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PROBLEMS AND SOME SOLUTIONS

Valuing capital investment opportunities is hard enough when you can do the entire job yourself. In most firms, however, capital budgeting is a cooperative effort, and this brings with it some challenges.

Ensuring that Forecasts Are Consistent. Inconsistent assumptions often creep into investment proposals. For example, suppose that the manager of the furniture division is bullish (optimistic) on housing starts but the manager of the appliance division is bearish (pessimistic). This inconsistency makes the projects proposed by the furniture division look more attractive than those of the appliance division.

To ensure consistency, many firms begin the capital budgeting process by establishing forecasts of economic indicators, such as inflation and the growth in national income, as well as forecasts of particular items that are important to the firm`s business, such as housing starts or the price of raw materials. These forecasts can then be used as the basis for all project analyses.

Eliminating Conflicts of Interest. Earlier we pointed out that while managers want to do a good job, they are also concerned about their own futures. If the interests of managers conflict with those of stockholders, the result is likely to be poor investment decisions. For example, new plant managers naturally want to demonstrate good performance right away. To this end, they might propose quick-payback projects even if NPV is sacrificed. Unfortunately, many firms measure performance and reward managers in ways that encourage such behavior. If the firm always demands quick results, it is unlikely that plant managers will concentrate only on NPV.

Reducing Forecast Bias. Someone who is keen to get a project proposal accepted is also likely to look on the bright side when forecasting the project`s cash flows. Such overoptimism is a common feature in financial forecasts. For example, think of large public expenditure proposals. How often have you heard of a new missile, dam, or highway that actually cost less than was originally forecast? Think back to the Eurotunnel project. The final cost of the project was about 50 percent higher than initial forecasts.

It is probably impossible to ever eliminate bias completely, but if senior management is aware of why bias occurs, it is at least partway to solving the problem.

Project sponsors are likely to overstate their case deliberately only if the head office encourages them to do so. For example, if middle managers believe that success depends on having the largest division rather than the most profitable one, they will propose large expansion projects that they do not believe have the largest possible net present value. Or if divisions must compete for limited resources, they will try to outbid each other for those resources. The fault in such cases is top management`s ¤if lowerlevel managers are not rewarded based on net present value and contribution to firm value, it should not be surprising that they focus their efforts elsewhere.

Other problems stem from sponsors` eagerness to obtain approval for their favorite projects. As the proposal travels up the organization, alliances are formed. Thus once a division has screened its own plants` proposals, the plants in that division unite in competing against outsiders. The result is that the head office may receive several thousand investment proposals each year, all essentially sales documents presented by united fronts and designed to persuade. The forecasts have been doctored to ensure that NPV appears positive.

Since it is difficult for senior management to evaluate each specific assumption in an investment proposal, capital investment decisions are effectively decentralized whatever the rules say. Some firms accept this; others rely on head office staff to check capital investment proposals.

Sorting the Wheat from the Chaff. Senior managers are continually bombarded with requests for funds for capital expenditures. All these requests are supported with detailed analyses showing that the projects have positive NPVs. How then can managers ensure that only worthwhile projects make the grade? One response of senior managers to this problem of poor information is to impose rigid expenditure limits on individual plants or divisions. These limits force the subunits to choose among projects. The firm ends up using capital rationing not because capital is unobtainable but as a way of decentralizing decisions.2

Senior managers might also ask some searching questions about why the project has a positive NPV. After all, if the project is so attractive, why hasn`t someone already undertaken it? Will others copy your idea if it is so profitable? Positive NPVs are plausible only if your company has some competitive advantage.

Such an advantage can arise in several ways. You may be smart or lucky enough to be the first to the market with a new or improved product for which customers will pay premium prices. Your competitors eventually will enter the market and squeeze out excess profits, but it may take them several years to do so. Or you may have a proprietary technology or production cost advantage that competitors cannot easily match. You may have a contractual advantage such as the distributorship for a particular region. Or your advantage may be as simple as a good reputation and an established customer list.

Analyzing competitive advantage can also help ferret out projects that incorrectly appear to have a negative NPV. If you are the lowest cost producer of a profitable product in a growing market, then you should invest to expand along with the market. If your calculations show a negative NPV for such an expansion, then you probably have made a mistake.