How Do You Win theCapital Allocation Game?

John A. Boquist - Todd T. Milbourn • Anjan V.Thakor

To remain compet-

itive, a company

needs to align its

capital budgeting

system with its

overall strategy.

John A. Boquist is the Edward

E. Edwards Professor ot

Finance, Indiana Unimslty.

Todd T. Milbourn is assistant

professor of finance. London

Business School. Anjan V.

Thakor is the Edward J. Frey

Professor of Banking and

Finance, University of

Michigan.

Wliich is better tor yoiir firm? Investprodigious amounts of capital or .scaleback on capital investment-' Reduceemployment \n raise the dollar aiiioLint ofassets at work per employee or elevateemployment to meet the demands createdhy new investments? Questions like theseconfront all senior managers as they for-mulate strategic pians and tillocate capital.The questions become more compellingas investors demand that corporationsconsistently deliver shareholder valueregardless of their long-term .strategy fordeploying human and financial capital.

An important factor that distinguishes thewinners from the losers in creating share-

holder value is the c/uality of investmentdecisions, which, in turn, depends on the.soundness of a firm's capital budgeting.system. Unfortunately, the history of cor-porate America is littered wilh examplesof poor investment decisions, rangingfrom investing too little in positive NPV(net pre.sent value) projects and too muchin negative NPV projects to inveslmenlinyopia.' Such distortions can distractcompanies from what they do best, caus-ing them to sink millions of dollars in thewrong products and ideas. For instance,Coca-Cola inve.sted in pa.stas and wines,products for which its rates of return werenot only well below those of its core soft-drinks business, but also below its cost ol

59

Sloan Management ReviewWinter 1998

Boquist • Milboum • ThakDi

60

Capital budgeting cannot be tbe

exclusive domain of financial analysts

and accountants.

capital. SLICII errors de|")lete shareholder \'alue andlead to corporate control contests that result in CEOivplaceiiients and hostile takec)\ers. ,

Despite the obvious consecjuences of niisallocaiiingcajiital and human resources, why tio coni[>aniescontinue to bUintler? We betie\e il is because theyluive flawed capital budgeting systems, which ttieyapparently fail to recognize. Some firms sen.se theweaknesses in their capital budgeting analy.ses bLitview them as indi\ idual problems rathei* than .sys-tenu'c deliciencies. They misdirect elforts to ivdre.ss

misiakes and produce greater frustration. As a result,corporate .strategy and tapilal allocation become mis-aligned and remain so despite disappointing financialperformance. Senior managemeni then gets tlieblame for failing to provide lhe appropriate leader-ship and strategic guidance.

Our goal is to pre.sent a framework tliat senior man-agers can use lo allocate capital. The frameworkexplicitly recognizes that cajiital budgeting cannot liethe exclusive domain of financial analysts andaccountants but is a multifunciitmal task thai iiuist beintegrated with a firm's overall sti-ategy. Our capitalbudgeting IrLimework has six key features, each indis-pensable (.see Figttre I j:

• It is dynamic, not static. It explicitly recognizes thailhe cjLiality ol tnfoi-mation can be in)[)ro\ed overlime. 'I'hus capital budgeting should be a .secjuential.

Figure 1What Is the Impact of Features Missing from the Capital Budgeting System?

Dynamic Strategy

Strategy

Dynamic

Dynamic

Dynamic

Dynamic

Dynamic

Options

Options

Options

Strategy

Strategy

Strategy

Strategy

Cross-Functional

CroSs-Funetional

Cro^s-Functional

Cross-

Compensation

Compensation

Compensation

Training

Training

Training

Options

Options

Opiions

Functional Compensation Traming

Compensation Training

Cross-Functional

Cross-Functional

Training

Compensation

Success

Biases inveslmeiit choiceagsinsl even value-enhancingprajeds wilh considerable un-certain information, e g , newproducts

Misestimation of casti flowsand misallocation of resources

S investment choiceagainst even value-enhancingprojects with high risk

Degrades quality of informationinputs in capital budgeting

Leads to gaming behavior andselection ol negative NPV proj-ects that maxirnize compensa-tion

Poor execution, including ana-lytical errors, bad assumptions,and nonuniform analvses

Boquist • MilbDum • Thakoi Sloan Management Review

Winter 1998

inulti|")lu tictision jiroccss tluit ititcgiatcs the informa-tion ncL'tk'cl to obtain cash Mow (.'stinialcs intti thelinaru iai atialysi.s of the tLi.sh Hows.

• It i>. intei;tal to the company's strategy. 'I'lius, wiiileits i'once[")tu;il uiiclerpintiings t'einain lhe same LierosseotnpLinius (f.^., using NP\' atialysist. lls details can\aiy greatly because it is tailored To the needs ot afirm's strategy,

• It rccogtii/es the options itilierent in value-enhanc-ing capital budgeting. Mosl capital inveslmenls pre-sent a company with a sec]iience of options, which,when explicitly analyzed in capital biitlgeling, lead ttja fLindanientally different \iev\' ot risk.'

• It takes a cros.s-fttnclional approach. The quality ofestimates of expected cash flows and the uncertaintyin cash flows are critical. Since the underlying infor-mation loi" these estiittates cotiies h'oiii tnany (i i tu-tions within the company, those providitig intbrma-lion tniist see thetiisekes as strategic partners in theprocess, i.e.. they tiuist liilly understatid the conse-(|uen(.es ol iheir in|iut.

• It views the cotnpatiy's conijK'nsation .system as acenterpiece of capital budgetitig. I'nless the way in\'>hi(.h rnanageis and etnployees are rewarded isaligned with how capital is allocated, there willalways be a possibility lor poor decisif)ns.

• It stresses the ititportance n\'/terfornmttce-hasedtraining. The people using capital budgeting tnustunderstand it, buy into it, and implement it consis-lently across the entire company. Cross-functionaliraitiing tiesignetl to enhance the performance ofthose involved is essential.

pt)tetitial revenue losses when tiew products catitii-

hali/e okl,

2. Lack of Dynamic StructureA good capital budgeting system must i t i \ohe nototiiy an analysis of capital allocatloti rec[uests whenthe ]iroject is executed, but also ati atialysis of all thecapital neetletl to generate infortnation (e.g., markettesearch. [•)rotot\pe developtiient, teslitig, and so oti)prior to iti\usting in the ptoject. Moreover, the atialy-,ses of tv\'o capital requiretiients shoitki be integratedwithin a dynatnic system that takes into account lheoptions inherent in tnost capital budgeting opportuni-ties. Many firms lack such a well-de\eloped sysletii.We illustrate two (of the potentially tnany) kinds ofpi'obletns this c'reates, itsing hypothetical cotn|")anies.Sundial lileclronics and Excellent Manttfacluring (seeIhe sidebars).

