Capital Investment Decision4agsts05

8/12/2019 Capital Investment Decision4agsts05

1/20

Use of Capital Budgeting Techniques and anAnalytic Approach to Capital Investment

Decisions in Canadian Municipal Governments

YEE-CHING LILIAN CHAN

Capital budgeting techniques are useful tools to municipal administrators inmanaging organizational resources. A survey of capital budgeting practices ofCanadian municipal governments reveals that a minority used capital budgetingtechniques; payback period dominates over discounted cash flow analysis inevaluating capital investments; and pitfalls are common in its application. Morespecifically, there is an emphasis of quantitative/financial items over qualitative/intangible factors. In this study, the analytic hierarchy process, a multi-attributedecision model that accounts for both tangibles and intangibles, is presented as atool for capital budgeting decisions such that resource allocation becomes moreeffective in municipal governments.

INTRODUCTION

As of mid-1999, Ontario municipalities have had an annual capital budget of $4 billion 1

and the amount is expected to increase to support the construction of infrastructure for

their growing population. Because funds are limited and financing is costly, municipal

governments will not be able to accept and fund all capital projects proposed. Municipal

administrators must be able to prioritize the capital projects and allocate the funds

available to the municipality effectively.

Yee-Ching Lilian Chan is Associate Professor in the Accounting and Financial Management Services Area

in the Michael G. DeGroote School of Business, McMaster University. Her current research interest

focuses on the application of cost and management accounting tools in the health care and government

sectors, and her work has been published in Advances in Management Accounting,Healthcare Management

Review, Hospital and Health Services Administration, Journal of Management Accounting Research,

Accounting and Business Research, andCanadian Journal of Administrative Science. She can be reached at

[email protected].

1. Ministry of Municipal Affairs and Housing,Municipal Capital Budget Handbook (Toronto: Queens

Printer for Ontario, 2000), 1.


2/20

As taxpayers and governing bodies are demanding more accountability and results for

the tax dollars and funds provided, municipal administrators have to adopt management

approaches that have been proven successful in the private sector, particularly in the

effective management and allocation of organizational resources. Capital budgeting is a

management tool that allows municipal administrators to plan for the infrastructurenecessary to support and enhance service levels in the next three to five years. Provincial

governments in Canada, such as Ontario, have published the Municipal Capital Budget

Handbook to assist municipalities in the development of their capital infrastructure

planning and budgeting processes. In the United States, the GAOs publication on

Leading Practices in Capital Decision Making,2 which summarizes 12 fundamental

practices that have been successfully implemented by organizations recognized for their

outstanding practices in capital investment decisions, also provides guidance to

municipal administrators in evaluating capital projects.

Despite the theoretical soundness of capital budgeting techniques, flaws are found in

their application in business organizations. There are also concerns about the

applicability of capital budgeting techniques in municipal governments where politics,

among other things, is influential in the selection of capital projects. In cases where

capital budgeting techniques are not applicable in evaluating capital projects,

municipal administrators have to rely on other decision models. The analytic hierarchy

process, as discussed later in this article, is a methodology designed to solve multi-

attribute decision problems where the criteria are not easily quantifiable. It provides

municipal administrators with a systematic framework in setting priorities for capital

projects based on predetermined criteria that are either quantitative or qualitative in

nature.The remainder of the article is organized as follows. A review of capital budgeting in

municipal governments is presented first. It is followed by a brief description of capital

budgeting techniques and its use to municipal administrators in making resource

allocation decisions. The results of a survey on the current state of capital budgeting

techniques adopted in Canadian municipal governments are then reported. This is then

followed by a description of the analytic hierarchy process and its application in the

ranking of capital projects in municipal governments. The final section includes some

concluding remarks and implications for practice.

CAPITAL BUDGETING IN MUNICIPAL GOVERNMENTS

Based on GAOs study on Leading Practices in Capital Decision Making, the integration

of the investment decision to the organizations strategic goals is critical to selecting the

successfulcapital projects. The use of an investment approach to evaluate capital projects

2. Government Accounting Office, Leading Practices in Capital Decision Making, GAO/AIMD-99-32

(Washington, DC, December 1999).


3/20

and the adoption of project management techniques to optimize a projects success are

critical success factors as well. Thus, an important element of the capital budgeting

process is to adopt an investment approach in defining the priorities/rankings of the

capital investment projects.

As recommended in the Municipal Capital Budget Handbook, capital projects shouldbe evaluated on the basis of five criteria: health and safety issues, cash savings/payback,

asset maintenance/replacement, growth-related needs, and service enhancement. Other

factors deemed important to the capital projects should also be analyzed. The capital

projects should be ranked as high, medium, or low on the basis of each of the five criteria

and the priorities of the capital projects should be set accordingly. The Finance and

Treasury Department of the municipal government should conduct detailed financial

evaluation of the capital projects, which include identifying the funding alternatives, debt

requirements, cash flow implications, reserve fund draws, long-term implications on

taxes, and user rates.3 As we can see here, the focus of the financial evaluation, as

described in the Municipal Capital Budget Handbook, is on the impact and implications

of the capital projects on financing. In addition to a lack of recommendation on which

investment approach should be used in prioritizing capital projects, there is little

emphasis and analysis on determining whether the benefits of the capital projects

outweigh its costs, both tangibles and intangibles.

