chapter 15 capital budgeting extensions

Chapter 15

CAPITAL BUDGETING : EXTENSIONS

The central theme of economics is the allocation of limited resources to various needs in order to maximize our happiness or satisfaction.

Similarly, in FINANCE the central theme is the allocation of limited capital to various projects in order to maximize our returns.

04/07/23 Capital Budgeting allocates limited capital to maximize our returns

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OUTLINE

• Choice between Projects of Unequal Life

• Interrelationship between Investment and Financing Aspects

• Capital Budgeting under Constraints

• Value of Options

• Sources of Positive NPV

• Qualitative Influences

• Corporate Strategy and Capital Budgeting

• Organisational Considerations

• Capital Budgeting in Public Sector Undertakings


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CHOICE BETWEEN PROJECTS OF UNEQUAL LIFE

Machine A Machine B• Investment Rs.75,000 Rs.50,000• Life 5 years 3 years• Annual operating costs

Rs.12,000 Rs.20,000

Present Value of All Costs

A : 75,000 + 12,000 x PVIFA (5 yrs, 12%) = Rs.118,260

B : 50,000 + 15,000 x PVIFA (3 yrs, 12%) = Rs. 86,030

This comparison is flawed because it overlooks the fact that machine B has a shorter life and has to be replaced earlier


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CHOICE BETWEEN PROJECTS OF UNEQUAL LIFE

For a proper comparison of the two alternatives, that have different lives, we have to convert the present value of costs into a uniform annual equivalent (UAE) figure.

PV of CostUAE =

PVIFAr,n

Machine A : UAE = = 32,804

Machine B : UAE = = 35,816

Since UAE (A) < UAE (B), A is preferable.

118,2603.605

86,0302.402


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INTERRELATIONSHIP BETWEEN INVESTMENT AND FINANCING ASPECTS

Projects tend to differ in their debt capacity and other

features like availability of subsidies. Hence financing and

investment decisions are likely to be interrelated. When

this is so, we must take into account the financing impact

of an investment decision. This may be done by calculating

the adjusted NPV.


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ADJUSTED NPV

Adjusted Base case

NPV NPV

Base case NPV is the NPV under the assumption that the

project is all-equity financed.

= +NPV of financingdecisions associated with the project


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ADJUSTED NPVInvestment : Rs.5 millionNet cash flow : Rs.1 million per year for 8 yearsOpportunity cost of capital : 15 percentCost of issuing equity : 5 percentDebt finance : Rs.2.4 millionInterest rate : 14 percentRepayment period : 8 equal annual instalmentTax rate : 60 percent

Base Case NPV 8- 5,000,000 + = - Rs.512,700

t = 1

1,000,000(1.15)t


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ADJUSTMENT FOR ISSUE COST

Equity finance : Rs.2,600,000

Since issue costs would absorb 5 percent of the gross

proceeds, the firm will have to issue Rs.2,736,842

(Rs.2,600,000/0.95) of equity stock in order to realise a net

amount of Rs.2,600,000. So, issue costs = Rs.136,842.

Adjusted NPV = - Rs.512,700 – Rs.136,842

= - Rs.649,542


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ADJUSTMENT FOR TAX SHIELD ASSOCIATED WITH DEBT

(Rs in '000)

Year Debt outstanding at Interest Tax shield Present value of tax shield the beginning 14% discount rate

1 2400 336 202 177 2 2100 294 176 135 3 1800 252 151 102 4 1500 210 126 75 5 1200 168 101 52 6 900 126 76 34 7 600 84 50 20 8 300 42 25 9

Total 604

Adjusted NPV = Base case NPV – Issue cost + PV of tax shield= - Rs 512,700 – Rs.136,842 + Rs.604,000= - Rs.45,542


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CAPITAL BUDGETING UNDER CONSTRAINTS

FEASIBLE COMBINATIONS APPROACH

1. Define all combinations of projects which are feasible, given the capital budget restrictions and project interdependencies.

2 Choose the feasible combination that has the highest NPV.

Let us find out most desirable feasible combination out of the following with a capital budget constraint of Rs. 3 million: (what will happen if there are 50 projects?)


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FEASIBLE COMBINATIONS APPROACH

Project Outlay NPVA 1,800,000 750,000B 1,500,000 600,000C 1,200,000 500,000D 750,000 360,000E 600,000 300,000


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CAPITAL BUDGETING UNDER CONSTRAINTS LINEAR PROGRAMMING MODEL

n Maximise NPVj Xj j=1 Subject to

m CFjt Xj < Kt (t = 1, 2, …, n)

j=1

0 < Xj < 1

where NPVj = net present value of project j Xj = proportion of project j accepted CFjt = cash outflow required for project j in period t Kt = capital budget available in period t


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More about Linear Programming (LP)• It is possible to: • allow carry forward of cash from one period

to another• Introduce non financial constraints like

availability of material• Even though ideally suited for capital

budgeting problems with limited resources, LP is not used widely as:

1. It assumes all future investments are known2. For truly worthwhile opportunities, capital

may not be a constraint


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Value of Options 1 Identify Options• In real life, two types of options seen:1. An incremental option opens opportunities

(beachhead) to make profitable investments in future e g Vedanta Group

2. A flexibility option gives wider latitude in manufacturing so that it can cope better with unforeseen changes & exploit future profitable opportunities e g design of RIL refineries


