Class 5 (Ch. 10,11-Advanced Capital Budgeting)

Professor Jawad M.
Addoum FIN303: Spring 2013

1
1
Schcc| cf 8u:ine::
/cmini:IrcIicn
Univer:iIy cf Micmi
Advanced Capital
Budgeting
CcrpcrcIe Fincncic| McncgemenI
/::ignec Feccing: & FrcL|em:
Fecc ChcpIer 10 & 11
ln ChcpIer 10 cc:
FrcL|em:: 87, 8, 812, 814, 815, 81, C1, C2, C4 {4
Ih
ec)
ln ChcpIer 11 cc:
Cue:Iicn:/Chc||enging Cue:Iicn:: 2,3,4,,13,18 {4
Ih
ec)
FrcL|em:: /10, 84, 88, 8, 812, C4 {cpIicnc|) {4
Ih
ec)
22
SEE END OF THE LECTURE NOTES FOR ADDITIONAL ASSIGNED PROBLEMS
Professor Jawad M. Addoum FIN303: Spring 2013
2
Lecrning CLjecIive:
ln Ihe:e |ecIure ncIe: ycu wi|| |ecrn Ic cpp|y ccpiIc|
LucgeIing Iechniue: Ic :c|ving prcL|em: IhcI c:k
ycu Ic:
Decice when Ic rep|cce cn c|c piece cf euipmenI wiIh
c new cne
Chcc:e LeIween Iwc mcchine: wiIh cifferenI u:efu| |ive:
DeIermine Ihe cpIimc| rep|ccemenI cyc|e fcr rep|ccing
cn c::eI :uch c: c f|eeI cf ce|ivery Iruck:
Icke inf|cIicn inIc ccccunI in ccpiIc| LucgeIing prcL|em:
Cc|cu|cIe Ihe cpIimc| hcrve:I Iime fcr |iving c::eI:
CpIimc||y inve:I wiIh ccpiIc| rcIicning"
Mcce| cnc vc|ue cpIicn: in mu|Ii-pericc prcjecI:
33
4
NcIcIicn
l=inve:ImenI cuI|cy {ccpiIc| expenciIure)
WC=wcrking ccpiIc|
F=revenue
C=cc:I: {ccIuc| cc:I: :uch c: cc:I: fcr inpuI mcIeric|: cnc
mcinIencnce-ncI ceprecicIicn cr cmcrIizcIicn expen:e:)
D=ceprecicIicn {cnc cmcrIizcIicn)
I=Iime {in pericc:, Iypicc||y yecr:)
I=ccrpcrcIe Icx rcIe
8
I
=Lcck vc|ue cr Icx Lc:i: cI Iime I {when c|ecr Ihe :uL:cripI
i: cfIen |efI cuI)
4
3
5
S
I
=:c|vcge price cI Iime I {when c|ecr Ihe :uL:cripI i: cfIen
|efI cuI)
Lefcre cny vc|ue mecn: chcnge in"
5
Ihe cc:h f|cw: Ic ci:ccunI cI W/CC Ic vc|ue c prcjecI cre:

CF/I:= - l - WC + F - C){1 - I) + ID + S-I{S-8)
Iypicc||y"
- l - WC i: pcic cI Ihe :IcrI cf c prcjecI
F - C){1 - I) + ID i: receivec ecch yecr Ihe prcjecI i: cpercIec
- WC + S-I{S-8) i: reccverec cI Ihe enc cf Ihe finc| yecr cf Ihe prcjecI

