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Preparation of the capital budget is not a rigid, bureaucratic exercise. There is plenty of give-and-take and back-and-forth. Divisional managers negotiate with plant managers and fine-tune the division’s list of projects. There may be special analyses of major outlays or ventures into new areas.

The final capital budget must also reflect the corporation’s strategic planning. Strategic planning takes a top-down view of the company. It attempts to identify businesses in which the company has a competitive advantage. It also attempts to identify businesses to sell or liquidate and declining businesses that should be allowed to run down.

In other words, a firm’s capital investment choices should reflect both bot- tom-up and top-down processes—capital budgeting and strategic planning, respectively. The two processes should complement each other. Plant and division managers, who do most of the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic planners may have a mistaken view of the forest because they do not look at the trees one by one.

Project Authorizations

Once the capital budget has been approved by top management and the board of directors, it is the official plan for the ensuing year. However, it is not the final signoff for specific projects. Most companies require appropriation requests for each proposal. These requests include detailed forecasts, discounted-cash-flow analyses, and backup information.

Because investment decisions are so important to the value of the firm, final approval of appropriation requests tends to be reserved for top management. Companies set ceilings on the size of projects that divisional managers can authorize. Often these ceilings are surprisingly low. For example, a large company, investing $400 million per year, might require top management approval of all projects over $500,000.

Some Investments May Not Show Up in the Capital Budget

The boundaries of capital expenditure are often imprecise. Consider the investments in information technology, or IT (computers, software and systems, training, and telecommunications), made by large banks and securities firms. These investments soak up hundreds of millions of dollars annually, and some multiyear IT projects have costs well over $1 billion. Yet much of this expenditure goes to intangibles such as system design, testing, or training. Such outlays often bypass capital expenditure controls, particularly if the outlays are made piecemeal rather than as large, discrete commitments.

Investments in IT may not appear in the capital budget, but for financial institutions they are much more important than outlays for plant and equipment. An efficient information system is a valuable asset for any company, especially if it allows the company to offer a special product or service to its customers. Therefore outlays for IT deserve careful financial analysis.

Here are some further examples of important investments that rarely appear on the capital budget.

Research and Development For many companies, the most important asset is technology. The technology is embodied in patents, licenses, unique products or services, or special production methods. The technology is generated by investment in research and development (R&D).

that you have just taken over a trucking firm that operates a merchandise delivery service for local stores. You decide to revitalize the business by cutting costs and improving service. This requires three investments:

1.Buying five new diesel trucks.

2.Constructing a dispatching center.

3.Buying a computer and special software to keep track of packages and schedule trucks.

A year later you try a postaudit of the computer. You verify that it is working properly and check actual costs of purchase, installation, and training against projections. But how do you identify the incremental cash inflows generated by the computer? No one has kept records of the extra diesel fuel that would have been used or the extra shipments that would have been lost had the computer not been installed. You may be able to verify that service is better, but how much of the improvement comes from the new trucks, how much comes from the dispatching center, and how much comes from the new computer? It is impossible to say. The only meaningful way to judge the success or failure of your revitalization program is to examine the delivery business as a whole.2

12.2 DECISION MAKERS NEED GOOD INFORMATION

Good investment decisions require good information. Decision makers get such information only if other managers are encouraged to supply it. Here are four information problems that financial managers need to think about.

Establishing Consistent Forecasts

Inconsistent assumptions often creep into investment proposals. Suppose the manager of your furniture division is bullish on housing starts but the manager of your appliance division is bearish. This inconsistency makes the furniture division’s projects look better than the appliance division’s. Senior management ought to negotiate a consensus estimate and make sure that all NPVs are recomputed using that joint estimate. Then projects can be evaluated consistently.

This is why many firms begin the capital budgeting process by establishing forecasts of economic indicators, such as inflation and growth in gross national product, as well as forecasts of particular items that are important to the firm’s business, such as housing starts or the price of raw materials. These forecasts can then be used as the basis for all project analyses.

