9-11. The Practice of Cash Flow Estimation for Capital Budgeting The analysis presented in this chapter and throughout the book suggests that generating unbiased

estimates of the cash flows from investment projects is extremely important to the success of the firm. A

survey supports this conclusion and provides considerable insight regarding the cash flow estimation

procedures used by larger firms (Fortune 500).

Ethical Issues Cash Flow Estimation Biases

The estimation of the cash flows associated with an investment project is the most important step in

the capital expenditure evaluation process. If the cash flow estimates associated with a project are

intentionally or unintentionally biased, a firm’s resources are unlikely to be allocated to the set of

investment projects that will maximize shareholder wealth.

There are several reasons why managers might produce biased cash flow estimates when preparing

capital expenditure project proposals. First, a manager might be tempted to overestimate the

revenues or underestimate the costs associated with a project if the manager is attempting to expand

the resource base over which he or she has control. By biasing the estimates of a project’s cash flows

upward, a manager is likely to receive a larger share of the investment resources of the firm.

Because managerial compensation is sometimes tied to the span of job responsibilities, managers

may be tempted to expand this span of control at the expense of other areas in the firm.

Second, some firms tie employee compensation to performance relative to stated objectives—a

compensation scheme often called management by objective. If a manager is confident that the best

estimate of the cash flows from a proposed project is sufficiently large to guarantee project

acceptance, the manager may be tempted to reduce these cash flow estimates to a level below the

“most likely outcome” level, confident that the project will continue to be viewed as an acceptable

Book Title: eTextbook: Contemporary Financial Management Chapter 9. Capital Budgeting and Cash Flow Analysis 9-11. The Practice of Cash Flow Estimation for Capital Budgeting

investment and that it will be funded. However, once the project is under way, the project manager

will feel less pressure to meet projected performance standards. The downward bias in the cash flow

estimates provides a cushion that permits suboptimal management of the project while achieving the

objectives enunciated when the project was first proposed.

What impact does intentionally biasing cash flow estimates for investment projects have on

achieving the goal of shareholder wealth maximization?

© Cengage Learning

The majority of the firms responding to the survey had annual capital budgets of more than $100 million.

Nearly 67 percent of the firms prepared formal cash flow estimates for over 60 percent of their annual

capital outlays, and a majority produced detailed cash flow projections for capital investments requiring

an initial outlay of $40,000 or more. Firms with high capital intensity and high leverage were more likely

to have one or more persons, such as a financial analyst, treasurer, controller, or department manager,

designated to oversee the process of cash flow estimation. This reflects the larger number of projects

associated with capital-intensive firms and the need to effectively manage the risk associated with high

leverage.

When asked about the type of cash flow estimates that were generated, 56 percent indicated that they

used single-dollar estimates, 8 percent used a range of estimates, and 36 percent used both single-dollar

estimates and a range of estimates. There was a significant positive correlation between firms that use

both types of estimates and measures of operating and financial risk, suggesting that the use of a range of

estimates is one procedure for managing high risk.

Forecasting methods employed by the respondent firms included subjective estimates from management,

sensitivity analysis, consensus analysis of expert opinions, and computer simulation. Many firms used

multiple cash flow forecasting techniques. The longer the forecasting horizon—that is, the longer the

economic life of the project—the more likely a firm is to use multiple methods for forecasting future cash

flows.

Financial factors considered to be important in generating cash flow estimates include working capital

requirements, project risk, tax considerations, the project’s impact on the firm’s liquidity, the anticipated

rate of inflation, and expected salvage value. Important marketing factors considered include sales

forecasts, the competitive advantages and disadvantages of the product, and product life. Important

production factors include operating expenses, material and supply costs, overhead and expenses for

manufacturing, capacity utilization, and start-up costs.

Three-fourths of the companies surveyed make comparisons between actual and projected cash flows,

with nearly all the firms comparing actual versus projected initial outlays and operating cash flows over

the project life; about two-thirds of these firms make comparisons of actual versus projected salvage

values. The most accurate cash flow estimates are reported to be the initial outlay estimates, and the least

accurate element of cash flow estimates is the annual operating cash flows. Cash flow forecasts were

more accurate for equipment replacement investments than for expansion and modernization

investments or for acquisitions of ongoing businesses. Firms with the information system in place to

generate cash flow forecasts tend to produce more accurate forecasts than firms with less sophisticated

capital project evaluation procedures.

11-3f. Risk-Adjusted Discount Rate Approach

The approach (RADR) adjusts for risk by varying the rate at which the

expected net cash flows are discounted when determining a project’s net present value. In the risk-

adjusted discount rate approach, net cash flows for each project are discounted at a risk-adjusted rate,

, to obtain the NPV:

(11.4).

where is the net cash flow in period t and NINV is the net investment. The risk-adjusted discount

rate, , is the sum of the risk-free rate, , and the appropriate project risk premium. The

magnitude of depends on the relationship between the total risk of the individual project and the

overall risk of the firm. The risk-free rate, , is the required rate of return associated with investment

projects characterized by certain cash flow streams. U.S. Treasury securities are good examples of risk-

free investments because there is no chance that investors will not get the dollar amount of interest and

the principal repayment on schedule. Thus, the yield on U.S. government securities, such as 90-day

Treasury bills, is used as the risk-free rate.

Most companies are not in business to invest in risk-free securities; individual investors can do that just

as well. Instead, companies assume some amount of risk, expecting to earn higher returns than those

available on risk-free securities. The difference between the risk-free rate and the firm’s required rate of

return (cost of capital) is an average risk premium to compensate investors for the fact that the company’s

assets are risky. This relationship is expressed algebraically as follows:

(11.5).

Book Title: eTextbook: Contemporary Financial Management 11-3. Adjusting for Total Project Risk 11-3f. Risk-Adjusted Discount Rate Approach

risk-adjusted discount rate

k

*

a

NPV =

n

∑

t=1

NCFt

(1 + k

*

a) t

− NINV

NCFt

ka * rf

ka *

rf

where is the average risk premium for the firm; , the risk-free rate; and , the required rate

of return for projects of average risk, that is, the firm’s cost of capital.

The cash flows from a project having greater than average risk are discounted at a higher rate, —

that is, a risk-adjusted discount rate—to reflect the increased riskiness. Total project risk premiums

applied to individual projects are commonly established subjectively. For example, some firms establish a

small number of risk classes and then apply a different risk premium to each class. Below-average-risk

projects, such as straightforward equipment replacement decisions, might be evaluated at 2 percent

below the firm’s cost of capital (a risk discount). Average-risk projects, such as equipment modification

decisions, might be evaluated at the firm’s cost of capital; above-average-risk projects, such as facility

expansions, might be assigned a risk premium of 3 percent above the firm’s cost of capital; and high-risk

projects, such as investments in totally new lines of business or the introduction of new products, might

be assigned a risk premium of 8 percent above the firm’s cost of capital.

Although the risk-class approach saves time in the analysis stage, it can lead to suboptimal decisions,

because the risk premiums themselves are usually determined subjectively and no explicit consideration

is given to the variation in returns of the projects assigned to individual classes. In short, the risk-class

approach is most useful when evaluating relatively small projects that are repeated frequently. In these

cases, much is known about the projects’ potential returns, and it is probably not worth the effort to try to

compute more “precise” risk premiums. The next section applies the capital asset pricing model to

compute risk premia in a more objective way.

θ = ka − rf

θ rf ka

ka *

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