The Competitive Market Assumption and Capital Budgeting Criteria

Author(s): Edward M. Miller

Source: Financial Management, Vol. 16, No. 4 (Winter, 1987), pp. 22-28
Published by: Wiley on behalf of the Financial Management Association International
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 The Competitive Market Assumption
and Capital Budgeting Criteria
Edward M. Miller

Edward M. Miller is Research Professor of Economics and Finance at

the University of New Orleans.

n It has been frequently observed that estimated bene-Textbooks discussing capital budgeting typically
fits from capital projects tend to be optimistic andconclude
that that all projects with positive net present val-
the net present values of completed projects are often
ues at the appropriate risk adjusted rate should be ac-
below those originally estimated. Statman and Tyebjee
cepted. Unfortunately, this and similar rules are non-
[9, p28] present evidence "that people who evaluate
operational in practice because the net present values
are not known. At best, the decisionmakers have esti-
forecasts consider the forecasts to be optimistically
biased." Bierman [1, pp. 64-65] presents a series of of net present value. The practically important
mates
quotes showing that overly optimistic forecastsproblem
are is how to make decisions using such esti-
regarded as a serious problem by financial officers mates.
of Students and practitioners reading the textbook
Fortune 500 corporations. Over 80% of the respon- literature are likely to conclude that one makes the best
dents to a survey [6, p47] of financial officers of estimates
For- possible and then inserts the estimates into
tune 500 companies felt that revenue forecasts are the textbook net present value formulas.
typi-
cally overestimated. It is important to understand how It will be shown here that this procedure (treating
these biases come to be, and how decisions can estimates
be as if they were correct) typically leads to
made in an environment where the basic estimates are
wrong decisions for firms in competitive economies.
known to be subject to error. Recognizing that a key problem is errors in estimates,

22

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MILLER/CAPITAL BUDGETING CRITERIA 23

explicitly Bayesian If we fully

decision
believed economic theory,
rules
resources ca
will be would the
argued that never be expended
most on investigating
useful proposed pr
rule involves a new factories because, even
minimum if of optimal design, they
acceptable es
ability ratio above
promiseone.
only a normal return, and if they are of subop-
timal design, they promise a less than normal return.
This poses a problem: businessmen should not search
I. Implications of
for such a
opportunities, Competit
since searching consumes re-
One of the most widely
sources. The easiest way out accepted
of the difficulty is to r
economics is that argue that occasionally projects offer abnormal
a competitive industre-
turn is to turns,
a and
limited that their extra returns cover
"normal" the costs of
competit
searching for them.
possible for new firms to In equilibrium,
enter profits a
fromcomp
suc-
cessful searches believe
they will do so if they will be just sufficient they
to provide nor- can
mal profits for
competitive (adjusted for the searching
risk)firm. This simple modifi-
return.
enter the industry, cation justifies
their the effort entry
of searching for profitable
reduc
existing firms investment opportunities.
either by Thus, projects with above pr
forcing
normal returns exist, but
creating excess capacity. In they equilibrium
are rare. To say some-
thing is rare
only normal profits. is to say that its probability all
Virtually is low. busi
An Illustration: To illustrate
exposed to this argument in the a problems
basic that eco
arise from of
Yet the implications ignoring this
the information
forabout the practi
distribu-
tion of
geting are not well potential projects, consider a simple
understood. discrete
Studen
mate annual cash flow as
example. Theory the
suggests it will bedifferenc
very hard to find
store locations that offer present
mated sales and estimated values of operating
expenses. Th
if the estimated netprofits exceeding
present the costs of establishing
value the store.
of t
The rent on risk
positive (at a suitable good locations will typically be bid up untilrat
adjusted
even the best locations offer only
project should be accepted. Ifnormal not, profits. it sh
ed. The economic theorySuppose that afterof rents have
the been bid up on good
firm th
laboriously learned store appears
locations, 48% of the possible sites will be bad
irrelevant
problem. ones, 48% medium ones, and only 4% good ones. Let
It will be argued us imagine that the
here present valuethe
that of the operating prof-
econom
its of the good
cerning the expected ones is + $200,000, that
return fromof the mediumnew
major implications onesfor
is + $100,000, and that of the bad ones
practical is zero
capita
plications should that be
(the store earns just enough included
to continue operating,
course. Earlier,
the author
eliminating any complications due[5] argued
to the possibility of
rates of return onabandonment).
new Opening investment
a new store costs $90,000 for sho
a problem in Bayesianfixtures and working capital. Thus the net present
statistics. One val- h
mate that is then ues of good, medium, and badby
modified stores are $110,000,
posteri
from the evaluation $10,000 and
of - $90,000
a respectively.
particular pr
no real guidance was The firm has analysts thatfor
given examine each proposed
selectin
estimates. new store and estimate the present value of operating
In the absence of profits
prior at a suitable risk adjusted discount rate. The
information, a
would be plausible. analysts are operating in an uncertain
However, with environment, a un
Bayesian approach reduces
and there to
are normally random errors. the
(An error here is st
simply a difference
technique. One purpose of between
thisthe forecast and the out-
paper is
strong implications come, of
and does economic
not imply that the analysts are incom-
theory
abilities. In particular,
petent or that their theory strong
forecasts could be appreciably im-
proved by better supervision or changing
the proper prior distribution for personnel).proj
The most favorable assumption
competing firms assigns low that can be made is that
probabili
the analysts are unbiased
mal returns. Investment and if we compared allthat
projects of the p
al output for sale analysts'
in predictions
competitiveto the actual results, their predic-
mark
above normal returns. tions would be, on average, correct. Suppose that half

