Discussion Assignment 3.1

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Kaunas University of Technology, Lithuania, [email protected]

Capital budgeting decisions are among the most important decisions made by business entities. Companies have patterns that guide how investment opportunities are identified and how investment decisions are made. During capital budgeting process investments compete for scarce corporate resources and some projects survive the intrinsic selection process while others don’t.

The most significant deficiency of corporate capital investment studies is their limited focus on project evaluation and risk analysis tools rather than on the entire investment decision-making process.

The main objective of this paper is to investigate the peculiarities of capital budgeting process. Research method – systematic scientific literature analysis. Keywords: capital budgeting process, investment decisions, organizational capabilities.

Under conditions of global economy the steady increase in the variety and scale of uncertainties, competitive interactions and risks prevail, and the difficulty to make reasonable investment decisions is growing.

Most academicians state that effective allocation can best be achieved with a sophisticated capital investment process. They assume that a sophisticated process increases the probability of making relevant investments by ensuring that corporate strategy will be followed, that all investment opportunities will be considered appropriately and consistently, and that the counterproductive political aspect of informal decision making will be minimized.

Because capital investment decisions rank among the most critical types of managerial decisions made in a company and can have major long-term implications, both positive and negative, for the success of a company, managers must understand how capital investment decisions are made if they are to participate in improving corporate performance.

Ultimate part of the research on capital investment has been conducted by financial scholars who have developed project evaluation techniques. Though, there is a management literature that takes a process approach to the subject and places financial evaluation in the context of a complex organizational decision process

The main aim of this paper is to investigate the peculiarities of capital budgeting process. Research method – systematic scientific literature analysis. Keywords: capital budgeting process, investment decisions, organizational capabilities.

Effective investment decision making is essential to corporate survival and long-term success. These decisions help to mould company’s future opportunities and develop competitive advantage by influencing, among other things, its technology, its processes, its working practices and its profitability.

There are several important features for capital budgeting decision making to be effective (Boquist et al. (1998), Adams et al. (2004)):

It is dynamic, not static. It explicitly recognizes that the quality of information can be improved over time. Thus capital budgeting should be a sequential, multiple decision process that integrates the information needed to obtain cash flow estimates into the financial analysis of the cash flows. It is linked to the strategy implementation in relation to the company’s multiple stakeholders. Therefore, project proposals should be supported by relevant non-financial data and forecasts. It recognizes the options inherent in value-enhancing capital budgeting. It takes a cross-functional approach. The quality of estimates of expected cash flows and the uncertainty in cash flows are critical. Since the underlying information for these estimates comes from many functions within the company, those providing information must see themselves as strategic partners in the process.

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It views the company’s compensation system as a centerpiece of capital budgeting. Unless the way in which managers and employees are rewarded is aligned with how capital is allocated, there will always be a possibility for poor decisions. It stresses the importance of performance-based training. The people using capital budgeting must understand it, buy into it, and implement it consistently across the entire company. Cross- functional training designed to enhance the performance of those involved is essential.

The decision making process constructs that are particularly relevant characteristics of capital budgeting processes literature are procedural rationality and politics (Eisenhardt & Zbaracki (1992), Dean & Sharfman (1996)). Procedural rationality is defined as the extent to which the decision process involves the collection of information relevant to the decision and the reliance upon analysis of this information in making the choice (Dean & Sharfman (1993)). Political dimension of decision making encompasses two main ideas. First, people in organizations have differences in interests resulting from functional, hierarchical, professional, and personal factors (Dean & Sharfman (1996)). Second, people in organizations try to influence the outcomes of decisions, so that their own interests will be served, and they do so by using a variety of political techniques.

Although it has been suggested that political behavior and procedural rationality are two ends of a continuum describing a single dimension of decision making and provide competing explanations for decision-making behavior, Dean & Sharfman (1993) empirically demonstrated that they are two distinct dimensions. This position is also supported by Eisenhardt & Zbaracki’s (1992) conclusion that strategic decision-making is best described by the weaving of both boundedly rational and political processes.

The research of investment management literature shows that two main approaches defining the capital budgeting can be distinguished: the normative approach and the process approach.

The normative approach represents the traditional theory on capital budgeting presenting rules on which basis the enterprise can make an investment decision. According to this approach the emphasis is on the financial evaluation and selection of the long term-investment in assets, and the development of advanced capital budgeting techniques and their application in various situations are key issues (Saaty (1994), Prueitt & Park (1997), Trigeorgis (2000), Madhani & Pankaj (2008), Angelou & Economides (2009)).

