Capital Budgeting: Decision Criteria and Real Option Considerations
Key Chapter Concepts
The net present value of an investment project is defined as the present value of the stream of expected net cash flows from the project minus the project’s net investment.
A project is acceptable if its NPV is greater than or equal to zero.
By maximizing the net present value of accepted projects, a firm will also maximize shareholder wealth.
The profitability index (PI) is the ratio of the preset value of expected net cash flows over the life of the project to the net investment.
If the project has a PI equal to or greater than 1.0, it is acceptable.
The PI can be used as a guide to resource allocation in a situation of capital rationing.
The internal rate of return (IRR) is defined as the discount rate that equates the present value of the expected net cash flows from a project with the present value of the net investment.
A project is acceptable if it has an IRR greater than or equal to the firm’s cost of capital.
The NPV and IRR approaches give the same accept reject signals for independent projects, except in the case of mutually exclusive investment alternatives.
The IRR approach can also lead to multiple internal rates of return in some cases.
The payback period of an investment is the period of time required for the cumulative cash inflows (net cash flows) from a project to equal the initial cash outlay.
Weaknesses of the payback method include that it ignores the timing of cash flows and cash flows beyond the payback period.
The payback technique can be used as a project liquidity measure and as a crude risk-screening technique.
Project post-audits and reviews can assist management in uncovering biases in the project analysis procedure of a firm, and can assist management in making abandonment decisions.
The use of conventional discounted cash flow techniques in capital budgeting without considering “real” options may result in a downward -biased estimate of the true value of a project’s net present value.
For international projects, the present value of a project’s net cash flows to the parent company is equal to the present value of the project’s net cash flows from the foreign company converted into the home country currency.
Real Options and the Automobile Production Process:The Case of Honda and Toyota
The car preferences of American consumers have been changing rapidly. At one time the overwhelming top vehicle choice by U.S. consumers was the 4-door family sedan. Each major automobile manufacturer had multiple entries in this large and lucrative market. Then Chrysler brought out the first minivan. It was an instant hit among the baby -boomer generation seeking to haul around a load of kids to soccer practice and other after-school events.
Although the minivan remains popular, the sport utility vehicle, or SUV, has become the hot vehicle of choice. Manufacturers rushed to make SUVs in every size class, from the monster Ford Excursion to the compact Honda CR-V. Changing consumer preferences have been the result of growing consumer affluence, family life cycles, and the desire for individual self-expression. Consumer preferences have also fluctuated in response to volatility in the cost of gasoline.
Faced with a highly volatile demand function of consumers for vehicles, car manufacturers have often found themselves stuck with excess capacity in plants capable of making only one type of vehicle.When demand for that vehicle type declines, the manufacturers are forced to resort to costly incentives to sell their unpopular models. In many cases, expensive plants have been closed either temporarily or permanently.
It used to take two years or more to convert a plant from making cars to making small SUVs, for example. With the high volatility of demand for various vehicle types, automobile manufacturers have increasingly been developing flexible plant designs that give them the option to convert a plant from one vehicle type to another in less than six months. Toyota has refitted its assembly plants around the world with common assembly equipment and plant layouts. Their goal is to be able to produce any vehicle type, from a car to a large SUV, without going through a major retooling of the plant.
Toyota recently completed the refitting of its Georgetown, Kentucky, plant to meet the new standards. This plant produces the popular family sedan, the Toyota Camry, but Toyota wants to be ready to shift production at that plant to other vehicles should demand for the Camry decline. Other auto manufacturers are pursuing similar goals. Honda claims that its plants can shift production to a new model in as little as three months. Similar plant reengineering efforts are underway at General Motors and most other major car companies.
The value of this increased flexibility can be seen in the case of Honda’s Swindon plant in the United Kingdom. Because of weak sales in Europe, Honda has found it difficult to operate this plant at anything close to its full capacity of 150,000 cars per year. During 2000, the plant produced only 76,500 vehicles.To complicate matters, the Swindon plant opened a second production line during the summer of 2001 with an additional capacity of 100,000 vehicles.At the same time, Honda found that it was running out of capacity at its Japanese and U.S. plants that produced their compact SUV.
By making investments in the manufacturing flexibility of the Swindon plant, Honda will be able to shift production of its compact SUV, the CR-V, and the hatchback version of the Honda Civic to Swindon, from Japan and the United States. These vehicles will then be exported to the U.S. market.
As this example illustrates, manufacturing flexibility is an important and valuable real option for corporations. This chapter considers a number of techniques that are useful when evaluating the cash flows anticipated from capital expenditures, such as Honda’s Swindon assembly plant. As we shall see in this chapter, in addition to estimating and evaluating the cash flows from a proposed investment, it is important to consider the value of real options that are inherent in an investment project.
This chapter looks at some widely used capital budgeting decision models, discussing and illustrating their relative strengths and weaknesses. When combined with the cash flow procedures developed in previously. These models provide the basis for making capital expenditure decisions. This chapter also examines project review and post -audit procedures and concludes by tracing a sample project through the capital budgeting analysis process.
