Briefing Capital investment decision-making:some results from studying entrepreneurial businesses

Francis Chittenden and Mohsen Derregia

Manchester Business School, University of Manchester

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Centre forBusinessPerformanceThoughtleadershipfrom theInstitute…

Briefing Capital investment decision-making:some results from studying entrepreneurial businesses

Francis Chittenden and Mohsen Derregia

Manchester Business School, University of Manchester

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bCentre forBusinessPerformanceThoughtleadershipfrom theInstitute…

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Introduction

This Briefing presents the results from a two-year study of the relevance of ‘Real Options’1 to capital investmentdecision-making in small, medium, and large firms. Inaddition, we have sought to discover whether there aredifferences between the capital budgeting practices adoptedby entrepreneurial firms and average performing businesses.

The study confirms that many firms use the payback (PB) method of

investment appraisal in addition to discounted cash flow (DCF) models.

This is a well known observation that has been attributed to the

apparent lack of sophistication of practising managers, amongst other

things. However, by exploring the nature of business risk we conclude

that the use of payback is consistent with ‘Real Options’ models of

investment decision-making. The increasing levels of risk and uncertainty

faced by businesses lead to a preference for rapid recovery of the funds

invested, and demand for flexibility. However, this does not mean that

discounted cash-flow models are no longer relevant. Many sophisticated

companies use PB, internal rate of return (IRR) and net present values

(NPV) as well as thinking about investment projects in ways that are

consistent with real options concepts. They perceive the use of multiple

techniques as different ways of looking at an investment.

Recently some firms began to offer various types of fixed assets through

operating leases and rental or hire contracts, thereby creating what we

call the ‘capital asset uncertainty market’ (CAUM). As a consequence,

companies of all sizes are now able to obtain some of the fixed assets

they require with the provision to terminate a lease or hire contract

subject to certain conditions. The practice of using CAUM to obtain

fixed assets, conserve funds, and enhance flexibility is widespread, but

it is limited by the degree of asset specialisation.

1 Real options are the options companies have when making capital investment decisions.

A company has the option to invest in such a project but can delay the decision. It can

also put an existing operation on hold, it can expand an investment or reduce it, and it

can also invest in flexibility, e.g. by purchasing versatile equipment.

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Methodology

Interviews, a postal questionnaire, and case studies were employed, recognisingthe different aspects of investment decisions that each method can reveal.

The 50 interviewees were exclusively directors with overall responsibility for theinvestment analysis and financing arrangements in their companies, with theexception of one that was with a consultant mathematician. Further details areincluded in Table 1:

Table 1: Interviewee and company information

Number of Position Sector Firm Size &Interviewees Ownership

7 Finance Director Manufacturing Large Listed

11 Finance Director Services Large Listed

3 Finance Director Manufacturing SME Listed

3 Finance Director Manufacturing Large Unlisted

3 Finance Director Services Large Unlisted

12 Finance Director Manufacturing SME Unlisted

10 Finance Director Services SME Unlisted

1 Consultant Mathematician

50

The second method of collecting data was a postal questionnaire, developed on the basis of information gained from the interviews. The postal questionnairealso facilitated investigation of the differences between entrepreneurial andaverage performing firms, listed and unlisted businesses, large companies andSMEs, and manufacturing and service firms. A summary of the 240 respondentsis set out in Table 2.

Table 2: Postal survey respondents by sector, size, and ownership

Listed UnlistedManufacturing Services Mixed Manufacturing Services Mixed

SME 4 8 2 11 100 7

Large 26 25 9 18 28 2

Total 30 33 11 29 128 9

Third, a collection of 12 firms had their investment decision-making processinvestigated as case studies focusing on the complete process, and whetherthere were any significant differences between entrepreneurial and averagebusinesses. The 12 businesses all engage in capital investment decisions. Sevenhave given their approval for the publication of these cases and two examplesare included in this Briefing.

To differentiate between entrepreneurial businesses and average performingfirms some relevant performance measures were employed. Only businesses thatare in the upper performance quartile on all the measures simultaneously wereincluded in the top-performing ‘entrepreneurial’ category. All firms used in thesample selection had been in business for at least five years.