4
7
Fcr pc:I/fuIure reference, we ccn c|:c wriIe:
CF/I: = - l - WC + F - C){1 - I) + ID + S-I{S-8)
= - l - WC + EBIT(1 T) + D + S-I{S-8)
where E8lI = Fevenue - Cc:I - DeprecicIicn
cnc fcr cn incremenIc| prcjecI
chcice/rep|ccemenI cnc|y:i::
8
5
/ Iypicc|" Excmp|e
Example: Ihe S.C. Jchn:cn Wcx Ccmpcny i: ccn:icering c
new f|ccr wcx prccucI
/n iniIic| ccpiIc| cuI|cy cf $,000,000 i: reuirec fcr euipmenI
$500,000 fcr ccciIicnc| wcrking ccpiIc| Ic :uppcrI prccucIicn cnc
mcrkeIing
Ihe euipmenI wi|| Le ceprecicIec cn c :IrcighI |ine Lc:i: fcr Icx
purpc:e: Ic c zerc Ierminc| Lcck vc|ue cver 8 yecr:
Ihe euipmenI wi|| hcve, hcwever, cn|y c -yecr u:efu| |ife
Ihe Ierminc| :c|vcge price {S) wi|| Le zerc
Fevenue fcr Ihe fir:I Iwc yecr: wi|| Le $7,000,000 LuI fc|| in re:pcn:e Ic
ccmpeIiIicn Ic $5,000,000 fcr Ihe remcining fcur yecr:
Cc:I: wi|| Le ccn:IcnI $2,000,000 per yecr
Ihe W/CC i: 17 cnc I=357.
Shcu|c SCJ inve:I in Ihe new wcx prccucI
Example: {ccnI.)
D={,000,000-0)8=750,000
ID=0.35{750,000)=22,500
{F-C){1-I)={7,000,000-2,000,000){1-0.35)=3,250,000
I=1&2
{F-C){1-I)={5,000,000-2,000,000){1-0.35)=1,50,000
I=3 Ic
S
-I{S
-8
)=0-{0.35){0-1,500,000)=525,000
8
=,000,000-{750,000)=1,500,000
10
6
11
$ Thousands
/ncIher ccmmcn wcy..
12
$ Thousands
7
Ihe Scme Excmp|e wiIh
M/CFS
Example: Ihe S.C. Jchn:cn Wcx Ccmpcny i: ccn:icering Ihe
:cme f|ccr wcx prccucI
Hcwever, Ihe euipmenI wi|| Le ceprecicIec ccccrcing Ic M/CFS cver
5 yecr:
13
14
The NPV is higher
with MACRS
than Straight-Line
Depreciation.
Why?
8
Fep|ccemenI /nc|y:i::
Mcchine:" wiIh Euc| Live:
Example: Unircyc| i: ccn:icering Ihe rep|ccemenI cf cn c|c
Iire mcnufccIuring mcchine wiIh c new cne
Fcr c rep|ccemenI cnc|y:i:, incremenIc| cc:h f|cw: cre
criIicc|:
15
Old machine:
Furchc:ec 5 yecr: cgc cI c cc:I cf $0,000
Hc: c remcining u:efu| |ife cf 5 yecr:
DeprecicIec Ly Ihe SIrcighI-|ine MeIhcc cver 10 yecr: Ic c
Ierminc| 8cck Vc|ue cf $0
D = {0,000 - 0)10=,000 per yecr
8cck Vc|ue I=0: 0,000 - 5{,000)=$45,000
Sc|e: Frice ncw: $5,000
Sc|e: Frice I=5: $0
1
9
New machine:
Furchc:e Frice cf $150,000 inc|ucing in:Ic||cIicn cc:I:
U:efu| Life cf 5 Yecr:
lncremenIc| Fevenue lncrec:e: $0 per yecr
lncremenIc| Cc:I Scving:: $50,000 per yecr
Sc|e price I=5 i: $10,000
DeprecicIicn: 3-Yecr M/CFS
lf :c|e: cre cnIicipcIec Ic Le unchcngec Ly Ihe purchc:e cf Ihe
new mcchine, :hcu|c Ihe mcchine Le purchc:ec /::ume IhcI
Unircyc|: Icx rcIe i: 347 cnc iI: W/CC ccju:Iec Ic prcjecI ri:k i: 157
17
t =0 CFAT Net Initial Outlay:
18
Price of New Machine I
After-tax Salvage of Old Machine
[S T(S B)] = 65,000 0.34(65,000 45,000)
I + S - T(S - B)]
$150,000
+ $ 58,200
- $91,800
10
1
t=1,2,,5 Operating CFAT Changes:
20
11
t=5 Net Salvage Cash Flow Changes:
21
After-tax Salvage Value of New Machine
[S T(S B)] = 10,000 0.34(10,000 0)
TerminaI VaIue
$6,600
$6,600
Iime|ine cf CF/I:
NFV @157 = $50,04
22
0 1 2 3 4
91,800 46,770 52,890 37,590 33,510
5
29,940
+ 6,600
36,540
RepIace OId Machine!
12
Decicing 8eIween Mcchine:" wiIh
DifferenI Live:
Ihi: ccpiIc| LucgeIing prcL|em c:k: Ihe fincncic| mcncger Ic
chcc:e cmcng prcjecI: wiIh DlFFEFENI |ive:
Example: IhrifIy FrinIer: neec: Ic chcc:e LeIween Iwc
Lrcnc: cf ccpier: fcr iI: :Icre. Ihe Xercx prinIer wcu|c hcve c
u:efu| |ife cf Iwc yecr:: Ihe Kyccerc prinIer wcu|c |c:I fcur
yecr:. lf W/CC {rec|) =107, which i: LeIIer
23
0 1 2 3 4
Xerox: - 100,000
Kyocera: - 100,000
60,000
33,500
60,000
33,500 33,500 33,500
NFV
Kyccerc
> NFV
Xercx
-8uI i: Kyccerc LeIIer
Cant say yet!
Critical: a new printer would be purchased after
the last printers useful life!
24
Xerox Kyocera
Life 2 Years 4 Years
NPV 4,132 6,190
13
Hcw cc ycu cecice LeIween Ihe:e prcjecI:
25
Two Methods can be used to answer this question:
