A Follow-up Note on Capital Budgeting 257Chapter 13
13. A Follow-up Note on Capital Budgeting
OBJECTIVES
Potential pitfalls in capital budgeting.
Introduction to the administrative process surrounding capital budgeting.
Issues in selecting hurdle rates.
The link between capital budgeting and corporate strategy.
Capital budgeting practices in Japan and the US.
Current thinking in capital budgeting.
Designing a capital budgeting system.The focus of capital budgeting should not be on the result of calculation but on the important assumptions on
which the calculation is based. The use of unrealistic assumptions is a more significant source of bad investment
decisions than the use of unscientific techniques. The project can still fail if the result is based on unrealistic
assumptions, however refined the technique may be. Measurement techniques like ROI and NPV do not consider
the subtle behavioral aspects of capital budgeting or the problems of single point estimates. Quite often the
strategic aspects of individual investments are not considered or an ad hoc evaluation of alternatives is
made. It is important to consider all alternatives before a decision is made. A firm can segregate its businesses
into three categories: those in which it wants to expand; those in which it wants to maintain position; and
those which no longer fit into the firm’s portfolio and, hence, need to be liquidated. The firm can set different
standards for different businesses. The upshot is that one project may be accepted despite low returns and
another project may be rejected despite high returns. This is indeed the case in some companies as we will
see later. The DCF approach breaks down when hurdle rates are arbitrarily chosen, especially while evaluating
unconventional technology. Executives tend to focus on a set of numbers while trying to be ‘practical’ in
evaluation. It is hard to believe that a truth as simple as ‘1 rupee today is worth more than 1 rupee tomorrow’
(the essential logic of DCF methodology) cannot be applied in real-life situations.
Selecting Hurdle Rates
Often, the hurdle rate in investment analysis is the firm’s cost of capital. The reason is quite simple: unless
a firm can earn at least what it costs to raise the necessary capital there is no justification for that investment.
The problem lies in measuring the cost of equity. The cost of equity is the return expected by investors,