Download Chapter 9

Chapter 9
Capital Budgeting Decision Criteria
and Real Option Considerations
This chapter explains four commonly used capital budgeting criteria, discusses project review and post
audit procedures, and discusses how capital rationing and inflation are included in capital budgeting
analysis. Real options and international capital budgeting are also covered.
I.
Four capital budgeting criteria are widely known and used. These are the net present value
(NPV), internal rate of return (IRR), profitability index (PI), and the payback period (PB).
A.
The net present value (NPV) of an investment project is defined as the present value of
the stream of future net cash flows from a project minus the project's net investment.
1.
The net present value is:
NPV = PVNCF - NINV
n
NPV =
 (1+ k )t t
NCF
- NINV
t=1
where:
NPV = net present value
NCFt = expected net cash flow in period t
n = expected project life
k = cost of capital
NINV = net investment
2.
The NPV decision rule is to accept a project when the NPV is positive and to
reject a project when its NPV is negative. If the present value of the project's net
cash flows exceeds the project's net investment outlay, the project contributes to
the total value of the firm.
3.
The benefits of using the NPV criterion include: (1) It accurately accounts for the
magnitude and timing of a project's cash flows over its entire life. (2) It shows
whether a proposed project yields the rate of return required by the firm’s
investors and, therefore, consistent with the goal of shareholder wealth
maximization. (3) It adheres to the principle of value additivity.
4.
A disadvantage of the NPV criterion is that it is not as easily understood by
1
untrained decision-makers as the payback or internal rate of return.
5.
What causes some projects to have positive or negative NPV's? When product
and factor markets are not perfectly competitive, it is possible for a firm to earn
above-normal profits and invest in positive NPV projects. Some examples of
conditions that allow above-normal profits include:
a.
b.
c.
d.
e.
f.
g.
h.
B.
buyer preferences for established brand names;
ownership or control of favored distribution systems;
patent control of superior product designs or production techniques;
exclusive ownership of superior natural resource deposits;
inability of new firms to acquire necessary factors of production
(management, labor, equipment);
superior access to financial resources at lower costs (economies of scale
in attracting capital);
economies of large-scale production and distribution arising from capital
intensive production processes and high initial start-up costs; and
access to superior labor or managerial talents at cost which are not fully
reflective of their value.
The internal rate of return (IRR) is defined as the rate of discount that equates the present
value of net cash flows of a project with the present value of the net investment. In other
words, the IRR is the discount rate that makes a project's NPV equal zero.
1.
The algebraic definition of the IRR is:
n
 (1+ r )tt
NCF
= NINV
t=1
where r = IRR.
2.
The IRR decision rule is to accept a project when its IRR exceeds the cost of
capital (k) and to reject a project when its IRR is less than k.
3.
Like the NPV, the IRR takes account of the magnitude and timing of a project's
net cash flows over its entire life.
4.
One occasional difficulty with the IRR is that an unusual cash flow pattern (cash
flows switching signs from positive to negative and vice versa) can result in
multiple rates of return.
5.
When two or more mutually exclusive projects are acceptable using the IRR and
NPV criteria, and if the two criteria disagree on which is best, the NPV criterion
is generally preferred.
6.
Both the NPV and IRR criteria will always agree on accept/reject decisions (i.e.,
if NPV > 0, then IRR > k; and if NPV < 0, then IRR < k), even if the NPV and
IRR do not rank the projects the same.
2
7.
C.
Different rankings result from the implicit reinvestment rate assumptions of the
two techniques: the NPV assumes that cash flows over the project's life may be
reinvested at the cost of capital k while the IRR assumes that cash flows may be
reinvested at the IRR.
The profitability index (PI) or benefit-cost ratio is the ratio of the present value of future
net cash flows over the life of the project to the net investment.
1.
Algebraically, the profitability index is
n
 (1+ k )t t
NCF
PI = t=1
NINV
D.
2.
The PI decision rule is to accept a project whose PI is greater than or equal to
one and to reject a project whose PI is less than one.
3.
The PI has the same advantages and disadvantages as the NPV criterion.
4.
The NPV is an absolute measure of the amount of wealth increase from a project,
whereas the PI is a relative measure showing the wealth increase per dollar of
investment.
The payback period (PB) of an investment is the number of years required for the
cumulative net cash inflows from a project to equal the initial cash outlay.
1.
If the future net cash inflows are equal in each year, the payback period is simply
the ratio of the net investment to the annual cash inflows.
PB =
Net investment
Annual net cash flow
When the future net cash flows are unequal, interpolation is frequently used in
the final period to get an accurate payback period.
II.
2.
The advantages of the payback method are that it is simple, it provides a measure
of project liquidity, and, in a sense, it may also be a measure of risk.
3.
On the other hand, the payback period is not a true measure of profitability and,
therefore, is not a good criterion for decision making. The payback period
ignores cash flows after the payback is reached and it ignores the time value of
money of the cash flows occurring within the payback period.
Capital budgeting analysis can be complicated by capital rationing, that is, when the total outlay
for projects exceeds available funds. One method for maximizing the wealth of the firm given a
funds constraint is the profitability index approach, which involves the following steps:
A.
Step 1: Calculate the profitability index (PI) for each of a series of investment projects.
3
III.
B.
Step 2: Array the projects from the highest to the lowest PI.
C.
Step 3: Starting with the project with the highest ratio, proceed through the list and
accept until the entire capital budget is utilized.
D.
In the event some capital investment funds cannot be fully utilized because the next
acceptable project is too large, there are three alternatives:
B.
V.