Replacement Chain/Common Life analysis
Equivalent Annual Annuity (EAA) analysis
Fep|ccemenI Chcin/Ccmmcn
Life /pprccch
WiIh Ihe rep|ccemenI chcin cr ccmmcn |ife meIhcc, we
hcve Ic finc c ccmmcn Iime fccIing"
Example (cont.):
Ihe Xercx prinIer |c:I: 2 yecr: cnc Kyccerc |c:I 4 yecr:, :c we
hcve Ic finc Ihe least common multiple cf 2 cnc 4: 4
Sc Ihe prcL|em ccn Le re-cc:I c::
Chcc:e Ihe prcjecI wiIh Ihe highe:I NFV cver c 4-yecr pericc"
2
Compare over a common Iife and take the
Project with the Highest NPV!
Decision RuIe
14
27
The Xerox printer anaIysis with "RepIication"
NPV@10% = $7,547
0 1 2 3 4
- 100,000
- 100,000
60,000
60,000
60,000
- 100,000
- 40,000
60,000
60,000
60,000
60,000
Take the Xerox printer! (RecaII the Kyocera's NPV over four
years = $6,190)
years = $6,190)
/|IerncIive|y, we ccn u:e NFV: :eric||y:
28
years = $6,190)
years = $6,190)
0 1 2 3 4
4,132
3,415
7,547
4,132
10%
Xerox printer anaIysis using NPVs seriaIIy
15
Euivc|enI /nnuc| /nnuiIy {E//)
Finc: Ihe ccn:IcnI cnnuiIy pcymenI whc:e FV i:
euc| Ic Ihe prcjecI: NFV cver iI: criginc| |ife
E// i: :imp|y Ihe |eve| cnnuiIy IhcI wcu|c mcke
Ihe firm incifferenI LeIween c ccn:IcnI cc:h f|cw
cnc Ihe {irregu|cr) cc:h f|cw: cf Ihe ccIuc| prcjecI"
2
Denominator is
PVAF
r,T
8cIh Ihe E// cnc Ihe Fep|ccemenI Chcining
meIhcc: give Ihe :cme ceci:icn
Hcwever, iI i: cfIen infec:iL|e Ic u:e Ihe chcining meIhcc:
fcr excmp|e, ccn:icer Ihe chcice LeIween prcjecI: wiIh
17- cnc 1-yecr u:efu| |ive:
Ihe E// cpprccch i: :Icnccrc
Di:cu::icn: Hcw cce: E// cccre:: Ihe reuiremenI
fcr c ccmpcri:cn cver c ccmmcn |ife
30
Choose the project with
the highest EAA
Decision RuIe
16
Example (cont.):
E//
Xercx
> E//
Kyccerc
Fick Ihe Xercx prinIerl
31
EAA Calculator Solution
FrcjecI Xercx
FV = Fcw NFV = $4,132
FV = 0
N = prcjecI |ife = 2
l = 107
FMI =
E//
Xercx
= $2,381
FrcjecI Kyccerc
FV = Fcw NFV= $,10
FV = 0
N = 4
l = 107
FMI =
E//
Kyccerc
= $1,53
Technical Note: Always do EAA Analysis in REAL DOLLARS with
the REAL WACC RATE
17
Decicing 8eIween Mcchine:"
wiIh DifferenI Live: cn Cc:I
Ihi: ccpiIc| LucgeIing prcL|em c:k: Ihe fincncic| mcncger Ic
chcc:e LeIween Iype: cf euipmenI IhcI perfcrm Ihe
lDENIlC/L I/SK cr mcke Ihe lDENIlC/L FFCDUCI LuI hcve
DlFFEFENI LlVES
Fevenue: cnc LenefiI: cre Iherefcre icenIicc|. Cc:I: cnc
ceprecicIicn expen:e: cre ncIl
We ccn ccmpcre Ihe inve:ImenI: ignoring revenues (more
generally, just evaluate the investment on cash flows that differ
among projects)
33
Two Methods can be used to answer this question:
Replacement Chain/Common Life analysis
Equivalent Annual Cost (EAC) analysis
/: wiIh E//, LcIh Ihe E/C cnc Ihe Fep|ccemenI
Chcining meIhcc: give Ihe :cme ceci:icn
/: wiIh Lefcre, iI i: cfIen infec:iL|e Ic u:e Ihe chcining
meIhcc: fcr excmp|e, ccn:icer Ihe chcice LeIween
prcjecI: wiIh 17- cnc 1-yecr u:efu| |ive:
Ihe E/C cpprccch i: :Icnccrc
Di:cu::icn: Hcw cce: E// cccre:: Ihe reuiremenI
fcr c ccmpcri:cn cver c ccmmcn |ife
34
18
Example: MighIy Fine Fizzc mu:I chcc:e LeIween
Iwc mcce|: cf ccr: fcr iI: ce|ivery pizzc criver:. Ihe
/:Icn cnc 8enI|ey ccr: genercIe Ihe icenIicc|
revenue:-Ihey ccn ce|iver Ihe :cme pizzc:-LuI
ciffer in cc:I:. LeI: c::ume Ihe {rec|) W/CC i: 107:
35
Cash FIows
Aston -20,000 -5,000 -5,000 -5,000
BentIey -15,000 -7,000 -7,000
0 1 2 3
3
Aston BentIey
Life 3 Years 2 Years
PV(Cost) 32,434 27,149
19
Fep|ccemenI Chcin
/pprccch
Ihe rep|ccemenI chcin cr ccmmcn |ife meIhcc
prcceec: c: wiIh E//. We :imp|y hcve Ic finc c
ccmmcn Iime fccIing"
Ihe /:Icn |c:I: 3 yecr: cnc Ihe 8enI|ey 2 yecr:, :c we hcve
Ic finc Ihe least common multiple cf 2 cnc 3: 6
Sc Ihe prcL|em ccn Le re-cc:I c::
Chcc:e Ihe ccr wiIh Ihe |cwer FV{Cc:I) cver -yecr:"
37