2 Owner-managers of private firms are known to have a variety of motives for operating theirbusinesses. Some seek to enrich themselves by withdrawing large salaries from theircompanies, while others may choose to draw very small salaries to finance their businessactivities and expansion. When calculating ROCE for private companies average directors’remuneration for each business size band was used and profits were adjusted for thedifferences between actual and expected salary.

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The following performance measures were employed:

Sales growth, calculated for quoted and private firms as their average turnovergrowth rate over three years.

Return on capital employed, estimated for quoted and private firms using astandard and research and development adjusted measure of return on capitalemployed (ROCE) to obtain average ROCE over three years.2

Market valuation of firms (for quoted companies only), market to book value was used as a performance measure as it reflects market expectations ofcompany performance.

By studying established entrepreneurial and average performing firms, thisproject looks for what can be learnt from their decision-making process to formguidelines for best practice.

Some background on capital investment decisions

A complicating feature of most capital investment decisions, which are to someextent irreversible, is the difficulty in predicting future events that could impacton the returns from such investments. In the past, best practice in investmentappraisal has been to predict expected returns and use a risk-adjusted discountrate to obtain the present value of payoffs. This practice facilitates comparingone investment with another using the present risk-adjusted value. Rising levelsof uncertainty about future events, however, complicate the process. Further, themore distant into the future a payoff is, the higher the uncertainty it is likely tobe subjected to. This line of thinking, together with the interlinking ofinvestment decisions with strategy, led to the development of real optionsmodels that consider investments as a collection of options to be exercised.

This research looks at the investment decision-making process in general with a special focus on investment and risk appraisal within that process. By studyingsuccessful entrepreneurial firms, we consider what can be learnt from theirdecision-making process to form guidelines for best practice. Although there isno mechanical solution to the investment decision-making problem, it is helpfulfor companies to think through the issues using a theoretically and practicallyinformed set of key features of successful processes.

The investment decision process

The making of a decision to invest is a multi-stage interactive process. Frominitiating an investment proposal, through appraisal and approval, tomanagement of implementation, the process involves making predictions aboutthe future using imperfect information. Moreover, the stages of the process areoverlapping and interconnected. A rigid bureaucratic investment decisionprocess has been highlighted as a possible hindrance to good investmentappraisal and performance. There is little evidence that this is so. The commercialconcerns included in this study show no relationship between degree offormality and performance; rather, formality has more to do with size and theneed to establish guidelines and processes throughout large businesses thatfacilitate the comparability and predictability of investment choices.

There are, however, important points to be considered in the design of aninvestment process. Entrepreneurial businesses that aggressively seek growth and increased profits do not limit their investments to projects with quantifiableexpected outcomes. They also rely on qualitative assessments. These businessesovercome problems with subjective judgments about the outcomes of

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investments by being problem solvers and accepting the limits to predictability.They accept the inevitability of deviation from expectations and keenly monitorproject progress so that problems can be rectified as they arise. Post audits arealso important as a crucial step in the process of learning from mistakes andidentifying shortcomings that may be avoided or overcome through betterprocess design.

Many businesses in the service sectors are able to avoid, to some extent, theinvestment problem by resorting to CAUM where fixed assets are available forlease, rent, and hire. Capital investment decisions can now be seen in thefollowing framework (Table 3):

Less successful firms may resort to CAUM because of lack of funds and even thesuccessful smaller companies tend to feel there is a need to conserve liquidresources. Larger companies, who mostly do not suffer from a lack of funding,seek flexibility through use of CAUM. These choices are summarised in Table 4:

The availability of market solutions to the investment problem through theprovision of fixed assets on a lease, rent, and hire basis using CAUM dependsupon how specialised the assets are. Alternatively some firms reduce their fixed-asset base by outsourcing certain manufacturing processes (e.g. by purchasingcomplete sub-assemblies).

