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Capital Budgeting Decision Rules

Capital Budgeting Decision Rules. What real investments should firms make?. Alternative Rules in Use Today. NPV IRR Profitability Index Payback Period Discounted Payback Period Accounting Rate of Return. What Provides Good Decision-Making?.

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Capital Budgeting Decision Rules

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  1. Capital Budgeting Decision Rules What real investments should firms make?

  2. Alternative Rules in Use Today • NPV • IRR • Profitability Index • Payback Period • Discounted Payback Period • Accounting Rate of Return

  3. What Provides Good Decision-Making? • Our work has shown that several criteria must be satisfied by any good decision rule: • Decision rule should be based upon cash flow. • The rule should incorporate all the incremental cash flows attributable to the project. • The rule should discount cash flows appropriately taking into account the time value of money and properly adjusting for the risk inherent in the project. - Opportunity cost of capital. • When forced to choose between projects, the choice should be governed by maximizing shareholder wealth given any relevant constraints.

  4. NPV Analysis • The recommended approach to any significant capital budgeting decision is NPV analysis. • NPV = PV of the incremental benefits – PV of the incremental costs. • NPV based decision rule: • When evaluating independent projects, take those with positive NPVs, reject those with negative NPVs. • When evaluating interdependent projects, take the feasible combination with the highest combined NPV.

  5. Lockheed Tri-Star • As an example of the use of NPV analysis we will use the Lockheed Tri-Star case. • To examine the decision to invest in the Tri-Star project, we first need to forecast the cash flows associated with the Tri-Star project for a volume of 210 planes. • Then we can ask: What is a valid estimate of the NPV of the Tri-Star project at a volume of 210 planes as of 1967.

  6. Lockheed Tri-Star – Key Points • Pre-production costs estimated at $900 million incurred between 1967 and 1971. • Total of 210 planes delivered from 1972-1977 • Revenues of $16 million per unit, 25% of revenue received 2 years in advance of delivery. • Production costs of $14 million (at 210 units could decline to $12.5 million at 300) from 1971-1976. • Discount rate of 10% per year.

  7. Tri-Star Cash Flows • 210 planes (1972-1977) • Planes per year = 210/6=35 • Production Costs (1971-1976) • 35($14M)=$490M per year • Don’t forget the preproduction costs of $900M • Revenues (1970-1977) • Total Revenues 35($16M)=$560M per year • Deposits=0.25($560M)=$140M (2 yrs in advance) • Net Revenues=$560-$140=$420M on delivery

  8. Tri-Star Cash Flows(210 Planes)

  9. Tri-Star NPV @10% in 1967

  10. Accounting Profits at 210 • Production revenues are $16M per plane and production costs are $14M per plane. Profit is $2M per plane. • 210×$2M = $420M production profits. $420M vs. $900M preproduction costs is breakeven? • Suppose production cost is $12.5M per plane (learning curve hits early). Profit per plane is $3.5M. At 210 planes this is $735M production profit. • Now take the extreme low-end of the $800M - $1B preproduction cost range. • Suddenly you have “breakeven.” Smart huh?

  11. Tri-Star NPV 1967 ($Millions)

  12. Tri-Star Cash Flows 1970(210 Planes)

  13. 1970 Tri-Star NPV @10%

  14. Tri Star Post Mortem • Accounting breakeven approximately 275 planes • $16M - $12.5M = $3.5M per plane • $3.5M275 = $962M profit versus $960M in actual development costs known in 1970 • This more realistic breakeven level announced subsequent to the guarantees being granted. • NPV breakeven approximately 400 planes • Total free world market demand for wide-body aircraft approximately 325 planes • Optimistic estimate: total demand 775 and 40% of that is 310 • Lockheed share price • $64 Jan 1967 drops to $11 Jan 1971 • ($64-$11)(11.3 Million shares)=-$599 Million • Compare to -$584 Million NPV

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