Comparing over a common Iife, take
the Project with the Lower PV(Cost)
Decision RuIe
LeI: u:e FV: :eric||y:
FV{Cc:I)
/:Icn
<FV{Cc:I)
8enI|ey
Chcc:e Ihe /:Icnl
38
20
Euivc|enI /nnuc| Cc:I {E/C)
3
Choose the project with
the Iowest EAC
Decision RuIe
Example (cont.):
E/C
/:Icn
<E/C
8enI|ey
Chcc:e Ihe /:Icnl
40
21
EAC Calculator Solution
FrcjecI /:Icn
FV = Fcw FV = -$32,434
FV = 0
N = prcjecI |ife = 3
l = 107
FMI =
E/C
/:Icn
= $13,042
FrcjecI 8enI|ey
FV = Fcw FV= -$27,149
FV = 0
N = 2
l = 107
FMI =
E/C
8enI|ey
= $15,643
Technical Note: Always do EAC Analysis in REAL DOLLARS with
the REAL WACC RATE
42
When implemented for a more complete problem, an EAC
analysis is really just a standard NPV calculationwith
revenues left outfollowed by an annuitization of that NPV
22
CpIimc| Fep|ccemenI Cyc|e:
Managers of firms make two broad types of capital
investment decisions:
1. Expcn:icn inve:ImenI: in new p|cnI & euipmenI fcr new
ccIiviIie: cnc cpercIicn:
ChcrccIerizec Ly |crge iniIic| cuI|cy: fc||cwec Ly c :Irecm cf ri:ky
cc:h f|cw:
2. Fep|ccemenI inve:ImenI: Ic keep exi:Iing p|cnI &
euipmenI cpercIicnc|
Deci:icn: c: Ic when i: Ihe Le:I Iime Ic rep|cce c ceIericrcIing c::eI
wiIh new cne
Fep|ccemenI inve:ImenI cc||cr: Iypicc||y exceec expcn:icn
inve:ImenI cc||cr: Ly c wice mcrgin
43
Optimal Replacement Cycles: This type of capital
budgeting problem asks the financial manager to
decide how often to replace a machine with an
IDENTICAL machine
Mcchine: wecr cver Iime cnc neec mcre mcinIencnce
c: Ihey cge. EvenIuc||y Ihey mu:I Le :c|vcgec /
ci:ccrcec
Keeping in minc Ihe purchc:e price cf new euipmenI,
hcw cc we mcke ceci:icn: cLcuI cpIimc| rep|ccemenI
cyc|e:
44
CaIcuIate EquivaIent AnnuaI Cost for
each possibIe cycIe & repIace at the
cycIe with the Iowest EAC
Decision RuIe
23
Example: Gui|cer Irucking, lnc. cwn: c f|eeI cf
Iruck: IhcI i: u:e: fcr ccnIrccI hcu|ing cf mcrL|e
frcm c |ccc| ucrry Ic c mc:cnry fcr cuIIing,
pc|i:hing, eIc.
Mr. Gui|cer hc: ccrrecI|y cL:ervec IhcI up Ihrcugh 4 yecr:
Ihe Iruck: cpercIe we||. After 4 years, however, hi: Iruck:
Legin Ic reuire :uL:IcnIic| mcinIencnce wiIh |crge cirecI
cc:I: in mcn hcur: cnc pcrI:
Mcrecver, Ihe Iime in Ihe repcir :hcp cc:I: Gui|cer
Irucking vc|ucL|e Lu:ine:: cppcrIuniIie:
He hire: c |ccc| ccccunIing firm fcr mcncgemenI ccvice
Note: this example will also show us how to calculate the
EAC cash flows in the first place
45
Ihe ccccunIcnI: hcve cc||ecIec Ihe fc||cwing
infcrmcIicn
Cc:I cf c Iruck: $100,000
Cyc|e: Ic ccn:icer: 4-7 yecr:
8cck Life: 5 yecr:
Ierminc| 8cck Vc|ue: $0
DeprecicIicn i: SIrcighI Line: D = {100,000 - 0)/5=20,000
Icx FcIe: I=407
W/CC =107
lf ycu were ccvi:ing Mr. Gui|cer, hcw cfIen wcu|c
ycu reccmmenc IhcI he rep|cce hi: Iruck:
4
24
Schecu|e cf McinIencnce Cc:I: cnc Sc|vcge
Vc|ue::
ln Ihi: excmp|e, mcinIencnce cc:I: cre cn|y incurrec if Ihe
euipmenI i: ncI :c|vcgec IhcI pericc {Ihere i: nc generc|
ru|e cn Ihi:-iI cepenc: cn Ihe prcL|em)
47
D
1
+ D
2
+ D
3
+ D
4
= 80,000
8cck Vc|ue
4
= 100,000 - 80,000 = 20,000
S
4
- I {S
4
- 8
4
) =25,000 - {0.40){25,000 - 20,000)=23,000
48
If Guilder sells the truck,
it does not maintain it
TD=(0.40)(20,000)
=8000
25
NcIe:
E/C cnc|y:i: mcyLe viewec c: E// cnc|y:i: wiIh revenue:
{F) :eI Ic zerc
E/C hc: LcIh cuIf|cw: {-) cnc inf|cw: {+)
E/C {E//) cnc|y:i: invc|ve: Iwc :Iep::
1. Cc|cu|cIe Ihe FV {NFV) fcr c cyc|e
2. /nnuiIize IhcI FV {NFV) cver c cyc|e Ic geI Ihe E/C {E//)
4
50
If Guilder keeps the truck for use in Year 5, it
maintains it at the end of Year 4:
Maintenance(1-T)=18,000(1-0.40)=10,800
26
51
Fully depreciated
52
27
/fIer c|| Ihe mcIh i: ccne, Ihe ceci:icn Leccme:
:imp|y Ic chcc:e Ihe cyc|e wiIh Ihe |cwe:I E/C:
Ihe cpIimc| rep|ccemenI cyc|e i: 5 yecr:l
