Chapter 23 Project Review and Administrative Aspects
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CHAPTER 23
PROJECT REVIEW ANDADMINISTRATIVE ASPECTS
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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
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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 somethreshold 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 withsuperior 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
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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.
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Economic Rate of Return and Book
Return on InvestmentCash 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 valueBook return on =
investment for a given year Book value at the beginning of the year
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 f low 14 16 17 29 29 29 29
(Rs. in mil li on)
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.
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(Rs in mi ll ion)
Year 1 2 3 4 5 6 7
1. Cash flow 14 16 17 29 29 29 29
2. Book value at the beginning of
the year, straight line depreciation 100 85.7 71.4 57.1 42.9 28.6 14.3
3. Book value at the end of the
year, straight line depreciation 85.7 71.4 57.1 42.9 28.6 14.3 0
4. Change in book value during the
year (3-2) -14.3 -14.3 -14.3 -14.3 -14.3 -14.3 -14.3
5. Book income (1+4) -0.3 1.7 2.7 14.7 14.7 14.7 14.7
6. Book return on investment(5/3) -0.0003 0.020 0.038 0.257 0.343 0.514 1.028
7. Book depreciation 14.3 14.3 14.3 14.3 14.3 14.3 14.3
Calculation of Book Return on Investment
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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 valuemodels 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 butoptimal, at least over short or intermediate spans of time, under
conventional accounting methods of evaluating operating performance.
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:
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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.
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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 :
m NCnPVCF=
n=1 (1+r)n
where mis the balance life of the project at the time of review and ris 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.
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I ni tial Analysis Analysis in Year 3
Year I ni tial forecast Present Year Actual cash Forecast Present value
of cash f low value at 12% flow in year 3 of cash f low at11%
0 (250) (250) (230)
1 30 26.8 20
2 50 39.9 303 80 60.0 65
4 100 63.6 1 80 72.1
5 100 56.7 2 90 73.1
6 80 40.6 3 70 51.2
7 60 27.1 4 50 33.0
8 50 20.2 5 40 23.7
Initial NPV = 84.9 NPV at the end of year 3 = 253.1
Illustration
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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.
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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 paperlossesand realised
lossesand 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 inthe hope of finally emerging as a winnerand 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.
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Overcoming Resistance
While the rational internal principalmay understand the benefits of
terminating a losing project, it may find it difficult to persuade theinternal 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.
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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.
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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
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Agency Problem
In theory, managers as agents of shareholders are supposed to take
actions that maximise the welfare of shareholders (the principals). Inpractice, 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.
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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.
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Evaluating the Capital Budgeting System of
an Organisation
Results
Techniques
Communication
Decentralisation
Intelligibility
Flexibility
Control
Review
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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. Does it really have to be new?
3. How are our competitors meeting compliance needs?
4. Is the left hand duplicating investments already made by the
right?
5. Are the tradeoffs between profits and capital spending wellunderstood?
6. Are there signs of budget massage?
7. Are we using shared assets fully?
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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 post-
completion 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
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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, calculatePVCF(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 betapped.
Investment proposals may be classified in many ways The following scheme of
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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 investmentdecisions 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
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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 thatmotivate 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 createsustainable value by conducting a rigorous evaluation of small-ticket items that are
often unnecessary and wasteful.
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