Capital budgeting: A case study analysis of

the role of formal evaluation techniques in the

decision making process

E Gilbert
Graduate School of Business, University of Cape Town

Received: September 2004 SAJAR

Revised: February 2005 Vol 19 No. 1
Accepted: March 2005 2005
pp.19 to 36

This paper furthers the understanding of capital budgeting by reviewing two individual capital
investment decisions taken by manufacturing firms in South Africa. This study indicates that
managers do not base their capital investment decisions on a comparison of the expected value of
potential investment opportunities as recommended by theory. Rather they follow a multi-stage
filtering process and reduce the list of projects by establishing the alignment with the firm’s
strategic goals on a qualitative basis. Discounted cash flow project evaluation methods (among
others) are then used to confirm that the selected projects are expected to achieve satisfactory
levels of financial performance. This analysis promotes a better understanding of the
unexpectedly limited use of discounted cash flow techniques by managers in capital investment
decision making.

KEY WORDS
Capital Budgeting, Decision making processes, Discounted cash flow techniques, Valuation, Net
Present Value (NPV), Case study.

Contact
Email: gilberte@gsb.uct.ac.za

INTRODUCTION

Finance theory recommends that managers should undertake capital investment projects
only if they add to the value of the firm. If we assume that managers act so to maximize
the value of the firm, managers should then identify, and undertake, all projects that add
value to the company so as to maximise shareholder value. This theory of capital
investment decision-making implies that managers should establish the expected value
that a project is expected to create. This should be done through the use of value based
or discounted cash flow (DCF) techniques, in particular, the net present value (NPV)
approach.1 Capital investment decisions should then be based on these estimates of
value.

1
See Copeland and Weston, 1992.

E Gilbert 19
Multiple surveys indicate that managers do not always use DCF techniques and that
when they do, they are used in conjunction with other, theoretically deficient,
techniques such as Payback Period (PP). While these surveys highlight the existence of
the gap between prescribed and observed behaviour in this area, they do not suggest
why this is the case. There is, thus, a need for an explicit analysis of the relative role
played by formal evaluation techniques in the capital investment decision making
process.

In order to address this gap, case study analysis of two capital investment decisions
made by manufacturing firms in South Africa was undertaken with a particular focus on
identifying the role played by formal evaluation techniques in the decisions taken. This
provides new evidence that allows for an enhanced understanding of the role of these
techniques in capital budgeting decisions.

The structure of this paper is as follows. A brief discussion of both the value
maximising model of capital investment decision-making and the survey data
concerning its descriptive accuracy is presented in the next section. Details of two
investment decisions are presented, with a particular focus on the role played by DCF
evaluation techniques in the decision-making process. The key differences between the
traditional model of capital investment decision-making and the observed behaviour are
summarised and, finally, the implications of this for further research are discussed.

Use of formal evaluation techniques

A basic tenet of finance theory is that managers act so as to maximize shareholder

value. In the context of capital budgeting, this has been interpreted to mean that
managers should choose all projects that add value to the company. To do so, managers
should establish the estimated value of all projects under consideration2 and select those
which add the most value to the firm (given a capital constraint, if any).

Establishing the expected value of projects involves the estimation of incremental cash
flows over the life of the project discounted at a rate that reflects both the time value of
money and the risk associated with these cash flows.3 If positive, the project adds value
and should be undertaken. In situations of capital rationing, the management should
prioritise the projects in terms of their contribution to the value of the firm and select all
that they can afford.

In terms of process, firms considering investments in new projects should thus estimate
both the incremental cash flows, the appropriate project specific risk adjusted discount
rate and then base their decisions to invest on the results of this DCF analysis. Surveys
of international capital budgeting practices suggest that this is not always the case.

2
Note that this approach does not say anything about the process whereby the projects being valued are
identified. The case study data presented in this paper suggests that the company’s competitive
strategies directly affect the need for new projects as well as provide the basis for judging the relative
attractiveness of the alternative projects.

3
This approach does not consider the value of real options i.e. the flexibility that firms have when
managing projects in the face of an uncertain future. While these options exist and do add value to
capital investment projects, for the purposes of this paper, the role of the traditional (no-flexibility)
investment evaluation techniques such as the Net Present Value (NPV) or Internal Rate of Return (IRR)
will be examined.

