PROJECT APPRAISAL PLANNING AND CONTROL

1. CHAPTER 17
JUDGMENTAL, BEHAVIOURAL,
STRATEGIC AND ORGANISATIONAL
CONSIDERATIONS

2. OUTLINE
• Managerial intuition and judgment
• Mission, strategy and capital budgeting
• Bridging the gulf between strategic planning and
financial analysis
• Informational asymmetry and capital budgeting
• Organisational considerations
• Reverse financial engineering
• Group process
• Impact on earnings

3. Managerial Intuition and Judgment
Many chief executives admit that ultimately their decisions are based
on gut-feeling. Robert Docktor conducted an experiment in which he
wired up a group of chief executive officers to an
electroencephalograph. He found that the brains of chief executive
officers were more active in right hemispheres, suggesting that they
frequently relied on intuitive hunches to define complex problems in
an open-ended state of ambiguity. Henry Mintzberg’s study likewise
showed that for making most of the strategic decisions managers
depend on the factor of judgment rather than explicit analysis. They
are often guided by their intuition and are not able to explain
adequately the how or why of their strategic decisions.

4. Factors Influencing Judgment
Judgment is influenced by a variety of factors such as :
 Quality of information
 Track record of the sponsor
 Internal politics
 Intangible benefits
 Opportunity cost
 Cost of reversing the decisions
 Superstition

5. Superstition
Astrologers and psychologists have argued that magical rites and
superstitious behaviour make the world look more deterministic and
instil confidence in our ability to manage it. Superstitious beliefs seem
to help in:
 Relieving anxiety
 Imparting a sense of control
 Encouraging necessary activity
Hence, such beliefs persist. And the more unpredictable or uncertain
the future appears to be, the greater may be the psychological urge to
rely on superstitions.

6. Mission
The mission of a firm provides the overarching perspective for its
activities which naturally cover strategy formulation and capital
budgeting. Most firms state their mission in formal terms. Here are
some examples of mission statements.
Merck : To preserve and improve life
IBM : To achieve value-added leadership position
Mckinsey : To help leading corporations and governments
to be more successful.
Ranbaxy : To be a research-oriented international
pharmaceutical company.
HDFC : To develop close relationships with individual
households; maintain position as the premier
housing finance institution in the country;
transform ideas into viable and creative
solutions.

7. Business planning Capital budgeting
April- Several scenarios are explored
August
September Initial premises are agreed to September Initial capital budgeting
guidelines are formulated
October - Work is continued toward October - Capital budget selection
December developing a final formal January is carried out in divisions
business plan and departments
January Final business plan is adopted February Capital budget is approved
by the executive committee
March Capital budget is approved
by the board
Linkages between Business Planning and Capital Budgeting

8. An Approach to Decision Making
Consistency
with Strategy?
Accept Positive NPV? Reject
Significant
Intangibles?
Yes
Yes
Yes
No
No
The key guidelines underlying the approach displayed above are :
 In a decision involving measurement as well as judgment, as far as possible,
separate the quantifiable and intangible factors.
 Don’t rely exclusively on measurable factors and spurious over- quantification.
Put differently, avoid the ‘what counts counts’bias.

9. Strategic Planning and Financial Analysis
Strategic planning Financial analysis
Objective Achieve a balanced goal structure Maximise shareholder value
Responsibility
- Internal Corporate planning department Finance department
- External Consultant Investment banker
Type of analysis Primary qualitative Primarily quantitative
Advantage Comprehensive qualitative Disciplined quantitative
assessment reasoning
Disadvantage Lacking in rigour Omission of hard-to-
quantify factors

10. Mistakes Committed in Financial Analysis
In applying DCF analysis, the following mistakes are commonly
committed:
• Mechanical projection of cash flows
• Optimistic bias in cash flows
• Emphasis on IRR
• Inconsistent treatment of inflation
• Unreasonably high discount rates
• Omission of embedded real options

11. Financial Naiveté' of Strategic Planning
Strategic planning is often naïve from the financial point of view. Wit the
following:
Strategic analysis focuses on variables like earnings per share and book rate
of return which are considered irrelevant by modern finance theory.
Strategic planning is sometimes based on the premise that a firm should, by
and large, depend on internally available funds. Put differently, the existence of
the capital market is ignored.
The hurdle rates applied in strategic planning are often not related to the
opportunity cost of capital.
Strategic planning typically emphasises a diversified business portfolio when
finance theory suggests that investors can resort to more efficient “home made”
diversification.

