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Capital Budgeting: Decision Criteria and Real Option Considerations

©2006 Thomson/South-Western

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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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Capital Budgeting Criteria

Net present value (NPV)

Internal rate of return (IRR)

Profitability index (PI)

Payback period (PB)

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Net Present Value

PV of the stream of future CFs from a project minus the project’s net investment

NINVPVNCFNPV

NINVNPV NCF

n

tk tt

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NPV Characteristics

NPV 0 acceptable above-normal profits 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 CFs over the project’s life reinvested at k Does not consider the value of real

options

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Conditions Allowing Above-Normal Profits Buyers preferences for established brand names Control of distribution systems Patent control Exclusive ownership of superior natural

resources Inability of new firms to acquire factors of

production Access to lower cost financial resources Economies of scale Access to superior labor or management talents

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Profitability Index

Ratio of the PV of future cash flows over the life of the project to the NINV

NINV

NCF

PI

n

ttk1 1

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PI Characteristics

PI > 1 acceptable Considers the time value of money CFs reinvested at k If the NPV and PI criteria disagree, with no

capital rationing, the NPV is preferred. Relative measure showing wealth

increase per dollar of investment Preferred under capital rationing

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IRR

Rate of discount that equates the PV of net cash flows of a project with the PV of the NINV

NINVNCF

n

ttt

r1 1

10

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IRR Characteristics IRR > k acceptable Considers the time value of money Unusual CF pattern can result in multiple

rates of return. more than one sign change If the NPV and IRR criteria disagree, NPV is

preferred. Always agree if NPV > 0, IRR > k; and if

NPV < 0, IRR < k IRR assumes CF is reinvested at IRR. Interpreted easier than NPV 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

Net InvestmentAnnual net CF

PB =

When net CFs are unequal, When net CFs are unequal, interpolation is required.interpolation is required.

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PB Characteristics Simple Provides a measure of project liquidity Measure of risk

risk increases with time Not a true measure of profitability Ignores CFs after the payback period Ignores the time value of money May lead to decisions that do not

maximize shareholder wealth.

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Capital Budgeting Under Capital Rationing Calculate the PI for projects

Order the projects from the highest to the lowest PI

Accept the projects with the highest PI until the entire capital budget is spent

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What Happens When the Next Acceptable Project is too Large? Search for another combination of

projects that increase the NPV

Attempt to relax the funds constraint

Excess funds Invest in short-term securities Reduce outstanding debt C/S dividends

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Post-Auditing Implemented Projects Find systematic biases or errors of

uncertain projected CFs

Decide whether to abandon or continue projects that have done poorly

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Incorporating Inflation into the Capital Budget Make sure the cost of capital takes

account of inflationary expectations

Make sure that future CF estimates include expected price and cost increases

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Real Options in Capital Projects Investment timing

option Evaluate additional

information Abandonment option

Reduce downside risk Shutdown options

Temporarily

Growth options Research programs,

expand a small plant, or strategic acquisition

Design-in options Input/output flexibility

options or expansion options

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Real Option Information on the Web

http://www.mbs.umd.edu/finance/atriantis/RealOptions.html

http://www.iur.ruhr-uni-bochum.de/forschung/real_options.html

http://www.real-options.com/

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How are Real Options Concepts Being Applied?

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

Analytical tool Option pricing models

Value the option characteristics of projects Analyzing various project opportunities

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International Capital Budgeting

Find the PV of the foreign CFs denominated in the foreign currency and discounted by the foreign country’s cost of capital.

Convert the PV of the CFs to the home country’s currency. multiplying by spot exchange rate

Subtract the parent company’s NINV from the PVNCFh to get the NPV.

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Amount and Timing of Foreign CFs Differential tax rates

Legal and political constraints on CF

Government-subsidized loans

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Small Firms

Should be the same as large firms

Discrepancies Lack experience to implement procedures Expertise stretched too thin Have cash shortages

Focus on the PB