A Question of Accuracy
The process of capital budgeting based on projected cash flows has been a part of the investment decision process for many years. This procedure for evaluating investment opportunities works well when cash flows can be estimated with certainty, but in real-world corporate practice, many investment decisions involve a high degree of uncertainty. The decision is even more complicated when the project under consideration is the acquisition of another company or part of another company.
Because estimates of the cash flows from an investment project involve making assumptions about the future, they may be subject to considerable error. The problem becomes more complicated as the period of time under consideration becomes longer as well as when the project is unique and there are no historical precedents to use in forming cash flow forecasts. Other complications may arise involving accounting for additional (extraordinary) cash flows, such as the cost of litigation, compliance with tougher environmental standards, or the costs of disposal or recycling of an asset at the completion of the project.
For managers of a firm, undertaking a new, major investment can be exhilarating. All too often, however, the initial champagne celebration gives way once the final cost of a deal is tallied. A large body of research suggests that, on average, mergers and acquisitions do not create much value for the acquiring firms, and, in fact, these deals may harm acquiring shareholders more often than not. Although the financial data necessary to generate discounted cash flow estimates are ever more readily available, more attention is being paid to the accuracy of the numbers. Inspired in part by increased scrutiny from government and the threat of shareholder lawsuits, board members have been pushing corporate managers to make a stronger case for the deals they propose. Says Glenn Gurtcheff, managing director and cohead of middle market M&A for Piper Jaffray & Co., “They’re not just taking the company’s audited and unaudited financial statements at face value; they are really diving into the numbers and trying to understand not just their accuracy, but what they mean in terms of trends.”
If valuation has improved so much, why do analyses show that the shareholders of acquiring companies often do not benefit from mergers and acquisitions? The answer may be found in the CEO’s office. Improvements in valuation techniques can be negated when the process deteriorates into a game of tweaking the numbers to justify a deal the CEO wants to do, regardless of price. This “make it work” form of capital budgeting may result in building the empire under the CEO’s control at the expense of the firm’s shareholders.
What would your options be when faced with the demands of an assertive CEO who expects you to “make it work”?
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