20 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

Cross sectional studies of use of formal evaluation techniques

There have been multiple cross sectional studies of the use of formal evaluation
techniques by firms. These have covered the behaviour of both international (see Istvan
(1961), Pullara and Walker, (1965), Meredith (1965), Christy (1966), Bavishi (1981),
Moore and Reichert (1983), Pike (1983), Bailes and McNally (1984), McIntyre and
Coulthurst (1987), Northcott (1992), Sangster (1993), Baddeley (1996), Harvey and
Graham (2001), and Ryan (2002)) and South African firms (see Andrews and Butler
(1986), Parry and Firer (1990), Hall (2000), and Gilbert (2003)). The following
statements summarise the results of these surveys:

1. Discounted Cash Flow (DCF) techniques are used, but a significant minority of
firms do not do so;

2. Larger firms are more likely to use DCF techniques; and

3. When these techniques are used, they are used in conjunction with other
techniques that are both theoretically deficient and redundant.

A criticism of cross-sectional studies is that they do not explicitly consider the

possibility that new evaluation techniques such as DCF would take time to diffuse
across all firms. This problem is avoided by longitudinal studies of evaluation technique
usage.

Longitudinal studies

Longitudinal studies of the use of evaluation techniques have been conducted by

Klammer (1972), Klammer and Walker (1984), and Pike (1996), for international firms
and by Andrews and Butler (1986), and Correia. Flynn, Uliana and Wormald (2003) for
South African firms. In brief, these studies indicate that:

1. The use of DCF techniques has grown over time; but

2. Their increase in use is NOT accompanied by a decline in the usage of other non-
DCF techniques.

This second point is a strong indication that DCF techniques are not playing the
decisive role in the decision-making process that traditional finance theory suggests it
should.

In summary, these surveys indicate that some (generally smaller) firms do not estimate
the expected value of their capital investment projects at all when considering capital
investment decisions. More unexpectedly, the firms that do use DCF techniques also
consistently continue to use other non-value related techniques when evaluating their
capital investments. This suggests that DCF techniques, when used, do not play the
decisive role in the decision making process that is assumed they should (in theory). An
analysis of the role of these evaluation techniques in the decision making process is
necessary to understand why this occurs.

E Gilbert 21
Research methodology

While the survey-based results discussed above indicate the extent of this behaviour
they do not provide any real basis for understanding why this is the case. The case study
approach is a very good way to acquire the data required to better understand the role of
these formal investment evaluation techniques in the capital investment decision
making process. This approach provides rich data on both the context and process of a
capital investment decision which are necessary to identify the relative role(s) of the
various investment evaluation techniques. The limitation of this methodology is that the
results may not be necessarily representative of the population of manufacturing firms.
However, given the current lack of data on this issue, these case studies can provide the
insight required to allow for hypotheses to be developed regarding the unexpected
behaviour reported in the previous section. The validity of these hypotheses should then
be tested across a more representative sample of firms.

Gilbert (2003) presents the results of a survey of the capital budgeting practices of
South African manufacturing firms conducted in 1997. 318 firms were approached of
which 118 responded to the survey. The respondent firms were then invited to
participate in additional case-study based research which aimed to understand the role
of DCF techniques in the decision-making process. Ten firms responded positively.
Two firms were selected on the basis of their different sizes, the importance of the
decision for the firms and (most importantly) the support of the firms in terms of the
quantity and quality of data made available for this research (including the provision of
access to the relevant decision makers). The following case studies were prepared on
the basis of a review of all project related documentation and interviews with related
managerial staff. The data was collected over the period of January to September 1998.

FIRM A: RELOCATING A PRODUCTION FACILITY

Firm A produces sisal matting for sale as floor coverings. It has two production
facilities - one in Johannesburg, Gauteng; and the other in Polokwane, which is
approximately 330 kilometres further north. The latter facility is the larger of the two.
The focus of this analysis is the decision to relocate this plant. Figure 1 provides an
overview of the decision-making process followed by this firm.

Throughout the decision-making process, the management of Firm A expressed a

commitment to two (sometimes conflicting) strategies4: export promotion and cost
minimisation. The first strategy reflected the firm’s belief that the export market
represented a better opportunity for sustained growth than the domestic market. The
current proportion of domestic to international sales was 70:30. The stated commitment
was to reverse this proportion within 10 years. Given the perceived limited potential for
product diversification in the sisal carpeting market, the other strategic commitment was
that of maintaining competitiveness through minimising costs.

4
There are many competing definitions of strategy, and consequently, how it should be dealt with (see
Mansfield, 1996). In this study the term strategy will refer to the firm’s perception of both the current
and future external environment; and how it sees the optimal role for itself in this environment. A
firm’s strategy thus will reflect its choice of what course of action is most likely to lead to a sustainable
profitable outcome, given the current decision-making environment.

