expectations. From then on, reports on the operation are reviewed on a regular basis
like those of other operations.
The post-audit has three main purposes:
1.Improve forecasts.When decision makers are forced to compare their projections
to actual outcomes, there is a tendency for estimates to improve. Conscious or un-
conscious biases are observed and eliminated; new forecasting methods are sought
as the need for them becomes apparent; and people simply tend to do everything
better, including forecasting, if they know that their actions are being monitored.
2.Improve operations.Businesses are run by people, and people can perform at
higher or lower levels of efficiency. When a divisional team has made a forecast
about an investment, its members are, in a sense, putting their reputations on the
line and will strive to improve operations if they are evaluated with post-audits. In
a discussion related to this point, one executive made this statement: “You acade-
micians worry only about making good decisions. In business, we also worry about
making decisions good.”
3.Identify termination opportunities. Although the decision to undertake a
project may be the correct one based on information at hand, things don’t always
turn out as expected. The post-audit can help identify projects that should be ter-
minated because they have lost their economic viability.
The results of post-audits often conclude that (1) the actual NPVs of most cost re-
duction projects exceed their expected NPVs by a slight amount, (2) expansion proj-
ects generally fall short of their expected NPVs by a slight amount, and (3) new prod-
uct and new market projects often fall short by relatively large amounts. Thus, biases
seem to exist, and companies that understand them can build in corrections and thus
design better capital budgeting programs. Our observations of businesses and govern-
mental units suggest that the best-run and most successful organizations put great em-
phasis on post-audits. Accordingly, we regard the post-audit as being one of the most
important elements in a good capital budgeting system.
280 CHAPTER 7 The Basics of Capital Budgeting: Evaluating Cash Flows
Techniques Firms Use to Evaluate Corporate Projects
Professors John Graham and Campbell Harvey of Duke
University recently surveyed 392 chief financial officers
(CFOs) about their companies’ corporate practices. Of those
firms, 26 percent had sales less than $100 million, 32 percent
had sales between $100 million and $1 billion, and 42 per-
cent exceeded $1 billion.
The CFOs were asked to indicate what approaches they
used to estimate the cost of equity: 73.5 percent used the
Capital Asset Pricing Model (CAPM), 34.3 percent used a
multi-beta version of the CAPM, and 15.7 percent used the
dividend discount model. The CFOs also used a variety of
risk adjustment techniques, but most still used a single hur-
dle rate to evaluate all corporate projects.
The CFOs were also asked about the capital budgeting
techniques they used. Most used NPV (74.9 percent) and
IRR (75.7 percent) to evaluate projects, but many (56.7 per-
cent) also used the payback approach. These results confirm
that most firms use more than one approach to evaluate
projects.
The survey also found important differences between the
practices of small firms (less than $1 billion in sales) and
large firms (more than $1 billion in sales). Consistent with
the earlier studies by Bierman and by Walker, Burns, and
Denson (WBD) described in the text, Graham and Harvey
found that smaller firms are more likely to rely on the pay-
back approach, while larger firms are more likely to rely on
NPV and/or IRR.
Source:From John R. Graham and Campbell R. Harvey, “The Theory and
Practice of Corporate Finance: Evidence from the Field,” Journal of Financial
Economics, Vol. 60, no. 2–3, 2001, 187–243. Copyright © 2001. Reprinted
with permission from Elsevier Science.
278 The Basics of Capital Budgeting: Evaluating Cash Flows