Decision Models for Evaluating Alternatives
Four criteria are commonly used for evaluating and selecting investment projects.
Net present value (NPV)
Profitability index (PI)
Internal rate of return (IRR)
Payback (PB) period
Net Present Value
Recall from Chapter 1 that the net present value rule is the primary decision -making rule used throughout the practice of financial management. The net present value —that is, the present value of the expected future cash flows minus the initial outlay —of an investment made by a firm represents the contribution of that investment to the value of the firm and, accordingly, to the wealth of the firm’s shareholders. In this chapter, we consider the net present value of capital expenditure projects.
The net present value (NPV) of a capital expenditure project is defined as the present value of the stream of net (operating) cash flows from the project minus the project’s net investment. The net present value method is also sometimes called the discounted cash flow (DCF) technique. The cash flows are discounted at the firm’s required rate of return; that is, its cost of capital. A firm’s cost of capital is defined as its minimum acceptable rate of return for projects of average risk.
The net present value of a project may be expressed as follows:
NPV = PVNCF – NINV
where NPV is the net present value; PVNCF, the present value of net (operating) cash flows; and NINV, the net investment. For a series of uneven net (operating) cash flows, the net present value of a project may be calculated as follows:
where NCFt is the net(operating) cash flow in year t, n is the expected project life (years), k is the cost of capital, and PVIFk,t is the present value interest factor. The net (operating) cash flow in the final year (n) of the project, NCFn, includes any salvage value remaining at the end of the project’s life. The summation sign (Σ) represents the arithmetic sum of the discounted cash flows for each year t over the life of the project (n years); that is, the present value of the net cash flows (PVNCF).
If all the net (operating) cash flows are equal over the life of the project, that is, an annuity NCF = NCF1 = NCF2 = . . . =NCFn, then Equation can be expressed as follows:
NPV = NCF _ PVIFAk,n – NINV
where PVIFAk,n is the present value of annuity interest factor (Table IV). the annual net cash flows for normal projects are usually positive after the initial net investment. Occasionally, however, one or more of the expected net cash flows over the life of a project may be negative.When this occurs, positive numbers are used for years having positive net cash flows (net inflows), and negative numbers are used for years having negative net cash flows (net outflows).
To illustrate net present value calculations, suppose Ace Lumber is considering two projects, A and B, having net investments and net cash flows as shown in Table. The net present value computations for the two projects are presented in Table. These calculations assume a 14 percent cost of capital. The calculations in these tables also assume that cash flows are received at the end of each year, rather than as a flow during the year.
This assumption, although a normal one, tends to slightly understate a project’s net present value or internal rate of return. Project A is shown in Table to have a negative net present value of $–1,387, and Project B has a positive net present value of $7,735. Spreadsheet software may also be used to solve for NPV as illustrated here:
In general, a project should be accepted if its net present value is greater than or equal to zero and rejected if its net present value is less than zero. This is so because a positive net present value in principle translates directly into increases in stock prices and increases in shareholders’ wealth. In the Ace Lumber example, Project A would be rejected because it has a negative net present value, and Project B would be accepted because it has a positive net present value.
If two or more mutually exclusive investments have positive net present values, the project having the largest net present value is the one selected. Assume, for example, that a firm has three mutually exclusive investment opportunities, G, H, and I, each requiring a net investment of $10,000 and each having a 5-year expected economic life.1 Project G has a net present value of $2,000; H has a net present value of $4,000; and I has a net present value of $3,500.
Of the three, H would be preferred over the other two because it has the highest net present value and therefore is expected to make the largest contribution to the objective of shareholder wealth maximization. Sources of Positive Net Present Value Projects What causes some projects to have a positive net present value and others to have a negative net present value? When product and factor markets are other than perfectly competitive, it is possible for a firm to earn above -normal profits (economic rents) that result in positive net present value projects. The reasons why these above-normal profits may be available arise from conditions that define each type of product and factor market and distinguish it from a perfectly competitive market. These reasons include the following barriers to entry and other factors:
Buyer preferences for established brand names
Ownership or control of favored distribution systems (such as exclusive auto dealerships)
Patent control of superior product designs or production techniques
Exclusive ownership of superior natural resource deposits
Inability of new firms to acquire necessary factors of production (management, labor, equipment)
Superior access to financial resources at lower costs (economies of scale in attracting capital)
Economies of large -scale production and distribution arising from a. Capital -intensive production processes b. High initial start -up costs
Access to superior labor or managerial talents at costs that are not fully reflective of their value
These factors can permit a firm to identify positive net present value projects for internal investment. If the barriers to entry are sufficiently high (such as a patent on key technology) so as to prevent any new competition or if the start -up period for competitive ventures is sufficiently long, then it is possible that a project may have a positive net present value.However, in assessing the viability of such a project, it is important that the manager or analyst consider the likely period of time when above -normal returns can be earned before new competitors emerge and force cash flows back to a more normal level.