22 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

Step 1: Recognition of the need to move

Management reported three reasons for the consideration of a move from the
Polokwane production facility: the loss of relative cost advantages, the low levels of
productivity at Polokwane and the increasing importance of export sales.

The original decision to locate the factory in Polokwane was in response to government
incentives both direct (e.g. rent) and indirect (production of sisal in the area was
subsidised). These have since been discontinued. The existence of significant negative
productivity differentials between the Polokwane and Johannesburg factories is a
continued management challenge. Finally, export sales, once non-existent, now
comprise thirty percent of the firm’s total sales. As both the raw materials and the
finished product are relatively bulky and raw materials need to be imported and the final
product exported (both by sea) Polokwane’s inland position counts heavily against it.
These reasons clearly reflect the firm’s strategic considerations.

1. Recognition of the need to move

2. Identify possible locations

3. Identify preferred locations:

1. Best Inland location (Johannesburg)
2. Best Coastal location (Durban/Pinetown)
3. Best Foreign location (Mauritius)

4. Identify optimal location (Mauritius)

5. Final Decision (Set up a pilot plant in Mauritius)

Figure 1: Overview of firm A’s decision-making process

Step 2: Identify possible locations

The first step in the decision-making process was to identify a list of possible
alternative locations. This list was composed in terms of the following criteria:

1. Access to reliable, flexible and cheap transport networks closely linked to a port
(for the imports of sisal and exports of finished goods);

2. Availability of adequate production premises;

3. Presence of supporting infrastructure of sufficient quality, such as engineering

facilities, and access to other vital inputs, for example dyes and latex; and

E Gilbert 23
4. Access to staff (preferably experienced/skilled in manufacturing).

The initial list drawn up included Durban, Pietermaritzburg, Port Elizabeth, the Gauteng
region (Johannesburg and its immediate environs), Polokwane, Reunion, Mauritius,
Maputo (Mozambique).

The list compiled was directly affected by individual bias. Cape Town, for example, had
every attribute required and yet was excluded because the managing director ‘did not
like the people there’. When asked about other areas which apparently fulfilled these
criteria the initial reaction was one of surprise that these options might have been
considered followed by a justification of their exclusion on some (apparently ad hoc)
basis, such as the lack of existing textile production facilities (Bloemfontein,
Uitenhage); or the infrequent stopping of ships at the ports (East London, Richards
Bay). No formal analysis of the cost (or value) implications of these (apparent)
deficiencies was deemed necessary. The (assumed) existence of these faults was
deemed sufficient for the exclusion of these alternatives from the rest of the process.

Step 3: Identify preferred locations

The company felt that a complete analysis of the list of possible locations identified was
not cost-effective. The second step in the decision-making process consisted of
selecting three sites from the initial list (the eventual choices made are in brackets):

1. The best domestic inland location (Gauteng/Johannesburg);

2. The best domestic coastal location (Durban/Pinetown); and

3. The best foreign location (Mauritius).

It was felt that these three categories captured the essential strategic choices. An inland
centre would be closer to the existing market (mainly Gauteng) which would be better
as domestic sales remained dominant in the short to medium term. A coastal venue
would be superior in terms of reducing transport costs for the export market – the long-
term strategic goal. Finally it was believed that a foreign location might be even more
attractive in terms of achieving the long-term strategy of increased export promotion.
Throughout the evaluation exercise, it was decided to retain Polokwane as a benchmark
case. The influence of the two strategic goals can be clearly seen at this point.

The destinations on the short list were selected on the basis of a series of comparative,
non-formal analyses concentrating on qualitative differences: two locations were
compared and the lack of a particular factor in one of the two locations, ceteris paribus,
was deemed enough to warrant its exclusion. For example, Port Elizabeth was excluded
(when compared to Durban) on the grounds of:

• It was further to Johannesburg than Durban. This would lead to higher transport
costs;

• There were fewer road transport companies on the route as compared to Durban.
There would be less flexibility in terms of the number of alternatives available and
(probably) higher costs per kilometre; and

24 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

• Shipping lines stopped less often in Port Elizabeth than Durban. This would again
limit the flexibility and increase cost of the transport in, of raw materials, and out,
of finished products.

No formal analysis of these existence or scale of these deficiencies was carried out.
Their perceived existence was sufficient to exclude these possible locations.