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2 Analyze Environmental Uncertainty• In uncertain environment, options are

valuable e g value of flexi raw crude usage at RIL refineries in a highly volatile crude market. Flexibility options more valuable in an uncertain environment

• Often such investments motivated by future uncertainty, not current profitability e g Mittal consolidating steel making capacities around the globe


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REAL OPTIONS

• Investment timing option

• Expansion option

• Growth option

• Shutdown option

• Abandonment option

• Flexibility option


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3 Value the Options• Black-Scholes Options Pricing

Model gives these insights:1. The greater the uncertainty in a

project, the higher the value of options embedded in it

2. The longer the duration of a project, the higher the value of options inherent in it


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Cash flows : 75 Options : 25




HIGH

LOW

LOW HIGH

PROJECT DURATION

Environmental Uncertainty

RELATIVE VALUES OF CASH

FLOWS AND OPTIONS


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SOURCES OF POSITIVE NPV (CEG, MPT)1. Cost advantage• Accumulated experience & comparative edge on the learning curve e

g Hero Honda, Maruti• Monopolistic access to low cost materials e g TISCO• A favorable location e g Rs. 60000 / Nano?2 Economies of scale• Increase in the scale of production (RIL), marketing (Godrej) or

distribution (HUL) leading to a decline in cost per unit. The greater the Capital requirement for economy of scale, the higher the entry barrier

3 Government policy• Govt. Policies that create entry barriers like:• Restrictive licensing e g Reliance Communications• Import restrictions & / or high tariff walls• Environmental controls • Special tax relief's e g SEZ


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SOURCES OF POSITIVE NPV4 Marketing reach• A penetrating marketing reach is an important source of

Competitive Advantage • e g AVON’s worldwide network of 1.2 million independent

sales representatives almost impossible to replicate• Or, HUL’s distribution too costly to replicate

5 Product differentiation• By effective advertising & superior marketing• Exceptional service e g pizza in 20 minutes or free• Innovative product features e g Nokia• High quality and dependability e g Godrej furniture

6 Technological edge• Examples: IBM, XEROX, Dr Reddy’s Labs,

Lakshmi Machine Works


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QUALITATIVE INFLUENCES• Intuition – right hemisphere – judgment, not analysis• Vision – serves as super ordinate goal • Superstition – Astrology – They help relieve anxiety, impart a sense of control, encourage necessary activity• Politics – Internal Political Games• Sponsorship – decision is a bet on the sponsor, his commitment, track record, ability to overcome obstacles, deliver goods• Intangible benefits – like enhancing flexibility, technological capability, improving product attractiveness, bringing a sense of pride, pleasing work environment, raising morale


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Some examples of Vision Statements

IBM Value added leadership positionRIL Integrated, world class capacity

empireHonda No. 1 world producer of best mobikesBajaj Auto Global PlayerITC India InternationalTata Motors Technological competenceBell System Our business is serviceRanbaxy A research based International

Pharmaceutical company


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How to strengthen the Links between Corporate Strategy & Capital Budgeting• Long range planning should precede

capital budgeting• Long Range plans should be formalized

& communicated to all involved in capital budgeting

• Investment proposals should be viewed in the context of the critical premises of Long Range Plans

• Allocate to missions rather than to activities or divisions


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Business Strength

Strong Average Weak

Invest Invest Hold

Invest Hold Divest

Hold Divest Divest

High

Medium

Low

Attractiveness

INDUSTRY

STRATEGY AND CAPITAL ALLOCATION

General Electric’s Stoplight Matrix


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AN APPROACH TO DECISION-MAKING

No Yes Yes No Yes No

Consistency with Strategy ?

Accept Positive NPV ? Reject

Significant Intangibles ?


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ORGANISATIONAL CONSIDERATIONS

• Compatibility with resources – 2

• Controllability – why pilot needed in a plane?

• Executive management endorsement @ LRP,

funds planning, development of budgetary controls


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CAPITAL BUDGETING IN PUBLIC

SECTOR UNDERTAKINGS

• Role of the Public Investment Board (1972) – headed by Secretary, Expenditure + sec’s to Planning Commission, DEA, PM, DPE, Ministry of Industrial Development, & Administrative ministry bringing up the proposal.

• Guidelines Provided by the Government – 1975 – Guidelines for Preparation of Feasibility Repots for

Industrial Projects - 1996 – Planning Commission issued A MANUAL ON FEASIBILITY STUDIES


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SUMMING UP

• For a proper comparison of alternate projects with different lives we have to look at the UAE figure.

• When investment and financing aspects of a project are inter-related, adjusted NPV is defined as:

Base case NPV + NPV of the ‘financing aspects’

• Mathematical programming models are helpful in coping with the problem of capital budgeting under constraints

• There are several options found in capital projects such as investment timing option, expansion option, growth option, shutdown option, abandonment option and flexibility option.


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• The important entry barriers that result in positive NPV projects are as follows: economies of scale, product differentiation, cost advantage, marketing reach, technological edge, and governmental policy.

• Intuition, vision, superstition, politics, project sponsorship, and intangible benefits are key qualitative influences bearing on capital expenditure decisions.

• Since the resource allocation strategy of a firm shapes, guides, and circumscribes individual project decisions, the desirability of a project cannot be assessed without considering the strategy of the firm.

chapter 15 capital budgeting extensions

Documents

marketing

uncertain

product differentiation

capital budgeting

adjusted npv

flexibility

technological

financing