53
CycIe EAC
4 18,591
5 18,065Lowest EAC
6 18,741
7 19,827
Ncminc| v:. Fec|
It's important to sort out which cash flows are real
and which are nominal
The Fisher Equation relates the real and nominal rates:
Fcr excmp|e, we ccn :c|ve fcr Ihe rec| rcIe:
54
28
Ic :ee why ci:ccunIing ncminc| cc:h f|cw: cI Ihe
ncminc| rcIe i: euivc|enI Ic ci:ccunIing rec| cc:h
f|cw: cI Ihe rec| rcIe, cL:erve IhcI in Ihe cne-
pericc cc:e:
55
Here: Ihe funccmenIc| ru|e:
5
Discount real cash flows at the real
rate and nominal cash flows at the
nominal rate
Be Consistent!
COMPLICATION: If there are different inflation rates for CFAT components (for
example, revenues or costs) and a single nominal WACC (as is the usual case), do a
nominal analysis inflating real cash flows (if necessary) at their respective inflation
rates. Alternatively, deflate nominal cash flows (if necessary) at their respective
inflation rates and discount at the real WACC based on the overall/average inflation
29
Example: Chri:Iicn Dicr i: Ihinking cLcuI Luying c
mcncgrcmming mcchine IhcI wcu|c reuire cn iniIic| cuI|cy
cf $100,000. Ihe mcchine wcu|c Le ceprecicIec Ic c zerc
Lcck vc|ue cver 4 yecr: cn c :IrcighI-|ine Lc:i: :c D=$25,000
ecch yecr. Ihe mcchine wcu|c genercIe cn incremenIc|
increc:e in real revenues and costs :uch IhcI Fec| F Fec|
C= $50,000 ecch yecr. /: Ihe re|evcnI Icx rcIe i: 407, Ihe real
after-tax revenues and costs wcu|c Le {F C){1 I)=$30,000.
/fIer 4 yecr: Ihe mcchine wi|| hcve nc :c|vcge vc|ue.
lnf|cIicn i: 87 per yecr cnc Ihe prcjecI: real required return i:
107
WhcI i: Ihe NFV cf Chri:Iicn Dicr: prcjecI
57
Approach 1: convert all cash flows to real values and
discount at the real required return
DeprecicIicn i: c wriIe-cff Ic fuIure IcxcL|e ncminc| inccme. Iherefcre,
Ihe rec| vc|ue cf fuIure ceprecicIicn Icx :hie|c: i::
58
Time
(t)
NominaI
Deprecation (1+infIation)
t
ReaI
Deprecation
ReaI Tax
ShieId
(T x ReaI D)
1
2
3
4
$25,000
25,000
25,000
25,000
(1.08)
1
(1.08)
2
(1.08)
3
(1.08)
4
$23,148
21,433
19,846
18,376
$9,259
8,573
7,938
7,350
30
5
Approach 2: convert all cash flows to nominal
values and discount at the nominal required return
0
Time
(t)
ReaI
After-tax
Operating Cash
FIow
x (1+infIation)
t
NominaI
After-tax Operating
Cash FIow
1
2
3
4
$30,000
30,000
30,000
30,000
x (1.08)
1
x (1.08)
2
x (1.08)
3
x (1.08)
4
$32,400
34,992
37,791
40,815
31
1
Why a discount rate of 18.8%?
(1+r
nominal
)=(1+r
real
)(1 + inflation)
=(1.10)(1.08)
=1.188
Approach 3: separately discount nominal cash
flows at the nominal required return & real cash
flows at the real required return
2
32
CpIimc| CuI-Iime" fcr cn /::eI
IhcI i: lncrec:ing in Vc|ue
Ccn:icer c prcL|em fccec Ly Ihe Fcper lncu:Iry:
WhcI i: Ihe cpIimc| Iime Ic hcrve:I cn c::eI cnc
Lring iI Ic mcrkeI
Ihi: prcL|em in iI: mcny fcrm: i: c c|c::ic cuI-Iime"
prcL|em. We ccn:icer Ihe cne :hcI cc:e {cnc igncre Ihe
fccI Ihe |cnc wi|| |ike|y Le rep|cnIec)
Ihe c::eI grcw: in :ize, cnc, hence, revenue ri:e: wiIh Iime
CriIicc||y, hcwever, Ihe rate of growth in the asset or the
rate of increase in cash flows is declining with time
3
4
time
Cash FIow
time
Cash FIow
Cash FIow
t
1
t
2
r
1
r
2
33
WhcI i: Ihe cpIimc| cuI Iime in Ihe |c:I grcph
When Ihe cppcrIuniIy cc:I cf ccpiIc| i: r
1
, Ihe cpIimc| cuI
Iime i: I
1
lf Ihe cppcrIuniIy cc:I cf ccpiIc| ri:e: Ic r
2
, Ihe cpIimc| cuI
Iime fc||: Ic I
2
/ ri:e in inIere:I rcIe: :hcrIer prcjecI/inve:ImenI hcrizcn
5
OptimaI
Cut Time (1)
Notes: Match real cash flow growth with real WACC or nominal cash
flow growth with nominal WACC
Let the asset grow untiI the growth
rate just faIIs to WACC:
/n Euivc|enI CpIimc| Iime Ic CuI Fu|e
Grow the asset for the time horizon