The role of real options models

Many facets of investment decision-making problems resemble real options.Businesses often have the option to make an investment but are not obliged todo so. They can postpone, expand, reduce, abandon, or put-on-hold a project.They can also invest in added flexibility to reduce the problem of irreversibilityassociated with investment in many types of fixed assets. Managers often behavein ways that are consistent with real options models, especially in dynamicgrowing businesses. They are aware of the impact that the irreversibility of capitalinvestments has on the decision-making process. They often seek ways to mitigatethe effect of irreversibility, such as delaying decisions to wait for better prospects,requiring higher returns to offset perceived downside risk, obtaining flexibleassets where available, and using operational leases with conditions that allow fortechnological upgrades and termination of agreements whenever possible.

Table 4: The role of CAUM

Firm size

Firm performance Large firms Smaller firms

Successful Important for increasing Use to conserve funds, and

flexibility enhance flexibility

Less successful Some use to increase flexibility Use to provide access to the

necessary resources

Table 3: The capital investment decision today

Sector Large firms Smaller firms

Manufacturing Often, specialised assets make Specialised assets may make purchase

purchase necessary, confidence necessary, otherwise use CAUM

is another motivator

Services Business confidence leads to Use CAUM, unless assets specialised

purchase, but specialised assets

can be important too

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In general, high performing firms attach relatively more importance to being firstin new opportunity areas. This reflects their aggressive stance on investment.They also value flexibility more than average performing firms. Intuitively this isin line with first-mover advantages and with the use of flexibility to reduce thecomparatively higher uncertainty facing a pioneering investment. Businesses alsotend to have a variety of investment projects with different characteristics, andthe majority of businesses surveyed report that from time to time they have todelay investment projects. The presence of real-options-like thinking is evenclearer in strategic considerations for investment projects.

Although the real options models as presented in academic work and in highlyspecialised practical applications are unlikely to be widely adopted, theunderlying thinking can be very useful when explicitly applied to investmentevaluation. There is evidence of firms using simpler versions of real optionsmodels to evaluate their investment opportunities.

A schematic of the investment decision-making process using real optionsthinking is presented in the appendix at the end of this Briefing.

Investment and risk appraisal

Evaluation of investment proposals involves appraising both an opportunity and its risk as a single step in the investment decision process. The spread of computers and software has made DCF techniques such as NPV and IRRapplicable even by smaller companies. This, however, has not reduced thepopularity of the simpler ‘payback’ technique that uses the time to recoupinginvestment outlay as a decision rule. Such an approach is in line with thethoughts underlying some real options models. The more distant into the futurea payoff is, the more uncertain it becomes. Businesses are more concerned withthe under-performance of investments because of the serious financialconsequences that may entail, and seek to limit their forecasting errors bypreferring projects with a relatively short payback time. Combining DCFtechniques with payback to evaluate payoffs beyond a payback time limit offersa simple, albeit crude, risk management alternative to complex risk modelling.Furthermore, using scenario and sensitivity analyses helps create informed upperand lower confidence limits to enable management to make judgments aboutthe robustness of assumptions underpinning an investment proposal.

Many companies, and in particular large successful businesses, tend to see thevarious capital budgeting techniques as alternative ways of looking at aninvestment opportunity, each revealing some aspects of the decision but notothers. They often use several techniques to capture as many facets of a projectproposal as possible. The ad hoc approach to uncertainty analysis can beimproved by making the process formal and explicit. A refined approach canalso help firms that are not aware of real options models, to improve theirdecision-making.

Successful firms look at their collection of investments when considering a capitalexpenditure proposal. Companies aggressively seeking to expand will have adifferent threshold for risk to less ambitious firms. They limit their exposure bycombining a number of projects of different risk characteristics while developing,on a continuous basis, risky projects that, if successful, would lead to highreturns. This practice together with being problem solvers is the main distinctionbetween high and average performing businesses. Average performing firmstend to be less aggressive, but they can also be limited by factors outside theircontrol such as the technology used in their sector or intensive competition.

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Case study 1 – highly successful UK multinational

This highly successful company is a large multinational based in the UK. It hasglobal competitors who hold equal market share to its own. Competition ismostly based on innovation, and therefore research and development (R&D)plays an important part in the success of this firm. Although it is a largecompany, it only has competitive advantages in certain product areas, and theseadvantages are the result of innovation.