It is generally unrealistic to expect to be able to earn above-normal returns over the entire life of an investment project. Thus, it may be possible for a firm to identify investment projects with positive net present values. However, if capital markets are efficient, the securities of the firm making these investments will reflect the value of these projects. Recall that the net present value of a project can be thought of as the contribution to the value of a firm resulting from undertaking that particular project. Therefore, even though a firm may be able to identify projects having expected positive net present values, efficient capital markets will quickly reflect these positive net present value projects in the market value of the firm’s securities.
Suppose Project B in the preceding example was a new baby care product from Johnson & Johnson. Its positive net present vaue could be the result of buyer preferences due to Johnson & Johnson’s established baby care business. Suppose Project A, on the other hand, involved a new soap product to compete with Procter & Gamble’s Tide. Consumers’ brand preferences for Tide, as well as Procter & Gamble’s economies of scale for production and distribution, could easily cause Project A to have a negative net present value.
Advantages and Disadvantages of the Net Present Value Method
The net present value of a project is the expected number of dollars by which the present value of the firm is increased as a result of adopting the project. Therefore, as we have pointed out, the net present value method is consistent with the goal of shareholder wealth maximization. The net present value approach considers both the magnitude and the timing of cash flows over a project’s entire expected life.
A firm can be thought of as a series of projects, and the firm’s total value is the sum of the net present values of all the independent projects that make it up. Therefore, when the firm undertakes a new project, the firm’s value is increased by the net present value of the new project. The additivity of net present values of independent projects is referred to in finance as the value additivity principle.
The net present value approach also indicates whether a proposed project will yield the rate of return required by the firm’s investors. The cost of capital represents this rate of return; when a project’s net present value is greater than or equal to zero, the firm’s investors can expect to earn at least their required rate of return.
The net present value criterion has a weakness in that many people find it difficult to work with a present value dollar return rather than a percentage return. As a result, many firms use another present value –based method that is interpreted more easily: the internal rate of return method. It is discussed later in the chapter. Also, the traditional NPV approach does not consider the value of real options that are part of a proposed project. Real options are discussed later in the chapter.
The profitability index (PI), or benefit–cost ratio, is the ratio of the present value of expected net cash flows over the life of a project (PVNCF) to the net investment NINV. It is expressed as follows:
Assuming a 14 percent cost of capital, k, and using the Ace Lumber data from Table the profitability index for Projects A and B can be calculated as follows:
The profitability index is interpreted as the present value return for each dollar of initial investment. In comparison, the net present value approach measures the total present value dollar return.
A project whose profitability index is greater than or equal to 1 is considered acceptable, whereas a project having a profitability index less than 1 is considered unacceptable. In the case of Ace Lumber, Project B is acceptable, whereas Project A is not.When two or more independent projects with normal cash flows are considered, the profitability index, net present value, and internal rate of return approaches all will yield identical accept –reject signals; this is true, for example, with Projects A and B.
When dealing with mutually exclusive investments, conflicts may arise between the net present value and the profitability index criteria. This is most likely to occur if the alternative projects require significantly different net investments.
Consider, for example, the following information on Projects J and K. According to the net present value criterion, Project J would be preferred because of its larger net present value. According to the profitability index criterion, Project K would be preferred.
When a conflict arises, the final decision must be made on the basis of other factors. For example, if a firm has no constraint on the funds available to it for capital investment —that is, no capital rationing —the net present value approach is preferred because it will select the projects that are expected to generate the largest total dollar increase in the firm’s wealth and, by extension, maximize shareholder wealth.
If, however, the firm is in a capital rationing situation and capital budgeting is being done for only one period, the profitability index approach may be preferred because it will indicate which projects will maximize the returns per dollar of investment—an appropriate objective when a funds constraint exists.
Internal Rate of Return
The internal rate of return is defined as the discount rate that equates the present value of the net cash flows from a project with the present value of the net investment,that is:
Subtracting NINV from both sides of Equation yields PVNCF – NINV = 0, or NPV = 0, which shows that the internal rate of return is the discount rate that causes a project’s net present value to equal zero. The internal rate of return for a capital expenditure project is identical to the yield to maturity for a bond investment.
PVNCF = NINV
A project’s internal rate of return can be determined by means of the following equation:
where NCFt /(1 + r)t is the present value of net (operating) cash flows in period t discounted at the rate r , NINV is the net investment in the project, r is the internal rate of return, and PVIFr,t is the present value interest factor . Subtracting the net investment, NINV, from both sides of Equation yields the following:
This is essentially the same equation as that used in the net present value method. The only difference is that in the net present value approach a discount rate, k, is specified and the net present value is computed, whereas in the internal rate of return method the discount rate, r, which causes the project net present value to equal zero, is the unknown. If all the net (operating) cash flows are equal over the life of the project, that is, an annuity NCF = NCF1 = NCF2 = . . . = NCFn, can be expressed as follows:
NCF PVIFAr,n = NINV
where PVIFAr,n is the present value of an annuity factor (Table ).
The internal rate of return for Ace Lumber’s Projects A and B can now be calculated. Because Project A is an annuity, its internal rate of return may be computed directly with the aid of a PVIFA table, such as Table. Substituting NCF = $12,500, NINV = $50,000, n = 6 into Equation yields
Capital Rationing and the Capital Budgeting Decision
For each of the selection criteria previously discussed, the decision rule is to undertake all independent investment projects that meet the acceptance standard. This rule places no restrictions on the total amount of acceptable capital projects a company may undertake in any particular period.
