ChapterNotesReview 7 1

MCS UNS
Chapter 7: Designing
Asset Allocation Methods
Creating Performance Measurement
Systems
04.04.05
1
Course Map Where are we?

Chps 13
Chps 12 & 13
Belief Systems
Boundary Systems
Risks to be
Avoided
Core Values
Business
Strategy
Todays
Topic
Chp 2
Chp 14
Strategic
Critical Perf
Uncertainties Internal Controls
Variables
Chp 13
Interactive
Diagnostic
Control Systems 4 LEVERSControl Systems
Chp 10
OF
CONTROL
Chp 10
Organizing for
Performance
Chp 3
What to Control
Chp 4
Building and
Evaluating
Budgets
Chps 5, 6, 7
Measuring
Performance
Chps 8 & 9
Designing
Employee Goals
and Incentives
Chp 112
Organizational Resources (Assets)

Materials
Labor
LT Assets
Firm
(transformation processes)
Outputs
A firm converts resources into outputs through some

process
This requires selecting and acquiring resources
AND
The resources acquired should support the firm strategy
3
Organizational Resources (Assets)

To assure that the resources acquired support the firm
strategy, organizations need procedures to evaluate
possible investments in resources
Resources available to support investment opportunities
(funds) are often smaller than desired, leading to a need to
compare possible investments (asset allocation)
Market dynamics
Firm mission
Business
strategy
Performance
goals
& measures
Actions
Firm resources
Acquisition of New Long Term

Assets
Asset acquisition is a decision based on
expectations about the future
A capital budgeting system provides methods for
evaluating and comparing investment
opportunities based on forecasts
Acquisition of New Long Term Assets:

Capital Budgeting
Step 1: a perceived need for new/additional
resources
From top management given strategic considerations
From operations (production, marketing)
Step 2: an evaluation of costs/benefits

Step 3: a comparison of possible investments and
funding available and allocation of the
funds in the most appropriate way
6
Acquisition of New Long Term Assets:

Possible Reasons for Acquisition
Production improvements: cost, quality, capacity,
cycle time, safety, environmental concerns
Marketing improvements: distribution systems,
advertising or promotional programs, changes in
product configurations or characteristics
External developments: changes in technology,
the market, customer needs
The Importance of Capital

Budgeting
Involves large sums of money and long
periods of time: can be crucial to firm
success
Often involve decisions that are difficult to
reverse: careful analysis including
sensitivity analysis is needed
8
Summary So Far
We have a pool of competing capital investments
that:
Involve a significant amount of money;
Cover a relatively long period of time and put large
amounts of firm resources at risk for large periods of
time and can seriously affect the future of the firm .
The firm wants the chosen investments to:

Repay the capital outlay;
Make a reasonable return on the funds given the risk
involved.
9
Capital Budgeting Terms

Asset allocation system: a set of formal
routines and procedures to process and
evaluate proposals for new assets
Capital budget: formal plan for the
acquisition of long term assets
10
Asset Allocation System

Provides a formal way to group such
proposals (as to how they support strategy)
Forces explicit recognition of benefit and
cost expectations from proposed
investments
Provides analytic methods for comparison
Provides guidelines for choosing
investments that fit the firms strategy
11
Capital Budget Policies

Limits on asset allocations: policies and
procedures provide (1) assigned limits on
dollar amounts and types of assets and (2)
formal approval requirements to help
mitigate the risk of investing large sums
based on expectations
12
Capital Budgeting:
Policies and Procedures
Designed by organizations as they feel is
most appropriate given their circumstances
Span of accountability: affects the types of
assets managers can choose to purchase
Spending limits: limits the dollar value that
can be committed without approval from
higher management
13
Policies and Procedures:

Limits on Asset Allocations
Recognition of a need for assets typically
originates at the lower levels of the firm
Policies and procedures specify limits on
types of expenditures that might be
approved rather than specifying the types of
assets (specifying the outcome rather than
the method)
method
14

Limits on Asset Allocations
Hurdle rate (minimum ROI or ROA): a
minimum acceptable expected rate of return
on an investment
Required to submit it for approval
Does not guarantee approval
The type of expenditure that might be
approved is one that at least earns the hurdle rate.
15

Required Content
Justification: information supporting the
need for the investment
Analysis: information on the costs and
benefits expected, effects on other parts of
the business, and the time frame in which
these are expected to occur
16

Required Content
Accurate projection of current conditions into the
future
Expected cash inflows and outflows and their
timing
Level of risk involved
Type of investment
Economic conditions
Timing of cash flows
Uncertainty matters!
17

Method (Formal Process)
Required information: specify the
information required to support a request
Process: how the information is gathered
and reviewed by those in a position to
approve
Time frame: when proposals are to be
submitted, reviewed, selected (designed to
coordinate with the budget)
18