The example of Sundial Klectrotiics higlilights theprohletiis associated with the cotiitnon practice of"tront loading" cash outlays lor a new project. Otieprobletn, in particular, is the propensity to incur,some engineering and tooling expen,ses early, whenthey should be incurred after project launch. When acompany finally evaluates a project JList before itsexecLiti(jn, it considers these initial outlays "sitnkcosts" that are irrelevatit to the decision to accept theproject. In this way, tnore capital is c'omtnitted to theproject than is accounted for in the capital budgetinganalysis. A dynamic capital budgeting system sen'esthe pitrpose of justifying all capital outlays when theyare, in fact, still relevant.

61

Common Drawbacks of CapitalBudgeting SystemsAltltougli there aie countless ways in which capitalbudgeting systetns can be Hawed, in our experience,the tnost cotiitnon clrawliLtcks fall into one of ninecategoties,

V Misalignment between Strategy and CapitalBudgetingMost ccttnpanies have a well-articulated vision state-tnetit or corporate goal, lollowed by a clescriptioti otthe strategy for attaining (hat g(xtl. The design of thecapital budgeting systetn, however, is often tiol inte-grated into the strategy. For example, a cotnpany'scorporate strategy tnay be lo grow aggressivelythrough new ptoduct introductions, yet its capitalbudgetitig ptactice tnay altach greal itnpoitatice to

The case of Excellent Manufacturitig detnonsttatesthat the anticipation (A future investtnent optiotis canalter the value oi present investment options. Theoption to acquire infortnation about project costsincreases the value of the option to acquire informa-tion aboLtt titatket detnatici. Thus these ofitiotis areinterrelalecL' In the exatnplc, if Excullenl decides tolaunch production at full capacity at the outset, thenit should spend otily a tnoderate atnount on tnarketre,search. But a greater expenditure on tnarketresuarch is optitnal if I-lxcellcnt recognizes that it canbetter exploit the ofition to acc|uire itilbrtnation aboittproduction costs by .se(/ue)itially conttnitting toexpanded proditction Litid thereby linkitig the deci-sion to continue or abandon the project to what Itlearns about costs. Many companies don't havedynatnic capital budgeting sy,s(ems that consider tnar-ket re,search and product developtiietit outlays as

Sloan Management ReviewWinter 1998

Boqjist • Milbaum • Thakor

62

What a company should use to determine

compensation are flow measures that it

can compute periodically.

investment.s in option.s and don'i integrate determin-ing the amouni to spend on the.se activities to theiroverall capital biidj^eting systems.

I

3, No Connection between Compensation andFinancial MeasuresMany c<impanie.s use fhe NPV criterion to select aproject hut cf)mpensate managers basetl on productearnings or rates of retLirn.' This misaligns their inter-e.sts with those of shareholders (see the sidebar onMultiproduct Corp.).

One reason lor misalignment between compensationand capital allocation system.s i.s that the NFV cannothe readily Li.sed to cietermine compensation becauseit is a stock measure. Moreover, NPV i.s a .summary'measure based on projected cash flows and not real-ized performance. What a company shoiikl use todetermine compensation are tlow measures that itcan compute periodically, say. every quarter or eveiyyear, as they are realized. Some companie.s use flowmeasures such as earnings and cash flow; unfortu-

nately, they can shift managers' behavior away fromshareholders' intere.sts. A flow measure .such as EVA(economic value ackletl) can be helpful, becau.se ittheoretically protiuce.s the same recotiimendaiions a.sthe NPV."

4. Deficiencies in Analytical TechniquesMany companies use Hawed analytital technicjues intheir capital hutlgeting. "Ihe mo.st common deficien-cies are:

Poor Base-Case Identification. For any capital budgeting analy.sis. a company needs to know the hasecase thai define.s the status quo NPV, i.e., what hap-pens if the company keeps things the way they cur-rently are. "I'he company then computes the NPVfrom the propo.sed alternative and asks which alter-native dominates. The vNorse ihe base ea.se looks, thebetter any altertiative appears: this .sometimes temptsfinancial analysts to make t!ie base case look terribleso their ' pef project seems irresistible.

Competition and Cannibalization Issues. A companyshould estimate the likelihood offompetilion u.singgame theor\' and pfobabilistic scenarios and deter-mine a probability distribution for the competitiveentry, along with its impact on project cash flows."The company should then integrate this informationinto its capital buclgetin,t;. Cannibalization estimates

Sundial Electronics

Sundial Electronics has two differentapproval processes, one for expense bud-gets and another for capital budgets. Itrecently approved the deveiopment of anew electronics product to be used as acomponent in TVs. The company estimatedthe capital required to purchase land, builda plant, and acquire equipment and workingcapital at $50 million, it tentativelyapproved this $50 million as part of the cap-ital budgeting process, pending the outcomeof market research and other studies beforethe product launch decision. !t set asideanother $5 million for conducting marketresearch with TV maniifacttjrers, dealers,and end users to get information for refiningproduct design and for the tooling, equip-ment, and tabor needed to develop proto-types. The company approved the $5 millionas part of Its expense budget. At the timethe product launch was approved. Sundialestimated the present value (PV) of cash

flows from the project at $60 million andthe net present value (NPV) at $60 - $50 -$5 = $5 million, considering all outlays. (Forsimplicity, we are ignoring the differences inthe timings of these cash outflows.)

During the market research and prototypedevelopment phase, the manager responsi-bte for developing and launching the prod-uct discovered that customers' qualityexpectations were higher than the compa-ny had initially thought. Consequently, thecompany needed to do additional marketresearch and more costly prototype devel-opment. Instead of $5 million, it wouldneed $7 million. Although this amount washigher than expected, if would sell theproduct af a higher price as well, and itrevised the PV of cash flows to $61 million.Moreover, the manager argued that thecompany had already invested six monthsof Its time and millions of dollars in fheproduct, so continuing was fhe bestapproach.

The expense budget committee approvedthe $2 million increase Two months later, itreceived a request for another $5 million,based on cost overruns, that it approved aswell Eventually, when it was time to decidewhether to invest fhe $50 million, the capi-tal budget committee got a request thatgave the project NPV as $11 million, basedon a PV of cash flows of $61 million and aninvestment of $50 million; the companyviewed Icorrectiy) the $12 million approvedby the expense budget committee and spentearlier as a sunk cost from the standpoint ofwhether or not to invest in the project.