However, many firms do not have unlimited funds available for investment. Rather than letting the size of their capital budget be determined by the number of profitable investment opportunities available, many companies choose to place an upper limit, or constraint, on the amount of funds allocated to capital investments.
This constraint may be either self-imposed by the firm’s management or externally imposed by conditions in the capital markets. For example, a very conservative firm may be reluctant to use debt or external equity to finance capital expenditures. Instead, it would limit capital expenditures to cash flows from continuing operations minus any dividends paid. Another firm may feel that it lacks the managerial resources to successfully undertake all acceptable projects in a given year and may choose to limit capital expenditures for this reason.
A number of externally imposed constraints might limit a firm’s capital expenditures. For example, a firm’s loan agreements may contain restrictive covenants that limit future borrowing. Similarly, a weak financial position, conditions in the securities markets, or both may make the flotation of a new bond or stock issue by the firm impossible or prohibitively expensive. Examples of such market -imposed constraints include depressed stock market prices, unusually high interest rates due to a “tight money” policy on the part of the Federal Reserve System, and a reluctance on the part of investors to purchase new securities if the firm has a large percentage of debt in its capital structure. Several different methods can be used in making capital budgeting decisions under capital rationing.
When the initial outlays occur in two (or more) periods, the methods are quite elaborate and require the use of linear, integer, or goal programming. However, when there is a single-period capital budgeting constraint, a relatively simple approach employing the profitability index can be used. Briefly, the approach consists of the following steps:
Step 1: Calculate the profitability index for each of a series of investment projects.
Step 2: Rank the projects according to their profitability indexes (from highest to lowest).
Step 3: Beginning with the project having the highest profitability index, proceed down through the list, and accept projects having profitability indexes greater than or equal to 1 until the entire capital budget has been utilized.
At times, a firm may not be able to use its entire capital budget because the next acceptable project on its list is too large, given the remaining available funds. In this case, the firm’s management should choose among the following three alternatives: Alternative 1: Search for another combination of projects, perhaps including some smaller, less profitable ones that will allow for a more complete utilization of available funds and increase the net present value of the combination of projects.
Alternative 2: Attempt to relax the funds constraint so that sufficient resources are available to accept the last project for which funds were not fully available.
Alternative 3: Accept as many projects as possible and either invest any excess funds in short-term securities until the next period, pay out the excess funds to shareholders as dividends, use the funds to reduce outstanding debt, or do a combination of the above.
The following example illustrates how these alternatives can be applied to an actual capital budgeting decision. Suppose that management of the Old Mexico Tile Company has decided to limit next year’s capital expenditures to $550,000. Eight capital expenditure projects have been proposed—P, R, S, U, T, V, Q, and W—and ranked according to their profitability indexes, as shown in Table. Given the $550,000 ceiling, the firm’s management proceeds down the list of projects, selecting P, R, S, and U, in that order. Project T cannot be accepted because this would require a capital outlay of $25,000 in excess of the $550,000 limit.
Projects P, R, S, and U together yield a net present value of $114,750 but require a total investment outlay of only $525,000, leaving $25,000 from the capital budget that is not invested in projects. Management is considering the following three alternatives:
Old Mexico Tile Company: Ranking of Proposed Projects According to Their Profitability Indexes
Alternative 1: It could attempt to find another combination of projects, perhaps including some smaller ones, that would allow for a more complete utilization of available funds and increase the cumulative net present value. In this case, a likely combination would be Projects P, R, S, T, and V. This combination would fully use the $550,000 available and create a net present value of $116,250—an increase of $1,500 over the net present value of $114,750 from Projects P, R, S, and U.
Alternative 2: It could attempt to increase the capital budget by another $25,000 to allow Project T to be added to the list of adopted projects.
Alternative 3: It could merely accept the first four projects—P, R, S, and U—and invest the remaining $25,000 in a short-term security until the next period. This alternative would result in an NPV of $114,750, assuming that the risk adjusted required return on the short-term security is equal to its yield.
In this case, Alternative 1 seems to be the most desirable of the three. In rearranging the capital budget, however, Old Mexico Tile Company should never accept a project, such as W, that does not meet the minimum acceptance criterion of a positive or zero net present value (a profitability index greater than or equal to 1).
Reviewing and Post-Auditing an Accepted Project
A final important step in the capital budgeting process is the review of investment projects after they have been implemented. This can provide useful information on the effectiveness of the company’s selection process. The post -audit procedure consists of comparing actual cash flows from an accepted project with projected cash flows that were estimated when the project was adopted. Because projected cash flows contain an element of uncertainty, actual values would not be expected to match estimated values exactly.
Instead, a project review should be concerned with identifying systematic biases or errors in cash flow estimation on the part of individuals, departments, plants, or divisions and attempting to determine why these biases or errors exist. This type of analysis, when properly performed, can help a company’s decision makers better evaluate investment proposals submitted in the future.