Even though quantitative analysis has become a major element of public manage-

ment4 and cost-benefit analysis was formally applied in federal legislation as the basis of

decision making in the United States since the 1930s,5,6 Farazmand and Neill7 state that

the theory of capital budgeting in the 1990s is at a crossroad in which the traditional

quantification techniques have yet to be reconciled to the qualitative influences on thebudgeting process. The major issue is that cost tends to be fairly clear whereas it is

difficult to define benefits of capital projects in the public sector. In fact, capital projects

in the public sector should be prioritized based on relevant criteria including hazard

elimination, legal mandates, regulatory compliance, commitment to project completion,

preservation of existing assets, service betterment, and cost-benefit justification.8 As

traditional capital budgeting techniques fail to quantify some of the aforementioned

benefits, their applicability in evaluating capital projects in the municipal governments

can be limited.

3. Ministry of Municipal Affairs and Housing, 16.

4. Kenneth J. Meier and Jeffrey Brudney, Applied Statistics for Public Administration (Belmont, CA:

Wadsworth, 1993).

5. D. Axelrod,Budgeting for Modern Government (New York: St. Martins, 1988), 115116.

6. Carl V. Patton and David S. Sawicki, Basic Methods of Policy Analysis and Planning (Englewood

Cliffs, NJ: Prentice Hall, 1993).

7. Ali Farazmand and Jon P. Neill, Capital Decision-Making: Analysis and Judgement, Public

Budgeting and Financial Management 8, no. 3 (1996): 428452.

8. Ibid.


4/20

At present, there is a lack of studies on the state of practice of capital budgeting in

Canadian municipal governments. In the United States,911 empirical evidence

indicates that there is an increase in the adoption of a separate capital budget in cities

over time, and these local governments are more inclined to account for risk and

uncertainty in their capital budgeting process. These studies have focused on the capitalbudgeting process and there is little evidence on whether capital budgeting techniques are

used. In this study, a survey was undertaken to report on the current practice of capital

budgeting techniques in Canadian municipal governments. This survey attempts to find

out whether capital budgeting techniques are used in evaluating capital projects in

Canadian municipal governments, and if discounted cash flow analysis is adopted

whether its application is subject to the common flaws described in the following section.

CAPITAL BUDGETING TECHNIQUES

In the private sector, management often has to evaluate a large number of capital

investments opportunities. They are accountable for the management of organizational

resources, which will be allocated to capital projects if and only if the investments are

profitableand provideexpected returnto stockholders of the firm. The potential risks and

rewards of these capital investments and major undertakings must be carefully weighed

and evaluated. The essence of financial management in the private sector is to determine

which capital investments are valuable and profitable to the firm. Even though

profitability is not an objective for municipal governments, capital budgeting techniques

can assist administrators in evaluating competing capital investment projects and bidsfrom contractors such that the bid with the lowest cost or greatest cost savings is

accepted.

Discounted cash flow analysis, such as net present value, internal rate of return,

profitability index, and breakeven time, as well as the payback period, are the most

commonly used capital budgeting techniques in practice.12 These capital budgeting

techniques focus on the impact of the capital investment on the firms cash flows. In

discounted cash flow analysis, the present value of cash inflows over the life of the capital

investment is evaluated against the present value of its cash outflows. The firms cost of

capital and required rate of return are accounted for by the discount rate used in

discounted cash flow analysis. Detailed instructions on the application of these capital

9. C.B. Doss, Jr., The Use of Capital Budgeting Procedures in U.S. Cities, Public Budgeting and

Finance7, no. 3 (Autumn 1987): 5769.

10. John P. Forrester, Municipal Capital Budgeting: An Examination,Public Budgeting and Finance

13, no. 2 (Summer 1993): 83105.

11. Thomas D. Lynch, Cynthia E. Lynch, and Richard A. Omdal, The State of Capital Budgeting in

Louisianas Local Governments, Public Budgeting and Financial Management 8, no. 4 (1997): 555577.

12. R.M. Burns and J. Walker, Capital Budgeting Techniques among the Fortune 500: A Rationale

Approach,Managerial Finance 23, no. 9 (1987): 315.


5/20

budgeting techniques are readily available in management accounting and financial

management texts.1315

Despite the conceptual soundness of discounted cash flow analysis, its use in practice

is anything but flawless. Management often compares proposed projects to the status

quo (asset replacement), assuming the future cash flows will continue at current levels ifno action is taken.16 Such an approach is unlikely to be tenable in the current operating

environment for the nonprofit sector, because operating costs of existing assets are likely

to increase and their effectiveness decline if replacements are not made. Kaplan and

Atkinson17 also point out that there tends to be an overemphasis on the quantifiable

aspects of capital projects as compared to intangible measures of benefits and costs.

