Meier and Tarhan (2006) conducted an interesting survey of corporate managers. The results are copied in Table 7 below. What proportion of managers are evaluating levered projects correctly?

Table 7: Consistency between hurdle rate and the calculation of cash flows | |||||||

Hurdle rate | Cash flow calculation (see below notes) | ||||||
---|---|---|---|---|---|---|---|

(i) | (ii) | (iii) | (iv) | (v) | Other | Total | |

WACC | 11.3% | 34.8% | 1.7% | 3.5% | 18.3% | 1.7% | 71.3% |

Equity levered | 0.0% | 2.6% | 0.9% | 0.0% | 0.9% | 0.9% | 6.1% |

Equity unlevered | 1.7% | 1.7% | 0.9% | 0.9% | 1.7% | 0.9% | 7.8% |

Other | 2.6% | 5.2% | 1.7% | 0.9% | 3.5% | 0.9% | 14.8% |

Total | 16.5% | 44.4% | 5.2% | 5.2% | 24.4% | 4.4% | 100.0% |

The rows of the cross-tabulation indicate what the self-reported hurdle rate represents and the columns denote five different ways to calculate cash flows, (i) to (v), plus the “other” category. Each cell then displays the fraction of all 113 respondents for a given combination of what the hurdle rate represents and how the firm calculates its cash flows when evaluating a project.

The definitions of the cash flow calculations (i)-(v) are as follows:

(i) Earnings before interest and after taxes (EBIAT) + depreciation

(ii) Earnings before interest and after taxes (EBIAT) + depreciation – capital expenditures – net change in working capital

(iii) Earnings

(iv) Earnings + depreciation

(v) Earnings + depreciation – capital expenditures – net change in working capital

Assume that the WACC is after tax, the required return on unlevered equity is the WACC before tax, all projects are levered, the benefit of interest tax shields should be included in the valuation, earnings = net profit after tax (NPAT) and EBIAT = EBIT*(1-tc) which is often also called net operating profit after tax (NOPAT).

What proportion of managers are evaluating levered projects correctly?