CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 10:

Capital Budgeting: Decision Criteria and Real Options

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

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TYPES OF CAPITAL BUDGETING CRITERIA

Net present value (NPV)

Profitability index (PI)

Internal rate of return (IRR)

Payback period (PB)

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NET PRESENT VALUE

Present value of the stream of future cash flows derived from a project minus the project’s net investment

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( )=

= −

= −+

∑

NetCashFlows

nt

tt 1

NPV PV Net Investment

Net Cash FlowsNPV Net Investment

1 k

CHARACTERISTICS OF NET PRESENT VALUE

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

Assumes that cash flows over the project’s life can be reinvested at the cost of capital, k

Does not consider the value of real options

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PROFITABILITY INDEX Ratio of the present value of future cash flows over the life of

the project to the net investment

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( )= +=

∑n

tt

t 1

Net Cash Flow

1 kPI

Net Investment

PROFITABILITY INDEX CHARACTERISTICS

Relative measure showing wealth increase per dollar of investment

Accept when PI > 1; reject when PI ≤ 1.

Considers the time value of money

Assumes cash flows are reinvested at k

If NPV and PI criteria disagree, with no capital rationing, NPV is preferred

PI is preferred to NPV under capital rationing7

INTERNAL RATE OF RETURN Rate of discount (k) that equates the present value of a

project’s net cash flows with the present value of the net investment

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( )=

=+

∑n

tt

t 1

Net Cash FlowNet Inves

ktment

1

Solve for this variable

IRR CHARACTERISTICS If IRR > k, then the project is acceptable

Considers the time value of money

Unusual cash flow pattern can result in multiple IRRs

If NPV and IRR disagree, NPV is preferred.

If NPV > 0, IRR > k; if NPV < 0, IRR < k

Assumes cash flows are reinvested at IRR.

Does not consider the value of real options

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PAYBACK PERIOD Number of years for the cumulative net cash flows from a

project to equal the initial cash outlay

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=InYears

Net InvestmentPay Back

Annual Net Cash Flow

PAYBACK PERIOD CHARACTERISTICS Simple to use and easy to understand

Provides a measure of project liquidity

Provides a measure of project risk

Not a true measure of profitability

Ignores cash flows after the payback period

Ignores the time value of money

May lead to decisions that do not maximize shareholder wealth 11

CAPITAL BUDGETING UNDER CAPITAL RATIONING

Calculate the profitability index for projects

Order the projects from the highest to the lowest profitability index

Accept the projects with the highest profitability index until the entire capital budget is spent

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NEXT ACCEPTABLE PROJECT IS TOO LARGE

Search for another combination of projects that increases the NPV

Attempt to relax the funds constraint

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WHEN EXCESS FUNDS EXIST

Invest in short-term securities

Reduce outstanding debt

Pay a dividend

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POST-AUDITING IMPLEMENTED PROJECTS

Find systematic biases or errors relating to projected cash flows

Decide whether to abandon or continue projects that have done poorly

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INFLATION AND THE CAPITAL BUDGET Make sure the cost of capital takes account of inflationary

expectations

Make sure that future cash flow estimates include expected price and cost increases

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REAL OPTIONS IN CAPITAL PROJECTS

Investment timing option

Abandonment option

Shutdown options

Growth options

Design-in options

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APPLYING REAL OPTIONS CONCEPTS

Foundation level of use of real options concept Increase awareness of value Options can be created or destroyed Think about risk and uncertainty Value of acquiring additional information

Real options as an analytical tool Option pricing models

Value the option characteristics of projects Analyze various project opportunities

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INTERNATIONAL CAPITAL BUDGETING Find the present value of the foreign cash flows denominated

in the foreign currency and discounted at the foreign country’s cost of capital.

Convert the present value of the cash flows to the home country’s currency using the current spot exchange rate.

Subtract the parent company’s net investment from the present value of the net cash flows to obtain the NPV.

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AMOUNT AND TIMING OF FOREIGN CFS

Differential tax rates in different countries

Legal and political constraints on repatriating cash flows

Government-subsidized loans may affect the WACC or discount rate

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SMALL FIRMS Principles are the same as for large firms

DiscrepanciesLack experience to implement proceduresExpertise stretched too thinCash shortages often require emphasis on payback period

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MAJOR POINTS

Four types of capital budgeting decision criteria: NPV Profitability Index IRR Payback Period

NPV is the preferred decision criteria when capital is not constrained

Remember to think about real options

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