Contemporary Financial Management

1. Contemporary Financial Management Chapter 10: Capital Budgeting: Decision Criteria and Real Options

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

4. Net Present Value • Present value of the stream of future cash flows derived from a project minus the project’s net investment

5. 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

6. Profitability Index • Ratio of the present value of future cash flows over the life of the project to the net investment

7. 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 rationing

8. 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 Solve for this variable

9. 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

10. Payback Period • Number of years for the cumulative net cash flows from a project to equal the initial cash outlay

11. 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

12. 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

13. Next Acceptable Project is too Large • Search for another combination of projects that increases the NPV • Attempt to relax the funds constraint

14. When Excess Funds Exist • Invest in short-term securities • Reduce outstanding debt • Pay a dividend

15. 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

16. 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

17. Real Options in Capital Projects • Investment timing option • Abandonment option • Shutdown options • Growth options • Design-in options

18. 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

19. 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.

20. 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

21. Small Firms • Principles are the same as for large firms • Discrepancies • Lack experience to implement procedures • Expertise stretched too thin • Cash shortages often require emphasis on payback period

22. 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