BUS 650 Week 2 Work
Chapter 6
Capital Budgeting: Investing to Create Value
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Learning Objectives
A�er studying this chapter, you should be able to:
Describe the significance of corporate investments in crea�ng value. Explain how iden�fying and classifying poten�al projects plays into project selec�on. Es�mate project cash flows. Show how to select independent projects using NPV and IRR. Describe how to select mutually exclusive projects that maximize value. Iden�fy the significance and different types of op�ons and how to adjust for the op�on effect.
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Ch. 6 Introduction
Throughout this text we have stressed the importance of crea�ng value for corporate shareholders. We also indicated that the greatest opportunity for crea�ng value lay in the inves�ng ac�vi�es of companies. In the context of the financial balance sheet, these are le�-hand side ac�vi�es. The poten�al payoffs on successful investments prompt ingenious efforts to develop new products, build exis�ng products at lower cost, improve product quality, and devise new marke�ng strategies. For example, the advent of e- commerce allows small companies to sell products worldwide and large companies to supplement or possibly supplant tradi�onal distribu�on channels. E-commerce has, in turn, spawned companies that design and manage websites, provide Internet services and make encryp�on so�ware.
Some product developments create virtually new industries. Consider the spectacular growth in wireless communica�ons that was made possible by the blending of satellite and digital technologies. In an effort to gain a compe��ve advantage, network providers have expanded their coverage areas, improved transmission quality, added services, and cut prices. Similarly, cell phone manufacturers embrace the latest in digital technology as they vie for market share.
In this chapter, we address the fundamentals of corporate inves�ng. First, we discuss product market opportuni�es created by imperfect compe��on. Next, we develop some guidelines for iden�fying and selec�ng investment opportuni�es. We then examine the investment decision itself, paying special a�en�on to decision criteria and discounted cash flows. Finally, we discuss op�ons that are intrinsic to many corporate investments.
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Shareholders must pay a�en�on to the product market when deciding on investment opportuni�es because compe�tors can
6.1 Corporate Investments and Value Creation
We will draw upon several important ideas covered thus far in the text in our discussion of corporate inves�ng:
It is cash flows, not income or earnings, that measure the success of a business or investment. The value of cash flows depends on when they are paid or received. The effect of �ming on the value of future cash flow is incorporated into the discount rate. The appropriate discount rate is the investors' required rate of return. This required rate of return is a func�on of risk.
Investors buy bonds and stocks that represent claims against future corporate cash flows. Corporate investments must, therefore, generate at least enough cash flow to provide all investors with their required returns. If investments generate less than the required return, the value of the company's securi�es—and, therefore, the value of the company—will decline. Of course, investments are made in the hope that they will produce enough cash to pay off creditors with enough le� over to increase returns to shareholders.
Investing in Fixed Assets
Depending on the industry, much corporate investment is in long-term, or fixed, assets. These assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts). Tradi�onal capital-intensive industries invest in factories that manufacture durable goods, such as metals, chemicals, transporta�on equipment, and machinery. However, virtually all companies, not just manufacturers, have fixed assets. Retailers either own or lease stores. R&D firms have laboratories and patents. Book and music publishers have copyrights and, perhaps, long-term contracts with writers and musicians. One of the best-known assets is the secret formula for Coca-Cola. Whether tangible or intangible, fixed assets are essen�al to the long-run viability of a firm.
Identifying Asset Value: NPV and IRR
The ability to iden�fy which assets are expected to add value to the firm is central to the financial management role. In this chapter, we explore this selec�on process (called capital budge�ng) in some detail. Essen�ally, to iden�fy value-crea�ng projects, businesses use either the net present value (NPV) or internal rate of return (IRR) criteria.
Net present value measures the dollar value added to the firm by the investment. The NPV of an investment is the present value of the future cash flows minus the ini�al investment.
Net present value = Present value of future cash flows – Ini�al investment
NPV directly measures the present value of the cash flows a project is expected to generate. It then compares this value to the project's cost. If the project value is expected to exceed the cost, the project should be pursued.
The IRR criteria compares the IRR (expected return) for a project to the required return for investors, given the project's risk. If the expected return exceeds that requirement, then the project should be pursued.
We will look at the equa�ons for finding NPV and IRR later in this chapter. For now, it is important to know that companies can add value to the business and increase owners' wealth by pursuing posi�ve NPV projects, or project's whose IRR exceeds its required return. With this objec�ve in mind, we will begin our discussion of corporate investments.
Product Market Opportunities
The financial model of the corpora�on is based on the premise that product markets provide valuable investment opportuni�es for firms. Firms that iden�fy and exploit these opportuni�es create value because they do what their shareholders individually cannot do. The search for investment opportuni�es occurs within the overall mission and strategic plan of the corpora�on.
Investment opportuni�es are o�en short-lived because successful products a�ract compe�tors. For example, the success of Starbuck's coffee spawned many purveyors of specialty coffees and espresso, and BlackBerry was supplanted by the iPhone a�er a few years of market dominance.
Compe��on, or the threat of compe��on, means that firms must not only remain alert for new opportuni�es but also try to protect their exis�ng markets. For example, major airlines on occasion have used some�mes illegal predatory pricing to discourage low-cost "no-frills" airlines from serving their hub ci�es. Even seemingly entrenched firms may be vulnerable to compe��on. Before Japanese autos entered the market, the United States was the nearly exclusive turf of the big three American automakers.
Firms have a number of weapons with which to fend off compe�tors. Patents and copyrights protect, for a �me, valuable intellectual property, such as inven�ons, publica�ons, and computer so�ware. Some�mes protec�ng a compe��ve posi�on requires investment. For example, McDonald's a�empted to forestall compe��on by being the first to buy choice restaurant loca�ons. Inves�ng in a modern plant may lower produc�on costs or increase product quality. Some industries invest heavily in promo�on. Athle�c apparel manufacturers engage in a frenzied compe��on to sign hot sports stars to expensive long-term contracts.
Seeking out and successfully pursuing valuable investments places great demands on management. There are many poten�al hazards. Managers may fail to recognize opportuni�es, or they may chase opportuni�es that do
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quickly overshadow a leading product as demonstrated by iPhone's dominance over BlackBerry.
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not exist. For example, a market may appear to be a�rac�ve because it produces extraordinarily high profits. Yet a closer examina�on reveals that exis�ng producers hold patents on key technologies or may control supply sources or distribu�on channels.
When an apparent investment opportunity reveals itself, managers should ask the following ques�ons:
If this is a genuine opportunity, why is there not greater compe��on in this market? Are compe�ng products on the horizon that may reduce market demand? Are there costly barriers to entry? Is the current compe��ve posture likely to remain over the long haul? Are market forces already at work to increase compe��on? Will the corpora�on be able to protect its investment by keeping compe�tors at bay?
Taking reasonable precau�ons should actually encourage inves�ng by making poor investments less likely. Companies that have a record of successful inves�ng may be more aggressive in searching for new opportuni�es than those that have experienced recent or costly failures.
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The compe��ve advantage with a commodity is generally the price. Differen�a�on strategies, such as performance, customer needs, tailoring products, flexibility, and trust also play major roles. What would you say is the differen�a�on strategy for a company like Amazon or Target?
High-end retailers like Neiman Marcus focus on a differen�a�on strategy that emphasizes style, quality, and service.
