A number of factors affect capital budgeting decisions, including potential inflation, soft benefits, and pressures on managers..
Inflation impacts cash flows that are expected to be received in the future. If inflation of 2% is expected to occur each year in costs, a company will want to include a price increase to compensate for the additional cost. Companies that plan for additional revenue due to inflation along with the costs provide a larger estimate of profit for the future. Omitting inflationary effects in costs can cause the present value to be a lot smaller. When the present value amount is understated, the internal rate of return will be smaller, and it is less likely that the net present value will be greater than zero. As a result, managers will often bypass good investments.
Inflation rates are stated as annual percentages such as 3%. Companies often use 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. From a practical standpoint, once an future cash flow is estimated, you multiply the cash flow amount by the estimated annual inflation rate to determine the estimated increase in cost due to inflation. This amount is then added to the original estimated cash flow to determine an estimate of the next period's cash flows.
Soft Benefits in Capital Budgeting
The financial aspects of capital budgeting are not the only consideration when evaluating capital budgeting decisions. Soft benefits are aspects that affect decisions but cannot be easily quantified in a capital budgeting analysis. They are often referred to as 'touchy-feely' considerations, and may impact how outsiders view a company, the effect on the environment, and employee considerations. Some examples of soft benefits are:
1. A company's reputation
2. Maintaining a competitive advantage
3. Employee moral
4. An environmental effect
Ignoring soft benefits may either cause managers to pass up investments that would be beneficial to the company, or accept investments that may not be in the best interest of a company.
Conflict Between Performance Evaluation and Capital Budgeting
Managers are often evaluated on the amount of short-term profits they generate. As such, a manager's objective is to maximize short-term profits so that any bonus, promotion, or other recognition is maximized.
Because accepting a capital budgeting investment often causes an initial drop in profits, managers are reluctant to invest, and often bypass investments that in the long-run would benefit the company. In a similar manner, 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 if it will decrease the manager's overall profitability. For example, assume a manager's investments are generating a 10% IRR, and a potential investment comes along that is expected to generate a 8% return. If top management specifies a required rate of return is 7%, a manager may choose to reject the 8% because it will decrease his current 10% return. While we expect managers to follow company policies and accept capital budgeting projects that meet top management's minimum required returns, managers often look out for themselves, rather than the best interest of the company. Actions such as these are often detrimental to the long-term value of the company.
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. Another method is to evaluate managers on accepting investments that achieve top management's minimum criteria.
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