The importance of the post-audit process has been highlighted in research by Brown and Miller.11 They observed that in the common situation where bad projects outnumber good ones, the simple procedure of making unbiased cash flow estimates and choosing projects with positive net present values will result in an upwardly biased acceptance rate for proposed projects (and returns that are, on average, below those that are expected) if there is uncertainty regarding future cash flows. In a situation such as this, the firm needs to correct for this potential bias when projects are being reviewed.
The information needed to make this necessary bias-eliminating correction can be gathered from careful project post-audits.
The importance of a good project review and tracking system is illustrated in the following example from Ameritech (merged with SBC Communications in 1999). Ameritech has a sophisticated tracking system that permits the company to identify the individual responsible for each estimate in a capital project proposal.
When the tracking system was announced and initiated, budgets had already been submitted for the coming year. Divisions were permitted to take back their budgets and resubmit them in light of the new tracking system. Seven hundred projects disappeared from the new budgets, and many others had reduced estimates of benefits!
Another objective of the project review process involves determining whether a project that has not lived up to expectations should be continued or abandoned. The decision to abandon a project requires the company to compare the cost of abandonment with any future cash flows that are expected over the project’s remaining life. These estimates of future cash flows will usually be more accurate after the project has been in service for a period of time.
A Comprehensive Example of Capital Budgeting: Opening a New Bank Branch
The First National Bank and Trust Company has a single banking office located in the downtown business district of a medium -size town. As the population moved to the suburbs, First National has seen its share of both local banking deposits and profits decline. Two of the bank’s vice presidents have proposed that First National try to reverse this trend by building a branch in a new, affluent suburban community. They have presented the bank’s executive committee with the following information.
The initial cost of the bank building and equipment is $1 million. This facility is expected to have a useful life of 20 years. Also, in 20 years at the end of the project the branch building and its equipment are expected to be sold for a $200,000 salvage value. The branch building and its equipment will be depreciated over their 20-year life using straight-line depreciation to a zero balance.We have assumed straight-line depreciation for simplicity.
In actual practice the bank would use MACRS depreciation with a 39-year life on the building and a 7-year life on the equipment. The annual straightline depreciation will be $1,000,000/20 = $50,000. The bank building is to be constructed on land leased for $20,000 per year. In addition to the $1 million investment for the building and equipment, the parent bank’s net working capital must be increased by $100,000 to accommodate the new branch.
Based on customer surveys, population trends, the location of competitor banks, and the experience other area banks have had with their branches, it is estimated that the annual revenues from the new branch will be $400,000. Of this $400,000 in revenues, $50,000 will be drawn away from the bank’s main office. (Assume that the main office will not attempt to cut its expenses because of this loss in revenues.)
In addition to the $20,000 annual expense for the land lease, the new branch will incur about $130,000 per year in other expenses, including personnel costs, utilities, and interest paid on accounts. Both expenses and revenues are expected to remain approximately constant over the branch’s 20-year life. The bank’s marginal tax rate is 40 percent and its cost of capital (required rate of return) is 9 percent after taxes.
Net cash flows are calculated for years 1 through 19 by subtracting branch operating costs and depreciation from the incremental revenues of $350,000. This yields operating earnings before taxes from which taxes (at the 40 percent rate) are deducted to arrive at operating earnings after taxes. By adding back depreciation, the net cash flow equals $140,000 for each year from 1 through. Net cash flows in year 20 are computed by adding the $120,000 estimated after -tax salvage and the $100,000 return of working capital to the annual net cash flow of $140,000 to equal $360,000.14
The $100,000 working capital requirement is added back to the year 20 cash flows because at the end of 20 years, when the project is terminated, there will no longer be a need for this incremental working capital, and thus the working capital of $100,000 can be liquidated and made available to the bank for other uses.
After the project cash flows have been computed and arrayed, the decision of whether to accept or reject the new branch project must be made. Next, the project is evaluated using three of the decision criteria discussed in this chapter, namely, net present value, internal rate of return, and profitability index.
Criterion 1: Net Present Value
The first term in the net present value equation is the present value of an annuity of $140,000 for 19 years at 9 percent, the bank’s cost of capital. Using the present value of an annuity table , an interest factor of 8.950 may be found. The second term is the present value of $360,000 received in 20 years at 9 percent. From the present value table, an interest factor of 0.178 is found. Thus, the net present value of this project at a 9 percent cost of capital is as follows:
Using the net present value criterion and a cost of capital of 9 percent, this project would be acceptable because it has a positive net present value.
Criterion 2: Profitability Index
The profitability index is the ratio of the present value of future net cash flows to the net investment. From the previous net present value calculation, we know that the present value of net cash flows at a percent cost of capital is $1,317,080 ($1,253,000 + $64,080). Thus, the profitability index is computed as follows:
Because the profitability index is greater than 1, the new branch bank project is acceptable according to this criterion.
Criterion 3: Internal Rate of Return
According to this method, a discount rate that makes the net present value of the project equal to zero must be found:
where r is the internal rate of return.