It is interesting to speculate about theextent to which the manager of the newproduct may have intentionally understatedthe market research and prototype develop-ment expenses or shifted postproductlaunch outlays to the preproduct launchphase in anticipation of the outlays heingtreated as sunk when the company had toapprove the capital appropriations request.

Milboum * Thakor Staan Managemenl ReviewWintet 1998

Excellent Manufacturing

Excellent Manufacturing Company Js con-sidering a new product introduction thatcalls for an Investment of $8 million. Thecompany faces uncertainty about futurerevenues and costs. Expected future rev-enues will be $2 million per year if productdemand is high, $1.25 million per year ifdemand is medium, and $0.5 million peryear if demand is low. Each of the threedemand scenarios is equally likely, i.e.. theprobahility is one-third that demand will behigh, one-third that it will be medium, andone-third that it will he low. There are twopossible cost scenarios that depend on,say. material prices and maintenancecosts: with probability of one-half, the costwill be $0.3 million per year (low), and withprobahility one-half, it will be $0.8 millionper year (high).

Low costs could be realized if, say, materi-al costs are low and machine breakdownsare infrequent, while costs could be high-er if material prices increase and themachinery needs frequent maintenance.

All costs and revenues are perpetual andafter tax, and the cost of capital is 10 per-cent. (The discount rate used for the costscould be lower since cost estimates maybe subject to less risk than revenue esti-mates.)

Excellent Manufacturing has to decidewhether to spend money on marketresearch to find out the level of demand.If it spends nothing, it will not knowwhich demand scenario to anticipate andwill view its expected revenue as theaverage of the three scenarios or {1/3 x$2 million + 1/3 X $1.25 million + 1/3 X$0.5 million} = $1.25 million per year. If itspends $1 million on market research, itwill be able to distinguish between lowand high demand, but the imprecise infor-mation will not enable it to distinguishmedium demand from the other two. It isequally likely that Excellent could mistakemedium demand for low or high demand,if the company spends an additional3200.000 on market research ($1.2 milliontotal), it will be able to pinpoint demandprecisely. (Assume these investments in

market research are after-tax.) Whatshould Excellent Manufacturing do?

First suppose that the company decides toinvest nothing in market research. Itassesses an average expected revenue of$1.25 million per year and an averageexpected cost of 1/2 x $0.3 million + 1/2X $0.8 million ^ $0.55 million per year.The present value of these perpetual cashflows is thus [$1.25 - $0,551/0.1 - $7 mil-lion. Since the required investment is $8million, the NFV is -$1 million; ExcellentManufacturing will therefore decide nottoinvest.

What if Excellent spends $1 million onmarket research? In the low-demand situa-tion, it will not invest, because the NPV isnegative regardless of whether thedemand is true low or medium. If, afterresearch, the company sees that demand ishigh, it could be true high or medium. If itis true high demand, the NPV is {[$2 -$0.551/0.1} - $8 - $6.5 million. If it is true

Sidcbiir coniinued on next page...

63

tl<i noi involve game tlicory bui do re([uirr [iroba-hilistif esiiniatL's that arc woven into the fapital bud-geting. Moreover, the NPV-relcvant impaet of eanni-balization i.s predicated on tlie as.sLiriiption.s about thecompetitive entry, an important interrelationship thatcompanies often erroneously ignore. The example of/nnavativc l^rodncl (j>. siiows the importance of rec-ognizing the interdepentience between the competi-tive entry and c-annibalization a,s.sumptions (sec thesidebar).

Inadequate Treatment of Risk. There are two maintypes of risk in capital budgeting: (I) ihe busine.ssand financial risk in cash (lows that is reflected in ihecost of capital (di.seount rate), and (2) the risk in esti-mating expected ca.sh flows. We can think of the firstrisk as arising from tlie distribution of cash flowsaround a known statistical mean. For example, in (hecontext of ihe capital asset pricing mode! (C^AI-'M).sueh a distribution implies a particular relationshij^with the return on ihe market portfolio, whicli, inturn, helps tletermine the cosl ol capital- The secondrisk arises from ihe analy.st's lack of knowledge oftlie statistical mean of the cash flow distribution, oruncertain information, h'ailure to assess botb risks incapital budgeting may produce a misleading picture

ol the project's riskiness. Ignoiing the .second riskoften leads lirms to work wiili point esiimates oflinantial measures like IRK (intern;il rate of return),NI'V. and yearly KVAs. Occasionally, companiesdevelop low-, medium-, and high-risk scenarios tocharaclcrize possible fiitLire project outcomes. Tlieseoverly simplistic characterizations are often inade-quate lor well-iniormed decision making. Many com-panies are, however, increasing the sophistication oftheir risk assessment. For example, Merck has devel-oped a sophisticated capital budgeting system thatdeals with both types of risk. Whirlpool has alsorecently moved away from di.screte characterizationsof risk to ranges of outcosnes and [irobability distrib-utions, something that we recommend.''

Nonuniform Assumptions. Many multidivisionalcompanies content! ^Aith unwanted variety in thea.ssumptions that their financial analysts use in capitalbLidgeting. Assumptions about residual values, ratesof growtli in eash Hows, inflation rates, cycle times,the amounts of capital required, and .so on may notbe uniform.'" With different assumptions in differentc;ipital allocation requests, senior managers are com-pelled to compare apples and oranges in rankingprojects for capital allocation.

Sloan Management ReviewWinter 199B

Boquist • Milboum • Thakai

64

. .continued

Excellent Manufacturing

medium, the NPV is {[$1.25 - $0.55]/0.1} -$8 = -$1 million. Before spending $1 mil-lion on market research, the companyassesses the probahility of tme highdemand as one-third and the probability ottrue medium demand with high demand asone-sixth. Thus, given that the companywill not invest in the low-demand situation,the overall NPV is 1/3 x $6.5 + 1/6 x(-$11 = $2 million, and the NPV is $1 mil-lion, after deducting the money spent onmarket research.

If Excellent spends $1.2 million on marketresearch, it can estimate demand preciselyand thus avoid investing in both low- andmedium-demand situations. Its NPV will be1/3 X $6,5 - $1,2 = $0,967 million, whichis less than the $1 million NPV from spend-ing $1 million on market research. Excel-lent Manufacturing therefore prefers tospend $1 million on market research; theadditional cost of obtaining informationabout medium demand is not worthwhile inlight of the benefit. Thus the value ofinvesting in information to learn about mar-ket demand is $1 million — the differencebetween the expected NPV from investing$1 million in market research and theNPV( = 0) from not investing in the project.

