What were Bierman’s findings from his survey of capital budgeting methods used by the Fortune 500 companies?
How did WBD’s findings differ from those of Bierman?
What general considerations can be reached from these studies?
T E C H N I Q U E S F I R M S U S E TO E VA L UAT E C O R P O R AT E P R O J E C T S
Professors John Graham and Campbell Harvey of Duke Univer- sity 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 percent exceeded $1 billion.
The CFOs were asked to indicate how frequently they use dif- ferent approaches for estimating the cost of equity: 73.5 per- cent use the Capital Asset Pricing Model (CAPM), 34.3 percent use a multi-beta version of the CAPM, and 15.7 percent use the dividend discount model. The CFOs also use a variety of risk ad- justment techniques, but most still choose to use a single hur- dle rate to evaluate all corporate projects.
The CFOs were also asked about the capital budgeting tech- niques they use. Most use NPV (74.9 percent) and IRR (75.7
percent) to evaluate projects, but many (56.7 percent) also use 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 ear- lier studies by Bierman and by Walker, Burns, and Denson (WBD) described in the text, Graham and Harvey found that small firms are more likely to rely on the payback approach, while large firms are more likely to rely on NPV and/or IRR.
SOURCE: John R. Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Forthcoming, Journal of Financial Economics,Vol. 60, No. 2–3.
Post-Audit
A comparison of actual versus expected results for a given capital project.
improve. Conscious or unconscious biases are observed and eliminated;
new forecasting methods are sought as the need for them becomes ap- parent; and people simply tend to do everything better, including fore- casting, if they know that their actions are being monitored.
2. Improve operations.Businesses are run by people, and people can per- form 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. If costs are above predicted levels, sales below expectations, and so on, executives in production, sales, and other areas will strive to improve operations and to bring results into line with forecasts. In a discussion related to this point, one executive made this
The allocationof capital insmall firms is as important as it is in large ones. Infact, giventheir lack of access to the capital mar- kets, it is oftenmore important inthe small firm, because the funds necessary to correct a mistake may not be available. Also, large firms allocate capital to numerous projects, so a mistake onone canbe offset by successes with others. Small firms do not have this luxury.
In spite of the importance of capital expenditures to small business, studies of the way decisions are made generally sug- gest that many small firms use “back-of-the-envelope” analysis, or perhaps no analysis at all. For example, the Graham and Har- vey study cited earlier in the box entitled “Techniques Firms Use to Evaluate Corporate Projects” points out that small firms are more likely to use simple rules such as payback, whereas large firms are more likely to rely on NPV and/or IRR. These findings confirm earlier results found by L. R. Runyon. Several years ago, Runyon studied 214 firms with net worths ranging from $500,000 to $1,000,000. He found that almost 70 percent relied upon payback or some other questionable criteria. Only 14 percent used a discounted cash flow analysis, and about 9 percent indicated that they used no formal analysis at all. Stud- ies of larger firms, on the other hand, generally find that most analyze capital budgeting decisions using discounted cash flow techniques.
We are left with a puzzle. Capital budgeting is clearly im- portant to small firms, yet these firms do not use the tools that have been developed to improve these decisions. Why does this situation exist? One argument is that managers of small firms are simply not well trained; they are unsophisticated. This ar- gument suggests that the managers would use the more so- phisticated techniques if they understood them better.
Another argument relates to the fact that management tal- ent is a scarce resource in small firms. That is, even if the man- agers were exceptionally sophisticated, perhaps demands on them are such that they simply cannot take the time to use
elaborate techniques to analyze proposed projects. In other words, small-business managers may be capable of doing care- ful discounted cash flow analysis, but it would be irrational for them to allocate the time required for such an analysis.
A third argument relates to the cost of analyzing capital projects. To some extent, these costs are fixed; the costs of analysis may be larger for bigger projects, but not by much. To the extent that these costs are indeed fixed, it may not be eco- nomical to incur them if the project itself is relatively small.
This argument suggests that small firms with small projects may in some cases be making the sensible decision when they rely on management’s “gut feeling.”
Note also that a major part of the capital budgeting process in large firms involves lower-level analysts’ marshalling facts needed by higher-level decision makers. This step is less neces- sary in the small firm. Thus, a cursory examination of a small firm’s decision process might suggest that capital budgeting de- cisions are based on snap judgment, but if that judgment is ex- ercised by someone with a total knowledge of the firm and its markets, it could represent a better decision than one based on an elaborate analysis by a lower-level employee in a large firm.
Also, as Runyon reported in his study of manufacturing firms, small firms tend to be cash oriented. They are concerned with basic survival, so they tend to look at expenditures from the standpoint of their near-term effects on cash. This cash and survival orientation leads firms to focus on a relatively short time horizon, and this, in turn, may lead to an emphasis on the payback method. The limitations of payback are well known, but in spite of those limitations, the technique is popular in small business, as it gives the firm a feel for when the cash committed to an investment will be recovered and thus avail- able to repay loans or for new opportunities. Therefore, small firms that are cash oriented and have limited managerial re- sources may find the payback method appealing. It represents a C A P I TA L B U D G E T I N G I N T H E S M A L L F I R M
statement: “You academicians worry only about making good decisions.
