some results from studying entrepreneurial businesses Francis Chittenden and Mohsen Derregia Manchester Business School, University of Manchester Chartered Accountants Hall PO Box 433 Moorgate Place London EC2P 2BJ Tel 020 7920 8100 Fax 020 7638 6009 www.icaew.co.uk Centre for Business Performance Thought leadership fromthe Institute Briefing Capital investment decision-making: some results from studying entrepreneurial businesses Francis Chittenden and Mohsen Derregia Manchester Business School, University of Manchester b b Centre for Business Performance Thought leadership fromthe Institute If you would like to know more about the Institutes leading-edge activities, please contact: Centre for Business Performance, Chartered Accountants Hall, Moorgate Place, London EC2P 2BJ Fax: 020 7638 6009 Tel: 020 7920 8634 Website: www.icaew.co.uk/centre Email: centre@icaew.co.uk The Centre for Business Performance promotes and funds, through the ICAEWs charitable trusts, leading-edge research on performance-related issues of immediate and long-term importance to the business community. Its goal is to advance thinking and practice related to performance enhancement and value creation and to encourage discussion of new ideas by directors, entrepreneurs and others. The views expressed in this publication are those of the authors and are not necessarily those of the Centre for Business Performance of the Institute of Chartered Accountants in England & Wales. This briefing was produced with the help of a grant from the Institute of Chartered Accountants in England & Wales charitable trusts. These trusts support educational projects relating to accountancy and economics. The Centre for Business Performance manages all grant applications. TECPLN 3582 1 Introduction This Briefing presents the results from a two-year study of the relevance of Real Options 1 to capital investment decision-making in small, medium, and large firms. In addition, we have sought to discover whether there are differences between the capital budgeting practices adopted by entrepreneurial firms and average performing businesses. The study confirms that many firms use the payback (PB) method of investment appraisal in addition to discounted cash flow (DCF) models. This is a well known observation that has been attributed to the apparent lack of sophistication of practising managers, amongst other things. However, by exploring the nature of business risk we conclude that the use of payback is consistent with Real Options models of investment decision-making. The increasing levels of risk and uncertainty faced by businesses lead to a preference for rapid recovery of the funds invested, and demand for flexibility. However, this does not mean that discounted cash-flow models are no longer relevant. Many sophisticated companies use PB, internal rate of return (IRR) and net present values (NPV) as well as thinking about investment projects in ways that are consistent with real options concepts. They perceive the use of multiple techniques as different ways of looking at an investment. Recently some firms began to offer various types of fixed assets through operating leases and rental or hire contracts, thereby creating what we call the capital asset uncertainty market (CAUM). As a consequence, companies of all sizes are now able to obtain some of the fixed assets they require with the provision to terminate a lease or hire contract subject to certain conditions. The practice of using CAUM to obtain fixed assets, conserve funds, and enhance flexibility is widespread, but it is limited by the degree of asset specialisation. 1 Real options are the options companies have when making capital investment decisions. A company has the option to invest in such a project but can delay the decision. It can also put an existing operation on hold, it can expand an investment or reduce it, and it can also invest in flexibility, e.g. by purchasing versatile equipment. 2 Methodology Interviews, a postal questionnaire, and case studies were employed, recognising the different aspects of investment decisions that each method can reveal. The 50 interviewees were exclusively directors with overall responsibility for the investment analysis and financing arrangements in their companies, with the exception of one that was with a consultant mathematician. Further details are included in Table 1: Table 1: Interviewee and company information Number of Position Sector Firm Size & Interviewees Ownership 7 Finance Director Manufacturing Large Listed 11 Finance Director Services Large Listed 3 Finance Director Manufacturing SME Listed 3 Finance Director Manufacturing Large Unlisted 3 Finance Director Services Large Unlisted 12 Finance Director Manufacturing SME Unlisted 10 Finance Director Services SME Unlisted 1 Consultant Mathematician 50 The second method of collecting data was a postal questionnaire, developed on the basis of information gained from the interviews. The postal questionnaire also facilitated investigation of the differences between entrepreneurial and average performing firms, listed and unlisted businesses, large companies and SMEs, and manufacturing and service firms. A summary of the 240 respondents is set out in Table 2. Table 2: Postal survey respondents by sector, size, and ownership Listed Unlisted Manufacturing Services Mixed Manufacturing Services Mixed SME 4 8 2 11 100 7 Large 26 25 9 18 28 2 Total 30 33 11 29 128 9 Third, a collection of 12 firms had their investment decision-making process investigated as case studies focusing on the complete process, and whether there were any significant differences between entrepreneurial and average businesses. The 12 businesses all engage in capital investment decisions. Seven have given their approval for the publication of these cases and two examples are included in this Briefing. To differentiate between entrepreneurial businesses and average performing firms some relevant performance measures were employed. Only businesses that are in the upper performance quartile on all the measures simultaneously were included in the top-performing entrepreneurial category. All firms used in the sample selection had been in business for at least five years. 