Investment decision making in UK manufacturing industry.
Throughout the 1980s and the 1990s thus far, there has been concern in the UK that the level of capital investment in manufacturing industry has not responded well to the economic recovery. There has been concern that, in the long term, economic recovery may well be jeopardized by companies arriving at capacity buffers. This paper reviews how companies have approached decision making over this period and the factors that companies see as important in influencing manufacturing investment.
In the paper we consider four main areas, starting with the influence of interest rates on capital investment decisions. We then examine other factors which may be relevant, including the system of corporate governance. We then go on to examine the financial appraisal techniques employed by companies, including the cost of capital used in such analyses, to see if these can explain the level of investment. Finally, we look at the particular problems involved when investing in advanced manufacturing technology.
Our findings are based on a survey of large manufacturing enterprises which was undertaken in the first quarter of 1994. We wished to ascertain the factors that the chief executives of the companies perceived to be important influences in capital investment decisions. We compare the responses to our survey with those obtained in surveys carried out by the CBI and the Bank of England.
Reasons cited in CBI Industrial Trends Surveys for expected modest rises in plant and machinery investment have included "inadequate" net return as well as uncertainty about demand. It is possible that project returns may be judged inadequate against over-demanding criteria for the near future. The long running debate on short-termism in financial markets was addressed by the Trade and Industry Committee's second report on competitiveness in manufacturing industry and aspects of this issue are examined later in the paper.
A postal questionnaire, together with a letter explaining the aims of the research, was sent to the managing directors of the 500 largest manufacturing companies in the UK as defined by Kompass [ILLUSTRATION FOR FIGURE 1 OMITTED!. It covered the four areas mentioned above, and some company characteristics (e.g. industry and turnover) were also sought. The questionnaire consisted for the most part of closed questions and groups of themed statements which respondents were asked either to rate on a scale of "strongly agree" to "strongly disagree" (e.g. "High interest rates are a major deterrent to manufacturing investment") or to rank in order of importance to their company (e.g.: "an improving UK economic outlook"; "an improving economic outlook in the EU", etc.). Investment in this context refers to capital expenditure on plant and equipment. Companies were also asked to compare their investment decision-making practices over a five-year period. Respondents were also given opportunities to provide free text comment about their answers. From a single mailing, 81 complete and usable responses were received and the data were analysed using SPSS.
The sizes of companies were near the top of the distribution of size as defined by turnover, but the full range of companies varied from some with well under [pounds]250m turnover to those with turnover measured in [pounds]billions. We concentrate here on responses as a whole, but also look at subdivisions by size (up to [pounds]250m and over [pounds]250m turnover) and by a division of companies between those engaged in engineering (comprising those companies involved in the automotive, chemical, electrical and other mechanical engineering industries) and those in other manufacturing industries.
Companies were asked about the significance to them of high, rising, low, falling, relative and real interest rates in decisions on manufacturing investment. The responses show evidence of asymmetry between the negative effects of high and rising rates of interest and the positive effects of low and falling rates. The proportions agreeing or strongly agreeing with the view that high interest rates and rising interest rates are a major deterrent to manufacturing investment were 52 per cent and 51 per cent of all respondents. Percentages disagreeing were 19 per cent and 16 per cent.
Those who indicated that high and rising interest rates cut off investment most often said that higher interest charges raised the required rate of return on new investments. However, our results suggest that the reverse process does not progress rapidly. Of secondary importance to the survey respondents was the fact that higher levels of interest rates affected the overall level of demand in an economy. The CBI survey confirmed that demand for the company's own products was a major influence on investment intentions. It may be that firms take a cautious view of the stimulating effect of interest rate cuts on demand for their goods and the time scale over which any effects may occur.
The stimulating effects of low or falling rates were agreed by 48 per cent and 37 per cent respectively, with 20 per cent disagreeing. The finding that only just over one firm in three agreed with the view that falling interest rates were a major stimulus to manufacturing investment is consistent with the view that it is easier to arrest economic recovery by increasing interest rates than it is to start and continue a recovery by reducing interest rates. And this appears to be the case even if other factors, such as the rate of inflation, are currently favourable.
