ISBN: 0-03-028931-9
Chapter 13 Other Topics in Capital Budgeting
The last four chapters have focused on capital budgeting. In Chapter 10, we showed how companies estimate the cost of capital. Then, given a set of cash flows and an estimated cost of capital, we described in Chapter 11 several approaches used to evaluate projects. We demonstrated that net present value (NPV) analysis is conceptually the best approach for evaluating projects. Next, Chapter 12 described techniques for estimating a project's cash flows and risk. Finally, in this chapter we discussed some topics that go beyond the simple capital budgeting framework, including the following:
If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis to put the projects on an equal life basis.
The replacement chain (common life) approach is used to adjust for unequal lives. Here we assume that each project can be repeated as many times as necessary to reach a common life. The NPV's over this common life are compared, and the project with the higher common life NPV is chosen.
Investing in a new project often brings with it a potential increase in the firm's future opportunities. Opportunities are, in effect, options (the right but not the obligation to take some future action).
A project may have an option value that is not accounted for in a conventional NPV analysis. Any project that expands the firm's set of opportunities has positive option value.
Opportunities to respond to changing circumstances are called managerial options because they give managers the option to influence the outcome of the project. They are also called strategic options because they are often associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called real options because they involve "real", rather than "financial" assets.
Real options exist when mangers can influence the size and riskiness of a project's cash flows by taking different actions during or at the end of the project's life.
Many projects include a variety of embedded options that can dramatically affect the true NPV. Examples of embedded options include: (1) the option to abandon or shut down the project, (2) the option to accelerate or delay a project, (3) "growth options" that might enable a firm to purchase other profitable future projects, and (4) "flexibility" options that allow a firm to modify its operations over time.
The abandonment option is the ability to abandon a project if the operating cash flows and/or abandonment value turn out to be lower than expected. It reduces the riskiness of a project and increases its value.
An investment timing option involves not only the decision of whether to proceed with a project but also the decision of when to proceed with it. This opportunity to affect a project's timing can dramatically change its estimated value.
Projects whose capital outlays are made in stages over several years are often evaluated using decision trees. Decision trees are also useful for identifying real options, which, in turn, may materially affect a project's true NPV.
If an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible, then the investment is said to contain a growth option.
A flexibility option is the option to modify operations depending on how conditions develop during a project's life, especially the type of output produced or the inputs used.
For planning purposes, managers need to forecast the total dollar amount that will be required to fund the acceptable projects, or the total capital budget for the planning period. They need this information to determine how much capital will have to be raised.
Capital rationing occurs when management places a constraint on the size of the firm's capital budget during a particular period.
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