The greatest failing in most capital review systems is not in the initial analysis phase, but in the post-completion phase, because there isn’t one. An analyst usually puts a great deal of effort into compiling a capital investment proposal form, educating managers about how to use it, and then setting up control points around the system to ensure that all capital requests make use of the approval system. However, if there is no methodology for verifying that managers enter accurate information into the approval forms, which is done by comparing actual results to them, then managers will eventually figure out that they can alter the numbers in the approval forms in order to beat the corporate hurdle rates, even if this information is incorrect. However, if managers know that their original estimates will be carefully reviewed and critiqued for some time into the future, then they will be much more careful in completing their initial capital requests. Thus, analysis at the back end of a capital project will lead to great accuracy at the front end.
Analysis of actual expenditures can begin before a capital investment is fully paid for or installed. An analyst can subtotal the payments made by the end of each month and compare them to the total projected by the project manager. A total that significantly exceeds the approved expenditure would then be grounds for an immediate review by top management. This approach works best for the largest capital expenditures, where reviewing payment data in detail is worth the extra effort if it can prevent large overpayments. It is also worthwhile when capital expenditures cover long periods of time, so that a series of monthly reviews can be made. On the other hand, it is not a worthwhile approach if the expenditure in question is for a single item that is made with one payment; however, this type of purchase can still be reviewed by comparing the company’s purchase order total to the amount noted on the capital investment proposal form.
Once a project is completed, there may be cash inflows that result from it. If so, a quarterly comparison of actual to projected cash inflows is the most frequent comparison to be made, with an annual review being sufficient in many cases. Such a review keeps management appraised of the performance of all capital projects, and lets the project sponsors know that their estimates will be the subject of considerable scrutiny for as far into the future as they had originally projected. For those companies that survive based on the efficiency of capital usage, it may even be reasonable to tie manager pay reviews to the accuracy of their capital investment request forms.
An example of a post-completion project analysis is shown in the following table. In this example, the top of the report compares actual to budgeted cash outflows, while the middle compares all actual cash outflows to the budget. Note that the cash outflows section is complete, since these were all incurred at the beginning of the project, whereas the inflows section is not yet complete, because the project has only completed the third year of a five year plan. To cover the remaining two years of activity, there is a column for estimated cash inflows, which projects them for the remaining years of the investment, using the last year in which there is actual data available. This projected information can be used to determine the net present value. We compare the actual and projected net present values at the bottom of the report, so that management can see if there are any problems worthy of correction. In this case, the initial costs of the project, both in terms of capital items and working capital, were so far over budget that the actual net present value is solidly in the red. In this case, management should take a hard look at reducing working capital, since this is the single largest cash drain in excess of the budget, while also seeing if cash inflow can be increased to match the budgeted annual amounts for the last two years of the investment.
Description |
Actual |
|
Budget |
|
Budget Present Value* |
Cash Outflows |
|
|
|
|
|
Capital Items |
$1,250,000 |
--- |
$1,100,000 |
$1,250,000 |
$1,100,000 |
Working Capital |
750,000 |
--- |
500,000 |
750,000 |
500,000 |
Total Outflows |
$2,000,000 |
--- |
$1,600,000 |
$2,000,000 |
$1,600,000 |
|
|
|
|
|
|
Cash Inflows |
|
|
|
|
|
Year 1 |
250,000 |
|
$250,000 |
$229,350 |
$229,350 |
Year 2 |
375,000 |
|
400,000 |
315,638 |
336,680 |
Year 3 |
450,000 |
|
500,000 |
347,490 |
386,100 |
Year 4 |
|
450,000 |
500,000 |
318,780 |
354,200 |
Year 5 |
|
450,000 |
500,000 |
292,455 |
324,950 |
Total Inflows |
$1,075,000 |
$900,000 |
$2,150,000 |
$1,503,713 |
$1,631,280 |
Net Present Value |
--- |
--- |
--- |
-$496,287 |
+$31,280 |
Note: Uses discount rate of 9%