SLIDE 3

It helps to use discounted cash-flow techniques to value new projects, but good investment
decisions also require good data. Therefore, we start this chapter by thinking about how firms
organize the capital budgeting operation to get the kind of information they need.

For most sizable firms, investments are evaluated in two separate stages

Stage 1: The Capital Budget

So what is the relationship between projects and the capital budget?

Capital budget is a list of planned investment projects.

Once a year, the head office generally asks each of its divisions and plants to provide a list of the
investments that they would like to make. These are gathered together into a proposed
capital budget. This budget is then reviewed and pruned by senior management and staf
specializing in planning and financial analysis.

Once the budget has been approved, it generally remains the basis for planning over the
ensuing year

The firms capital investment choices should reflect both bottom-up and topdown processes
capital budgeting and strategic planning, respectively. The two processes should complement
each other.

STAGE 2 : PROJECT AUTHORIZATIONS

The fact that your pet project has been included in the annual budget doesnt mean you have
permission to go ahead with it. At a later stage you will need to draw up a detailed proposal
setting out particulars of the project, cash-flow forecasts, and present value calculations. If your
project is large, this proposal may have to pass a number of hurdles before it is finally approved.

The type of backup information that you need to provide depends on the project category

1. Outlays required by law or company policy, for example, for pollution control equipment.
The main issue is whether requirements are satisfied at the lowest possible cost. The
decision is therefore likely to hinge on engineering analyses of alternative technologies.
2. Maintenance or cost reduction, such as machine replacement
Classical capital budgeting problems
3. Capacity expansion in existing businesses.
Forecasts of demand, possible shifts in technology, and the reactions of
competitors.
4. Investment for new products.
Projects in this category are most likely to depend on strategic decisions

SLIDE 4
We know that capital budgeting is a cooperative efort, and this brings with it some challenges.

Ensuring That Forecasts Are Consistent

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

Eliminating Conflicts of Interest

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. So they might propose quick-payback projects even if NPV is sacrificed

Reducing Forecast Bias

Overoptimism is not altogether bad. Psychologists stress that optimism and confidence are
likely to increase efort, commitment, and persistence. The problem is that it is difficult for
senior managers to judge the true prospects for each project. S ometimes a head office seems
actually to encourage project sponsors to overstate their case

Other problems stem from sponsors eagerness to obtain approval for their favorite projects. As
the proposal travels up the organization, alliances are formed.

since it is difficult for senior management to evaluate each specific assumption in an investment
proposal, capital investment decisions are efectively decentralized whatever the rules say

Sorting the Wheat from the Chaf

How then can managers ensure that only worthwhile projects make the grade?

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.

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.

We look at how they try to ensure that everyone involved works together toward a common
goal.

SLIDE 5

What-if analysis is crucial to capital budgeting.

managers dont simply turn a key to start a project and then walk away and let the cash flows
roll in. There are always surprises, adjustments, and refinements. What-if analysis indicates
where the most likely need for adjustments will arise and where to undertake contingency
planning

SLIDE 6

Sensitivity analysis Analysis of the efects on project profitability of changes in sales, costs,
and so on.

Table 10.1. To keep the example simple we have assumed no inflation. We have also assumed
that the entire investment can be depreciated straight-line for tax purposes, we have neglected
the working capital requirement, and we have ignored the fact that at the end of the 12 years
you could sell of the land and buildings.

SLIDE 7

you look at how NPV may be afected if you have made a wrong forecast of sales, costs, and so
on. To do this, you first obtain optimistic and pessimistic estimates for the underlying variables.
These are set out in the left-hand columns of Table 10.2 .

Value of Information

Now that you know the project could be thrown badly of course by a poor estimate of sales,
you might like to see whether it is possible to resolve some of this uncertainty. Perhaps your
worry is that the store will fail to attract sufficient shoppers from neighboring towns. In that
case, additional survey data and more careful analysis of travel times may be worthwhile. On
the other hand, there is less value to gathering additional information about fixed costs .
Because the project is marginally profitable even under pessimistic assumptions about fixed
costs, you are unlikely to be in trouble if you have misestimated that variable.

HOWEVER, you cannot push one-at-a-time sensitivity analysis too far. It is impossible to
obtain optimistic and pessimistic values for total project cash flows from the information in
Table 10.2 . Still, it does give a sense of which variables should be most closely monitored.

SLIDE 8`

Scenario analysis allows them to look at diferent but consistent combinations of variables.
Forecasters generally prefer to give an estimate of revenues or costs under a particular
scenario rather than to give some absolute optimistic or pessimistic value.