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 24 FINANCIAL MANAGEMENT/WINTER 1987

Exhibit 1. Decision Tree Analy

Probability
Calculation
ood Project E = $300,000
ver estimated T = $200,000 .04 H .25 = .01
25%

Project Correctly
$200,000 Evaluated T = $200,000 .04 H .50 = .02
Good 50% Good Project E== $200,000
25%

Good Project E = $100,000

Under Estimated

T = $200,000 .04 H .25 = .01

4%

Medium Project E = $200,000 .48 H .25 = .12

Over Estimated T = $100,000
25%

Potential 48% Medium 50% Medium Project.48 H .50.24

r48ct % 50% .48 H .50 = .24
Project Project Correctl E = $100,000
$100,000 Evaluated T= $100,000
25%

Medium Project E = $0
Under estimated .48 H .25 = .12
T = $100,000
48%

Poor Project E = $100,000

SOver Estimated
T = $0
48 H .25.12
25%

Poor jPoor Project E = $0

Project 50% Correctly
$o 0 - Evaluated T = $0 .48 H .50 = .24

E is the estimated cost. % Poor Project E = - $100,000

T is the true cost. Under Estimated .48 H .25 = .12
r = $0

the time they are exactly correct, and a quarter of the
time they are high by $100,000 and a quarter of the
time they are low by $100,000. A very good perfor-
mance. Furthermore, suppose the estimation errors are
independent of the project's true merits.
The situation can easily be depicted in the decision
tree format of Exhibit 1. Nature first randomly deter-
as the product of the two probabilities. For instance,
the probability of following the sequence of branches,
poor project followed by an overestimate, is the prob-
ability of the project being truly poor (.48) multiplied
by the probability of the project being overestimated
(.25), for a total probability of following that path of
.12.

mines the project's true return, and then estimation One thing should be noted from the diagram; there
errors occur. Each branch of the tree can be identified are multiple ways to certain outcomes. For instance,
by the value of the estimated return that it produces. consider the three outlined boxes. A report estimating
For instance, if one takes a poor project (a true 0) and the present value of operating profits at $100,000 can
then overestimates the profitability (a + $100,000 er- reach the president's desk in three different ways. It
ror), one arrives at an estimated present value of may be a normal project whose profits have been cor-
$100,000. One can go out each branch of the tree and rectly estimated. It may be a poor project whose profits
calculate the probability of arriving at the final branch have been over estimated. It may be a good project that