2 Owner-managers of private firms are known to have a variety of motives for operating their businesses. Some seek to enrich themselves by withdrawing large salaries from their companies, while others may choose to draw very small salaries to finance their business activities and expansion. When calculating ROCE for private companies average directors remuneration for each business size band was used and profits were adjusted for the differences between actual and expected salary. 3 The following performance measures were employed: Sales growth, calculated for quoted and private firms as their average turnover growth rate over three years. Return on capital employed, estimated for quoted and private firms using a standard and research and development adjusted measure of return on capital employed (ROCE) to obtain average ROCE over three years. 2 Market valuation of firms (for quoted companies only), market to book value was used as a performance measure as it reflects market expectations of company performance. By studying established entrepreneurial and average performing firms, this project looks for what can be learnt from their decision-making process to form guidelines for best practice. Some background on capital investment decisions A complicating feature of most capital investment decisions, which are to some extent irreversible, is the difficulty in predicting future events that could impact on the returns from such investments. In the past, best practice in investment appraisal has been to predict expected returns and use a risk-adjusted discount rate to obtain the present value of payoffs. This practice facilitates comparing one investment with another using the present risk-adjusted value. Rising levels of uncertainty about future events, however, complicate the process. Further, the more distant into the future a payoff is, the higher the uncertainty it is likely to be subjected to. This line of thinking, together with the interlinking of investment decisions with strategy, led to the development of real options models that consider investments as a collection of options to be exercised. This research looks at the investment decision-making process in general with a special focus on investment and risk appraisal within that process. By studying successful entrepreneurial firms, we consider what can be learnt from their decision-making process to form guidelines for best practice. Although there is no mechanical solution to the investment decision-making problem, it is helpful for companies to think through the issues using a theoretically and practically informed set of key features of successful processes. The investment decision process The making of a decision to invest is a multi-stage interactive process. From initiating an investment proposal, through appraisal and approval, to management of implementation, the process involves making predictions about the future using imperfect information. Moreover, the stages of the process are overlapping and interconnected. A rigid bureaucratic investment decision process has been highlighted as a possible hindrance to good investment appraisal and performance. There is little evidence that this is so. The commercial concerns included in this study show no relationship between degree of formality and performance; rather, formality has more to do with size and the need to establish guidelines and processes throughout large businesses that facilitate the comparability and predictability of investment choices. There are, however, important points to be considered in the design of an investment process. Entrepreneurial businesses that aggressively seek growth and increased profits do not limit their investments to projects with quantifiable expected outcomes. They also rely on qualitative assessments. These businesses overcome problems with subjective judgments about the outcomes of 4 investments by being problem solvers and accepting the limits to predictability. They accept the inevitability of deviation from expectations and keenly monitor project progress so that problems can be rectified as they arise. Post audits are also important as a crucial step in the process of learning from mistakes and identifying shortcomings that may be avoided or overcome through better process design. Many businesses in the service sectors are able to avoid, to some extent, the investment problem by resorting to CAUM where fixed assets are available for lease, rent, and hire. Capital investment decisions can now be seen in the following framework (Table 3): Less successful firms may resort to CAUM because of lack of funds and even the successful smaller companies tend to feel there is a need to conserve liquid resources. Larger companies, who mostly do not suffer from a lack of funding, seek