Excellent views outlays on R&D, marketresearch, and so on as the prices ofoptions. Investing $1 million in marketresearch enables Excellent to avoid invest-ing when the research reveals the demandto be low It would erroneously reject thenew product if it ignored the option natureof its market research outlay.

The interactioti of various options is anoth-er aspect of dynamic capital budgeting.Suppose that investing $4 million, half therequired amount, would enable Excellent to

learn about cost. It could find out whethermachine breakdowns were frequent withsmall test-production runs and also deter-mine the amount of materials needed- If,after learning about cost, it decides that itdoes not want to invest, it can liquidateits investment at $3.5 million; it would lose$500,000 and avoid further investment.

vSuppose Excellent ignores the option ofinvesting in market research. It hasalready calculated the expected NPV ofinvesting in the project if it also ignoresthe option to find the cost. This is $1 mil-lion. What is the expected NPV if thecompany exercises the option to find thecost? Since it hasn't invested in marketresearch, the expected ieysme is $1-25million per year. If it invests $4 million ini-tially and learns that the cost is low, thenthe NPV = {[$1.25 - $0.31/0.1} - $8 = $1.5million and it will invest in the project. Ifit invests $4 million and learns that thecost is high, then the NPV of investing inthe project is {i$1.25 - $0.81/0.1} - $8 =-$3.5 million, which is less than the NPVof not investing in the project and liqui-dating the $4 million, which Is -$0.5 mil-lion. Thus the expecrerf NPV {prior toinvesting in learning about cost) with theoption to find the cost equals 1/2 x $1,5+ 1/2 X -$0.5 - $0.5 million, which is alsothe value of the option to learn aboutcost. Having computed the value of eachoption separately. Excellent now examinestheir value together to show that value-additivity does nof hold in this setting.

Now suppose that Excellent spends $1million on market research and learns thatdemand is high. It knows that demand is$2 million per year with probability two-thirds and $1.25 million per year withprobability one-third. That is, expecteddemand is $1 75 million per year. Even ifthe cost is high, the NPV is {|$175-$0-81/0.1} • $8 = $1.5 million. Thus the

company will invest the full $8 million inanticipation of high demand. If it perceiveslow demand, il will not invest. Conse-quently, the NPV of spending $1 million onmarket research and then investing is thesame as before — $1 million, which isalso the value of the two options (to learnabout market demand and to learn aboutcost) added together when each option istreated separately. This value is nof $1 mil-lion (value of learning about marketdemand) + $0.5 million (value of learningabout cost); that is double-counting.

What if the company spends $1.2 million?In the medium-demand situation, if thecompany invests $4 million and the cost islow, the NPV is [{1.25 - $0.3}/0.1] - $8 =$1.5 million, so Excellent will invest theentire $8 million. But if the cost of materi-als is high, the NPV is [{1.25 - $0.8}/0-l] -$8 = -$3.5 million, so it is better for Excel-lent to cut its losses by liquidating the ini-tial $4 million investment and losing only$500,000. Thus the overall NPV in themedium-demand situation is 0.5 x $1.5million -i- 0.5 [ -$0.5 million] - $0.5 million.

To summarize, if Excellent spends $1,2million on market research, the NPV is$6.5 million if the product is in highdemand, $0.5 million if in mediumdemand, and 0 if low demand. The overallexpected NPV is 1/3 x $6.5 + 1/3 x $0-5-(-1/3 x0 -$1 ,2 -$2 -33 -$1 .2 = $1.13million. Thus Excellent Manufacturingprefers to spend $1.2 million on marketresearch, rather than $1 million (NPV = $1million) It would have set the wrong mar-ket research budget had it ignored thesequential investment option embedded inits $8 million capital investment. More-over, value-additivity does not bold here-Wben tbe two options are independent,tbeir total value is $1 million, but whentheir interdependency is correctly recog-nized, their total value is $1,13 million.

5. Finance Function Not a Strategic PartnerI'iiumi. i;il analysis (.loing capiial biKlgetin^; aa*tlnu's .st'tMi more as traffic coiis th;in .strategic pailncrs.They olten eiiler ihe capital hutljietin^ [process nearthe end merely lo riihher-slaiiip A conclusion ihiit amarketing or nianLifucluring executive reiiclietl e;irlier.In other companies, financial analysts may he involvedearly on. bul if the numbers they come up wilh are

not '.salislatloiy/' llicy j^el IIK' capital budjicling [iro-posal hack with the atlmonilion, "Oet ihe IKK [\p lo 2peixeiit or else we tan't approve this ri.'(|iicsl." Thi,sinvites massaging ol the numbeis- Capital hiidgetingthen becoiiu's an exerci.se in finding the values thaiprotluce ihe desired answer, and. conse(]Liently, ihe(.(ualily ot the information for i.'a|ilial budgeting is .seri-ously eompronii-sed."

BoquisI • Mllboum • Ttiakar Sloan Management ReviewWinter 1998

Muttiproduct Corp.

Multjproduct Corp. must choose one of three projects. It can invest$50 mjltion to impmve an existing product, $110 million to intro-duce an extension of an existing product line, or $240 million tointroduce a completely new product. Improving the existing prod-uct Vi'ould generate incremental net operating profits after-tax(NOPAT) of $50 million in one year and $40 million in two years,after which the company terminates the project. Introducing theproduct-line extension would generate incremental NOPATs (adjust-ing for possihle cannibalization of the sates of existing products) of$45 million the first year, $70 million the second year, and $70 millionthe third year, and then the project is ended. The new product wouldgenerate Incremental NOPATs (after adjusting for cannibalization) of$55 million the first year. $75 million the second year, $80 million thethird year, and again the project is terminated.

Which project would a manager select if his or her compensation istied to the rate of retum of the project, to product eamings (NOPAT),or to EVA? Assume that the capital cost is 10 percent and that capitallevels are maintained at their original levels throughout the life ofeach project. That is, new capital investment in any year equalsdepreciation. Moreover, assume that the capital is sold at its bookvalue in the last year of each project's life. As a consequence, freecash flow will be equal to NOPAT in each year except for the last yearwhen the capital is recovered.

The product earnings (NOPATs), free cash flows, IRRs andNPVs are:

Project

Improving existing product

Producl-line extension

New pfotliicl

NOPAT

in Millions

$50. $40

$45, $70, $70

$55, $75, $80

Free Cash Flows

in Millions

$50, $90

$45, $70.3180

$55, $75. S320

IRR

93%

53%

28%

NPV

in Millions

$69 83

$12-1

$1124

Clearly the product-line extension project is the best choice forMultiproduct's shareholders. However, a compensation or capital allo-cation scheme based on IRR would lead the manager to proposeimproving the existing product. If the company compensates the man-ager based on product earnings, he or she will prefer to introduce thenew product. But, if the company uses EVA to com-pensate man-agers, Multiproduct will choose the correct project where (EVA =NOPAT - (capital employed at beginning of period x cost of capital):

Project

Improving existing product

Product-line extension

New product

EVA in millions

S45, $35

S34, $59, $59

$31, $51, $56

NPV=PV of EVAs

in millions

$69.83

$124

$1124

65

Innovative Product Co.

