1. DISCUSSION CASE

Many small and medium-sized companies tend not to use discounted cash flow techniques when analyzing capital expenditures. Instead, if any analysis of capital expenditures is performed, techniques such as the payback method or the simple rate of return are used. Required:

I. Why might smaller companies prefer to use techniques such as cash payback or the simple rate of return over discounted cash flow techniques?

II. Do you think it is any less beneficial for smaller companies to use discounted cash flow techniques when analyzing capital expenditures than it is for larger companies? Why or why not?

2. Capital Budget Reviews and the Role of the Post-Audit [LO1]

Stephen Scott recently joined the Finance and Planning Division of the Carrigan Bank (Bassillo) Limited as an assistant chief financial officer (CFO). Scott is a certified management accountant and has spent the previous four years working in the accounting department of a large Canadian manufacturing company. He took the job at the bank because it provided an opportunity to get some international business experience.

One of Scotts responsibilities is to perform an initial review of the capital budgeting proposals developed by the various divisions at the bank. Because the banks divisions are very large and have a high degree of operating autonomy, each division has its own divisional controller, who prepares the proposals with input from key managers in the division and other bank personnel. For 2015, the bank budgeted $500,000 for capital spending in each of the six major divisions for projects requiring less than $100,000 of expenditures. For projects of that size, the divisions are free to go ahead and spend the funds as they see fit, without the need for centralized review and approval. The bank budgeted a further $20 million in capital spending for 2015 to be allocated to the divisions on the basis of the project proposals submitted as part of the capital budget review process. These proposals are for individual projects requiring capital expenditures in excess of $100,000.

All project submissions are ranked from most to least profitable using the project profitability index: Net present value of project Investment required. The final review of the proposals is conducted by the CFO, the assistant CFO, and the vice-president of Finance (VPF). In addition to these three individuals, the review meeting is attended by the senior manager and controller of each division. Non-financial factors, such as the importance of the expenditure for maintaining the banks competitive position and its impact on customer retention and growth, are considered as part of the review and approval process. However, these factors typically have a smaller impact on the final decision than the project profitability index, which senior management believes to be more objective and reliable.

As part of his initial review of the proposals, Scott was instructed by the CFO to evaluate the reasonableness of the assumptions and to check the accuracy of the calculations. Where necessary, he was to follow up with the divisional controllers if he had any questions about the details. As Scott began his review, he was struck by the relatively high project profitability index on the vast majority of the projects. Indeed, most of the proposals (about 75%) had a project profitability index in excess of 30%, while the remaining 25% had an index between 20% and 30%. In several instances, the assumptions underlying the proposal seemed very optimistic, so he decided to follow up with the individual divisional controllers.

Almost without fail, the controllers admitted to using highly optimistic cash inflows in order to make their proposals look as good as possible. The controllers also commented that the division managers viewed the capital budget review process as a game that they wanted to win by getting as many of their projects approved as possible. As one controller put it (but said hed deny it if ever asked), Whats the harm in a little optimism as long as the estimates in all of the proposals are more or less equally overstated? Scott also learned from the controllers that word had leaked out that last year only those projects with a project profitability index over 30% were funded, and that they had been instructed by their divisional managers to make sure the current-year proposals met that threshold. The divisional controllers also suggested that it was clear that senior management at the bank condoned the optimism included in their proposals since the use of post-audits had been discontinued several years ago after the CFO at the time (who has since been replaced) concluded that the cost of the audits exceeded their benefits.

As Scott sat in his office after a conversation with one of the divisional controllers, he wasnt sure what to do next. The divisional controllers told him hed be wasting his time going to the CFO or the VPF, since they all knew how the capital budgeting game was being played. He was also concerned that rocking the boat would upset the divisional controllers, with whom he had to work closely on other aspects of his job. But he couldnt shake the feeling that this was an issue that deserved more attention.

Required:

I. What should Scott do?

II. Would the use of post-audits solve the problem of the overly optimistic project proposals being submitted at the bank? Why or why not?

III. Who should be involved in conducting the post-audit process?