flexibility through use of CAUM. These choices are summarised in Table 4: The availability of market solutions to the investment problem through the provision of fixed assets on a lease, rent, and hire basis using CAUM depends upon how specialised the assets are. Alternatively some firms reduce their fixed- asset base by outsourcing certain manufacturing processes (e.g. by purchasing complete sub-assemblies). The role of real options models Many facets of investment decision-making problems resemble real options. Businesses often have the option to make an investment but are not obliged to do so. They can postpone, expand, reduce, abandon, or put-on-hold a project. They can also invest in added flexibility to reduce the problem of irreversibility associated with investment in many types of fixed assets. Managers often behave in ways that are consistent with real options models, especially in dynamic growing businesses. They are aware of the impact that the irreversibility of capital investments has on the decision-making process. They often seek ways to mitigate the effect of irreversibility, such as delaying decisions to wait for better prospects, requiring higher returns to offset perceived downside risk, obtaining flexible assets where available, and using operational leases with conditions that allow for technological upgrades and termination of agreements whenever possible. Table 4: The role of CAUM Firm size Firm performance Large firms Smaller firms Successful Important for increasing Use to conserve funds, and flexibility enhance flexibility Less successful Some use to increase flexibility Use to provide access to the necessary resources Table 3: The capital investment decision today Sector Large firms Smaller firms Manufacturing Often, specialised assets make Specialised assets may make purchase purchase necessary, confidence necessary, otherwise use CAUM is another motivator Services Business confidence leads to Use CAUM, unless assets specialised purchase, but specialised assets can be important too 5 In general, high performing firms attach relatively more importance to being first in new opportunity areas. This reflects their aggressive stance on investment. They also value flexibility more than average performing firms. Intuitively this is in line with first-mover advantages and with the use of flexibility to reduce the comparatively higher uncertainty facing a pioneering investment. Businesses also tend to have a variety of investment projects with different characteristics, and the majority of businesses surveyed report that from time to time they have to delay investment projects. The presence of real-options-like thinking is even clearer in strategic considerations for investment projects. Although the real options models as presented in academic work and in highly specialised practical applications are unlikely to be widely adopted, the underlying thinking can be very useful when explicitly applied to investment evaluation. There is evidence of firms using simpler versions of real options models to evaluate their investment opportunities. A schematic of the investment decision-making process using real options thinking is presented in the appendix at the end of this Briefing. Investment and risk appraisal Evaluation of investment proposals involves appraising both an opportunity and its risk as a single step in the investment decision process. The spread of computers and software has made DCF techniques such as NPV and IRR applicable even by smaller companies. This, however, has not reduced the popularity of the simpler payback technique that uses the time to recouping investment outlay as a decision rule. Such an approach is in line with the thoughts underlying some real options models. The more distant into the future a payoff is, the more uncertain it becomes. Businesses are more concerned with the under-performance of investments because of the serious financial consequences that may entail, and seek to limit their forecasting errors by preferring projects with a relatively short payback time. Combining DCF techniques with payback to evaluate payoffs beyond a payback time limit offers a simple, albeit crude, risk management alternative to complex risk modelling. Furthermore, using scenario and sensitivity analyses helps create informed upper and lower confidence limits to enable management to make judgments about the robustness of assumptions underpinning an investment proposal. Many companies, and in particular large successful businesses, tend to see the various capital budgeting techniques as alternative ways of looking at an investment opportunity, each revealing some aspects of the decision but not others. They often use several techniques to capture as many facets of a project proposal as possible. The ad hoc approach to uncertainty analysis can be improved by making the process formal and explicit. A refined approach can also help firms that are not aware of real options models, to improve their decision-making. Successful firms look at their collection of investments when considering a capital expenditure proposal. Companies aggressively seeking to expand will have a different threshold for risk to less ambitious firms. They limit their exposure by combining a number of projects of different risk characteristics while developing, on a continuous basis, risky projects that, if successful, would lead to high returns. This practice together with being problem solvers is the main distinction between high and average performing businesses. Average performing firms tend to be less aggressive, but they can also be limited by factors outside their control such as the technology used in their sector or intensive competition. 