The business generates investment opportunities through R&D that is itselfmotivated by the need for a product in the market. Investments are mostlymanagement initiated for strategic reasons, customer and demand initiated, and R&D initiated when some basic research calls for further investment.Strategic reasons on occasions limit the search for investment opportunities to areas of existing competitive advantage.

When proposing investments, the company considers proposals made by teams that include at least one person in a position of profit responsibility. Ideasrequiring investment may emerge from an individual but additional people are drawn in to make a formal proposal, and amongst those staff there has to be a line manager or regional manager. Decisions are classified into fiveseparate categories. Categories one and two are approved by finance people at positions lower than the finance director as they generally involve relativelysmall investments. Other categories are submitted to the finance director forapproval. All through the process proposals are presented formally and in adetailed manner.

At the preliminary selection stage a group of individuals, including the financedirector, form a committee to consider the suitability of a proposal to thecompany’s product portfolio. This committee looks at the quality of the initialresearch, the commercial case for the investment, and the likely effect it wouldhave on the company’s strategies. Scientific and regulatory risks are important in defining the form the investment should take. When projects are hard toquantify because of unknown demand and prices, the company builds its own‘demand curve’ and investigates optimal pricing by looking at price-valuationoptions. Projects are not eliminated because quantification of returns is notpossible, but at later stages as an investment takes shape attempts at calculatingreturns are made to see whether a project should continue. Usually there areplenty of projects at various stages of development to be considered for funding.

Different people carry out the evaluation of alternatives at the various stages of product development. Payback, NPV, probability-adjusted NPV, sensitivityanalysis, and an intuitive sense of real options are all used in investmentevaluation in categories three and above. The reason for using so manytechniques is to look at and compare the different results emerging from thetechniques. At stages one and two, often there is not enough data to carry outmuch calculation.

The flexibility of projects is considered as valuable and often a qualitativejudgment is made about the worth of flexibility; mothballing and postponingoptions are often exercised until circumstances change. The finance director of this company stated that investment decisions are often delayed to wait forclearer prospects, with a quarterly review of delayed decisions. The main factorsresponsible for delaying investment decisions are uncertain demand andtechnical/scientific issues, with internal and external funding being of littleimportance. Interest rate uncertainty is unimportant. Most of the investments areregarded as irreversible, with investments reviewed at the stage where they passfrom one category to another. Although projects may have different

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characteristics, the same techniques are applied but with different interpretationsof the results.

The company has a distributed finance organisation so communication must beformal. The portfolio committee authorises projects in categories three and four.Category five projects are authorised by the board of directors. The time taken to reach a decision on a project varies with its size and importance. Decisionsinvolving substantial amounts of money require a lot of data and analysis.Approximately, it takes three to six months to approve substantial investments.Some rejected projects are sold to other companies, while lessons learnt fromresearch are added to the knowledge data bank. The proportion of authorisedprojects from the total proposals received is observed.

Monitoring occurs when projects move from one category to another, withresults included in the internal annual investment report. It is difficult to monitorprogress and a lot of resources are required in order to do this. Projects that donot perform to expectation may be brought back on track. This is quite oftenachieved by investing more in order to solve the problems faced.

The chief executive officer and the finance director conduct quarterly post audit reviews where all projects are looked at by observing sales volumes, market penetration, and other performance indicators to see by how much the investment is deviating from expectations. By considering projects forprogression from one category to another until they reach the market,expectations are usually not too wide of the mark. Post audits are seen asbeneficial despite their cost because they highlight problems with projectevaluations and instigate ways of dealing with deviations from expectations and improving procedures for the future.

Case study 2 – highly innovative small company

Being a small privately owned company has not prevented this business frombeing highly innovative, fast growing and profitable. It operates in a low growthmarket with an expansion rate of between 0–5 per cent per year. It has about 27 per cent share of the market and three main competitors with roughly thesame share as its own. It is difficult for new firms to enter the market and alsodifficult for buyers to find substitutes.