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MILLER/CAPITAL BUDGETING CRITERIA 25

has been nized by

underestimated. Of describing
course, the
no way of
knowing appreciable downsid
which particular pa
by a offset by the
particular project. What issmall
he to(o
Finance textbooks project
suggest is really a go
a procedure
estimates: compare the present each
attached to valuebra
of
pected
operating profits with thevalue given
present an
value
the first exceeds the
thesum
second, the
of the pro
produ
accepted. Otherwise,true values,
it should beas show
rejecte
at the results of this strategy.
Type of Proba-
II. Application of
Project Bayes'
bility True Value Product Theo
Poor .324 0 0
It is possible to calculate the probabilit
ect with a particular Medium .649 $100,000 $64,900
estimated net pres
particular true Good .027
value. $200,000
This is$ 5,400
a routin
Bayes' Theorem.' For each
All 1.00of the paths t
$70,300
estimate of $100,000, the probabilities a
project being a bad Note
project
that that has been
the present v
(.48 x .25, by the flows
argument given abo
for all projects who
.50) for it being a $100,000project
normal is only correc
$70,3
and .01 (.04 x .25) shortfall.
for it being a good
If the president
estimated. book procedure and accept
Notice the that
symmetrical
present for
error
values of positive
assumed, the probability
he would accept all an
that it is theu p
good project is veryestimated at $100,000,
much less than thesi
it is an overestimated poor
costs of a newproject (
store. How
This is a simple implication ofinvesting
rule would be standard in
ory's prediction ofthe
more poor potential
expected present value
good ones. As discussed above,
This simple this
result sc
is a ve
projects is a fundamental result
the economic of econ
theory that
tion among firmsreturns
seeking good
will projec
be rare (i.e.
By Bayes' theorem
sian it is possible
statistics providesto
a w
probability that the project is
probability indeed goo
information w
is estimated to have a $100,000
lows present
that the textbook pr
ational profits. The
ectstotal probability
with positive net pres
reaching the president's desk are
if the estimates with a
unbias
$100,000 is the sum of results
sion the probabilities
from basic e
rate sequence that leads to this resul
theorem.3
.01), or .37. Given a $100,000 estimate th
that the project is really a poor one is .
that it is really a medium one
2It may be noted is Brealey
that .649 and
(.2
the argument of this paper than
it is really a good one is .027 (.01/.37
that if estimates of the returns fro
abilities add up toappear one, as
to be theyAlas,
attractive. must.
the m
evaluation clearly made
says that
errors this is rathe
in estimation a m
projects.
and this is indeed the single most pro
there is an appreciable chance (over one t
3The above uses only three types of projects and only three possible
really an overestimated
errors. Real world problems havepoor project.
many more. However, similar calcu-
lations are feasible with modern computers forthis
In the business vocabulary, realistic distributionspossibi
of
true values and estimation errors. The posterior distribution can be
calculated for any prior distribution and any distribution of estimation
errors (often referred to as the sampling distribution in Bayesian statis-
'Bayes' Theorem states that: P(Sk I X) = P(X I sk)P(Sk)/IP(X I
where P0 means probability of, tics).
sk It may
is be convenient in some cases to have an analytical
the particular state solution.of nature
the observed information (here Such analytic
the solutions are available if both the prior
estimates), distribution I
P(sk and X)
the the pro
of the state of nature sk given estimation
informationerror distributions are normal
X. (see Fora standard text such as
further discuss
virtually any statistics text. [4]).

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 26 FINANCIAL MANAGEMENT/WINTER 1987

