internal cash flow generation,
  3. secure the remaining resources needed,
  4. control cash flow.

A rigorous examination of these functions is not required in order to see the dominant role of capital budgeting in the corporate financial picture. The need for capital budgeting is based on the simple realization that "resources" are limited in this world.

That resources are limited is obvious in the first phase of situation analysis ‑ examining the environment of the firm. The geographical location of the firm and its markets present the first limiting consideration. The industry of the firm and its market/sales forecasts are also major limitations to

4.

the firm. The financial environment of the firm is summarized in the various components of its cost of capital (K). Hence, the key environmental inputs to a CBS consist of the firm's various costs (Kd = cost of debt, Ks = the cost of stock or equity, Ka = weighted average cost of capital, and Km = the market's average cost of capital).

Due to the complex nature of the capital budgeting process, it should be considered as a "system." This "system" may require a computer installation and some reorganization in a larger company. A study of the complete system should proceed any implementing action. The study should go into great detail and thus may be quite expensive. Current writers on the control process are in general agreement that such a study will far more than justify its expense. A F.A.S.T. (Functional Analysis of Systems Technique) chart is a great help in keeping goals, objectives and strategies in perspective throughout the study. A very simple and general F.A.S.T. chart follows, to provide an example of the idea. However, an actual F.A.S.T. chart would be tailored to the specific company and would be far more detailed. Robert Mockler suggests the following guidelines for the study.
  1. Begin with a feasibility study.
  2. A top executive should head and participate actively.
  3. The scope should be defined early. Adequate time money and manpower should then be allocated to the project.

5.

F.A.S.T Chart

F.A.S.T. chart
Problem (Goal) Objectives Action Needed Method
Maximize the allocation of scarce resources through application of a capital budgeting system. A tailored “system” Generate suitable projects Procedures: Forms Reviews
  Acceptance by management Determine cost of capital (K)  
  Means of selecting capital projects Risk analysis Prioritizing Computing NPV IRR Payback P.I.
    Post-installation analysis Project audits

6.

4. Major decision-making areas should be defined. Their required information for decisions should also be de­fined.
5. The study group should include someone from each affected operating section. Deadlines should be used to insure continuous and complete involvement.
6. No one functional area should dominate a "system."
7. Equipment commitments should be withheld until needs are clear.
8. Relocation and education plans should be developed, since major organization changes will occur.
9. A considerate, informative initial approach will yield cooperation and educational interchange in later stages of development.
10. A final report should list all findings, conclusions and recommendations.

B. IDENTIFY ALTERNATIVES

First, are there any alternatives to a CBS? Certainly it is possible to carry‑on without one. As the dollar volume and number of projects get large, allocating scarce dollars without some "system" makes profit maximization less likely. If we agree that some "system" is needed, it must be described in detail.

C. COMPARE ALTERNATIVES

The original goal of this paper prohibits a lengthy discussion of capital budgeting techniques. Therefore an attempt will be made to outline the main alternatives and selection criteria.

1. What is the optimal capital structure?

We can determine our spending limit from the optimal capital structure, which is where the average cost of capital (Ka) is minimized. The marginal cost of capital schedule, which should be used for screening or evaluating capital projects, is also minimized when financing at the optimal capital structure.

2. What technique should be used for investment analysis?

Techniques that recognize the time value of money: Techniques that ignore the time value of money: 8.

3. How will projects be classified?

a. replacement ‑ maintenance b. numbered priorities

c. There are many variations possible here which are a function of the individual business.

4. What procedures should be used to estimate cash flows on projects?

5. What types of risk analysis of projects should be used?

D. CHOOSING ALTERNATIVES

We can group the capital investment decision into four elements:
  1. the required rate of return,
  2. the amount of cash inflow per year,
  3. the economic life of the project,
  4. the amount of investment.
9
The project classification and analysis techniques might be viewed as mere tools for finding these four elements.

1. Depending on which technique is used for investment analysis, the required rate of return might be the firm's marginal cost of capital or a return dictated by one of the five methods mentioned for assigning risk to a pro­ject.