that Maximizes NPV
OptimaI
Cut Time (2)
Note: Match real cash flow with real WACC or nominal cash flow with
nominal WACC
34
Example: Ycu cwn 500 ccre: cf IimLer|cnc wiIh ycung
IimLer wcrIh $40,000 if |cggec ncw. Ihi: repre:enI: 1,000
ccrc: cf wccc wcrIh $40 per ccrc neI cf cuIIing cnc hcu|ing
cc:I:. When :hcu|c ycu hcrve:I Ihe |umLer Ycu hcve Ihe
fc||cwing infcrmcIicn:
lnf|cIicn rcIe: 47
Ncminc| W/CC: 7
7
First method in real terms
lI i: impcrIcnI Ic Le ccn:i:IenI wiIh re:pecI Ic ncminc| cnc rec|
cc:h f|cw:
We|| neec Ic ccnverI ncminc| W/CC Ic rec| W/CC:
8
35
LeI: ccmpcre Ihi: rec| W/CC wiIh rec| cc:h f|cw grcwIh
rcIe:-Ihe grcwIh rcIe in Ihe numLer cf ccrc: cf wccc i:
rec||y rec|
End of Year 8 is the

optimal cut time
Ncw |eI: Iry Ihe second method using nominal terms:
70
Timber Grows in $ by multiplying by (1+16%)(1+4%)
Calculator
Solution
FV=84,728
PMT=0
N=4
I=9
PV=?60,023
36
71
72 Maximum NPV is at the end of Year 8:
OptimaI Cut Time is t=8
37
73
Discussion: What critical assumption are we making
about our use of the land? Do we use the land
again? How would that impact our analysis?
CcpiIc| FcIicning
Capital Rationing results when a firm places limits
on the amount of cash available for new
investments by a department, division, or
subsidiary
Why cc firm: rcIicn ccpiIc|
Mc:I ccrpcrcIicn: engcge in ccpiIc| rcIicning
ncIwiIh:Icncing Ihe IhecreIicc| view IhcI /LL pc:iIive NFV
prcjecI: :hcu|c Le uncerIcken
WiIh |crge efficienI ccpiIc| mcrkeI:, inve:Icr: :hcu|c Le
wi||ing Ic :upp|y func: Ic c ccrpcrcIicn Ic func c|| pc:iIive
NFV prcjecI:
/fIer c||, c pc:iIive NFV mecn: IhcI Ihe prcjecI i: ecrning c
rcIe cf reIurn grecIer Ihcn IhcI which wcu|c Le reuirec
Ly inve:Icr: in :imi|cr ri:k c|IerncIive inve:ImenI:
74 74
38
Hcrc FcIicning
Hcrc rcIicning i: cIIriLuIcL|e Ic market
imperfections which |imiI Ihe cLi|iIy cf ccrpcrcIicn:
Ic rci:e func: in Ihe ccpiIc| mcrkeI: cI fcir" price:
Transactions costs c::ccicIec wiIh i::uing :ecuriIie: mcy
|imiI Ihe cmcunI cf func: IhcI c ccrpcrcIicn ccn cnc i:
wi||ing Ic rci:e in Ihe mcrkeI
Ihe:e Ircn:ccIicn: cc:I: inc|uce cirecI f|cIcIicn cc:I: cf
inve:ImenI Lcnker: cnc |cwyer:
{Hcwever, Ihi: crgumenI cn|y cpp|ie: when Ihe firm cce: ncI
hcve :ufficienI inIernc| func: Ic Icke c|| pc:iIive NFV prcjecI:)
lf civi:icnc| mcncger: were re:pcn:iL|e fcr pcying Ihe:e cc:I:,
Iheir ccrrecIec NFV: fcr :cme prcjecI: wcu|c Le negcIive
75 75
Asymmetric information i: c|:c re|evcnI. Ccn:icer Ihi:
|ine cf rec:cning:
lf Ihe mcncger: cre i::uing new :Icck, Ihey mu:I Ihink IhcI
Ihe firm: :Icck i: cvervc|uec :c lm wi||ing Ic pcy |e:: fcr c
new :hcre"
7 7
39
ScfI FcIicning
ScfI rcIicning re:u|I: frcm management and
organizational issues
Career-minded divisional managers-fighIing fcr
ccpiIc| frcm ccrpcrcIe- mcy cver:IcIe Iheir
inve:ImenI cppcrIuniIie: {:eek Ic func negcIive
NFV prcjecI:).cn excmp|e cf cn cgency cc:I"
Ihe ccrpcrcIe CFC mcy impc:e rcIicning cn her civi:icnc|
mcncger: rcIher Ihcn :crIing Ihrcugh ecch prcjecI her:e|f
Ihi: LucgeI ccn:IrcinI Ihen fcrce: civi:icnc| mcncger: Ic pricriIize
in fcvcr cf mcre pc:iIive/|e:: negcIive NFV prcjecI:
77 77
Ihe inve:ImenI ceci:icn mcy invc|ve organizational
costs external to the NPV calculation
/ civi:icnc| mcncger mcy ncI ccn:icer Ihe ccciIicnc|
:Ircin: IhcI rcpic civi:icnc| grcwIh mcy impc:e cn
ccrpcrcIe mcncgemenI
Lcnger hcur: cr cc:I|y recruiIing cf ccciIicnc| mcncgemenI
CcrpcrcIe :uppcrI funcIicn: :uch c: ccccunIing
ln Ihe:e cc:e:, rcIicning prcxie: fcr figuring Ihe:e cc:I: cirecI|y
inIc Ihe NFV cc|cu|cIicn
78 78
40
Hcw Dc We Chcc:e Frcm /mcng Fc:iIive NFV
FrcjecI: When CcpiIc| i: FcIicnec Ihe FrcfiIcLi|iIy
lncex {Fl)
FrcjecI Chcice wiIh CcpiIc|
FcIicning
7 7
DEClSlCN FULE: Fcnk Crcer prcjecI: Lc:ec cn Ihe
FrcfiIcLi|iIy lncex cnc func, in rcnk crcer, Ihc:e wiIhin
LucgeI
Example: Which prcjecI: wcu|c Ihe mcncger
:e|ecI if her LucgeI i: $115,000
80 80
Project InitiaI Cost NPV ProfitabiIity
Index
A 10,000 1,100 1.110
B 20,000 3,600 1.180
C 20,000 800 1.040
D 15,000 1,600 1.107
E 30,000 4,000 1.133
F 39,000 4,200 1.108
G 25,000 1,400 1.056
41
Example (cont.): Fcnk Crcer Ihe prcjecI: Lc:ec
cn Ihe FrcfiIcLi|iIy lncex cnc mcke :e|ecIicn
:euenIic||y:
81 81
Index
Cum. OutIay
B 20,000 3,600 1.180 20,000
E 30,000 4,000 1.133 50,000
A 10,000 1,100 1.110 60,000
D 15,000 1,600 1.107 75,000
F 40,000 4,200 1.105 115,000
G 25,000 1,400 1.056 140,000
C 20,000 800 1.040 160,000
The answer is choose: B, E, A, D, & F
Ihere cre |imiIcIicn: hcwever..
Simple Example:
/ firm hc: $1M exactly cnc Iwc prcjecI:
FrcjecI 1 cc:I: ju:I $100 cnc hc: cn NFV cf $100 imp|ying
Fl=1+100/100=2
FrcjecI 2 cc:I: Ihe fu|| $1M cnc hc: cn NFV cf $500,000 imp|ying
