CAPITAL BUDGETING

1 THE PROCESS OF INVESTMENT DECISION MAKING

• A typical model for investment decision making has some distinct stages. During the project’s
progress, project controls should be applied.

1.1 Creation of capital budgets

The capital budget will normally be prepared to cover a longer period than sales, production,
and resource budgets, say from three to five years, although it should be broken down into
periods matching those of other budgets. It should indicate the expenditure required to cover
capital projects already underway, and those it is anticipated will start in, say, the three to five
year period of the capital budget.

The budget should, therefore, be based on the current production budget and future expected
levels of production and the long-term development of the organization, and industry, as a
whole.

Budget limits or constraints might be imposed internally (soft capital rationing) or externally
(hard capital rationing).

Projects can be classified in the budget into those that generally arise from top management
policy decisions or from sources such as mandatory government regulations (health, safety, and
welfare capital expenditure) and those that tend to be appraised using the techniques covered in
this chapter.
(a) Cost reduction and replacement expenditure.
(b) Expenditure on the expansion of existing product lines.
(c) New product expenditure.

The administration of the capital budget is usually separate from that of the other budgets.
Overall responsibility for authorization and monitoring of capital expenditure is, in most large
organizations, the responsibility of a committee.

1.2 The investment decision-making process

Capital expenditure often involves the outlay of large sums of money, and expected benefits
may take some years to accrue. For these reasons, capital expenditure must be subject to a
rigorous process of appraisal and control.

A typical model for investment decision making has some distinct stages:

Origination of proposals.

Project screening.

Analysis and acceptance.

Monitoring and review.

1.3 Origination of proposals

Investment opportunities do not just appear out of thin air. They must be created. An
organization must set up a mechanism that scans the environment for potential opportunities
and gives an early warning of future problems. A technological change that might result in a
drop in sales might be picked up by this scanning process, and steps should be taken
immediately to respond to such a threat.
 Ideas for investment might come from those working in technical positions. A factory manager,
for example, could be well placed to identify ways in which expanded capacity or new
machinery could increase output or the efficiency of the manufacturing process. Innovative
ideas, such as new product lines, are more likely to come from those in higher levels of
management, given their strategic view of the organization’s direction and their knowledge of
the competitive environment.

The overriding feature of any proposal is that it should be consistent with the organization’s
overall strategy to achieve its objectives.

1.4 Project screening

Each proposal must be subject to detailed screening. So that a qualitative evaluation of a
proposal can be made, some key questions such as those below might be asked before any
financial analysis is undertaken. Only if the project passes this initial screening will a more
detailed financial analysis begin.
(a) What is the purpose of the project?
(b) Does it ‘fit’ with the organization’s long-term objectives?
(c) Is it a mandatory investment, for example, to conform with safety legislation?
(d) What resources are required, and are they available, e.g., money, capacity, labor?
(e) Do we have the necessary management expertise to guide the project to completion?
(f) Does the project expose the organization to unnecessary risk?
(g) How long will the project last, and what factors are key to its success?
(h) Have all possible alternatives been considered?

1.5 Analysis and acceptance

The analysis stage can be broken down into some steps.
Step 1 Complete and submit standard format financial information as a formal investment proposal.
Step 2 Classify the project by type – to separate projects into those that require a more or less
rigorous financial appraisal, and those that must achieve a greater or lesser rate of return to
be deemed acceptable.
Step 3 Carry out financial analysis of the project. We look at this in more detail below.
Step 4 Compare the outcome of the financial analysis to predetermined acceptance criteria.
Step 5 Consider the project in light of the capital budget for the current and future operating
periods.
Step 6 Make the decision – accept/reject. This is considered in more detail below.
Step 7 Monitor the progress of the project (covered below).

