Advanced Corporate Finance Finance 7330 Lecture 2.2 Ronald F. Singer

Practical Problems in Capital Budgeting We have stated that we want the firm to take all projects that generate positive NPV and reject all projects that have a negative NPV. Capital budgeting complications arise when you cannot, either physically or financial undertake all positive NPV projects. Then we have to devise methods of choosing between alternative positive NPV projects.

Mutually Exclusive Projects IF,AMONG A NUMBER OF PROJECTS, THE FIRM CAN ONLY CHOOSE ONE, THEN THE PROJECTS ARE SAID TO BE MUTUALLY EXCLUSIVE. For example: Suppose you have the choice of modifying an existing machine, or replacing it with a brand new one. You could not do both and produce the desired amount of output. Thus, these projects are mutually exclusive. Given the cash flows below, which of these projects do you choose?

Mutually Exclusive Projects Time Modify Replace Difference 0 -100,000 -250,000 -150,000 1 105,000 130,000 25,000 2 49,000 253,500 204,500 IRR .40 .30 .25 NPV(@ 10%) 36,000 77,700 41,700 Notice the conflict that can exist between NPV and IRR.

EXAMPLES OF CAPITAL BUDGETING COMPLICATIONS 1. Optimal Timing 2. Long versus Short Life 3. Replacement Problem 4. Excess Capacity 5. Peak Load Problem (Fluctuating Load) 6. Capital Constraints

EXAMPLES OF CAPITAL BUDGETING COMPLICATIONS These Capital Budgeting Complications will stop the Firm from taking all possible positive NPV PROJECTS. Thus, the firm is faced with the choice of two possibilities. Remember: Goal is still Max NPV of all possibilities

EXAMPLES OF CAPITAL BUDGETING COMPLICATIONS We can divide these problems into three separate classes, each with their own method of solutions. (1) Once and for all deal. Choose the one alternative having the highest NPV. (2) Repetitive Deal. Choose the one alternative having the highest equivalent annual cash flow. (3) Capital Budgeting Constraint Choose the combination of projects having the highest NET PRESENT VALUE.

Once and For all Deals INVESTMENT TIMING: When is the optimal time to take on an investment project? Consider T possible times, where, t = 1, ...T. Then each "starting time" can be considered a different project in a set of T mutually exclusive projects. Then find that t which Max: NPV(t) (1+r)t

Once and For all Deals Example You are in the highly competitive area of producing laundry soap and detergents. You have a new product which you feel does a superior job in washing clothes, but you anticipate that the product will have difficulty being accepted by the consumer. Thus you expect that if you introduce the product now, you will have to suffer a few years of losses until the product is accepted by the consumer. A competitor is about to come out with a similar product. You feel that if you allow your competitor to come out with the product first, you can benefit from the time he spends acclimating your potential customers. However, you will then be giving up your competitive edge.

Once and For all Deals The initial investment in the product has already been spent, is a sunk cost and can be ignored for this problem. The anticipated life of the productive process is ten years from the time the product is first produced. Thereafter, there will be so much competition that any new investment in this product will have a zero NPV. The discount rate is 15%.

Once and For all Deals Expected cash flows are: CASH FLOW ($ MILLIONS ) year (from start of project 1 2 3 4-10 _______________________________________________ immediately -4 -3 -2 20 If introduced after one year -1 1 3.5 19.5 two years 0 2 4 19 WHAT SHOULD YOU DO?

Once and For all Deals NPV(0) (Introduced Immediately) is: 47.649 million NPV(1) (Introduced in one year's time) is: 55.531 million NPV(2) (Introduced in two year's time) is: 56.118 million WHICH ONE OF THESE THREE OPTIONS SHOULD BE TAKEN? 47.649 55.531 56.118 | | | 0 1 2 3 4 5 Calculate NPV from time 0.

Once and For all Deals Shortcut Calculate the annualized rate of change of NPV. If delaying causes the NPV to increase by more than the discount rate, the project should be delayed. If not, the project should not be delayed.

Once and For all Deals Caution This method assumes that the project cannot be reproduced at a positive NPV after the initial life of the project. Otherwise, you have to also account for the fact that the project that is started earlier can also be reproduced earlier. In that case, the alternatives look like: START IMMEDIATELY 0 10 20 30 _______________________________ ONE YEAR DELAY 0 1 11 21 31 _________________________________ THIS LEADS TO THE SECOND CLASS OF PROBLEMS: