Multinational Capital Budgeting Systems on the Move

Jan Gadella, John Hall and Wim Westerman1

January 2002

**********************************************

Wim Westerman

Faculty of Management and OrganizationUniversity of Groningen

P.O. Box 8009700 AV Groningen

1 Jan Gadella works at the Faculty of Economics at the University of Northampton, United Kingdom. John Hall works at the Faculty of Economics of the University of Pretoria, South Africa. Wim Westerman works at the Faculty of Management and Organisation of the University of Groningen, The Netherlands. The authors are indebted to suggestions and comments of several of their colleagues. Of course the usual disclaimer remains.

The NetherlandsTelephone: +31-50-3637088

Fax: +31-50-3637356Internet: w.westerman@bdk.rug.nl

Abstract

The continuous expansion of the body of knowledge and experience of capital

budgeting systems within multinational organisations has led to vast changes. The

traditional project management approach begins with assigning tasks to team

members, linking authorisations to hierarchical levels. Assembling and processing

information, as well as operational risks assessment, lead to specification(s) of the

investment. The financial performance of the project is monitored. Behavioural

considerations influence the rationality of the decision-making process. In the

strategic planning approach, the strategy design must govern the allocation of

resources. It is imperative that the range of strategic risks is identified and quantified,

including relative competitive positions created by the capital investment. The

investment decision-making process may depend heavily upon a suitable financial

planning approach. One can examine and analyse the magnitude of the investment

expenditure, at the same time addressing the required and available sources of

finance. The financial appraisal may utilise both accounting and discounted cash flow

methodologies. In addition, the financial analysis may incorporate different types of

financial risk assessment, e.g. sensitivity and scenario analyses.

1

Section 1. Introduction

The capital budgeting process is an important aspect of financial management.

However, more is involved than just the selection of capital projects. According to

Northcott [1992], capital budgeting includes both selecting long-term investments

and planning for their financing. As a part of the management control cycle of a firm,

capital budgeting is about the control of capital outlays and corresponding operational

cash flows. Multinationals are very complex organisations, because they operate

across national borders. The home country headquarters, as a rule, directs the foreign

operational units. In most cases these units are structured according to the normal

systems of business and/or functional areas. The capital budgeting systems of such

firms involve not only financial control of capital investments, but also intense

personal relationships management, targeted local strategy development and the

building of complex financial information systems. The capital budgeting systems of

multinationals are influenced by varying attitudes of external stakeholders

(governments, suppliers, consumers and so on) as well as internal stakeholders

(especially employees, managers and shareholders). While these factors may have a

considerable effect at a corporate level, one factor in particular has made a large

2

impact on systems development overall, namely the ever-expanding body of

knowledge and experience of capital budgeting. Both managers and scientists have

been working on new concepts. This article describes the evolution of the

developments, present an overarching framework and discusses three case studies.

Despite occasional warnings by renowned scholars such as Pinches [1982] and Ross

[1999], many financial professionals and theorists have attempted to improve

financial investment selection techniques, without taking into account issues of

organisational behaviour and those relating to strategy adequately. Nevertheless,

more pertinent literature has appeared over the last two decades. For example, Myers

[1984] and Wissema [1985] began a theoretical trend when they combined strategic

and financial issues. Later Tomkins [1991], Northcott [1992], Oldcorn and Parker

[1996], Grundy [1992; 1998], Slagmulder [1997] and others amalgamated

organisational factors, strategy developments and financial elements into one value-

based management concept of capital investment. Interestingly, a number of

consultancy firms are in the process of refining this management approach. This more

holistic approach to the capital investment decision-making process is deemed to

have been accepted as the present day best practice [cf: Lumby & Jones, 2001].

However, Farragher, Kleiman and Sahu [1999] and Verbeeeten [2001] in recent

surveys based in the USA and the Netherlands could find conclusive evidence that a

higher level of sophistication in the capital budgeting process leads to more

3

substantial corporate performance. Perhaps capital budgeting is not about developing

a superior decision-making system (“one fits all”), but should it focus on enhancing a

contingency review procedure of the organisation in question (“it suits me”).

Goold and Campbell [1987] point out that management control styles should be

adapted to the characteristics of the corporate environment and the corporate

resources concerned. The control matrix they propose consists of two axes. The

horizontal axis, the x-axis, reflects the amount of centralisation in the planning,

whereas the vertical axis, the y-axis, delineates the flexibility or tightness of the

control. The principal approaches focus on the strategic planning style, the strategic

control style and the financial control style. The strategic planning approach stresses

centralised strategic planning, and requires limited control of strategic results of

capital investments. As a rule, strategic control involves loose planning but tight

control procedures. In the context of capital budgeting, strategic checks tend to be of

minor importance. However, the concepts of project control should be applied to

manage the operation of the investment process. Instead of a financial control

approach, this article would suggest the inclusion of a financial planning approach.

The latter approach is especially cognizant of ex-ante financial measures, but treats

ex-post checks as a matter of growing importance. The three above approaches have

grown in depth and breadth, including more specialised knowledge and experience,

whilst incorporating increased areas of interest.

4

In this article, firstly the approaches to capital budgeting systems in multinational

firms are examined, moving on to the domain of the management control cycle. The

development of three capital investment approaches in multinational firms is

explored. Secondly, the project control approach is described. Thirdly the strategic

planning approach is discussed. Fourthly, the financial planning approach is

addressed. Fifthly, a conceptual framework is presented and applied to three case

studies. Finally, recommendations are made to both academics and practitioners.