Steps 1 to 6 above can be seen in the context of the decision-making process that was described
in chapter 1, section 3.7. After all, investing in capital projects involves a decision about
whether to spend and how much to spend.
Step 1 Define the problem. The problem that leads to capital expenditure decisions may be that
existing assets are getting old and less reliable, and management wants to decide how to
improve reliability and efficiency in production. The problem may be that the organization
wants to expand the scale of its operations or diversify into a new line of business, and to do
this, it needs to invest in new assets.
Step 2 Identify the decision-making criteria. There are several different ways of evaluating
investment options. As we shall see later, the decision-making criteria may be that any new
investment should earn a minimum return on capital invested, or should add value to the
business, or that any amount invested should be recovered within a given number of years.
Step 3 Develop alternatives. With capital investment decisions, the alternatives may be presented
 simply as “Invest in a specific asset” or “Do not invest.” However, there may be other
options to consider, such as whether to buy Asset 1 or Asset 2 (which may be a bigger and
more expensive item). There may also be different options about when to invest – whether to
invest now or whether to defer the spending until a later time. In the exam, the options are
likely to be either to invest or not to invest ‘now.’
Step 4 Analyze the alternatives. Each of the alternatives should be analyzed and evaluated, using
the chosen decision-making criterion. If the alternatives are either to invest or not to invest,
the analysis is carried out by evaluating the decision to invest.
Step 5 Select an alternative. If investing is worthwhile, the “don’t invest” option is rejected. If
investing seems worthwhile, the “don’t invest” option is rejected.

1.5.1 Financial analysis

The financial analysis will involve the application of the organization’s preferred
investment appraisal techniques. In many projects, some of the financial implications
will be extremely difficult to quantify, but every effort must be made to do so to have a
formal basis for planning and to control the project.

Here are examples of the type of question that will be addressed at this stage:
(a) What cash flows/profits will arise from the project, and when?
(b) Has inflation been considered in the determination of the cash flows?
(c) What are the results of the financial appraisal?
(d) Has any allowance been made for risk, and if so, what was the outcome?

Some types of projects, for example, a marketing investment decision, may give rise to
cash inflows and returns, which are so intangible and difficult to quantify that a full
financial appraisal may not be possible. In this case, more weight may be given to a
consideration of the qualitative issues.

1.5.2 Qualitative issues

Financial analysis of capital projects is vital because of the amount of money involved
and the length of time for which it is tied up. A consideration of qualitative issues is
also relevant to the decision, i.e., factors that are difficult or impossible to quantify. We
have already seen that qualitative issues would be considered in the initial screening
stage, for example, in reviewing the project’s ‘fit’ with the organization’s overall
objectives and whether it is a mandatory investment. There is a very wide range of other
qualitative issues that may be relevant to a particular project.
(a) What are the implications of not undertaking the investment, e.g., adverse effect on
staff morale, loss of market share?
(b) Will acceptance of this project lead to the need for further investment activity in
the future?
(c) What will be the effect on the company’s image?
(d) Will the organization be more flexible as a result of the investment, and better able
to respond to market and technology changes?

1.5.3 Go/no go decision

“Invest” or “Don’t invest” decisions (Go/no go decisions) on projects may be made at
different levels within the organizational hierarchy, depending on three factors:
(a) The type of investment.
(b) Its perceived riskiness.
(c) The amount of expenditure required.
 For example, a divisional manager may be authorized to make decisions up to P25,000,
an area manager up to P150,000 and a group manager up to P300,000, with board
approval for greater amounts.

Once the go/no go, or accept/reject, the decision has been made, the organization is
committed to the project, and the decision-maker must accept that the project’s success
or failure reflects on his or her ability to make sound decisions.

1.6 Monitoring the progress of the project

During the project’s progress, project controls should be applied to ensure the following:

Capital spending does not exceed the amount authorized.

The implementation of the project is not delayed.

The anticipated benefits are eventually obtained.

The first two items are probably easier to control than the third because the controls can
normally be applied soon after the capital expenditure has been authorized, whereas monitoring
the benefits will span a longer period.