Other reported common pitfalls in discounted cash flow analysis18,19 include arbitrary

cutoffs on the timing and amount of cash flows, unrealistic discount rates or required

rates of return, inappropriate assumptions about reinvestment rates, misrepresentation

or omission of inflation effects, and inappropriate risk adjustments. The nature of each

of these pitfalls and how they may induce suboptimal project selections will be described

in the following sections so that municipal administrators are aware of their

shortcomings when applying capital budgeting techniques.

Using the Status Quo as the Baseline in Evaluating New Capital Investment

When evaluating a new capital investment proposal, the manager, either consciously or

subconsciously, is comparing the proposal with some alternative investments. Unless

alternative investments are being proposed at the same time, the present condition or

status quo provides a convenient and seemingly reasonable baseline for evaluating a newinvestment proposal.

The potential problem with using the status quo as the baseline is that it may overlook

the impact of inaction. The assumption that nothing will be affected by deciding not to

replace an existing asset is not realistic.

Consider the case where the municipal administrator is evaluating the upgrading of the

municipal buildings heating system. In a period of fiscal constraints, the municipal admin-

istrator is likely to postpone the upgrade as much as possible. However, he/she has

13. Charles Horngren, George Foster, Sakar M. Datar, and Howard Teall, Cost Accounting: A

Managerial Emphasis, 2nd Canadian ed. (Toronto: Prentice Hall Canada, 2000).

14. Aswath Damodaran,Corporate Finance: Theory and Practice, 2nd ed. (New York: John Wiley and

Sons, 2001).

15. S.A. Ross, R.W. Westerfield, B.D. Jordan, and G.S. Roberts, Fundamentals of Corporate Finance,

4th Canadian ed. (Toronto: McGraw Hill-Ryerson, 2000).

16. Robert S. Kaplan and Anthony Atkinson,Advanced Management Accounting, 3rd ed. (Englewood

Cliffs, NJ: Prentice Hall, 1998), 598.

17. Ibid, 602.

18. Colin Drury and Mike Tayles, The Misapplication of Capital Investment Appraisal Techniques,

Management Decision 35, no. 2 (1997): 8693.

19. Kaplan and Atkinson, 595602.


6/20

overlooked the impact on energy costs as the current heating system deteriorates and

becomes more and more inefficient. Also, as the heating system ages, more maintenance and

repair will be needed. Thus, the cost savings from an upgrade increase at a greater rate as the

current heating system deteriorates and becomes more inefficient. In fact, the cost savings

may outweigh the initial cost of upgrading the heating system. Hence, simply assuming thatthe status quo will remain unchanged biases decisions against (desirable) capital investments.

Imposing Arbitrary Cutoff on Timing of Cash Flows

Sometimes, managers reportedly limit the number of future periods that they consider in

evaluating capital projects. Such cutoffs have the purported advantage of limiting the

organizations risk exposures but they also can introduce a bias. Imposing an arbitrary

cutoff period (or maximum payback period) on the cost savings of a capital project can

introduce a bias against projects that have large amounts of cash flows (in terms of cost

savings) in their later years or that sustain cash flows over a long period of time.

Using Unrealistic Discount Rate or Required Rate of Return

When applying the net present value method, a discount rate has to be specified for

determining the present value of future cash flows. Theoretically, this discount rate

should be the expected return from alternative uses of the resources and can be proxied

by the organizations weighted cost of capital. The use of a weighted cost of capital as the

discount rate works for municipal governments that do not have a profit objective.

The weighted cost of capital of a firm depends on the nature of its business and risk,which is affected by its capital structure. For a municipal government, its sources of

funds from the provincial/state government, tax base, and debt structure determine its

nature of risk. In general, the cost of debt can be used as a proxy for a municipal

governments cost of capital. For municipal governments with large amount of debt, the

higher the cost of debt/capital and the higher the discount rate that would be used in

determining the present value of capital projects. In general, the range of weighted cost of

capital for low-risk to high-risk organizations is about 5 to 8 percent. When higher

discount rates are used in application, it results in a bias against accepting capital

projects that would otherwise be valuable to the organization.

While calculating a projects internal rate of return does not require a discount rate tobe specified, a hurdle rate needs to be established as a benchmark in evaluating capital

projects. With an unrealistically high hurdle rate, it is likely that some projects that are

valuable to the municipal governments will be rejected.

Unrealistic Assumptions about Reinvestment Rates

Under the net present value method, cash flows that occur during the projects life are

assumed to be reinvested at the discount rate specified for the net present value


7/20

calculation. The internal rate of return method, on the other hand, assumes that cash

inflows are reinvested at a rate equal to the internal rate of return. As discussed earlier,

managers tend to use high discount rates and required rates of return when applying

discounted cash flow analysis. Thus, the reinvestment rates for both the net present value

method and the internal rate of return method, especially projects with a higher internalrate of return, are overstated. Accordingly, discounted cash flow analysis using higher

discount rates will bias against projects with more cash flows later in the projects life.