The company currently has excess capacity. Investments are usually to increaseefficiency or for capital replacement and are operations or demand initiated.R&D is also important. Individual managers or management teams makeinvestment proposals. The proposals become formal once they reach the seniormanagement level, and comprise market data, models, engineering and costevaluations.

Management makes preliminary selections using payback. For payback periodsof one year or less, the approval is almost automatic. Projects with up to fiveyears payback are considered, but projects of a strategic nature are consideredfor any payback period and even if the initial investment is never recouped.Being a small firm, management knows all the projects in progress and considersinteraction amongst them and between new and existing investments. Projectsthat are hard to quantify are considered using estimates or reckoning. Inability to quantify projects does not necessarily eliminate them. Usually a long list ofdifferent projects is considered and priority is given to the more urgent orimportant proposals.

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Senior management evaluates the alternative projects. Payback is used and, once a payback period is acceptable, DCF in the form of IRR is applied using computersoftware. Sensitivity analysis is conducted to deal with uncertainty. When projectswith a relatively long payback time (i.e. three years or more) are subject to a lot of variability in the sensitivity analysis, delay is considered until market conditionsimprove or prospects become clearer. Equipment purchased tends to be highlyspecialised and made to order and thus irreversible. Flexible plant is not an optionthat is frequently available for the company but high quality equipment that canhave multiple uses is chosen whenever possible. To deal with uncertain interestrates and the prospect of inflation the discount rate is ‘loaded’ to make sure theassumptions are robust. The most important factor in delaying investments isdemand uncertainty. Internal funding constraints are moderately important andexternal funding is of average importance. Investments may be scaled back inresponse to economic circumstances but not as a result of operational or financialconstraints.

Senior management communicate evaluation outcomes to the people responsiblefor proposals using formal and informal channels. Authorisation for commencingwork on projects is given by senior management, which meets once a month tolook at a number of issues including investment projects. Projects that are notapproved at a meeting but are seen as worthy of future consideration are revisitedon a monthly basis to see if sufficient factors have changed to warrant re-appraisal.

A project development team is responsible for following up projects, mainlylooking at scientific issues in a formal manner. This process is difficult and tends to focus on technical problems, which may lead to cost escalation or even failure if not resolved. When problems are identified, action is taken to address them,sometimes with further research and development or re-formulation work.

A member of senior management who authorised the project carries out the post audit. Usually this is conducted 12 months after start of work, and it seeks to determine whether initial expectations have been met. Post-audit is regarded as beneficial and the process is not costly.

Lessons from the case studies

The 12 case studies conducted were designed to reveal organisational differencesbetween high performing firms and average performers insofar as the investmentdecision-making process is concerned. We looked at the market conditions facedby firms and found little evidence of dominance in the market place for successfulfirms. However, favourable market conditions seem to have assisted firms in thehigh performing categories. Sector conditions do have some influence on businessperformance. However, not all firms from buoyant sectors perform well, and thevariety of company activities in the set of case studies gives some useful indicatorsfor well-designed investment decision-making procedures.

Successful firms tend to be more aggressive and demanding of their investmentgeneration process. They regard investment to be essential to their future growthand profitability. They are more prepared to accept projects with less clearprospects, taking more risk but expecting greater rewards. Management demandsvery high standards of analysis and implementation with procedures to observeprogress and identify weak performance as early as possible. These firms alsoconduct post audits to learn from mistakes and improve administrativeprocedures. This behaviour is absent from a number of average performing firms,with one firm’s finance director highlighting problems with the process andnoting that the board had failed to make improvements.

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All companies pay attention to strategic issues and new investments are restrictedby their existing strategies. Top management does, however, take strategicdecisions that change existing restrictions. This may be a further source ofdifference between average and top performing businesses. In general, successfulfirms tend to be very aware of strategic issues, the importance of quality andvalue, and the need to work on problems emerging from investment decisions to find solutions. Real options thinking helps integrate investment and riskappraisal with strategic thinking, an activity successful companies attempt toachieve using what tools they have. The element of uncertainty present to someextent in all investment decisions makes it important to explore the impact ofpossible future events on projects and on the company as a whole.