Low UK interest rates relative to other countries were seen as a stimulus to UK investment by only 35 per cent of respondents, with 26 per cent disagreeing with this view. Real interest rates were seen as a more significant factor than nominal rates by 58 per cent (12 per cent actively disagreed, while 25 per cent were neutral). The results are displayed in Figure 2.
There may be a relationship to size in these responses. For firms in the lower size category (turnover up to [pounds]250m) high rates of interest were seen as a deterrent by 63 per cent, with 68 per cent deterred by rising rates, the proportions for the larger group of firms being 49 per cent or 47 per cent. The finding on real interest rates is consistent with the CBI finding that larger companies prefer to work in terms of real rates, although this was not the case for companies overall. The evidence suggests that engineering firms are less sensitive to interest rate changes and levels than are other manufacturers. Those deterred from investment by high or rising rates were 49 per cent and 44 per cent of respondents respectively. In the case of other manufacturers the corresponding proportions were 60 per cent and 63 per cent.
Respondents were fairly evenly divided on whether the level of interest rates was, overall, an important factor in manufacturing investment decisions. Rather more were against (52 per cent of those responding) than for (48 per cent). One firm explained that interest rates were an important factor to its investment decisions "only if interest rates were high". Clearly, for some firms (e.g. those in building) there is a better understood relationship between interest rate levels and activity in the industry. Otherwise, it would appear that the direct investment stimulating effects of a low interest rate policy are likely to be limited.
Other influencing factors
Breadth of outlook will influence responses on the significance of inflation rates, interest rates, and taxation levels in the UK. Firms did not see these as being as important as factors related to business confidence. Indeed, the level of UK interest rates was cited by fewer than one firm in six as an important factor, while just over one in seven said concerns about increased taxation were important, with barely one in 14 emphasizing inflation. In more detail, firms were asked to rank nine factors in order of importance to their company's UK manufacturing investment. Percentages of respondents citing the stated factors as important are shown in Figure 3.
While no firm cited interest rates, concerns about taxation or inflation as the most important factor influencing their manufacturing investment, interpretation should be cautious. For example, while the lowly placing of interest rates is consistent with responses to other questions, it is possible that lack of concern about inflation and tax increases may mean that these issues are seen as under control. The finding on inflation should also be seen in relation to the stated importance of real (i.e. inflation adjusted) interest rates. However, if inflation is seen as having stabilized at lower levels, this ought to feed through to significantly lower required rates of return.
Company-specific factors would top most lists of important influences. The CBI showed the level of demand for the company's products (90 per cent) as the most important influence on required rates of return. While it is possible to construct a list so that a given factor will appear in a low position, it may be that factors topping political agenda may not top industrial agenda for stimulating investment. Other factors cited as important to individual firms included exchange rates with major currencies, environmental and safety regulations and criteria set by industry regulators.
One interesting result reflects the greater importance to British manufacturers of economic prospects in Europe and the rest of the world over the domestic outlook. Larger firms saw improving EU prospects as the second most important factor after overall company profitability. The UK outlook came fourth, with the world outlook next. In contrast, EU outlook was fifth most important for firms with up to [pounds]250m turnover. These results reflect the wider horizons of larger companies and the significance of European and global outlook as company size increases. An improving UK economic outlook was less important to engineering firms than to other manufacturers.
There has been much discussion of whether short-term outlooks adversely affect manufacturing and other UK investment decision making. See, for example, the second report of the Trade and Industry Select Committee and Miles. Short-termism, seen as a culture of low levels of investment seeking easy financial returns, may evidence itself in many ways - for example by conditioning judgements of what is desirable at a strategic level, in the type of quantitative measures used and the way in which any particular method is employed.
