10: Cash Flow and Capital Budgeting10 When a company is faced with capital rationing, how can the profitability index (PI) be used to
select the best projects? Why does choosing the projects with the highest PI not always lead to the
best decision?11 Under what circumstance is the use of the equivalent annual cost (EAC) method to compare
substitutable projects with different lives clearly more efficient computationally than using multiple
investments over a common period where both projects terminate in the same year?12 In almost every example so far, companies must decide to invest in a project immediately or not
at all. But suppose that a company could either invest in a project today or wait one year before
investing. How could you use NPV analysis to decide whether to invest now or later?13 Can you articulate circumstances under which the cost of excess capacity is zero? Think about why
the cost of excess capacity normally is not zero.CONCEPT REVIEW QUESTIONS 10-4
10-5 THE HUMAN FACE OF CAPITAL
BUDGETING
This chapter illustrates which cash flows analysts should discount and which cash flows they should
ignore when valuing real investment projects. There are relatively simple rules of thumb that guide
managers in this task; however, executing these rules appropriately in practice is an obvious challenge.
Deciding which costs are incremental and which are not, incorporating the myriad tax factors that
influence cash flows, and measuring opportunity costs properly are much more complex manoeuvres
than we or anyone else can convey in a textbook. The nuances of capital budgeting are best learned
through practice.
There is another factor that makes real-world capital budgeting more complicated than textbook
examples: the human element. Neither the ideas for capital investments nor the financial analysis used
to evaluate them occur in a vacuum. Almost every investment proposal important enough to warrant a
thorough financial analysis has a champion behind it, an individual who believes that the project is a
good idea and that it perhaps will advance their own career. When companies allocate investment capital
across projects or divisions, they must recognise the potential for an optimistic bias to creep into the
numbers. This bias can arise through intentional manipulation of the cash flows to make an investment
look more attractive, or it may simply arise if the analyst calculating the NPV is also the cheerleader
advocating the project in the first place.
One way that companies attempt to control this bias is by putting responsibility for analysing
an investment proposal under an authority independent from the individual or group proposing the
investment. For example, it is common in large companies for a particular group to have the responsibility
of conducting the financial analysis required to value any potential acquisition targets. In this role,
financial analysts play a gatekeeper role, protecting shareholders’ interests by steering the company away
from large, negative NPV investments. Naturally, these independent analysts face intense pressure from
the advocates of each project to portray the investment proposal in its best possible light. Consequently,LO10.6
How does the approval process
for new investment ideas work
at various companies?thinking cap
question