IT
Project Capital Budgeting: Is there more to it than meets the eye?
An aspect of projects sometimes ignored (at our peril) by the IT fraternity is the money and management side of undertaking them and in particular, the complex issue of the capital budgeting involved and the considerations which inform it.
In this context, perhaps it is worth channelling some of out IT think time into looking at these considerations from the perspective of the financial fraternity who normally undertake this process for us.
The
following paragraphs use the work of King, a latter day financial and investing
luminary, as a classical benchmark to illustrate how the approach to projects
involving capital investment and budgeting in a typical contemporary IT services
company has evolved. One of King’s papers in particular, written in October
1975 and entitled ‘Is the emphasis of Capital Budgeting Theory Misplaced’ is
very appropriate in this context.
In
his paper, King questions the utility of the synoptic or scientific approach to
capital budgeting, advocated by a large body of literature, which usually breaks
down the decision making involved into a series of sequential stages as follows:
TRIGGERING – Projects are
often launched as a function of an event or accident such as plant breakdown or
similar pressing need
SCREENING – This process often
involves just a bare outline of the project including elements such as if there is a good profit record,
availability of resources , fit
with corporate strategy and any risks involved
DEFINITION – Normally based on
limited information and restricted criteria which describe the form and context
of the project
EVALUATION - Validation process
in which alternatives are assessed and justified and a formal case made to
support a particular form of the investment project
TRANSMISSION – A political
process in essence which works its way through the organisation in which
divisional management present and commit their proposals to top management
DECISION - At this stage the
project is brought before corporate management who consider the implications for
overall strategy, assess the management involved and formalise their commitment
to the project. Usually a single alternative is accepted and funds are rarely
refused. It is a process of endorsement rather that judgement
In a typical IT services environment
there is a constant flow of project work both in the realm of undertaking
internal investment and meeting client requirements. Those projects, which
involve meaningful levels of capital budgeting and investment, usually fall
within three groups:
1. Large scale internal requirements such as acquiring premises- which seldom occur
2. Continuous spending on upgrading for example, data centres and global communications networks. The amount of money involved, which can be considerable and include intangibles such as design ,testing and training, is often not subject to a formal project specific, capital budgeting process.
3.
Large scale projects sold to and undertaken for clients, involving
considerable capital outlays and risk
Unlike much of internal capital investment, client focussed, revenue earning projects are typically subjected to rigorous control processes such as:
· .Developing plans and budgets for capital investment
· .Authorization of specific projects
·
.Ongoing checking whether projects perform as
promised
As these projects are often the main
focus of capital budgeting in IT services organisations they represent the most
fruitful area of discussion with regard to King
The core goal for contemporary
managers in terms of proposing project related capital investments for
authorization by top management, is basically to maximise return on investment
or net present value (NPV)
Projects are formally acquired not ‘triggered’, by sales personnel who identify and present them to divisional management for adoption.
A formal
analysis of elements such as technical feasibility, estimated revenue/gross
margin, strategic fit, past history both with the client and similar projects,
risk factors, resources needed, existing (sunk cost) collateral and cost of
sales, usually ensues.
Senior
managers impose discipline on this process by establishing rigid capital
expenditure limits which increase proportionally the higher a manager is in a
company’s hierarchy. In addition to compensating for any ‘agency’ elements
(inadequate or mis-communication between principals and agents i.e. within
management hierarchies or upwards with their shareholder’s representatives or
principals) in the process, this form of capital rationing is there to
facilitate decentralizing and testing decisions and typically not because of any
especial lack of capital resources.
‘Evaluation’ focuses on the financials, especially project NPV and the responsibility of financial management to consider all related investments, whether in or outside the capital budget, as well as ensuring which investments (projects) are important to the company and where and how financial analysis will payoff.
In terms of the principal/agent relationship, which underpins agency theory, the financial manager acts as a principal to and for the divisional managers who are promoting the project
In order to
ensure that the correct projects are evaluated and undertaken, managers, in
addition to providing work which meets the corporate i.e. shareholder, cost of
capital requirement, may need to ensure returns in excess of this through
earning an economic value add.
