Other Capital Budgeting Issues
Inflation impacts the amounts of estimated cash flows. It is often stated as an annual percentage such as 3%. It is taken into account by multiplying the current period’s cash flow amount by the expected rate of inflation to determine an estimate of the next period's cash flows. Different inflation rates are often used for different costs, such as 2% for maintenance costs, 4% for labor costs, etc. The rate of inflation can be obtained from economic forecasts or other sources but is ultimately estimated by management.
If inflation is omitted from expected future cash flows, managers may reject acceptable projects. When inflation is added to future cash flows, the net cash inflows are larger, providing a more realistic approach to estimating how viable a project is. Using cash flows amounts without inflation factored in means that the cash flows are smaller than cash flows expected, which in turn causes all four capital budgeting methods--NPV, IRR, ARR and the payback period method to produce smaller results. Because the results are smaller, the likelihood of accepting a potential investment is smaller because fewer investments will meet the company's minimum criteria. As a result, managers will often bypass good investments.
Soft Benefits in Capital Budgeting So far we have addressed primarily the financial aspects of capital budgeting. Most decisions involved some type of touchy-feely considerations known as soft benefits. Ignoring soft benefits may cause managers to pass up investments that would be beneficial to the company.
Soft benefits are hard to quantify but should still impact the decision making process. Some examples are:
(1) A company's reputation
(2) Maintaining a competitive advantage
(3) Employee moral
Conflict Between Performance Evaluation and Capital Budgeting
Some managers are evaluated on the amount of short term profits they generate. Some capital budgeting projects will generate small or negative operating cash flows during the early years and greater positive impacts on profit during the latter years of a proposed investment's life. Because accepting the capital budgeting investment causes an initial drop in profits, managers are reluctant to invest and often bypass investments that in the long-run would benefit the company. Even though a potential investment may have a positive NPV, an IRR that exceeds the company's required rate of return, or a payback period that quickly recovers the cash outflow, managers may reject the investment to avoid looking bad for their annual performance evaluation. These actions are often detrimental to the long-term value of the company.
A couple of solutions exist. One solution is to bring other factors into the performance evaluation of managers. Giving managers stock ownership in the company often motivates them to focus on both the long and short run when making decisions in an effort to add value to the company, i.e., increase owners' equity through retained earnings.
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