Page 137 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes Capital Investment Analysis: Most proposals require significant amounts of new capital and
techniques for analyzing proposals such as NPV, IRR are used. Net present value is the excess of
the present value of estimates cash inflows over the amount of investment required, and the
internal rate of return implicit in the relationship between inflows and outflows. An important
point is that these techniques are used in only about half the situations in which, conceptionally,
they are applicable. There are at least four reasons for not using present value techniques in
analyzing all proposals.
1. The proposal may be so attractive that a calculation of its net present value is unnecessary,
e.g. a newly developed machine that reduces costs substantially.

2. The estimates involved in the proposal are so uncertain that making present value
calculations are not worth the effect. Since one can’t draw a reliable conclusion from
unreliable data. For e.g., the estimates of sales volume of new products for which no good
market data exist. In these situations, payback method is used.
3. The rationale for the proposal is something other than increased profitability e.g.,
investments made to improve employee morale, the company’s image or safety.
4. The proposed investment is necessary to comply with guidelines of ‘Regulatory
Authorities’, for example: environmental laws.

Did u know? The Management Control System provides an orderly way of deciding on
proposals that cannot be analyzed on quantitative techniques.
The following are some considerations that are useful in implementing capital expenditure
evaluation systems.
1. Rules: Companies, usually, have rules and procedures for the approval that can be approved
by the plant manager, subject to annual budgetary amount and larger amounts go to
business unit heads, CEO or to the board of directors.
The rules also contain guidelines for preparing proposals and general guidelines for
approving them. For example: small cost saving proposals may require a maximum
payback of two or three years. For other proposals, a minimum required earnings rate to
be used either in NPV or IRR analysis same for all proposals or different rates for different
risk characteristics. Proposals for additional working capital may have a lower rate than
for fixed assets.
2. Avoiding manipulation: To avoid manipulation of estimates by sponsors, the project
analyst should have some great feeling. The reputation of project sponsors with excellent
track record can provide a safeguard.
3. Models: In addition to the basic capital budgeting model, there are specialized techniques,
such as: risk analysis, simulation, scenario, planning, and game theory, option processing
models, contingent claim analysis and decision trace analysis. The planning staff should
require their use in situations.
4. Organization for analysis: A team may be formed to evaluate large and important
proposals and the process may require a year or more. Even for smaller proposals, there
is usually considerable discussion between the person who is sponsoring the proposal
and the headquarters staff. For an important proposal, it has to go through a large number
of line and staff executives, before it is submitted to the CEO. The CEO may retain the
proposals for the further analysis, before final decision is taken.

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