Introduction to Finance

DISCUSSION QUESTION 3
What are your ideas for how to keep managers “honest” when they estimate cash fl ows 
and the risk associated with a capital budgeting project they favor?
17.11
Risk-Related Considerations
The degree of risk associated with expected cash infl ows may vary among diff erent invest-
ments. For example, a decision about whether to replace an existing machine with a new, more 
effi
cient machine would not involve substantial cash infl ow uncertainty, because the fi rm has 
some operating experience with the existing machine. Likewise, expansion in existing product 
lines allows the fi rm to base cash fl ow expectations on past operating results and marketing 
data. These capital budgeting decisions can be made by discounting cash fl ows at the fi rm’s 
cost of capital, or required rate of return, because they are comparable in risk to the fi rm’s 
other assets.
Expansion projects involving new areas, new product lines, and overseas expansion are 
usually associated with greater cash infl ow uncertainty. To compensate for this greater risk, 
23
Bent Flyvbjerg, Massimo Garbuio, and Dan Lovallo, “Better Forecasting for Large Capital Projects,” McKinsey 
& Company, (December 2014), accessed February 24, 2016, at http://www.mckinsey.com/business-functions/
strategy-and-corporate-fi nance/our-insights/better-forecasting-for-large-capital-projects.
24
R. Pohlman, E. Santiago, and F. Markel, “Cash Flow Estimation Practices at Large Firms,” 
Financial Management
, 
Summer 1988, pp. 71–78.
25
In the last chapter, we argued that safety margin concerns may lead managers to prefer selection methods such as 
IRR and PI over NPV. With error rates such as these, you can see why safety margins would concern analysts and 
decision makers.
26
Vincent Ryan, “Future Tense,” 
CFO
, (December 2008), p. 37–42.

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548
C H A PT E R 1 7 Capital Budgeting Analysis
fi nancial managers often use concepts based upon the trade-off between risk and expected 
return. A higher-risk project needs to be evaluated using a higher required rate of return. To 
use a fi nancial markets analogy, given the current return off ered on safe short-term Treasury 
bills, investors will not want to invest in risky common stocks unless the expected returns 
are commensurate with the higher risk of stocks. Similarly, managers should not choose 
higher-risk capital budgeting projects unless the projects’ expected returns are in line with 
their risks.
The