Section 2. Project control approach

Multinational firms usually consist of a (regional) headquarters and local subsidiaries.

Headquarters supervises and assists the subsidiaries. In order to realise particularly

corporate scale and scope effects [Funk, 1999], subsidiaries do not perform all

management functions all by themselves. That is why intra-firm groupings, for

example, of sales subsidiaries vis-à-vis production subsidiaries, may exist. Also, local

subsidiaries may cover one or more lines of business. This gives rise to groupings in

divisions, business units and so on. Moreover, geographic distance may interfere with

intra-firm interaction. This may cause firms to group their subsidiaries per region, be

it a continent, a country or even a province. All in all, multiple layers may exist

within multinational firms. Capital investment involves the joint effort of many

5

general and specialist corporate officers [Bower, 1970]. Therefore, project teams may

differ with regards to length of time in operation, number of officers (changing over

time), functional composition and personal involvement. Defining individual and

group tasks goes along with assigning responsibilities. Authorisation to decide on the

use of resources depends on the nature of the unit at hand and the level of

management involved. Task control as a part of project control is about checking

whether the rules are complied with [Anthony, Dearden & Govindarajan, 1992]. It

may enter the scene of the investment project either via personal supervision or via

formal information systems.

Information briefings or memoranda serve as focal points in the decision-making

process. One of the main tasks of a project team is to assemble and process data on

the capital investment. Aspects from various functional areas may have to be taken

into account, such as production, marketing, finance and human resources. Readily

available internal and external data form the basis of the data gathered. However,

these data may be of limited use for investment decisions (for example, historical cost

price figures) or may even be wrong (for example, old price lists from suppliers).

Many important data cannot be assembled on a regular basis. They must either be

searched for ad hoc, or have to be bought from external providers. Additional

information may be informally acquired, for example, from e.g. non-executive board

members and suppliers. Nevertheless, lack of information may remain a problem,

6

particularly in (new) product development projects. The same problem may apply

when there is a severe lack of time, for example, when competitors threaten to

capture a market. In the processing of the information assembled, data are created for

decision-making. Strategic planning techniques, financial planning tools and

professional judgement, among other factors, facilitate information processing (via

software). Corporate capital investment manuals, including targeted standard

guidelines and forms, may end up guiding the process [Bierman and Smidt, 1993, pp.

504 –521; Segelod, 1997].

The assembly and processing of information goes hand in hand with the identification

and handling of operational risks. These may influence capital investments especially

in multinational firms. Jahrmann [1991] distinguishes between

1) market risks (e.g. sales markets are falsely or insufficiently targeted);

2) price risks (the danger of price changes, e.g. caused by competitors);

3) credit risks (stemming from partial, late, or from non-payment);

4) delivery risks (suppliers do not comply with delivery terms);

5) transport risks (damage or loss of goods); and

6) currency risks (effects of currency rate fluctuations on transactions).

The non-currency risks may be reduced by avoiding specific markets, as well as by

using price clauses in contracts, hedging on commodities exchanges, requiring down

7

payments, asking for credit guarantees (for example using bills of exchange), closing

transport insurance and changing distribution channels. Exposure to the currency

risks on transactions can be hedged by closing forward contracts with banks, using

standardized futures contracts and closing currency options contracts [Eiteman,

Stonehill and Moffett, 2001]. Firms may leave operational risks partially open. Risk

attitudes tend to be strongly influenced by both financial and strategic considerations.

Investment projects are usually not controlled in a scientific manner, as suggested by

the standard literature [cf: Meredith and Mantel, 1996]. The desired results of capital

investment projects may only be partly defined upfront. Several tasks may have to be

performed and they may be unclear. Also, the subdivision and coordination of tasks

may be accomplished ad hoc. However, according to Pike and Neale [1993, p. 255],

“the best projects emerge from a tightly controlled process”. The capital investment

project control in terms of timing, precedence, outlay and performance may be poor,

however. Bounded rational decision-makers who have a limited capacity to process

information cannot accomplish optimal results. They replace optimising by

“satisficing”, sequentially searching for solutions on problems, developing repertoires

of actions, restricting alternatives and decomposing programmes [March and Simon,

1958]. In addition, organisational learning involves developing decision-making rules

[Cyert and March, 1963]. It may also be explicitly striven for in capital investments

[Butler et al., 1993]. Decision structures are governed by common rationalisations

8

along chains of reasoning [Weick, 1979]. In order to be able to undertake some

capital investment projects, mental schemas (representations) need to be broken down

in a change process [Tomkins, 1991].

The project control approach focuses on handling capital investments according to

standard operating rules. Information management and risk management serve as

central devices in rolling out projects. Investment processes are governed by bounded

rationality, though. There is little strategic planning or financial planning. The

approach may best suit high-tech firms (such as dot-coms), government firms and

regulated firms. It may also fit with replacement investments and forced investments.

It may be applicable to small firms and small investments.