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6.2 Project Selection
Each firm must develop a compe��ve strategy for exploi�ng market opportuni�es. The most common of these strategies are cost leadership and differen�a�on. Low-cost producers can undercut their compe�tor's prices; Wal-Mart, for example, uses this strategy. On the other hand, a differen�a�on strategy may take many forms. A company may offer higher quality, a func�onally dis�nct product, or be�er service. Among clothing retailers, there are Nordstrom and Neiman Marcus (quality and service) and L. L. Bean (func�onally dis�nct). Differen�a�on frequently prompts large investments in adver�sing. In 1999 CNET, Inc. launched a $100 million ad campaign to promote their technology website, even though the investment would wipe out their posi�ve cash flows. A firm's compe��ve strategy determines where it looks for market opportuni�es. For example, Wal- Mart would not be likely to focus on product quality and service if that jeopardized its posi�on as a cost leader.
A firm's compe��ve strategy guides its strategic planning. These strategic plans are then translated into investments. The process of transla�ng plans into investments begins with iden�fying a set of poten�al projects. This requires the following steps:
Step 1: Iden�fy possible projects that fit into the corporate strategic plan or mission.
Step 2: Classify projects by size and purpose so that management a�en�on can be directed to those that are most important.
Step 3: Eliminate or integrate projects that are in some way dependent on other projects.
Let's look at these more closely.
Compe��ve Strategies
Identifying Potential Projects
Ideally, a company's search for investment opportuni�es would transcend its tradi�onal products and markets. For example, a company doing business in the United States may consider overseas markets. A bank might consider providing computer services. A manufacturer of industrial equipment might also consider making consumer products.
Classifying Projects
Companies o�en find it useful to categorize poten�al projects by their size and the company's experience with such projects. Large projects, with which the company has li�le experience, require careful scru�ny. An example of such a project would be an American company inves�ng for the first �me in a less-developed country. At the other extreme are rou�ne investments such as replacing a worn-out machine. Management resources are finite. By confining the search to projects that fit the company's mission and then classifying them, management can direct its a�en�on to a rela�vely few, crucial projects.
Projects that may seem risky and deserving of great management scru�ny must be judged in the context of exis�ng company opera�ons. Table 6.1 provides a representa�ve scheme for classifying projects according to the amount of management a�en�on required.
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Foreign investment is one example of a diversifica�on project. Today, it is not only countries like the U.S. and Great Britain that are expanding overseas; industrial pioneer, China, is inves�ng money into the crumbling economy of the Congo. How does China's involvement in foreign investment impact compe��ve markets?
Table 6.1: Project types and management oversight
Project type Descrip�on Management a�en�on required Example
Replacement projects
Update or upgrade exis�ng capacity. Senior management typically does not make decisions on these rela�vely rou�ne investments.
Replacing worn-out or obsolete machinery and equipment.
Expansion projects
Used to expand exis�ng capacity, such as adding new machinery or equipment to increase output.
Require only moderate management scru�ny because capacity expansion is a response to increased or an�cipated demand.
Retailers lease larger facili�es or open addi�onal stores.
Diversifica�on, or dispersion, projects
Add new products or new regions to a company's opera�ons.
Demands on management may vary, depending on how related the new products or regions are to exis�ng ones.
Ini�al overseas expansion of a domes�c corpora�on (high level of management a�en�on). Inves�ng in freight cars to lease to private carriers (lower level of management a�en�on).
Chinese Investment in the Congo
There are two other investment categories that don't fit neatly into a risk classifica�on. One is investment mandated by law, such as pollu�on control equipment to comply with environmental regula�ons and plant improvements to conform to occupa�onal safety and health codes. The other is investment in other companies. Mergers and acquisi�ons are risky in part because they combine corporate cultures. Most mergers expand exis�ng capacity, diversify product lines, or extend opera�ons to new regions.
Eliminating Project Dependencies
When we first iden�fy poten�al investments, we may include projects that are either complementary or mutually exclusive. Pipelines to bring crude oil to the refinery and transport refined petroleum to ports or markets must accompany a new oil refinery. It makes li�le sense to evaluate the refinery separately from the pipelines. These are complementary projects and should be considered a single investment.
Mutually exclusive projects are subs�tutes for each other, requiring either/or decisions. There may be alterna�ve types of pipelines that can be built to serve the oil refinery, or rail cars or barges may be used in place of pipelines. The company must select the best op�on for each task and discard the others.
Once the company's financial analysts have combined complementary projects and chosen among mutually exclusive projects, those that remain are independent projects. Independent projects all have equal status, meaning that the company may invest in all, none, or any combina�on of projects, knowing that each investment decision does not affect the others. This greatly simplifies the analysis and allows management to focus on the process of crea�ng wealth. As is usual in business, even though simplifying assump�ons aids our analysis, we must deal at some point with less simple reali�es. In truth, individual projects must be viewed in the context of the por�olio of investments.
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Purchasing new pipelines for a new oil refinery is an example of a complementary project because they are interconnected. Can you think of any other examples of complementary projects?
Hans-Peter Merten/Digital Vision/ Ge�y Images
6.3 Estimating Project Cash Flows
Once a company's financial analysts have iden�fied an array of independent projects, they must evaluate each as a poten�al investment. First, they must es�mate cash flows that are associated with the project. These include the ini�al investment, opera�ng income and expenses spread over the life of the project, and project termina�on. Opera�ng and termina�on cash flows are discounted, and their present value is then compared to the ini�al investment. If the present value of the future cash flows is greater than the ini�al investment, the investment has a posi�ve net present value. A posi�ve net present value indicates that the investment will add value to the company.
Recall from Sec�on 6.1 that
Net present value = Present value of future cash flows – Ini�al investment
In order to calculate net present value, we must es�mate the amount and �ming of the investment's cash flows. In this sec�on, we provide some ground rules for es�ma�ng cash flows and then show how they are used in a discounted cash flow model.
Consider Only Incremental Cash Flows
The most difficult part of project analysis is iden�fying and quan�fying cash flows related to the project. Here, the guiding principle is to include only incremental cash flows, defined as the change in corporate cash flows a�ributable to the project. This seems simple enough, but these cash flows can be elusive. Even the cost of some projects may be impossible to pin down. Consider how difficult it is to es�mate the completed cost of an office building or plant that may take years to complete. Some cash flows may escape a�en�on altogether, such as the effect of one project on another project's cash flows. Here are a few guidelines for iden�fying incremental cash flows:
Beware of allocated costs, such as corporate overhead. Usually allocated costs do not change as a result of taking on projects. For example, a new project may use exis�ng idle capacity on the company's computer network. Assuming that there is no alterna�ve use for the network capacity and support staff, there is no incremental cost. So nothing should be allocated to the new project. On the other hand, the project's demand for network services may compel the company to add capacity. In this case, the cost incurred is incremental and should be included in the project. Consider the opportunity costs of currently owned resources. Take for example, a plant built on land owned by the company. The land entails no out-of-pocket costs; however, it is not a free resource because it has alterna�ve uses. The analyst must consider, as the cost of the land, the income that could be produced from its next-best use. Perhaps it could become a parking lot, be sold, be leased, or be used for growing tomatoes. Ignore sunk costs. A sunk cost is money that has already been spent and cannot be recovered. However, it can be difficult (on many levels) to abandon projects on which a great deal of money has been spent. Abandonment has its own costs, and some�mes finishing a project that may have been unwise to begin with is the only way to recover at least some of its costs. The analyst must consider the incremental costs and revenues of comple�ng a project. Consider incidental effects of the project. A new product may reduce sales of other company products. For example, a retailer that opens a second loca�on in the same town will lose some customers to the new store. There may be posi�ve incidental effects as well. For instance, large airlines subsidize small feeder airlines to deliver passengers to and from their hub airports. For the feeder airlines, these incidental effects make them viable. Iden�fying and cos�ng all incidental effects of a project is easier said than done. Projects that depend on incidental effects may be very risky and should be taken on with cau�on.
