Calculate Investment Return for Project Approval

Dec. 1, 2003
“Why does Jim always get his projects approved and I never do?” you wonder. “He must just be better at company politics than I am.” Jim may indeed be better at company politics, but that may well have nothing to do with the outcome.

It seems obvious to automation professionals that automation technology is valuable and can help the plant operate better. However, it’s important to recognize the fact that every corporation has limited capital, and automation projects must compete with others for this money. This competition is won not by having better technology proposals, but by having a realistic higher projected economic return on the investment (ROI).

The first consideration in the project approval process is to make sure that a well-crafted proposal is submitted on time. Capital budgets are normally set yearly, with the capital released shortly after the start of the fiscal year. If the project is a major one, and requires new estimates of benefits and costs, the study to develop these numbers has to be initiated about nine months prior to the start of the fiscal year. Typically, these studies will take about three months to complete, which results in estimates that are available about six months prior to the expenditure period.

Over the next three months the project proposals are developed, critiqued, reworked and prioritized by plant management. At the end of this period, typically about three months prior to the new fiscal year, they are submitted to a corporate financial group for approval. This corporate group reviews the proposals from all plants, prioritizes them, and perhaps asks for more information and supporting documentation. It then approves the overall number of proposals that can be funded within the capital budget limits approved for the fiscal year.

Don’t wait

This schedule implies that you need to be thinking seriously about the projects you want funded almost a year prior to their actual approval. Beginning to assemble a complex project proposal one month before the deadline is almost guaranteed to produce disappointment.

The next issue is to write the proposal in the language of the financial group that will be reviewing it. Although the specific evaluation protocols vary from company to company, they all have at their center the calculation of the net present value of the net benefits and the comparison of that with the net present value of the required investment. If the former is larger than the latter, the project is considered for funding.

Net present value implies discounting a sequence of financial expenditures or receipts back to the current time, but there are many subtleties. In a strict financial analysis, the discount rate for the investments should be based on a rate called the corporate weighted average cost of capital, which represents how much the company has to pay to obtain additional financing. The discount rate for the net benefits should be based on the expected risk of the investment, with a lower discount rate for routine investments, such as replacement of an existing valve, and a higher rate for installing new or untried technologies in the plant.

The correct calculation of benefits involves estimating the net after tax cash flow generated by the investment with a correction for maintenance or support costs. Of course, you need to follow the particular standards for investment evaluation used by your corporation.

In the evaluation process, the financial group will rank the project proposals in terms of ROI and their consistency with the strategic directions of the company. For example, is the stated corporate goal to continually reduce costs of production for existing products, or is it to diversify the product mix to reduce dependency on a specific market? If you want to improve your chances for approval, it helps to know these strategic directives and to write the proposal document in a way that supports them.

Douglas C. White, PhD, Chemical Engineering, [email protected], is vice president, Advanced Process Control Services, for the Process Solutions Division of Emerson Process Management.