Section 3. Strategic planning approach

Although one does not necessarily need to agree with Maccarone [1996] that most of the

capital budgeting processes should be looked at in the context of strategic planning, it is

indeed true that corporate strategy is often the driving force of capital investments in

multinational firms. Firms may focus on designing strategies here [Mintzberg, 1990;

Mintzberg and Lampel, 1999]. Strategy development is done deliberately instead of

intuitively or instantly. The chief executive (corporate, business, or local) officer acts as

a creative architect. The strategy design is kept simple: strategy development is just

9

about making choices. A well-known strategic design technique for capital budgeting

processes is the Strength, Weaknesses, Opportunities & Threats (SWOT) analysis

[Aaker, 1998]. An internal analysis unfolds the strengths and weaknesses of the firm or

unit itself. An external analysis shows the opportunities and threats stemming from the

environment. Key success factors (KSF’s) to be used as an input for capital budgeting

may become clear this way. Firms may focus on the synergy between a specific

investment and the firm as a whole [Wissema, 1985]. When developing capital

investments they may also strive to dig deeper, uncovering core competencies and

assigning strategic resources to these [Hamel and Prahalad, 1994]. Finally, balanced

scorecard concepts, distinguishing between financial, commercial, internal and

learning/growth aspects [Kaplan and Norton, 1996], are increasingly applied.

Multinational firms may also want to model their strategy in terms of a sequence of

steps, each consisting of all kinds of checklists and techniques [Mintzberg, 1990;

Minzberg and Lampel, 1999]. Chief Executive Officers (CEO’s) carry the overall

responsibility for strategic modelling, whilst lower-level staff tends to actually appraise

the investment proposals. Capital budgets contain financial analyses which may be

verified in performance reports, thus in a sense linking strategic modelling to financial

planning and financial control. The actual financial modelling is often preceded by the

practice of benchmarking internal and external best practices [Oldcorn and Parker,

1996]. Strategic gaps between objectives and results can be ascertained and methods to

10

close these gaps may be developed. Firms may subsequently focus on modelling growth

routes, such as market penetration, market development, product development and

diversification [Ansoff, 1965]. Forecasting techniques include brainstorming, scenario-

analysis and decision trees, evolving into figures, tables, graphs and the like, eventually

ending in databases, spreadsheets and expert systems. Dynamics from learning may be

introduced in the capital budgeting process, using experience, dialogues and careful tests

[Butler et al., 1993; Piëst, 1995]. Strategic modelling then goes with project planning.

Operating uncertainties may be routinely dealt with when capital investment projects are

managed. However, investment planning may incur various strategic uncertainties.

These uncertainties may alternatively possess a positive (chance or option) or a negative

(risk) connotation [Funk, 1995; Luehrmann, 1998-2]. Strategic uncertainties include the

following categories:

1) commercial risk (especially as to markets, prices, deliveries and transport);

2) occupational risks (for instance on pollution, natural disasters, claims or

operational guarantees);

3) financing risks (such as on credit and loan terms, including financial

guarantees supplied);

4) currency risks (exchange rate changes hurting activities and assets); and

5) political risks (e.g. legal licenses, legal structures, subsidies or taxes).

11

Commercial risks are discussed as non-currency risks in Section 3, even though a long-

term perspective is used here. Organisations can often insure themselves against

occupational risks if they are of a standard nature. If the risks are not standard

operational and financial instruments may be available to hedge against such risks.

Interrelated financing risks and currency risks may be covered by balance sheet and cash

flow hedges, leading and lagging cash flows, interest clauses and currency clauses,

forward, futures, swap and options contracts, moving financing or activities to other

countries and other methods [Eiteman, Stonehill and Moffett, 2001]. Insurance,

negotiating a favourable environment or evading certain courses of action may help an

organisation to address political risks. Sometimes other operational and financial

instruments can be used (see Section 3).

Organisations may focus their strategic planning on the development of market

structures by seizing profitable positions in well-distinguished sectors, businesses or

countries. In collaboration with personnel from outside the organisation, internal

management may occupy an important role, if not the most vital role, as they furnish

management with important information for strategic directions. All the stages of the

organisation’s product and market life cycles must be explicitly recognised. Portfolio

matrices may, for example, uncover problems, strengths and weaknesses. As a result

of such analyses these areas in the organisation may be invested in selectively, at

various levels of intensity [Grundy, 1992]. Firms may scrutinise barriers to market

12

structure changes [Porter, 1980; 1985]. Organisations may also plan to invest

selectively in order to optimise their competitive positions, following cost leadership,

differentiation, cost focus or differentiation focus strategies. Combinations of these

strategies may be justified where firms choose suitable, acceptable and feasible

combinations of price and perceived added value [Johnson and Scholes, 1997]. When

value drivers are compared with value chains or groups of primary and support

activities are evaluated, the financial values of the strategic advantages discerned may

be identified [Rappaport, 1986]. A redesign of corporate, business and country

portfolios (using core competencies to invest and divest) integrates the above types of

strategic planning. Combinations of strategic planning with project control and

financial planning are feasible here.

In a strategic planning approach, strategy formation is made explicit. Attention may

be focussed on designing properties, modelling outcomes, encountering risks and

portfolio formation. Various concepts may be used and an optimal mix chosen

specifically for each case. This approach to planning may match the expansion or

improvement investment projects, new product development or even mere strategic

proposals. The above approach may possess a special appeal for non-traditional

production and service firms, as project control and financial planning are less

feasible in such firms. It may be especially useful for substantial investment projects

in large organisations.

13

Section 4. Financial planning approach

Multinational firms that select long-term investments and plan for their financing

[Northcott, 1992] employ a financial planning approach in their capital budgeting

system. Capital expenditure refers to the commitment of financial resources [Welsch,

Hilton and Gordon, 1988]. Outlays include fixed assets and related current assets.

Expenses on minor investments can be calculated per unit as undesignated amounts.