Accounting for Inflation Effects

An organizations weighted cost of capital reflects the return that the providers of capital

require from the organization. As such, it already includes an allowance for expected

inflation. When using the weighted cost of capital to evaluate projects, the cash flows

need to be adjusted for inflation. Otherwise, the effects of inflation would be double

counted (once through increasing the weighted cost of capital and again via using cash

flows in real terms).

The pitfall is that some managers may not adjust predicted future cash flows for

expected inflation, thus inadvertently causing the effects of inflation to be double

counted. By failing to consider the effects of inflation on relevant costs, an unintended

bias against projects with a longer horizon is introduced. This bias comes about because

the more distant a future cash flow, the greater the compounding effect caused by

inflation. Thus, nominal rates should be used in discounting nominal (inflation-adjusted)

cash flows, whereas cash flows of constant purchasing power should be discounted by the

organizations real cost of capital.

Excessive Risk Adjustment

Adjusting the discount rate or hurdle rate is a common approach to accounting for the

risks of capital investments when applying discounted cash flow analysis. Similar to the

adjustments for inflation, this approach can introduce an intended bias in project

selection. In general, the larger the risk premium added to the discount rate, the more

future cash flows are discounted in obtaining a projects net present value. Thus, to avoid

introducing an inadvertent bias against projects with longer horizons and/or with more

of their cash inflows in later years, it is important not to overly inflate the discount rate asan allowance for risk.

A further aspect of managing capital investment is to be sure that the expected costs

and benefits are realized as well as to respond to unexpected future changes. Thus, post-

expenditure audits are as important as a correct application of discounted cash flow

analysis to capital budgeting decisions.

Because there is a lack of empirical evidence in the practice of capital budgeting and

the adoption of discounted cash flow analysis in Canadian municipal governments, a

survey was conducted to gain an understanding of the current practice. The objective of


8/20

the study is to determine whether capital budgeting techniques are used to evaluate

capital investment projects in Canadian municipal governments and whether such

application is susceptible to the pitfalls of discounted cash flow analysis as described

here. What follows is a report of the findings of the survey.

SURVEY OF CURRENT PRACTICE

Sample

A questionnaire20 was mailed in October 2001 to a random sample of 484 Canadian

municipal governments. After a second mailing in January 2002, a total of 10621

completed questionnaires were returned, with a response rate of 21.90 percent.

Respondents included chief administrative officers, chief financial officers, directors of

finance, treasurers, and administrators of the municipal governments who, on average,

have about ten years of tenure in their respective positions.

An equal number of the respondent municipal governments (46.7 percent) are located

in urban and rural communities while a minority (6.6 percent) is located in suburban

centers. Over 80 percent of the respondent municipal governments serve in communities

of less than 50,000 citizens and have employees of fewer than 250 full-time equivalents.

The sample, in general, consists of small municipalities. Based on the chi-square test of

independence, there is no significant difference in the location and size of the

municipalities (as measured by the serving population and employees) between the

early and late respondents. Also, there is no significant difference between the early and

late respondents with respect to whether their organizations have adopted capital

budgeting techniques or are required to prepare business cases in seeking funding

approvals. Thus, nonresponse bias is not an issue in the reported findings. However, due

to the relatively small size of the respondent municipal governments, care should be

taken in generalizing the findings reported in the following sections, which do provide

some interesting glimpses into the current capital budgeting practices of this particular

set of municipal governments.

Findings

Over 40 percent of the respondents (46) indicated that their organizations had to prepare

a business case for seeking funding approval from another government agency for

proposed capital investment projects. Only a quarter of the respondents (26) reported

20. The questionnaire is available upon request from the author.

21. The sample consists of 101 cities (population 10,000 or more) and 383 towns, townships, and

municipal districts (all with populations of 1,000 or more). Responses from 24 cities (24 percent) and 77

towns/townships/municipal districts (20 percent) were returned. There should be little concern on

nonresponse bias as the response rate from each subsample (in terms of serving population) is similar.


9/20

that their organizations used some type of capital budgeting techniques, such as net

present value, internal rate of return, and payback period, to evaluate long-term capital

investment projects. Thus, despite the fact that capital budgeting techniques are widely

used in the for-profit private sector, its adoption in municipal governments is limited.

One possible explanation is the lack of profit objective in the government sector. Also,many of the capital projects, such as construction and rehabilitation of water treatment

facilities, are essential to the services provided by the municipal governments to their

citizens and must be undertaken. However, as discussed earlier, discounted cash flow

analysis can be a useful capital budgeting tool to municipal administrators in evaluating

alternative biddings from contractors for a specific capital project such that biddings

with the lowest costs or highest cost savings are selected.

Despite the relatively low adoption of capital budgeting techniques in the sample,

their preference and application will provide some insight into whether discounted cash

flow analysis has been applied correctly by municipal administrators.

