Capital project analysis and evaluation methods

Capital Project

According to the AMA, capital budgeting is "the decision-making process used by companies to evaluate long-term investments in large capital assets" (Hampton, 2011). Zeit (2013) makes the point that construction projects are included in the category of capital investment decisions, and that designers and architects are often involved. Reiter et al. (2000) argue that because of their size and critical strategic nature, "capital investment decisions are among the most important decisions made by firms."

What this means is that capital projects tend to be large-scale projects that have several key characteristics. They require a lot of money, to the point where that money may need to be acquired through financing. So construction projects in particular like new buildings or new wings would qualify. There is some ambiguity in the research if a takeover or merger would qualify as a capital project when financed with cash, but a small-scale acquisition probably would be. Capital projects do not include smaller purchases, such as the routine purchases of medical equipment in the normal course of doing business. Large-scale equipment purchase relating to opening a new department might qualify, however. Part of the key to differentiating a capital project is that funding for such projects is not contained within the operating budget.

Another way to look at the definition is to look at it as an accountant would. A capital asset is understood to be one that would be amortized or depreciated because it has a high cost and long-term usage life. Remember that all assets per definition convey future usage that has value (FASB, 1985). A capital asset therefore is one that fits this definition, while other assets are ones acquired at relatively low cost for short-term benefit. They are acquired as part of everyday operations and are expensed and short-term in nature. Capital investment decisions only concern capital assets by definition.

2. The text claims that there are four steps to the capital decision making process. These are generation of project information, evaluation of projects, decisions about which projects to fund and project implementation and reporting. The first stage is the generation of project information. This is the stage where "information is gathered that can be analyzed and evaluated." The text outlines that there are six types of information, including the identification of available alternatives, the identification of the available resources, cost data, benefit data, prior performance and risk projection. In essence, the firm needs to know what options exist for capital projects, and then gather information that will help to make the capital investment decision. This stage is critical, because bad information now will lead to bad investment decisions later.

The next stage is the evaluation of projects. The company at this point has the information it needs to make a determination about which projects to fund, and how much capital is available to fund said projects. The first thing that needs to be clear here is that the decision is both financial and strategic. That is to say, both quantitative and qualitative factors go into the decision. The text points out the obvious -- projects that are not financial viable should be rejected. A project with a positive net present value should at least be considered, and clearly the amount of capital available for the projects acts as a constraint that might rule out some projects. The evaluation should also be strategic in nature. If there are mutually exclusive options, management needs to have a sense of which of these options is better for the organization in the pursuit of its mission, which projects are more likely to succeed in the current internal and external operating environment and what projects are a better fit with the competencies of the health care organization.

The third stage is the decision. The evaluation process has provided good analysis of the information gathered in the first stage. Now, the organization must make a determination based on its evaluation criteria as to which projects are going to be financed and which ones will not. There are many techniques for doing this.

The fourth stage is the implementation and reporting. The projects that have been approved must now be funded and brought to life. Most of this is not part of the capital decision process, but the funding part is. The organization now has to acquire the financing. Then, the organization needs to continually evaluate the projects. There is an old maxim "don't throw good money after bad" which means that if a project that was approved starts to look like it is not going to be viable, management must make the decision to proceed or not. The capital investment decision process is not just an initial process, but one that needs to be revisited occasionally to ensure that all projects are going to be profitable. If something has changed with respect to the status of a project, management needs to be aware of that change and make strategic adjustments accordingly.

3.

There are six types of information that are needed in capital project investment analysis. They are available alternatives, available resources, cost data, benefit data, prior performance and risk projection. The available alternatives requires creative thinking to determine what options are out there for the organization with respect to capital investments. These alternatives are going to be the choices from which management needs to decide which projects to pursue and which to not. The availability of resources is a critical piece of information because it represents a constraint on capital investment. All health care organizations have budgets for capital projects, and they have worked with their financiers to determine how much financing is available. There are also other resources -- human, technical, construction -- that need to be considered because the availability of any critical resource will act as a constraint and could change the cost dynamics of a proposed project.

The cost data is important, as is the benefit data. The cost data is going to be more certain than the benefit data, but the organization needs to know how certain the cost data is. Benefit data is likely going to be estimates since some of the benefits will be years down the road. Yet, despite the uncertainty the organization needs to have a high level of confidence in the numbers because the project is going to be approved or rejected on the basis of those numbers. The net present value calculation is going to be made on the basis of the cost and benefit data.