Major investments may be budgeted for separately. Both are summed per time period

in the capital expenditures budget. Cash budgets include planned cash receipts and

cash disbursements. Investment cash flows, operating cash flows and financing cash

flows are budgeted directly or indirectly to identify cash excesses and shortages by

time period. Both partial and total analyses of the capital investment “problem” can

be carried out, eventually including positive or negative synergies between

investments [Bouma, 1980]. As long as operational planning issues have been dealt

with sufficiently, liquidity and solvency considerations may govern the allocation of

capital resources [Olfert, 1992]. Financial markets may be tapped if internal cash

flows are insufficient, using a pecking order to evade dilution of control [Myers,

1993]. Internal and/or external capital rationing leads to a need to select investments

[Pike and Neale, 1993]. If investments are selected on a cash flow basis, outlay

amounts, operating cash flows, interest coverage and payback periods may be taken

into account.

14

Firms may base the financial planning of their investments on targeted book profits

and asset values. Profits can be broken down into various margins, depending on

which costs are ignored. If eventual depreciation values are taken into account, they

act upon the asset bases used. Investment selection methods may include [Walsh,

1996; Barker, 2001]:

1) sales volumes, occupancy rates and (direct or indirect) staff numbers;

2) selling prices, various cost prices, profit margins (to sales), operating

results (before or after tax deduction) and break even volumes or sales;

3) return on equity, return on assets and return on capital employed; and

4) balance sheet values, profits per share and price-earnings ratios.

These accounting methods are relatively simple, easy to apply and inexpensive to use.

It is easy to create links to both the corporate, business and local management control

system and the performance evaluation system. The theoretical deficiencies of the

methods may not necessarily be operationally present [O’ Brien, 1997]. If captured in

market-grounded rules of thumb, their application may lead to “correct” decisions

[Ross, 1995]. This may also explain why accounting selection methods are still

widely applied in multinational capital budgeting [Buckley, 1996].

15

Despite the corresponding effort, cost and uncertainty, firms may also want to take

(the timing of) cash flows and risk attitudes into account when they select their

capital investments. Methods to be used include [Walsh, 1996; Barker, 2001]:

1) discounted returns (e.g. discounted payback time and discounted profit);

2) the net present value (NPV) (the sum of discounted net cash flows); and

3) the internal rate of return (IRR) (discount rates make the NPV zero).

To arrive at cash flows, instead of direct calculations, accounting numbers can be

used [Rappaport, 1986; Northcott, 1992; Buckley, 1996]. Multinational firms may

look at incremental investment outlays, periodical operational cash flows and

terminal cash flows. One can also distinguish between three types of investments.

Operational cash flows consist of net receipts from activities. Investment cash flows

are concerned with capital outlays and receipts. Financing cash flows stem from

equity and debt capital. Applying the Capital Asset Pricing Model leads to discount

rates. Market premiums, mitigated by the beta coefficients of the equity or debt

instruments used, are added to risk free rates. However, taking shortcuts may yield

figures that can be disputed. A value driver analysis may create links to the

company’s operational, investment and financing strategies. An Economic Value

Analysis (EVA) of discounted cash flows could also lead to economic profits

[Stewart, 1991]. A performance analysis may then provide project control elements.

16

Multinational firms may consider particularly financial risks in the financial modeling of

their capital investments [Tomkins, 1991; Oldcorn and Parker, 1996; Buckley, 1996].

Shareholders are usually only interested in risks that they cannot diversify away.

Operational business risks, caused by operational activities, determine the volatility of

asset returns. These returns are influenced by business cycle sensitivity and the

appropriate cost and revenue structures. Financing with debt exaggerates the returns,

because the interest paid is tax deductible. However, the financial risk to residually

rewarded equity holders grows as the "financial leverage" increases, because an eventual

default will hurt them the most. Firms may want to estimate probabilities and calculate

standard deviations to identify the risks they have identified. Sensitivity and scenario

analyses may provide information as well. The required financial results, payback

periods and accounting rates of return may take financial risk into account. Forecasted

cash flows and discount rates may be adjusted to arrive at suited present values. If

uncertainties are viewed as opportunities, in addition to present value techniques, real

options analysis may be useful. The Black and Scholes formula includes time, intrinsic

value, interest rate and volatility elements. Simplification of the formula improves its

applicability [Luehrmann, 1998-1]. By taking financial risks and real options into

account, strategic values and financial values can be connected.

Financial planning of capital investments may focus on capital expenditures, book

profits and asset values, as well as discounted cash flows. Risks may also be

17

modelled. The approach may be especially appealing in cost reduction proposals, in

expansion or improvement investments and in new product development. The

approach may be most suited to traditional production and service firms, as project

control and strategic planning can be included here as well. Varying in sophistication,

it may be useful for a range of mid-size to large-size investments and large-size firms.

Section 5. Conceptual framework

Three approaches to capital budgeting in multinational firms had been sketched above.

The project control approach stresses organisational behaviour; the strategic planning

approach focuses on strategy development; the financial planning approach specifies

financial selection. In the above sections, the capital budgeting approaches (and even to

a large extent their elements) have been arranged in order of their historical occurrence.

Firms gradually enter the domain of the management control cycle. However, the

sequences to be displayed can only be partly discerned at the macro level of

multinational firms: project control only precedes strategic planning partly, which in turn

goes along with financial planning. Within each approach, sequences can be discerned.

