Topic 1

Basic Framework of
Capital Budgeting

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 References

To prepare this course, I relied a lot on:

Pamela P. Peterson and Frank J. Fabozzi, Capital Budgeting: Theory and Practice, John
Wiley & Sons, 2002

Peter Lustig, W. Sean Cleary and Bernhard H. Schwab, Finance in a Canadian Setting,
6th edition, John Wiley & Sons, 2001

Carmel De Nahlik and Frank J. Fabozzi, Project Financing: Analyzing and Structuring,
World Scientific, 2021

Stephen A. Ross, Randolph W. Westerfield, Jeffrey F. Jaffe and Gordon S. Roberts,

Corporate finance, 8th Canadian Edition, McGraw-Hill Ryerson, 2019.

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 1 – Investment Decisions

Objective

Financial manager’s objective is to maximize owners’ wealth

Regarding investments, the manager has 3 options

1) no investment, cash flows are completely distributed in dividends
- the entity shrinks over time since it does not even replace its aging assets
2) keep enough cash flows to replace deteriorating assets, pay the rest as dividends
- the entity maintains its level of operations
3) replace deteriorating assets and invest in profitable projects (no dividends)
- the entity will continue to grow

Does option 3 necessarily maximize owners’ wealth?

only if investments provide a return that is higher than what owners could have earned from

investing their dividends elsewhere

manager has a personal incentive to keep CF (larger company ➜ higher salary)

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 1 – Investment Decisions

Objective is to Maximize Shareholders’ Wealth

Board members are elected by shareholders (voting rights):

annual meeting: shareholders elect directors for the next year

see Alimentation Couche-Tard’s Circular (2021, p.iii)

The CEO is appointed by the Board:

who also evaluates his/her performance and approves his annual compensation

the Board may decide to renew the labor contract, to put an end to it, etc.

see ACT’s Circular (2021, p.44)

CEO and Board members have an incentive to work in shareholders’ best interests

This objective ignores social perspective (employees, consumers, citizens, etc.)

models developed in finance favor shareholders

other stakeholders advocate using other means (unions, associations, law, etc.) 4
 1 – Investment Decisions

«Capital» Investment Projects

« Capital » refers to investment in assets expected to produce benefits ≥ one year

« Capital budgeting » is the process of identifying and selecting such investments

A « project » involves a set of assets that are contingent on one another

Ex.: consider adding a new product to our offering

purchase of production equipment, enlarging the building, etc. (long-term assets)

need to increase the inventory (raw material, finished goods)

need to allow more credits to customer (expect an increase in credit sales)

higher cash balance (higher risk of discrepancy between cash outflow and inflow)

Ex.: consider replacing an old equipment with a new equipment

purchase + disposal, inventory may be reduced because more efficient, etc. 5
 1 – Investment Decisions

A Clear Corporate Strategy

It starts with a sound and honest understanding of the entity’s capabilities

the ones it has and needs to protect; the ones it wishes to acquire/develop

Superior returns require superior capabilities (competitive advantage):

assets, financing sources and/or skills that competitors cannot easily replicate

superior returns: returns greater than the mere compensation for risk

perfect competition: returns only compensate for the risk

Superior capabilities provide a solid foundation for successful strategies:

differentiation strategy: to offer something that is not available elsewhere

 enables them to charge a higher price (micro-brewery, Starbuck)

efficiency strategy: offer the same thing as competitors do, but at a lesser price

 enables them to sell larger volumes (grocery stores)

remember that competitive advantages are usually hard to sustain

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 1 – Investment Decisions

Characteristics of Capital Investments

Economic life:
may be finite

 life of an asset, obsolescence, foreseeable entry of a competitor, intent, etc.

indefinite: acquiring a subsidiary, adding a new product line, a new store, etc.

the longer it is ➜ the more important the impact of the time value of money
➜ the more difficult it is to forecast future cash flows (unreliable)

Risk pertaining to the materialization of future cash flows:

inherent risk of the project and the entity’s experience with similar projects

lower risk:

 replacement of assets
 expansion in existing product lines or existing markets
higher risk:

 new products, new markets (competitors reaction?), new technology, etc.