Cash Flow Categories
It is convenient to categorize project cash flows by their �ming, that is, when they occur. The ini�al investment occurs at the beginning of the project's life, opera�ng income and expense are annual cash flows occurring during the project's life, and termina�on cash flows occur when the project ends. Each category includes cash flows from different sources. Figure 6.1 outlines these categories, and they are discussed in further detail below.
Figure 6.1: Cash flow categories over a project's life�me
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Project cash flows can be categorized across the life of the project. Ini�al investment cash flows occur at the beginning of the project's life, opera�ng income and expense flows occur during the project, and termina�on cash flows occur at the end of the project.
Wages for employees are a cash ou�low opera�ng expense. What addi�onal examples of opera�ng expenses can you think of?
Jus�n Guariglia/Na�onal Geographic Stock
Ini�al Investment
Project cost (cash ou�low) may include transporta�on, insurance, setup, employee training, and prepaid maintenance. For some projects, it may also include infrastructure costs such as roads and u�li�es. Also included may be planning and design costs such as architectural fees. Be careful to not include sunk infrastructure, planning, and design costs. For simple projects, the ou�low occurs at the present �me (t = 0). However, large projects, such as plant construc�on, may take several years to complete.
Investment tax credits (cash inflow) reduce taxes paid in some propor�on to the project cost. From �me to �me, governments provide tax credits for certain kinds of investments. Currently, there is no general investment tax credit ( ITC) in the United States, but there are ITCs in other countries.
Change in net working capital (cash ou�low or inflow) may be required by expansion, diversifica�on, and dispersion projects. Increased inventories and receivables may be needed to support increased produc�on. These current assets are �ed to the investment and are therefore incremental costs. Generally, we assume that this increased working capital is reduced to its prior level on termina�on of the project, resul�ng in a decrease, or recovery of net working capital. Some investments may actually reduce the need for net working capital. For example, a new produc�on facility may employ just-in-�me inventory control, reducing the need for inventory stocks.
Sale of exis�ng asset (cash inflow) generally occurs only for replacement projects.
Tax effect of asset sale (cash inflow or ou�low) must be considered when the sale price of the asset is greater than its depreciated book value and the company owes tax on the difference. If the sale price is less than the book value, the loss reduces the company's taxable income.
Opera�ng Income and Expense
Opera�ng income and expense are annual revenues and expenses occurring during the opera�ng life of the project. Of the three categories, the incremental cash flows associated with opera�ons are the most difficult to iden�fy.
Cash revenues (cash inflow) include sales and other incidental income. These cash flows are usually not an annuity because unit sales and prices will not be constant from year to year.
Cash expenses (cash ou�low) include materials, labor, fuel or power, maintenance, rents, contract services, and any number of other incremental costs. As with sales, they normally vary from period to period. Replacement projects may reduce expenses, producing cash savings. These are all opera�ng expenses and do not include interest or other capital costs. Costs of capital are included in the discount rate.
Deprecia�on (cash inflow) of fixed assets is noncash, tax deduc�ble expense. The tax saving is the only cash flow resul�ng from deprecia�on. For a replacement project, only the change in deprecia�on between the new and old projects is relevant.
Project Termina�on
Income from project sale (cash inflow) results from assets that have economic value beyond the life of the project. They may be sold intact, in parts, or as scrap. Companies o�en plan to resell assets a�er a specified period. Their resale or terminal value may add significantly to a project's value.
Tax effect of project sale (cash inflow or ou�low) is treated in the same way as that on the sale of an exis�ng asset.
Recovery of net working capital (cash inflow or ou�low) occurs at the termina�on of a project, when the ini�al change in net working capital is reversed in order to return to the original net working capital posi�on.
Cash Flow Calculations
Now, we look at specific calcula�ons for two types of project cash flows. Processing math: 0%
The Tax Effect of Asset Sales
If an asset is sold for more than its depreciated book value, the difference between the sale price and book value is a taxable capital gain. The tax that must be paid equals the gain �mes the marginal corporate tax rate. A capital loss resul�ng from a sale price less than book value reduces the company's tax, assuming that it has other taxable income. The tax treatment of asset sales applies to both ini�al investment and termina�on cash flows. To illustrate, consider a project in which exis�ng equipment is to be replaced by new equipment cos�ng $10,000 (shown in Table 6.2). The exis�ng equipment may be sold for $3,000, but it has a depreciated book value of $2,500, crea�ng a $500 taxable gain on the sale. The tax rate is 34%. Cash flows are starred (*).
Table 6.2: Tax effect of asset sale
Data Category Value
*Project cost ($10,000)
*Sales price of exis�ng asset $3,000
Book value of exis�ng asset $2,500
Gain (Loss) $500
Tax effect of sale (gain x tax rate) ($170)
To determine the ini�al cash flow, we add the tax effect to the project cost and sale price:
Ini�al cash flow = Project cost + Sale price + Tax effect
Ini�al cash flow = (10,000) + 3,000 + (170) = ($7,170)
Some or all of the gain on an asset sale actually represents the recapture of deprecia�on. If the tax rate on capital gains and losses is the same as the tax rate on income, the source of the gain is immaterial. However, if the capital gain tax rate is less than that on ordinary income, then deprecia�on recapture must be calculated and the appropriate tax rate applied.
Opera�ng Cash Flows
The es�mates of annual opera�ng income and expenses must be converted to opera�ng cash flows. This is done using the net income approach to calcula�ng cash flows.
Step 1: Calculate taxable income. Earnings before tax (EBT) equal cash revenues minus opera�ng expenses and deprecia�on.
EBT = S – E – dep
Step 2: Calculate corporate income tax. Corporate tax is the product of EBT and the marginal corporate tax rate (tx).
Step 3: Calculate net income or earnings a�er tax (EAT) by subtrac�ng the tax from the EBT. The final step is to calculate opera�ng cash flow (OCF) by adding deprecia�on to net income.
OCF = EAT + dep
Project cash flows and the calcula�on of opera�ng cash flow are summarized in Table 6.3.
Table 6.3: Classifying project cash flows
Cash flow Classifica�on
Ini�al investment
Project cost Ou�low
Investment tax credit Inflow
Change in net working capital Ou�low/inflow
Sale of asset Inflow
Tax effect of sale Ou�low/inflow
Opera�ng cash flows
Cash revenues (S) Inflow
Cash expenses (E) Ou�low
Deprecia�on (dep) Noncash expense
Tax Ou�low
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Earnings before tax (EBT) S – E – dep
Corporate tax EBT × tx
Earnings a�er tax EAT = EBT − tax
The Challenge of Estimating Project Cash Flows
These guidelines for es�ma�ng project cash flows do not capture the difficulty of actually gathering informa�on and producing es�mates. A single independent project may include building a plant, installing produc�on equipment, buying trucks, and training workers. Such a project involves gathering and si�ing large quan��es of informa�on. Incomplete or inaccurate informa�on may lead to an incorrect decision. The large amounts of capital required by many projects make the cost of incorrect decisions that much greater.
Some cash flows, such as equipment costs and taxes, are rela�vely easy to es�mate because their costs are explicit. Future cash flows that are dependent on the success of the project require more sophis�cated and �me-consuming es�mates. Table 6.4 divides project cash flows into two categories: those that are fairly easy to es�mate and those that are more difficult. Keep in mind that these categories are guidelines only, not absolutes.
Table 6.4: Es�ma�ng project cash flows
Step in project life cycle Less difficult to es�mate More difficult to es�mate
Ini�al investment Project cost Investment tax credit Sale of exis�ng asset Tax effect of asset sale
Change in net working capital
Opera�ng cash flows Deprecia�on Cash revenues Expenses
Project termina�on Income from sale of project Tax effect of project sale Recovery of net working capital
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6.4 Selecting Independent Projects
As discussed earlier, independent projects are those that do not affect a company's other projects. Once an independent project has been iden�fied, we must determine whether or not it is a worthwhile endeavor. Recall that net present value plays a key role in project selec�on by determining expected cash flows.