Moreover, the elements of the approaches are interrelated in many ways. Multinational

firms are increasingly developing eclectic capital budgeting systems that are specifically

targeted towards their own needs. They typically extend, combine and overhaul elements

of all three approaches discerned here. An overarching conceptual framework for capital

18

budget system development in multinational firms summarises and connects the text

thus far (see Figure 1 overleaf). This framework can be applied to two short corporate-

level cases and one long investment-specific case. The cases come from firms with

headquarters located in the respective countries of the authors: The Netherlands, South

Africa and Great Britain.

Case study 1: BRM

The first case study focuses on Bollegraaf Recycling Machinery (BRM). This small

Dutch firm has been a producer and supplier of machines for the recycling industry since

1961. It is a leading manufacturer for example, of multifunctional recycling balers. The

firm specialises in high quality customer-specified turnkey solutions. The holding has

subsidiaries in the Netherlands, Germany, France, England and Spain, as well as a stake

in an American importer. Since the mid 1990s, the firm has experienced extensive

organic and acquired growth, leading to current sales of € 30 million, balance sheet of

€ 20 million, and employee numbers of 180. This resulted BRM’s having to implement a

high level of industrialisation and professionalism. Capital investment in BRM is

principally concerned with small to mid-size replacement of plant and machinery, cost

reductions, expansion or improvements and new products.

19

Figure 1 Developing multinational capital budgeting systems

Project control Strategic planning Financial planning

Assigning tasks and responsibilities

Assembling and processing information

Handling operational project risks

Controlling bounded rational behaviour

Designing allocationof resources

Benchmarking and forecasting

Strategic risk assessment

Assessing competitive positions

Handling capital expenditures

Calculating profits and values

Analysing sensitivities and scenarios

Determination present values

Project control process of capital investments is continually updated, and specific tasks

and responsibilities in the capital investment decision-making process have been

allocated to relevant members of staff. The management of project information has

become more structured. Operational risks have been identified and diversified away. In

addition, a lot of emphasis has been put on the rationalisation of capital investment

behaviour. BRM now attempts to follow a pre-formulated strategic direction in the

20

context of capital investments. In addition, the holding's subsidiaries are gradually

directing more attention to aspects of benchmarking and forecasting. Strategic risks,

relating, for example, to European Union market issues, disasters and other

contingencies, in addition to political factors, are now being incorporated in the capital

investment decision-making process. The company’s continued growth requires a great

deal of attention to its competitive and market environment. Capital expenditures are

forecasted in strategic, tactical and operational plans. In this process, the inputs from

subsidiaries are gradually gaining importance. At present BRM does not apply a formal

financial modelling procedure. Finally, although BRM is aware of present value

appraisal techniques, the firm does not intend to apply these methods. In conclusion,

BRM currently has a project control approach on capital budgeting, thereby gradually

incorporating strategic planning and financial planning elements (see Figure 2 overleaf).

Case study 2: SABMiller

The second case study is about the capital budgeting system at South African

Breweries Miller plc (SABMiller). This large multinational firm has been a beer

brewer in South Africa for over 100 years and has virtually become a monopoly. SAB

Ltd’s flagship brand, Castle Lager, accounts for over 50% of its sales. SAB recently

acquired the Miller Brewing Company in the USA. SABMiller is the second largest

beer brewer in the world and it aims at business growth and long-term shareholder

value. The holding company (currently in the UK) has 111 breweries in 24 countries.

21

Figure 2 Capital budgeting system BRM

Project control Strategic planning Financial planning

Tasks and responsibilitiesare specifically allocated

More structuring in management of project information now

Operational projectrisks identified anddiversified away

Gradual rationalisation investment behaviouris striven for

Pre-formulated strategic direction

More attention is paid to benchmarking and forecasting

Strategic risks are taken into account in decision-making

Attention is paid to competitive and market positions

Capital expendituresforecasted in plans

Financial modelling not formalised, but results estimated

Tentative analysis of sensitivities and scenarios

Present values arenot calculated

The organisation employs 38,000 people and had a profit before interest and tax of

US$m704 for the year ending 31 March 2002. Capital budgeting in SABMiller for

the 2002 financial year amounted to €258m and covered replacements, cost

reductions, expansions (acquiring entire breweries), improvements and new products.

22

Project control of capital investments is detailed and is administered by the subsidiary

involved. Tasks and responsibilities on capital investments are detailed. Regarding

the strategic planning of capital investments, the capital expenditure of each company

in the group has to be approved by its board. There are, however, different levels of

approval and relatively large expenditures or acquisitions have to be approved by the

holding company’s board of directors. Capital expenditure projects are evaluated by

means of a detailed cash flow analysis with a statistical scenario analysis of possible

deviations (risks concerning currency rate fluctuations as well as political risk are

taken into account). Evaluation techniques include NPV, IRR as well as adjusted

(modified) IRR. The discount rate used is calculated by using the weighted average

cost of capital, and more specifically, the capital asset pricing model (CAPM) to

determine the cost of equity. In conclusion: while SABMiller currently employs all

three capital budgeting approaches to a large extent, it emphasises financial planning

more than project control and strategic planning (see Figure 3 overleaf).

Case study 3: W H Smith

The last case study discusses a major investment by W H Smith (WHS), a large UK-

based stationary and book-retail conglomerate. The capital project to be focused upon

here was essentially an investment in a paperback book distribution facility. To

incorporate this facility into WHS, a new subsidiary division was formed: Heathcote

Books (HB). The facility is situated on a new development site in Central England.