Innovative Product Co. is thinking of intro-ducing a new product that requires aninvestment of $6 million and is expected toproduce a perpetual after-tax cash flow of$1 million per year. However, the companyalso expects that the new product will can-nibalize its existing product line to theextent of $500,000 in after-tax cash flowsper year perpetually There is also a 0.8probability that a competitor will enter witha new product. If this happens. InnovativeProduct's existing product line will suffer anafter-tax cash flow decline of $600,000 peryear regardless of whether it introduces itsnew product or not, and the new productwill suffer an after-tax cash flow decline of

$100,000 per year. Should Innovative Prod-uct introduce the new product? Its weightedaverage cost of capital is 10 percent.

Eirst suppose that Innovative takes intoaccount the cannibalization impact of thenew product introduction but ignores thecompetitive entry. Then, the NPV of intro-ducing the new product is:

and Innovative would forgo the new product.

Now suppose that Innovative also accountsfor the impact of competition. Then, theNPV of introducing the new product is:

0.10= $3 million.

where the company has not charged thenew product for cannibalizing the existingproduct line because the competitor's newproduct has an impact on the existing prod-uct. If the competitor does not enter, theNPV of the new product is -$1 million (cal-culated earlier). Thus the expected NPV ofthe new product is:

(0,8 X $3)-(0.2x $1) = $2,2 million.

This means that considering cannibaliza-tion and competitive entry simultaneouslychanges the decision.

6. Lack of Integration

In matiy [irni.s, capital huclgt'ting and cxpease hudgct-itij arc tli.stinci processes. For example, tlie companiesthat do capital budgeling make assiimptions alx)LUfuture ca.sh Hows that are dependent on certain adver-tising and sales promotion outlays. However, the.seoutlays are typically covered hy the expense budget.Hven in companies in which llie deiermination oC the

expc-tise iet|uests is tied at the oLit.set to the capitalre<|Lie.sts. the people approving the two requests donot necessarily try to ensure consistency betweenthe two budgets. And, even when consistency isachieved at the outset, a meltdown occurs laterpressure to produce short-term financial results causescutbacks in expense budgets, resultitig in two negativecon.se(|uences. First, the eash Hows promised in earlier-

Sloan Managemeni Review

Winter 1998Baquist • MilbDiim • Thakor

Post-audits can end up being a policing

device, creating suspicion and mistrust.

approved capital reciLicsts fail to [nattrkilizc hccauM.* irctliKtion.s in kt.->' i-xpt-nscs. Second, ihe pooivr-than-promised financial resulls lead to skepticism ahoutpromi.se.s in future capital request.s and threaten tochoke off capital to future iio.sitive NPV projects.'-

7. Confusing Financial MeasuresMany La[}iuil liLidgcung syslcin.s sutler Irom a multi-plicity of financial measures, .some of whicli prtxlucecontlicting recommendations in project ranking. Forexample, coiii|")anies often calculale the NPVs, IKKs,ant! payback periods tor the projects they analyi^e. Inrecognition of tlie obvious conHicts between therankinj>.s [-x-odLiced by the tlitTerent measures, compa-nie.s sometimes develop a "point rating" .sy.stem inwhich they assign each financial measure a relativeweight and then rank projects based on their overallscores. The weighting scheme in such sy.slems i$ arbi-traiy and often leads to decisions that do not maxi-mize values.

8. Poorly Trained Financial AnalystsHven the most sojilii.siicated capital budgeting systemwill fail iftho.se executing it are not trained tf> u.sethe available tools. Many companie.s have greatenthusiasm for new ideas and teclini([Lies (e.g., FVA)but none for empl<jyee training. When resources areconstrained, often the easiest expenditure to cut istraining. This is an expen.se-budget problem, sincetraining outlays are typically (incorrectly, in our opin-ion) treated as expen.ses nUher than investments.However, without the ncces.sary investmeni in up-grading those involved in capital budgeting, expect-ing good capital allocation is akin to expecting towin a battle by sending in people unfamiliar withgun.s.

9. Inadequate Post-AuditsPost-auditing the capital budgeting proces.s is theexamination of [>reviou.s investments, comparingthem to projections contained in the capital request,and documenting the causes of the ob.served devia-tions. When this process works well, it i.s an invalu-able learning device, facilitating continuous improve-ment. It also prfimpts a review of the base-casea.s.sumptions, thereby .stimulating a rea.sse,s.smentofthe competition. However, many companies misun-

Baquist • Milboum • Thakot

tlerstand the post-audit process and either don't u.se itor misu.se it. The process ends up being a policingdevice, ci'eating suspicion and mistrust.

Framework for Dynamic CapitalBudgetingThe fratiiework tor capital budgeting that we proposehas the familiar objective of maximizing shareholderwealth. To meet this objective, we designed a .sy.stemwilh three simultaneous steps:

• Map oul tile strcileiiv of the firm. The capital bud-geting system is a plan to execute the strategy.• ne\'elop an eralucition system tor project propos-als. The goal of evaluation is to separate winnersfrom losers; ihe efTectivene.ss with which a chosenproject helps execute the strategy is the measure olsuccess.

• Develop a culture within the firm that is consistentwith the strategy and the evaluation system.

Strategy and Capital BudgetingA coni|>aiiy must fii.si identify a status c[uo strategyand its performance to maximize shareholder value.It must ask what kinds <A' investments have enabledthe strategy to be succe.ssful. The company can thenunderstantl the cflc-ctive parts ofthe strategy and theamount of risk within which it must operate.

The strategy also helps define a fundamental trade-offin capital butlgeting between cycle (ime :mi\ risk. Themore time and resources ihat a firm is wilHtig to com-mit to collecting information about project cash flows,the more it can learn about the cash flows and thelower the informational risk. But it achieves this riskreckiction at the expense of a longer cycle time (seeInjure 2. in which ABCI) represents the cycletime-risk-efficiency frontier for a new and risky prod-uct initiative). It is impossible for a company to liebelow the frontier, given existing lutman capital, orga-nization structure, and technology. For any poitit oftthe frontier, say, point H, there is another point on thefrontier that the firm would prefer. For example, pointB represents a shorter cycle time with the same levelof risk as point E, and point C represents a lower levelof risk with the same cycle time as E. Depending onthe cycle time-risk tratle-off that the firm desires, itwould prefer either point H or C lo jioiiit E.