2. Projections of cash inflow are the key input to in­vestment analysis decisions. One of the five techniques for analyzing risk may be used to cope with uncertain cash flow projections. It is important to be well aware of the effects on cash flow caused by: 3. Projected economic life is very important because it directly affects total cash flow estimates. In most cases the economic life is considerably shorter than the physical life, due to technological progress (obsolescence) and product/market changes. So one must be cautious about blindly using a manufacturer's projected physical life

10.
for cash flow projections, even if they are quite correct.

4. The total amount that a firm should invest should be derived from an analysis of optimal capital structure.

E. Critical Characteristics of the Investment Analysis Techniques

First of all money does have time value and any technique that ignores this fundamental fact (packback or simple ROI) is basically invalid. Payback and simple ROI are discussed simply because they are still used often in practice.

a. Net Present Value (NPV)
  1. assumes reinvestment at the cost of capital used.
  2. not useful for ranking investments, since the size or scale of the investments directly affects NPV
  3. varies with the cost of capital, so projects with early cash flow will be favored in times of tight or expensive money
b. Present Value (Profitability Index - P.I.)
  1. assumes that cash receipts will be reinvested at the cost of capital used
  2. a relative figure that produces accurate ranking while using NPV figures, which cannot in themselves be used for ranking
11.
c. Internal Rate of Return (IRR)
  1. assumes reinvestment at the IRR
  2. requires computer assistance for constant use
  3. there may be as many rates of return ("answers") as there are sign changes in cash flow
  4. has the working advantage that it is stated as an easily understandable interest rate, rather than some arbitrary number
  5. difficulty arrises when cash inflows are not constant, which is usually the case
  6. can result in different choices than the NPV method due to different interest rates being applied to early versus later cash flow receipts
  7. can be used for ranking of investments
Techniques that ignore the time value of money
a. Payback Period
  1. can be made a valid indicator, if all cash flows are discounted to their present values (not usually done)
  2. the resulting "discounted payback period" could only indicate whether the investment was profitable, not how profitable it was
  3. based on the premise that risk increases as cash flows are planned further in the future (not always valid)
  4. ignores cash receipts beyond the payback period
  5. ignores differences in economic life of projects
12.
b. Simple Rate of Return (ROI)
  1. incorrect, if depreciation is deducted from operating revenues in forecasting future benefits from an investment
  2. conforms to methodology for computing ROI in assets for a fiscal period
  3. there is no reason why ROI for an investment's entire life should equal ROI for a single period
  4. will always understate the true return. The shorter the time period involved, the more serious is the understatement.

F. SUPPORT NEEDED (PLANS)

  1. Time
  2. Budget dollars
  3. Manpower (departmental and organization wide support)
  4. Training (both inter and intra department)
  5. Equipment (particularly computer time)
  6. Facilities (offices, etc.)

G. QUANTIFIED PLANS (BUDGET)

    Salaries
  1. Fringe benefits allocation
  2. Consulting expense. (Computer Systems Analysis)
  3. Supplies
  4. Expenses (computer time, refreshments for seminars, etc.)
  5. Training
  6. Recruiting/travel etc.
13.

II. ORGANIZING

A. GOAL

Provide support to accomplish the overall goal of the capital budgeting system.

B. OBJECTIVES

  1. Maximize the utilization of manpower in the specific corporation for capital budgeting!
  2. Establish the chain of command (hierarchy) for capital budgeting decisions/the organization chart.
  3. Encourage the delegation (supervision) of work inside and out of the capital budgeting department.
  4. Define job duties.

C. SITUATION ANALYSIS

The needs of the specific corporation should be examined in view of organizations used in current practice.

D. COMPARISON AND CHOICE OF ALTERNATIVES

  1. How low in the organization can the capital budgeting decision be made? (e.g. directors, chairman, president, a vice president, director of manufacturing engineering, etc.) What dollar amounts should serve as break‑points requir­ing various levels of paperwork, studies, formality and higher authority for projects?
14.