23

Figure 3 Capital budgeting system SABMiller

Project control Strategic planning Financial planning

Detailed tasks and responsibilities allocation

Hierarchically formalisedinformation assemblingand processing

Operational projectrisks handled routinelyby BU management

Highly rationalised control of capital investments

Group plan allocation of (BU) resources

Forecast outcome deviations with scenario analysis

Currency risk and political risk assessment

Judgment market and competitive positions

Budgets capital expenditures

Cash flows and (CAPM-based) discount rates

Financial analysis of respective scenarios

NPV, IRR, modified IRR

HB is a central distribution operation established to offer book distribution services to

other parts of the WHS Group and to independent booksellers. It enables booksellers

to obtain all their paperback requirements from just one source. The WHS

Group’s paperback sales (including some double counting due to internal trading)

exceeded £80million in 1989 when grossed up to retail sales value (RSV).

24

The aim of the HB-project was to obtain a facility to stock and distribute paperback

books to WHS’s own stores, as well as to operate it as a central corporate

warehousing facility and a central distribution centre for small independent

bookshops. A new book distribution strategy was proposed with the following

objectives: to reduce costs, to increase the intensity of the use of remaining resources,

to question the extent of WHS-owned operations, as well as to segregate distribution

activities into their components and suggest different approaches for each one. The

UK WHS book marketing activities operate as a series of independent profit centres.

For this reason the WHS Board has agreed that rather than form individual profit

centres, more marketing opportunities could be created via one central corporate

facility. This might result in an overall group-wide performance increase, by either:

1) utilising the buying power of the enlarged business taken as a whole; 

2) inviting publishers to trade their distribution costs for improved retail

terms (against which WHS matched their own distribution efficiency

through shared costs); or

3) setting up a wholesale operation to serve internally on wholesale terms.

The experience of WHS with a central book distribution facility was based on

hardback books only. These represented a different market environment to that of

paperbacks. However, the experience with a central stock holding of hardback books

had provided WHS with a large number of benefits, including shorter lead times,

25

reduced safety stocks, more security of supply and less administrative costs. A central

paperback distribution facility was likely to be cost beneficial and conformed to the

objectives of the corporate strategy. As a result, the WHS Distribution management

asked itself why the company had not previously established a central stockholding

for paperback books. However, they were aware that an operation of this kind could

further institutionalise infrastructure costs, thus reducing the ability to make costs

more flexible in the light of trading fluctuations. The WHS Retail Division's high

'fixed costs' had been the object of corporate criticism for some time and with the

above proposal these costs could increase. Many operational advantages could be

created, though. These were in themselves valuable, particularly as the sales mix of

books inclined towards paperback sales. The problems incurred specifically in the

distribution of paperback books involved mainly logistical aspects.

The HB operation was designed to guarantee a 24-hour turnaround service. To be

able to supply the full range of titles, a physical distribution operation was required

comprising about 12,000 titles. HB was in fact projected to have a stockholding of

about 38,000 paperback titles and some hardback ones. In the actual economic

investment appraisal, formal management accounting data were introduced. These

played only a minor part in the project selection exercise. The Retail Management

and the Project Development team had evaluated all the numbers and analysed the

assumptions made. They were also satisfied that any organisational, distribution and

26

marketing problems had been solved. It was estimated that the financial benefits of

HB ranged from £1m to £2.6m per annum, based on the Development team's

perceptions of the risks of the different project alternatives (see above). At that time

the financial appraisal of Alternative 1 did not look very promising. However, the

project appraisers were of the opinion that the financial forecasts reflected the future

market and environmental conditions correctly. The HB distribution project, when

fully operational, required a capital outlay of £940,000 and with an IRR of 17%

would increase corporate net contribution by £1.3m per annum.

In fact, the actual overall capital investment outlay in HB has been about £950,000,

consisting of property, fittings and fixtures, computer equipment etc., but

excluding working capital. The working capital requirement for 1988/89 was about

£2.2m. This was considered to be a relatively small expenditure to deal with an

annual turnover, at retail value, of about £50m, and about 8,000 to 10,000 titles. In

the first year of trading, HB suffered severe computer problems, which prevented

orders from being processed and caused a large backlog of book deliveries. As a

result, a number of customers switched part or all of their business to other

wholesalers. During this period, the auditors were very critical of the possibility of

managing and controlling the business as well as the accuracy of the accounts.

27

However, during the next nine months, service improved and lost sales were

recovered. A fast order turnaround and a high order fulfilment rate were regularly

achieved, and trade customers started to return. Improvements in service came from

better warehouse methods. The HB warehouse costs were, at 8% of sales, relatively

high. This was related to the wide range, 40,000 titles, which overburdened the

operational and space elements of the warehouse, and the computer system could not

cope with the large number of book titles. After a review, management implemented

a lower cost, more service/user-oriented information system. Also, a staff incentive

scheme was introduced which improved productivity to cope with the increased

number of orders. Finally, efforts were made to improve the external sales of both

traditional and non-traditional business. The costs for these so-called Development

Sales efforts were budgeted for at £350K per year for the next three years. In

addition, in response to the efforts of its management, HB received growing support

from publishers who recognised an opportunity to reduce their own distribution costs.

