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Contemporary Financial

Management

Capital Budgeting: Decision Criteria and Real Options

Introduction

•

This chapter looks at capital budgetingdecision models

It discusses and illustrates their relativestrengths and weaknesses - It examines project review and post-auditprocedures, and traces a sample projectthrough the capital budgeting process

Types of Capital Budgeting Criteria

•

Net present value

(NPV)

•

Profitability index

(PI)

•

Internal rate of return

(IRR)

•

Payback period

(PB)

Net Present Value

•

Present value of the stream of future cashflows derived from a project minus theproject’s net investment 4

(

)

=

−

−

∑ Net CashFlows n t t t 1 NPV PV Net Investment Net Cash Flows NPV Net Investment 1 k Docsity.com

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 lifecan be reinvested at the cost of capital, k - Does not consider the value of real options

Profitability Index

•

Ratio of the present value of future cashflows over the life of the project to the netinvestment 6 ( ) =

= ∑ n t t t 1 Net Cash Flow 1 k PI Net Investment Docsity.com

Profitability Index Characteristics

Relative measure showing wealth increase perdollar 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 capitalrationing, NPV is preferred - PI is preferred to NPV under capital rationing

Internal Rate of Return

•

Rate of discount (k) that equates the presentvalue of a project’s net cash flows with thepresent value of the net investment 8

(

)

=

+

∑

n t t t 1 Net Cash Flow Net Inves k tment

Solve for this variable Docsity.com

IRR Characteristics

If IRR > k , then the project is acceptable - Considers the time value of money - Unusual cash flow pattern can result in multipleIRRs - 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

Payback Period

•

Number of years for the cumulative net cashflows from a project to equal the initial cashoutlay 10 = In Years Net Investment Pay 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

Capital Budgeting Under Capital Rationing

Calculate the profitability index for projects - Order the projects from the highest to thelowest profitability index - Accept the projects with the highestprofitability index until the entire capitalbudget is spent

Next Acceptable Project is too

Large

•

Search for another combination of projectsthat increases the NPV

Attempt to relax the funds constraint

When Excess Funds Exist

•

Invest in short-term securities

Reduce outstanding debt - Pay a dividend

Post-Auditing Implemented

Projects

•

Find systematic biases or errors relating toprojected cash flows

Decide whether to abandon or continueprojects that have done poorly

Inflation and the Capital Budget

•

Make sure the cost of capital takes account ofinflationary expectations

Make sure that future cash flow estimatesinclude expected price and cost increases

Real Options in Capital Projects

•

Investment timing option

Abandonment option - Shutdown options - Growth options - Design-in options

Applying Real Options Concepts

•

Foundation level of use of real optionsconcept

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

International Capital Budgeting

•

Find the present value of the foreign cashflows denominated in the foreign currencyand discounted at the foreign country’s costof capital.

Convert the present value of the cash flowsto the home country’s currency using thecurrent spot exchange rate. - Subtract the parent company’s netinvestment from the present value of the netcash flows to obtain the NPV.

Amount and Timing of Foreign CFs

•

Differential tax rates in different countries

Legal and political constraints on repatriatingcash flows - Government-subsidized loans may affect theWACC or discount rate

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 paybackperiod

Major Points

•

Four types of capital budgeting decisioncriteria:

NPV - Profitability Index - IRR - Payback Period - NPV is the preferred decision criteria whencapital is not constrained - Remember to think about real options