1.6.1 Controls over excess spending

There are some controls that organizations can implement to ensure that capital
spending does not exceed the amount authorized.
(a) The authority to make capital expenditure decisions must be formally assigned.
(b) Capital expenditure decisions should be documented, and approval of the project
should specify the manager authorized to carry out the expenditure and hence
responsible for the successful implementation of the project, the amount of
expenditure authorized and the period in which the expenditure should take place.
(c) Some overspending above the amount authorized – say 5% or 10% – might be
allowed. If the required expenditure exceeds the amount authorized by more than
this amount, a fresh submission for reauthorization of the project should be
required.
(d) There should be a total capital budget, and the authorization of any capital
expenditure, which would take total spending above the budget, should be referred
to, for example, board-level for approval.

1.6.2 Control over delays

If there is a delay in carrying out the project and the capital expenditure has not taken
place before the stated deadline is reached, the project should be resubmitted for fresh
authorization, and the proposer should be asked to explain the reasons for the delay.

1.6.3 Control over the anticipated benefits

Further control can be exercised over capital projects by ensuring that the anticipated
benefits do materialize, the benefits are as big as anticipated, and running costs do not
exceed expectations.

A difficulty with control measurements of capital projects is that most projects are
‘unique’ with no standard or yardstick to judge them against other than their appraisal
data. Therefore if actual costs were to exceed the estimated costs, it might be impossible
to tell just how much of the variance is due to bad estimating and how much is due to
inefficiencies and poor cost control.
 In the same way, if benefits are below expectations, is this because the original
estimates were optimistic or because management has been inefficient and failed to get
the benefits they should have done?

Many capital projects, such as the purchase of replacement assets and marketing
investment decisions, do not have identifiable costs and benefits. The incremental
benefits and costs of such schemes can be estimated, but it would need a very
sophisticated management accounting system to be able to identify and measure the
actual benefits and many of the costs. Even so, some degree of monitoring and control
can still be exercised using a post-completion appraisal or audit review.

2 POST AUDIT
• A post-audit cannot reverse the decision to incur the capital expenditure, because the
expenditure has already taken place, but it does have a certain control value.

Definition
A post-completion audit (PCA) is an objective, independent assessment of the success of a capital
project to the plan. It covers the whole life of the project and provides feedback to managers to aid
the implementation and control of future projects.

The PCA is, therefore, is a forward-looking rather than a backward-looking technique. It seeks to
identify general lessons to be learned from a project.

2.1 Why perform a post-completion appraisal (PCA) or audit?

(a) The threat of the PCA will motivate managers to work to achieve the promised benefits
from the project.
(b) If the audit takes place before the project life ends, and if it finds that the benefits have
been less than expected because of management inefficiency, steps can be taken to improve
efficiency. Alternatively, it will highlight those projects which should be discontinued.
(c) It can help to identify managers who have been good performers and those who have been
poor performers.
(d) It might identify weaknesses in the forecasting and estimating techniques used to evaluate
projects, and so should help to improve the discipline and quality of forecasting for future
investment decisions.
(e) Areas, where improvements can be made in methods which should help to achieve better
results in general from capital investments, might be revealed.
(f) The original estimates may be more realistic if managers are aware that they will be
monitored, but post-completion audits should not be unfairly critical.

Research by Neale and Homes (1990) found that managers see the following advantages to
PCAs.
(a) They improve the quality of decision making.
(b) They improve organizational performance.
(c) They improve control and guidance.
(d) They encourage a more realistic approach to new investment project decision making.
(e) They help to identify critical success factors.
(f) They enable changes to be made more quickly to projects that are not doing very well.
 (g) They encourage (when relevant) project termination.

2.2 Which projects should be audited?

A reasonable guideline might be to audit all projects above a certain size, and a random
selection of smaller projects.

A PCA does not need to focus on all aspects of an investment but should concentrate on those
aspects which have been identified as particularly sensitive or critical to the success of a project.
The most important thing to remember is that post-completion audits are time-consuming and
costly, and so careful consideration should be given to the cost-benefit trade-off arising from the
post-completion audit results.

2.3 When should projects be audited?

If the audit is carried out too soon, the information may not be complete. On the other hand, if
the audit is too late, then management action will be delayed, and the usefulness of the
information is greatly reduced.

There is no correct answer to the question of when to audit, although research suggests that in
practice, most companies perform the PCA approximately one year after the completion of the
project.