Fl = 1 + 500,000/1,000,000 = 1.5
Which prcjecI wcu|c ycu Icke {FememLer, ycu hcve ju:I $1M
even)
82 82
What is the reason for this effect? Hint: Think back to one of the
reasons that IRR fails in a similar circumstance
42
Previous Example (revisited.):
WhcI if Ihe LucgeI i: $100,000
Answer is NOT to select B, E, A, D, G
8, E, /, F hc: c higher IcIc| NFV Ly 4,200-1,00-1,400=1,200l
83 83
Index
Cum. OutIay
B 20,000 3,600 1.180 20,000
E 30,000 4,000 1.133 50,000
A 10,000 1,100 1.110 60,000
D 15,000 1,600 1.107 75,000
F 40,000 4,200 1.105 115,000
G 25,000 1,400 1.056 140,000
C 20,000 800 1.040 160,000
Issue: If ALL the budget cannot be exactly invested
in rank order, the technique fails!!
Solution: Calculate the sum total of the NPVs for all
affordable project combinations and choose the
combination with the highest sum total NPV
84
43
Why /re CpIicn: in FrcjecI:
Vc|ucL|e
If a firm recognizes options as part of an investment
opportunity, the additional flexibility can materially
affect the firms investment decision!
85 85
A Nearly Universal Example: Ccn:icer c :imp|e
re:IcurcnI which reuire: c $100,000 inve:ImenI
cnc prccuce: fcur cc:h f|cw: cf -25,000 wiIh
prcLcLi|iIy cr +75,000 wiIh prcLcLi|iIy
8
44
Duh, dont you stop doing something if youre losing money??
Ihi: cpIicn i: wcrIh 7,507-{-20,753) =28,20 LuI cc:I:
ncIhing
87
Recognizing the option to
abandon makes this project
feasible!
Iype: cf Fec| CpIicn:
CpIicn: Ic /Lcnccn
Ihe righI Ic IermincIe cpercIicn: cnc :e|| prccucIicn cr F&D ccpcLi|iIie:
CpIicn: Ic Defer / WciI & Lecrn / Fc:Ipcne
Ihe righI Ic cefer Ihe :IcrI cf c prcjecI. Ihe grecIer Ihe uncerIcinIy c: Ic
prcjecI pcycff:, Ihe grecIer Ihe vc|ue cf c ceferrc| cpIicn
CpIicn: Ic Expcnc / Fc||cw-cn
Ihe cpIicn Ic grcw c Lu:ine::, fcr excmp|e, Ly increc:ing prccucIicn
ccpcLi|iIy in re:pcn:e Ic mcrkeI cemcnc cnc inpuI cc:I:
CpIicn: Ic ExIenc
Fcr excmp|e, Ihe cpIicn Ic exIenc c |ec:e cI c pre:pecifiec renIc| rcIe
CpIicn: Ic Vcry CuIpuI / SwiIch FrccucIicn MeIhcc:
Ihe righI Ic :huI ccwn cpercIicn: cnc recpen cI c |cIer Iime
88 88
45
CcpiIc| 8ucgeIing CpIicn:
Fcr c prcjecI,
NPV =Discounted Cash Flow NPV (DCF-NPV)
+ Value of Options Cost of Options
/|Ihcugh iI ccn Le cifficu|I Ic vc|ue ccpiIc|
LucgeIing cpIicn:, Ihey :hcu|c ncI Le igncrecl
8 8
Example: GigcL|cck, lnc. mcy inve:I in c :IcIe-cf-
Ihe-crI infcrmcIicn :y:Iem {lS) IhcI prcmi:e:
pc::iL|e cc:I :cving:. Ihe lS wi|| cc:I $10 M cnc wi||
genercIe eiIher $30 M cr $10 M cnnuc| cc:I:
:cving: wiIh ecch wiIh c 507 prcLcLi|iIy lf Ihe cc:I
cf ccpiIc| cpprcpricIe fcr Ihi: prcjecI i: 107, whcI i:
Ihe NFV cf Ihi: Ircn:ccIicn
0 0
46
GigcL|cck ccu|c c|:c cefer cr pc:Ipcne Ihe
inve:ImenI fcr cne yecr, |eI Ihe lS mcnufccIurer
geI Ihe Lug: cuI cf Ihe :y:Iem {c: iI :e||: Ic iI: cIher
c|ienI:), cnc ceIermine wheIher Ihe Irue :cving:
cre $30 M cr $10 M
WhcI: Ihe NFV cf Ihe ceferrc| :IrcIegy
1 1
GigabIock has an option to postpone !
2
/I I=1, Ihere cre Iwc pc::iLi|iIie::
/I I=0, Ihe NFV cf Ihe prcjecI Leccme::
2
47
CpIicnc|
Ihe cpIicn vc|ue i: Ihe pre:enI vc|ue cf Ihe fcregcne |c:::
Ihe cpIicn cc:I i: Ihe fcregcne :cving: frcm u:e cf Ihe
new :y:Iem fcr yecr 1 |e:: Ihe inIere:I ecrnec cn Ihe
inve:Iec ccpiIc| fcr yecr cne:
NPV = DCF-NPV + Value of Options Cost of Options
= $40M + $27.27M - $3.4M
= $63.64M
3
LimiIcIicn: cf SIcnccrc NFV
Ihe :Icnccrc NFV /pprccch preccmmiI: Ihe firm
Ic Ihe inve:ImenI cnce cnc fcr c||-iI cce:nI
reccgnize IhcI Ihe firm mcy hcve f|exiLi|iIy c: Ihe
prcjecI evc|ve:
/|IerncIive|y, Ihe NFV cpprccch c::ume: IhcI firm:
hc|c rec| c::eI: pc::ive|y
ln rec|iIy, McncgemenI ccn ccc vc|ue Ic rec| c::eI: Ly
re:pcncing Ic chcnging circum:Icnce::
4 4
Inclusion of options recognizes management can amplify
good fortune and mitigate losses through future decisions
48
NFV & Deci:icn Iree:
Cne cirecI exIen:icn Ic Ihe NFV cpprccch IhcI
c||cw: fcr f|exiLi|iIy i: Ihe Deci:icn Iree /pprccch
We u:ec c ceci:icn Iree cpprccch in Ihe GigcL|cck
excmp|e
LeI: cc cncIher excmp|e
5 5
Example: ScienIi:I: cI VegeIrcn, lnc. hcve ceve|cpec c
geneIicc||y mccifiec fcrm cf whecI re:i:IcnI Ic c|| kncwn
pe:I::
Ihe reuirec inve:ImenI Ic Lring Ihe prccucI Ic mcrkeI i:
$1,000M cnc hc: c W/CC cf 107
McncgemenI fee|: Ihere i: c 107 chcnce Ihe whecI wi|| ccu:e
nc envircnmenIc| prcL|em:, cnc Ihe prcjecI wi|| genercIe c
perpeIuiIy cf $250M per yecr cfIer Icxe:
Hcwever, Ihere i: c 07 chcnce envircnmenIc| prcL|em: wi||
re:IricI :c|e: Ic c |imiIec mcrkeI, cnc Ihe prcjecI wi|| genercIe
$75M per yecr
McncgemenI hc: Ihe cpIicn Ic uncerIcke c pi|cI phc:e Ic Ie:I
Ihe whecI in Ihe fie|c cnc |ecrn wheIher envircnmenIc|
prcL|em: wi|| cri:e. Ihe pi|cI wcu|c Le fcr cne yecr cI c cc:I cf
$125M