6 Case study 1 highly successful UK multinational This highly successful company is a large multinational based in the UK. It has global competitors who hold equal market share to its own. Competition is mostly based on innovation, and therefore research and development (R&D) plays an important part in the success of this firm. Although it is a large company, it only has competitive advantages in certain product areas, and these advantages are the result of innovation. The business generates investment opportunities through R&D that is itself motivated by the need for a product in the market. Investments are mostly management initiated for strategic reasons, customer and demand initiated, and R&D initiated when some basic research calls for further investment. Strategic reasons on occasions limit the search for investment opportunities to areas of existing competitive advantage. When proposing investments, the company considers proposals made by teams that include at least one person in a position of profit responsibility. Ideas requiring investment may emerge from an individual but additional people are drawn in to make a formal proposal, and amongst those staff there has to be a line manager or regional manager. Decisions are classified into five separate categories. Categories one and two are approved by finance people at positions lower than the finance director as they generally involve relatively small investments. Other categories are submitted to the finance director for approval. All through the process proposals are presented formally and in a detailed manner. At the preliminary selection stage a group of individuals, including the finance director, form a committee to consider the suitability of a proposal to the companys product portfolio. This committee looks at the quality of the initial research, the commercial case for the investment, and the likely effect it would have on the companys strategies. Scientific and regulatory risks are important in defining the form the investment should take. When projects are hard to quantify because of unknown demand and prices, the company builds its own demand curve and investigates optimal pricing by looking at price-valuation options. Projects are not eliminated because quantification of returns is not possible, but at later stages as an investment takes shape attempts at calculating returns are made to see whether a project should continue. Usually there are plenty of projects at various stages of development to be considered for funding. Different people carry out the evaluation of alternatives at the various stages of product development. Payback, NPV, probability-adjusted NPV, sensitivity analysis, and an intuitive sense of real options are all used in investment evaluation in categories three and above. The reason for using so many techniques is to look at and compare the different results emerging from the techniques. At stages one and two, often there is not enough data to carry out much calculation. The flexibility of projects is considered as valuable and often a qualitative judgment is made about the worth of flexibility; mothballing and postponing options are often exercised until circumstances change. The finance director of this company stated that investment decisions are often delayed to wait for clearer prospects, with a quarterly review of delayed decisions. The main factors responsible for delaying investment decisions are uncertain demand and technical/scientific issues, with internal and external funding being of little importance. Interest rate uncertainty is unimportant. Most of the investments are regarded as irreversible, with investments reviewed at the stage where they pass from one category to another. Although projects may have different 7 characteristics, the same techniques are applied but with different interpretations of the results. The company has a distributed finance organisation so communication must be formal. The portfolio committee authorises projects in categories three and four. Category five projects are authorised by the board of directors. The time taken to reach a decision on a project varies with its size and importance. Decisions involving substantial amounts of money require a lot of data and analysis. Approximately, it takes three to six months to approve substantial investments. Some rejected projects are sold to other companies, while lessons learnt from research are added to the knowledge data bank. The proportion of authorised projects from the total proposals received is observed. Monitoring occurs when projects move from one category to another, with results included in the internal annual investment report. It is difficult to monitor progress and a lot of resources are required in order to do this. Projects that do not perform to expectation may be brought back on track. This is quite often achieved by investing more in order to solve the problems faced. The chief executive officer and the finance director conduct quarterly post audit reviews where all projects are looked at by observing sales volumes, market penetration, and other performance indicators to see by how much the investment is deviating from expectations. By considering projects for progression from one category to another until they reach