264 Corporate Finance
Following a System
It pays to follow a well-defined system of capital budgeting. The following guidelines may be borne in mind,
while establishing a capital budgeting system:
- Start with the end in mind. The process of capital allocation should be driven by the strategic thrust of the
company. Establish long and short range plans, and translate them into short-term objectives and specific
capital expenditure proposals. Evaluate investments in the context of company objectives and plans for
the future. - Personnel at all levels can often turn their experience into ideas for new and better ways of doing jobs.
Management should not have monopoly on ideas. Be open for discussion—both formal and informal.
The organization climate should be conducive for such an experiment. Involve operating personnel in
preparing short-term guidelines. Prepare them for meaningful evaluation of capital projects. Inadequately
trained executives often mix up expenses, capital expenditure and sunk costs. This leads to a bias in the
estimation of initial investment and NPV. - Avoid over centralization. Develop general definition of types of projects for which authority approval
can safely be delegated to junior officials. For instance, a manager at the shop floor level could be authorized
to spend up to Rs 50,000. The amount and degree of delegation depend on size of the company and im-
portance of the project. - Evolve your own methods of analysis and decision criteria. Estimating divisional hurdle rates is as much
an art as a science. Evolve criteria for allocation of funds to projects with different risk levels - Avoid spending money on a first-come-first-serve basis. Be receptive to investment proposals throughout
the year. A great investment idea that surfaces later in the budget period may not get funded if the budget
is exhausted. - Check whether a decision from one division affects other divisions, quantify the effect and factor into
analysis. Incorporate product cannibalization, competitive advantages and disadvantages in the analysis. - Use the post-implementation appraisal as feedback for fine-tuning both analysis and administrative pro-
cesses. Continuous improvement in the capital budgeting system can be expected in companies where
post-implementation appraisal is seriously implemented. - Do not hold executives responsible for narrow deviations from forecasts. Establish a band of acceptable
tolerances. Otherwise, there will be scope for downward biasing. Initially, the forecast will be set below
the expected value, resulting in ‘happy surprises’ later on. - There should be as few guidelines as possible to ensure that they are well-known and fully understood by
everyone in the organization. - Create an organization climate conducive for trying innovative product ideas and processes. The best way
to drive home the message—that the top management is serious about the strategy adopted by the company
or about the ideas from employees—is to spend money on such projects. - Finally, the objective of creating wealth for shareholders should be the guiding post for acceptance of
project proposals. Executives prepare summary measures, like payback period and IRR for project eva-
luation. These measures, along with ROI, may be used for performance appraisal. But, from the share-
holders’ perspective, NPV is the most consistent measure. So there is a conflict of interest between managers
and shareholders. Tying executive compensation to measures of shareholder value can reduce the conflict.
Measures like EVA, total shareholder return, etc. will be taken up at a later stage. The management pro-
cess starts with the Chief Executive Officer’s vision for the company, gets translated into a set of strategies,
and ends with appraisal of those strategies at the end of the planning period.