Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects PDF
Preview Capital Budgeting Valuation: Financial Analysis for Today's Investment Projects
CAPITAL BUDGETING VALUATION The Robert W. Kolb Series in Finance provides a comprehensive view of the field of finance in all of its variety and complexity. The series is projected to include approximately65volumescoveringallmajortopicsandspecializationsinfinance, rangingfrominvestments,tocorporatefinance,tofinancialinstitutions.Eachvol- umeintheKolbSeriesinFinanceconsistsofnewarticlesespeciallywrittenforthe volume. Each volume is edited by a specialist in a particular area of finance, who devel- ops the volume outline and commissions articles by the world’s experts in that particularfieldoffinance.Eachvolumeincludesaneditor’sintroductionandap- proximately thirty articles to fully describe the current state of financial research andpracticeinaparticularareaoffinance. Theessaysineachvolumeareintendedforpracticingfinanceprofessionals,grad- uatestudents,andadvancedundergraduatestudents.Thegoalofeachvolumeis toencapsulatethecurrentstateofknowledgeinaparticularareaoffinancesothat thereadercanquicklyachieveamasteryofthatspecialareaoffinance. Pleasevisitwww.wiley.com/go/kolbseriestolearnaboutrecentandforthcoming titlesintheKolbSeries. CAPITAL BUDGETING VALUATION Financial Analysis for Today’s Investment Projects H. Kent Baker Philip English TheRobertW.KolbSeriesinFinance JohnWiley&Sons,Inc. Copyright(cid:2)c 2011byJohnWiley&Sons.Allrightsreserved. PublishedbyJohnWiley&Sons,Inc.,Hoboken,NewJersey. PublishedsimultaneouslyinCanada. Nopartofthispublicationmaybereproduced,storedinaretrievalsystem,or transmittedinanyformorbyanymeans,electronic,mechanical,photocopying, recording,scanning,orotherwise,exceptaspermittedunderSection107or108ofthe 1976UnitedStatesCopyrightAct,withouteitherthepriorwrittenpermissionofthe Publisher,orauthorizationthroughpaymentoftheappropriateper-copyfeetothe CopyrightClearanceCenter,Inc.,222RosewoodDrive,Danvers,MA01923,(978) 750-8400,fax(978)646-8600,orontheWebatwww.copyright.com.Requeststothe PublisherforpermissionshouldbeaddressedtothePermissionsDepartment,John Wiley&Sons,Inc.,111RiverStreet,Hoboken,NJ07030,(201)748-6011,fax(201) 748-6008,oronlineathttp://www.wiley.com/go/permissions. LimitofLiability/DisclaimerofWarranty:Whilethepublisherandauthorhaveused theirbesteffortsinpreparingthisbook,theymakenorepresentationsorwarrantieswith respecttotheaccuracyorcompletenessofthecontentsofthisbookandspecifically disclaimanyimpliedwarrantiesofmerchantabilityorfitnessforaparticularpurpose.No warrantymaybecreatedorextendedbysalesrepresentativesorwrittensalesmaterials. Theadviceandstrategiescontainedhereinmaynotbesuitableforyoursituation.You shouldconsultwithaprofessionalwhereappropriate.Neitherthepublishernorauthor shallbeliableforanylossofprofitoranyothercommercialdamages,includingbutnot limitedtospecial,incidental,consequential,orotherdamages. Forgeneralinformationonourotherproductsandservicesorfortechnicalsupport, pleasecontactourCustomerCareDepartmentwithintheUnitedStatesat(800)762-2974, outsidetheUnitedStatesat(317)572-3993orfax(317)572-4002. Wileyalsopublishesitsbooksinavarietyofelectronicformats.Somecontentthat appearsinprintmaynotbeavailableinelectronicbooks.Formoreinformationabout Wileyproducts,visitourwebsiteatwww.wiley.com. LibraryofCongressCataloging-in-PublicationData: Baker,H.Kent(HaroldKent),1944- Capitalbudgetingvaluation:financialanalysisfortoday’sinvestmentprojects/ H.KentBakerandPhilipEnglish. p.cm.–(TheRobertW.Kolbseriesinfinance) Includesindex. ISBN978-0-470-56950-4(cloth);ISBN978-1-118-04456-8(ebk); ISBN978-1-118-04454-4(ebk);ISBN978-1-118-04455-1(ebk) 1.Capitalbudget. 2.Capitalinvestments. 