Finance Chapter 4 Capital Budgeting Capital Budgeting The Two Firms Were Similar That

Chapter 04 – Capital Budgeting

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CHAPTER 4

Capital Budgeting

1. The two firms were similar in that both exhibited the planning fallacy in respect to

building the most complex planes they had ever attempted. Both firms were late in

completing the projects. The executives at Airbus promised to begin delivering the Airbus

before the plane’s first test flight in December 2009. And although Boeing’s plans had

initially called for it to deliver the first 787 to All Nippon Airways in February 2011, delivery

only took place in September and began carrying customers in October. Notably, the

Dreamliner project went billions over budget.

Additional details about the experiences of Airbus and Boeing are provided in

Additional Resources for Chapter 4. The additional details make clear that both firms set

themselves high aspirations with the A380 and the Dreamliner. The A380 project was

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100,000 different wires, totaling 330 miles in length, which were to perform 1,150 separate

years since Boeing started development of a new plane, the 777, and in the interim it had

terminated at least two other major projects. This would only serve to reinforce the feeling of

some in the firm that they were operating in the domain of losses.

In developing the Dreamliner, Boeing succumbed to the planning fallacy even though

its culture had become more conservative after the merger between Boeing and McDonnell

German), with the French and the Germans also using different software systems. Looking

back at the problems, and the decisions the firm took trying to maintain its lead over Boeing,

Chapter 04 – Capital Budgeting

The planning fallacy involves confirmation bias, with insufficient weight being assigned to

past performance in respect to project success. Historically, problems have been common in

McNerney acknowledged the firm’s overconfidence when he stated that Boeing had been

“overly ambitious” in its development program for the plane.

2. Both Motorola’s Iridium project and Boeing’s Dreamliner project featured the planning

fallacy. Neither project destroyed the firms that ran them, but both were value destructive and

generated all kinds of negative surprises. For Iridium, the biggest issue was the evolution of

the cellphone industry, although there were also product quality issues, such as Iridium

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3. Given the problems that Iridium’s managers recognized at the time, these promotional

4. Most people would not be surprised to learn that Iridium went out of business, but would

be surprised to hear that it had turned cash flow positive. Overconfidence tends to produce

surprises.

5. Perhaps time was of the essence, and the economics of the project were so apparent that it

made little sense to undertake a cash flow analysis. Or, perhaps there was no meaningful way

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6. Leaders articulate vision and lead the way, undeterred by minor distractions. Optimism

and confidence help to maintain focus, and not become unnecessarily discouraged because of

setbacks that typically occur. However, the problem with excessive optimism and

7. The geologists’ responses ranged from five to ten years, thereby placing the historical

8. These types of changes arise because of overconfidence and availability bias. In designing

the tunnels first, availability bias leads engineers to be prone to “out of sight, out of mind”

thinking. That is, they do not properly anticipate issues that will become salient later in the

Chapter 04 – Capital Budgeting

Minicase

Case Analysis Questions

1. The point of this question is to help students learn to engage in thought processes

associated with reference class forecasting, a key feature of outside view thinking. The

presentation of the minicase emphasizes the inside view of the CityCenter project, meaning

the details of the project, as is common.

In respect to budget, MGM began with a gross budget of $4 billion in 2004 to over

overconfidence, and availability bias associated with the planning fallacy. This is because

they place too little probability weight on unfavorable outcomes, some of which they do not

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completed all of the guaranteed maximum price contracts with its contractors. In respect to

revenue, the minicase case suggests that the most significant issue was “the sale of 2,400

condominium units in a collapsed Las Vegas residential market and the leasing of the

450,000 square foot Crystals shopping mall. Relative to its previous forecasts, MGM could

not sell as many units as it anticipated, and was forced to decrease prices on the ones it could

sell.”

Although the Standish Group pertains to software projects, the general pattern of its

findings plausibly apply across many types of projects. The chapter text states the following:

“For the year 2000, and based on all projects in the study survey, budget cost overruns ran at

1.45… Projects differ in important ways. Standish reports that low- and medium-risk

projects appear to be excessively pessimistic, not optimistic. However, the opposite holds

true in respect to high-risk projects. Similar remarks apply to large projects and complex

projects. The CityCenter project was high risk, large, and complex.

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In connection with the Standish report, the chapter text indicates that “the originally

specified features and functions, 67 percent were available on the released project.” The

Harmon Hotel project represents the most significant instance of a planned project feature

that was not part of the completed project.

In respect to project timetable, the case states: “In December 2009 CityCenter

opened, but without the Harmon hotel, which was not expected to open until late 2010.” The

Harmon Hotel never opened. The chapter discussion states that only 37 percent of private

sector projects come in on schedule. The discussion of the Standish report specifies 1.63 as

the average completion time overrun.

2. Once the project was underway, sunk costs were inevitable. At issue is whether negative

surprises, such as cost overruns, labor disputes, safety infractions, and shrinking revenues left

MGM in a position where they would have been better off terminating the CityCenter project

than continuing it.

According to the minicase, MGM made decisions that suggest they did not engage in

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3. The major counterpart projects in the Chapter are the Sony’s Chromatron project, Syntex’s

Enprostil, Eurotunnel’s Channel Tunnel, Motorola’s Iridium, Boeing’s Dreamliner, and

Airbus’s A380.

The evidence suggests that Sony and Syntex both engaged in escalation of

commitment, whereas there is no strong evidence to support the contention that MGM did so

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