FINANCE IN A CANADIAN SETTING Sixth Canadian Edition Lusztig, Cleary, Schwab

CHAPTER TWELVE Capital Budgeting: Additional Topics

Learning Objectives 1. Discuss why cash flows need to be projected in nominal terms when market discount rates are used. 2. Explain what discount is used and why, when a business faces capital rationing. 3. Explain why projects should be ranked according to their benefit-cost ratio.

Learning Objectives 4. Discuss the additional considerations of international capital budgeting. 5. Describe and define the relationship between capital budgeting, general corporate planning, strategic planning, and operating budgets.

Discounted Cash Flow Analysis and Inflation The standard process of measuring inflation is called the current dollar discounting The standard process of measuring inflation is called the current dollar discounting Inflation influences two aspects of capital budgeting: Inflation influences two aspects of capital budgeting: 1. The general level of future cash flows generated by a project 2. The cost of capital that is used as a discount rate

Discounted Cash Flow Analysis and Inflation Forecasting the inflation rate over extended time periods is extremely difficult Forecasting the inflation rate over extended time periods is extremely difficult Constant dollar discounting method – is alternative method used to forecast the general level of inflation explicitly by removing the inflation component out of the cost of capital Constant dollar discounting method – is alternative method used to forecast the general level of inflation explicitly by removing the inflation component out of the cost of capital Constant dollar discounting is used in the public sector but not in private sector project evaluation because there are interactions between the tax code and inflation Constant dollar discounting is used in the public sector but not in private sector project evaluation because there are interactions between the tax code and inflation

Project Interdependencies Interdependencies occur when the cash flow generated from one project depends on other investments that the firm may consider Interdependencies occur when the cash flow generated from one project depends on other investments that the firm may consider Extreme examples include: Extreme examples include: Mutually exclusive Mutually exclusive Contingent projects Contingent projects Generally the interdependence of projects may be either complementary or negative Generally the interdependence of projects may be either complementary or negative

Capital Rationing Capital rationing – when money has to be rationed among projects that compete for scarce funds Capital rationing – when money has to be rationed among projects that compete for scarce funds Under normal circumstances all positive NPV projects should be accepted Under normal circumstances all positive NPV projects should be accepted Project ranking based on NPV becomes the practice when firms face a capital constraint Project ranking based on NPV becomes the practice when firms face a capital constraint

International Aspects of Capital Budgeting Large multinational firms view it as essential to be active in the major industrial areas of North America, Europe, and Asia-Pacific Large multinational firms view it as essential to be active in the major industrial areas of North America, Europe, and Asia-Pacific Firms invest abroad to: Firms invest abroad to: minimize the cost of production minimize the cost of production achieve economies of scale achieve economies of scale circumvent trade barriers or regulations circumvent trade barriers or regulations exploit future opportunities exploit future opportunities

International Aspects of Capital Budgeting Expected cash flows of international projects can be affected by: Expected cash flows of international projects can be affected by: economic incentives economic incentives different tax rates and regulations different tax rates and regulations different business conduct different business conduct repatriation of profits repatriation of profits Factors affecting project risk in international projects include: Factors affecting project risk in international projects include: political uncertainty political uncertainty foreign exchange rates foreign exchange rates

International Aspects of Capital Budgeting Factors affecting the discount rate in the international markets include: Factors affecting the discount rate in the international markets include: underdeveloped financial markets underdeveloped financial markets favourable government financing offers favourable government financing offers exchange rate risk exchange rate risk

Organizational Issues Investment planning is within general corporate planning Investment planning is within general corporate planning Capital budgeting has both a “top down” and a “bottom up” component Capital budgeting has both a “top down” and a “bottom up” component Approval of investment proposals proceeds in several stages depending on the type, size, and complexity of the proposal Approval of investment proposals proceeds in several stages depending on the type, size, and complexity of the proposal

Organizational Issues Firms often group investment proposals into distinctive categories such as: Firms often group investment proposals into distinctive categories such as: 1. projects required by law 2. safety and working condition improvements 3. essential replacements and additions 4. cost reduction and quality improvements 5. capacity expansion for existing products 6. new products or markets

Organizational Issues Management is often faced with distortions from divisions and departments competing with each other for scarce corporate resources Management is often faced with distortions from divisions and departments competing with each other for scarce corporate resources Management can deal with distortions by: Management can deal with distortions by: requesting additional information about the proposed project requesting additional information about the proposed project systemic post-audits of projects systemic post-audits of projects An approach to avoid competitive bidding for projects is for management to decentralize decision-making An approach to avoid competitive bidding for projects is for management to decentralize decision-making

Organizational Issues There are two types of errors that can be made in investment decisions: There are two types of errors that can be made in investment decisions: accept a bad project (type 1 error) accept a bad project (type 1 error) reject a good project (type 2 error) reject a good project (type 2 error) Trade-offs occur in trying to manage both types of errors Trade-offs occur in trying to manage both types of errors

Summary 1. Given inflation, it is important that in both the cash flow projections and choice of the discount rate, general price-level changes be reflected in a consistent manner. 2. Interrelations between projects can become important in affecting diversification and risk. Any direct interdependencies between investments need to be recognized. In extreme cases, projects may be either mutually exclusive or contingent.

Summary 3. When a firm faces capital rationing the discount rate to be used is the opportunity cost of funds, which equals the yield on the most attractive investment opportunity foregone. 4. Projects should be ranked on the basis of their benefit-cost ratio, which equals the net present value per unit of capital invested. The larger ratios are the more attractive.

Summary 5. International capital budgeting uses the same basic concepts and technologies, but added considerations affecting expected cash flows, risk, and the discount rate may exist. 6. Capital budgeting is linked to both strategic planning and to operating budgets. Ultimately, positive net present values are only created when a firm can do things better or cheaper than its competitors.