Step 4: Identify optimal location

For each of the three locations a comparison of estimated direct costs for each location
to current direct costs at Polokwane was completed as was an estimated profit/loss
statement. Two scenarios, based on differing assumptions regarding the rates of growth
of the domestic and foreign components of their current demand, were used in these
exercises. The first assumed an annual (compounded) rate of growth (in real terms) of
the export market of 15 percent and the second, a growth in export demand of 7
percent5. In both cases, demand in the domestic market was assumed to grow by 5
percent (also in real terms). These rates of growth were identified as being the two most
likely scenarios representing ‘good’ or ‘bad’ future outcomes.

These exercises indicated that the Mauritius option clearly represented a superior choice
to all the domestic alternatives in terms of both relative costs and expected profits. The
quantified benefits of significantly lower wages, the absence of any company taxation,
and significantly reduced internal transport costs outweighed the quantified negatives of
higher rental costs, higher transport costs to the South African market; and the un-
quantified problems of managing across borders and over such a distance.

The Polokwane region presented the most profitable domestic site due to the
significantly cheaper current rental charge used. Two qualifications to this result were
immediately raised by management. Firstly, the low rental charge used for Polokwane
in the calculations was not likely to last for the period covered by the model. Secondly,
the exercise assumed that the increases in output were to be produced with the existing
labour and capital stocks which would be extremely difficult to achieve in Polokwane.
Consequently the Gauteng/Johannesburg site was considered to be the best domestic
alternative.

This penultimate stage of the decision-making process provides the first application of a
formal evaluation technique. Identification of relative cost differences is consistent (in
part) with the traditional model of decision-making and the choice of the final location
was determined by the results of this technique. However there are some key
shortcomings with the process.

Extensive efforts were made by management to establish the extent of these cost
differentials. However, management only focussed on estimating current cost
differentials – there was no systematic attempt to anticipate future changes to
production costs in these alternative locations and so the sustainability of these relative

5
Both of these real growth rates are clearly not sustainable in the long run. This, however, did not limit
their use in the evaluation exercise.

E Gilbert 25
current cost advantages was not explicitly considered.6 Other sources of incremental
cash flows were not established. Inflation and exchange rate movements were ignored
which simplifies the analysis, but had the effect of increasing Mauritius’ relative
attractiveness. The lack of any attempt to formally investigate these variables further
highlights the importance of the question of minimising its current costs – again
emphasising the importance of the firm’s cost management strategy.

By not discounting the projected profits the time value of money was ignored and, more
importantly, the risks of producing in the alternative locations were effectively treated
equally. This is especially important given that Mauritius is situated in an entirely
different economic, political and cultural environment and so should be considered to
be on a different level of risk.

The formal evaluation exercise allowed management to identify what the probable
relative production costs would be (in present terms) at the various locations – not the
expected value of the alternative sites. This was sufficient as it dealt with what the
decision makers believed was their key strategic objective – minimising production
costs.

Step 5: The final decision

In spite of Mauritius’ overwhelming advantage over the domestic locations in terms of

relative costs and expected profit, the potential risks of doing business in a completely
new cultural and economic environment were perceived to be very large. Consequently,
management decided to keep the production facility in Polokwane running for another
year at least to allow for a pilot plant to be set up in Mauritius to make products for
export to the European market. This deferred the decision to move the entire production
facility from Polokwane for a year. Moreover, the experience of running the pilot plant
would give management the experience to more accurately evaluate the viability of
running a production plant in Mauritius.

The nature of the final decision suggests that that management recognised the
limitations of the formal evaluation exercise. It allowed them to identify Mauritius as
their first choice for a future production facility. However, they decided to limit their
exposure by setting up a pilot plant in Mauritius and deferring the decision to move for
a year. While the results of the formal evaluation exercise were seen to be directionally
correct, they were deemed not to be sufficiently accurate to allow management to
commit to the choice suggested by the evaluation exercise. This suggests that the formal
evaluation exercise had a limited impact on the eventual decision. However their to
invest in a pilot plant only is entirely consistent with the conclusions of Real Options
theory which recognises that delaying an investment decision until key uncertainties
have been resolved is a valuable source of flexibility7.

In summary, this case study highlights a role for the formal (financial) evaluation
exercise different to that proposed by the traditional model. Rather than being the

6
Management’s decision in the final step of the process indicates that they were aware of the
shortcomings of this evaluation exercise.
7
The author is indebted to an anonymous referee for pointing this out. It does not, however, rescue the
decision making process from the critical analysis presented in this paper.