A comjiany should view the frontier as a given, atleast as a starting point. Where along the frontier it

Sloan Management ReviewWintBi 199E

wants to IK' i.s a matter of strategic choicL'. A firm thatis more tolerant of informational risk may prefer tobe at point n, whereas one that is less tolerant ofinformational risk may prefer C. If these two firmshave the same risk-effieiency frontier, then the firmthat ehooses B will be more error-prone in identify-ing CListoLiier tastes, estimating market demanti, andso on. but when it is right, it will have a competitivefirst-mciver advantage over the firm that prefers pointC. This is an important aspect of time-based cotnpeti-tion. A firm wilh shorter cycle times has a competi-ti\'e edge, but it is also assuming more risk becausethe quality of the information on whii h ils capitalbudgeting is based is not as good as tliat of a firmwilling to tolerate longer cycle times. For example,some claim that Japanese companies prefer shortercycle times (and greater risk) than U..S. companieswhen introtlucing new products.'^ Of course, a firmneed not consider the frontier as a given, but couldivy to push the frontier down to, say, A'D'. Ihis LISLI-

ally requires a fundamental reengineering, which, ifachieved, can be a powerful ccMiipetitive advantage.

Firms that perceive different fronliers may also makedifferent decisions about product introductions.Suppose two finns both view R as the acceptablelevel of risk. The firm on the risk-effieiency frontierAHCn would see its cycle time as T,, whereas theone on the frontier A'D' would view it as T,. The

Figure 2Trade-Off between Cycle Time and Risk

Cycle Time-Risk-Efficiency Frontier

Cycle Time

firm with ihe shorter cycle time would spend lessmoney before product Uumch and bring the [iroductto market fasier: thus it would assess a higher NPVfrom this product than ils slower competitor. TheNPV might be positive for the faster firm and nega-tive for the slower firm, so that one firm wouldrejcil the product and the other would introduce it.An example of this is the flat screen that Westing-house patented but never commercially produced.The Japanese powerhouse Sharp bought the earlypatents and successfully Lnarketed the product nt)tonly for computer monilors but also for Mat-screen,high-re.sokition TVs."

Whatever the risk-efficiency frontier, the company sstrategy determines tiie point along that frontier wherethe company wants to be. The company should com-niunic;ilc the implications of this strategic choice to thepeople responsible- for tapital budgeting, just as im-portantly, those who screen capital requests and allo-cate capital should ensure that the criteria they use areconsistent with the company's strategic ciioice. Hreak-downs occur when a company's strategy is decoupledfrom its project-ranking criteria.

For example, the strategy may be to grow aggressive-ly through global expansion in developing markets,yet a key eapilal budgeting criterion may be to dis-criminate against projects with payback periodslonger than three years. Alternatively, the strategyLnay be to introduce a new product every year, yetthe demands on the quality of market research dataused lo support assumi^tions aboul sales vokime maybe so great that it is imjiossible to ai'hieve the cycletime-risk trade-off consistent with the strategy. It's nowonder that some innovative customer-focused com-panies like Compa(|, Motorola, and Steelcase areshortening cycle times for new produci introtkictionsby rcchicin^t> iheir dependence on market research

Evaluation SystemThe s\stem (or e\aluatiiig projects anti [ireparing cap-ital allocation requests musi be consistent with thestrategy and reflect the role of financial analysts asstrategic partners. It must be a dynamic system withwell-dehned checkpoints for examining the consisten-cy of projects with strategy (see Figitrc 3). Many com-jianies liave adopted (or are adopting) such multi-phase evaluation processes for major capital in\est-ments. for example. Merck, Shell. Lhiited Technolo-gies, HcK'ing, and Whirlpool,

67

Slsan Management ReviewWinlHt 1998

Boquist • Milboum • Thakor

Figure 3Dynamic Project Evaluation System

Phase 1New lijcas

Strategic Totlgate

Evaluate whether pro-Do posed project is con-

sistent with stralegy.

Set a budget foreiqienses during pre-liminarv evaluation.

Set date for prelimi-nary tollgate.

Phase 2PreliminaryEvaluation Phase

Preliminary productfeasibility studies,estimation of costsand capital require-ments, and marketdemand estimates.

Preliminary Tailgate

Make assessment of preiiminatyestimates of cash flows and NPV, asweil as assumptions regarding com-petitive entry and cannibalization.

Make sure base case is correctlyidentified.

Set budget for expenses during busi-ness evaluation.

Phase 3Business EvalunticnPhase

Complete develop-ing product prnlo-tvpes, gather marketresearch data, refinsearlier assumptiDri.iregarding costs,capital requirementsand market demand

Phase 4

•Reject 1

•Approve and Execute

Business Tollgate

Make final evaluation of all keyassumptions regarding basecase, competitive entry, canni-balization. and residual value.

Identify criteria and dates forpost-audit.

Assess NPV and risk in project.

Set date for business tollgate.If project approved, specify anexpense budget that is linked tothe capital budget.

Set date for product launch

The sysletTi has four phases anti ihrcc tollj^att'S. Forapproval, a project must pass ihroiigh all three* toll-gates, with a review at each gate, Tn the first phase,the company generates new idea.s. This is a multi-functional process; many firms have formally chargedadvanced product-concept groups with this task. Thecompany screens ideas at the strategic tollgate forconsistency wilh its strategy. Thus the cotnpanyshould present ideas as proposals that outline consis-tency with the strategy and enhancement of share-holder value. Moreover, the cotnpany must determinea budget for expenses that it will incur tluring prelimi-nary evaluation and set a date for the nexl review.This ensures c(.)nsistency of the cycle time betwetin thestrategic and preliminary tollgates and the strategy.

Touring preliminaiy evaluaU'on. the company shouldshajie the idea into practical reality and obtain pre-liminary estimates of costs and capital recjuiremefits.It should formulate explicit assumptions regardingproduct demand. Also, it should clearly identify thebase case and crystallize assumptions about the com-petition and cannibalization. This should lead fo pre-liminary estitnates of cash flows and NFV and theneed for additional information. This, in turn, willhelp determine the expense budget and the durationf)f the next phase, business evaluation.

The expense budget for the business evaluation phaseincludes the amounts allocated for informatif)n acqui-sition and product development. The company should

Boquist • Milboum • ThaliBr

see the amotint allocated for accjuiring inlortiiation asthe cost of purchasing an option. Thus the analysis (jthow much to invest in informauon accjuisition duringthis |)liase could exjiloit lhe insights of option pricingtheory. In particular, the greater the informational riskin the project, the more the cotnpany should be will-ing lo invest in infortnation acquisition, since option.son riskier securities are more valuable.

