Advanced capital budgeting : refinements in the economic analysis of investment projects

386 Pages·2007·7.252 MB·English

by  Smidt, Seymour, Bierman, Harold

Advanced Capital
Budgeting
Refinements in the economic
analysis of investment projects
Harold Bierman, Jr. and
Seymour Smidt
Advanced Capital Budgeting
This book is a companion volume to the author's classic The Capital Budgeting Decision
and explores the complexities of capital budgeting as well as the opportunities to
improve the decision process where risk and time are important elements.
There is a long list of contenders for the next breakthrough for making capital budg­
eting decisions and this book gives in-depth coverage to:
■ Real options. The value of a project must take into consideration the flexibility that
it provides management, acknowledging the option of making decisions in the future
when more information is available. This book emphasizes the need to assign a value
to this flexibility, and how option-pricing theory (also known as contingent claims
analysis) sometimes provides a method for valuing flexibility.
■ Decomposing cash flows. A project consists of many series of cash flows and each
series deserves its own specific risk-adjusted discount rate. Decomposing the cash
flows of an investment highlights the fact that while managers are generally aware
that divisions and projects have different risks, too often they neglect the fact that
the cash flow components may also have different risks, with severe consequences
on the quality of the decision-making.
Designed to assist business decisions at all levels, the emphasis is on the applications of
capital budgeting techniques to a variety of issues. These include the hugely significant
buy versus lease decision which costs corporations billions each year. Current business
decisions also need to be made considering the cross-border implications, and global
business aspects, identifying the specific aspects of international investment decisions,
which appear throughout the book.
Harold Bierman, Jr. is the Nicholas H. Noyes Professor of Business Administration at
the Johnson Graduate School of Management, Cornell University.
Seymour Smidt is Professor Emeritus at the Johnson Graduate School of Management,
Cornell University.
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Advanced
Capital
Budgeting
Refinements in the
economic analysis of
investment projects
Harold Bierman, Jr. and
Seymour Smidt
1} Routledge
!\ Taylor &. Francis Group
First published 2007 by Routlcdge
270 Madison Ave, New York, NY 10016
Simultaneously published in Great Britain
b/y RoutledgOe
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Routlcdge is an imprint of the Taylor Francis Group, an informa business
© 2007 Harold Bierman, Jr. and Seymour Smidt
Typeset in Perpetua and Bell Gothic by Newgen Imaging Systems (P) Ltd, Chennai, India
Printed and bound in Great Britain byTJ International Ltd, Padstow, Cornwall
All rights reserved. No part of this book may be reprinted or reproduced or utilized in
anv form or by anv electronic, mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any information storage or
retrieval system, without permission in writing from the publishers.
Library of Congress Cataloging in Publication Data
Bierman, Harold.
Advanced capital budgeting: refinements in the economic analysis of investment projects /
Harold Bierman, Jr. and Seymour Smidt.
p. cm.
Includes bibliographical references and index.
1. Capital budget. 2. Capital investments — Evaluation. I. Smidt, Seymour. II.Title.
HG4028.C4B537 2006
658.15'4 - dc22 2006019474
British Library Cataloguing in Publication Data
A cataloOgu e record for this book is available from the British LibrarvJ
ISBN 10: 0-415-77205-2 (hbk) ISBN13: 978-0^15-77205-1 (hbk)
ISBN 10: 0 415 77206 0 (pbk) ISBN13:978 0 415 77206 8 (pbk)
Contents
List of illustrations xiii
Preface xvii
PARTI
CAPITAL BUDGETING AND VALUATION UNDER CERTAINTY 1
1 THE STATE OF THE ART OF CAPITAL BUDGETING 3
Decision-making and corporate objectives 3
The evolution of capital budgeting practice 5
Surveys of practice 5
The discount rate 7
Cash flow components 8
The calculation of the discount rate 8
The time risk interaction 8
Real options 9
Three problems 10
Time discounting 10
Present value addition rule 11
Present value multiplication rule 11
The term structure of interest rates 11
Risk and diversification 13
Strategic considerations 14
Three basic generalizations 16
The capital market 16
Global business aspects 17
Conclusions 17
Problems 18
Discussion question 19
Bibliography 19
2 AMOUNTS DISCOUNTED AND DISCOUNT RATES 21
The FCF method 23
The CCF method 24
The adjusted present value method 25
V ■
CONTENTS
Equivalence of the methods 26
The FCF method 27
The CCF calculation: the value to investors 27
Adjusted present value 28
Costs of financial distress 29
The costs of capital 29
The WACC with debt 31
Valuation: a summary 32
With no debt 33
With $600 of debt substituted for stock 33
With debt (use of APV) 34
The use of r* (the CCF method) 34
Calculation of discount rates 35
Finite-lived assets 36
Global business aspects 36
Conclusions 37
Problems 38
Discussion question 39
Bibliography 39
Appendix derivations 39
PART II
CAPITAL BUDGETING AND VALUATION UNDER UNCERTAINTY 41
3 CAPITAL BUDGETING WITH UNCERTAINTY 43
Tree diagrams 43