2.4 Who performs a PCA?

Because it can be very difficult to evaluate an investment decision completely objectively, it is
generally appropriate to separate responsibility for the investment decision from that for the
PCA. Line management involved in the investment decision should, therefore, not carry out the
PCA. To avoid conflicts of interest, outside experts could even be used.

2.5 Problems with PCA

(a) Many uncontrollable factors are outside management control in long-term investments,
such as environmental changes.
(b) It may not be possible to identify the costs and benefits of any particular project separately.
(c) PCA can be a costly and time-consuming exercise, although ‘contrary to what is often
thought, conducting a PCA does not appear to be an expensive business’ reported Brantjes,
von Eije, Eusman, and Prins in Management Accounting (Post-completion auditing with
Heineken) in April 1999.
(d) Applied punitively, post-completion audit exercises may lead to managers becoming over-
cautious and unnecessarily risk-averse.
(e) The strategic effects of a capital investment project may take years to materialize, and it
may, in fact, never be possible to identify or quantify them effectively.

Despite the growth in popularity of post-completion audits, you should bear in mind the
possible alternative control processes:
(a) Teams could manage a project from beginning to end, control being used before the project
is started and during its life, rather than at the end of its life.
(b) More time could be spent choosing projects rather than checking completed projects.

Case study
A 1999 Management Accounting article looked at post-completion auditing at Heineken (the
Dutch beer producer) and how it was applied to a project to replace a 20-year old bottling line.
The following table shows the planned objectives of the investment and the actual situation at
 the time a PCA was carried out on the investment. (Guilders were the Dutch currency before
the euro.) This should give you an idea of the type of objectives that can be monitored with a
PCA.
Objectives Plan Actual
Efficiency Increase from 65% to 80% No increase yet
Staff savings From 13 to 7 per shift Achieved
Forklift savings One vehicle less One and possibly two vehicles less
Savings on an 1.3 million guilders of Savings achieved, but as a result of reusing
overhaul of the old savings part of the old bottling line another 1.8
bottling line million guilders was spent in additional
overhaul costs
Savings on Savings of 0.4 million Savings estimated at 0.3 million guilders
maintenance guilders annually annually
Quality 50% reduction in damage Achieved
Working conditions Level of noise All much improved, but not quantified
Accessibility
Safety
Attainability

Now that we have discussed all the stages involved in the capital budgeting process, we will
return to study in detail the stage that many managers consider to be the most important: the
financial appraisal. A decision about whether to invest is often made on financial
considerations, and the decision criterion is related to financial return. We will begin with what
is probably the most straightforward appraisal technique: the payback method.

3 THE PAYBACK METHOD

• The payback method looks at how long it takes for a project’s net cash inflows to equal the
initial investment.

Definition
Payback is the time required for the cash inflows from a capital investment project to equal the cash
outflows so that the returns from the investment pay back the initial outlay.

Payback is often used as a ‘first screening method.’ By this, we mean that when a capital investment
project is being subjected to financial appraisal, the first question to ask is: ‘How long will it take to
pay back its cost?’ The organization might have a target payback, and so it would reject a capital
project unless its payback period was less than a target maximum number of years.

When deciding between two or more competing projects, management may prefer the one with the
shortest payback.

If payback were the only method of evaluation used, the decision criterion would be to recover the
initial capital outlay as quickly as possible.

However, a project should not be evaluated based on payback alone. Payback should be a first
screening process, and if a project gets through the payback test, it ought then to be evaluated with a
more sophisticated project appraisal technique.

Payback is a cash-based measure. Ideally, it is based on the project’s cash inflows versus its cash
outflows.
It does not consider profit. In the absence of cash flow information; however, profits before
depreciation can be used as a very rough approximation of annual cash flows.
With some methods of capital expenditure appraisal, it is commonly assumed that cash flows in each
period occur on the last day of the period. However, with the payback method, either of two different
assumptions may be used:
(a) that the cash flows in each period do occur at the end of the period: this means that capital
expenditure at the beginning of the first year is assumed to occur in ‘Year 0’, which is the year
that has just ended. When this assumption is used, payback will occur at the end of a particular
year.
(b) That the cash flows occur at an even rate throughout each period, when this assumption is used,
payback will normally occur at some time during a particular year, not at the end of a year.

