Posted: October 7th, 2022
This discussion has 2 parts:
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 inten- tionally 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 compensa- tion is sometimes tied to the span of job responsibili- ties, 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 compen- sation 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, con- fident that the project will continue to be viewed as an acceptable investment and that it will be funded. How- ever, once the project is under way, the project man- ager 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 achiev- ing 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?
Post by classmate 1
Firms with higher leverage and capital intensity might not have a financial analyst or oversee the cash flow estimation process as most of the forecast could be executed by a simulation method based on past experience or market behavior through software. Firm’s use both types of estimates and measure of financial and operating risks might also need to benchmark themselves against the standard cash flow related ratio like liquidity ratios additionally to estimate risk free cash flow positions. The more the economic life of a project the more uncertain would the pay-back period become and the timing of the discounted cash flows gain importance. More than multiple methods of forecasting, it is important to accurately estimate the discounting rate and cash flow streams over the economic life of the project.
The strategy of using WACC as a discount rate to discount the future expected future cash flows from the proposed capital budgeting projects is correct. The free cash flow to the firm must be discounted using WACC, while free cash flow to equity must be discounted using cost of equity.
Post by classmate 2
McConnell, J. &. (1975). McConnell, J., & Sandberg, C. (1975). The Weighted Average Cost of Capital: Some Questions on Its Definition, Interpretation, and Use: Comment. The Journal of Finance, 30(3), 883-886.
Moyer, R. C., McGuigan, J. R., & Rao, R. (2018). Contemporary financial management. Mason, OH: Cengage-Southwestern.
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