If the company det:ides against committing furtherresources to the project at the preliminary tollgate, itshould terminate the project. Tf the company decidesto go through business e\aluaiit)n, then the expen.sebudget committed to this phase and its durationshould be consistent with lhe cycle time-risk trade-off implied by the firm's strategy.

The company .should do lhe bulk of its informationgathering during busine.ss evaluation, Tl should com-plete product specifications, develop and test prototype.s, conduct market research, and refine all the ear-lier a.ssumptions regarding costs and capital require-ments. The purpose of this phase is lo implement theinformation-acfjuisition strategy developed during thepreliminary phase and approved at the preliminary'tollgate. Information gathering during busine.ss evalu-ation is a multifunctional task. The financial analy.st,working as a strategic patmer with olhers from manu-facturing, technology, and marketing, should elicitinformation to accurately estimate future cash flowsbut alscj a.ssess risk. If lhe information from manufac-

Sloan Management ReviewWinter 199B

tLiring, technology, and marketing managers is in theform of point estimates, for example, how can thelinancial analyst obtain ranges and probabilities ofpo,ss[ble future outcomes? Thus the method for elicit-ing information is critically important. Moreover, theanalyst mu.st be trained to judge the quality of theintormation, so he or she can quantify informationaluncertainty in a.s,se.ssing project risk.

A benefit of a dynamic capital budgeting

system is the opportunity for learning.

lXiring business evaluation, the financial analystshould also revisit the as.sumptions made earlierabout lhe base case, since base-case cash flow esti-mates may change over time. The analysts shoLildrehne |^robabiiislic estimates <jf competitive entry andits impact on cash flows and evaluate the overall jointimpact of cannibalization and C{impetition. The ana-lyst should determine the variables to review in thefirsi post-aittlii and its si heduled date.

The capital allocation request sliouki stipulate theexpense levels in each year of the project's life thatwill support the cash flow assutnptions. There shouldbe a link between the capital invested in a given yearand the expcn.se budget for that year to ensure thatthe two remain temporally and .strategically aligned.

The analyst should prepare a brief summar\' of thekey \'alue drivers and financial performance measuresfor the [iroject. The performance measures couldinclude the project's NPV and the F.VA for each yearof the projects life. Moreover, lhe risk analy.sis couldinclude probability distributions of the NTA' and eachyear's EVA.

Ranking Projects. A comfxiny tan Li.se probabilitydistributions of project financials to rank projects if itis rationing capital. Some companies use an NFV di.s-tribution-strategy grid analy.sis to rank projects (seeFigure 4). The grid shows the range of NPVs for eachof a company's proposed projects within each majorstrategy grid. Each vertical line represents the rangeof NPVs for that project, 1 he company can chooseprojects based on each project's contribution to theoverall risk of the project portfolio (the range of pos-sible NPVs for the project is useful) and allocate theamount of capital to each stralegy based cm the com-pany's overall strategy. Thus, in lhe grid, if all four

strategies are equally important, senior managersshould ask why there are only two projects proposedin stralegy III. Perhaps the people proposing projectsunder this strategy are playing it too safe. Moreover,since each strategy, other than III, contains projectswith NPVs that could hti negative, how many thecompany funds depends on the overall portfolio riskthat it wants to take. This kind of analysis is integralto capital budgeting.

A benefit of a dynamic capital budgeting .sy.stem isthe opportunity for learning. The financial analysis offulLire projects is aided by feedback from previousprojects. As one project proceeds through the capitalbudgeting proce.ss, a firm can ask:1, How reliable was the information generated byearlier market re.search?2, Did (he tjuality of iliis infcjrtnation justify its cost?3, What traction of the total cycle time was consumedby market research and what fraction by productdevelopment?

One way to as.se.ss the value of risk reduction ex po.slis to calculate the project s Ni'V, .say, at the businesstollgate, including the previous expenditures or thecosts that the company now considers sunk. Althougha company should never use a project's NPV, includ-ing sunk costs, to accept or reject a project at thebusine.ss tollgate, it can u.se it for accountability andlearning, Tn particular, the company can monitor andcurb analysts' propensity to front-load project outlaysso as to treat them as sunk costs at the business toll-gate (as in the Sundial Electronics example). More-over, if the NPV with sunk costs is negative and theNPV without sunk costs is positive, the cotnpany

Figure 4Grid for Determining Project Rankings

Strategy I Strategy II Strategy III Strategy IV

I 0

Sloan Management ReviewWiniet 1996

Soquist • Milbaum • Thakar

would accept the project hut conclude that the risk-reduction anti produtt development outlays wereexcessive. Such iniornialion would hf valuable forfuture projects.

Culture.Mlliough companies often ignore these three culturalaspects, they are crucial to the suecess of eapital bud-geting in implementing tlie chosen strategy:

70 Conunitment. A company s CLilture should be consis-tent with both the chosen strategy and the proposedevaluation system. In some companies, employees[lerct'ive no long-term commitment to strategy.Various aspects of the strategy are viewed as "pco-grams of the month," which impedes implementation.

Training. Hssenlial to effective capital budgeting isemployee training. Financial analysts and peoplefrom (ither functional areas should learn the system'sconceptual underpinnings and details, so that theyimderstand its pivotal role in implementing strategy.'!"he cxMiipany should design the training to improvethe perftirmance of those invcjived in capital budget-ing. Moreover, training should be a strategic instru-ment for eliciting information from financial analystsand line managers that could help refine the evalua-tion process. In particular, il should provide anopportunity lo find the organizational Impediments toexecuting strategy. In this regard, training can be adirect instrument for organizational cliange. The com-pany should capitalize and amortize training outlaysrather than view them as expenses.

Compensation. Compensation is central to aligning

the incentives of people involved in eapital budgetingwith shareholders" incentives. Thus it is imperativeto develoji a compensation system in which bonus-es are tied tt) performance measures that correlatehighly with shareholder wealth. Many companies,such as (:oea-C:ola, ATikT, CSX, and Hriggs »!iStratton. have recently adopted compensation sys-tems based on HVA. In a capital bLidgeting context,this system is equivalent to basing them on NFV,because EVA is the flow equivalent of the stockmeasLire NPV. Thus, by tying compensation to EVA.management provides wage incentives that arealigned with maximizing NPV.

