San Miguel Corporation's Capital Investment Progam: A Summative Evaluation
*Benjamin D. de La Cruz
Abstract
Background
In 1974, SMC prepared an LRP with the objective of hitting P1.0 billion in sales by the year 1980. It was to be supported by a capital investment program of expansion, modernization and diversification. A capital expenditure planning and control system was then implemented. This was done in view of the contribution of investment projects to the overall profitability and growth of the company. Furthermore, the long term commitment of corporate funds stands to increase financial risk, and that the magnitude of capital expenditure is substantial and the penalties for wrong decisions are usually severe. Good results in this area depends on a seasoned business judgment aided by evaluation methods or techniques to assess profitability of proposed capital investment.
Problem Statement
This study attempted to assess the capital budgeting techniques used in evaluating proposed capital expenditures that San Miguel had been using in the last 20 years. In sum the study tried to determine:
1) What is SMC's capital budgeting system?
2) What are the evaluation methods or techniques used?
3) Which of the available methods of evaluation proved to be efficient?
4) What are the advantages and disadvantages of each method?
5) What changes are necessary?
The general objective of the study is to be able to rank the available methods being used in evaluating investment in the order of efficiency. The specific objective aimed to select the most suitable method given specific capital investment proposals.
Summative Evaluation
The Study used the historical and descriptive method of research and relied substantially on documentary analysis, library research and interviews. A summative formal evaluation of the Capital Investment Program with emphasis on the budgeting techniques was completed with stress on retrospective process evaluation. This entailed reliance on the researcher's career experience in the company and his long exposure in the CAPEX system of SMC.
Findings
The result of the study, in relation to the specific problems revealed the following:
1. SMC's Capital Budgeting System Has a two‑stage process, the planning stage and the implementation and control stage. In the planning stage, an approval in principle was obtained only after an evaluation process had been completed.
2. Evaluation Methods or Techniques Used The evaluation or techniques used are the simple measures consisting of Payback Period and the Return on Funds employed [ROFE] and the time‑adjusted, measures consisting of the Internal Rate of Return [IRR], Net Present Value [NPV] and Present Value Index [PVI].
3. Evaluation Methods Proven Effective The time‑adjusted measures were efficient, however the company also relied on the simple measures. Based on the type of budget and magnitude of expenditure, decisions were made using the cited measures.
4. Advantages and Disadvantages of Each Method
Payback Period
The advantages were:
Simple to calculate
Universally understood indicator of liquidity and risk; the sooner an investment is recovered, the shorter the period of uncertainty regarding its worth.
The disadvantages were:
Fails to consider project profitability or economic efficiency since it stops analysis with recovery of investment.
Fails to consider the time value of money.
Return on Funds Employed (ROFE)
The advantages were:
Simple to calculate
Places emphasis on profitability, rather than liquidity.
The disadvantages are:
Essentially an averaging technique
Fails to consider the time value of money.
Internal Rate of Return (IRR)
The advantages were:
It is conceptually superior to Payback Period and ROFE methods
Does not ignore any periods in the project life or any cash flows
Takes into account the time value of money
Yields a percentage that management can examine and make judgment about when cost of capital is not known with confidence.
Favors early cash flows over late ones.
The disadvantages were:
Requires an estimate of the organization's cost of capital, or at least a range of values in which it is likely to be found
Is much more difficult to apply without a computer than payback period or ROFE and when cash flows are non‑uniform, much more difficult to apply than the net present value method.
Does not distinguish between projects of different size and/or different economic lives.
Often yields multiple, thus ambiguous results when there is more than one sign change in the cash flows.
Implicitly assumes that cash flows may be reinvested at a return equal to IRR.
Net Present Value (NPV)
The advantages were:
Is conceptually superior to Payback Period and ROFE
Does not ignore any periods in the project life nor any cash flows
Takes into account the time value of funds
Is easier to apply than the IRR since it involves evaluating a polynomial rather than finding a root
Favors early cash flows than late ones.
The disadvantages were:
Requires that the organization has an estimate of its cost of capital
Is more difficult to apply than payback and ROFE, and thus less suitable for use by lower levels in the organization without proper training in its application
Gives a distorted comparison between projects of unequal size and/or unequal economic lives, unless modified by conversion to uniform annual equivalent and converted to profitability index.
Present Value Index (PVI)
The advantages were:
Provides ready comparability between investment proposals of different magnitudes
Provides a ranking or prioritization of projects.
The disadvantages are:
Expresses only relative profitability
Requires knowledge of the firm's cost of capital.
5. Necessary Changes
The present methods of evaluation, should be retained. However, concern was raised on the routine application of the measures without first understanding the underlying assumptions and or limitations of the measures. The implication of this is that the methods now in current use are still very much valid measurements of capital projects, however the now routine application could result in focusing on the numbers and percentages, rather than an interplay of the methods and other quantitative and qualitative factors when appraising capital projects.
