1. © 2004 by Nelson, a division of Thomson Canada Limited Contemporary Financial Management Chapter 10: Capital Budgeting: Decision Criteria and Real Options

2. © 2004 by Nelson, a division of Thomson Canada Limited 2 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

3. © 2004 by Nelson, a division of Thomson Canada Limited 3 Types of Capital Budgeting Criteria  Net present value (NPV)  Profitability index (PI)  Internal rate of return (IRR)  Payback period (PB)

4. © 2004 by Nelson, a division of Thomson Canada Limited 4 Net Present Value  Present value of the stream of future cash flows derived from a project minus the project’s net investment

5. © 2004 by Nelson, a division of Thomson Canada Limited 5 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 life can be reinvested at the cost of capital, k  Does not consider the value of real options

6. © 2004 by Nelson, a division of Thomson Canada Limited 6 Profitability Index  Ratio of the present value of future cash flows over the life of the project to the net investment

7. © 2004 by Nelson, a division of Thomson Canada Limited 7 Profitability Index Characteristics  Relative measure showing wealth increase per dollar 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 capital rationing, NPV is preferred  PI is preferred to NPV under capital rationing

8. © 2004 by Nelson, a division of Thomson Canada Limited 8 Internal Rate of Return  Rate of discount (k) that equates the present value of a project’s net cash flows with the present value of the net investment Solve for this variable

9. © 2004 by Nelson, a division of Thomson Canada Limited 9 IRR Characteristics  If IRR > k, then the project is acceptable  Considers the time value of money  Unusual cash flow pattern can result in multiple IRRs  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

10. © 2004 by Nelson, a division of Thomson Canada Limited 10 Payback Period  Number of years for the cumulative net cash flows from a project to equal the initial cash outlay

11. © 2004 by Nelson, a division of Thomson Canada Limited 11 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

12. © 2004 by Nelson, a division of Thomson Canada Limited 12 Capital Budgeting Under Capital Rationing  Calculate the profitability index for projects  Order the projects from the highest to the lowest profitability index  Accept the projects with the highest profitability index until the entire capital budget is spent

13. © 2004 by Nelson, a division of Thomson Canada Limited 13 Next Acceptable Project is too Large  Search for another combination of projects that increases the NPV  Attempt to relax the funds constraint

14. © 2004 by Nelson, a division of Thomson Canada Limited 14 When Excess Funds Exist  Invest in short-term securities  Reduce outstanding debt  Pay a dividend

15. © 2004 by Nelson, a division of Thomson Canada Limited 15 Post-Auditing Implemented Projects  Find systematic biases or errors relating to projected cash flows  Decide whether to abandon or continue projects that have done poorly

16. © 2004 by Nelson, a division of Thomson Canada Limited 16 Inflation and the Capital Budget  Make sure the cost of capital takes account of inflationary expectations  Make sure that future cash flow estimates include expected price and cost increases

17. © 2004 by Nelson, a division of Thomson Canada Limited 17 Real Options in Capital Projects  Investment timing option  Abandonment option  Shutdown options  Growth options  Design-in options

18. © 2004 by Nelson, a division of Thomson Canada Limited 18 Applying Real Options Concepts  Foundation level of use of real options concept 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

19. © 2004 by Nelson, a division of Thomson Canada Limited 19 International Capital Budgeting  Find the present value of the foreign cash flows denominated in the foreign currency and discounted at the foreign country’s cost of capital.  Convert the present value of the cash flows to the home country’s currency using the current spot exchange rate.  Subtract the parent company’s net investment from the present value of the net cash flows to obtain the NPV.

20. © 2004 by Nelson, a division of Thomson Canada Limited 20 Amount and Timing of Foreign CFs  Differential tax rates in different countries  Legal and political constraints on repatriating cash flows  Government-subsidized loans may affect the WACC or discount rate

21. © 2004 by Nelson, a division of Thomson Canada Limited 21 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 payback period

22. © 2004 by Nelson, a division of Thomson Canada Limited 22 Major Points  Four types of capital budgeting decision criteria: NPV Profitability Index IRR Payback Period  NPV is the preferred decision criteria when capital is not constrained  Remember to think about real options