Capital Budgeting: Decision Criteria and Real Option Considerations

1. 9 Capital Budgeting: Decision Criteria and Real Option Considerations

2. Introduction • This chapter looks at capital budgeting decision models. • It discusses and illustrates their relative strengths and weaknesses. • It examines project review and post-audit procedures, and traces a sample project through the capital budgeting process.

3. Capital Budgeting Criteria • Net present value (NPV) • Internal rate of return (IRR) • Profitability index (PI) • Payback period (PB)

4. Net Present Value • PV of the stream of future CFs from a project minus the project’s net investment

5. NPV Characteristics • NPV 0 acceptable above-normalprofits • Considers the time value of money • Absolute measure of wealth • Positive NPVs increase owner’s wealth • Negative NPVs decrease owner’s wealth • NPV not easily understood • CFs over the project’s life reinvested at k • Does not consider the value of real options

6. Conditions Allowing Above-Normal Profits • Buyers preferences for established brand names • Control of distribution systems • Patent control • Exclusive ownership of superior natural resources • Inability of new firms to acquire factors of production • Access to lower cost financial resources • Economies of scale • Access to superior labor or management talents

7. IRR • Rate of discount that equates the PV of net cash flows of a project with the PV of the NINV

8. IRR Characteristics • IRR >k acceptable • Considers the time value of money • Unusual CF pattern can result in multiple rates of return. more than one sign change • If the NPV and IRR criteria disagree, NPV is preferred. • Always agree if NPV > 0, IRR > k; and if NPV < 0, IRR < k • IRR assumes CF is reinvested at IRR. • Interpreted easier than NPV • Does not consider the value of real options

9. Profitability Index • Ratio of the PV of future cash flows over the life of the project to the NINV

10. PI Characteristics • PI > 1 acceptable • Considers the time value of money • CFs reinvested at k • If the NPV and PI criteria disagree, with no capital rationing, the NPV is preferred. • Relative measure showing wealth increase per dollar of investment • Preferred under capital rationing

11. Net Investment PB = Annual net CF Payback Period • Number of years for the cumulative net cash flows from a project to equal the initial cash outlay When net CFs are unequal, interpolation is required.

12. PB Characteristics • Simple • Provides a measure of project liquidity • Measure of risk • risk increases with time • Not a true measure of profitability • Ignores CFs after the payback period • Ignores the time value of money • May lead to decisions that do not maximize shareholder wealth.

13. Capital Budgeting Under Capital Rationing • Calculate the PI for projects • Order the projects from the highest to the lowest PI • Accept the projects with the highest PI until the entire capital budget is spent

14. What Happens When the Next Acceptable Project is too Large? • Search for another combination of projects that increase the NPV • Attempt to relax the funds constraint • Excess funds • Invest in short-term securities • Reduce outstanding debt • C/S dividends

15. Post-Auditing Implemented Projects • Find systematic biases or errors of uncertain projected CFs • Decide whether to abandon or continue projects that have done poorly

16. Incorporating Inflation into the Capital Budget • Make sure the cost of capital takes account of inflationary expectations • Make sure that future CF estimates include expected price and cost increases

17. Investment timing option Evaluate additional information Abandonment option Reduce downside risk Shutdown options Temporarily Growth options Research programs, expand a small plant, or strategic acquisition Design-in options Input/output flexibility options or expansion options Real Options in Capital Projects

18. Real Option Information on the Web • http://www.mbs.umd.edu/finance/atriantis/RealOptions.html • http://www.iur.ruhr-uni-bochum.de/forschung/real_options.html • http://www.real-options.com/

19. How are Real Options Concepts Being Applied? • Foundation level of use of real options concept • Increases awareness of value • Options can be created or destroyed • Think about risk and uncertainty • Value of acquiring additional information • Analytical tool • Option pricing models • Value the option characteristics of projects • Analyzing various project opportunities

20. International Capital Budgeting • Find the PV of the foreign CFs denominated in the foreign currency and discounted by the foreign country’s cost of capital. • Convert the PV of the CFs to the home country’s currency. • multiplyingby spot exchange rate • Subtract the parent company’s NINV from the PVNCFh to get the NPV.

21. Amount and Timing of Foreign CFs • Differential tax rates • Legal and political constraints on CF • Government-subsidized loans

22. Small Firms • Should be the same as large firms • Discrepancies • Lack experience to implement procedures • Expertise stretched too thin • Have cash shortages • Focus on the PB