E. SUPPORT NEEDED (BUDGET)

  1. Supplies
  2. Theory/experience in management organizing.
  3. Personnel department services and advice.

III. STAFFING

A. GOAL

Provide the proper manpower necessary to accomplish the over­all capital budgeting goal.

B. OBJECTIVES

  1. Recruit qualified personnel.
  2. Provide training for both department personnel and corporate personnel in general.

C. SITUATION ANALYSIS

D. ALTERNATIVES

E. CHOOSING ALTERNATIVES

Choices will probably be dictated by compromises between the ideal staff to do a perfect job and dollars that can be spared and justified by the capital budgeting function.

F. SUPPORT NEEDED

G. STAFFING BUDGET

  1. Salaries.
  2. Fringe benefit allocation.
  3. Recruitment expenses:
    travel
    moving
  4. Training expenses.

IV. DIRECTING

A. GOAL

Provide direction for the accomplishment of the overall capital budgeting goal.

16.

B. OBJECTIVES

  1. Monitor and review the capital budgeting plan.
  2. Supervise the accomplishment of the capital budgeting plan.
  3. Create, nurture and motivate a receptive environment for capital budgeting.

C. SITUATION ANALYSIS

Study the attitudes, viewpoints, education and prejudices of corporate management toward modern capital budgeting principles.

D. ALTERNATIVES

Alternatives in directing a capital budgeting department (installation) reduce to the question of leadership versus discipline. Since actual authority will be lacking in many interactions, the choice of alternatives becomes almost rhetorical. Great interpersonal/leadership skills will be required.

17.
In order to assure the effectiveness of the capital budgeting staff's working relationship with corporate managers, the Management By Objectives (MBO) approach is highly recommended.

E. SUPPORT NEEDED

    Authority and/or upper management cooperation in issuing policy guidelines. Department personnel for:

D. DIRECTING BUDGET

Mainly:

V. CONTROL

A. GOAL

Ensure the accomplishment of the capital budgeting goal.

B. OBJECTIVES

  1. Define the capital budgeting control problem for the firm in question.

    18.

    Focus the nature and level of the specific capital budgeting control situation
    A statement of the direction of the control effort can prevent wasted time and resources.
  2. Install a system capable of facilitating straight‑forward management control and operational control of the CBS.

C. SITUATION ANALYSIS

The control portion of the capital budgeting system study should address the following questions which are key factors to the control function. Answers to these questions constitute the base situation for which the control system will be designed.
  1. What planning factors or constraints on the CBS will this particular corporation dictate?
  2. What are the specific characteristics of this control situation?
    • procedural flow of capital budgeting proposals
    • the organization chosen and/or needed
    • needs for information exchange
    • critical aspects of implementing chosen capital budgeting techniques
  3. What is the purpose of the control tools under consideration?
    • who will use them?
    • for what types of decisions?
  4. What nature of control tools will be needed to support the CBS?
    • accounting controls

      19.

    • financial controls
    • non‑financial controls
    • graphic or mathematical computer tools
    • data processing and reporting
  5. What control standards will be needed for this CBS?
    • budget limits or breakpoints
    • what cost(s) of capital
    • what present value index
    • what payback period
    • what ROI
    • estimates of economic life of types of equipment
    • depreciation schedule to use
    • non‑financial priorities (safety, employee comfort/convenience, pollution control, community relations, plant protection, legal)
  6. What special factors may affect this CBS?
    • management's attitudes, experiences
    • motivation or leadership problem areas
    • interdepartmental politics, power struggling, etc.
    • public opinion about certain product or market areas
    • proposed legislation (taxes, incentives, restrictions, FTC, threat of anti‑trust suits etc.)

D. IDENTIFY ALTERNATIVES

Many control alternatives have already been discussed and

20.
compared in the planning and key factors affecting the control situation sections. The development of additional alternatives and the choice of available alternatives may be limited by the past experience of the firm's management, management's work habits and exposure to current techniques, as well as existing work patterns and corporate organization.