An independent project should be taken if its NPV is posi�ve (NPV > 0). NPV is a direct measure of the project's contribu�on to firm value. Even projects with small NPVs should be taken, at least in principle. Any posi�ve NPV project is expected to produce a cash flow in excess of that needed to provide investors with their required rates of return. Cash flow from a project whose NPV = 0 should provide these required returns; however, it would produce no residual cash flow to increase shareholder wealth. Therefore, shareholders would be indifferent toward the project.
Next we will examine the equa�ons used to calculate net present value and internal rate of return for an independent project.
Calculating NPV and IRR for Independent Projects
Recall that net present value is equal to present value of future cash flows minus the ini�al investment (NPV = PV – II). Present value (PV) is the summa�on of the discounted opera�ng cash flows (OCF) plus the discounted terminal cash flows (TCF). The formula for calcula�ng NPV is
Table 6.5 breaks down the components of Equa�on (6.1) and Equa�on (6.2).
Table 6.5: Variables in NPV and IRR equa�ons
Variable Value
II Ini�al investment
OCFt Opera�ng cash flows in year t
TCF Terminal cash flows
t Year
N Life span (in years) of the project
R(r) Project required rate of return
Remember that internal rate of return is the expected rate of return on a project. IRR is found by solving for the discount rate that equates the present value of future cash inflows to the project cost. To calculate IRR, we use trial and error to find the discount rate that sa�sfies the condi�on PV = II, which is equivalent to NPV = 0. Solving for a project's IRR is the func�onal equivalent of solving for a bond's yield to maturity.
For a single future cash flow or a mul�ple period annuity cash flow, IRR can be solved algebraically. However, project cash flows are seldom annui�es, leaving us no choice but to find IRR through trial and error. This is a tedious process without the assistance of a calculator or computer.
The formula for IRR is
Comparing NPV and IRR Results on Independent Projects
If a project is found to have a posi�ve net present value, it will also have an internal rate of return greater than its required rate. On the other hand, if the project NPV is found to be nega�ve (less than 0), then the IRR would also be less than the required rate of return. Symbolically, the rela�onship between NPV and IRR may be stated
If NPV > 0, then IRR > R(r).
If NPV = 0, then IRR = R(r).
If NPV < 0, then IRR < R(r).
Although IRR does not directly measure the project's contribu�on to firm wealth, we see the equivalency of NPV and IRR decision rules (if NPV > 0, then IRR > R(r), etc.). This equivalency leads to an important point: For independent projects, both NPV and IRR analyses will cause us to accept and reject the same projects. Therefore, it does not ma�er which method of analysis we choose. Both use discounted cash flows and the required rate of return in the investment decision. Net present value uses the required rate of return as a discount rate and produces a dollar value for the project; IRR uses the required return as a hurdle rate, or reference point against which to compare the project's internal rate of return.
Now, let's apply what we have learned about determining project value.
Application: The Pogo Harness Project
Nine years ago, engineer Paula Bauer founded Pacific Offshore Ltd. (POL) as a supplier of high-quality hardware and gear for sailboats. Five years ago, a successful ini�al public offering of stock provided the capital POL needed to meet demand and expand its product line. Paula is most directly involved in product development and is always looking for ideas that can be turned into new products for the sailor. She o�en sails with her dog Pogo. A�er having to fish Pogo out of the water on several occasions, Paula
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While the Pogo harness could be considered a product sailors will use, it is essen�ally an independent project as POL's investment in it does not affect any other company product.
ZUMA Press/Corbis
recognized the need for a harness that would keep Pogo on board yet give the dog some freedom to move about the boat. Paula and her vice president, Sonny Wheeler, designed and tested a harness that met with Pogo's approval.
Paula and Sonny calculate that they can produce the harness and associated hardware with an investment of $57,000 in tools and equipment. Alterna�vely, they could invest about $225,000 in automated, high-speed machine tools that would greatly reduce unit produc�on costs at higher produc�on volume. Because the Pogo harness is an untested product, they opt for the lower investment. It will cost an addi�onal $11,000 to slightly alter their manufacturing facility to handle this new product. Increased sales from the Pogo harness project should increase average receivables and inventory from $23,000 to $25,000. Distribu�on will be handled through normal catalog and chandlery sales, but they also plan to market through pet supply stores, and the Pogo harness will be featured on POL's new website. Paula and Sonny agree that they will push ahead with the website even if they decide to not produce the Pogo harness. The reconfigura�on of the manufacturing facility will allow POL to sell some older equipment for an es�mated $7,800.
Paula es�mates that the Pogo harness will produce cash flows for five years. A�er five years, if demand warrants, she will invest in automated equipment to cut produc�on costs. If there is insufficient demand or if lower-cost compe�tors have flooded the market, she will cease produc�on. Either way, POL will no longer need
the exis�ng tools. Paula's produc�on manager es�mates that the rather specialized tools will bring no more than $12,000 when they are sold in five years. Tools, equipment, and reconfigura�on costs are depreciated on a seven-year accelerated cost-recovery schedule. Pacific Offshore's effec�ve tax rate on income is 34%, and its tax rate on capital gains is 28%. The projected cash flows for the Pogo harness project are shown in Table 6.6 and Table 6.7.
Table 6.6 presents data on the sale of the exis�ng equipment and the sale in Year 5 of the tools of the Pogo harness project. All project cash flows, including opera�ng cash flows, are shown in Table 6.7.
Table 6.6: Pogo harness project: Calcula�ng the tax effect of asset sales
Data Category Cash Value
Sale of exis�ng equipment (Year 0)
Book value (book) $0
Sale price (sale)* 7,800
Capital gain or loss (gain) 7,800
Tax effect of sale (gain) × (tax)* 2,184
Sale of Pogo harness project tools (Year 5)
Original purchase price $57,000
Book value (book)** 12,717
Sale price (sale)* 12,000
Capital gain or loss (gain) (717)
Tax effect of sale (gain) × (tax)* (201)
* Designates cash flow ** At the end of Year 5, accumulated deprecia�on totals 77.69% Book value = $57,000 x (1 – 0.07769) = $12,717 Capital gain tax rate = 28%
Table 6.7: Pogo harness project: Cash flows
Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Ini�al investment
Tools and equipment ($57,000)
Plant reconfigura�on ($11,000)
Added net working capital ($2,000)
Sale of asset $7,800
Tax effect of sale $2,184
Total ($64,384)
Opera�ng cash flows
Cash revenues (S) $42,500 $49,300 $55,216 $60,185 $65,602Processing math: 0%
Expenses (E) $29,750 $29,580 $33,130 $30,093 $32,801
Deprecia�on (Dep) $9,717 $16,653 $11,893 $8,493 $6,072
Earnings before tax (EBT = S – E – dep)
$3,033 $3,067 $10,193 $21,600 $26,729
Tax (tax=0.34) (EBT x tax)
$1,031 $1,043 $3,466 $7,344 $9,088
Earnings a�er tax (EAT = EBT – tax)
$2,002 $2,024 $6,728 $14,256 $17,641
Add back deprecia�on (EAT + Dep)
$11,719 $18,677 $18,621 $22,749 $23,713
Project termina�on cash flow
Income from sale $12,000
Tax effect of sale $201
Recovering net working capital $2,000
Total $14,201
Annual deprecia�on rate 14.29% 24.49% 17.49% 12.49% 8.93%
Calcula�ng the NPV and IRR for the Pogo Harness Project
The Pogo harness project's cash flows are summarized in Table 6.8. Pacific Offshore's required rate of return on investments is 12.5%. For our analysis, this required return (R(r)) is given. In Chapter 7 we will show how to es�mate the required rate of return for a project.