On time horizons, when asked if the company took into account cash flow beyond three, five, ten or 15 years, 38 per cent said they did consider flows beyond ten years. While this may seem encouraging, questions remain of how and to what extent later cash flows are taken into account. Larger firms were more likely to think in the long term, with 42 per cent having horizons over ten years. Only 26 per cent of smaller (though still relatively large) firms looked beyond a decade, with none looking beyond 15. By industry groups, 43 per cent of other manufacturing firms looked beyond ten years, but only one engineering firm in three (34 per cent) said that it did this.
Another aspect of short-termism has been the influence attached by decision makers to accounting measures such as earnings per share and the weight given to the views of financial analysts. Firms were asked if the concerns of financial analysts with movements in earnings per share was a major factor in their manufacturing investment decisions. Results, as percentages of those responding to this question, are shown in Figure 4.
Interpretation of these results is largely judgemental, but preoccupation with analysts' concerns and earnings per share is not evident here.
Companies were asked if the recommendations of the Cadbury Committee would lead to changes in their investment decision-making procedures. Cadbury is concerned with issues of accountability. One of the factors influencing the setting up of the committee was a Bank of England discussion paper which suggested that UK corporate governance was not as helpful to modern industry as that of some competitors. It was suggested that present investment decision-making processes within companies led to short-term decisions. Cadbury recommended that institutional investors assess company performance over longer periods. This would alter the factors taken into account by boards when making investment decisions. But the consistent response to the question of whether Cadbury's recommendations would bring changes in investment decision-making processes was no - as shown in Figure 5.
One valid reason given by respondents for not making changes as a result of the Cadbury recommendations is that the company already conforms with the recommendations. While this may be true in some cases, perceptions can be conveniently elastic. As one respondent claimed: "We already comply with the Cadbury spirit", and another: "We basically meet the Cadbury criteria already" (authors' italics). Just two firms were set to make real changes, one being about to appoint "non-executives to boards previously involving principals and executives only". Another intended, as part of a revised legal policy, to ensure that all business practices complied with all relevant laws and regulations including capital investment proposals. But it is clear that in the short term at least, the impact of Cadbury on investment decision making will be marginal.
Financial appraisal methods
Financial appraisal methods used in the UK and elsewhere are an important focus of study. The methods used can have important effects on both the level and nature of capital investment and the international competitiveness of the UK. We asked firms to rank, for 1989 and 1994, their methods of investment appraisal in order of frequency of use. The methods listed were internal rate of return (IRR) which is also known as discounted cash flow rate of return or yield, net present value (NPV), payback period and accounting rate of return (ARR). Firms could include another method in the ranking if they wished. First, however, it was confirmed that few firms rely on a single method, a large majority citing more than one technique. The results are shown in Figure 6.
Among those stating the number of methods used, the average was 2.9 in 1989 and three in 1994. The proportion of firms using more than one method, 85 per cent overall in 1994, is greater than indicated by most earlier studies. Sangster compared his 1989 study with earlier surveys by Mcintyre and Coulthurst[8,9] and Pike's 1981 and 1975 studies. Further comparative details are given in Wilkes et al..
Notably, no one used accounting rate of return alone, and only one firm in each case used IRR, NPV or an unlisted method by themselves. Even payback was the sole technique in only six cases (7.4 per cent). Nearly six out often firms used three or four methods, with the most popular three method combination being payback, yield and NPV (22 per cent overall).
Multiple method usage, at least in larger companies, is firmly established and has continued to strengthen. The use of more than one method is consistent with a cautious approach (as suggested by Sangster) of seeking to avoid inappropriate decisions. Pike has suggested that the reason may be that no single technique combines ease of understanding with reflection of a complex reality. There is also consistency with the views that managers may select methods favouring their proposals or that firms simply lack confidence in the individual methods. Details of how firms made use of more than one method were not explicitly sought. But while a few firms specified preferences for different methods for different types of project (large or small, property or non-property) others used more than one measure when assessing an individual project.
Now consider the extent to which methods were included at all in companies' rankings. Payback is nearly always used, and there was little change between 1989 and 1994 - results as percentages are shown in Figure 7.