12. Reconciling the Differences
To bridge the gap between strategic planning and financial analysis, a conscious
effort is required on both the sides.
 Financial analysts must avoid the mistakes commonly committed by them
and expand the scope of their work to reflect the values of options
embedded in investments of strategic significance.
 Strategic planners must understand the logic of DCF analysis, acquire
familiarity with the meaning of capital market data, and calculate the
NPVs, at least as a rough check on the results of their analysis.
While a complete reconciliation is not practical, a sincere attempt to see
each other’s point of view and to unearth hidden premises will facilitate better
communication and understanding. This will ensure that strategic analysis is not
financially naïve and financial analysis is not insensitive to strategic issues.

13. Informational Asymmetry and Capital Budgeting
The conventional ‘text book’ approach to capital budgeting is starkly simple :
accept projects which have a positive NPV. It does not make any difference
whether the investment decision making is centralised or decentralised; it is
irrelevant whether the existing firm implements it or a newly set up firm executes
it; it does not matter what mix of financing is employed.
The behaviour of firms, however, is not always in conformity with what has
been said above. In the real world :
 Firms often ration capital and do not invest in all projects that have positive
NPVs.
 A lot of attention is paid to the extent to which capital budgeting decisions are
centralised.
 Often, new projects are organised as separate corporate entities.
 The mix of financing is considered to be very important.

14. Why does a discrepancy exist between what the conventional model says
and how the real world firms behave ? Informational asymmetries of various
sorts seem to create such a hiatus. Informational asymmetry exists if the
transacting parties have unequal information, ex ante or ex post.
We may classify informational asymmetry into three broad types :
· Informational asymmetry between shareholders and bondholders
· Informational asymmetry between current shareholders and prospective
shareholders
· Informational asymmetry between managers and shareholders

15. Informational Asymmetry between Shareholders
and Bondholders
Informational asymmetry between shareholders and
bondholders has two possible distorting consequences
Asset substitution moral : Shareholders may prod
hazard management to substitute riskier
assets for safer assets, at the
expense of bondholders
Underinvestment moral : In firms with risky debt,
hazard shareholders have an incentive
to avoid investing in new projects
that have a positive NPV, because
they would not like the cash flows
of new projects to be diverted for
servicing existing risky debt.

16. Informational Asymmetry between Current Shareholders
and Prospective Shareholders
When there is informational asymmetry between current shareholders
and prospective shareholders, the latter will not fully appreciate the
future payoffs of various resources commitments. The common
distortions resulting from such informational asymmetry are :
Preference for projects with shorter payback period.
· A greater degree of capital rationing.
· Centralisation of capital budgeting.
. Accumulation of liquidity despite the existence of positive NPV
projects.

17. Informational Asymmetry between Managers
and Shareholders
Thanks to their informational advantage, managers enjoy latitude to
choose investments aimed at building their reputation, rather than
enhancing shareholders wealth. The concern for managerial reputation
may lead to three kinds of distortions in investment decisions:
Visibility Bias Managers seek to improve short term indicators of
performance.
Resolution Preference Managers attempt to advance the arrival of
good news and delay the announcement of bad news.
Mimicry and Avoidance Managers try to imitate the actions of
superior managers and avoid the actions of inferior managers.

18.  Squeezing of an investment to improve short term cash flows
 Premature liquidation of assets to show that they are worth a lot.
 Adoption of projects with earlier payoffs.
 Avoidance of worthwhile projects that carry risk of early
failure to protect short-term reputation.
 Escalation of inferior projects to avoid admission of failure
 Undertaking projects which are supposed to have benefits in
distant future to protect short-term reputation.
 Conformity with other managers to avoid the ‘odd manager’ label.
 Deviation from other managers to avoid seeming mediocre.
These incentives may lead to the following investment biases:

19. Reverse Financial Engineering
 Many organisations have reasonably well-defined quantitative
indicators (such as IRR > 20 percent) for approving projects.
 Since a project sponsor is keen to get his project included in the
capital budget, he is likely to massage the numbers and dress up his
project proposal.

