Question

1. What purposes are served by a post-audit of approved capital expenditure proposals?

2. What weaknesses are inherent in the payback period and in the accounting rate of return when used as an investment criterion?

3. State two basic differences between the net present value and the internal rate of return models that often lead to the differences in the evaluation of competing investment proposals.

4. Identify several nonquantitative factors that are apt to play a decisive role in the final selection of projects for capital expenditures.

Answer 1

Q1. Post-audit of capital expenditure measures the effectiveness of the project control process. Measuring capital project effectiveness has to be assessed across the capital expenditure cycle. The capital expenditure cycle includes the following three stages, viz.,

Pre-feasibility/ Proposal:

- Pre-feasibility/ feasibility and planning;

- Resource allocation and committment.

Execution:

- Contractor selection;

- Contract management

Post Completion:

- Commissioning and turnover/ hand-over

- Maintenance

A post audit of the capital expenditure proposal stage will include process risks/ considerations of:

i. the Pre-Feasibility/ Feasibility & Planning process; and

ii. Resource Allocation and Committment process.

Pre-feasibility / Feasibility and Planning

Process risk and considerations of this process include:

a. A post audit will indicate whether the business case was documented, and approved by the appropriate personnel;

b. Documentation of process to perform scoping study, pre-feasibility and feasibility analysis. A post audit will indicate whether the processes were followed;

c. Documented process for site selection and acquisition, environmental analysis, and finaancial analysis. A post-audit will reveal whether the processes indicated above were followed.

d. A post audit will indicate the adequacy of budget to complete the project;

e. Apost audit will also show whether all identifiable risks to the successful completion of the project have been addressed in their entirety.

Resource Allocation and Committment

A post audit of the resource alocation and committment will assess :

a. Supply chain inefficiencies. The supply chain for the project will include the procurement and sourcing processes;

b. Allocation of sufficient resources to the project by the management.

Q2. Weaknesses of the Pay back period (including discounted payback period) and Accounting Rate Return approach to evaluating projects

Pay back period approach

The payback period approach:

a. Uses expected cash flows and not expected accounting income;

b. Cash flows are not discounted. ( The discounted Pay back period approach addresses this lacuna); and

c. Does not factor results after the maximum payback period.

More specifically, the payback period approach does not taken into account the:

i. Time value of money;

ii. Cash flows after the payback period. This also includes any cash flows from the residual value of the project.;

iii. Does not measure the feasibility of the total or entire project;

The pay back period is expected to be arbitrary.

Where, the Discounted Payback Period approach is used, it must be noted that the "time value of money is subject to uncertainity" as it relates to assuming an interest rate relating to future periods.

Weaknesses of the Accounting Rate of Return Approach  

The Accounting Rate of Return (or Simple Rate of Return) has three weaknesses. They are:

i. Ignores the time value of money;

ii. Uses accrual accounting values and not cash flows from the projct;

iii. Adopting different depreciation methods will yield different results.

Q3.

The Net Present Value ( NPV) and Internal Rate of Return (IRR) assume that cash flows generated by the project are immediately invested elsewhere. This is not a realistic assumption as many firms may not seek to re-invest their cash flows elsewhere. IRR and NPV methods make different assumptions regarding the Rate of Return that is earned on the cash flows. The NPV assumes that the rate of return is the discount rate.

The key differences are:

i. NPV is calculated in terms of unit of currency, whereas the IRR is expressed as a percentage that a project is expected to return;

ii. NPV calculates additional wealth, whereas the IRR does not do so;

iii. The IRR cannot be used for projects having varying types of cash flow. eg, cash inflow followed by outflow follwed by inflow (example mining projects);

iv. NPV uses different discount rates. This will result is different recommendations. The IRR generates only one rate, and therefore, only one recommndation is possible.

Q4.

Quantitaive factors are measured in numercial terms, whereas qualitative factors are measured subjectively. Capital investments are driven by quantitative factors. However, it is imperative that managers today assess a project from qualitatively. Qualitative considerations include:

i. Company culture.

Company culture including the management quality, existence of processes and procedures for capital investments, are important considerations. Capital investment can impact - favorably or unfavorably - the way work is performed in an organization. A new project can impact communication and information flows between diufferent teams engaged on the project. A project will involve teams both at the head quarters and at the site/ (s). The movement of head quarters personnel during project implementation can result in them being unavailable for temporary periods for head office duties or regular operations work. So, it is important for maanagers to understand how personnel work individually, and together as a team, employee morale, and their levels of motivation to override frequent conflicts and hurdles that are bound to manifest during the project.

ii. Environment and pollution concerns

The risk of environmental damage and pollution are real time concerns. Capital project have varying impacts on the environment. Example, coal mining impacts the environment by de-forrestation, displacing tribal communities from their habitat, toxic chemical residues in underground water. The coal generated from this project can cause air pollution leading to sickness.  

iii. Ethics

The tone at the top and culture of ethics are key to successful project completion. Capital investments will always include the flow of a lot of money to the project. Utilization of project funds are going to be dependant on the level of ethics. Diversion of project money to other projects or to private businesses are one example of unethical behaviors. In evaluating a project, a manager should factor the existing safeguards to ensure that breach of ethics will be identified as early as possible.

iv. Safety

The safety concerns of all personnel and public during and after completion of a project are key determinants that have to be taken into consideration. Capital projects like mining are fraught with risk at every stage. Blowouts, mine collpses during tunnelling operations are real dangers. It is necessary to identify all risks to project and non-project personnel.

v. Product/ Service quality

Investments for product and/ or service quality may not be really measurable. Such investments may also be for increasing capacity to produce goods or deliver service. The quality of capital resorces can have a direct bearing on the final quality of goods and services flowing from the project. But they are for the long term.