3.Valueadded. I.English,Philip. II.Title. HG4028.C4B2852011 658.15’4–dc22 2010049527 PrintedintheUnitedStatesofAmerica 10 9 8 7 6 5 4 3 2 1 Contents Acknowledgments ix 1 CapitalBudgeting:AnOverview 1 H.KentBakerandPhilipEnglish PART I Foundation and Key Concepts 17 2 CorporateStrategyandInvestmentDecisions 19 DanielFerreira 3 CorporateGovernanceandInvestmentDecisions 37 FodilAdjaoud,DorraCharfi,andLamiaChourou PART II Capital Investment Choice 57 4 MeasuringInvestmentValue:FreeCashFlow,NetPresent Value,andEconomicValueAdded 59 TomArnoldandTerryNixon 5 Alternative MethodsofEvaluatingCapitalInvestments 79 TomArnoldandTerryNixon 6 CapitalRationingforCapitalBudgeting 95 AlexanderBru¨ggen 7 AnalyzingForeignInvestments 111 WimWestermanandJohnHenryHall 8 PostcompletionAuditingofCapital Investments 131 JariHuikku v vi Contents 9 CapitalBudgetingTechniquesin Practice:U.S. SurveyEvidence 151 TarunK.MukherjeeandNaseemM.AlRahahleh PART III Project Cash Flows and Inflation 173 10 EstimatingProjectCashFlows 175 KyleMeyerandHalilKiymaz 11 CapitalBudgetingandInflation 197 IgnacioVe´lez-ParejaandJosephTham PART IV Risk and Investment Choice 215 12 BasicRiskAdjustmentTechniquesinCapitalBudgeting 217 JohnH.HallandWimWesterman 13 CapitalBudgetingwithPolitical/CountryRisk 241 YacineBelghitarandEphraimClark 14 RiskManagementinProjectFinance 259 StefanoGattiandStefanoCaselli 15 RiskSimulationConceptsandMethods 279 TomArnoldandDavidNorth PART V Real Options and Project Analysis 299 16 RealOptionsAnalysis:AnIntroduction 301 TomArnoldandBonnieBuchanan 17 ApplicationsofRealOptionsAnalysis 321 TomArnoldandBonnieBuchanan PART VI Estimating the Project Cost of Capital 337 18 CostofCapital:An Introduction 339 OctavianIonici,KennethSmall,andFrankD’Souza 19 UsingtheCapitalAssetPricingModelandArbitrage PricingTheoryinCapitalBudgeting 363 S.DavidYoungandSamirSaadi CONTENTS vii 20 FinancingMixandProjectValuation:Alternative MethodsandPossibleAdjustments 381 AlexPierruandDenisBabusiaux PART VII Special Topics 403 21 CapitalBudgetingforGovernmentEntities 405 DavinaF.Jacobs 22 DecisionMakingUsingBehavioralFinanceforCapital Budgeting 421 YuriBiondiandGiuseppeMarzo 23 MergerandAcquisitionPricing:TheValuation ofSynergy 445 RainerLenz 24 MulticriteriaAnalysisforCapital Budgeting 463 FernandoR.Fernholz AnswerstoDiscussionQuestions 483 Index 507 Acknowledgments CapitalBudgetingValuation—FinancialAnalysisforToday’sInvestmentProjects reflects the involvement both directly and indirectly of many people. A distinguishedgroupofacademicsandpractitionerscontributedtheirsub- stantial talents to writing highly informative and useful chapters. Much of their work, however, relies upon numerous individuals who have contributed to the field of capital budgeting during the past five decades, many of whom are ref- erenced specifically in each chapter. Special thanks go to Meghan Nesmith from American University, who edited the chapters and provided many helpful sug- gestions.ThepublishingteamatJohnWiley&Sons,Inc.,includingEvanBurton, ClaireWesley,EmilieHermanandmanyothers,didafirst-classjobinbringingthe book to final production. We also thank Bob Kolb for including this book in the RobertW.KolbSeriesinFinanceandtheKogodSchoolofBusinessAdministration atAmericanUniversityforprovidingsupport.Finally,wethankLindaBakerwho providednotonlyencouragementbutalsoreviewedpartsofthemanuscript. ix Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects by H. Kent Baker and Philip English Copyright © 2011 John Wiley & Sons CHAPTER1 Capital Budgeting: An Overview H.KENTBAKER UniversityProfessorofFinanceandKogodResearchProfessor, KogodSchoolofBusiness,AmericanUniversity PHILIPENGLISH AssistantProfessorofFinance,KogodSchoolofBusiness,AmericanUniversity INTRODUCTION Capitalbudgetingreferstotheprocessthatmanagersusetomakedecisionsabout whether long-term investments or capital expenditures are worth pursuing by their organizations. In other words, capital budgeting is the process of planning, analyzing, selecting, and managing capital investments. The basic notion is that managersusethecapital,usuallylong-termfunds,raisedbytheirfirmstoinvestin assets(alsocalledcapitalgoods)thatwillenablethefirmtogeneratecashflowsfor atleastseveralyearsintothefuture.Typicalinvestmentsincludereplacementsof existingassetsandexpansionofexistingornewproductlines.Capitalbudgeting is one of