CAPITAL BUDGETING

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CHAPTER 17

• CAPITAL BUDGETING

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CHAPTER OVERVIEW

• I. BASICS OF CAPITAL BUDGETING
• II. ADJUSTED NET PRESENT VALUE
• III. POLITICAL RISK ANALYSIS
• IV. GROWTH OPTIONS AND PROJECT EVALUATION

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BASICS OF CAPITAL BUDGETING

• where I0 initial cash outlay
• CFt net cash flow at t
• k cost of capital
• n investment horizon

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BASICS OF CAPITAL BUDGETING

• Investment rule
• Accept project if NPV gt 0.
• Reject project if NPV lt 0.
• Given the variables, calculation of NPV is easy.
• What is the hard part of capital budgeting?

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Incremental, after-tax cash flows.

• Rule of thumb
• Incremental Global Global
• cash flows corporate - flow
• cash flow without
• with project project

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Incremental, after-tax cash flows.

• Suppose Vancouver Co. exports 50 of its
  production to China. Proposed project is an
  assembly plant in China in a nearly empty
  warehouse they paid 2 million for 5 years ago
  (market value 5 million).
• Suppose that all production of the proposed
  Bejing plant will be used to satisfy the China
  demand thus replacing exports from the Vancouver
  plant.

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Incremental, after-tax cash flows.

• What if Vancouver Co. expects sales in China to
  increase because of the higher exposure from
  producing locally?
• Should the empty warehouse be considered a cost
  of the project? If so, what cost?
• Intangible benefits?
• Better customer service
• Closer to customers meaning better knowledge.
• Suppose Vancouver Co. plans to finance the
  project with 50 debt and the Chinese government
  is offering an interest-free loan.

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ADJUSTED NET PRESENT VALUE

• where k cost of all-equity financing
• Tt tax savings in year t (id ? Dt)
• id before-tax cost of HC debt
• St before-tax HC value of subsidies
• (rate of subsidy x par value loans)

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ADJUSTED NET PRESENT VALUE

• Let
• I0 5 million 7 million (equipment)
• CFt 4 million k 12
• Tt .06 (.40) 6 million 144,000
• St .06 ( 6 million) 360,000
• ANPV ?

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ADJUSTED NET PRESENT VALUE

• From where does k come?
• Capital Asset Pricing Model
• k rf ?(rm rf)
• where rf risk free rate of return
• ? beta associated with the project cash
  flows
• rm required return for market

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ADJUSTED NET PRESENT VALUE

• From where does ? come?
• If we have the companys beta, we just
  unleverage the company beta.

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ADJUSTED NET PRESENT VALUE

• Find ke and k.
• Suppose (rm rf ) 9.1, ?e 1.2, the firms
  debt ratio is 40, the marginal tax rate is 40,
  and rf 3.

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REALISM IN CAPITAL BUDGETING

• Three Stage Approach -to simplify project
  evaluation
• 1. compute subsidiarys project cash flows
• 2. evaluate the project to the parent
• 3. incorporate any indirect effects

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REALISM IN CAPITAL BUDGETING

• International Diesel Corporation is thinking
  about opening a plant in UK.
• NPV from project viewpoint
• NPV -3.2m 1.4m 2.6 m
• 800,000

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REALISM IN CAPITAL BUDGETING

• However, some expenses are cash inflows to the
  parent.
• Parts as production inputs (line D)
• Licensing fees and royalties (line F)
• Dividends (line S)
• Minus cost of paying dividends? (witholding tax)
• NPV 13m 2.4m 2.6m
• 18m

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REALISM IN CAPITAL BUDGETING

• The cumulative NPV is negative until salvage
  value if included at the end of year five.
• What if the political environment changes, i.e.,
  exchange controls, blocked funds, or
  expropriation, before the end of year five?

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POLITICAL RISK IN CAPITAL BUDGETING

• Suppose a firm projects a 5m perpetuity from an
  investment of 20m in Indonesia. If k 20, how
  large does the probability of expropriation in
  year four have to be to make the NPV negative?
• Without expropriation

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POLITICAL RISK IN CAPITAL BUDGETING

• With expropriation
• Let p probability of expropriation
• (1 - p) probability of no expropriation

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POLITICAL RISK IN CAPITAL BUDGETING

• NPV -20m perpetuity of 5m - perpetuity of
  5m(p) starting in year 3
• Set NPV 0 and solve for p.

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REAL OPTIONS

• When discussing management of economic exposure
  we discussed shifting production among a
  companys plants.
• Obviously, the firm needs plants elsewhere in the
  world in order to have this option.
• Discounted cash flow methods are unable to
  account for the value of this option.

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REAL OPTIONS

• There are four types of real options.
• Option to make follow-on investment
• Option to abandon a bad project
• Option to wait before investing
• Option to adjust production levels once project
  has begun.

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REAL OPTIONS

• For example, suppose its 1992 and your company
  writes computer software. The internet is just
  starting out.
• You can spend 10m and become one of the first
  search engine.
• Using current projections over 10 years, the NPV
  -5.6m
• However, the investment allows you to make
  follow-on investments in technology.

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REAL OPTIONS

• Another example is IDCs proposed investment in
  the U.K. Its 12.3m NPV would be substantially
  higher if IDC included the value of the option to
  shift production to the U.K. when the pound
  depreciates.

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REAL OPTIONS

• Suppose it costs 1m to open a gold mine that has
  40,000 ounces of gold that could be mined in one
  year. Variable costs of production are currently
  390.
• The future gold price is unknown, but with p.5
  it is 300 an ounce, and with p.5 the price is
  500 an ounce.

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REAL OPTIONS
Traditional DCF analysis But suppose after
paying the 1m (the premium), the firm can
choose not to mine the gold.
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REAL OPTIONS
With p .5 price is 300 and the firm
chooses not to mine. NPV-1m (the option
premium) With p.5, price is 500 and the firm
mines. Overall NPV .5(2.8m) - .5(-1m)
913,044
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REAL OPTIONS

• By accounting for the option to postpone
  production, the NPV is positive!
• Option value 913,044 - (-652,174)
  1,565,218
• In general, the value of options changes how
• with length of time decision can be delayed?
• with riskiness of the project?
• with the level of interest rates?
• with the projects exclusiveness / value?