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Issues in Capital Budgeting

Issues in Capital Budgeting. FINA 4463 (Chapter 12 in text). Free Cash Flow to Equity (FCFE). FCFE. FCFE is an alternative definition of cashflow Related to, but different from, FCFF

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Issues in Capital Budgeting

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  1. Issues in Capital Budgeting FINA 4463 (Chapter 12 in text)

  2. Free Cash Flow to Equity(FCFE)

  3. FCFE • FCFE is an alternative definition of cashflow • Related to, but different from, FCFF • Whereas FCFF is the cashflow generated for the firm overall (debt + equity), FCFE is the cashflow that goes to shareholders • FCFE is what is “left over” from FCFF after paying debtholders

  4. FCFE • NPV can be done using FCFF or FCFE • If done correctly, should get same answer either way • FCFF is the more common cashflow definition in capital budgeting • FCFF is easier to use to calculate NPV (see example coming up)

  5. FCFE FCFE = Net Income + Depreciation • Change in non-cash Working Capital • Capital Expenditures + Net New Debt - Preferred Dividends (or + new preferred shares)

  6. Or, FCFE = FCFF – Interest(1-tax) + Net New Debt - Preferred Dividends

  7. For NPV purposes: • FCFF should be discounted at the weighted average cost of capital (WACC) • Remember, if no preferred shares:

  8. Since FCFF represents cashflows to both debt and equity, should be discounted at a rate that is a mix of debt and equity • FCFE is the cashflow that goes exclusively to shareholders. • FCFE should be discounted at the required return on equity (cost of equity)

  9. Example: • Firm has target capital structure that is 50% debt, 50% equity • Interest rate on new debt would be 9% • Required return on equity is 12% • Tax rate is 35% • Project will generate FCFF=$50 per year, forever • Any debt taken on because of the project will be perpetual, principal never paid back • Initial investment = $500 • What is NPV using FCFF and using FCFE?

  10. Real Options and Capital Budgeting

  11. Real Options • Traditional capital budgeting analysis: • estimates cashflows each period • discounts to get NPV • firm decides to invest/not invest BIG PROBLEM: Traditional analysis assumes that a firm’s only choice is accept/reject the project. THIS IS NOT TRUE!!

  12. In a real business situation, firms face many choices with respect to how to operate a project, both before it starts and after it is underway. • Eg. • Flexibility: • use a production technology that is adaptable • can produce more than one product • if market for one product goes down, can switch production • to the other • the option to change production if the firm wants • to (the flexibility) is valuable • makes the project worth more • traditional NPV analysis assumes cashflows fixed, • will not change with future business conditions – ignores • the value of this option

  13. Eg. • Abandonment • firm invests in project • after a time the firm may be able to shut down production • if things are not going well • option to abandon • traditional analysis assumes that the firm either takes • the project and runs it for its life, or rejects it • But…the ability to start a project and shut it down • (perhaps temporarily) if conditions warrant is valuable

  14. Eg. • Option to Delay • traditional analysis assumes firm accepts project now • or never invests • But…what if firm has choice to delay making decision? • Wait and see how things develop and then decide to invest • or not • The choice to delay if the firm wants is valuable • Other examples of valuable options (choices) a firm may have include: • option to expand/shrink production • option to move into new market • R&D gives the option to develop new products if • they become viable • development options on natural resources • et cetera

  15. Real Options • Any time a firm has the ability to make choices, there is a • value added to the project in question • traditional NPV analysis ignores this value • the study of real options attempts to put a dollar value on the • ability to make choices

  16. How are real options valued? Three major ways: • Use methods developed for pricing financial options • Black-Scholes Model • Discussed in “What’s It Worth?” article • May be problems • 2) Decision trees • look at this method here • 3) Stochastic optimization problems • like (2) but using far more complicated • (and realistic) models for the probability • of different events occurring

  17. Option to Delay • simple example from “Irreversibility, Uncertainty and Investment”, • Robert Pindyck [Journal of Economic Literature, 1991] • for $800 a firm can build widget factory • makes 1 widget per year • factory is built instantly • investment is irreversible • if factory built, first widget produced immediately • no costs of manufacturing • no taxes • appropriate discount rate is 10%

  18. Option to Delay • the price of widgets is currently $100 • next year the price will be either $150 (50% probability) or • $50 (50% probability) • whatever price holds next year will hold forever after

  19. year 2 year 0 year 1 Price = $150 Price = $150 prob. = 0.5 Price = $100 prob. = 0.5 Price = $50 Price = $50

  20. Traditional NPV Analysis Expected year 1 price = E[price] = 0.5($150) + 0.5($50) = $100 Standard analysis says NPV > 0, so start project.

  21. Option to Delay • BUT… firm has another option. Delay the choice of whether • to invest or not. • Wait until next year to decide. • Can see what price turns out to be before making decision. • If you delay, you lose on the year 0 sales ($100). • The bad part of delaying – lost sales. • But, you get to see what price will be before making • irreversible investment. • The good part of delaying, reduced uncertainty.

  22. CASE 1: If delay and price turns out to be $50: • NPV < 0 , so firm will not invest. • From today’s perspective, NPV = 0 if price turns out to be $50.

  23. CASE 2: If delay and price turns out to be $150: Firm will invest if the price goes to $150.

  24. the essence of the option to delay is that it allows the firm to avoid • the “bad” outcome • delay deciding until you see what the state of the world is: • you lose some sales on delay • if the market turns out to be bad, you do not invest • and do not take the loss • does the avoided loss make the foregone sales • worthwhile? Price = $150 NPV = 772.73 NPV = ?? Price = $50 NPV = 0

  25. NPV in year 0 of delaying project = (0.5)(772.73) + (0.5)(0) = $386.36 • the NPV of delaying ($386.36) is more than the NPV of • starting immediately ($300) • therefore, firm should delay start of project • the flexibility of being able to wait another year to decide • whether to invest or not is worth an additional $86.36 • Does this mean that firms should always delay projects? • No, if probability of high price in this example was • 90% it would be best to start immediately

  26. Option to Abandon • ability to abandon a project if things are not going well is valuable • allows firm to avoid bad outcomes • value of the option to abandon can be calculated in similar • way to option to delay • see example handout

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