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Capital Budgeting & Biases: Eliminating Manager Biases

Since capital budgeting decisions involve the estimation of a project's future cash flows and the rate at which they should be discounted is still a relatively subjective process, the behavioral traits of managers still affect this process. How can managers better improve their ability to eliminate biases in their forecasting.

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Capital budgeting is defined by Gitman (2006) as the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owners' wealth. This definition shows that capital budgeting needs procedures to analyze and properly select long-term investment. It further requires estimation of future cash flows, applying the appropriate decision techniques, and making decisions. The heart of the project is therefore the estimation of cash flows that are yet to come in the future on the basis of certain assumptions.

Using the discounted cash flow methods (e.g. Net present value, Profitability index, and IRR), the finance manager makes use of estimates of future cash flows, the timing of these cash flows, and the discount rate that will be used in discounting the future cash flows to the present (to compute their present values). The above statement which says that the estimation of future cash flows and the selection of a discount rate are subjective in nature is right. The capital budgeting process relies too much on estimates of future ...

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This solution provides a detailed discussion of the given finance question.