Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

financial experts need to know more than just which cash flows count in the NPV calculation. They

also need to have a sense of what is reasonable when forecasting a project’s profit margin and its growth

potential. Analysts must also prepare to defend their assumptions, explaining why their (often more

conservative) projections do not line up with those offered by the managers advocating a given investment.

Many experienced managers say that they have never seen an investment with a negative NPV. They

do not mean that all investments are good investments, but rather that all analysts know enough about

NPV analysis to recognise how to make any investment look attractive. In this environment, another

skill comes into play in determining which project receives funding. We refer to this skill as storytelling,

as opposed to number-crunching. Most good investments have a compelling story behind them – a

reason, based on sound economic logic, that the investment’s NPV should be positive. The best financial

analysts not only provide the numbers to highlight the value of a good investment but also explain why

the investment makes sense. We return to this storytelling element of capital budgeting in Chapter 11.

14 What role does the human element play in the capital budgeting decision process? Could it cause

a negative NPV project to be accepted?

CONCEPT REVIEW QUESTIONS 10-5

Raghu Rajan, University of

Chicago

‘Capital budgeting is not

just about estimating

cash flows and discount

rates, but is also a lot

about horse trading.’

See the entire interview on

the CourseMate website.

COUrSEMATE
SMArT VIDEO

Source: Cengage Learning

finance in practice

CFO SURVEY EVIDENCE

Throughout this chapter we have stressed that

managers should focus on cash flows rather than

accounting earnings, both in intra-company financial

analysis (including capital budgeting assessments)

and in the financial data they report to external

stakeholders. Do practising managers actually

follow this advice? Unfortunately, survey evidence

clearly suggests that financial managers place far

greater emphasis on accounting earnings, especially

earnings per share (EPS), than they do on any other

financial metric. The following graph describes how

401 financial executives ranked the importance of

company metrics provided to outsiders. Over half

(51%) of the respondents listed earnings as the

most important metric they report, with pro forma

earnings and revenues the two next most important

measures reported. Cash flows from operations

and free cash flows, two of the metrics we stress in

this chapter, were selected by only 12% and 10% of

respondents, respectively.

The researchers conducting this survey

also reported the disquieting fact that 78% of

responding managers admitted a willingness

to sacrifice company value to smooth reported

earnings. In response to the question, ‘How large

a sacrifice in value would your company make to

avoid a bumpy earnings path?’, 52% of managers

reported a willingness to make a small sacrifice,

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