Objectives
The general objective of ranking the available methods being used in evaluating investment in the order of efficiency was achieved. The present methods of evaluation ranked in the order of efficiency are:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Return on Funds Employed (ROFE) and Payback Period
Present Value Index (PVI)
Others i.e. Economic Value Added (EVA), Cost Benefit Analysis (CBA), and Free CashFlow‑Shareholder Value (FCF‑SV)
The specific objective of selecting the most suitable method given specific capital investment proposals, was likewise achieved. Since all the measures were used simultaneously on all capital projects it was deemed that the measures were all suitable, except on projects involving land acquisitions, and emergency items.
Conclusions
Good results to be realized in this area of decision making will highly depend on a combination of seasoned business judgment and the effective use of available planning and control devices for capital expenditure.
Conversely, excessive spending can raise operating costs and tie‑up corporate funds. Failure to make timely replacements of inefficient equipment can impair the quantity and quality of the corporation's output. The company can also lose its position as No. 1 by failing to expand or diversify to meet growing market demands.
Recommendations
The following are recommended to strengthen SMC's Capital budgeting process:
SMC's Corporate Planning and Funds Planning departments be involved in the early stages of planning at operating levels so that the proper combination of measures and ranking methods of evaluation can be ascertained.
Project justifications and measures used should be highlighted and the corresponding assumptions and projections be reviewed thoroughly and not mechanically and that of the technical groups endorsing the project, be streamlined.
Evaluation method for land acquisition be a subject of further studies as to the applicability of the present methods versus the methods used by property developers.
Emergency capital budget items be limited to payback and ROFE measurements similar to those of government required projects.
The amount of capitalizable limits should be reviewed. Frequent review should be made in relation to inflation. This will make the current methods of evaluation effective.
The overlapping of evaluation being done by the proponents of capital expenditure and that of the technical groups endorsing the project, be streamlined.
The post evaluation of capital projects proposal versus actual, should proceed so as to validate the results of evaluation methods currently in use.
In view of the foregoing, it is recommended that the present methods of evaluation be retained, while new methods are being explored. SMC should build further on the experience of the last two decades and strengthen not only the knowledge of techniques but rather not to lose sight of other factors and aspects of capital expenditure. The present methods of evaluation, are useful and should be retained and usage enhanced.
A Special Research Project
Presented to the Faculty of the Graduate School of Polytechnic University of the Philippines
In Partial Fulfillment of the Requirements in RH 511
*BENJAMIN D. DE LA CRUZ
31 October 1995
Approved by:
DR. Mercedes M. Leuterio
Chairman
DR. Carolina V. Prada
Member
Dean Rodolfo T. dE Lara, Ph.D.
Program Coordinator
Prof. Leticia R. Arbis
Research Adviser
*Benjamin D. de La Cruz
Abstract
Background
In 1974, SMC prepared an LRP with the objective of hitting P1.0 billion in sales by the year 1980. It was to be supported by a capital investment program of expansion, modernization and diversification. A capital expenditure planning and control system was then implemented. This was done in view of the contribution of investment projects to the overall profitability and growth of the company. Furthermore, the long term commitment of corporate funds stands to increase financial risk, and that the magnitude of capital expenditure is substantial and the penalties for wrong decisions are usually severe. Good results in this area depends on a seasoned business judgment aided by evaluation methods or techniques to assess profitability of proposed capital investment.
Problem Statement
This study attempted to assess the capital budgeting techniques used in evaluating proposed capital expenditures that San Miguel had been using in the last 20 years. In sum the study tried to determine:
1) What is SMC's capital budgeting system?
2) What are the evaluation methods or techniques used?
3) Which of the available methods of evaluation proved to be efficient?
4) What are the advantages and disadvantages of each method?
5) What changes are necessary?
The general objective of the study is to be able to rank the available methods being used in evaluating investment in the order of efficiency. The specific objective aimed to select the most suitable method given specific capital investment proposals.
Summative Evaluation
The Study used the historical and descriptive method of research and relied substantially on documentary analysis, library research and interviews. A summative formal evaluation of the Capital Investment Program with emphasis on the budgeting techniques was completed with stress on retrospective process evaluation. This entailed reliance on the researcher's career experience in the company and his long exposure in the CAPEX system of SMC.
Findings
The result of the study, in relation to the specific problems revealed the following:
1. SMC's Capital Budgeting System Has a two‑stage process, the planning stage and the implementation and control stage. In the planning stage, an approval in principle was obtained only after an evaluation process had been completed.
2. Evaluation Methods or Techniques Used The evaluation or techniques used are the simple measures consisting of Payback Period and the Return on Funds employed [ROFE] and the time‑adjusted, measures consisting of the Internal Rate of Return [IRR], Net Present Value [NPV] and Present Value Index [PVI].
3. Evaluation Methods Proven Effective The time‑adjusted measures were efficient, however the company also relied on the simple measures. Based on the type of budget and magnitude of expenditure, decisions were made using the cited measures.
4. Advantages and Disadvantages of Each Method
Payback Period
The advantages were:
Simple to calculate
Universally understood indicator of liquidity and risk; the sooner an investment is recovered, the shorter the period of uncertainty regarding its worth.
The disadvantages were:
Fails to consider project profitability or economic efficiency since it stops analysis with recovery of investment.