Although rigorous evaluation tools are important components of a sophisticated capital budgeting process, investment success depends on improving the entire process. Almost three decades ago, it was noted that too much emphasis was being placed on methods of ranking and selecting capital budgeting proposals. Focusing on the simple selection phase is myopic, and a more global approach is necessary to fully understand the capital budgeting process (Farragher et al. (1999), Adler (2000), Burns & Walker (2009)). Therefore from this point of view the capital budgeting process must be viewed in its entirety and the informational needs to support effective decisions must be built into the company’s decision support system.

The process approach to the capital budgeting endorses broader perspectives, attempting to explain the way the companies actually handle into effect the investment decisions, the way the investment opportunities are identified and analyzed, the way the decisions are made, the way the returns on investments are evaluated (Ducai (2009)). The models deriving from the process approach are mostly based on extensive case studies achieved in the enterprises to identify the decisive stages related to the investment opportunity. Therefore the scientific literature on the subject therefore tends to be strongly empirically oriented.

In academic literature exists the large variety of opinions concerning the stages of the capital budgeting. Maccarrone (1996) state, that capital budgeting should be held in the wider context of strategic

planning and identifies six fundamental phases in the capital budgeting process. At first investment opportunities are identified, then development and evaluation is performed by collecting relevant and detailed information for each alternative, and evaluating their profitability and global attractiveness. A screening of investment proposals which have passed through the previous phase might be necessary because of financial or strategic factors. As a result, some projects might be cancelled or postponed to another planning period. Authorization or project approval, and implementation/control are next phases. Final stage is post-auditing, that enables to compare the outcomes of each project with budget targets in order to assess forecast accuracy and identify error patterns with a feedback effect on the whole decision process. Under post-audit and control, if a project does not appear to be developing as expected, the firm may want to abandon the project and reallocate its capital (Prueitt & Park (1997)).

Koch et al. (2009) also list six components in the process. The stages are identification, search, information acquisition, selection, financing, and implementation and control.

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According to Ducai (2009), the process of capital budgeting is being carried out in five stages: examining and the selection of the investment projects, the proposal of the capital budget, the approval of the budgeting and its authorization, surveying the execution of the project and exerting the control after the projects execution starts.

Whereas, Burns & Walker (2009) describe the capital budgeting process in terms of four phases: identification, development, selection, and control. The identification stage comprises the overall process of project idea generation including sources and submission procedures and the incentives/reward system, if any. The development stage involves the initial screening process relying primarily upon cash flow estimation and early screening criteria. The selection stage includes the detailed project analysis that results in acceptance or rejection of the project for funding. Finally, the control stage involves the evaluation of project performance for both control purposes and continuous improvement for future decisions. All four stages have common areas of interest including personnel, procedures, and methods involved, along with the rationale for each.

As the literature review above described, various researchers have applied various labels, yet the main idea of the process sequence is almost the same and the stages of the investment process are, in substance, proposal initiation, proposal development, proposal management, and project approval. An investment proposal is initiated in response to identification of a need or a problem. The development of the proposal includes estimation of the costs and benefits, and evaluation of alternatives. Proposal management is the guiding of the investment proposal through the organization, culminating in project approval.

These stages have been found to occur in a bottom-up manner, with some iteration between contiguous stages. Proposals are initiated and developed by the division specialists thought to be closest to the relevant product market or operation and thus to have the best information with which to identify needs and opportunities. Division managers conduct proposal management. The participation of senior management is indirect, consisting primarily of providing the organizational structural and strategic contexts for the investment decision.

This generalized model, describing a complex multi-stage process, is the standard process model of capital investment or the Bower-Burgelman model (Maritan & Coen (2004)).

However, the capital budgeting process of investing in strategic projects that generate new capabilities is considerably different. Senior managers are directly involved in the definition and impetus stages of these projects as well as indirectly involved through setting the structural and strategic contexts.

Most existing research hasn’t investigated how the process might vary with investment characteristics and almost in all capital budgeting process studies multiple investment decisions were examined, but the resulting models were based on generalities across investments.

Maritan (2001) considered the population of 164 capital investment proposals and revisited the Bower-Burgelman model using a resource-based view lens to investigate the process of investing in strategic projects that create organizational capabilities.

A capability is a company’s capacity to deploy its tangible or intangible resources, to perform a coordinated task or activity to achieve a desired outcome (Amit & Schoemaker (1993), Helfat & Peteraf (2003), Maritan & Florence (2008)). Arguments in the literature (Helfat (1997), Helfat & Peteraf (2003)) suggest investment as a means for developing capabilities. However, capabilities involve complex combinations of resources and therefore are generally non-tradeable in factor markets (Amit & Schoemaker (1993)).