Alternative 1: Search for another combination of projects, perhaps including
some smaller, less profitable projects, which will allow for a more complete
utilization of available funds and increase the NPV of the combination of
projects.
2.
Alternative 2: Attempt to relax the funds constraint so that sufficient resources
are available to accept the last project.
3.
Alternative 3: Accept as many projects as possible and invest any excess funds
in short-term securities until the next period, or pay out the excess funds to
reduce outstanding debt or as common stock dividends.
Reviewing or post-auditing is a final step to review the performance of investment projects after
they have been implemented.
A.
IV.
1.
While projected cash flows are uncertain and one should not expect actual values to agree
with predicted values, the analysis should attempt to find systematic biases or errors by
individuals, departments, or divisions and attempt to identify reasons for these errors.
Another reason to audit project performance is to decide whether to abandon or continue
projects that have done poorly.
Inflation is easily incorporated into the basic capital budgeting criteria.
A.
Make sure the cost of capital takes account of inflationary expectations.
B.
Make sure that future cash flow estimates also include expected price and cost increases.
C.
If these are done, the capital budgeting techniques outlined in these chapters serve the
financial decision-maker reasonably well.
Real options are not incorporated into the conventional discounted cash flow techniques (NPV,
IRR, and PI). A real option gives the firm the right, but not the obligation, to buy, sell, or
otherwise transform an asset at a set price during a specified time period.
A.
The firm will exercise its real options in the future if it is advantageous to do so. These
real options can be a major part of the value of capital projects. The bad news is that
option valuation in capital budgeting is complicated. Managers must recognize their
presence.
4
B.
Five types of real options exist.
1.
Investment timing options.
Delaying investment in a project, i.e. for a year
or so, may allow the firm to evaluate additional information about demand, costs,
or technology. Then the firm can make a better decision. The "waiting-to-see"
option is a very common real option.
2.
Abandonment option. A project can be abandoned by shutting it down
completely, selling the asset, or by switching it to some alternative use. The
abandonment option can reduce the downside risk of a project.
3.
Shutdown options. A firm may have the option of shutting down temporarily a
project to avoid negative cash flows.
4.
Growth options: Many projects can be expanded later. Examples of growth
options are in research programs, building a small plant that can be expanded if
the market grows, or making a strategic acquisition in a new line of business.
5.
Designed-in options. Some options occur naturally, and others can be designed
in. These designed-in options are input flexibility options, output flexibility
options, or expansion options.
C.
VI.
Using conventional discounted cash flow analysis in capital budgeting without
considering the value of real options can result in a downward-bias in estimates of a
project's true net present value.
International capital budgeting must account for cash flows in different currencies and for
financial market conditions in different countries.
A.
The net present value of a foreign investment can be found in simple steps. First, find the
present value of the foreign cash flows denominated in the foreign currency and
discounted by that foreign country's applicable cost of capital:
n
PVNCF f =
 (1+ k )t t
NCF
t=1
Then convert the present value of the cash flows to the home country's currency by
multiplying by the spot exchange rate (expressed in units of home currency per unit of
foreign currency):
PVNCF h = PVNCF f  S 0
Finally, subtract the parent company's net investment from the PVNCFh to get the NPV.
NPV = PVNCF h - NINV
B.
The amount and timing of the cash flows to a foreign subsidiary and to a parent may not
be the same for several reasons.
5
VII.
VIII.
1.
Differential tax rates for foreign and domestic companies exist in many countries.
2.
There may be legal and political constraints on cash remittances from the foreign
country to the home country.
3.
Many governments offer subsidized loans, which obviously are valuable only in
the country that grants them.
The principles of capital budgeting apply to entrepreneurial, or small, firms as well as large firms.
However, there are some differences in practice.
A.
Large firms tend to use the conceptually correct NPV and IRR methods while small firms
often use incorrect procedures such as the payback and accounting rate of return.
B.
There are logical reasons for the discrepancy in how large and small firms apply capital
budgeting techniques.
1.
Small firms may lack the expertise to implement formal capital budgeting
procedures, or they may have the expertise but it is simply stretched too thin to
do a careful analysis.
2.
There are more costs associated with a formal, complete analysis. The smaller
projects being considered by small firms may not justify this expensive analysis.
3.
Many small firms may have critical cash shortages, which causes them to focus
on the payback period.
(Appendix to Chapter 9) When two or more mutually exclusive projects have unequal lives, the
net present value and internal rate of return criteria can be unreliable unless the projects are being
evaluated for an equal period of time. The two basic approaches to evaluate unequal lives,
mutually exclusive projects are the replacement chain approach and the equivalent annual annuity
approach.
A.
B.
In the replacement chain approach, follow these logical steps:
1.
Find the least common multiple of the projects' lives (i.e., find the smallest
number that is an integer multiple of each project's life).
2.
For each project, lay out the replacement chain cash flows over the least common
multiple of lives (you may have to reinvest in each project one or more times
over a long time period).
3.
Find the net present value of the replacement chain cash flows for each project.
Choose the alternative with the best NPV.
In the equivalent annual annuity approach, follow these steps:
1.
Compute the net present value of each project over its expected economic life.
6
2.
Obtain an equivalent annual annuity for each project by dividing its net present
value by the present value of an annuity factor (PVIFA) over its original life.
Choose the project with the better equivalent annual annuity.
3.
If a net present value is desired, the net present value for each project may be
found by assuming the equivalent annual annuity is a perpetuity. The net present
value of a perpetuity is found by dividing the equivalent annual amount by the
cost of capital. Choose the project with the greater NPV. (This will always
agree with your decision in step 2.)
7