Since the calculated internal rate of return (r), equals 11.56 percent, which is greater than the cost of capital, the project is acceptable by this criterion. Based on these calculations, it appears that the new branch proposal will increase shareholder wealth and therefore should be undertaken. The only step remaining is to monitor the performance of the project to see if it meets, falls short of, or exceeds its projected cash flow estimates. Based on the actual results of this project, the bank’s management will be able to evaluate other new branch bank proposals in a more knowledgeable manner.
A Framework for International Capital Expenditure Decisions
The capital budgeting decision criteria discussed earlier in this chapter can also be used to evaluate international capital expenditure projects. To illustrate, suppose McCormick & Company, a U.S. spice company based in Maryland, is considering expanding its German spice operations.
The company plans to invest $5 million in additional German facilities. Based on this level of investment, McCormick estimates that it proposed German expansion project will generate annual net cash inflows of 1.5 million euros for a period of 10 years and nothing thereafter. Also, based upon its analysis of present German capital market conditions, McCormick has determined that the applicable German cost of capital, k, for the expansion project is 15 percent.The present value of the expected net cash flows from the project, denominated in the foreign currency, is calculated as follows:
Using Equation a present value of approximately 7.53 million euros is obtained for the net cash flows of McCormick’s proposed German expansion:
The present value of the project’s net cash flows from the foreign viewpoint, PVNCFf , is used to calculate the present value of the project’s net cash flows to the parent company in the home country, PVNCFh, as follows:
where S0 is the spot exchange rate expressed in units of home country currency per unit of foreign currency. Using a spot exchange rate of $0.80 per euro, the present value of the net cash flows to the parent company for McCormick’s proposed expansion project is approximately $6.024 million.
PVNCFh = 7.53 million euros _ $0.80/euro = $6.024 million
The project’s net present value is calculated by subtracting the parent company’s net investment in the project from PVNCFh, the parent company’s present value of the net cash flows:
A net present value of approximately $1.024 million is obtained for the McCormick project.
NPV = $6.024 million – $5.0 million = $1.024 million
Based on this analysis, McCormick’s proposed German expansion is an acceptable project.
The McCormick example assumes that an efficient capital market exists in the foreign country, as it does in Germany and other developed countries. Assets can be bought and sold and the required rates of return for projects can be determined from prices of other comparable assets in the foreign capital market.
The McCormick example also assumes that the amount and timing of the expected net cash flows to the foreign subsidiary are the same as for the parent company. If the amount and timing of the net cash inflows to the foreign subsidiary and the parent company are not the same, the evaluation of the capital expenditure project is more complex than the example presented in this section. Some of the reasons that the amount and timing of the net cash flows to the foreign subsidiary and parent may differ include the following:
Differential tax rates for foreign and domestic companies in the country in which the project is planned
Legal and political constraints on cash remittances from the foreign country to the home country
The example presented in this section shows that the present value of a project’s net cash flows to the parent company is simply the present value of the project’s net cash flows from the foreign viewpoint converted into the home country currency at the current spot exchange rate.
Inflation and Capital Expenditures
During inflationary periods, the level of capital expenditures made by firms tends to decrease. For example, suppose the Apple Manufacturing Company has an investment opportunity that is expected to generate 10 years of cash inflows of $300,000 per year. The net investment is $2,000,000. If the company’s cost of capital is relatively low—say, 7 percent—the net present value is positive:
According to the net present value decision rule, this project is acceptable. Suppose, however, that inflation expectations increase and the overall cost of the firm’s capital rises to say, 10 percent. The net present value of the project then would be negative:
Under these conditions, the project would not be acceptable. The example assumes that expected cash inflows are not affected by inflation.Admittedly, project revenues usually will increase with rising inflation, but so will expenses. As a result, it is somewhat difficult to generalize about net cash inflows. Past experience, however, seems to indicate that cash flow increases often are not sufficient to offset the increased cost of capital. Thus, capital expenditure levels tend to be lower (in real terms) during periods of relatively high inflation than during low inflation times.
Fortunately, it is quite easy to adjust the capital budgeting procedure to take inflationary effects into account. The cost of capital already includes the effects of expected inflation. As the expected future inflation rate increases, the cost of capital also tends to increase. Thus, the financial manager has to estimate future cash flows (revenues and expenses) that reflect the expected inflationary rate.
For example, if prices are expected to increase at a rate of 5 percent per year over the life of a project, the revenue estimates made for the project should reflect this rising price trend.Cost or expense estimates also should be adjusted to reflect anticipated inflationary increases, such as labor wage rate increases and raw material price increases. If these steps are taken, the capital budgeting procedure outlined in this and the preceding chapter will assist the financial manager even in an inflationary environment.
The capital budgeting techniques discussed in this chapter are appropriate for use when evaluating proposed investment projects in both small, or entrepreneurial, and large firms. Conceptually, there is no difference between the value-maximizing capital investment techniques used by large and entrepreneurial firms. In practice, however, there are often significant differences between the capital budgeting procedures used by entrepreneurial firms and larger firms.
