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Net present value decisions

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The division managers of Chester Construction Corporation submit capital investment proposals
each year for evaluation at the corporate level. Typically, the total dollar amount requested by the
divisional managers far exceeds the company's capital investment budget. Thus, each proposal is
first ranked by its estimated net present value as a primary screening criterion.
Jeff Hensel, the manager of Chester's commercial construction division, often overstates the
projected cash flows associated with his proposals, and thereby inflates their net present values. He
does so because, in his words, "Everybody else is doing it."

a. Assume that all the division managers do overstate cash flow projections in their proposals.
What would you do if you were recently promoted to division manager and had to compete for
funding under these circumstances?

b. What controls might be implemented to discourage the routine overstatement of capital budgeting
estimates by the division managers?

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Solution Preview

Net Present Value

Introduction: Following my normal procedure for addressing these questions, I will begin with the development of some definitions.

1. Capital investment proposals: Capital investments are for infrastructure and other organizational systems expected to have a long-term lifespan. As an example, organizations purchase a new building or a new piece of machinery with the expectation of the item lasting many years (Hofstrand, 2013).

2. Exceeding the organization's capital investment budget in department capital budget requests: This happens when division managers are trying to gain a financial advantage over other departments.

3. Estimated net present value: It is challenging to calculate net present value without a software program to facilitate the calculation.

NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial Investment
- where R is the rate of return, and T is the number of time periods (Boyte-White, 2016)

Estimated NPV is an accounting functions designed to forecast future value; "Present Value is today's value of an amount of money in the future" (Bartel, 2010).

4. Estimated net present value as a primary screening criterion: When the organization's financial team faces deciding how to divide the capital ...

Solution Summary

This response provides the student with information on budgeting decisions companies make based on net present value estimations. The question presents the assumption that divisional managers are coming forward with inaccurate financial predictions in an attempt to gain an advantage over other divisions. The response to the students presents the idea that making inaccurate financial statements may place the managers in violation of the Sarbanes-Oxley Act of 2002.

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