the most challenging tasks facing management because it concerns the investmentdecision,whichdealswithallocatingfundsovertimeinordertoachievea firm’sobjectives.Formostcompanies,theinvestmentdecisionhasagreaterimpact onvaluethandoesthefinancingdecision,whichdealswithacquiringneededfunds. However,bothinvestmentandfinancingdecisionsareintertwinedandattheheart offinancialmanagement. Capital budgeting has a long-term focus that provides a link to an organi- zation’s strategic plan, which specifies how an organization expects to accom- plish long-term strategic goals. Many capital investments require a substantial commitment of a firm’s resources that directly affect firm performance, com- petitive position, and future direction. Because capital investments often com- mit a large amount of funds for lengthy periods, they are not only difficult or costly to reverse but also difficult to convert to more liquid assets (Migliore and McCracken,2001).Also,errorsincapitalbudgetingcanaffectthefirmoveralong horizon. 1 2 CapitalBudgetingValuation CapitalBudgetingProcess The capital budgeting process is a system of interrelated steps for generating long- terminvestmentproposals;reviewing,analyzing,andselectingthem;andimple- menting and following up on those selected. This process is dynamic because changing factors in an organization’s environment may influence the attractive- ness of current or proposed projects. Although no universal consensus exists on theprocess,BakerandPowell(2005,p.196)viewcapitalbudgetingasasix-stage process: 1. Identify project proposals. Develop and provide preliminary screening of projectproposals. 2. Estimate project cash flows. Identify and estimate the incremental, after-tax cashflowsforaproposedproject. 3. Evaluateprojects.Determinethefinancialviabilityofaprojectbyevaluating theproject’sincrementalafter-taxcashflows. 4. Selectprojects.Choosetheprojectsthatbestmeettheselectioncriteria. 5. Implementprojects.Determinetheorderofimplementation,initiate,andtrack theselectedprojects. 6. Performapostcompletionaudit.Periodicallycomparetheactualcashflowsfor theprojecttothepriorestimatesinthecapitalbudgetingproposal. Allstagesofthecapitalbudgetingprocessareimportant.Thefailuretoprop- erly complete any stage of the capital budgeting process could have detrimental results.Theprocessstartswiththeidentificationofinvestmentopportunitiesand thepreliminaryscreeningofprojectproposals.Withouthavingpotentiallyviable projectsthatmeetthefirm’sstrategicconcerns,theremainderofthecapitalbud- getingprocesswouldbemeaningless. Arguably, the most challenging phase of this process is estimating project cashflowsbecausenolaterstageintheprocesscanfullyovercometheinevitable forecastingerrorsresultingfrommanagersdealingwithanuncertainfuture.Miller (2000,p.128)notesthat“Intherealworld,virtuallyallnumbersareestimates.The problemwithestimates,ofcourse,isthattheyarefrequentlywrong.” Despitetheimportanceofestimatingprojectcashflows,thefinancialliterature tends to emphasize the evaluation and selection stages. Improper valuation can lead to incorrect decisions despite the identification of potentially viable projects and accurate estimation of their cash flows. Although many capital budgeting techniquesareavailableforevaluatingcapitalbudgetingprojects,thebestmethods typically recognize the amount, the time value, and the riskiness of a project’s cashflows. Selecting capital investments involves a unique set of challenges. Allocating fundsamongalternativeinvestmentopportunitiesiscrucialtoafirm’ssuccessand isespeciallyimportantintermsoffinancialconsequences.Capitalassetsrepresent amajorportionofthetotalassetsofmanyfirms.Theselectionstageisparticularly important in the face of limited investment funds, an area of capital budgeting known as capital rationing. While some organizations have sufficient resources availabletofundalldesirableprojects,mostfaceascarcityofcapitalthatenables them to fund some projects but not others. Capital rationing, whether internally
Description:The list of books you might like