Based on an average 5% growth in turnover over the past 12 years, paperback book

sales at the end of 2002 reached approximately £144m. The total, WHS (UK alone)

Retail Division turnover, at the end of 2002, had increased to £1,501m. (The Retail

Division’s worldwide turnover had increased to £1,855m). HB management

envisaged extensive growth in the normal wholesale sector in 1989, to the possible

detriment of sales to their existing bookselling accounts. The ultimate corporate

28

strategy of WHS was to improve its market share position of the HB part of the

wholesale market from 5.3% to 25.8%. The capital investment in HB has greatly

contributed to WHS's objectives. We conclude that the investment appraisal, although

in the end it included all three capital budgeting approaches distinguished here, was

ultimately driven by a refined strategic planning approach (see Figure 4 overleaf).

Figure 4 Capital budgeting system WHS

Project control Strategic planning Financial planning

Retail Management +Project DevelopmentTeam set up new BU

Much assembling and processing of various operational information

Operational risks mainly handled in project phase

Many control efforts to improve performance

Redefining strategy, three alternatives for corporate facility

Capital investment is benchmarked against other central facility

Strategic risks mainly include flexibility loss

Reflection market and environment condition

Capital outlay fore- cast along operatio-nal specifications

Focus financial modelling: contri- bution, cash flows

Three alternatives are appraised

Net contribution and IRR calculation

29

Section 6. Conclusions and recommendations

We have presented three approaches to capital budgeting: a project control approach, a

strategic planning approach and a financial planning approach. In line with common

corporate practice, we thus focused more on planning than on control. Our approach was

quite eclectic, as we explicitly included risk assessment, for example. We combined the

selected approaches in a conceptual framework. Multinational firms may first focus on

project control, then pay attention to strategic planning and finally to financial planning.

They may thus gradually enter into the domain of the management control cycle. We

mentioned four variables that may influence actual capital budgeting systems: the actual

business case, the type of investment, the size of the firm and the size of the investment.

We also feel that average project periods, knowledge and experience, time pressures felt,

formality and hierarchy, outsourcing levels, the level of involvement of consultants and

cultural differences may influence systems designs. Firms have to take specific

circumstances into account and should therefore not apply our framework too

rigorously. It may, for example, be more important to budget capital expenditures

accurately (financial planning) than to assess difficulty of the project or to assess

competitive positions precisely (strategic planning), when a firm is rapidly leading sales

or procurement changing markets. Moreover, capital budgeting systems can never be

regarded as complete, but should, instead, always be ‘under construction’.

30

Many studies on capital budgeting systems have focused on one or two of the

following topics: project management, strategic management, management control,

corporate finance or international management. We have tried to combine all of these

views in this paper, thereby of course losing detail, but on the other hand gaining

broader insight. Instead of giving an account of in-depth case research or reporting on

a written survey, we have provided an eclectic overview of today’s corporate practice

in multinational firms. We hope that our qualitative approach will not only trigger

related theoretical but also empirical research. Case research may reveal additions to

and limits of our framework. Also, timely developments in multinational firms may

be signalled this way. Oral or written surveys may uncover details of typical current

capital budgeting systems. It is beyond the scope of this paper to answer the empirical

question of how capital budgeting systems development is beneficial to

multinationals. Further empirical research might be very interesting, though. It would

be interesting to learn whether multinationals that have more sophisticated capital

budgeting systems do indeed outperform comparable firms that have less

sophisticated systems in terms of value. Our analysis not only suggests that adding

capital budgeting approaches creates firm value, but also that digging deeper into a

specific approach may be a source of value. Researchers could therefore also try to

measure the amount of sophistication of capital budgeting systems and study its

impact on share prices. Thus, empirical research on capital budgeting is by no means

unnecessary, as long as actual systems of multinational firms are ‘on the move’.

31

References

Aaker, D.A., Strategic Market Management, Wiley, New York, fifth edition 1998.

Ansoff, H.I., Corporate Strategy, McGraw Hill, New York, 1965.

Anthony, R.N.; J. Dearden; V. Govindarajan, Management Control Systems, Irwin,

Homewood Il, seventh edition 1992.

Barker, R., Determining Value: Valuation Models and Financial Statements,

Financial Times/Prentice Hall, Harlow, 2001.

Bierman, H.; S. Smidt, The Capital Budgeting Decision: Economic Analysis of

Investment Projects, MacMillan, New York, eighth edition 1993.

Bouma, J.L., Leerboek der Bedrijfseconomie, deel 2; De theorie van de financiering

van ondernemingen, Delwel, Wassenaar, tweede druk 1980.

Bower, J.L., Managing the Resource Allocation Process: A Study of Corporate

Planning and Investment, Harvard Business Press, Boston Mass, 1970 (1986).

Buckley, A., Multinational Capital Budgeting, Prentice-Hall, London, 1996.

Butler, R.; L. Davies; R. Pike; J. Sharp, Strategic investment decisions: theory,

practice and process, Routledge, London, 1993.

Cyert, R.M.; J.G. March, A Behavioral Theory of The Firm, Prentice-Hall,

Englewood Cliffs NJ, 1963.

32

Eiteman, D.K.; A.I. Stonehill; M.H. Moffett, Multinational Business Finance,

Addison-Wesley, Reading Mass, ninth edition 2001.

Farragher, E.J.; R.T. Kleiman; A.P. Sahu, Current Investment Practices, The

Engineering Economist, Vol. 44 No. 2, 1999, pp. 137-150.

Funk, J., Aspekte der Unternehmensbewertung in der Praxis, Zeitschrift für

betriebswirtschaftliche Forschung, 47. Jg., 1995-5, pp. 491-514.

Funk, J., Wie schaffen diversifizierte Unternehmen Wert?, Zeitschrift für

betriebswirtschaftliche Forschung, 47. Jg., 1999-7/8, pp. 759-773.