III. Selecting an
handle Investment
projects of different scales. A plausible simpli-
If calculations of fication
the is that
typeestimation errors are proportional to the
illustrated a
possible estimatedvalues being estimated. It is alsothe
values, plausible thatresult
projects
showing the (true)of the same type facing the same
expected competitors will have va
present
the same shape
ing to any particular for the prior distributions.
estimate. The tab
With these simplifications,
discover what expected return one can replace the crite-
corresp
rion that net present
timate. It then remains to values must exceed estimated
decide if a p
costs by a certain
is desirable. One could use amount
thewith the standard
criterion that esti-
rion of whether thismated present values must exceed estimated
posterior costs by a
(correcte
induced bias) certain proportion.
estimate for This the
is equivalent to requiring a
present
cash flows minimum
exceeds theprofitability index, where the profitability
present value
index is the
Computational costs ratio of estimated
and the present value of positive
difficulty
the required information aboutof estima
cash flows to estimated present value costs.
For instance, in
about the prior distribution prevent the preceding example the estimated
these detailed computations for If ever
present value exceeds the true value by $29,700. this
leads one to look was typical
for of the other estimates, a project to
alternatives with an go
full procedure for estimated present value ofdecision.
every positive cash flows of Su
require simple criteria that can $119,700 would have an expected presentbe
value equal
give
managers. to the $90,000 cost and would be at the margin of
To do this, notice that once the minimum acceptable acceptance. Such a project would have a profitability
estimate is determined, any estimates above this can be index of 1.33, or about one and a third. If the firm
accepted for projects with the same prior distributions thought the above case was typical, and applied to
and error distributions. If one has determined that a stores of different sizes, its optimal strategy would be
store with an estimated present value of operating prof- to accept projects only if their estimated present value
its of $120,000 is acceptable, similar stores with the of positive cash flow was at least 1.33 times the cost. If
same prior distributions and error distributions but a firm does not know what profitability ratio is optimal
with higher estimated present values will be accept- as a cut off ratio, it may be useful to calculate the
able. Thus, by determining the minimum acceptable profitability ratios for proposed projects and then de-
estimate, one would have the general decision criterion bate whether the estimated ratio provides an adequate
of accepting similar stores if and only if their estimated safety margin against the biases induced by poor esti-
present value exceeds $120,000, or alternatively, ifmates in a competitive environment.
their estimated present value exceeds costs by at least
IV. A Case for the Profitability Ratio
$30,000 (for a project with costs of $90,000).5
Unfortunately, one will seldom find proposed stores The profitability ratio is usually dismissed as con-
to be sufficiently similar to use this criterion. This is taining no information not present in a net present
because the distributions of true values must have not value calculation, while not always giving the correct
only the same general shape, but also standard devi- choice among mutually exclusive projects [3, p282;
ations of the same magnitude. A potential store whose 2]. After all, in the usual framework there is no differ-
most likely sales is $100,000 has quite different distri- ence between subtracting the present value of costs
butions than one with most likely sales of $1,000,000. from the present value of operating profits and accept-
For one thing, the estimation errors are likely to being the project if the difference is positive, and calcu-
bigger for the larger store. A procedure is needed tolating the ratio of the two numbers and accepting the
project if the ratio exceeds one. The former procedure
avoids treating negative cash flows (costs) differently
4In theory, decisions may be affected by the mean, the standard devi- than positive ones and provides a simpler link with the
ation, and by other characteristics of the posterior distribution. These
parameters may be combined in many ways to give a measure of merit. normative goal of accepting projects that increase the
This paper focuses on the case where adjusted means contains all of the firm's anticipated cash flows and stock price.
relevant information. The argument would not be altered if another However, the analysis here shows that the profit-
statistic calculated from the posterior distribution was given weight.
ability ratio (often referred to as the benefit/cost ratio
SThe argument can easily be generalized to include uncertainty about for public projects) provides one very important piece
costs. of information. It shows the safety margin as a percent-

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MILLER/CAPITAL BUDGETING CRITERIA 27

