What are some of the practical problems of capitalbudgeting in large corporations?For most large corporations there are two stages in theinvestment process: the preparation of the capital budget,which is a list of planned investments, and the authorizationprocess for individual projects. This process is usually acooperative effort.Investment projects should never be selected through apurely mechanical process. Managers need to ask why aproject should have a positive NPV. A positive NPV is plausibleonly if the company has some competitive advantagethat prevents its rivals from stealing most of the gains.
How are sensitivity, scenario, and break-even analysesused to see the effects of forecasting errors on projectprofitability? Why is an overestimate of sales moreserious for projects with high operating leverage?Good managers realize that the forecasts behind NPV calculationsare imperfect. Therefore, they explore the consequencesof a poor forecast and check whether it isworth doing some more homework. They use the followingprincipal tools to answer these “what if ” questions:• Sensitivity analysis, where one variable at a time ischanged.• Scenario analysis, where the manager looks at theproject under alternative scenarios.• Simulation analysis, an extension of scenario analysisin which a computer generates hundreds or thousandsof possible combinations of variables.• Break-even analysis, where the focus is on how farsales could fall before the project begins to losemoney. Often the phrase “lose money” is defined interms of accounting losses, but it makes more sense todefine it as “failing to cover the opportunity cost ofcapital”—in other words, as a negative NPV.• Operating leverage, the degree to which costs arefixed. A project’s break-even point will be affected bythe extent to which costs can be reduced as salesdecline. If the project has mostly fixed costs, it is saidto have high operating leverage. High operating leverageimplies that profits are more sensitive to changesin sales.
Why is managerial flexibility important in capitalbudgeting?Some projects may take on added value because they givethe firm the option to bail out if things go wrong or tocapitalize on success by expanding. These options areknown as real options, which include options to expand,abandon, delay investment, or make use of flexible productionfacilities. We showed how decision trees may beused to set out the possible choices.
How do Canadian firms make their capital budgetingdecisions?A survey reports that most firms use multiple capitalbudgeting methods to assess capital investments, includingthe NPV, IRR, and payback rules. For purposes ofcash-flow forecasting, firms use quantitative methods,such as sensitivity analysis, as well as qualitative methods,such as management’s subjective estimates. Strategicconsiderations are very important in capital budgetingdecisions.