26 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

(decisive) basis for this entire decision-making process, it can be seen as a mechanism
which enabled the firm to identify the lowest cost alternative site from a pre-selected
group. It is an important step in the overall process but the importance of the strategic
factors was far greater especially in terms of defining the need for the capital investment
decision and the criteria by which alternatives should be chosen for further analysis.
They determined which locations should be (imperfectly) formally evaluated.
Moreover, whilst guided by the results of the formal evaluation exercise the final
decision taken was directly affected by the uncertainty regarding the accuracy of the
formal evaluation exercise and thus its conclusions. Even at this late stage in the
decision-making process, the results of the valuation exercise did not provide the
managers of Firm A with a sufficiently strong foundation for them to commit to their
final choice of location as was evidenced by the choice to build a pilot plant.

In terms of process, decision makers seemed to follow a filtering process rather than a
once-off comparison of estimates of value. Initially, a broad ‘mesh’ or filter is applied
to eliminate unwanted choices and then finer and finer filters are applied as the process
continues. The (truncated) value-related estimation exercise was effectively the final
mesh used to identify the optimal location.

FIRM B’S DECISION TO EXPAND ITS CAPACITY

Firm B is a large South African paper manufacturing company and the decision
analysed in this section was taken by the Tissue Paper Division. Capital expenditure
proposals are motivated at the divisional level but permission has to be obtained at the
group level if the amount to be spent is above R1 million. This is formally done through
a presentation to Firm B’s Board of Directors. Figure 2 provides an overview of the
capital investment decision-making process followed by the Division.

1. Recognition of the need for additional capacity

2. Identify First List of options: Option A selected

3. Identify Revised List of options : Option H selected

4. Pre-engineering Study: Option H rejected; Option E selected

5. Board Presentation: Option E accepted

Figure 2: An overview of firm B’s capital expenditure decision-making process

E Gilbert 27
Firm B’s Tissue Division held the largest market share of 37 percent. Management
viewed the market as essentially a commodity market with little room for product
differentiation. Consequently they believed that long term profitability could only be
achieved through high operating efficiencies and continued market dominance. This
implied that, firstly, the division must produce at the lowest possible overall cost (i.e. it
must not over-capitalise itself); and secondly, it must maintain a level of excess capacity
to block potential entrants. A key challenge for management was seen to be one of
balancing the two competing aims and this conflict becomes apparent at almost every
stage of the process.

Step 1: Recognition of the need for additional capacity

Two reasons were given by the division’s management for the need to consider
additional production capacity. Firstly, the rate of growth of market demand was
expected to increase; and secondly, they believed it to be a strategic necessity to
continue to maintain sufficient excess capacity to protect the firm’s dominant market
position from potential new entrants.

The change (increase) to the expected rate of growth of market demand (sales) for tissue
products was largely the result of the personal input of the group managing director. In
July 1995 he indicated to the Division that they should base their capital expenditure
planning on three scenarios: five, ten and fifteen percent annual growth in levels of
market demand (sales). Prior to this the Tissue Division had considered three alternative
scenarios of five, seven and a half and ten percent. It was estimated that the division’s
capacity constraints would be reached in 1998, 1997 and 1996, under the three new
scenarios respectively. The division thus proceeded to look for alternative ways to
supply the perceived need for an increase in productive capacity.

Step 2: Identify first list of options

Table 1 reports the four options which were initially presented to the Division capital
expenditure committee for consideration in August 1995.

Option C was rejected as only offering a short-term solution. It was then argued that
that the lack of in-house technical resources meant that it could only manage one of the
remaining three alternatives at a time. The required level (and timing) of the additional
capacity required was very sensitive to the accuracy of the expectation regarding the
rates of growth in future demand. It was felt that the highly significant increase in
demand (50 percent or greater) which would necessitate the consideration of a new
plant was not certain enough to take the risk of over-capitalising the division. Options A
and B could provide sufficient breathing space (in terms of additional capacity) to
confirm accuracy of these expectations. The upgrading options (A and B) should thus
be considered first as they would provide incremental tonnage at the lowest cost (and
risk). Moreover these options would allow the Division to correct for the lack of
adequate investment in the past which was constraining its current and future operating
efficiency levels.

28 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

Table 1. The first set of options considered by the division8

Additional
Option Action Capacity
(000’s tons p.a.)
Rebuilding of paper machine three (PM3) at the Site K
A 2 000
factory.
B Upgrading of paper machine four (PM4) at the Site B factory. 9 000
C Renegotiate the supply contract with SAPPI. 4 000
D Build a new paper machine. 27 000

Further consideration of Option D – building a new paper machine – was effectively

stopped at this stage on the basis that the risk of over-capitalisation was too great due to
both the higher cost of investment in a new machine and the significant additional
capacity it would bring. However, there was no formal analysis of the risk of the rate of
growth in reaching the levels necessary to justify this investment.

