266 Corporate Finance
booking might be the relevant measures whereas from a customer’s perspective, customer satisfaction index,
customer ranking survey, and market share might be the relevant measures. A company can start by assessing
its current position on these perspectives and arrive at the priority areas where attention is required. Com-
panies can often create lot of value for shareholders by fine-tuning project choice.
IN CONCLUSION
Capital budgeting rules like NPV are based on several questionable assumptions. For instance, NPV is cal-
culated by discounting cash flows at WACC. The standard procedure for estimating cost of equity is the
capital asset pricing model. As pointed out in the chapter on risk and return, the CAPM has been challenged
by many recent studies. Likewise, hurdle rates are calculated on the basis of the market price of stock. The
implicit assumption is that the market is efficient. This is usually not true. So capital budgeting when prices
are inefficient and managers are fully rational is more complex than in the rational world.^9 Modern capital
budgeting suggests that only systematic risk matters. This approach ignores the impact of the new project on
the firm’s total risk and therefore leads to an inappropriate assessment of the value of the project. Total risk
is often costly and it is necessary to take total risk into account in capital budgeting to make capital budgeting
and capital structure decisions consistent.^10
REFERENCES AND SUGGESTED READING
Barwise, Patrick, Paul R Marsh, and Robin Wensley (1989). ‘Must Finance and Strategy Clash?’, Harvard Business Review,
Sep–Oct.
Donaldson, Gordon (1972). ‘Strategic Hurdle Rates for Capital Investments’, Harvard Business Review, March–April.
Hastie, Larry (1974). ‘One Businessman’s View of Capital Budgeting’, Financial Management.
Hayes, Robert and Samuel Hayes (1982). ‘Managing as if tomorrow mattered’, Harvard Business Review, May–June.
Hayes, Robert and William J Abernathy (1980). ‘Managing Our Way to Economic Decline’, Harvard Business Review,
July–Aug.
Hertz, David (1968). ‘Investment Policies That Pay Off’, Harvard Business Review, Jan–Feb.
Kaplan, Robert S and David P Norton (1993). ’Putting the Balanced Scorecard to Work’, Harvard Business Review, Sept–Oct.
Lerner and Rappaport, A (1968). ‘Limit DCF in Capital Budgeting’, Harvard Business Review, Sept–Oct.
Mathews, John (1959). ‘How to Administer Capital Spending’, Harvard Business Review, March–April.
Myers, S C (1984). ‘Finance Theory and Financial Strategy’, Interfaces, Vol. 14, No. 1.
Prahalad, C K and Gary Hamel (1990). ‘The Core Competence of the Corporation’, Harvard Business Review, May–June.
Shapiro, A C (1985). ‘Corporate Strategy and the Capital Budgeting Decision’, Midland Corporate Finance Journal, Vol. 3,
No. 1.
Stein, Jeremy (1996). ‘Rational Capital Budgeting in an Irrational World’, Journal of Business, Vol. 69, No. 4.
Tiles, Seymour (1966). ‘Strategies for Allocating Funds’, Harvard Business Review, Jan–Feb.
Welter, Paul (1970). ‘Put Policy First in DCF Analysis’, Harvard Business Review, Jan–Feb.
Woods, Donald H (1966). ‘Improving Estimates That Involve Uncertainty’, Harvard Business Review, July–Aug.
(^9) Stein, Jeremy (1996).
(^10) Stulz, Rene (1999). ‘What’s Wrong with Modern Capital Budgeting?’, Financial Practice and Education, Fall–Winter.
This will be explained in greater detail at a later stage.