Table 6.8: Pogo harness project cash flow summary
Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Ini�al investment ($64,384)
Opera�ng cash flows $11,719 $18,677 $18,621 $22,749 $23,713
Ending cash flows $14,201
Cash flows ($64,384) $11,719 $18,677 $18,621 $22,749 $37,914
Present value ($64,384) $10,417 $14,757 $13,078 $14,202 $21,040
NPV $9,110
IRR 17.2%
Required rate of return 12.5%
Using the data given, we can expand Equa�on (6.1) to determine the project's NPV:
The NPV indicates that the harness project will add $9,110 in value to the company if our cash flow es�mates are correct and if 12.5% is the appropriate required rate of return. Note that the cash flow in Year 5 is the sum of the opera�ng cash flow and termina�on cash flow ($23,713 + $14,201).
Now, let's solve for the IRR for this project.
Solving for the discount rate, the IRR for the Pogo harness project is 17.2%. This is the rate that equates the present value of the cash flows in Years 1 through 5 to $64,384.
Comparing NPV and IRR Results for the Pogo Harness Project
As we discovered in our calcula�ons above, the IRR for the Pogo harness project is greater than its required rate of return (17.2% > 12.5%), making it a worthwhile project for the company to pursue. If Pacific Offshore Ltd. chooses to invest in the project, it will add $9,110 to the value of the company. Stated another way, if it does not take on the project, it will have missed an opportunity to increase firm value by that amount.
The rela�onship between NPV and the discount rate is worth exploring further. Figure 6.2 plots the NPV of the Pogo harness project at various discount rates. One of the discount rates is the IRR, which is 17.2%. The IRR of 17.2% is the point at which NPV = 0. (This is where the line crosses the x-axis.) Note that at discount rates less than 17.2%, NPV is posi�ve, while rates above 17.2% yield nega�ve NPVs.
Figure 6.2: Pogo harness project NPV at various discount rates Processing math: 0%
The NPV of a project declines if the project has a higher required return.
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A city that wants an upgraded stadium must decide whether to renovate or build anew. This is an example of a mutually exclusive project.
Ge�y Images News/Ge�y Images
6.5 Selecting Mutually Exclusive Projects
With the Pogo harness project, we saw that both NPV and IRR will lead to the correct accept or reject decision. The harmony between NPV and IRR exists because the Pogo harness project is independent. When projects are not independent, the harmony between NPV and IRR breaks down. There are primarily two types of project dependency: mutually exclusive projects and limited capital budget (capital ra�oning). In each case, acceptable projects (i.e., those with NPV > 0 and IRR > R(r)) must compete against one another. This implies that some acceptable projects will not be taken. In this sec�on we deal with mutually exclusive projects.
Mutually exclusive projects compete with others, all of which are acceptable using NPV and IRR decision rules. The analyst must choose the best of these projects and discard the rest. In most cases, both NPV and IRR will iden�fy the same best project; that is, the project with the highest NPV will also have the highest IRR. However, the analyst watches for condi�ons under which NPV and IRR disagree:
The �ming of cash flows differs substan�ally between projects. For example, most cash flows for one project occur early in its life, while those for another project occur late in its life. Projects are of substan�ally different size, meaning that one requires a much larger investment than the other.
Timing of Project Cash Flows
Let's look at four mutually exclusive projects to see how �ming of cash flows impacts the accord between IRR and NPV.
Table 6.9 shows cash flows, IRR, and NPV for mutually exclusive projects A–D. The required rate of return, R(r), equals 10%. The �ming of cash flows differ over the six-year period.
Table 6.9: Mutually exclusive projects with different �ming of cash flows
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10% IRR
A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 $1,453 15.3%
B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 $1,849 14.6%
C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 ($1,596) 3.4%
D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 $1,468 19.4%
Both NPV and IRR indicate that project C is not acceptable; therefore, we can concentrate on the remaining three projects. Project A is an annuity, project B's cash flows occur mostly in the later years, and project D's cash flows occur mostly in the early years. No�ce that the project with the late cash flows (B) has the highest NPV, and the project with the early cash flows (D) has the highest IRR. Project A, the annuity, has neither the highest NPV nor the highest IRR. Projects A, C, and D all have IRR greater than the R(r) of 10%; this means that they could all be considered acceptable projects, because their IRR > R(r).
Why does �ming of cash flows lead to conflicts between NPV and IRR? Because, for acceptable projects, NPV discounts cash flows at a lower rate, R(r), than does IRR. This affects project selec�on because discount rates are also compounding rates of return.
In general, IRR favors projects whose cash flows occur mostly in the early years. NPV, which is less affected by compounding because of its lower discount rate, does not favor projects with early cash flows. NPV favors project B with its greater dollar cash flows, even though they occur in the later years. Although this may seem like a technical triviality, it is not if it causes disagreement between NPV and IRR.
Differences in Size of the Initial Investment
Now, let us look at four mutually exclusive projects to see how a different size in ini�al investment disrupts the harmony between IRR and NPV.
Table 6.10 shows the ini�al investment, cash flows, NPV, and IRR for mutually exclusive projects E–H. As in the previous example, the required rate of return, R(r), equals 10%.
Table 6.10: Mutually exclusive projects with different ini�al investments
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 NPV at 10% IRR
E ($5,000) $1,800 $1,800 $1,800 $1,800 $1,800 $1,800 $2,839 27.7%
F ($10,000) $3,300 $3,300 $3,300 $3,300 $3,300 $3,300 $4,372 23.9%
G ($15,000) $4,500 $4,500 $4,500 $4,500 $4,500 $4,500 $4,599 19.9%
H ($20,000) $5,700 $5,700 $5,700 $5,700 $5,700 $5,700 $4,825 17.9%
We see that the largest project (H) has the largest NPV. We expect larger projects to produce greater value. Conversely, the smallest project (E) has the highest IRR. In general, lower-cost investments tend to have higher IRR. If two investments have equal cash flows, the investment that costs the least must have the highest rate of return.
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Resolving the Conflict: Choosing NPV Over IRR
Most of the �me, an analyst will not be faced with having to resolve a conflict between NPV and IRR. Conflicts are irrelevant if projects are independent. For mutually exclusive projects, conflicts are likely only when there are substan�al differences in �ming of cash flows or differences in project size. When conflicts arise, there are three reasons for choosing NPV.
Reason 1: The Rate of Return. For acceptable projects, NPV assumes that project cash flows are compounded at the required rate of return, whereas IRR assumes that cash flows are compounded at a higher rate [IRR > R(r)]. Consider project D in Table 6.8 with its IRR of 19.4%. This project generates a $5,000 cash flow in Year 1 of a six-year life. The IRR method implicitly assumes that this $5,000 is invested at 19.4% for the remaining five years. The NPV method, on the other hand, assumes that the $5,000 is invested at 10% over the same period. Unless the company has other investment opportuni�es that yield close to 19.4%, it is more prudent to assume that the project cash flows will earn about 10%, which represents the company's opportunity cost.
Reason 2: Value Crea�on. NPV is a direct measure of value. For example, project H in Table 6.9 is expected to add $4,825 in value to the company, whereas project E, which has the highest IRR, will add only $2,839 in value.
Reason 3: Mul�ple IRRs. The cash flows for all investments follow the same basic pa�ern: An ini�al investment is followed by cash inflows, usually over a number of years. Some�mes the ini�al investment may last for a number of years before the cash inflows begin. For most projects, once the cash inflows begin, they con�nue un�l the project is terminated. However, there are cases where a project may require a midlife investment. A planned upgrade of a plant or equipment would be an example. The cash flow pa�ern of such an investment is shown in Table 6.11.