20. Mitigating Financial Manipulation
 McGrath and MacMillan have suggested a process they call discovery-
driven planning that has the potential of improving the quality of analysis.
 It reverses the sequence of the steps in the stage-gate process.
 In traditional method:
Assumptions Financial Projections
 Discovery-driven planning starts with the minimal acceptable revenue,
income, and cash flow statement and then asks: “What assumptions must
be fulfilled to get these numbers?”
 McGrath and MacMillan refer to this as “reverse income statement.”
 The traditional method focuses the spotlight on financial projections, while
obfuscating the assumptions.
 By contrast, discovery-driven planning focuses the spotlight on the
assumptions that reflect the key uncertainties.

21. Group Process
 In theory, a group decision is supposed to exploit the synergies arising
from bringing together people with diverse skills, perspectives, and
values.
 Many groups are unable to achieve process gains due to the following:
 In intellectual tasks groups tend to outperform individuals whereas
in judgmental tasks groups tend to under perform individuals.
 Groups tend to become polarised in respect of risk tolerance.
 As a result of group discussion, group members tend to readily
accept a decision.

22. Reasons for Group Errors
 Groupthink Like individuals, group are characterised by a
collective form of confirmation bias called groupthink.
 Poor Information Sharing.
 Inadequate Motivation.

23. Countering Groupthink
According to Hersh Shefrin groupthink can be checked by:
 Asking group members to refrain from stating their positions at
the beginning of the discussion.
 Explicitly encouraging debate, disagreement, and information
sharing.
 Designating one member of the group to be a devil’s advocate
for each major proposal.
 Regularly inviting outside experts to attend meetings, with the
charge that they challenge the group to refrain from meek
conformism.

24. Impact on Earnings
 In theory, managers are supposed to maximise firm value
by choosing projects on the basis of their NPVs.
 In practice, managers look at NPVs as well as the
accounting implications of their decisions.
 In particular, they are concerned with the impact of
investments on reported earnings in the short run.

25. Reasons and Consequences of Emphasis on Short-term
Earnings
 Reasons for Emphasis on Short-term Earnings.
 Short-term incentive compensation of top management is often
linked to earnings.
 Value of stock options and stock grants depends on corporate
earnings, at least in the short run.
 When reported earnings are good, top managers enjoy greater
freedom.
 Favourable earnings inspire greater confidence in all stakeholders.
 The emphasis on short-term earnings may lead to acceptance of
projects that are earnings-accretive but NPV-negative.

26. SUMMARY
 A mosaic of influences that can be described qualitatively have an
important bearing on capital expenditure decisions.
 Capital budgeting is the principal instrument for implementing a firm’s
strategy. Hence the two should be properly linked.
 In a decision involving measurement as well as judgment, as far as
possible, separate the quantifiable factors and the intangible factors.
 Strategic planning, among other things, is concerned with the issue of
allocating a firm’s resources across different lines of business. In this
sense, strategic planning may be viewed as capital budgeting on a grand
scale.
 Strategic planning is often naïve from the financial point of view and /
or the results of strategic planning and financial analysis are not
properly reconciled.

27.  In applying DCF analysis, the following mistakes are commonly
committed: mechanical projection of cash flows, optimistic bias in cash
flows, emphasis on IRR, inconsistent treatment of inflation, and
unreasonably high discount rates.
 To bridge the gap between strategic planning and financial analysis, a
conscious effort is required on both the sides. Financial analysts must
avoid the mistakes commonly committed by them and strategic planners
must understand the logic of the DCF analysis.
 The behaviour of firms in the real world is often at variance with the
textbook model. The discrepancy arises mainly because of
informational asymmetries.
 In theory, managers are supposed to maximize firm value by choosing
projects on the basis of their NPVs. In practice, managers look at NPVs
as well as the accounting implications of their investment decisions. In
particular, they are concerned with the impact of investments on
reported earnings in the short run.

28.  Since a project sponsor is keen to get his proposal included in the capital
budget, he is likely to massage the numbers to dress up his project
proposal. Is there some way by which such financial manipulation can
be checked? McGrath and MacMillan have suggested a process they
call discovery-driven planning that has the potential of improving the
quality of analysis.
 In order to be meaningful and viable, the capital budget of a firm must
satisfy some conditions: (i) It must be compatible with the resources of
the firm. (ii) It must be controllable. (iii) It must be endorsed by the
executive management.