Thus almost nine firms out of ten included payback, although not necessarily as the most frequently used method. In the 66 cases where frequency of use rankings were given for both years, payback maintained its position in 52 cases. Payback moved down company ranking in nine cases and moved up the list in five cases. Pike's survey of large UK firms found payback showing "a small but unmistakable increase in usage" and was as prevalent among larger firms as smaller ones. In the short-termism context there is little evidence here for a declining influence for payback. However, as described below, payback did not rank as high in the pecking order as might be supposed from its near universal use.
The length of the payback period is an important consideration - the shorter the required payback period, the more likely is bias against longer-term investments, such as those in more advanced technologies. The Bank of England found 40 per cent of its respondents requiring capital projects to pay back in three years. The CBI survey, which concentrated on manufacturing industry, found that two-thirds of companies sought payback in three or even two years, the average being 2.7 years. The CBI survey found that even for firms using methods other than simple payback, less than half assessed their returns over the full expected life of the equipment. These are disconcerting findings for UK manufacturing. Our survey was somewhat more encouraging. We asked manufacturers whether, when considering an investment, they took into account cash flow beyond three, five, ten or 15 years. Two out of five firms said that they took projected cash flow beyond ten years into account (one in nine considered cash flow beyond 15 years), although if high rates of discount are used the present value of returns beyond 15 years is slight and a bias against long-term, high growth, projects remains. Looking at the CBI and Bank of England length of payback results alongside the claims of our respondents to look beyond ten years suggests that the longer view may be taken only for those projects which also meet payback criteria.
Both of the discounted cash flow methods (NPV and IRR) were also used by the majority of respondents; only one firm in six used neither. Of the two methods, IRR was more often included than was net present value. Details are shown in Figure 8.
In 1989 three-quarters of responding firms use IRR as one of their quantitative measures, and by 1994 this proportion had risen to four out of five. In contrast, the CBI survey showed 48 per cent of its respondents using IRR, a proportion well below that in our survey and below that of Sangster.
We found that only 11 per cent used a method other than NPV, IRR, payback or ARR. If another method was used, this was usually alongside one or more of the listed methods. There was no evident consistency among the other methods; criteria cited were: landed cost analysis, price earnings ratio, incremental PBT/EPS profile, economic value added, a CFROI measure and shareholder value analysis.
Usage results for IRR and payback are reconciled by the tendency to use both methods. For example, in 1994 95 per cent of firms using IRR also used payback and 86 per cent of those using payback also used IRR. This raises the question of frequency of use within organizations. In 1994 the most frequently used individual technique within companies was IRR, followed by payback, net present value and, at a considerable remove, accounting rate of return. While the mix of methods in the two years is broadly comparable, the relative influence, if not the frequency of use, of payback may be less than supposed at least among larger manufacturers. This argument is given support if the discounted cash flow methods (NPV and IRR) are taken together and their frequency of use within organization compared to payback. Results are shown in Figure 9.
The CBI found 68 per cent of firms using payback as their main investment criterion although their results support the view that larger companies rely "rather more" on more sophisticated methods including DCE Sangster, in surveying the 500 largest Scottish companies, found that DCF usage was increasing and that ARR was in decline. The Bank of England found that a substantial minority of firms used payback. Conceivably, this could be reconciled with our results on frequency of use. Real differences in results are more likely to lie in differences between the groups of firms surveyed than in distinctions between terms such as: "most frequently used" and "main". On balance, there does not seem to have been a sea change in methods of financial appraisal in large manufacturers.
Table I extends the comparison between the current survey (WSG), that of Drury et al., Sangster, Pike's results for 1992, and the results of Mcintyre and Coulthurst[8,9] and Mills and Herbert. Table I shows percentages using the methods.