Table 6.11: Sample cash flow for project with midlife investment
Year Cash flow (+ or –)
1 –
2 +
3 +
4 +
5 –
6 +
7 +
With this or any similar cash flow pa�ern involving more than one sign change, there is more than one discount rate that renders NPV = 0. Therefore, the project has more than one IRR. For such projects, the calculated IRR is unreliable, and IRR should be abandoned in favor of NPV.
Payback as an Alternative to NPV and IRR
Before electronics gave us a hand in making complex calcula�ons, payback was the most common means of evalua�ng a project. Payback period is simply a measure of how many years it takes a project to recoup its ini�al investment. Table 6.12 compares the payback period for projects A–D from Table 6.9 with their NPV and IRR.
Table 6.12: Comparing payback to NPV and IRR for mutually exclusive projects
Project Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Payback Years NPV at 10% IRR
A ($9,000) $2,400 $2,400 $2,400 $2,400 $2,400 $2,400 3.75 $1,453 15.3%
B ($9,000) $500 $500 $2,000 $2,000 $6,000 $6,000 4.67 $1,849 14.6%
C ($9,000) $1,700 $1,700 $1,700 $1,700 $1,700 $1,700 5.29 ($1,596) 3.4%
D ($9,000) $5,000 $5,000 $1,000 $1,000 $300 $300 1.8 $1,468 19.4%
The calcula�on of payback is quite simple. Project A in has an ini�al investment of $9,000, and its inflows are outlined in Table 6.13.
Table 6.13: Project A cash inflows
Year Cash flow Cumula�ve cash inflow
1 $2400 $2400
2 $2400 $4800
3 $2400 $7200
4 $2400 $9600
5 $2400 $12000
6 $2400 $14400Processing math: 0%
The benefit of simple calcula�on is no longer a viable reason to use payback rather than NPV and IRR as advanced so�ware and calculators now do the work for you.
PR Newswire/Associated Press
From the cumula�ve cash flow column, we see that the $9,000 will be returned some�me during the fourth year. Through interpola�on, we determine that payback occurs three-quarters of the way through the fourth year, making the payback period 3.75 years. Payback periods for projects B–D are similarly calculated.
Payback's single virtue is that it is easily calculated. However, payback has some serious short-comings. First, we have not discounted future cash flows, so the �me value of money is ignored. This flaw could be overcome by calcula�ng a payback period using discounted annual cash flows. Discoun�ng complicates the calcula�on, elimina�ng payback's most basic virtue. Payback also disregards cash flows occurring a�er the payback period. Project D's payback is 1.8 years, yet the project produces cash flows for 4 more years. If the last 4 years of Project D's cash flows were to disappear, its payback would remain at 1.8 years although the project's value would have diminished.
No�ce in Table 6.12 that projects with the lowest payback period are those with the highest IRR. This is because both payback and IRR favor projects with large early cash flows. If we are seeking projects with the greatest NPV, payback leads us down the wrong path. No�ce also that we cannot automa�cally exclude project C, which has a payback of 5.29 years. Project C is unacceptable because of its nega�ve NPV and IRR, which is less than the 10% required return. However, we do not know whether 5.29 years is an unacceptably long payback period. This absence of a defini�ve criterion for accep�ng or rejec�ng a project is yet another failing of payback. Ease of calcula�on is not a compelling enough reason to use payback in the age of electronics.
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Op�ons are more familiar than you would think, as coupons are a type of op�on. Can you think of any other examples of everyday op�ons?
PR Newswire/Associated Press
6.6 Options in Capital Projects
To most people, op�ons are synonymous with stock op�ons, which are contracts that investors buy and sell in the op�ons market. Stock op�ons have become big news in recent years because they are o�en a major part of the compensa�on of execu�ves and employees. In this sec�on, we describe op�ons, explain why they are valuable, and iden�fy op�ons that are associated with capital projects.
Characteristics of Options
All op�ons have certain features in common. First, they give the holder the right to buy or sell valuable assets at some future �me. Some, like call op�ons, specify the price and �me period in which the asset can be purchased. Other op�ons give the holder the right to perform a certain ac�on. For example, a company may contract with a labor union for an op�on to lay off factory workers temporarily during cyclical reduc�ons in demand for its product. The company holds a put op�on, which is the right to sell or rid itself of unneeded labor (an asset). In return, the union may extract concessions from the company in the form of job security or compensa�on. A second feature of op�ons is that they do not bind the holder to buy or sell. The holder will only exercise the op�on when it is in his or her interest (i.e., it is profitable to do so). A third feature of op�ons is that the seller must honor the terms of the op�on when the holder chooses to exercise it. Many op�ons, however, carry specific expira�on dates. Once the date has passed, the op�on has no more value than an expired lo�ery �cket, and the seller is no longer required to honor the terms.
There are two prices associated with op�ons. The first is the price paid by the buyer. This could be in the form of cash, concessions, or some other form. The second is the price paid when the holder exercises an op�on to buy an asset. It may also be the price received when the holder of a put op�on exercises an op�on to sell. The price paid on a call op�on or received on a put op�on is called the exercise price.
An Option Example
You may be more familiar with op�ons than you realize. Consider a pizza coupon. Suppose The Pizza Company offers a coupon that gives you the right to buy their famous Kitchen Sink pizza that normally sells for $13.99 for $9.99, however, you must use it by November 15. This coupon is an example of a call op�on contract. The valuable asset is the pizza, the exercise price is $9.99, and the expira�on date is November 15.
Another familiar example involves buying a house. A buyer makes an offer on a house for $200,000. The buyer accompanies the offer with an earnest money check for $2,000. This earnest money is the price of a call op�on on the house, effec�vely taking the house off the market and giving the buyer a few days to reconsider and arrange financing. The buyer may then exercise her op�on to buy the house for the exercise price of $200,000. If she chooses not to buy, she loses her earnest money.
The cost of the op�on on the home is explicit, $2,000. The pizza coupon is nominally free, but there is a cost (at least The Pizza Company hopes there is a cost). If you were going to buy a Kitchen Sink pizza without the coupon, then The Pizza Company has lost the difference between the regular price and the coupon price. On the other hand, you may be tempted to visit The Pizza Company instead of your regular pizza parlor and try a Kitchen Sink pizza. If you like it, you could become a regular customer of The Pizza Company. If you don't, you paid only $9.99 for the pizza.
We exercise a call op�on when the value or price of the asset exceeds the exercise price. Obviously, the pizza coupon would be worthless if you could buy the pizza for $9.99 or less without the coupon. Conversely, we exercise a put op�on (to sell) if the exercise price exceeds the value of the asset. O�en a put op�on can be thought of as the opposite of a call op�on. For example, if The Pizza Company thought that it could sell all the pizzas it could make at $13.99, it would not offer the coupon. It offers the coupon because selling pizza for $9.99 is be�er than selling it for a lower price, giving away free pizza, or losing inventory through spoilage.
It is important to note that, because op�ons do not have to be exercised, they can never have a nega�ve value. Op�ons are exercised only when they have value to the holder; otherwise, they simply expire. This is not to say that an investor cannot lose money by buying an op�on. If you pay $100 for an op�on that ul�mately proves to be worthless, you will not exercise the op�on, and you will have lost $100. If the op�on has a value of $50, you will exercise it, losing only $50. This is an important point. If the op�on has any value at all, it should be exercised. Doing so will at least cut your loss. Next, we examine the five factors that make op�ons valuable.