When it is assumed that cash flows occur at an even rate throughout the year (except any cash from
the disposal of a capital asset, which happens at the very end of the project), the payback period is
calculated as follows.
(a) Calculate the cumulative cash flows at the end of each year. The initial capital outlay is a cash
outflow, so the cumulate cash flow will remain negative until payback is achieved.
(b) Payback is achieved during the year that the cumulative cash flows change from negative to
positive.
(c) The time in the payback year that payback occurs is found by calculating the proportion: (Extra
cash inflow needed for payback at the start of the year/Cash flow during the year)
(d) Multiply this proportion by 12 months to get the payback month in the year.

For example, suppose that the cumulative cash flow for a project at the end of Year 3 is - P15,000,
and the cash flow in Year 4 is P36,000. The payback period will be 3 years + [(15,000/36,000) × 12
months] = 3 years 5 months.

3.1 Why is payback alone an inadequate project appraisal technique?

Look at the figures below for two mutually exclusive projects (this means that only one of them
can be undertaken).
Project P Project Q
Capital cost of asset P60,000 P60,000
Profits before depreciation
Year 1 P20,000 P50,000
Year 2 P30,000 P20,000
Year 3 P40,000 P5,000
Year 4 P50,000 P5,000
Year 5 P60,000 P5,000

Project P pays back in year 3. If we assume that cash flows occur at the end of the year, payback
occurs at the end of year 3. If we assume that cash flows occur at an even rate throughout each
year, Project P will pay back one-quarter of the way through year 3 (after two years three
months).

Project Q pays back in year 2. If we assume that cash flows occur at the end of the year,
payback occurs at the end of year 2. If we assume that cash flows occur at an even rate
throughout each year, Project Q will pay back halfway through year 2 (after one year six
months).

Using payback alone to judge projects, project Q would be preferred. But the returns from
project P over its life are much higher than the returns from project Q. Project P will earn total
 profits before depreciation of P200,000 on investment of P60,000, whereas project Q will earn
total profits before depreciation of the only P85,000 on investment of P60,000. Choosing
between the projects on payback alone would be inappropriate: total return must also be
considered.

3.2 Disadvantages of the payback method

There are two serious drawbacks to the payback method:
(a) It ignores the timing of cash flows within the payback period, the cash flows after the end
of the payback period, and, therefore, the total project return.
(b) It ignores the time value of money, which is a concept incorporated into more sophisticated
appraisal methods. This means that it does not take account of the fact that P1 today is
worth more than P1 in one year. An investor who has P1 today can either consume it
immediately or alternatively, can invest it at the prevailing interest rate, say 10%, to get a
return of P1.10 in a year.

There are also other disadvantages:

(a) The method is unable to distinguish between projects with the same payback period.
(b) The choice of any cut-off payback period by an organization is arbitrary.
(c) It may lead to excessive investment in short-term projects.
(d) It takes account of the risk of the timing of cash flows but does not take account of the
variability of those cash flows.

3.3 Advantages of the payback method

The use of the payback method does have advantages, especially as an initial screening device:
(a) Long payback means capital is tied up.
(b) Focus on early payback can enhance liquidity.
(c) Investment risk is increased if the payback is longer.
(d) Shorter-term forecasts are likely to be more reliable.
(e) The calculation is quick and simple.
(f) Payback is an easily understood concept.

4 THE ACCOUNTING RATE OF RETURN METHOD

• Like the payback method, the accounting rate of return method is popular despite its limitations.

The accounting rate of return (ARR) method (also called the return on capital employed (ROCE)
method or the return on investment (ROI) method) of appraising a project is to estimate the
accounting rate of return that the project should yield. If it exceeds a target rate of return, the project
will be undertaken. Profits rather than cash flows are used to measure the size of returns.