In business, we also worry about making decisions good.”
The post-audit is not a simple process — a number of factors can cause com- plications. First, we must recognize that each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reason- ably aggressive firm will necessarily go awry. This fact must be considered when appraising the performances of the operating executives who submit capital ex- penditure requests. Second, projects sometimes fail to meet expectations for reasons beyond the control of the operating executives and for reasons that no one could realistically be expected to anticipate. For example, the 2000 runup compromise between the need for extensive analysis on the one
hand and the high costs of analysis on the other.
Small firms also face greater uncertainty in the cash flows they might generate beyond the immediate future. Large firms such as AT&T and General Motors have “staying power” — they can make an investment and then ride out business downturns or situations of excess capacity in an industry. Such periods are called “shakeouts,” and it is the smaller firms that are generally shaken out. Therefore, most small-business managers are un- comfortable making forecasts beyond a few years. Since dis- counted cash flow techniques require explicit estimates of cash flows through the life of the project, small-business managers may not take seriously an analysis that hinges on “guesstimate”
numbers that, if wrong, could lead to bankruptcy.
THE VALUE OF THE FIRM AND CAPITAL BUDGETING The single most appealing argument for the use of net present value in capital budgeting is that NPV gives an explicit measure of the effect the investment will have on the firm’s value: If NPV is positive, the investment will increase the firm’s value and make its owners wealthier. In small firms, however, the stock is often not traded in public markets, so its value cannot be observed. Also, for reasons of control, many small-business owners and managers may not want to broaden ownership by going public.
It is difficult to argue for value-based techniques when the firm’s value itself is unobservable. Furthermore, in a closely held firm, the objectives of the individual owner-manager may ex- tend beyond the firm’s monetary value. For example, the owner- manager may value the firm’s reputation for quality and service and therefore may make an investment that would be rejected on purely economic grounds. In addition, the owner-manager may not hold a well-diversified investment portfolio but may in-
stead have all of his or her eggs in this one basket. In that case, the manager would logically be sensitive to the firm’s stand-alone risk, not just to its undiversifiable component.
Thus, one project might be viewed as desirable because of its contribution to risk reduction in the firm as a whole, whereas another project with a low beta but high diversifiable risk might be unacceptable, even though in a CAPM framework it would be judged superior.
Another problem faced by a firm that is not publicly traded is that its cost of equity capital is not easily determined — the P0term in the cost of equity equation k D1/P0g is not ob- servable, nor is its beta. Since a cost of capital estimate is re- quired to use either the NPV or the IRR method, a small firm in an industry of small firms may simply have no basis for esti- mating its cost of capital.
CONCLUSIONS
Small firms make less extensive use of DCF techniques than larger firms. This may be a rational decision resulting from a conscious or subconscious conclusion that the costs of sophis- ticated analyses outweigh their benefits; it may reflect non- monetary goals of small businesses’ owner-managers; or it may reflect difficulties in estimating the cost of capital, which is re- quired for DCF analyses but not for payback. However, nonuse of DCF methods may also reflect a weakness in many small firms. We simply do not know. We do know that small businesses must do all they can to compete effectively with big business, and to the extent that a small business fails to use DCF meth- ods because its manager is unsophisticated or uninformed, it may be putting itself at a serious competitive disadvantage.
SOURCE: L. R. Runyon, “Capital Expenditure Decision Making in Small Firms,” Jour- nal of Business Research,September 1983, 389–397. Reprinted with permission.
in oil prices adversely affected many projects. Third, it is often difficult to sep- arate the operating results of one investment from those of a larger system. Al- though some projects stand alone and permit ready identification of costs and revenues, the cost savings that result from a new computer, for example, may be very hard to measure. Fourth, it is often hard to hand out blame or praise because the executives who were responsible for launching a given investment have moved on by the time the results are known.
Because of these difficulties, some firms tend to play down the importance of the post-audit. However, observations of both businesses and governmental units suggest that the best-run and most successful organizations are the ones that put the greatest emphasis on post-audits. Accordingly, we regard the post- audit as being one of the most important elements in a good capital budgeting system.
S E L F - T E S T Q U E S T I O N S
What is done in the post-audit?
Identify several purposes of the post-audit.
What are some factors that can cause complications in the post-audit?
U S I N G C A P I T A L B U D G E T I N G T E C H N I Q U E S I N O T H E R C O N T E X T S
The techniques developed in this chapter can help managers make a number of different types of decisions. One example is the use of these techniques when evaluating corporate mergers. Companies frequently decide to acquire other firms to obtain low-cost production facilities, to increase capacity, or to expand into new markets, and the analysis related to such mergers is conceptually sim- ilar to that related to regular capital budgeting. Thus, when AT&T decided to go into the cellular telephone business, it had the choice of building facilities from the ground up or acquiring an existing business. AT&T chose to acquire McCaw Cellular. In the analysis related to the merger, AT&T’s managers used the techniques employed in regular capital budgeting analysis.