Approval Choices
By span of accountability: wider spans
associated with higher spending limits
Strategic investments:
top management
Investments in incremental
improvements: lower-level managers
By type of investment: often used with

spending limits different procedures for
assets with different purposes
19

Approval By Span of Accountability
Cost center managers: not responsible for
ROI so generally do not approve capital
investments
Profit center managers: wider span of
accountability responsible for
performance measures that include balance
sheet accounts do approve investments
(subject to spending limits)
20

Approval By Type of Investment
Assets to meet health/safety requirements
Assets to improve operating efficiency or
increase revenue
Assets to improve competitive position
21
Evaluating Proposals for Assets to

Meet Health/Safety Needs
Employee safety
Environmental protection
Governmental regulations
Cost/benefit analysis is not needed: these
are inescapable investments
Analysis consists of finding the most cost
effective means of satisfying the need
22
Assets to Meet Health/Safety Needs:

Examples
Smokestack scrubbers
Incineration or other treatment of waste
products
Water decontamination
Guardrails
Protective clothing
Early warning systems (CO2 detectors)
23
Assets to Improve Operating

Efficiency/Revenues: Examples
Replacing software, equipment, facilities
Repair/renovation of existing resources
Upgrading old technology to reduce cost,
improve reliability or quality
Eliminating bottlenecks, decreasing cycle time
(increases revenues by increasing volume)
Needed investments, but timing is not crucial
24
Evaluating Assets Acquired to Improve

Operating Efficiency: Terminology
Weighted average cost of capital
Hurdle rate
Payback
Discounted present value:
net present value
internal rate of return
25
Evaluating Assets Acquired to

Enhance Operating Efficiency
Weighted average cost of capital: a
combination of the cost of debt and of
equity weighted by their respective portion
of firm capital
Hurdle rate: a rate of return selected by a
firm as the minimum acceptable rate for
projects
26
Evaluating Assets Acquired to

Enhance Operating Efficiency
Payback: amount of time required to break
even on a project (inflows equal outflows)
Discounted present value
Net Present Value: value of the cash flows
from a project discounted using a firm selected
rate
Internal Rate of Return: the discount rate that

equates inflows and outflows (NPV = 0)
27
Net Present Value

Advantages:
Takes into account time value of money
Allows comparisons of projects with different
time horizons
Disadvantages:
Using a uniform firm discount rate ignores risk
Ignores firm position at the end of the period
Ignores relative risk as you progress through the
investment period
28
Choosing a Discount Rate

What discount rate should be used? Any of the
following could be used:
Average (during the project life) firm cost of capital
Opportunity cost of capital (what you could get in an
investment elsewhere)
Average current cost of capital already raised
Risk related cost of capital
Competitive risk related cost of capital
Other?
29
Internal Rate of Return

Makes the assumption that funds received
during the period of the investment can be
re-invested at the IRR
30
Evaluating Proposals for Assets to

Improve Competitive Effectiveness
Alignment with existing strategy/capabilities
Risks in acquiring/not acquiring the asset
Quality of information supporting the
proposal: guesses and statistical extrapolations
Who is asking for the money: track record and
ability of the champion
Feasibility and cost of reversing the decision:
how easily can you bail out?
31
Evaluating Assets Acquired for

Competitive Effectiveness
Why effectiveness rather than
efficiency?
32

Competitive Effectiveness
High risk: large sums of money for long
periods of time in projects that are relatively
hard to stop
Often require approval by top management
Dealing with future (uncertain) cash flows
Dealing with expected relationships that may
not provide as much synergy as anticipated
(e.g., expected economies of scale and scope)
33
Competitive Effectiveness: Alignment

with Strategy/Capabilities
Want projects that:
Build on existing competencies
Support firm strategy
34
Risks in Acquiring the Asset

Assets for competitive effectiveness often
alter existing practices and change firm
resources (high uncertainty)
Success is not just an extrapolation of the past
but requires correct choices as conditions
change
Higher risk of failure than with ongoing
operations: unknown reactions of competitors,
new areas of venture, more problems/issues to
address
35
Risks in Not Acquiring the Asset

Failure to act may be accompanied by
competitors choosing to act
Any first-mover advantage may be lost
Some opportunities are of limited duration
36
Quality of Information Supporting

the Proposal
Market analysis
Economic forecasts
Cash flow estimates
Competitive analysis
Expected returns
What degree of confidence would

you place on each of these?
On the assumptions
underlying them?
Is there sensitivity analysis?
Based on which variables?
37
Track Record and Ability of the