With the exception of Drury and the early studies' results for the use of ARR, the results from the present survey are consistent with sustained higher levels of use of all methods. Pike's results showed somewhat higher usage for all methods, although the ranking of the methods is the same as that for the current survey. However, Drury's result for the use of NPV and that of Pike in 1992 are also above the run of the figures as a whole. Different sample populations are involved in each case. We surveyed the largest UK manufacturers so, with the exception of Drury's study, there may be a size effect, with the larger firms tending to use more methods. Against this, Sangster's study suggested that the relationship between size and method of appraisal may now only be valid when the size differential is substantial. The current survey's result for the overall use of DCF (84 per cent) is [TABULAR DATA FOR TABLE I OMITTED] precisely the same as the figure found for the use of DCF methods in the US by Scapens and Sale in 1981. Scapens and Sale found the use of ARR to be 41 per cent which also compares closely with our figure. However, their result for payback, at 56 per cent, is markedly lower than all UK survey results. Other evidence suggests that the use of payback in the USA is markedly lower than in the UK.
Organizational differences between companies of different size or changes in firms which have grown or just survived may account for higher use of the relatively sophisticated DCF methods. A simpler and not inconsistent argument is that historic resistance to DCF methods on grounds of calculation difficulty should have lessened now that spreadsheets include a wide range of financial functions. Thus it is not sustainable to argue difficulty of calculation, if it ever was, given the sums involved in major capital investments. Nonetheless, the persistent popularity of payback stands out. The 7 per cent lead which payback had over DCF in Sangster's study is paralleled by the 6 per cent differential in the 1994 results from the current study. As between the two DCF methods, we found that NPV apparently had 81 per cent of the popularity of IRR. The corresponding proportion in Sangster's study was 83 per cent.
Cost of capital
A sustained environment of lower interest rates should mean a lower cost of capital. How much lower depends on the method of funding, but lower it should undoubtedly be. If, from a position established when interest rates were higher, a firm does not adjust its cost of capital when interest rates settle at lower levels, it cuts out potentially profitable investments. If firms apply higher than warranted discount rates a bias is created against longer-term alternatives because of the exponential impact of discounting on more distant returns.
We asked firms to what extent reductions in interest rates since September 1992 had been reflected in their required rates of return and project discount rates. We did not seek to differentiate the manner of calculation (pre -or post-tax, nominal or real) in this question. There was a spread of opinion as to how far changes in the level of interest rates had fed through. One company in six confirmed a full corresponding reduction in required rates of return, and one in three indicated a partial response. However, more than two out of five firms said that reductions in interest rates had not been reflected at all in their required rates of return and project discount rates. The average reduction was marginally greater than 1 per cent - results are shown in Figure 10.
There is a depressing consistency in our findings and the CBI results that, for a "vast majority" of companies, there had been no change in the nominal rate in the past two years and that the average required rate of return was 17 per cent for firms using nominal rates and 16 per cent for those using real rates. The Bank of England found (within its broader group) that an average post tax nominal rate of return of 20 per cent was being applied while the real rate post tax users averaged 15 per cent.
Although there was widespread use of subjective judgement in taking inflation into account, the CBI found the average inflation rate which firms were factoring into their investment decisions was 5 per cent, a figure unchanged by most firms between 1992 and 1994. This compares with the 1-4 per cent Government target range for underlying retail price inflation. Thus the low interest rate, low inflation environment was paralleled by marginal reductions in project discount rates. While it is possible that judgemental factors not included in the financial appraisal may have been more positive since 1992, no respondents drew attention to such a phenomenon and the benefit of interest rate reductions lay in improved net revenues.
The pattern of responses to lower interest rates was broadly similar in both size and industry groupings. Companies which see themselves as operating in long-term industries may reflect this in capital structure by relatively low gearing and with borrowing being longer term, possibly at fixed rates. The result of this is that the cost of capital is relatively insensitive to interest rate movements in the shorter term, particularly if the UK yield curve is steep, a factor one respondent gave as a reason for an unchanged project discount rate. Companies may have capital structures which dampen or eliminate sensitivity to interest rate changes.
However, there are other possible reasons for the discount rate stasis. Companies may be unconvinced that interest rates have settled at lower levels and may take the view that rates will rise again in the medium term. On a macro scale this view may be self-justifying. If there is less investment because of a belief that lower rates will not last, this will help to bring about circumstances to which authorities will react by raising interest rates.