Preference of Payback Period to Discounted Cash Flow Analysis

Even though it is conceptually superior to account for the time value of money in capital

budgeting analysis, payback period dominates over discounted cash flow analysis in

evaluating capital projects among our respondents. For the respondents whose

organizations use capital budgeting techniques, over half indicated that payback period

was the primary evaluation criterion for their decisions and the net present value method

was the most widely used discounted cash flow analysis (about one-third) when

compared to internal rate of return, profitability index, and breakeven time. About 70

percent of the respondents whose organizations used payback period as the primary

evaluation criterion did not impose a specific payback period for rejecting capital

projects. For those who imposed a maximum cutoff period, the most commonly adopted

cutoff period was ten years. Also, all but two of the respondents indicated that their

organizations used secondary evaluation criteria for capital projects. Breakeven time and

payback period are the most commonly used secondary evaluation criteria.

The preceding findings stand in sharp contrast to the survey results of Fortune 500

companies but are similar to results of small business firms. Burns and Walker22 reported

that 84 percent of Fortune 500 companies used internal rate of return while 73 percent

used net present value. When there was conflict in preference using multiple methods,

70.7 percent gave either the internal rate of return or net present value method priority.

Only 7.9 percent gave payback method priority in case of conflict among methods. In

contrast, in a survey of small business firms, Block23 found that, similar to the findings of

the current study, the payback method was the preferred method by 42.7 percent of the

22. Burns and Walker.

23. S. Block, Capital Budgeting Techniques Used by Small Business Firms in the 1990s, The

Engineering Economics 42, no. 4 (1997): 289302.


10/20

firms and discounted cash flow analysis was used by only 27.6 percent of the respondents.

In another survey of UK companies, Drury and Tayles24 also reported that larger

organizations preferred the net present value method while smaller organizations used

the payback method more often. Respondents from larger organizations also ranked

internal rate of return as an important technique in appraising capital projects whilerespondents from smaller organizations ranked payback period as more important.

The dominance of a conceptually inferior capital budgeting technique (the payback

period) in municipal governments may suggest that municipal administrators still prefer

simplicity and ease of use in its application of capital budgeting techniques. Moreover,

given the lack of access to the public markets for funding and increasing pressure for

results and accountability, municipal administrators might be especially concerned about

the recovery of their initial investment. A method such as the payback period, which can

be a quick indicator about the risk of the investment projects, can be quite useful under

such circumstances. Such considerations, however, do not obviate the need to select

optimal uses for the available funds, and our findings of the dominance of the payback

period suggest room for improvement.

Susceptibility to Pitfalls of Discounted Cash Flow Analysis

Three-quarters of our respondents indicated that their municipal governments did

evaluate capital projects against the status quo and all but one of the remaining

respondents did not use any explicit baseline for comparison. For those who applied

discounted cash flow analysis, 40 percent imposed a cutoff period in estimating future

cash flows, and the most widely used cutoff period for estimating cash flows was tenyears. The ten-year cutoff period is relatively long term for evaluating capital projects.

Nevertheless, this arbitrary cutoff period introduces bias against capital projects with

longer horizon and greater cash flows in later years.

Relating to the discount rate used in discounted cash flow analysis, the range varies

from a low of 3 percent to a high of 12 percent. The most frequently cited discount rates

by our respondents is 5 and 6 percent, which is not highly overstated. Also, three-

quarters of our respondents did not adjust the discount rate for inflation and only three-

eighths adjusted the projects future cash inflows and outflows by expected inflation.

Thus, only a minority of the respondents is correct in applying nominal discount rate to

inflation-adjusted cash flows when using discounted cash flow analysis. On the other

hand, only one-eighth of our respondents indicated that the discount rate was adjusted

for risk. This again introduces bias against capital projects with greater cash flows in

later periods.

With respect to the treatment of tangible (quantitative) versus intangible factors, our

respondents indicated that the extent to which their municipal governments explicitly

considered intangible costs and benefits in evaluating capital projects was moderate

24. Drury and Tayles.


11/20

(average responses of 5.13 and 5.87, respectively, on a 9-point scale where the greater the

number, the greater the extent). Also, the weight given to intangible costs and benefits in

evaluating capital projects as compared to readily quantifiable costs and benefits is 5.053,

using a similar 9-point scale. Thus, by and large, our respondents did not perceive

intangible costs and benefits to be very important in evaluating capital investmentprojects. This is consistent with the criticism made by Kaplan and Atkinson25 that

managers put too much emphasis on tangibles, especially financials, to evaluate capital

projects. This is, however, contradictory to the recommendations stated in the Municipal

Capital Budget Handbook where four of the five evaluation criteria suggested are

intangibles. Some examples of intangible costs given by the respondents include negative

public perception, reduced service to the public, political consequences, staffing concerns,

employee morale, potential liability for health and safety, and efficiency in organizations.