Formulae to learn
Unfortunately, there are several different definitions of ARR.
The average annual profit from investment × 100%
ARR =
Average investment

Estimated total profits

ARR = × 100%
Estimated initial investment

Or
Estimated average profits
ARR = × 100%
Estimated initial investment
The measurement of ARR is different according to whether ‘average annual profit’ or ‘total profits
over the asset life’ is the figure above the line. Similarly, ARR differs according to whether ‘average
investment’ or ‘initial investment’ is used below the line.
Note: Average investment = [(Initial cost + Estimated residual value)/2].

Whichever method of measuring ARR is selected (assuming that the ARR method is used as a
decision criterion), the method selected should be used consistently. For examination purposes, we
recommend the first definition (average profit as a percentage of the average investment) unless the
question indicates that some other one is to be used.

Note that this is the only appraisal method that we will be studying that uses profit instead of cash
flow. If you are not provided with a figure for profit, assume that net cash inflow minus depreciation
equals profit.

Worked Example: Target accounting rate of return

A company has a target accounting rate of return of 20%, using the first definition above, and is now
considering the following project.
The capital cost of the asset P80,000
Estimated life Four years
Estimated profit before depreciation
Year 1 P20,000
Year 2 P25,000
Year 3 P35,000
Year 4 P25,000

The capital asset would be depreciated by 25% of its cost each year and will have no residual value.
Assess whether the project should be undertaken.

Solution
The annual profits after depreciation, and the mid-year net book value of the asset, would be as
follows.
Year Profit after depreciation Mid-year net book value ARR in the year
1 P0 P70,000 0%
2 5,000 50,000 10%
3 15,000 30,000 50%
4 5,000 10,000 50%

As the table shows, the ARR is low in the early stages of the project, partly because of low profits in
Year 1 but mainly because the NBV of the asset is much higher early on in its life. The project does
not achieve the target ARR of 20% in its first two years but exceeds it in years 3 and 4. Should it be
undertaken?

When the ARR from a project varies from year to year, it makes sense to take an overall or ‘average’
view of the project’s return. In this case, we should look at the return over the four years.
Total profit before depreciation over four years P105,000
Total profit after depreciation over four years 25,000
Average annual profit after depreciation 6,250
The original cost of investment 80,000
 Average net book value over the four-year period ((80,000 + 0)/2) 40,000

The project would not be undertaken because its ARR is (6,250/40,000) × 100% = 15.625% and so it
would fail to yield the target return of 20%.

4.1 The ARR and the comparison of mutually exclusive projects

The ARR method of capital investment appraisal can also be used to compare two or more
projects which are mutually exclusive. The project with the highest ARR would be selected,
provided that the expected ARR is higher than the company’s target ARR.

4.2 The drawbacks and advantages to the ARR method of project appraisal
The ARR method has a serious drawback that it does not take account of the timing of the
profits from a project. Whenever capital is invested in a project, money is tied up until the
project begins to earn profits which pay back the investment. Money tied up in one project
cannot be invested anywhere else until the profits come in. Management should be aware of the
benefits of early repayments from an investment, which will provide money for other
investments. There are some other disadvantages:
(a) It is based on accounting profits, which are subject to some different accounting
treatments.
(b) It is a relative measure rather than an absolute measure and hence takes no account of the
size of the investment.
(c) It takes no account of the length of the project.
(d) Like the payback method, it ignores the time value of money.

There are, however, advantages to the ARR method:

(a) It is quick and simple to calculate.
(b) It involves a familiar concept of a percentage return.
(c) Accounting profits can be easily calculated from financial statements.
(d) It looks at the entire project life.
(e) Managers and investors are accustomed to thinking in terms of profit, and so an appraisal
method that employs profit may, therefore, be more easily understood.

5 RISK AND UNCERTAINTY IN DECISION MAKING

5.1 What are the risks and uncertainty?

An example of a risky situation is one in which we may say that there is a 70% probability
that returns from a project will be over P100,000, but a 30% probability that returns will be
less than P100,000. If no information can be provided on the returns from the project, we
are faced with an uncertain situation.

