Published on April 28, 2008
CHAPTER 17: CHAPTER 17 CAPITAL BUDGETING CHAPTER OVERVIEW:: CHAPTER OVERVIEW: I. BASICS OF CAPITAL BUDGETING II. ADJUSTED NET PRESENT VALUE III. POLITICAL RISK ANALYSIS IV. GROWTH OPTIONS AND PROJECT EVALUATION BASICS OF CAPITAL BUDGETING: BASICS OF CAPITAL BUDGETING where I0 = initial cash outlay CFt= net cash flow at t k = cost of capital n = investment horizon BASICS OF CAPITAL BUDGETING: BASICS OF CAPITAL BUDGETING Investment rule: Accept project if NPV > 0. Reject project if NPV < 0. Given the variables, calculation of NPV is easy. What is the hard part of capital budgeting? Incremental, after-tax cash flows.: Incremental, after-tax cash flows. Rule of thumb: Incremental Global Global cash flows = corporate - flow cash flow without with project project Incremental, after-tax cash flows.: 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. Incremental, after-tax cash flows.: 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. ADJUSTED NET PRESENT VALUE: 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) ADJUSTED NET PRESENT VALUE: 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 = ? ADJUSTED NET PRESENT VALUE: 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 ADJUSTED NET PRESENT VALUE: ADJUSTED NET PRESENT VALUE From where does * come? If we have the company’s beta, we just unleverage the company beta. ADJUSTED NET PRESENT VALUE: ADJUSTED NET PRESENT VALUE Find ke and k*. Suppose (rm – rf ) = 9.1%, e = 1.2, the firm’s debt ratio is 40%, the marginal tax rate is 40%, and rf = 3%. REALISM IN CAPITAL BUDGETING: REALISM IN CAPITAL BUDGETING Three Stage Approach -to simplify project evaluation 1. compute subsidiary’s project cash flows 2. evaluate the project to the parent 3. incorporate any indirect effects REALISM IN CAPITAL BUDGETING: 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 REALISM IN CAPITAL BUDGETING: 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 REALISM IN CAPITAL BUDGETING: 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? POLITICAL RISK IN CAPITAL BUDGETING: 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: POLITICAL RISK IN CAPITAL BUDGETING: POLITICAL RISK IN CAPITAL BUDGETING With expropriation: Let p = probability of expropriation (1 - p) = probability of no expropriation POLITICAL RISK IN CAPITAL BUDGETING: 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. REAL OPTIONS: REAL OPTIONS When discussing management of economic exposure we discussed shifting production among a company’s 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. REAL OPTIONS: 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. REAL OPTIONS: 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. REAL OPTIONS: REAL OPTIONS Another example is IDC’s 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. REAL OPTIONS: 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. REAL OPTIONS: REAL OPTIONS Traditional DCF analysis But suppose after paying the $1m (the premium), the firm can choose not to mine the gold. REAL OPTIONS: 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 REAL OPTIONS: 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?