Improved service to the public, positive public perception, political benefits, employee

consideration, staffing effectiveness, and environmental benefits are some intangible

benefits cited by the respondents. Finally, half of our respondents indicated that their

municipal governments did conduct post-expenditure audits on approved long-term

capital projects. This allows municipal administrators to take corrective actions when

post-expenditure audits signal problems about the implementation. This reflects

positively on the practice of capital budgeting among our sample of Canadian municipal

governments. There are, however, opportunities for improvement.

As reported by our respondents, intangible costs and benefits were not considered

explicitly to a great extent in making capital investment decisions. This can be attributed

to the difficulty in quantifying such intangible costs and benefits and the inability of

capital budgeting techniques to incorporate qualitative factors in the analysis. Theseintangible factors such as reduced service to the public or improved public perception,

however, are critical to evaluating the value of the capital projects to the municipal

governments. Thus, municipal administrators have to search for decision models that

incorporate both tangible (quantitative) and intangible (qualitative) factors in the

analysis. The following section proposes a way of coping with intangibles and qualitative

factors in capital budgeting decisions, using the analytic hierarchy process.

THE ANALYTIC HIERARCHY PROCESS AND ITS APPLICATION IN CAPITAL

BUDGETING

The analytic hierarchy process is a methodology that helps management set priorities on

capital investment projects. It provides a method of including tangibles and intangibles,

quantitative and qualitative items for decision making. By allowing all relevant factors to

be evaluated objectively, the analytic hierarchy process can improve on current capital

budgeting techniques, which tend to be entrenched in the quantitative aspects of the

25. Kaplan and Atkinson, 602603.


12/20


13/20

In modeling the problem-solving process of the human mind, users of the analytic

hierarchy process first identify the factors that may affect the problem. The factors are

then grouped on the basis of their common characteristics, if they exist. These groupings

become the different levels of the hierarchy. In this way, the user constructs a hierarchy

of criteria, subcriteria, and alternatives, which is the cornerstone of the analytic hierarchyprocess.

An Application of Analytic Hierarchy Process in Capital Budgeting

As recommended in the Municipal Capital Budget Handbook, capital projects should be

evaluated on the basis of five criteria: health and safety issues, cash savings/payback,

asset maintenance/replacement, growth-related needs, and service enhancement. The

capital projects should then be ranked as high, medium, or low on the basis of each of the

five criteria and the priorities of the capital projects should be determined accordingly.

As there are no clear guidelines on how to account for the five criteria and their rankings

in establishing the priorities of the capital projects, the analytic hierarchy process can be

a useful tool especially in the case when the evaluation criteria are not quantifiable.

In the following application, the city mayor and the director of finance are evaluating

a number of capital projects that include major remodeling of the public buildings to

increase capacity utilization, rehabilitation of water treatment facility components, and

boulevard reforestation. As the funds available for these capital projects are limited, it is

necessary to prioritize the projects. The five criteria recommended in the Municipal

Capital Budget Handbookare the basis for evaluating the capital projects. When applying

the analytic hierarchy process, the city mayor and the director of finance have toestablish the relative importance of one criterion as compared to another using the

following pairwise comparisons:

1. How much more (or less) important are health and safety issues than cash savings/

payback in determining the desirability of capital projects?

2. How much more (or less) important are health and safety issues than assets

maintenance/replacement in determining the desirability of capital projects?

3. How much more (or less) important are health and safety issues than growth-

related needs in determining the desirability of capital projects?

4. How much more (or less) important are health and safety issues than service

enhancement in determining the desirability of capital projects?

In fact, the city mayor and the director of finance have to respond to a total of ten

questions (5 4 2510) to complete the pairwise comparisons of the five criteria.

Rather than a simple more or less important answer to these questions, the analytic

hierarchy process conventionally uses a 9-point response scale that measures the relative

degree of importance of one criterion over another and allows flexibility in interpreting

the relationships among the five criteria. In this illustration, the 9-point scale can be

defined as follows:


14/20

15 the first criterion is as important as the other;

35 the first criterion is weakly more important than the other;

55 the first criterion is strongly more important than the other;

75 the first criterion is demonstrably more important than the other;

95 the first criterion is absolutely more important than the other;2, 4, 6, and 8 are intermediate judgments.

For example, using the scale above, if cash savings/payoff is weakly more important

than health and safety issues in determining the desirability of capital projects, then the

score is 3 for the cash savings/payoff and health and safety issues comparison. For the

reverse comparison of health and safety issues versus cash savings/payoff, the analytic

hierarchy process assumes that health and safety issues are weakly less important than

cash savings/payoff, thus enforcing transitivity. Saaty35

proposed the use of thereciprocal of 3 (i.e., 2) as the score for this reverse comparison. The results of the ten

(5 4 25 10) paired comparisons (i.e., the responses to the questions above) are

summarized in the square matrix in Table 1A. As can be seen in Table 1A, the lower half

of the matrix is comprised of the reciprocals of the elements in the upper half, with

diagonal elements equal to 1 as each criterion is as important as itself, following Saatys

proposal.