Factors That Affect the Value of an Option
Let's begin by examining two of the factors that make op�ons valuable. The first is the value of the op�oned asset. The second is the exercise price. Op�ons gain value as the difference between the asset value and exercise price widens. For a call op�on, this will occur if the asset value rises or the exercise price falls. Returning to The Pizza Company example, if the normal price of the pizza rises to $15.99 from $13.99, the coupon rises in value by $2.00. At $13.99, the $9.99 coupon saves you $4.00. At $15.99, it saves you $6.00. If The Pizza Company offers another coupon for a Kitchen Sink pizza at $8.99, this coupon would be worth $1.00 more than the $9.99 coupon because the savings on a $13.99 pizza would rise from $4.00 to $5.00. If there were a market for pizza coupons, their minimum value would equal the amount of the savings, which is the market price minus the exercise price. It is possible that the value could be greater, depending on whether pizza prices were expected to rise.
Summarizing the first two factors that affect op�on value:
1. All else being equal, as an op�on's exercise price goes down, the value of a call op�on increases.Processing math: 0%
2. All else being equal, the higher the price of the underlying asset is, the higher the value of a call op�on will be.
Note as well that the coupon might have value even if the current promo�onal price of a pizza were less than the coupon price. The coupon has value, for example, if it does not expire for a month, during which �me there is a reasonable chance that the price of pizza will rise above the coupon price. Now, suppose that the coupon will expire tomorrow. It is unlikely that the promo�on will end by tomorrow. In that case, the coupon is essen�ally valueless. Time to expira�on, therefore, is another factor affec�ng op�on value:
3. All else being equal, as the �me to expira�on increases, the value of a call op�on increases.
Consider a situa�on in which pizza prices are highly variable because of a shortage of mozzarella cheese. When The Pizza Company has to pay a premium for cheese, the price of the Kitchen Sink pizza may rise to as much as $19.99. The possibility of prices greater than $13.99 makes the coupon even more valuable. People will conserve their coupons when the price is $13.99 to use when the price is $19.99. At prices above the exercise price, the savings—and hence the value of the coupon—increases dollar for dollar. At $19.99, the coupon is worth $10.00 ($19.99 – $9.99). When the price is $13.99, the coupon is nominally worth $4.00; however, with the price of pizza almost certain to rise above $13.99, people are willing to pay more than $4.00 for a coupon. Price vola�lity of the asset, therefore, is another factor affec�ng op�on value.
4. All else being equal, the more vola�le the price of the underlying asset is, the more valuable the op�on will be.
The final factor that affects op�on value relates to the �me value of money lessons we learned earlier in this text. In effect, op�ons allow us to defer payment, and because money has �me value, this deferred payment adds value to the op�on. The �me value of the deferred payment increases with the interest rate.
5. All else being equal, as interest rates rise, the value of op�on contracts will also increase.
Table 6.14 summarizes the five factors that affect the value of op�ons.
Table 6.14: Factors affec�ng the value of call op�ons
Factor 1 As an op�on's exercise price goes down, the value of a call op�on increases.
Factor 2 The higher the price or the underlying asset, the higher the value of a call op�on.
Factor 3 As the �me to expira�on increases, the value of a call op�on increases.
Factor 4 Higher vola�lity of the price of the underlying asset increases the value of the op�on.
Factor 5 As interest rates rise, the value of op�on contracts also increases.
Real Options
Op�ons associated with capital projects are known as real op�ons. These are called real op�ons, to dis�nguish them from op�ons contracts on stocks and other securi�es. Real op�ons are important a�ributes of many projects, although they are o�en difficult to iden�fy and value. Here, we look more closely at different types of real op�ons, and why the valua�on of real op�ons is o�en problema�c.
Many companies have learned that taking into account the op�ons in projects significantly affects their inves�ng decisions. This op�ons approach has become a par�al subs�tute for long-range planning, which relies on forecasts of future events. By contrast, op�ons thrive on uncertainty. Rather than relying on forecasts to select projects, companies may seed a number of projects, recognizing that many will never be developed. They expect that those that are developed will be very profitable. By seeding a number of projects, a company is giving itself the op�on to develop the projects that are most promising as �me goes by and markets develop.
Op�ons as a Strategic Investment. Op�ons are ideal hedges against an uncertain future, such as unforeseen changes in product demand. For example, a car company could opt to pay an extra $3 million in design and manufacturing costs for a plant that can quickly change produc�on from one model to another. This would allow the manufacturer to change over produc�on in just a few days, as opposed to the industry standard of several weeks. This changeover op�on represents a hedge against unforeseen changes in demand for certain car models. It allows the company to reduce the risk associated with an unclear future, but the op�on does come with a price (in this case, the price is $3 million).
Op�ons to Close Down and Start Up. The op�on to close a project down and then start it back up at a later �me can be valuable. This op�on can be par�cularly profitable when dealing with products whose market prices are subject to great vola�lity, such as electricity.
The Op�on to Abandon a Project. In NPV analysis, we es�mate the life of the project. However, as men�oned earlier in this chapter, there are �mes when the project should be abandoned or terminated prior to the end of its expected life. To determine whether the project should be abandoned in any par�cular year, we compare the salvage value in that year to the discounted value of the project's remaining cash flows. If the salvage value exceeds the discounted value of the remaining cash flows, then the project should be immediately terminated. In effect, we are determining whether the project is worth more dead than alive.
To understand the abandonment op�on, consider the prin�ng press project in Table 6.15. The press ini�ally costs $60,000 and will be used to print a weekly newspaper. Revenues are generated from adver�sing and subscrip�ons. The expected life of the project is six years. The project's a�er-tax cash flows follow a typical life cycle pa�ern. They rise as sales build and then fla�en and decline as compe�ng newspapers enter the market or as demand for weekly newspapers wanes. Because the prin�ng press has many alterna�ve uses, its salvage value ini�ally declines slowly, reflec�ng wear and tear rather than obsolescence. At a discount rate of 12%, the six-year project has a posi�ve NPV of $14,410, so the project is accepted.
Table 6.15: Cash flows for prin�ng press project
Data Category Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Opera�ng cash flows $12,000 $16,000 $18,000 $18,000 $14,000 $10,000Processing math: 0%
Salvage value $56,000 $52,000 $48,000 $44,000 $34,000 $27,000
To determine the op�mal termina�on date, we compute the NPV, including salvage value, for each year. For example, if we abandon a�er the first year, we receive the opera�ng cash flow of $12,000 for Year 1 plus the salvage value of $56,000. Discoun�ng at 12% results in an NPV (abandon a�er year 1) of $714.29
Using this approach, the NPV of abandonment at Years 2 through 5, are
This analysis shows that the highest NPV occurs when the project ends a�er Year 4. Beyond Year 4, the present value of the addi�onal opera�ng cash flows do not compensate for the loss in the asset's salvage value. In other words, the cost of con�nuing exceeds the benefits of con�nuing to receive opera�ng cash flows. Being able to abandon the project early, in Year 4, raises project value by $1,274, which is the value of the project if it is sold in Year 4 minus its value if it is sold in Year 6 (15,684 – 14,410). If the company had to buy the op�on to terminate the project before Year 6, it could pay up to this amount and shareholders would s�ll benefit. Thus, the abandonment op�on is worth $1,274.
The value of the abandonment op�on increases with the salvage value of the asset. A primary determinant of salvage value is the number of alterna�ve uses for the asset. A generic asset that can be used in many applica�ons is generally more valuable than a highly specialized asset with few uses. Specialized assets—machines and equipment— tend to be produc�vely more efficient. Quite o�en a company must consider the tradeoff between a specialized asset that increases opera�ng cash flows by lowering produc�on costs and a generic asset that increases salvage value.