The reasons given for the decision taken to focus on options A and B were that it would
allow the Division to use its existing assets more efficiently and avoid overcapitalising
the division. The decision to exclude Options C and D was thus made on their inability
to meet the Division’s strategic goals – not through a comparison of the expected value
of the range of alternatives.

Outside consultants were briefed with the aim of identifying whether options A and B
were feasible and what the potential associated costs might be. This led to the next set
of alternatives considered in November 1995 – these are summarised in Table 2.
Options E to I are mutually exclusive with each other, but not with options One and
Two.

Step 3. Identify revised list of options

The outside consultants advised that further consideration of option A was not required
as option B provided clearly superior output and cost advantages. Five alternative forms
of option B were presented for consideration (see options E, F, G, H and I in Table 2 –
these are mutually exclusive alternatives). At this stage, the technical director, again on
the advice of the consultants, introduced two additional proposals for expenditure on
projects of a replacement/upgrade nature (Options One and Two in Table 2). Of these
alternatives, Option H, One and Two were selected for further analysis. The total
expected increase in capacity would be approximately 6 000 tons per annum.

The process for deciding between these options is seemingly based on criteria similar to
those proposed by the traditional value based approach discussed above. As shown in
Table Two, each option was presented with its expected benefit (additional output
added), its relative (estimated) capital costs, and finally, its Internal Rate of Return

8
The estimated capital costs of each of these alternatives were not reported at this point – however, as
the reference to overcapitalization in the rejection of Option D shows, this variable was deemed to be of
importance – even on an order of magnitude basis.

E Gilbert 29
(IRR) measure. Furthermore, the option with the highest IRR was the one selected
(Option H)9.

Table 2. The second set of options considered by the division

Additional Estimated IRR Payback

Option Action
Capacity Cost (%) Period
Upgrading PM4’s stock preparation using 5 700 tons 4 yrs 6
E R45 million 23.45
latest technology p.a. months
Option E but with essential equipment
5 300 tons 3 yrs 11
F only (risk of negative yield/quality R35 million 28.06
p.a. months
effects)
Upgrade and combine PM3 and PM4’s 5 000 tons 3 yrs 11
G R33 million 28.06
stock preparation p.a. months*
Utilise existing PM3 stock preparation 4 000 tons 2 years 6
H R15 million 46.59
with upgraded PM4 stock preparation p.a. months
Start up of PM3 machine (currently
4 700 tons
I mothballed – but concerns on quality, - - -
p.a.
technology exist)
Implementation of Distributed Control 4 years 5
One 817 tons p.a. R8 million 24.05
System months
1 170 tons 4 years 10
Two Fitting of Gas Fired Drying Hood R10 million 21.55
p.a. months
* The IRR and Payback Period calculated for options F and G were identical. When questioned about this
highly unlikely outcome the Technical Director for the Division (who prepared the document) said that
these results were correct and any similarity was simply a coincidence.

There are two problems with this conclusion, however. Firstly, the results of the
supposedly redundant payback period (PP) measure were presented for all of the
options considered. When interviewed, management regularly referred to the PP results
when explaining the relative attractiveness of that alternative. This indicates that
decision-makers do not agree with the theoretical redundancy of the PP measure and do
not feel comfortable with the use of DCF techniques in isolation10. Secondly, while the
choice of Option H is justified (as it had the highest IRR), options One and Two were
also selected for further analysis – even with their very ordinary IRR (and PP) figures.
This suggests that the IRR (or even PP) measures were not the primary basis for the
decision at this point. When asked about this choice, the Divisional Managing Director
indicated that because of his (personally) pessimistic outlook regarding future demand,
he had wanted the smallest possible investment of additional assets into the production
process. He felt that anything more would have been unnecessary and would have led to
the division over-capitalising itself. Option H, One and Two offered this combination.
The importance of the division’s strategic aims in this decision-making process re-
emphasised at this point as the inclusion of options One and Two only makes sense as
they maximising management’s ability to implement their strategy of ‘sweating the
assets’.

9
This is in spite of the potential problems with using IRR to rank mutually exclusive alternatives. The
author is indebted to an anonymous referee for drawing my attention to this point.
10
An alternative explanation pointed by an anonymous reviewer is that the PP method is a common
proxy for the risk associated with a project. This could explain its near ubiquitous presence but if
correct, implies that the use of a risk adjusted discount rate by the DCF approaches is somehow
inadequate.

30 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

The next stage of the capital expenditure process was a pre-engineering study to
determine a more accurate estimation of the costs of options H, One and Two for
budgeting purposes.