Required rates may be determined by parent companies abroad on the basis of interest rates elsewhere, but foreign ownership is not a bar to firms using DCF methods determining required rates in ways that reflect local conditions. For example, one of the largest companies in our study has the policy of using local after-tax rates for each market. On the other hand, the manner of global operation may minimize the impact of national policies: "Investment decisions are not made on a country basis but on an international market need basis". Discount rates for this company were set on a worldwide, long-term basis which was not influenced by relatively recent interest rate changes in the UK.
Unchanged perception of risk is a consideration: "the risk of variability needs to be discounted", as one respondent emphasized. We are inclined to take it for granted that this must be so, but not all Japanese companies appear to act in this fashion, possibly choosing the approach of redefining the project. Other reasons offered in free text comment ranged widely from: "All capital has to be self-generating" and "competition for available funds from associated companies", through to: "the company is cash rich", and "the owner requires 15 per cent per annum growth in profitability regardless of external factors".
Investment in advanced manufacturing technology
Adequate investment in advanced manufacturing technology (AMT) is essential for competitive manufacturing in the longer term. AMT investments need sustained capital outlay and offer company-wide impact, mass customization possibilities and growth. There are also hard to measure benefits intangibles. AMT projects are adversely affected by high discount rates more than traditional process alternatives. Thus discount rates held at levels similar to those in 1992 will select against this type of investment. We asked firms to give representative discount rates for their assessment of AMT investments. With averages of 17 per cent for 1992 and 16.8 per cent for early 1994 or late 1993, the responses showed a similar picture to the wider category of investments in both overall levels and lack of change over the two years.
We also asked firms investing in AMT how they took account of factors they might regard as intangible, such as improved quality, flexibility and longevity. In 1994 almost one in three respondents still took no account of intangibles (but better than the two out of five in 1989). Of those considering intangibles, 21 per cent placed a value on them and included this in the financial appraisal. A similar proportion made a judgement of the worth of intangibles compared with any shortfall on a narrower financial appraisal. Nineteen per cent made a judgement by other means and 8 per cent used a mixture of methods - results are shown in Figure 11.
The role of managerial judgement in making due allowance for intangibles is clearly important, and could materially be affected if the Cadbury recommendations were followed. The majority of firms felt that existing methods of appraising AMT investments did allow a fair comparison with conventional alternatives, 87 per cent taking this view with only one in eight finding their methods at fault. While respondents might not be expected to condemn practice in their own companies, the size of the affirmative response may reflect the view that sufficient informal flexibility is used. If so, judgement may simply override financial appraisals rather than being incorporated in a more sophisticated manner.
The survey confirmed trends in the use of appraisal methods and showed the distinct perceptions of influencing factors held by firms. A slow pace of adjustment was revealed within companies and the financial environment to capital investment decision making and the financial requirements on such investments. The effects of interest rate changes on investment decision making are muted and, with exceptions, more indirect than direct. This at best damped adjustment is not necessarily illogical for individual firms, but the effects are more widespread. With manufacturing investment at lower than desirable levels, economic recovery is jeopardized by capacity constraints and macroeconomic responses to consequent inflationary and balance of trade pressures.
To move forward from this position, policy makers need to reflect on influences on investment as perceived by firms, and reasons for the lagged perception that macro stability is lasting. In micro terms, all parties to major investment decisions should regularly review required rates of return, time horizons and appraisal methods. Those still wedded to payback should consider time scales and how use of the method relates to long-term objectives. For users of IRR and NPV, a modest change in the discount rate can make a disproportionate difference to present worth, particularly for the longer term, strategic investments crucial to the future of UK manufacturing.
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15 Scapens, R.W. and Sale, J.T., "Performance measurement and formal capital expenditure controls in divisionalized companies", Journal of Business Finance and Accounting, Autumn 1981.
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F.M. Wilkes, J.M. Samuels and S.M. Greenfield, Birmingham Business School, University of Birmingham, UK
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|Author:||Wilkes, F.M.; Samuels, J.M.; Greenfield, S.M.|
|Date:||Jul 1, 1996|
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