Champion
Champion: someone who believes in the
project and argues for it
Track record and reputation
38
Feasibility and Cost of Reversing

the Decision
Conduct a worst case analysis:
analysis what if
everything goes wrong
What opportunities are there to change the
decision and what would it cost?
Can the asset/resource be easily converted
to another use?
39
Feasibility and Cost of Reversing

the Decision
Asset specificity: the more specificity there
is, the more the likelihood that unanticipated
circumstances will make them non
producing sunk costs.
Uncertainty: leasing may be lower risk.
Frequency: if the asset is seldom used,
outside contracting for its use may be more
appropriate.
40

Competitive Effectiveness: Examples
Information systems (SAP, proprietary);

Investments in R&D;
Investments in new product development;
Regional expansion
New distribution system
41
An Example:
Evaluating a New Distribution System
Quality of information supporting the proposal:
guesses and statistical extrapolations
42

Customer service strategy
New distribution system would reduce cycle time

43


High fixed cost requires jump in volume to justify
Competitors may lower their delivery times to our
current level

Who is asking for the money: track record and ability
of the champion
Feasibility and cost of reversing the decision: how
easily can you bail out?
44


Guesses: one third of the expected benefits are from an
increase in sales due to the reduced delivery time
(currently the best in our industry)
Statistical extrapolations: two thirds of the expected
benefits are from manufacturers specifications
Who is asking for the money: track record and ability of
the champion
Feasibility and cost of reversing the decision: how easily
can you bail out?
45

Quality of information supporting the proposal

Supported by both marketing and production
Supported by someone who has been right (or wrong)
before
Feasibility and cost of reversing the decision: how

easily can you bail out?
46

Quality of information supporting the proposal

Investment all in year zero
Investment in stages
Convertibility of the investment
47
Common Flaws in Analysis of

Capital Projects
Several surveys in the mid 1980s (cited in Cost
Management Summer 1993 p. 28) indicate that firms are
not satisfied with their capital budgeting results:
In a survey of 200 Fortune 500 firms, 98% reported
having difficulties with their capital budgeting processes
Another reported that first construction estimates for
process plants involving new technology are usually off by
more than half of the final cost
cost
Research indicates that 80% of new projects fail to
achieve their market share targets and projections
projections
Why?
48
Potential Problems with Investment Analysis

Projections colored by emotional commitment
Filtering of the information
Lack of understanding of current operations

Insufficient analysis: failure to consider
49

Accentuate the positive and ignore the negative
Fully reveal all potential inflows and ignore risks to them
Overestimate the speed with which projects can be
implemented

50

implemented

Makes the forecasting of actual effects less accurate
51

implemented

Makes the forecasting of actual effects less accurate

Implementation delays
Supply problems
Learning curve with new technologies
52

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ChapterNotesReview 7 1

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MCS UNS

Course Map Where are we?

Organizational Resources (Assets)

A firm converts resources into outputs through some

Organizational Resources (Assets)

Acquisition of New Long Term

Acquisition of New Long Term Assets:

Step 2: an evaluation of costs/benefits

Acquisition of New Long Term Assets:

The Importance of Capital

The firm wants the chosen investments to:

Capital Budgeting Terms

Asset Allocation System

Capital Budget Policies

Policies and Procedures:

Policies and Procedures:

Policies and Procedures:

Policies and Procedures:

Policies and Procedures:

Policies and Procedures:

By type of investment: often used with

Policies and Procedures:

Policies and Procedures:

Evaluating Proposals for Assets to

Assets to Meet Health/Safety Needs:

Assets to Improve Operating

Evaluating Assets Acquired to Improve

Evaluating Assets Acquired to

Evaluating Assets Acquired to

Internal Rate of Return: the discount rate that

Net Present Value

Choosing a Discount Rate

Internal Rate of Return

Evaluating Proposals for Assets to

Evaluating Assets Acquired for

Evaluating Assets Acquired for

Competitive Effectiveness: Alignment

Risks in Acquiring the Asset

Risks in Not Acquiring the Asset

Quality of Information Supporting

What degree of confidence would

Track Record and Ability of the

Feasibility and Cost of Reversing

Feasibility and Cost of Reversing

Evaluating Assets Acquired for

Information systems (SAP, proprietary);

Evaluating a New Distribution System

Risks in acquiring/not acquiring the asset

Evaluating a New Distribution System

Risks in acquiring/not acquiring the asset

Quality of information supporting the proposal:

Evaluating a New Distribution System

Quality of information supporting the proposal:

Evaluating a New Distribution System

Who is asking for the money: track record and

Feasibility and cost of reversing the decision: how

Evaluating a New Distribution System

Alignment with existing strategy/capabilities

Feasibility and cost of reversing the decision:

Common Flaws in Analysis of

Potential Problems with Investment Analysis

Lack of understanding of current operations

Potential Problems with Investment Analysis