Step 4: Pre-engineering study

The significant results of this study were that the chosen option (H) was discarded on
the advice of the consultants11. Option G was also excluded on the same basis while
option I was rejected on the basis that it did not present a long term solution.12 The
choice was thus between Options E and F.

Option F, while offering a higher IRR, suffered from the problems of technology
obsolescence in the future which would negatively affect the productivity of all the
associated machinery and lead to lower quality levels. On the other hand, option E
would allow PM4 to run at its designed capacity. It would correct for the original lack
of support processes and thus would increase both levels of output and improve the
efficiency of the existing capital stock. While significantly more expensive (R45 million
as compared to R15 million), its use of new technology would mean that it would
require replacement much later than any other alternative. The importance of these
efficiency gains would be multiplied by their relative longevity13.

In spite of it having a lower IRR (and a longer PP) than option F, option E was selected.
The basis for this decision was that it would supply sufficient additional capacity for the
(downgraded) expected needs of the Division as well as prolong the life of the PM4
machine and improve its operating efficiency measures over this period. This suggests
that either these benefits either not fully reflected in the IRR calculations completed in
the previous stage, or alternatively, that the IRR measures, if accurate, are not important
in the decision-making process. Management indicated that these benefits were not
initially included because they were judged to be unquantifiable and it was only after
the pre-engineering study that this data was available. However it is important to
remember that the choice of focus of the pre-engineering study was option H.
Consequently it was effectively only an accident this data on Option E became
available. Furthermore, new IRR estimates were not estimated and presented in support
of this choice.

This stage of the process highlights a significant problem with the implementation of a
model of decision-making based on the comparison of estimates of value. The data
required to accurately estimate the value of the competing alternatives is very expensive
either in terms of management time (or consultants’ fees). As a result, managers need to
prioritise options for further consideration and in this case, they did it on qualitative and

11
It was not possible to cost effectively implement this option given the physical layout of the Site B
plant at the time of this study.

12
The machinery’s technology was obsolete and the expected quality of the output was deemed to be
not be of a sufficient quality.
13
This strongly indicates that the alternatives under consideration had significantly different economic
lives. This raises further problems with the use of IRR to rank these projects – the reinvestment rate
assumption becomes a problem. I am again indebted to the anonymous referee who brought this to my
attention.

E Gilbert 31
strategic grounds (the ability of Option E to minimise additional investment while
leveraging the unused production capacity of the existing assets).

The process of elimination outlined in this step clearly highlights the continued
importance of qualitative variables in the decision-making process in spite of the
apparent use of DCF techniques. Each alternative was carefully evaluated judged in
terms of its alignment with the strategic goals – in spite of there being estimates of the
projects’ IRRs14. The estimate of value produced by a DCF evaluation technique
depends on the accuracy of their assumptions regarding the future values of all relevant
factors. The above example suggests that these techniques produce estimates that are
not accurate enough to provide decision makers with an adequate basis for deciding
between alternatives. The DCF evaluation techniques are either somehow incapable of
accurately capturing the value of the alternative’s alignment with these goals, or,
alternatively, it may be that the costs of acquiring information required for the use of the
traditional decision-making approach are too great to allow for its use in comparing
alternative courses of action. The fact that this type of analysis is completed for the
presentation to the board suggests that the latter reason is correct in this case.

The final stage of the decision-making process was to present the results to the Capital
Expenditure Committee of the Group’s Board of Directors in August 1996.

Step 5: Board presentation

The proposal to upgrade PM4 consisted of the Division’s request for permission to
carry out their planned course of action (Options E, One and Two). The upgrading of
PM4 was presented as a viable short-term alternative until the installation of a new
machine could be seen to be ‘strategically appropriate’. The division’s management
clearly communicated this choice as an opportunity to improve the efficiency of its
capital stock and reduce the need for additional future non-productive investment
expenditure. This alternative allowed it revitalised the capital stock of its existing
production facility and avoided the gradual decline in its long term capacity. The board
approved the application and the changes to PM4 took place.

Some formal evaluations of the proposed alternatives (IRR; PP) were included but these
results were not used to justify the course of action selected by indicating how these
were the best results available. The only other course of action mentioned in this
presentation was to bring the installation of a new paper machine forward. No analysis
of the expected value of this alternative was presented15. This suggests that the only role
of the formal evaluation included in this presentation was to confirm the viability of the
proposed plan of action to the board rather than its necessary superiority over
competing alternatives.