Managers also use capital budgeting techniques when deciding whether to downsize personnel or to sell off particular assets or divisions. Like capital bud- geting, such an analysis requires an assessment of how the action will affect the firm’s cash flows. In a downsizing, companies typically spend money (i.e., in- vest) in severance payments to employees who are no longer needed, but the companies then receive benefits in the form of lower future wage costs. When assets are sold, the pattern of cash flows is reversed from those in a typical cap- ital budgeting decision — positive cash flows are realized at the outset, but the firm is sacrificing future cash flows that it would have received if it had contin- ued to use the asset. So, when deciding whether it makes sense to shed assets, managers compare the cash received with the present value of the lost outflows.
If the net present value is positive, the asset sale would increase shareholder value.
Most decisions should be based on whether they contribute to shareholder value, and that, in turn, can be determined by estimating the net present value of a set of cash flows. However, as you will see in the next chapter, the hardest part is coming up with reasonable estimates of those cash flows.
S E L F - T E S T Q U E S T I O N
Give some examples of other decisions that can be analyzed with the capi- tal budgeting techniques developed in this chapter.
This chapter has described five techniques (payback, discounted payback, NPV, IRR, and MIRR) that are used in capital budgeting analysis. Each approach provides the firm with a different piece of information, so in this age of com- puters, managers often look at a number of measures when evaluating corpo- rate projects. However, NPV is the best single measure, and its use has been in- creasing over time.
We simplified things in this chapter. You were given a set of cash flows and a cost of capital, and you were then asked to evaluate the projects. The hard part, however, is estimating a project’s cash flows and its risk, which affects its cost of capital. We will address these issues in the next chapter. Before pro- ceeding, though, the key concepts covered are listed below.
■ Capital budgetingis the process of analyzing potential fixed asset invest- ments. Capital budgeting decisions are probably the most important ones financial managers must make.
■ The payback period is defined as the number of years required to re- cover a project’s cost. The regular payback method ignores cash flows be- yond the payback period, and it does not consider the time value of money. The payback does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invested capital will be
“at risk.”
■ The discounted payback method is similar to the regular payback method except that it discounts cash flows at the project’s cost of capital.
It considers the time value of money, but it ignores cash flows beyond the payback period.
■ The net present value (NPV) method discounts all cash flows at the project’s cost of capital and then sums those cash flows. The project is ac- cepted if the NPV is positive.
■ The internal rate of return (IRR) is defined as the discount rate that forces a project’s NPV to equal zero. The project is accepted if the IRR is greater than the cost of capital.
■ The NPV and IRR methods make the same accept/reject decisions for in- dependent projects,but if projects are mutually exclusive,then ranking conflicts can arise. If conflicts arise, the NPV method should be used. The NPV and IRR methods are both superior to the payback, but NPV is su- perior to IRR.
■ The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, while the IRR method assumes reinvestment at the proj- ect’s IRR. Reinvestment at the cost of capital is generally a better as- sumptionbecause it is closer to reality.
■ The modified IRR (MIRR) methodcorrects some of the problems with the regular IRR. MIRR involves finding the terminal value (TV)of the cash inflows, compounded at the firm’s cost of capital, and then determin- ing the discount rate that forces the present value of the TV to equal the present value of the outflows.
■ Sophisticated managers consider all of the project evaluation measures be- cause each measure provides a useful piece of information.
■ The post-auditis a key element of capital budgeting. By comparing ac- tual results with predicted results and then determining why differences occurred, decision makers can improve both their operations and their forecasts of projects’ outcomes.
■ Small firms tend to use the payback method rather than a discounted cash flow method. This may be rational, because (1) the costof conducting a DCF analysis may outweigh the benefits for the project being consid- ered, (2) the firm’s cost of capital cannot be estimated accurately,or (3) the small-business owner may be considering nonmonetary goals.
Although this chapter has presented the basic elements of the capital budgeting process, there are many other aspects of this crucial topic. Some of the more important ones are discussed in the following chapter.
Q U E S T I O N S
11-1 How is a project classification scheme (for example, replacement, expansion into new markets, and so forth) used in the capital budgeting process?
11-2 Explain why the NPV of a relatively long-term project, defined as one for which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project.
11-3 Explain why, if two mutually exclusive projects are being compared, the short-term proj- ect might have the higher ranking under the NPV criterion if the cost of capital is high, but the long-term project might be deemed better if the cost of capital is low. Would changes in the cost of capital ever cause a change in the IRR ranking of two such projects?
11-4 In what sense is a reinvestment rate assumption embodied in the NPV, IRR, and MIRR methods? What is the assumed reinvestment rate of each method?
11-5 “If a firm has no mutually exclusive projects, only independent ones, and it also has both a constant cost of capital and projects with normal cash flows in the sense that each proj- ect has one or more outflows followed by a stream of inflows, then the NPV and IRR methods will always lead to identical capital budgeting decisions.” Discuss this state- ment. What does it imply about using the IRR method in lieu of the NPV method? If each of the assumptions made in the question were changed (one by one), how would these changes affect your answer?