the market, expectations are usually not too wide of the mark. Post audits are seen as beneficial despite their cost because they highlight problems with project evaluations and instigate ways of dealing with deviations from expectations and improving procedures for the future. Case study 2 highly innovative small company Being a small privately owned company has not prevented this business from being highly innovative, fast growing and profitable. It operates in a low growth market with an expansion rate of between 05 per cent per year. It has about 27 per cent share of the market and three main competitors with roughly the same share as its own. It is difficult for new firms to enter the market and also difficult for buyers to find substitutes. The company currently has excess capacity. Investments are usually to increase efficiency or for capital replacement and are operations or demand initiated. R&D is also important. Individual managers or management teams make investment proposals. The proposals become formal once they reach the senior management level, and comprise market data, models, engineering and cost evaluations. Management makes preliminary selections using payback. For payback periods of one year or less, the approval is almost automatic. Projects with up to five years payback are considered, but projects of a strategic nature are considered for any payback period and even if the initial investment is never recouped. Being a small firm, management knows all the projects in progress and considers interaction amongst them and between new and existing investments. Projects that are hard to quantify are considered using estimates or reckoning. Inability to quantify projects does not necessarily eliminate them. Usually a long list of different projects is considered and priority is given to the more urgent or important proposals. 8 Senior management evaluates the alternative projects. Payback is used and, once a payback period is acceptable, DCF in the form of IRR is applied using computer software. Sensitivity analysis is conducted to deal with uncertainty. When projects with a relatively long payback time (i.e. three years or more) are subject to a lot of variability in the sensitivity analysis, delay is considered until market conditions improve or prospects become clearer. Equipment purchased tends to be highly specialised and made to order and thus irreversible. Flexible plant is not an option that is frequently available for the company but high quality equipment that can have multiple uses is chosen whenever possible. To deal with uncertain interest rates and the prospect of inflation the discount rate is loaded to make sure the assumptions are robust. The most important factor in delaying investments is demand uncertainty. Internal funding constraints are moderately important and external funding is of average importance. Investments may be scaled back in response to economic circumstances but not as a result of operational or financial constraints. Senior management communicate evaluation outcomes to the people responsible for proposals using formal and informal channels. Authorisation for commencing work on projects is given by senior management, which meets once a month to look at a number of issues including investment projects. Projects that are not approved at a meeting but are seen as worthy of future consideration are revisited on a monthly basis to see if sufficient factors have changed to warrant re-appraisal. A project development team is responsible for following up projects, mainly looking at scientific issues in a formal manner. This process is difficult and tends to focus on technical problems, which may lead to cost escalation or even failure if not resolved. When problems are identified, action is taken to address them, sometimes with further research and development or re-formulation work. A member of senior management who authorised the project carries out the post audit. Usually this is conducted 12 months after start of work, and it seeks to determine whether initial expectations have been met. Post-audit is regarded as beneficial and the process is not costly. Lessons from the case studies The 12 case studies conducted were designed to reveal organisational differences between high performing firms and average performers insofar as the investment decision-making process is concerned. We looked at the market conditions faced by firms and found little evidence of dominance in the market place for successful firms. However, favourable market conditions seem to have assisted firms in the high performing categories. Sector conditions do have some influence on business performance. However, not all firms from buoyant sectors perform well, and the variety of company activities in the set of case studies gives some useful indicators for well-designed investment decision-making procedures. Successful firms tend to be more aggressive and demanding of their investment generation process. They regard investment to be essential to their future growth and profitability. They are more prepared to accept projects with less clear prospects, taking more risk but expecting greater rewards. Management demands very high standards of analysis and implementation with procedures to observe progress and identify weak performance as early as possible. These firms also conduct post audits to learn from mistakes and improve administrative procedures. This behaviour is absent from a number of average performing firms, with one firms finance director highlighting problems with the process and noting that the board had failed to make improvements. 