Conclusions and recommendations

Capital budgeting with its traditional assortment of techniques, although a crucial activity for companies regularly needing to purchase capital assets in orderto prosper, is no longer a relevant process for all businesses. Many firms acquirefixed assets because they simply need them and evaluate their decision using aframework that is consistent with real options thinking. They investigate optionsopen to them and evaluate these with their eyes on goals and strategy.

The market has also developed solutions to reduce the impact of uncertainty on business operations through leasing, hiring, renting and outsourcing (CAUM).These types of solutions help smaller firms with both the conservation of limitedfinancial resources and the provision of enhanced operational flexibility. Incontrast larger companies face fewer financial constraints and so primarily usethese solutions to enhance their flexibility. Access to leasing, hiring, renting andoutsourcing, however, is limited by the nature of a company’s business activitiesand how much it relies on highly specialised equipment.

Confidence in a business’s market position is also an important factor indetermining whether a company invests in capital assets, given that such assetstend to have purchase, set up and installation costs and a degree of irreversibility.

Firms that apply investment appraisal regularly deploy concepts that are in linewith real options models. Finance directors frame and subsequently manage theinvestment process by looking at the options available and their financial andstrategic values. The application of such concepts is more apparent in successfulcompanies, possibly as a result of a better understanding of their businessenvironments.

Investment decisions are made in the context of strategy. In line with real options models, strategic considerations are crucial when evaluating investmentopportunities. This is something that is ignored by basic DCF methods ofinvestment appraisal. Practitioners appreciate the limitations of traditionalinvestment appraisal techniques and apply a range of measures to highlightdifferent aspects of the proposed investment, as follows (Table 5):

Table 5: Using a range of measures provides information about differentaspects of the investment project’s potential

Technique Result

PB Approximate time to break even

IRR The present value rate of return on an investment

NPV The total expected present value of all cash flows

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The choice of investment appraisal techniques appears to depend on thecircumstances that surround the investment proposal. In evaluating acquisitionsof other businesses, for instance, DCF methods are used because the nature of the investment and its lengthy time horizon is inappropriate for employing PB. Generally, in making long-term commitments, as is often necessary in R&D projects, businesses cannot expect PB to come quickly.

Successful entrepreneurial businesses have a very proactive approach toinvestment decision-making. Accepting that prediction is fraught with inaccuracy,they closely monitor projects for any signs of failure to fulfil expectations and takeappropriate action to remedy problems. Entrepreneurial businesses, whileacknowledging the importance of short-term performance, attach a great deal ofweight to strategic and other long-term investment opportunities, e.g. by valuingfirst mover advantages. Producing numerical estimates of expected investmentperformance measures is important but in the absence of reliable figuresqualitative assessments are used to evaluate opportunities.

In summary the main findings of this Briefing are:

• Market mechanisms such as leasing, renting, outsourcing and subcontractingenable many firms to avoid some or all capital investment decisions.

• Successful firms take a problem-solving approach to investment decision-making and the management of projects, accepting that problems are part of the process and making sure they are detected and dealt with early.

• Choosing a collection of projects that limit the company’s exposure to risks,while ensuring that opportunities for growth are not stifled, is an approach to the management of investments that is often adopted by successful firms.

• Business success depends on market conditions, but what distinguishesentrepreneurial businesses is their aggressive pursuit of opportunities anddetermination to make their investments a success.

• Successful firms are not necessarily discouraged by projects that cannot beexpressed clearly in financial numbers. They rely on qualitative and intuitiveassessments, and on their early detection and problem solving capabilities.

• Simple practical techniques are used to approximate the values of investmentsand the options available to companies. The use of the simpler ‘payback’technique is in line with thoughts underlying some real options models.

• Thinking about investment opportunities in real options terms by looking at flexibility, expansion, mothballing, scaling down, reversibility andabandonment, and any other relevant decision options, helps to identify keyfeatures of the opportunity that should make the structure of an investmentclearer to decision-makers.