age of project costtion about

between the
the distr
estima
of positive cash particular
flows competi
and the proje
evant
very useful statistic theory does
in debating n
wheth
Only
between the estimated netinpresent
a few cas
val
net present value, which the
measure we would
prior d
petitive economy, will
with a be large
large enou
number
project undesirable.
a random sample of
One advantage of they
keepingperformed.
operating Hc
costs find
separate is that theaccepting proj
size of foreca
ly closely relatedexpensive a research
to the magnitude
being forecast. Thus,
cases knowing
it may be these
possi
istics of the
sists in making intelligent rejected
judgments
case is for
possible errors. As aa firm never to know the true
simple merits of
example,
rejected projects. value of $50,0
ect with a net present
difference between Typically estimated opera
a firm will have to estimate a suitable cut
with a present value of
off value for each type $100,000 and
of project and then judge wheth-
of $50,000, many er it was too stringent or not stringentwould
businessmen enough. This a
will normally with
ect, feeling that even be on the basis of the performance
some of the
estim
project is probablyprojects that just passed the test. For instance,
worthwhile. If suppose
$50
a firm uses a cutoff ratio
was left after incurring costsof 1.33. It might
ofcollect data
$1,00
on the performance
life businessmen would of the projects whose
reject the ratios proj
were
insufficient safetyestimated to be 1.33 to 1.66. If these
margin. While projects appeared
bus
to have estimatedbehind
unaware of the reasons returns that were on average only
the unc
bias, experience 25% above taught
has the true values (discovered
them from hind- th
sight), the firm
below estimates more might lower itsthan
often cut off ratio to 1.25.
abov
Likewise, if the
the total amount that mayprojects that were on the been
have margin of
acceptance proved to actually have negative
mated is useful information. The net pres-
pr
provides this key ent values, the standard
piece of for acceptance would be raised
information
until the marginal project appeared to have a true net
V. Setting the Minimum
present value of zero. Ac
Profitability This
Ratio
emphasizes the importance of post completion
How would the audits
above [8]. If the firm does not go back andactua
theory examine
how it did on completed projects
Projects could be classified into it will have no basis
uncert
that, within each for revising its decision
class, they criteria. Economic
aretheory athaslea
parable in terms not
of yet progressed
their far enough that it can provide
prior suit-
distr
magnitude of theirable decision criteria for use with the estimated data on
uncertainty bia
below, cost reducing
which firms actually projects, expa
have to base decisions. (The cri-
product ventures teria
will providednormally
by financial theory require that be the in
relevant
Types of projects a firm parameters, including
has measures to of expected
evaluat
normally make up return anda risk,class, especially
be known with certainty and they are
not.)
happens) the competitors are the sam
might put lease purchases in one cl
VI. Conclusions
chains might put new stores of a part
Real life decisions
one class. A minimum must be made with estimates,
acceptable estim not
ity index would precisely
be chosen known probability for
distributions.
eachDecision
Unfortunately, itmaking
willin an uncertain
seldom environmentbe
requiresposs
a Baye-
calculate the minimum acceptable prof
in the manner done above. The basic
one cannot estimate exactly the prior
6Petroleum leases rejected by one firm may be tested by others, and the
the estimation errors.
rejecting firm may be Eventually, e
able to discover how much oil was under the
may develop to the
leases point
it rejected. where it can

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 28 FINANCIAL MANAGEMENT/WINTER 1987

sian approach in References

which the prior proba
probability distribution opport of the true
1. H. Bierman,
an important role. The Jr., Implementation oftheory
economic Capital Budgeting Tec
o
tive market tells oneniques, Financial Management Association, 1986.
something about the
2. R. Brealey and S. Myers, Principles of Corporate Financ
prior probability distribution, namely th
New York, McGraw-Hill, 1984.
ties to earn above normal profits will b
3. E. Brigham and L. Gapenski, Intermediate Financial Man
insight from economic theory about the p
agement, Chicago, The Dryden Press, 1985.
different outcomes 4. should be and
T. Dyckman, S. Smidt, incorporate
A. McAdams, Managemen
budgeting theory. Decision Making Under Uncertainty, London, McMillan,
Firms have discovered1969. that projects typi
turn out as well as5. E.they estimated
Miller, "Uncertainty they
Induced Bias in Capital Budgeting,"
phy's Law). They correct for
Financial Management (Autumn 1978),this
pp. 12-18. by u
budgeting 6. S. Pruitt
procedures and L. Gitman,
that are"Capital Budgeting
more Forecast Bias:
conse
net present value Evidence
as from the Fortune 500,"
well as Financial
by Management
frequ
relatively (Spring 1987), pp.
conservative 46-51.
estimating pro
7. M. Ross, "Capital Budgeting Practice of Twelve Large
instance, hurdle rates are frequently high
Manufacturers," Financial Management (Winter 1986), pp.
opportunity cost of
15-22.capital [7].) Firms m
back projects' estimated cash flows. The
8. S. Smidt, "A Bayesian Analysis of Post Audits," Journal of
m
discussed here provides a pp.
Finance (June 1979), conceptual
675-688. fr
making these adjustments, and thus
9. M. Statman and T. Tyebjee, "Optimistic Capital Budgeting it
less arbitrary than many of the
Forecasts: An Experiment," methods
Financial Management (Au-
use. tumn 1985), pp. 27-33.

EUROPEAN FINANCE ASSOCIATION

15TH ANNUAL MEETINGS

DATES: September 1-3, 1988

PLACE: Istanbul, Turkey
DEADLINES: Abstracts by April 1, 1988
Papers by June 15, 1988
PROGRAM: N. Bulent Gultekin
The Central Bank of the
Ankara, Turkey
TRAVEL Kontuar Turizm
INFORMATION: Cumhuriyet Caddesi no: 283
Harbiye 80230 Istanbul, Turkey
Phone: (90-1) 131 1546
Telex: 22 313 tkon tr

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