9 All companies pay attention to strategic issues and new investments are restricted by their existing strategies. Top management does, however, take strategic decisions that change existing restrictions. This may be a further source of difference between average and top performing businesses. In general, successful firms tend to be very aware of strategic issues, the importance of quality and value, and the need to work on problems emerging from investment decisions to find solutions. Real options thinking helps integrate investment and risk appraisal with strategic thinking, an activity successful companies attempt to achieve using what tools they have. The element of uncertainty present to some extent in all investment decisions makes it important to explore the impact of possible future events on projects and on the company as a whole. Conclusions and recommendations Capital budgeting with its traditional assortment of techniques, although a crucial activity for companies regularly needing to purchase capital assets in order to prosper, is no longer a relevant process for all businesses. Many firms acquire fixed assets because they simply need them and evaluate their decision using a framework that is consistent with real options thinking. They investigate options open to them and evaluate these with their eyes on goals and strategy. The market has also developed solutions to reduce the impact of uncertainty on business operations through leasing, hiring, renting and outsourcing (CAUM). These types of solutions help smaller firms with both the conservation of limited financial resources and the provision of enhanced operational flexibility. In contrast larger companies face fewer financial constraints and so primarily use these solutions to enhance their flexibility. Access to leasing, hiring, renting and outsourcing, however, is limited by the nature of a companys business activities and how much it relies on highly specialised equipment. Confidence in a businesss market position is also an important factor in determining whether a company invests in capital assets, given that such assets tend to have purchase, set up and installation costs and a degree of irreversibility. Firms that apply investment appraisal regularly deploy concepts that are in line with real options models. Finance directors frame and subsequently manage the investment process by looking at the options available and their financial and strategic values. The application of such concepts is more apparent in successful companies, possibly as a result of a better understanding of their business environments. Investment decisions are made in the context of strategy. In line with real options models, strategic considerations are crucial when evaluating investment opportunities. This is something that is ignored by basic DCF methods of investment appraisal. Practitioners appreciate the limitations of traditional investment appraisal techniques and apply a range of measures to highlight different aspects of the proposed investment, as follows (Table 5): Table 5: Using a range of measures provides information about different aspects of the investment projects potential Technique Result PB Approximate time to break even IRR The present value rate of return on an investment NPV The total expected present value of all cash flows 10 The choice of investment appraisal techniques appears to depend on the circumstances that surround the investment proposal. In evaluating acquisitions of other businesses, for instance, DCF methods are used because the nature of the investment and its lengthy time horizon is inappropriate for employing PB. Generally, in making long-term commitments, as is often necessary in R&D projects, businesses cannot expect PB to come quickly. Successful entrepreneurial businesses have a very proactive approach to investment decision-making. Accepting that prediction is fraught with inaccuracy, they closely monitor projects for any signs of failure to fulfil expectations and take appropriate action to remedy problems. Entrepreneurial businesses, while acknowledging the importance of short-term performance, attach a great deal of weight to strategic and other long-term investment opportunities, e.g. by valuing first mover advantages. Producing numerical estimates of expected investment performance measures is important but in the absence of reliable figures qualitative assessments are used to evaluate opportunities. In summary the main findings of this Briefing are: Market mechanisms such as leasing, renting, outsourcing and subcontracting enable many firms to avoid some or all capital investment decisions. Successful firms take a problem-solving approach to investment decision- making and the management of projects, accepting that problems are part of the process and making sure they are detected and dealt with early. Choosing a collection of projects that limit the companys exposure to risks, while ensuring that opportunities for growth are not stifled, is an approach to the management of investments that is often adopted by successful firms. Business success depends on market conditions, but what distinguishes entrepreneurial businesses is their aggressive pursuit of opportunities and determination to make their investments a success. Successful firms are not necessarily discouraged by projects that cannot be expressed