Reducing Forecast Bias

Anyone who is keen to get a project accepted is likely to look on the bright side when forecasting the project’s cash flows. Such overoptimism seems to be a common feature in financial forecasts. Overoptimism afflicts governments too, probably more than private businesses. How often have you heard of a new dam, highway, or military aircraft that actually cost less than was originally forecasted?

2Even here you don’t know the incremental cash flows unless you can establish what the business would have earned if you had not made the changes.

You will probably never be able to eliminate bias completely, but if you are aware of why bias occurs, you are at least part of the way there. Project sponsors are likely to overstate their case deliberately only if you, the manager, encourage them to do so. For example, if they believe that success depends on having the largest division rather than the most profitable one, they will propose large expansion projects that they do not truly believe have positive NPVs. Or if they believe that you won’t listen to them unless they paint a rosy picture, you will be presented with rosy pictures. Or if you invite each division to compete for limited resources, you will find that each attempts to outbid the other for those resources. The fault in such cases is your own—if you hold up the hoop, others will try to jump through it.

Getting Senior Management the Information That It Needs

Valuing capital investment opportunities is hard enough when you can do the entire job yourself. In real life it is a cooperative effort. Although cooperation brings more knowledge to bear, it has its own problems. Some are unavoidable, just another cost of doing business. Others can be alleviated by adding checks and balances to the investment process.

Many of the problems stem from sponsors’ eagerness to obtain approval for their favorite projects. As a proposal travels up the organization, alliances are formed. Preparation of the request inevitably involves compromises. But, once a division has agreed on its plants’ proposals, the plants unite in competing against outsiders.

The competition among divisions can be put to good use if it forces division managers to develop a well-thought-out case for what they want to do. But the competition has its costs as well. Several thousand appropriation requests may reach the senior management level each year, all essentially sales documents presented by united fronts and designed to persuade. Alternative schemes have been filtered out at an earlier stage. The danger is that senior management cannot obtain (let alone absorb) the information to evaluate each project rationally.

The dangers are illustrated by the following practical question: Should we announce a definite opportunity cost of capital for computing the NPV of projects in our furniture division? The answer in theory is a clear yes, providing that the projects of the division are all in the same risk class. Remember that most project analysis is done at the plant or divisional level. Only a small proportion of project ideas analyzed survive for submission to top management. Plant and division managers cannot judge projects correctly unless they know the true opportunity cost of capital.

Suppose that senior management settles on 12 percent. That helps plant managers make rational decisions. But it also tells them exactly how optimistic they have to be to get their pet project accepted. Brealey and Myers’s Second Law states:

The proportion of proposed projects having a positive NPV at the official corporate hurdle rate is independent of the hurdle rate.3

This is not a facetious conjecture. The law was tested in a large oil company, whose capital budgeting staff kept careful statistics on forecasted profitability of proposed projects. One year top management announced a big push to conserve cash. It imposed discipline on capital expenditures by increasing the corporate hurdle rate by several percentage points. But staff statistics showed that the fraction of proposals

3There is no First Law; we thought that “Second Law” sounded better. There is a Third Law, but that is for another chapter.

Perks. Our hypothetical financial manager gets no bonuses. Only $X per month. But he or she may take a bonus anyway, not in cash, but in tickets to sporting events, lavish office accommodations, planning meetings scheduled at luxury resorts, and so on. Economists refer to these nonpecuniary rewards as private benefits. Ordinary people call them

perks (short for perquisites.)

Empire building. Other things equal, managers prefer to run large businesses rather than small ones. Getting from small to large may not be a positive-NPV undertaking.