As we have seen, larger firms tend to use the net present value and the internal rate of return approaches to evaluate proposed capital expenditures. A study by Runyon of firms with a net worth under $1 million found that nearly 70 percent used payback or another technically incorrect procedure, such as the accounting rate of return, to evaluate capital expenditures. a Several of the firms surveyed reported that they performed no formal analysis of proposed capital expenditures. Several reasons have been advanced to explain the dramatic differences in the practice of capital expenditure analysis between large and entrepreneurial firms.
First, many entrepreneurs may simply lack the expertise needed to implement formal analysis procedures. Or managerial talent may tend to be stretched to its limits in many entrepreneurial firms, such that the managers simply cannot find the time to implement better project evaluation techniques. Also, one must recognize that implementing and maintaining a sophisticated capital budgeting system is expensive. Large fixed costs are associated with putting a formal system in place, and continuing costs are associated with collecting the data necessary for the system to function effectively. In entrepreneurial firms, investment projects tend to be small, and they may not justify the cost of a complete, formal analysis.
The emphasis on the use of payback techniques by entrepreneurial firms may also reflect the critical cash shortages that face many small and rapidly expanding firms. Because of their limited access to the capital markets for additional funds, these firms may be more concerned with the speed of cash generation from a project than with the profitability of the project. Regardless of these impediments to the use of valuemaximizing capital budgeting techniques, entrepreneurs have an excellent opportunity to improve their competitive position by implementing effective managerial control techniques. Entrepreneurs who rely on incorrect techniques, such as payback, to make their project accept –reject decisions are more likely to make poor investment decisions than managers who analyze their investment projects correctly.
Real Options in Capital Budgeting16
In our discussion of capital budgeting, we have used so -called conventional discounted cash flow techniques; that is, we determine a project’s net present value by discounting the expected net cash flows at an applicable cost of capital, minus the net investment. This type of analysis does not consider the value of any operating (real) options that may be embedded in the project or the value of any options, or flexibilities, that the firm may choose to incorporate into the project’s design. An option gives its holder the right, but not the obligation, to buy, sell, or otherwise transform an asset at a set price during a specified time period.
Classification of Real Options in Capital Budgeting
Real options in capital budgeting can be classified in the following manner.
Investment Timing Options
Delaying investment in a project, say for a year or so, may allow a firm to evaluate additional information regarding demand for outputs and costs of inputs, for example. Investing in a project today or waiting one year to invest in the same project is an example of two mutually exclusive projects. In this example, the firm should select the project with the higher net present value, assuming at least one project has a positive net present value. The “waiting-to-invest” option is a common real option.
The option to discontinue a project is an important real option in capital budgeting. A project may be discontinued either by shutting it down completely and selling the equipment or by switching its use to an alternative product. To illustrate how an abandonment option may influence the net present value of a project, consider a manufacturing firm that calculates a negative net present value on a proposed project to purchase a new lathe to make a series of industrial parts for a particular application.
The project’s negative net present value is based on a cash flow analysis that assumes that the lathe will produce the parts for the entire economic life of the project. This cash flow analysis does not take into consideration the option of the company to abandon the project and sell the lathe in the active secondary market that exists for lathes and other manufacturing equipment. Shutting down the project represents a put option to sell the project for the salvage value of equipment. Or the company could simply choose to switch from making the specific parts to another potentially more profitable product. The abandonment option is embedded in the project; its existence may limit the downside risk of the project.
The Use of Shareholder Resources
Managers are employed by the owners of a firm with the objective of maximizing wealth for the shareholders. As we have learned, this objective can be accomplished by investing in the set of projects possessing the maximum expected net present value. As discussed in Chapter , the managers of some firms, such as Berkshire Hathaway, have focused intently on this objective and have had good success in achieving their objective. Other managers, however, seem to have strayed frequently from this objective.
Investing in projects with negative net present values is most likely to occur in firms possessing large discretionary cash flows. Usually these are firms in mature industries with few true growth opportunities. Mature firms tend to generate substantial cash flows over which managers have considerable control. Marginal projects may be accepted, often with little analysis, because of their “strategic” importance to the firm. Managers may be reluctant to pay these “excess” cash flows out to shareholders as increased dividends because that will cause the firm to grow at a slower rate in the future. Stern Stewart’s Performance 1000 is a corporate performance measuring system designed to consider how effective managers have been in adding to their shareholders’ investment.
Their “Market Value Added” (MVA) measure can be viewed as the “net present value of all of a company’s past and projected capital investment projects.” For example, as shown in Table, Coca-Cola has an MVA of more than $82 billion; Merck has about $107 billion in MVA; and General Electric has more than $222 billion of MVA. In contrast,AT&T has an MVA of over $–72 billion and General Motors has an MVA of nearly $–16 billion. What factors might cause managers to consistently adopt investment projects with negative net present values? What are the consequences of these decisions for shareholders? What are the consequences of these decisions for the U.S. economy?
A firm may have the option of temporarily shutting down a project in order to avoid negative cash flows. Consider a mining or manufacturing operation characterized by relatively high variable costs. If output prices drop below variable costs, a business has the option to shut down until output prices recover and rise above variable costs. The shutdown option also reduces the downside risk of a project.