Some limitations in the control of the firm's capital bud­geting may be solved by educational seminars, and quotas or time limits for proposing new projects. Problems of fitting the CBS into the existing corporate organization may warrant a systematic study of the entire corporate organization and control process.

E. COMPARE ALTERNATIVES

To evaluate any alternative controls Robert Mockler suggests the following procedure, which is also applicable to any of the capital budgeting controls.
  1. List the background factors.
  2. List the range of alternatives.
  3. Classify and segregate alternatives.
  4. List advantages and disadvantages of each.
  5. Specify the outcome of each.
  6. Project the probability of each outcome.
  7. Narrow the selection.
  8. Select the best.
  9. Plan the implementation.
  10. Implement and compare results with projections.
21.

F. CHOICE OF ALTERNATIVES

Although many of the capital budgeting controls will be dictated by overall plans for the system, the long-term credi­bility of a CBS depends upon auditing.

Auditing capital projects serves two main purposes: Auditing can be expensive, particularly if current controls or accounting procedures cannot be used to obtain the necessary data. While some of this problem can be solved by planning for capital budgeting and accounting as a system, there will always be unforeseen data demands placed by special projects. The question is always ‑ does the audit justify its price? Though there is no comprehensive answer, writers on the subject note that the best run and most successful organizations are the ones that put the greatest emphasis on post‑audits.

G. SUPPORT NEEDED

  1. Man‑hours
  2. Funding
  3. Training, seminars
  4. Personnel department assistance
22.
5. Computer time
6. Facilities (offices, supplies, etc.)

H. THE CONTROL BUDGET

  1. Salaries
  2. Fringe benefit allocation
  3. Training expense (for man-hours, refreshments at seminars)
  4. Computer time/expense
  5. Supplies

I. EXERCISING CONTROL

For the CBS to work it will have to operate in a positive atmosphere. This can be encouraged by:
  1. Use of participation to raise enthusiasm and cooperation ‑ encourage ideas and proposals.
  2. Be creative in analyzing audit variances to find the true causes and thereby improve future forecasting and operations.
Before exercising control or changing standards the following questions should be investigated:
  1. Is the information accurate?
  2. Are the auditing standards and capital budgeting investment analysis valid?

J. AUDIT REPORTING

Capital project audits can involve some very delicate
23.
situations, since so many areas of corporate management can affect a large project's performance. Therefore, the final audit should be as thorough as possible and very carefully written.

One should be aware of the following basic restrictions on auditing and the resulting reports:
  1. The auditing information system:
    • cost of computer time
    • computer schedules
  2. The reporting equipment:
    • computer storage capacity
    • access time
    • programming costs
    • personnel capacity and
    • capability

3. Human factors:

K. REPORT ON THE CONTROL SYSTEM

Some time after the capital budgeting control system, has been implemented a report should be written on how and why the system was chosen and the method of implementing it. The report should include:
  1. Introduction
  2. Factors influencing control of the CBS

    24.

  3. Alternative control methods available
  4. Evaluation and justification of the recommendation
  5. Methods of implementing the control system for the CBS
25.

Acknowledgements

Theories and opinions, presented in this paper, were largely a product of the following works:
Anthony, Robert N. Planning and Control Systems: A Framework for Analysis, Boston: Graduate School of Business Adminis­tration, Harvard University, 1965.
Anthony, Robert N. and Reece, James S. Management Accounting: Text and Cases (Chapters19 and 20) 5th Edition, Homewood, Illinois‑ Richard D. Irwin, Inc., 1975.
Brigham, Eugene F. Financial Management: Theory and Practice (Chapters 5 , 7 , 10, 11, 17, 18, 20), Hinsdale, Illinois: The Dryden Press, 1977.
Fremgen, James M. Accounting for Managerial Analysis (Chapters 16 and 17), Homewood, Illinois: Richard D. Irwin, Inc., 1976.
Johnson, Robert W. Financial Management (Chapters 8 and 11)
Fourth Edition, Boston: Allyn & Bacon, Inc., 1971
Mockler, Robert J. The Management Control Process, New York: Meredith Corp., 1972.

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