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 1 – Investment Decisions

Characteristics of Capital Investments

Degree of dependence on other projects:

independent project (decision doesn’t reduce/increase acceptance of other project)

mutually exclusive projects (it is one or the other, not both; replacement project)

contingent projects (decision is conditional to the acceptance of another project)

complementary projects (the acceptance of one enhances/hinders another project)

 new product will have a negative impact on the sales of another product

➜ it will condition the way that we analyse a project

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 1 – Investment Decisions

Characteristics of Capital Investments

Scope of the project:

replacing an aging asset by a similar one vs automating the whole assembly line

complex project involves more variables and unknowns

Some projects are costly to undo:

long-term contracts are signed, important penalties, etc.

may be difficult to dispose of the assets acquired

(shares of a private company, luxury hotel in wilderness)

Approval of capital investments:

may be assigned to junior vs senior level manager

may require the approval of the Board

may go through a long process with multiple steps

 replacing a photocopier vs opening a store in a new country

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 1 – Investment Decisions

Examples

 renting vs acquiring a building

 launching a new product, a new store
 continuing a project vs terminating it (store, mine, product, etc.)
 replacing workforce by robotic equipment
 acquiring new equipment to improve the safety of the assembly line
 acquiring new equipment to improve the efficiency of the assembly line
 choosing between equipment A and equipment B
 acquiring an existing business vs creating a new business

The benefits/savings of a desirable project should at least:

 cover operating costs, and
 provide a return that compensates fund providers adequately for their risk

More than one project are desirable?

 choose the one (or a combination) that maximizes shareholder’s wealth

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 2 – Information to Gather

Consider both direct and indirect costs:

new machine? insurance, electricity, space, maintenance, repairs, server, etc.

opportunity cost? vacant land to be used in a project could have been sold

corporate tax consequences

Consider both positive and negative impacts on revenue:

adding an espresso machine? less sales of regular coffee (cannibalization)

Consider non-quantifiable impacts:

impact on public image, creativity, safety, environment, ethical concerns, etc.

government may impose new regulations (Airbnb, Uber, bitcoins, self-driving cars)

Projecting the future is inherently uncertain and entails many hypothesis

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 3 – Evaluation Methods

Best Method: the Net Present Value (NPV)

Step 1: estimate all incremental CF generated over the expected life of the project
Step 2: discount CF for each year back to the present at the required rate of return
Step 3: add the discounted CF
The sum is zero or positive ➜ go
The sum is negative ➜ no go

This method (and other methods) focuses on what is measurable in dollars

qualitative impacts must be discussed and assessed

 positive vs negative impact, low/medium/high impact, etc.

 may be the ultimate deciding factors when competing projects have same NPVs

Other methods seen later in the course

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 3 – Evaluation Methods

A Simplified Example of NPV: Acquisition of a Parking Lot

 initial cost of the parking lot is $425,000

 forecast: annual revenue of $75,000 and costs of $35,000
 the plan is to use the land for 5 years and then sell it (MV estimated at $500,000)
 the required rate is 10%

t0 t1 – t5 t5
Initial cost -425,000
Net operating revenues +40,000
Proceeds from the sale +500,000
PV of operating revenues +151,636 =40,000 x 3.7909
PV of the sale proceeds +310,460 = 500,000 x .62092
NPV (10%) = +37,096

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 4 – Capital Budgeting Process

1) Project selection: based on a first estimation of how projects will affect future CF

2) Project approval: selected projects are refined and revaluated, sent for approval

3) Launching: once approved, someone is put in charge of the project

expenditures for the project are now allowed, periodic reports to supervisor

4) Project tracking by supervisor:

compares revenue, expenses, cost of new assets, etc. to budget approved

at some point, decides if the project continues or is terminated

5) Post-completion audit:
learn and hone forecasting skills for future projects

learn and improve staff competencies, process, control, etc.

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