Chapter 23 Project Review and Administrative Aspects

7/22/2019 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.

Chapter 23 Project Review and Administrative Aspects

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