Adjusting NPV for the Option Effect
Compu�ng a precise value for real op�ons is difficult because the amount and �ming of payoffs is uncertain and, in some cases, not measurable. In some situa�ons there is no need to make the computa�on. For example, suppose that a project has a posi�ve NPV before considera�on of an abandonment op�on. In this case, the op�on merely adds value to an already acceptable project. Unless you are faced with pursuing capital ra�oning or choosing between mutually exclusive investments, where the op�on may change a project's rela�ve standing among compe�ng projects, there is no reason to calculate the op�on value. Remember that for an independent project the only requirement for acceptance is that it has a posi�ve NPV.
When a project has a slightly nega�ve NPV before considera�on of poten�ally value-enhancing op�ons, we must es�mate the op�on's value, using the five factors that affect op�on value as a guide. A sufficiently valuable op�on could cause us to accept a project that may otherwise be rejected. Any analysis must begin by determining whether or not the op�on might ever be used. For example, if we know we will con�nue with a project through its en�re economic life, then the abandonment op�on has no value and no further considera�on is needed. Of course, not all op�ons are imbedded in projects. Some must be purchased. Other op�ons, even though they may be a�ached to projects, may add cost to the project. In these cases, the decision must be made on whether to buy the op�on, and this requires us to es�mate the op�on's value.
Ignoring op�ons that are a�ached to investment projects means ignoring some of the projects' poten�al value, implying that some profitable projects will be rejected. Valuing real op�ons remains elusive, but the five factors that affect op�on value can serve as a framework for making es�mates. Considering these op�ons, even in this rough way, helps managers iden�fy profitable investments.
A final word of cau�on: We must be careful when we modify rigorous analyses with educated guesses. It is possible for a manager to use such hasty analysis to make any project look profitable. If a project is accepted because of the value of its a�ached op�ons, then those op�ons and the source of their value must be carefully considered. The presence of op�ons, real or imagined, should not be used as a pretext for taking on ill-advised projects.
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Ch. 6 Conclusion
The decision to invest in long-term assets is crucial to the long-run success of a corpora�on. This investment represents the implementa�on of the corporate mission and goals. If the company does not have a clear sense of where it is going, it may invest its resources in inappropriate product markets. In this chapter, we outlined a process for transla�ng a corporate strategic plan into iden�fica�on of specific projects. We also suggested a method of classifying projects according to the amount of management a�en�on required.
We then showed how to dis�ll dependent projects down to an array of independent projects, which can be evaluated using either NPV or IRR. We showed that NPV and IRR methods of analysis are en�rely consistent with each other for independent projects but may give conflic�ng accept/reject signals when used to choose from among mutually exclusive projects. If such conflicts arise, we should opt to select projects on the basis of NPV rather than IRR. In the final analysis, NPV gives us a direct measure of the value added to the company by an investment project.
Finally, we showed that many investment projects also contain call op�ons on future investment opportuni�es and put op�ons on projects that may be terminated. Although these op�ons may be difficult to value explicitly, they may nonetheless be useful enough to influence the investment decision.
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Ch. 6 Learning Resources
Key Ideas
Fixed assets can be classified as tangible (machinery, real estate) or intangible (copyrights, patents, contracts). Net present value measures the value added to the firm by an investment. The NPV of an investment is the present value of the future cash flows minus the ini�al investment. The IRR criteria compares the expected return for a project to the required return for investors, given the project's risk. If the expected return exceeds that requirement, then the project should be pursued. Companies may choose to undertake three types of projects: replacement, expansion, and diversifica�on. Mutually exclusive projects are subs�tutes for each other, requiring either/or decisions. Independent projects all have equal status, meaning that the company may invest in any knowing that each investment decision does not affect the others. When es�ma�ng cash flows, consider only incremental cash flows by remembering to beware of allocated costs, consider the opportunity costs of currently owned resources, ignore sunk costs, and consider incidental effects of the project.
Key Equa�ons
Cri�cal Thinking Ques�ons
1. Individuals and families, like corpora�ons, have long-term investments. What are two investments that most families have? 2. Some companies, such as Motorola, spend millions of dollars each year on employee training. The cost of this training is treated as an accoun�ng expense, but it may really
be an investment. Why might training be an investment? 3. Apple is now the highest valued company in the world at over $600 billion. Apple earned this posi�on by producing products with very high profit margins. Think about
Apple's products and explain what Apple does to maintain such high profit margins (much higher than compe�tors). High profit margins almost always imply products with large posi�ve NPVs. What is the source of Apple's huge posi�ve NPVs?
4. Over the past few years, we have seen film cameras and video rental stores disappear, many book stores close, and much discussion about whether print newspapers will survive this decade. What does this imply about project proposals that assume 10 or 15 years of high cash flows?
5. In July 2011, Nortel Networks, a now closed Canadian telecommunica�ons company, auc�oned off its patents. The auc�on brought in $4.5 billion from bidders that included Apple, Microso�, and four other companies. Google was among the companies that were outbid. Why would these companies spend so much on patents? See Web Resources at the end of Chapter 6 for more details about this auc�on.
Key Terms
Click on each key term to see the defini�on.
abandonment (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The op�on to terminate or sell a project before the end of its func�onal life.
a�er-tax cash flows (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The amount of cash flow remaining a�er taxes have been deducted.
allocated costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Costs, such as overhead costs, that do not necessarily change as a result of taking on a project.
call op�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The right, but not the obliga�on, to buy an asset at a specified price within a specified �me period.
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capital budge�ng (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The process in which a business determines whether projects are worth pursuing.
complementary projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investment projects that are related such that all or none must be taken.
dispersion projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investments that add new geographic regions, including other countries, to a company's opera�ons.
diversifica�on projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investments that add new products or product lines to a company's opera�ons.
exercise a call op�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The purchase of an asset under the terms of an op�on contract.
exercise price (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Price at which an asset may be bought or sold by the owner of an op�on.
expansion projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investments that expand exis�ng capacity, such as adding new machinery or equipment to increase output.
expira�on date (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The date that an op�on to buy or sell an asset lapses.
fixed assets (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Long-term investments. They may be tangible, such as machinery and equipment, or intangible, such as patents and employee training.
hurdle rate (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
A required rate of return, or reference point, against which to compare a project's internal rate of return.
incidental effects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Indirect effects of an investment. Costs or revenues not normally associated with the investment.
incremental cash flows (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The change in corporate cash flows a�ributable to a project.
independent projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The decision to invest in any project has no impact on the decision to invest in any other project.
internal rate of return (IRR) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The discount rate that equates the present value of an investment's future cash flows with the investment's cost.
mutually exclusive projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investment projects that are related such that only one can be taken.
net present value (NPV) (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The present value of future cash flows minus the ini�al investment. NPV is the present value of all cash flows connected to an investment. Processing math: 0%
opportunity costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The amount of the highest valued forgone alterna�ve.
payback period (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
A measure of how many years it takes to recoup the ini�al investment in a project.
put op�on (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The right, but not the obliga�on, to sell an asset at a specified price within a specified �me period.
real op�ons (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Op�ons associated with capital projects.
recovery of net working capital (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
The reduc�on in net working capital associated with the termina�on of an investment.
replacement projects (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
Investments that update or upgrade exis�ng capacity; such as replacing worn out or obsolete machinery and equipment.
sunk costs (h�p://content.thuzelearning.com/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/front_ma�er/books/AUBUS650.13.1/sec�ons/fro
A cost that has already been incurred. The cost is irretrievable. Sunk costs are not relevant in decision making.
Web Resources
A Business Week ar�cle from July 19, 2011 discusses the importance of patents to leading technology companies: h�p://www.bloomberg.com/news/2011-07-20/patents-are-veryvaluable-tech-giants-discover-nathan-myhrvold.html (h�p://www.bloomberg.com/news/2011-07-20/patents-are-very- valuable-tech-giants-discover-nathan-myhrvold.html)
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