clearly in financial numbers. They rely on qualitative and intuitive assessments, and on their early detection and problem solving capabilities. Simple practical techniques are used to approximate the values of investments and the options available to companies. The use of the simpler payback technique is in line with thoughts underlying some real options models. Thinking about investment opportunities in real options terms by looking at flexibility, expansion, mothballing, scaling down, reversibility and abandonment, and any other relevant decision options, helps to identify key features of the opportunity that should make the structure of an investment clearer to decision-makers. Combining DCF techniques with payback to evaluate payoffs beyond a payback time limit offers a simple risk management alternative to complex risk modelling. Furthermore, using scenario and sensitivity analyses helps create informed upper and lower confidence limits to enable managers to make judgments about the stability of assumptions underpinning an investment proposal. The application of investment and risk appraisal effectively requires a thorough appreciation of the information yielded by the investment appraisal methods employed. For understandable reasons firms are generally keen on employing PB, but for innovative investments it is unlikely to be a basis for good investment decisions. Growth and profit seeking firms need to look beyond the PB period to see whether, given the companys risk preferences and strengths and weaknesses, a longer-term view can be beneficial for the future. Finally, to summarise these findings the traditional approaches to capital investment decision making are contrasted below with the more dynamic processes observed in entrepreneurial businesses (Table 6): Table 6: Contrasting approaches to capital investment decision-making Traditional Dynamic Perspective Tactical Strategic Proposals considered Independently Part of the businesss portfolio of projects with a variety of risk and return profiles Extent of quantification Only considered if fully Quantified where possible, quantified but judgement and reckoning also used Point where decision is Single point of approval Multi-stage process approved Nature of decision Go/No go Options identified and considered at each stage e.g. postpone, conduct trial, complete phase one only, proceed to next stage, scale up or down, abandon Location of responsibility Project proposer No project approved unless Board for success member takes ownership Appraisal techniques DCF regarded as superior, PB, NPV, IRR, sensitivity and but PB more widely used scenario analyses each used to provide a variety of perspectives Monitoring of progress Yes, but data collection and Very tight monitoring, rapid feedback takes time feedback and swift action Post investment audit Rare Mandatory 11 12 Appendix: Options-based investment decision-making process New Investment Proposal Idea Assemble data, identify options available (e.g. expand project), determine degree of reversibility, prepare case & submit proposal for screening in the organisation Value the option to divide the project into stages & proceed in this way if beneficial Are (some) assets available from CAUM? Is there value in reducing impact of uncertainty by increasing flexibility or conserving funds using CAUM? Use Payback & NPV to determine the distribution of cash flow over time of various project configurations and options. Use sensitivity & scenario analyses to establish boundaries and (subjective) probability of outcomes. Consider interaction with existing projects Consider whether the options to: abandon, mothball, and scale back are relevant, and value them Consider timing option; is there a first mover advantage? If not, is it beneficial to wait for clearer prospects? Use reckoning and qualitative analysis, establish if project is strategically important or has some other source of importance Invest and monitor progress. Take swift action if problems arise, considering options available Further stages to implement Fully qualified? Use CAUM Post audit Yes Yes Yes No No No No Yes ibc1 About the author Francis Chittenden Francis Chittenden is ACCA Professor of Small Business Finance at Manchester Business School. Before becoming an academic, Francis was a practising accountant whose work experience had also encompassed manufacturing industry, distribution, retailing and banking. During this time he founded or co-founded four businesses. Professor Chittendens current research interests include the impact of the tax and regulatory regime on owner-managed firms, cash flow management, capital investment decisions, and the capital structure of SMEs. Mohsen Derregia Mohsen Derregia is a doctoral candidate at the Manchester Business School, researching capital investment decision-making and uncertainty. He was appointed as a research assistant to carry out this project. Mohsen has a first degree in management science and mathematics from St Andrews and an MBA from Edinburgh Business School. He joined Manchester Business School after spending several successful years as an entrepreneur. A full research report entitled Capital investment decision-making: some results from studying entrepreneurial businesses by Mohsen Derregia and Francis Chittenden has been published by the Centre for Business Performance and is available for sale priced 20. For further details, please visit www.icaew.co.uk/centre, click Publications and select Enterprise category.