Once the values of the responses and their reciprocals have been organized in matrix

form, the data are analyzed using matrix algebra via the Expert Choice36 software

package. Expert Choice calculated a set of eigenvalues that represents the relative

importance of the criteria in determining the desirability of the capital projects. Ingeneral, the key criterion with the highest calculated value is the most important and vice

versa. In this example, service enhancement is the most important criterion

(value50.446), whereas health and safety issues are the least important (value5 0.036)

in evaluating capital projects.

Once the city mayor and the director of finance have established the relative

importance of the five evaluation criteria, they can assess how well each capital project

fares with respect to each of the five criteria. In this case, the evaluation of the capital

projects on the basis of the criterion of health and safety issues will be conducted with the

following questions:

35. Thomas L. Saaty, The Analytic Hierarchy Process: Planning, Priority Setting, Resource Allocation

(New York: McGraw Hill, 1980).

36. Expert Choice is a software package designed by Expert Choice Inc. Expert Choice uses the

eigenvalue approach for computing the values used in ranking criteria and alternatives from the response

matrices. In sum, the eigenvalue or priority vector is determined by (CnI)1, where C is the response

matrix of the pairwise comparisons of the criteria or alternatives, I is the identity matrix, and n is the

dimension of matrix C. Readers who are interested in the eigenvalue approach and the operating

procedures of Expert Choice can refer to Saatys book on analytic hierarchy process and the manual

published by Expert Choice Inc.


15/20

TABLE 1

Applying the Analytic Hierarchy Process to the Setting of Priorities of Capital Projects


16/20

1. How much better (or worse) is the remodeling of public buildings than the

rehabilitation of the water treatment facility component with regard to health and

safety issues?

2. How much better (or worse) is the remodeling of public buildings than boulevard

reforestation with regard to health and safety issues?3. How much better (or worse) is the rehabilitation of the water treatment component

than boulevard reforestation with regard to health and safety issues?

Similar comparisons would be made (scoring on a 9-point scale as before) for each of

the other four evaluation criteria. As can be seen, one interprets the 9-point scale

differently in the second stage of comparisons from the comparison of the key evaluation

criteria. Instead of being used to decide on the relative importance of one evaluation

criterion over another, the scale is used to evaluate the relative superiority (or inferiority)

of one capital project over another with respect to each evaluation criterion. For

example, a score of 2 assigned to a comparison of the rehabilitation project with the

remodeling project on health and safety issues indicates that the rehabilitation project is

weakly better than the remodeling project with respect to health and safety issues. Like

the comparison of the key evaluation criteria, the results of the project comparisons on

the five key evaluation criteria are summarized in five matrices, and their relative

rankings are given by the corresponding vector of eigenvalues calculated using Expert

Choice (see Tables 1Ba and 1Bb). The results show that the rehabilitation project has the

highest relative ranking with respect to health and safety issues (value50.57) while the

reforestation project is the best in terms of cash savings/payoff (value5 0.79) and the

remodeling project tops in the remaining three evaluation criteria.While the five sets of relative rankings on the key evaluation criteria communicate

valuable information to the city mayor and the director of finance, the analytic hierarchy

process can assist further by deriving an overall ranking of the capital projects. As shown

in Table 1C, the overall ranking is derived by multiplying the vectors of relative rankings

of the capital projects with the vector of relative importance of the five evaluation

criteria. This simple weighting procedure results in the remodeling project, with a global

ranking of 0.554, being the best based on an assessment of the five key evaluation

criteria. Also, because the 9-point scale used in the paired comparison is a ratio scale, it is

appropriate to conclude that the remodeling project is almost three times better than the

reforestation project (0.554 0.2045

2.72 times).

Pros and Cons of the Analytic Hierarchy Process

From the above example, one can glean a number of positive attributes of the analytic

hierarchy process. First, the analytic hierarchy process is superior to ad hoc weighting

schemes when multiple criteria are involved because the procedure enforces transitivity

and improves consistency in responses. Second, the methodology allows for synthesis of

multiple viewpoints on multiple criteria into a single unified result. Because of its


17/20

flexibility, the analytic hierarchy process can handle large numbers of criteria,

subcriteria, and alternatives and far more than a three-level hierarchy as illustrated in

the example. For instance, the cash savings/payback criteria can be expanded and

referred to as financial impact. Under this criterion of financial impact, a number of key

financial issues (subcriteria), such as implications of taxes, impact on debt, financingalternatives, net present value, and payback, can be included. In this case, the capital

projects will be assessed on the basis of the subcriteria in determining their relative

priorities. An extension of the analytic framework for capital budgeting decisions is

included in Figure 1. Third, by forcing organization members to make the required

pairwise comparisons, the participants have to reveal their preferences. The commu-

nication is likely to make it easier to reach a consensus among the participants.

