270 Part Three Best Practices in Capital Budgeting
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Earlier chapters explained how companies calculate a project’s NPV by forecasting the cash flows
and discounting them at a rate that reflects project risk. The end result is the project’s contribu-
tion to shareholder wealth. Understanding discounted-cash-flow analysis is important, but there is
more to good capital budgeting practice than an ability to discount.
First, companies need to establish a set of capital budgeting procedures to ensure that decisions
are made in an orderly manner. Most companies prepare an annual capital budget, which is a list of
investment projects planned for the coming year. Inclusion of a project in the capital budget does
not constitute final approval for the expenditure. Before the plant or division can go ahead with a
proposal, it will usually need to submit an appropriation request that includes detailed forecasts, a
discounted-cash-flow analysis, and back-up information.
Sponsors of capital investment projects are tempted to overstate future cash flows and under-
state risks. Therefore, firms need to encourage honest and open discussion. They also need pro-
cedures to ensure that projects fit in with the company’s strategic plans and are developed on a
consistent basis. (These procedures should not include fudge factors added to project hurdle rates
in an attempt to offset optimistic forecasts.) Later, after a project has begun to operate, the firm can
follow up with a postaudit. Postaudits identify problems that need fixing and help the firm learn
from its mistakes.
Good capital budgeting practice also tries to identify the major uncertainties in project propos-
als. An awareness of these uncertainties may suggest ways that the project can be reconfigured
to reduce the dangers, or it may point out some additional research that will confirm whether the
project is worthwhile.
There are several ways in which companies try to identify and evaluate the threats to a proj-
ect’s success. The first is sensitivity analysis. Here the manager considers in turn each forecast or
assumption that drives cash flows and recalculates NPV at optimistic and pessimistic values of that
variable. The project is “sensitive to” that variable if the resulting range of NPVs is wide, particu-
larly on the pessimistic side.
Sensitivity analysis often moves on to break-even analysis, which identifies break-even values
of key variables. Suppose the manager is concerned about a possible shortfall in sales. Then he or
she can calculate the sales level at which the project just breaks even (NPV = 0) and consider the
odds that sales will fall that far. Break-even analysis is also done in terms of accounting income,
although we do not recommend this application. Projects with a high proportion of fixed costs
are likely to have higher break-even points. Because a shortfall in sales results in a larger decline
in profits when the costs are largely fixed, such projects are said to have high operating leverage.
Sensitivity analysis and break-even analysis are easy, and they identify the forecasts and
assumptions that really count for the project’s success or failure. The important variables do not
change one at a time, however. For example, when raw material prices are higher than forecasted,
it’s a good bet that selling prices will be higher too. The logical response is scenario analysis,
which examines the effects on NPV of changing several variables at a time.
Scenario analysis looks at a limited number of combinations of variables. If you want to go
whole hog and look at all possible combinations, you will have to turn to Monte Carlo simulation.
In that case, you must build a financial model of the project and specify the probability distribu-
tion of each variable that determines cash flow. Then you ask the computer to draw random values
for each variable and work out the resulting cash flows. In fact, you ask the computer to do this
thousands of times in order to generate complete distributions of future cash flows. With these
distributions in hand, you can get a better handle on expected cash flows and project risks. You
can also experiment to see how the distributions would be affected by altering project scope or the
ranges for any of the variables.
Elementary treatises on capital budgeting sometimes create the impression that, once the man-
ager has made an investment decision, there is nothing to do but sit back and watch the cash
flows unfold. In practice, companies are constantly modifying their operations. If cash flows are
better than anticipated, the project may be expanded; if they are worse, it may be contracted or
abandoned altogether. Options to modify projects are known as real options. In this chapter we● ● ● ● ●SUMMARY