In summary, the decision that Firm B took was initially prompted by a change of
expectations, modified by the division’s existing competitive strategies and then
justified by the formal analysis of a limited number of alternative solutions. The key

14
The validity of the use of these IRRs to rank alternatives is doubtful given the mutually exclusive
nature of the alternatives and the variation in the alternative projects’ lives.
15
This option had been effectively discarded at the first opportunity (see the discussion of Step 2
above).

32 SA Journal of Accounting Research Vol. 19 : No. 1 : 2005

choices throughout the process were made with the aim of balancing the competing
strategic aims. These choices made were justified on the grounds of qualitative, and not
quantitative, criteria. When used, the DCF techniques (combined with the PP method)
provided support for the decision taken on other grounds.

KEY DIFFERENCES TO THE TRADITIONAL MODEL

The review of these decisions suggests that the recognition of the need for additional
investment is affected by their strategic choices. The final choice made is a result of the
application of a multi-staged filtering approach to a range of potential alternative
solutions. Qualitative factors are applied over a series of steps in this filtering process to
reduce the list of alternatives which are further evaluated. Of these, the degree of
alignment of the alternatives with the company’s strategic goals is usually the most
important factor. Estimates of project value are not the key basis for management’s
choice between alternative capital investment opportunities. This data suggests that
capital investment behaviour can be better understood within the context of the
competitive environment of the firm and its choice of strategic responses. In particular,
this model deviates from the traditional model of decision-making in the following key
areas:

1) The traditional model does not consider the genesis of the projects being evaluated.
This study suggests that capital investment decision-making processes are triggered
by a change in expectations regarding future investment needs. These changes in
expectations are normally closely related to the management’s strategic focus. For
example, Firm A would not have considered the need to change its plant’s location
if it had not decided to try and increase its export sales;

2) Unlike the traditional model which implicitly assumes a one stage process, the
observed decision-making process consists of several stages. At each stage a filter
is applied and a smaller list of alternatives is identified for further analysis;

3) At each stage of this process the choice of the alternatives for further analysis is
done primarily on the basis of a series of qualitative factors. Alignment with
strategic goals is the most common rationale used for these choices. Estimates of
the value of alternative courses of action are not calculated or used in these early
stages. If anything, management seem more focused on establishing the expected
relative costs of alternative options;

4) Formal evaluations of projects (when conducted) are used to justify the viability of
the preferred course of action, not as a basis for the choice between alternative
projects. While it is an important discipline imposed on the outcome of the choice
process, it does not provide the key input upon which the final choice is made.

By focusing attention on (correctly) estimating the value of the alternatives, the

traditional model implicitly assumes that all sources of potential value can be measured
and incorporated into the estimation of the incremental cash flows. However while costs
can be established with some degree of accuracy (and are usually vital to the
companies’ competitive strategy choices), other factors which affect the expected value
associated with the project are hard to identify.

E Gilbert 33
Another key barrier to the usefulness of DCF techniques in practice is the significant
investment of managerial time required to obtain the data required to complete these
estimations with confidence. It is not usually cost effective to complete this data
collection exercise for all alternatives.

IMPLICATIONS FOR FUTURE RESEARCH

There is a need for a survey to establish how the behaviour observed is representative
for other South African firms.

The importance of competitive strategy in the triggering and filtering of capital

investment decisions suggests that the structure of the industry in which the firm
operates could have an impact on firms’ capital investment decisions. Alternative forms
of competition (e.g. through product differentiation or service offerings) could lead to
different capital investment responses to similar changes in the environment. Both the
firms examined in this paper viewed the products they produced as commodities which
lead to their focus on capital investment decisions which minimised costs – but this is
not necessarily the case for all firms.

The perceived usefulness of DCF techniques is directly related to both the confidence
that the decision makers have in accuracy of the assumptions used in these techniques
and/or the ease with which these assumptions can be confidently made. Firms should
use DCF techniques more often if the economic environment is stable; and/or they are
operating in less concentrated industries.

CONCLUSION

The challenge facing managers making capital investment decisions is significant.

Formal evaluation techniques promise an objective, value maximising solution to this
problem. However, as managers have a limited awareness of opportunities and time to
evaluate them, their observed responses involve the use of shortcuts and
approximations. Understanding companies’ competitive environments and strategic
reactions to these environments are vital to understanding their capital investment
decision-making behaviour. While DCF techniques can, and do, play an important role
in capital investment decision-making, the costs (and sometimes impossibility) of
completing them properly means that their use is always going to be limited. If an
analysis of capital budgeting focuses only on the use of these measures, it will be
similarly limited.

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