Measuring an
‘economic’ profitability (EP) rate of return is based on the formula:
EP = Cash Receipts + change of price
Beginning price
Corporations usually pay additional incentives to managers involved in projects which deliver positive EVA. This in turn gives rise to extending established processes of post audit in order to measure and monitor the progress of approved projects and the generation of EVA
Agent/principal theory underlies the
EVA and other compensation incentives in order to promote projects with quick
payback and avoid ‘empire building’ or the use of scarce capital resources
on projects with zero or less NPV
Returning to the project approval process, usually, when the financial process is complete the project is ‘transmitted’ to and signed off by the managers involved at the divisional level At this stage given that the NPV and other financial and non-financial data is acceptable collating all of the relevant information and preparing a targeted presentation for top management is undertaken
Provided that the financial case is clear and good supporting information is in place the top management decision process is normally a formality
Top
management additionally use these decision making events to ensure that the
project is in line with broad company strategy as well as assessing divisional
management and ensuring that the necessary ‘checks’ and ‘balances’ IE
post audit, will be applied.
In general terms the capital budgeting
process in a typical IT services company follows the steps outlined by King with
some important differences
The suggestion is that projects are adopted often more by ‘triggering’ and that there is not a ready supply of them does not quite fit with actuality. Indeed project flow benefits from an approach based on NPV calculations as an accurate and efficient contemporary evaluation measurement for them.
King does not emphasize the key role of management incentives, controls and compensation with regard to addressing the problems of ‘agency’ in the capital budgeting process
Likewise,
there is no emphasis on the critical need to make sure that good information is
made available because projects that have divisional approval are seldom
rejected by top management. (Study by Peter Bower of a large multidivisional
company)
In his
article ‘Free cash flow problems, i.e. Entrenching investment and empire
building’, Michael Jensen under the heading of incentives analyses the effect
of empire building and the tendency to invest in zero/negative NPV projects,
especially where there is plenty of cash but limited project opportunities
available.
The whole area of monitoring is
largely ignored by the classical approach. In modern companies this is
accomplished by rigorous audit requirements as well by internal audit and
statutory audit The importance of effective auditing cannot be over stressed as
for example, statutory audit, which, should it result in a ‘qualified
opinion’ outcome, could ruin a company and the managers who work in it
Compensation
is a key feature in contemporary businesses for ensuring that by employing it,
they facilitate maximum productivity from capital budgeting for projects. This
was not recognized in many companies in former times who preferred to constrain
the earnings of managers. In this regard for example, they were often unwilling
to separate out those elements that determine compensation which are the
responsibility of the manager, from those elements outside his control, EG
economic recession. CEO compensation in the US is often exaggerated according to
Jensen and Murphy who found that they held only 0.14% of outstanding shares on
average.
The whole area of measuring and rewarding performance for example based on EVA and residual income, is very important principally for two reasons:
· They are based on absolute performance rather than performance related to shareholders expectations
·
They make it possible to measure more junior
managers performance whose responsibility may extend to the divisional level
The
fundamental difference between the classical approach to project capital
investing and budgeting, with its emphasis on form as described by King, and
contemporary practices, is the recognition of the need to employ systems that
underpin the delivery of shareholder
value. By factoring cost of capital metrics (what companies need to return to
investors and lenders) into discounting formulae such as Net Present Value (NPV)
companies are effectively and efficiently enabled to identify satisfactory
returns. Compensating managers to achieve in excess of the shareholder return
requirement is another key element of the modern approach.
Shareholders
want managers to invest only if the expected rate of return exceeds the cost of
capital. Because of this managers cannot ignore the cost of capital imperative
and indeed their focus should be on returns over and above the cost of capital.
This has given rise to a growing number of companies using EVA in manager
compensation packages, especially since it resolves agency problems and
generates incentives for managers to focus on increasing shareholder wealth.
It is hoped that contrasting the contemporary with the classical approach to capital budgeting and investing will have served to better illustrate the scope of this often complex subject. No apology is made to IT colleagues for the technical nature of some of the material above since technical, above all else, is what we are reputed to be.
(First
published by Ittoolbox in January 2005)