Vegetron has an option to wait and Iearn with
a piIot phase!
49
WhcI i: Ihe NFV if VegeIrcn igncre: Ihe emLeccec cpIicn
VegeIrcn :imp|y inve:I: L|inc|y-wiIhcuI Ihe Ie:I mcrkeIing infcrmcIicn
7 7
WhcI if Ihe firm Ie:I: Ihe prccucI fir:I
8 8
10%
90%
Vegetron's Decision Tree
50
CpIicnc|
/gcin, Ihi: cnc|y:i: fiI: wiIhin cur fcrmu|c
NPV = DCF-NPV + Value of Options Cost of Options
= - 75M + 204.54M- 118.18M
= 11.36M

Excmp|e: CpIicn Ic Expcnc
Example: G|cxc-We|ccme i: ccn:icering cn inve:ImenI cf $2,500,000
{pcic ncw) in c new re:ecrch iniIicIive Ic fighI HepcIiIi: C. Ihe cirecI
pcycff: frcm Ihi: re:ecrch cre expecIec Ic Le CF/IS cf $200,000 per
yecr in perpeIuiIy :IcrIing cfIer Ihe re:ecrch cnc Iric|: cre
ccmp|eIec {fir:I cc:h f|cw receivec in yecr 2)
ln ccciIicn, Ihere i: c 107 chcnce IhcI Ihi: re:ecrch wcu|c |ecc Ic new
in:ighI: inIc Ihe IrecImenI cnc prevenIicn cf |iver ccncer.
Ihe inve:ImenI fcr Ihi: :eccnc prcjecI wcu|c Le $1,000,000 {pcic in yecr
1). Ihe:e cc:h f|cw: wcu|c Le immen:e, $25,000,000 per yecr in
perpeIuiIy, :IcrIing cfIer ccciIicnc| re:ecrch cnc Iric|: cre ccmp|eIec
{fir:I cc:h f|cw receivec in yecr 3)
/::ume Ihe ri:k-ccju:Iec W/CC i: 157 cnc cn:wer Ihe fc||cwing
ue:Iicn::
WhcI i: Ihe NFV cf Ihe HepcIiIi:-C re:ecrch iniIicIive igncring Ihe cpIicn Ic cpp|y
Ihe re:ecrch Ic fighIing cIher ci:ec:e:
WhcI i: Ihe vc|ue cf Ihe cpIicn Ic cpp|y Ihi: re:ecrch Ic fighIing ccncer
WhcI mi:Icke wcu|c G|cxc-We|ccme mcke if iI igncre: Ihe cpIicn: inherenI Ic iI:
re:ecrch prcjecI:
100 100
51
Excmp|e {CcnI.)
HepcIiIi: C prcjecI cc:h f|cw:
Liver Ccncer cc:h f|cw: wiIh 10% probability:
101 101
0 1 2 3 4 5 6
0
0 1 2 3 4 5 6
0 0
Excmp|e {CcnI.)
NFV cf HepcIiIi: C c|cne:
Vc|ue cf Liver Ccncer CpIicn {FV):
102 102
52
Excmp|e {CcnI.)
NPV = Discounted Cash Flow NPV (DCF-NPV)
+ Value of Options Cost of Options
= -1,340,57.71 + 12,515,437.3 - 0
= 11,174,858.22
Ignoring embedded options can kill an excellent
opportunity for a firm!
103 103
Mcjcr pcinI: Ic rememLer
Kncw hcw Ic cpp|y Ihe Iechniue: cf Ihe:e |ecIure ncIe:
cnc cecice wheIher Ic/hcw Ic:
Fep|cce cn c|c piece cf euipmenI wiIh c new cne when LcIh
piece: cf euipmenI hcve Ihe :cme u:efu| |ive:
Chcc:e LeIween Iwc mcchine: IhcI hcve cifferenI u:efu| |ive:
u:ing rep|ccemenI chcin/ccmmcn |ife cnc|y:i: cr E///E/C
DeIermine Ihe cpIimc| rep|ccemenI cyc|e fcr rep|ccing cn c::eI
:uch c: c f|eeI cf ce|ivery Iruck: u:ing E/C
Icke inf|cIicn inIc ccccunI in ccpiIc| LucgeIing prcL|em:
Cc|cu|cIe Ihe cpIimc| hcrve:I Iime fcr |iving c::eI: :uch c: fcre:I:
CpIimc||y inve:I when c firm impc:e: ccpiIc| rcIicning
Mcce| cnc vc|ue cpIicn: cnc chcnge: in cc:h-f|cw ri:k in mu|Ii-
pericc prcjecI:
104
53
Finc| IhcughI:
Mcncgeric| lncenIive: cnc Ferfcrmcnce Evc|ucIicn
lf mcncger: cre evc|ucIec cnc rewcrcec fcr Iheir perfcrmcnce,
:e|f-inIere:Iec Lehcvicr |ecc: Ic cpIimc| perfcrmcnce fcr Ihe
gccc cf Ihe firm
Fc:I-/uciI:
/ pc:I-cuciI i: c prccecure fcr evc|ucIing Ihe perfcrmcnce cf c
ccpiIc| LucgeIing ceci:icn cfIer iI: imp|emenIcIicn
/LcnccnmenI cpIicn
/cvcnIcge cf hinc:ighI
105 105
/cciIicnc| Hcmewcrk
You own 250 acres of timberland with 1,000 cords of wood. The current price per
cord is $55 per cord, so the value of the timber if sold now is $55,000. The land is
worth 500 per acre for a total land value of $125,000. The nominal cost of capital
is 10% in the timber business and the inflation rate is 4% for the price of timber and
land. Given the following information, when is the optimal cut time for your timber?
Years Growth
1-3 18%
4-6 7.9%
7+ 6%
Timber Growth Rates
54
Sc|uIicn: /cciIicnc| Hcmewcrk

Class 5 (Ch. 10,11-Advanced Capital Budgeting)

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Class 5 (Ch. 10,11-Advanced Capital Budgeting)

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Professor Jawad M.

Addoum FIN303: Spring 2013

Ihe cc:h f|cw: Ic ci:ccunI cI W/CC Ic vc|ue c prcjecI cre:

Professor Jawad M. Addoum FIN303: Spring 2013

Grow the asset for the time horizon

End of Year 8 is the

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