A firm may have an opportunity to undertake a research program, build a small manufacturing facility to serve a new market, or make a small strategic acquisition in a new line of business. Each of these examples may be a negative net present value project, but each project can be viewed as having generated a growth option for the company which, if exercised, may lead ultimately to a large positive net present value project.
To illustrate a growth option, suppose a company is considering a large Internet investment project that has the potential for either failure, i.e., large losses with a high probability of occurrence, or success, i.e., large profits with a low probability of occurrence. The investment consists of two stages. The first stage (today) is an investment in a Web site and the second stage (one year from today) is an investment in an electronic commerce venture. The investment in the Web site has an NPV of $–10 million. Setting up the Web site (first stage) gives the company the option, but not the obligation, to invest in the electronic commerce business (second stage) one year from today. While the cash flows are highly uncertain, ranging from large losses to substantial profits, the best estimate today is that the electronic commerce business has an NPV of $–60 million.
Based on the NPV decision rule, the Internet investment project would be unacceptable since it has an NPV of $–70 million [–$10 million + ($–60 million)]. However, one year from today, the company will have more information and be better able to estimate whether the electronic commerce business (second stage) is worth pursuing. At that time, suppose new information about the cash flows of the electronic commerce venture shows that it will be extremely profitable, yielding an overall NPV of $200 million for the Internet project.
Clearly, the project would be worth undertaking at that time. Investing in the Web site today, even though it has a negative NPV, preserves the company’s ption to invest in a positive NPV project in the future. By investing only in the Web site initially, the company is able to limit its downside risk ($–10 million NPV) while preserving the upside potential ($200 million NPV) for the Internet investment project.
In addition to options that can occur naturally in projects, managers have the opportunity to include options in projects in order to increase net present value. These designed -in options are classified either as input flexibility options, output flexibility options, or expansion options.
Input flexibility options allow a firm to design into a project the capability of switching between alternative inputs because of input cost differences. To illustrate a designed-in option, consider an electric power plant project that is evaluating whether to use a gas burner or an oil burner to fire the turbines. The designed -in option in this instance would be a flexible dual -fuel boiler that can switch back and forth between gas and oil, depending on which energy source is cheaper to acquire and use. It may be, under certain conditions, that the flexible boiler project has a higher net present value than either of the projects using the gas -fired boiler or the oil-fired boiler, even though the initial cost of the flexible boiler is higher than the cost of either of the two single-fuel boilers.
In other words, the value of the designed-in option may be greater than the additional cost of the flexible boiler. Output flexibility options allow a firm to design into a project the capability of shifting the product mix of the project if demand or relative product prices dictate such a shift. Oil refineries normally have output flexibility options. The investment in manufacturing flexibility by Toyota and Honda, cited in the “Financial Challenge” at the beginning of the chapter, is another example of the use of output flexibility options to increase efficiency and returns. Expansion options give project managers the ability to add future capacity to a project at a relatively low marginal cost.
For example, consider a company that currently needs a manufacturing facility totalling 50,000 square feet. If instead, it builds a facility now with 70,000 square feet of space, the cost to the company to expand by 20,000 square feet in the future may be less than if it has to build a separate 20,000 -square -foot facility later. Even if the need for the additional capacity never materializes, the value of the expansion option may justify the cost of the larger initial facility beforehand, particularly if significant uncertainty about future product demand exists.
While option valuation in actual capital budgeting projects is complicated, financial managers should recognize the presence of options in projects and should consider including designed -in options when possible in planning projects.
Using conventional discounted cash flow analyses in capital budgeting without considering real options often results in a downward-biased estimate of the true value of a project’s net present value. Some operating options, such as an option to expand, may increase a project’s upside potential, while other operating options, such as an option to abandon, may reduce a project’s downside risk.
How Are Real Options Concepts Being Applied?
Real options analysis is being used in different ways by leading companies. Some firms use real options concepts to frame a way of thinking about decision analysis problems involving capital investments. This may be viewed as the foundation level of use of real options concepts. When used as a way of thinking about corporate investment problems, real options analysis increases awareness of the value of the various options that may exist within a project. It also helps managers to recognize that valuable options can be created or destroyed because of the decision actions taken by managers.
When used in this way, real options thinking helps managers to think about risk and uncertainty as assets that can be exploited in a project, rather than negative factors that should be avoided. In addition, real options thinking helps to focus managers on the value of acquiring additional information before making irrevocable investment decisions.
Other firms use real options concepts as an analytical tool. These firms apply formal option pricing models, such as the Black –Scholes model and the binomial option pricing model, to formally value the option characteristics of investment projects. More complex models are also being used by a growing number of firms to value the option characteristics of investment projects. Some firms that have used real options approaches when analyzing various investment project opportunities include
Genentech, which has used the real options approach to value drug development projects.
Intel has used the real options approach to value investments in flexible manufacturing facilities.
ChevronTexaco has used the real options approach to value oil and gas development projects.
A large amount of advanced work on real options has been done and more is being done Financial managers should attempt to incorporate options analyses in project evaluations whenever possible.