Entrenching investment. Suppose manager Q considers two expansion plans. One plan will require a manager with special skills that manager Q just happens to have. The other plan requires only a general-purpose manager. Guess which plan Q will favor. Projects designed to require or reward the skills of existing managers are called entrenching investments.5

Entrenching investments and empire building are typical symptoms of overinvestment, that is, investing beyond the point where NPV falls to zero. The temptation to overinvest is highest when the firm has plenty of cash but limited investment opportunities. Michael Jensen calls this a free-cash-flow problem: “The problem is how to motivate managers to disgorge the cash rather than investing it below the cost of capital or wasting it in organizational inefficiencies.”6

Avoiding risk. If a financial manager receives only a fixed salary, and cannot share in the upside of risky projects, then safe projects are, from the manager’s viewpoint, better than risky ones. But risky projects can have large, positive NPVs.

A manager on a fixed salary could hardly avoid all these temptations all of the time. The resulting loss in value is an agency cost.

Monitoring

Agency costs can be reduced in two ways: by monitoring the managers’ effort and actions and by giving them the right incentives to maximize value.

Monitoring can prevent the more obvious agency costs, such as blatant perks or empire building. It can confirm that the manager is putting sufficient time on the job. But monitoring costs time, effort, and money. Some monitoring is almost always worthwhile, but a limit is soon reached at which an extra dollar spent on monitoring would not return an extra dollar of value from reduced agency costs. Like all investments, monitoring encounters diminishing returns.

Some agency costs can’t be prevented even with spendthrift monitoring. Suppose a shareholder undertakes to monitor capital investment decisions. How could he or she ever know for sure whether a capital budget approved by top management includes (1) all the positive-NPV opportunities open to the firm and (2) no projects with negative NPVs due to empire-building or entrenching investments? The managers obviously know more about the firm’s prospects than outsiders ever can. If the shareholder could list all projects and their NPVs, then the managers would hardly be needed!

5A. Shleifer and R. W. Vishny, “Management Entrenchment: The Case of Manager-Specific Investments,” Journal of Financial Economics 25 (November 1989), pp. 123–140.

6M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 76 (May 1986), p. 323.

Who actually does the monitoring? Ultimately it is the shareholders’ responsibility, but in large, public companies, monitoring is delegated to the board of directors, who are elected by shareholders and are supposed to represent their interests. The board meets regularly, both formally and informally, with top management. Attentive directors come to know a great deal about the firm’s prospects and performance and the strengths and weaknesses of its top management.

The board also hires independent accountants to audit the firm’s financial statements. If the audit uncovers no problems, the auditors issue an opinion that the financial statements fairly represent the company’s financial condition and are consistent with generally accepted accounting principles (GAAP, for short).

If problems are found, the auditors will negotiate changes in assumptions or procedures. Managers almost always agree, because if acceptable changes are not made, the auditors will issue a qualified opinion, which is bad news for the company and its shareholders. Aqualified opinion suggests that managers are covering something up and undermines investors’ confidence that they can monitor effectively.

A qualified opinion may be bad news, but when investors learn of accounting problems that have escaped detection by auditors, there’s hell to pay. On April 15, 1998, Cendant Corporation announced discovery of serious accounting irregularities. The next day Cendant shares fell by about 46 percent, wiping $14 billion off the market value of the company.7

Lenders also monitor. If a company takes out a large bank loan, the bank will track the company’s assets, earnings, and cash flow. By monitoring to protect its loan, the bank protects shareholders’ interests also.8

Delegated monitoring is especially important when ownership is widely dispersed. If there is a dominant shareholder, he or she will generally keep a close eye on top management. But when the number of stockholders is large, and each stockholding is small, individual investors cannot justify much time and expense for monitoring. Each is tempted to leave the task to others, taking a free ride on others’ efforts. But if everybody prefers to let somebody else do it, then it won’t get done; that is, monitoring by shareholders will not be strong or effective. Economists call this the free-rider problem.9

Compensation

Because monitoring is necessarily imperfect, compensation plans must be designed to give managers the right incentives.