Goold, M.; A. Campbell, Strategies and Styles: the role of the center in managing

diversified corporations, Basil Blackwell, Oxford, 1987.

Grundy, T., Corporate Strategy and Financial Decisions, Kogan Page, London, 1992.

Grundy, T. (with G. Johnson and K. Scholes), Exploring Strategic Financial

Management, Prentice Hall Europe, Harlow, 1998.

Hamel, G.; C.K. Prahalad, Competing for the Future: Breakthrough Strategies for

Seizing Control of Your Industry and Creating the Markets of Tomorrow, Harvard

School Business Press, Boston, 1994.

Jahrmann, U., Aussenhandel, Kiehl, Ludwigshafen (Rhein), sixth edition 1991.

Johnson, G.; K. Scholes, Exploring Corporate Strategy: Text and Cases, Prentice-Hall,

London, fourth edition 1997.

33

Luehrmann, T.A., Investment Opportunities as Real Options: Getting Started on the

Numbers, Harvard Business Review, July-August 1998, pp. 51-67.

Luehrmann, T.A., Strategy as a Portfolio of Real Options, Harvard Business Review,

September-October 1998, pp. 89-99.

Lumby, S.; C. Jones, Fundamentals of Investment Appraisal, Thomson Learning,

London, 2001.

Maccarone, P., Organizing the capital budgeting process in large firms,

Management Decision, Volume 34 Number 6 1996, pp. 43-56.

March, J.G.; H.A. Simon, Organizations, Wiley, New York, 1958.

Meredith, J.R.M.; S.J. Mantel, Project Management: a Managerial Approach, Wiley,

New York, third edition 1996.

Mintzberg, H., Strategy Formation Schools of Thought, in: J. Frederickson (ed.),

Perspectives on Strategic Management, Harper Business, Ballinger 1990, pp. 105-235.

Mintzberg, H.; J. Lampel, Reflecting on the Strategy Process, Sloan Management

Review, Spring 1999, pp. 21-30.

Myers, S.C., Finance Theory and Financial Strategy, Interfaces, Vol. 14 no. 1,

January-February 1984, pp. 126-137

Myers, S.C., Still Searching for Optimal Capital Structure, Journal of Applied

Corporate Finance, Spring 1993, pp. 4-14.

34

Northcott, D., Capital Investment Decision-Making, Academic Press, London, 1992.

O Brien, M., Payback: a gulf between managerial accounting and financial theory in

practice - a view from accountants and finance officers in Ireland , The International

Journal of Accounting, vol. 32 no. 2, 1997, pp. 173-186.

Oldcorn, R.; D. Parker, The Strategic Investment Decision: Evaluating Opportunities

in Dynamic Markets, Pitman Publishing, London, 1996.

Olfert, K., Investition, Friedrich Kiehl, fifth edition, 1992.

Piëst, E., Strategische besluitvorming: planning of leren, in: H. Sminia (red.), Van

ondernemingsbeleid naar strategisch management, Labyrinth, Capelle a/d IJssel, 1995,

pp. 79-89.

Pike, R.; B. Neale, Corporate Finance and Investment: Decisions and Strategies,

Prentice-Hall, Englewood Cliffs NJ, 1993.

Pinches, G.E., Myopia, Capital Budgeting and Decision Making, Financial

Management, 11(3), 1982, pp. 6-19.

Porter, M.E., Competitive Strategy: techniques for analyzing industries and

competitors, The Free Press, New York, 1980.

Porter, M.E., Competitive Advantage: creating and sustaining superior performance,

The Free Press, New York, 1985.

35

Rappaport, A., Creating Shareholder Value: The New Standard for Business

Performance, The Free Press, New York, 1986.

Ross, S.A., Uses, Abuses, and Alternatives to the Net-Present-Value Rule, Financial

Management, Vol. 24, No. 3, Autumn 1995, pp. 96-102.

Ross, S.A.; R.W. Westerfield; J.F. Jaffe, Corporate Finance, Homewood Il, fifth

edition 1999.

Segelod, E., The content and role of the investment manual - a research note,

Management Accounting Research, no. 8, 1997, pp. 221-231.

Slagmulder, R., Using management control systems to achieve alignment between

strategic investment decisions and strategy, Management Accounting Research, no. 8,

1997, pp. 103-139.

Tomkins, C., Corporate Resource Allocation: Financial, Strategic and

Organizational Perspectives, Basil Blackwell, Oxford, 1991.

Verbeeten, F.H.M., The Impact of Uncertainty on Capital Budgeting Practices: an

Empirical Analysis of the Interrelationships between Uncertainty, Other Contingency

Factors, Capital Budgeting Practices and Performance, WLP, Nijmegen, 2001.

Walsh, C., Key management ratios: how to analyze, compare and control the figures

that drive company value, Financial Times/Prentice Hall, Harlow, 1996.

Ward, K.; T. Grundy, The Strategic Management of Corporate Value, European

Management Journal, vol. 14, no. 3, 1996, pp. 321-330.36

Weick, K.E., The Social Psychology of Organizing, Addison-Wesley, Reading MA,

second edition 1979.

Welsch, G.A., R.W. Hilton, P.N. Gordon, Budgeting: Profit Planning and Control,

Prentice-Hall, Englewood Cliffs NJ, fifth edition 1988.

Wissema, J.G., An Introduction to Capital Investment Selection, Frances Pinter,

London, 1985.

37