However, not ail companies that tie eompensation toEVA recxjgnize that the desired behavioral changerequires more than just asking financ ial analysts tocalculate F.VA in addition to other financial measures.Quite often, a fundamental overhaul of the entirecapital budgeting system is required, as Whirlpool, F.liLilly, and R.R. Donnelley have recognized.

Putting It All to WorkCapital allocation, as one key to developing competi-tive advantage, should be carefully aligned with acompany's strategy- Cxxnpanies can no longer com-pete only along product dimensions. Rather, theycompete with all firms in the global community. Aeompany with an effective capital budgeting systeminvests capital more effeetively. finds it easier to raiseadditional eapital, invests in Ri* D and protluct inno-vation, and grtjws. Developing such a sysieni re(|uirescareful integration of corporate strategy, a dynamicproject evaluation system, and corporate culture.

References

We would like to thank Dick Brealey, Sarah Cliffe.and two anonymous referees for very fielpful com-ments Any errors are solely our own.

• 1 See W. Fruhan, "Pyrrhic Victories in Fights forMarket Share," H3\/ard Business Review, volume 50.September-October 1972, pp 100-107; andA.V. fhakor, "Investment 'Myopia' and the InfernalOrganization of Capital Allocafion Dficisions."Journat of Law. Economics and Organi/ation, volume6. Spring 1990. pp. 129-154.• 2. See L. Trigeorgis, Real Options (Cambridge,Massachusetts MIT Press, 199B|; andA.K. Oixit and R.S. Pindyck, "The Options Approachto Capital Investment," Harvard Business Review.volume 73, May-June 1995, pp. 105-118.• 3. See, for example.R.F Mager, What Every Manager Should Know

Boquist • Uilhautn • Thakor

atiout Training [Qelmont, California: Lake Publishing,19921• 4. For interesting research on this issue, see:L Trigeorgis, "The Nature of Option Interactions andthe Valuation of Investment with Multiple RealOptions," Journal of Financial and QuantitativeAnalysis, volume 28, number 1,1993, pp. 1-20.• 5. In firms with large amounts ot debt followingleveraged buyouts, it is typical to lie compensationto cash flows because a key objective is to generatecash flows to pay off the debt.• 6. FVA is defined as ireturn on net assets - weight-ed average cost of capital] x net assets. Thus thepresent value of all future EVAs for a project equalsits NPV• 7. See A M. Brandenburg and B.J. Nalebuff, "TheRight Game. U.se Game Theory to Shape Strategy,"Harvard Business Review, volume 73, July-August1995, pp. 57-73, andFW. Barnett. "Making Game Theory Work in

Practice," Wall Street Journal, 13 February 1995.• 8. N.A. Nichols, "Scientific Management at MerckAn Interview with CFO Judy tewent," HarvardBusiness Review, volume 72, January-February 1994,pp. 88-99.• 9. One way to evaluate both types of risks is withMonte Carlo simulation Analysts can forecast inputranges (or probability distributions) for a project's keyvalue drivers (e.g., units sold, price, costs, and so on)instead of assigning a single expected value. Thesevalues determine the project's yearly free cash flowsIFCFs), which are then discounted at the cost of capi-tal to arrive at the project's NPV. A simulation thendraws from these input distributions, resulting in adistribution of yearly FCFs and NPVs. The analystnow has the expected NPV and the likelihood thatthe NPV is positive, given the underlying assump-tions. All else equal, the firm should accept all proj-ects with positive expected NPVs. However, in lightof capital constraints, corporate strategy, and project

Sloan Management ReviewWinter 1998

interactions, the distribution of NPVs may be veryimportant in making key decisions.Simulation analysis is also usefui for calculating theexpected vearly FCFs when there are interdependen-cies across different variables or options latent intbe project. For example, price and unit demand maybe negatively correlated or tbere may be an aban-donment option. Often, tbe analytical solution totbese relationsbips is difficult to obtain, tberebymaking tbe simulation analysis useful in calculatingthe numerical solution to tbese problems.• 10. In one company, we observed analysts in oneregion wbo consistently assumed that tbe assetsinvested in new products had no residual value afterten years, wbereas analysis in anotber region wouldassume that tbe residual value was the present

value of a perpetual stream of tbe net operatingprofits after tax in tbe tentfi year Both regions com-peted for the same capital pool Guess wbich regionreceived larger capital allocations?• 11. Tbis issue was raised by

R Barwise, RR. Marsb, and R. Wensley, "MustFinance and Strategy Clash?," Harvard BusinessReview, volume 67, September-Oclober 1989, pp. 85-90.

• 12. For a discussion ot otber consequences of dra-conian expense cutting, see.

B. Wysocki, Jr., "Some Companies Cut Cost Too Far,Suffer 'Corporate Anorexia/" Wall Street Journal, 5July 1995.

• 13 Another benefit of consistently having sbortcycle times is tbat the firm becomes quite adept at

responding quickly to change, wbich may result in alowered operating risk for the project, thereby offset-ting some of the information risk. There may also belearning benefits (learning by doing) associated witbshort cycle times.• 14, It is important to note that while a firm's strat-egy will dictate where tbe firm sbould be in terms ofcycle time and risk for different types of projects, theoption valuation metbod for risk reduction willenable the firm to focus its capital allocation on proj-ects that are consistent witb that strategy.

• 15, See, for example:J. Martin, "Ignore Your Customer," Fot^une, 1 May1995, pp. 121-126.

Reprint 3925

71

Entrepreneurial leadershipbegins at Babson.

Create ^rowrh (ipportunitics within your company... be cntrcprcnctiri;il. .Acquire these leadership skillsa t t h e S c h o o l of E x e c u t i v e K d t i e a t i o n at B a b s o n C o l l e g e . F o r m o r e i n f o r m a t i o n on t h e]'>yS p r o g r a m s , ca l l l -8()0-882-F.XEC or 781-239-4354. emai l e x e c @ b a b s o n . e d u or wr i te t heSchool of Execu t ive Educa t ion , Babson Col lege , Babson Park, MA 02157-0310.

Strategic Plannintr and Management in Retailing;FcbruaiA 8-13 (Turkey), Marcb 28-April 3 (Virj inia), May 2-8(Babs()n) and May 23-29(Ireland)Leadership and Influenee May 11-15 and Oetobcr 19-23Strategy and Taeries of Priein^^ May 27-29 and October 14-16Fortiine and Managin^^ Straceiiie Alliances June 14-17 and Oetober 13-16 ^ ^ ^Making Teams Work June 14-17 and Oetober 25-28 ^C«fc T> A r» r ^ A X T

^ ^ BABSON

SiDan Management ReviewWinler 1998

Boquist • Milhoum • Thakoi