The approach to use the concept of capability in defining individual investment opportunities and investigating the capital budgeting process as an investment-level rather than a firm-level construct, endues the possibility that the same company simultaneously follows distinct processes for distinct investment projects and potentially develops a higher-order capability to manage these different processes.

Three types of investments in capabilities can be defined, that is investments to maintain the stock of an existing capability, investments to add to the stock of an existing capability, and investments to build a new capability (Maritan (2001), Maritan & Coen (2004)).

Maintain and add investments require no qualitative change to a company’s capability stock. These investments decision makers make to preserve or to increase the “quantity” of a capability, with the intent of leveraging existing capabilities and competencies. Conversely, new investments represent a qualitative change to the company’s capability stock, and decision makers fulfil this change with the intent of

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broadening the opportunity set available to the company. Related to these quantitative and qualitative changes in capability stocks prevail differences in uncertainty.

A decision related to maintaining a capability stock would usually involve the least uncertainty, since it is a decision to preserve an existing condition. A decision related to adding to an existing capability stock typically involves more uncertainty. The company involved has familiarity and experience with both accumulating and using the capability, but there is some uncertainty about whether the company will achieve the desired ends with the increased quantity. A decision about creating a new capability involves the highest degree of uncertainty. The firm does not have experience either accumulating or using the capability. Because of these underlying differences in the level and type of uncertainty, differences in the organizational process used to make the three types of investment decisions subsists.

The clearest differences are between the processes followed for investments to maintain or add to existing capabilities and the process followed for investments to build new capabilities. The Bower- Burgelman process model essentially captures the information flows and the relationships between elements of the process of investing in an existing capability, whether the investment maintains that capability or adds to it. However, the standard model captures neither the information flows nor the relationships between process elements for investing in a new capability. Hence, the three originally defined categories can be resolved into two, “existing”, which combines maintain and add investments, and “new”, which appears a separate type.

The main difference between existing capability sub-model and new capability sub-model is that new strategic projects originate at a more senior level of an organization, specifically, at the senior division level rather than at the operating level (Maritan (2001), Maritan & Coen (2004), Adams et al. (2004)). Senior managers prosecute broader, less local information searches than operating-level managers and are consequently better able to identify investment opportunities in new capabilities that are outside their current experience. Another difference is the direct intervention in the development of the investment proposal by both senior division and corporate managers. This intervention results in a less procedurally rational and more political decision process. There is more extensive exercise of power and use of negotiation, resulting in quasi decision making, wherein decisions are effectively made by senior management well in advance of formal, final approval.

If potential investments in new and existing capabilities could be identified and classified a priori, a decision process could be matched to each investment. This explicit matching of process to investment type could itself be developed as an organizational capability (Maritan (2001), Maritan & Coen (2004, 2011)).

The capability to match investment decision process to investment type is an example of a higher- order capability, what is sometimes referred to as a dynamic capability (Teece et al. (1997), Maritan & Coen (2011)). This higher-order capability provides the capacity to make changes to the lower-order ones, in this case, the capability to effectively manage decisions about investing in operating-level capabilities. If matching process to type leads to improved performance, a company with a superior capability to make the required distinctions among investment types and match an investment to a decision-making process may develop a competitive advantage.

Capital investment decision-making has long been of interest to management scholars. In contrast to the normative approach, the process approach has a broader perspective and tries to explain and describe the whole process by which projects become identified, developed, justified and finally approved. Most models describing the capital budgeting process are based on extensive case studies, and literature on the subject therefore tends to be strongly empirically oriented. Academicians have however, also tried to analyze how firms could improve their investment processes, why it is difficult to make a clear distinction between descriptive statements and normative views.

The dominant process model of capital investment is the Bower-Burgelman model. This model describes a complex multi-stage process in which managers at multiple levels of a company play distinct roles. A technical and economic process driven by lower-level managers leads to project definition, a sociopolitical process driven by middle managers give a project impetus and organizational structures, systems and objectives and priorities developed by senior managers provide structural and strategic contexts for the investment decision.

However, the process of investing in strategic projects that create new organizational capabilities is different. Senior managers are directly involved in the definition and impetus stages of these projects as well

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as indirectly involved through setting the structural and strategic contexts. This finding supports the idea that investment decision making is a decision-level and not a firm-level construct.

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