People may be risk-seekers, risk-neutral, or risk-averse.

Definitions
Risk involves situations or events which may or may not occur, but whose probability of
occurrence can be calculated statistically and the frequency of their occurrence predicted from
records. Therefore insurance deals with risk.

Uncertain events are those whose outcome cannot be predicted with statistical confidence.

5.2 Risk and capital investment decisions

 In general, risky projects are those who have future cash flows, and hence project returns, that
are likely to be variable. The greater the variability, the greater the risk.

The problem of risk is more acute with capital investment decisions for the following reasons:
(a) Estimates of capital expenditure might be for several years ahead, such as those for major
construction projects. Actual costs may well escalate above budget as the work progresses.
(b) Estimates of benefits will be for several years ahead, sometimes 10, 15, or 20 years ahead
or even longer, and such long-term estimates can at best be approximations.

In everyday usage, the terms risk and uncertainty are not distinguished. If you are asked for a
definition, do not make the mistake of believing that the latter is a more extreme version of the
former. It is not a question of degree; it is a question of whether or not sufficient information is
available to allow the lack of certainty to be quantified. As a rule, however, the terms are used
interchangeably.

5.3 Risk preference

People may be risk-averse, risk-neutral, or risk seekers.

Definitions
A risk-averse investor requires compensation for risk and will avoid risk unless the expected
return adequately compensates for it. If two investments have the same expected return, they
will choose the one with the lowest risk. However, a risk-averse decision-maker may be
prepared to invest in a more risky project, provided that the expected return is higher.

An investor is risk-neutral if they are indifferent to the level of risk involved in an investment
and only concerned about the expected return. A risk-neutral decision-maker would be
indifferent between investments that offered the same expected return, regardless of the risk
with each investment.

A risk seeker is an investor who is attracted to risk. They would choose an investment that
offers the possibility of a higher level of return, even when there is a high probability of a much
lower return. For example, a risk seeker might choose to invest in something that offers a 10%
chance of a return of P20,000 and a 90% chance of P0 in preference to an investment that is
100% certain to provide a return of P5,000.

This has clear implications for managers and organizations. A risk-seeking manager working
for a characteristically risk-averse organization is likely to make decisions that are not
congruent with the goals of the organization. There may be a role for the management
accountant here, who could be instructed to present decision-making information in such a way
as to ensure that the manager considers all the possibilities, including the worst.

Case study
What constitutes an acceptable amount of risk will vary from organization to organization. For
large public companies, it is largely a question of what is acceptable to the shareholders. A
‘safe’ investment will attract investors who are, to some extent, risk-averse, and the company
will, therefore, be obliged to follow relatively ‘safe’ policies. A company that is recognized as
being an innovator or a ‘growth’ company in a relatively new market, like Yahoo!, will attract
investors who are looking for high performance and are prepared to accept some risk in return.
Such companies will be expected to make ‘bolder’ decisions.
 The risk of an individual strategy should also be considered in the context of the overall
‘portfolio’ of investment strategies adopted by the company.
(a) If a strategy is risky, but its outcome is not related to the outcome of other strategies, then
adopting that strategy will help the company to spread its risks.
(b) If a strategy is risky but is inversely related to other adopted strategies so that if strategy A
does well, other adopted strategies will do badly and vice versa, then adopting strategy A
would reduce the overall risk of the company’s investment portfolio.

5.4 Scenario planning

Scenario planning can be useful in providing a long-term view of a strategy, where a few key
factors may influence success. It is designed to improve decision making by considering the
impact of possible future situations that may occur and their likely implications. These may be
favorable or unfavorable changes for the business concerned.

Scenario planning can be used:

To develop contingency plans to cope with specific threats or risks, e.g., the likelihood of
an oil spillage for a petroleum company

As a technique to predict the possible future operating environment for the company and to
identify appropriate actions, e.g., a financial services company may forecast the likely
impact on its business of different states of the economy (recession, growth, etc.)

Scenario planning, involves asking ‘what if?’ and ‘what is the effect of?’ questions about the
future.