7Cendant was formed in 1997 by the merger of HFS, Inc., and CUC International, Inc. It appears that about $500 million of CUC revenue from 1995 to 1997 was just made up and that about 60 percent of CUC’s income in 1997 was fake. By August 1998, several CUC managers were fired or had resigned, including Cendant’s chairman, the founder of CUC. Over 70 lawsuits had been filed on behalf of investors in the company. Investigations were continuing. See E. Nelson and J. S. Lubin. “Buy the Numbers? How Whistle-Blowers Set Off a Fraud Probe That Crushed Cendant,” The Wall Street Journal (August 13, 1998), pp. A1, A8.

8Lenders’ and shareholders’ interests are not always aligned—see Chapter 18. But a company’s ability to satisfy lenders is normally good news for stockholders, particularly when lenders are well placed to monitor. See C. James “Some Evidence on the Uniqueness of Bank Loans,” Journal of Financial Economics 19 (December 1987), pp. 217–235.

9The free-rider problem might seem to drive out all monitoring by dispersed shareholders. But investors have another reason to investigate: They want to make money on their common stock portfolios by buying undervalued companies and selling overvalued ones. To do this they must investigate companies’ performance.

Compensation can be based on input (for example, the manager’s effort or demonstrated willingness to bear risk) or on output (actual return or value added as a result of the manager’s decisions). But input is so difficult to measure; for example, how does an outside investor observe effort? Therefore incentives are almost always based on output. The trouble is that output depends not just on the manager’s decisions but also on many other events outside his or her control.

The fortunes of a business never depend only on the efforts of a few key individuals. The state of the economy or the industry is usually at least as important for the firm’s success. Unless you can separate out these influences, you face a dilemma. You want to provide managers with a high-powered incentive, so that they capture all the benefits of their contributions to the firm, but such an arrangement would load onto the managers all the risk of fluctuations in the firm’s value. Think of what this would mean in the case of GE, where in a recession income can fall by more than $1 billion. No group of managers would have the wealth to stump up a significant fraction of $1 billion, and they would certainly be reluctant to take on the risk of huge personal losses in a recession. A recession is not their fault.

The result is a compromise. Firms do link managers’ pay to performance, but fluctuations in firm value are shared by managers and shareholders. Managers bear some of the risks that are outside their control and shareholders bear some of the agency costs if managers shirk, empire build, or otherwise fail to maximize value. Thus, some agency costs are inevitable. For example, since managers split the gains from hard work with the stockholders but reap all the personal benefits of an idle or indulgent life, they will be tempted to put in less effort than if shareholders could reward their effort perfectly.

If the firm’s fortunes are largely outside managers’ control, it makes sense to offer the managers low-powered incentives. In such cases the managers’ compensation should be largely in the form of a fixed salary. If success depends almost exclusively on individual skill and effort, then managers are given high-powered incentives and end up bearing substantial risks. For example, a large part of the compensation of traders and salespeople in securities firms is in the form of bonuses or stock options.

How do managers of large corporations share in the fortunes of their firms? Michael Jensen and Kevin Murphy found that the median holding of chief executive officers (CEOs) in their firms was only .14 percent of the outstanding shares. On average, for every $1,000 addition to shareholder wealth, the CEO received $3.25 in extra compensation. Jensen and Murphy conclude that “corporate America pays its most important leaders like bureaucrats,” and ask “Is it any wonder then that so many CEOs act like bureaucrats rather than the valuemaximizing entrepreneurs companies need to enhance their standing in world markets?”10

Jensen and Murphy may overstate their case. It is true that managers bear only a small portion of the gains and losses in firm value. However, the payoff to the manager of a large, successful firm can still be very large. For example, when

10M. C. Jensen and K. Murphy, “CEO Incentives—It’s Not How Much You Pay, But How,” Harvard Business Review 68 (May–June 1990), p. 138. The data for Jensen and Murphy’s study ended in 1983. Hall and Liebman have updated the study and argue that the sensitivity of compensation to changes in firm value has increased significantly. See B. J. Hall and J. B. Liebman, “Are CEOs Really Paid Like Bureaucrats?” Harvard University working paper, August 1997.