The use of the analytic hierarchy process does require educating the participants in the

method, which can be time consuming. The pairwise comparison required in the

procedure has been criticized, as it lacks a stated frame of reference and there is a concern

that the 9-point scale is not descriptive of rational behavior and not subject to empirical

tests. It has also been suggested that rank reversal is a potential problem in the analytic

hierarchy process with the addition of an identical alternative.37 These criticisms have

been refuted and answered adequately by Saaty and other proponents of the analytic

hierarchy process.38 Nevertheless, the analytic hierarchy process is a valuable tool in

modeling decision problems with multiple attributes as illustrated in the capital

budgeting decision setting.

CONCLUDING REMARKS AND IMPLICATIONS FOR PRACTICE

Even though discounted cash flow analysis such as the net present value method and the

internal rate of return method are widely used in the private sector, its use among

Canadian municipal governments is not as widespread. Among the sample of municipal

governments (26) that have used some form of capital budgeting techniques, the majority

relies on the payback period while 40 percent use discounted cash flow analysis as the

primary evaluation criterion for capital investment decisions. Their application of the

discounted cash flow analysis still retains some of the common flaws found in practice,

including using the status quo as the baseline for comparison, imposing an arbitrarycutoff period for analyzing cash flows, and making improper adjustment for inflation.

Surprisingly, the sample of municipal governments did not explicitly consider intangible

costs and benefits in evaluating capital investment projects to a great extent. Even if

intangible costs and benefits are considered explicitly, the weight assigned in the capital

37. J.S. Dyer, Remarks on the Analytic Hierarchy Process, Management Science 36, no. 3 (1990):

249258.

38. P.T. Harker and L.G. Vargas, Reply to Remarks on the Analytic Hierarchy Process by J.S. Dyer,

Management Science 36, no. 3 (1990): 269273.


18/20

Selection of a Capital Project for Municipal Government

Health and Safety Financial Asset Maintenance/ Growth-Related Service

Issues Impact Replacement Needs Enhancement

`

A B C D E F G H I J K L M

Reconstruction of

Remodeling of Water Treatment Boulevard

Public Buildings Facility Components Reforestation

Properties of

Properties of Reconstruction of Properties of

Remodeling of Water Treatment Boulevard

Public Buildings Facility Components Reforestation

where:

A and B: health and safety issues such as improved air quality and reduced toxic waste;

C, D, E, and F: financial impacts such as impact on taxes, impact on financing, debt requirement,and payback;

G and H: assets maintenance/replacement such as improved capacity and enhanced efficiency;

I, J, and K: growth-related needs such as increased parking, increased green space, and library

resources; and

L and M: service enhancement such as reduced waiting time and improved service quality.

FIGURE 1

A Four-Level Hierarchy of Criteria, Subcriteria, Alternatives, and Properties of Alternatives

for the Selection of a Capital Project for Municipal Government


19/20

budgeting decision is moderate. The findings thus far imply that the majority of

Canadian municipal governments neither use capital budgeting techniques nor consider

much about intangible costs and benefits in making capital budgeting decisions. This

may lead to suboptimal allocation of resources to capital projects, and improvements to

the decision-making process are needed.If municipal administrators do not perceive capital budgeting techniques or other

quantitative analysis helpful in making capital budgeting decisions, they may want to

apply the analytic hierarchy process, a methodology designed to solve multi-attribute

decision problems where the criteria are not easily quantifiable. As illustrated in the

previous section, the analytic hierarchy process requires the decision maker to develop

the criteria (subcriteria) key to the decision problem, perform pairwise comparisons in

ranking the criteria (subcriteria), and evaluating capital project alternatives. The

methodology is flexible in that it can accommodate multiple decision makers and

multiple levels of hierarchy with any number of criteria and subcriteria. The analytic

hierarchy process provides a comprehensive measure, and its procedures allow

participative input both at the stage of ranking the evaluation criteria and evaluating

capital projects on the basis of each criterion. Using pairwise comparisons and the

eigenvalue approach, relative rankings of the evaluation criteria and the capital projects

per evaluation criterion are determined. The vectors of the relative rankings are then

weighted by those of a higher hierarchy, thereby forming an overall assessment on the

priority of the capital projects. The analytic hierarchy process improves on ad hoc

procedures and many other weighting models, as greater consistency of responses is

maintained with the pairwise comparisons.

Even though the analytic hierarchy process improves over other ad hoc weighting andmulti-attribute decision models, it takes time to learn the methodology and complete the

pairwise comparisons. However, with participative inputs from a number of adminis-

trators, their diverse belief systems on the pros/cons of the capital projects can be

brought together in a consistent and organized way. In fact, as municipal governments

are working toward democratization of the capital budgeting process through expanding

the use and diversity of citizen input via formal capital project committee structures,39

the analytic hierarchy process can be a useful tool in synthesizing opinions of various

members of the committee. In this way, the resources of the municipal governments can

be allocated more effectively among the many capital projects that they have to fund.

39. Susan A. MacManus, Democratizing the Capital Budget Planning and Project Selection Process at

the Local Level: Assets and Liabilities, Public Budgeting and Financial Management 8, no. 3 (1996):

406427.


20/20

Documents

Capital Investment Decision4agsts05