Fails to consider the time value of money.
Return on Funds Employed (ROFE)
The advantages were:
Simple to calculate
Places emphasis on profitability, rather than liquidity.
The disadvantages are:
Essentially an averaging technique
Fails to consider the time value of money.
Internal Rate of Return (IRR)
The advantages were:
It is conceptually superior to Payback Period and ROFE methods
Does not ignore any periods in the project life or any cash flows
Takes into account the time value of money
Yields a percentage that management can examine and make judgment about when cost of capital is not known with confidence.
Favors early cash flows over late ones.
The disadvantages were:
Requires an estimate of the organization's cost of capital, or at least a range of values in which it is likely to be found
Is much more difficult to apply without a computer than payback period or ROFE and when cash flows are non‑uniform, much more difficult to apply than the net present value method.
Does not distinguish between projects of different size and/or different economic lives.
Often yields multiple, thus ambiguous results when there is more than one sign change in the cash flows.
Implicitly assumes that cash flows may be reinvested at a return equal to IRR.
Net Present Value (NPV)
The advantages were:
Is conceptually superior to Payback Period and ROFE
Does not ignore any periods in the project life nor any cash flows
Takes into account the time value of funds
Is easier to apply than the IRR since it involves evaluating a polynomial rather than finding a root
Favors early cash flows than late ones.
The disadvantages were:
Requires that the organization has an estimate of its cost of capital
Is more difficult to apply than payback and ROFE, and thus less suitable for use by lower levels in the organization without proper training in its application
Gives a distorted comparison between projects of unequal size and/or unequal economic lives, unless modified by conversion to uniform annual equivalent and converted to profitability index.
Present Value Index (PVI)
The advantages were:
Provides ready comparability between investment proposals of different magnitudes
Provides a ranking or prioritization of projects.
The disadvantages are:
Expresses only relative profitability
Requires knowledge of the firm's cost of capital.
5. Necessary Changes
The present methods of evaluation, should be retained. However, concern was raised on the routine application of the measures without first understanding the underlying assumptions and or limitations of the measures. The implication of this is that the methods now in current use are still very much valid measurements of capital projects, however the now routine application could result in focusing on the numbers and percentages, rather than an interplay of the methods and other quantitative and qualitative factors when appraising capital projects.
Objectives
The general objective of ranking the available methods being used in evaluating investment in the order of efficiency was achieved. The present methods of evaluation ranked in the order of efficiency are:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Return on Funds Employed (ROFE) and Payback Period
Present Value Index (PVI)
Others i.e. Economic Value Added (EVA), Cost Benefit Analysis (CBA), and Free CashFlow‑Shareholder Value (FCF‑SV)
The specific objective of selecting the most suitable method given specific capital investment proposals, was likewise achieved. Since all the measures were used simultaneously on all capital projects it was deemed that the measures were all suitable, except on projects involving land acquisitions, and emergency items.
Conclusions
Good results to be realized in this area of decision making will highly depend on a combination of seasoned business judgment and the effective use of available planning and control devices for capital expenditure.
Conversely, excessive spending can raise operating costs and tie‑up corporate funds. Failure to make timely replacements of inefficient equipment can impair the quantity and quality of the corporation's output. The company can also lose its position as No. 1 by failing to expand or diversify to meet growing market demands.
Recommendations
The following are recommended to strengthen SMC's Capital budgeting process:
SMC's Corporate Planning and Funds Planning departments be involved in the early stages of planning at operating levels so that the proper combination of measures and ranking methods of evaluation can be ascertained.
Project justifications and measures used should be highlighted and the corresponding assumptions and projections be reviewed thoroughly and not mechanically and that of the technical groups endorsing the project, be streamlined.
Evaluation method for land acquisition be a subject of further studies as to the applicability of the present methods versus the methods used by property developers.
Emergency capital budget items be limited to payback and ROFE measurements similar to those of government required projects.
The amount of capitalizable limits should be reviewed. Frequent review should be made in relation to inflation. This will make the current methods of evaluation effective.
The overlapping of evaluation being done by the proponents of capital expenditure and that of the technical groups endorsing the project, be streamlined.
The post evaluation of capital projects proposal versus actual, should proceed so as to validate the results of evaluation methods currently in use.
In view of the foregoing, it is recommended that the present methods of evaluation be retained, while new methods are being explored. SMC should build further on the experience of the last two decades and strengthen not only the knowledge of techniques but rather not to lose sight of other factors and aspects of capital expenditure. The present methods of evaluation, are useful and should be retained and usage enhanced.
A Special Research Project
Presented to the Faculty of the Graduate School of Polytechnic University of the Philippines
In Partial Fulfillment of the Requirements in RH 511
*BENJAMIN D. DE LA CRUZ
31 October 1995
Approved by:
DR. Mercedes M. Leuterio
Chairman
DR. Carolina V. Prada
Member
Dean Rodolfo T. dE Lara, Ph.D.
Program Coordinator
Prof. Leticia R. Arbis
Research Adviser
The paper is available at the PUP Graduate School Library.
AC Research Journal
Volume 9 Number 1
February 2001
1 comment:
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