Period-by-period summaries 46
Sensitivity analysis 46
Simulation 48
Risk preferences 50
Certainty equivalents 52
Time and risk 53
Risk adjusted discount rates 54
The required return 55
Default-free rate of discount 55
The borrowing rate 57
Changing the uncertainty 57
Global business aspects 58
Conclusions 58
Problems 59
Discussion question 60
Bibliography 60
4 ELEMENTS OFTIME AND UNCERTAINTY 62
The investment process 63
The discount rate 66
Converting expected cash flows 68
The discount rate assumption 69
Capital budgeting with constant risk aversion 69
CONTENTS
Capital budgeting with a constant risk adjusted rate 71
A capital market perspective 73
A qualification of the CAPM decision rule 74
Global business aspects 74
Conclusions 74
Quiz 75
Problems 75
Discussion question 76
Solution to quiz 76
Bibliography 77
5 THE STATE PREFERENCE APPROACH 79
Prices with certainty 79
Prices with uncertainty 80
The three factors 82
The expected risk-adjustment 84
Countercyclical assets 84
Required rates of return 85
Application of the risk-adjusted present value approach 86
Multiperiod investments 86
Applying the risk-adjusted present value factors 88
Global business aspects 90
Conclusions 90
Problems 91
Discussion question 93
Bibliography 94
6 RESOLUTION OF UNCERTAINTY 95
Risks, returns and the resolution of uncertainty 95
Introducing the three assets 97
Asset values by node 101
Expected rates of return by asset and node 102
Conclusions about the three assets 104
An alternative calculation 106
Introducing the two projects 107
Global business aspects 108
Generalizations 108
Problems 109
Discussion question 111
Bibliography 111
7 DIVERSIFICATION AND RISK REDUCTION 112
Systematic and unsystematic risk 113
Diversification 114
Introduction to portfolio analysis 115
The portfolio problem in perspective 116
The co-variance 117
The efficient frontier of investment alternatives 120
Perfect positive correlation 120
vii
CONTENTS
Perfect negative correlation 121
Imperfect correlation 122
The power of diversification: independent investments 122
Positively correlated investments 124
Observations regarding diversification 126
The risk-free asset 127
The assumptions 127
Portfolio analysis with a riskless security: the capital asset pricing model 128
The expected return 130
Use of the CAPM 131
Systematic and unsystematic risk 131
Implications for corporate investment policy 133
Unsystematic risk 134
Global business aspects 134
Conclusions 135
Review problem 1 136
Review problem 2 136
Review problem 3 136
Problems 137
Discussion question 140
Solution to review problem 1 140
Solution to review problem 2 141
Solution to review problem 3 141
Bibliography 142
Appendix: Statistical background 143
8 PROJECTS WITH COMPONENTS HAVING DIFFERENT RISKS 145
A new product project with two different cash flow components 146
Calculating the value of an asset by discounting its net cash flow 147
Increasing the proceeds 150
A new market for an old product 150
Disadvantages of using a single discount rate 152
Finding the composite discount rate for projects with a finite life 152
Buy versus lease 154
Discount rates and corporate income taxes 156
The present value calculation technique used 157
Global business aspects 157
Conclusions 158
Problems 158
Discussion question 160
Bibliography 160
Appendix: Derivation of the formula for the after-tax discount rate for
a cash flow component 160
9 PRACTICAL SOLUTIONS TO CAPITAL BUDGETING
WITH UNCERTAINTY 162
The two basic approaches 162
Approach 1: Using payback, present value profile, and sensitivity analysis 163
Approach 2: Calculate the net present value of the expected cash flows 164
CONTENTS
WACC: The weighted average cost of capital 165
The cost of retained earnings 167
Costs of retained earnings and of equity with investor taxes 168
Costs of retained earnings with investor taxes 168
Cost of new equity capital with investor taxes 169
Debt and income taxes 171
The relevant source of funds 171
Global business aspects 172
Computing the firm's weighted average cost of capital 172
Capital structure and the effect on the WACC 173
The optimum capital structure 174
The firm's WACC and investments 175
The project's WACC 177
The pure play 177
Default-free rate of discount 178
Discounting stock equity flows 179
Simulation and the Monte Carlo method 181
Value-at-risk 183
Conclusions 183
Problems 184
Discussion question 185
Bibliography 186
PART III
OPTION THEORY AS A CAPITAL BUDGETING TOOL 187
10 REAL OPTIONS AND CAPITAL BUDGETING 189
Two types of stock options 192
Valuing call options on common stock 193
The value of a call option on common stock: a numerical example 193
Formulas for call option valuation 195
Formulas for composition of the replicating portfolio 196
Certainty equivalent formulas for the value of an option 198
A multi-period call option 199
The replicating portfolio method for a two-period option 199
The certainty equivalent method for a two-period option 201
Number of periods 202
Valuing real options 202
Description and valuation of the underlying asset without flexibility 203
An option to abandon 206
An option to expand 209
Multiple options on the same asset 210
Conclusions 210
Problems 211
Discussion question 211
Bibliography 212
Appendix A: Increasing accuracy by using a large number of short periods 213
Appendix B: Valuation with multiple options on an asset 215
ix ■