• Combining DCF techniques with payback to evaluate payoffs beyond a paybacktime limit offers a simple risk management alternative to complex risk modelling.Furthermore, using scenario and sensitivity analyses helps create informed upperand lower confidence limits to enable managers to make judgments about thestability of assumptions underpinning an investment proposal.

• The application of investment and risk appraisal effectively requires a thoroughappreciation of the information yielded by the investment appraisal methodsemployed. For understandable reasons firms are generally keen on employingPB, but for innovative investments it is unlikely to be a basis for goodinvestment decisions. Growth and profit seeking firms need to look beyond thePB period to see whether, given the company’s risk preferences and strengthsand weaknesses, a longer-term view can be beneficial for the future.

Finally, to summarise these findings the ‘traditional’ approaches to capitalinvestment decision making are contrasted below with the more dynamicprocesses observed in entrepreneurial businesses (Table 6):

Table 6: Contrasting approaches to capital investment decision-making

Traditional Dynamic

Perspective Tactical Strategic

Proposals considered Independently Part of the business’s portfolio of

projects with a variety of risk and

return profiles

Extent of quantification Only considered if fully Quantified where possible,

quantified but judgement and reckoning

also used

Point where decision is Single point of approval Multi-stage process

approved

Nature of decision Go/No go Options identified and considered

at each stage e.g. postpone,

conduct trial, complete phase one

only, proceed to next stage, scale

up or down, abandon

Location of responsibility Project proposer No project approved unless Board

for success member takes ownership

Appraisal techniques DCF regarded as superior, PB, NPV, IRR, sensitivity and

but PB more widely used scenario analyses each used to

provide a variety of perspectives

Monitoring of progress Yes, but data collection and Very tight monitoring, rapid

feedback takes time feedback and swift action

Post investment audit Rare Mandatory

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Appendix: Options-based investment decision-making process

New Investment Proposal Idea

Assemble data, identify options available (e.g. expandproject), determine degree of reversibility, prepare case& submit proposal for screening in the organisation

Value the option to divide the project intostages & proceed in this way if beneficial

Are (some) assetsavailable from CAUM?

Is there value in reducing impact ofuncertainty by increasing flexibilityor conserving funds using CAUM?

Use Payback & NPV to determine the distribution of cash flow overtime of various project configurations and options. Use sensitivity& scenario analyses to establish boundaries and (subjective)probability of outcomes. Consider interaction with existing projects

Consider whether theoptions to: abandon,mothball, and scale back arerelevant, and value them

Consider timing option; is there a firstmover advantage? If not, is it beneficialto wait for clearer prospects?

Use reckoning and qualitativeanalysis, establish if project isstrategically important or hassome other source of importance

Invest and monitorprogress. Take swiftaction if problems arise,considering optionsavailable

Further stagesto implement

Fully qualified?

Use CAUM

Post audit

Yes

Yes

Yes

No

NoNo

NoYes

ibc1

About the author

Francis ChittendenFrancis Chittenden is ACCA Professor of Small Business Finance

at Manchester Business School. Before becoming an academic,

Francis was a practising accountant whose work experience had

also encompassed manufacturing industry, distribution, retailing

and banking. During this time he founded or co-founded four

businesses. Professor Chittenden’s current research interests include

the impact of the tax and regulatory regime on owner-managed

firms, cash flow management, capital investment decisions, and

the capital structure of SMEs.

Mohsen DerregiaMohsen Derregia is a doctoral candidate at the Manchester

Business School, researching capital investment decision-making

and uncertainty. He was appointed as a research assistant to carry

out this project. Mohsen has a first degree in management science

and mathematics from St Andrews and an MBA from Edinburgh

Business School. He joined Manchester Business School after

spending several successful years as an entrepreneur.

A full research report entitled ‘Capital investment decision-making:some results from studying entrepreneurial businesses’ by MohsenDerregia and Francis Chittenden has been published by the Centre forBusiness Performance and is available for sale priced £20. For furtherdetails, please visit www.icaew.co.uk/centre, click ‘Publications’ andselect ‘Enterprise’ category.