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PPT-McGuigan-14e-Chapter17.pptx

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Managerial Economics Applications, Strategies and Tactics, 14e

James R. McGuigan

R. Charles Moyer

Frederick H. deB. Harris

© 2017 Cengage Learning® May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning management system for classroom use.

PART V – ORGANIZATION ARCHITECTURE AND REGULATION

Chapter 17 –

Long-Term Investment Analysis

Chapter 16 – Government Regulation Overview (1 of 2)

THE NATURE OF CAPITAL EXPENDITURE DECISIONS

A BASIC FRAMEWORK FOR CAPITAL BUDGETING

THE CAPITAL BUDGETING PROCESS

ESTIMATING THE FIRM’S COST OF CAPITAL

COST-BENEFIT ANALYSIS

STEPS IN COST-BENEFIT ANALYSIS

OBJECTIVES AND CONSTRAINTS IN COST-BENEFIT ANALYSIS

Chapter 16 – Government Regulation Overview (2 of 2)

ANALYSIS AND VALUATION OF BENEFITS AND COSTS

THE APPROPRIATE RATE OF DISCOUNT

COST-EFFECTIVENESS ANALYSIS

Ch 17 – The Nature of Capital Expenditure Decisions (1 of 1)

This chapter considers decisions to replace or expand the firm’s capital investment outlays

Capital outlays, by definition, have a long-range impact by determining products that will be produced, markets to be entered, the location of plants and facilities, and the type of technology (with its associated costs) to be used

Capital expenditures require careful analysis because they are costly to make and often more costly to reverse

Capital expenditure – A cash outlay designed to generate a flow of future cash benefits over a period of time extending beyond one year

Capital budgeting – The process of planning for and evaluating capital expenditures

Ch 17 – A Basic Framework for Capital Budgeting (1 of 1)

This basic capital budgeting decision-making framework is illustrated in Figure 17.1; the model assumes that all projects have the same risk

This schedule of projects is often called the investment opportunity curve

Graphically, the projects are arranged in descending order by their rates of return, indicating that no firm has a limitless number of possible new projects that all generate high rates of return

The marginal cost of capital curve represents the marginal cost of capital to the firm, that is, the cost of each additional dollar of investment capital raised in the capital markets

Using this model, the firm should undertake projects A, B, C, D & E, because their returns exceed the firm’s marginal cost of capital

Figure 17.1 – A Simplified Capital Budgeting Model

Ch 17 – The Capital Budgeting Process (1 of 1)

The process of selecting capital investment projects consists of the following important steps:

1. Generate alternative capital investment project proposals

2. Estimate cash flows for the project proposals

3. Evaluate and choose investment projects to implement

4. Review the investment projects after they have been implemented to assure assumptions were accurate. Otherwise, one should modify assumptions as required for similar future projects

Ch 17 – The Capital Budgeting Process Generating Capital Investment Projects (1 of 1)

Ideas for capital investments can come from many sources both inside and outside the firm, and from all levels in the firm

Most medium- and large-sized firms have departments to accomplish this, which include cost accounting, industrial engineering, marketing research and development, and corporate planning

Ch 17 – The Capital Budgeting Process Estimating Cash Flows (1 of 1)

Certain basic guidelines are helpful here

First, cash flows should be measured on an incremental basis.

Second, cash flows should be measured on an after-tax basis, using the firm’s marginal tax rate

Third, all the indirect effects of the project throughout the firm should be included in the cash-flow calculations

Fourth, sunk costs should not be considered when evaluating the project

Fifth, the value of resources used in the project should be measured in terms of their opportunity costs

Ch 17 – The Capital Budgeting Process Evaluating & Choosing the Investment Projects to Implement (1 of 2)

Typically, a project will result in an initial (first-year) outflow (investment) followed by a series of cash inflows (returns) over a number of succeeding years

Internal rate of return (IRR) – The discount rate that equates the present value of the stream of net cash flows from a project with the project’s net investment

Net present value (NPV) – The present value of the stream of net cash flows resulting from a project, discounted at the required rate of return (cost of capital), minus the project’s net investment

Ch 17 – The Capital Budgeting Process Evaluating & Choosing the Investment Projects to Implement (2 of 2)

NPV versus IRR

Both the net-present-value and the internal-rate-of-return methods result in identical decisions to either accept or reject individual projects

NPV is greater than (less than) zero if and only if the IRR is greater than (less than) the required rate of return k

In the case of mutually exclusive projects, the two methods may yield contradictory results

Table 17.1 – NPV Versus IRR for Mutually Exclusive Investment Projects

Table 17.2 – Summary of the Capital Budgeting Decision Criteria

Ch 17 – Estimating the Firm’s Cost of Capital (1 of 4)

Cost of capital – The cost of funds that are supplied to a firm. The cost of capital is the minimum rate of return that must be earned on new investments undertaken by a firm

Cost of Debt Capital

The pre-tax cost of debt capital to the firm is the rate of return required by investors

Ch 17 – Estimating the Firm’s Cost of Capital (2 of 4)

Cost of Internal Equity Capital

This is the equilibrium rate of return required by the firm’s common stock investors

Firms raise equity capital (1) internally, through retained earnings, and (2) externally, through the sale of new common stock

Dividend Valuation Model

Dividend valuation model – A model (or formula) stating that the value of a firm (i.e., shareholder wealth) is equal to the present value of the firm’s future dividend payments, discounted at the shareholder’s required rate of return. It provides one method of estimating a firm’s cost of equity capital

Ch 17 – Estimating the Firm’s Cost of Capital (3 of 4)

Cost of Internal Equity Capital

This is the equilibrium rate of return required by the firm’s common stock investors

Firms raise equity capital (1) internally, through retained earnings, and (2) externally, through the sale of new common stock

Dividend Valuation Model

Ch 17 – Estimating the Firm’s Cost of Capital (4 of 4)

Cost of External Equity Capital

This is greater than the cost of internal equity because:

Flotation costs associated with new shares are usually high enough that they cannot realistically be ignored

The selling price of the new shares to the public must be less than the market price of the stock before announcement of the new issue, or the shares may not sell.

Ch 17 – Estimating the Firm’s Cost of Capital (1 of 1)

Weighted Cost of Capital

Firms calculate their cost of capital to determine a discount rate to use when evaluating proposed capital expenditure projects

The capital whose cost is measured and compared with the expected benefits from these proposed projects should be the next or marginal capital the firm raises

Also, as a firm evaluates proposed capital expenditure projects, it normally does not specify the proportions of debt and equity financing for each individual project; instead, each project is presumed to be financed with the same proportion of debt and equity contained in the company’s target capital structure

Thus, the appropriate cost-of-capital figure to be used in capital budgeting is not only based on the next capital to be raised but also weighted by the proportions of the capital components in the firm’s long-range target capital structure

This figure is called the weighted, or overall, cost of capital

Ch 17 – Cost-Benefit Analysis (1 of 1)

Cost-benefit analysis – A resource allocation model that can be used by public and not-for-profit sector organizations to evaluate programs or investments on the basis of the magnitude of the discounted benefits and costs

Accept-Reject Decisions

Social discount rate – The discount rate to be used when evaluating benefits and costs from public sector investments

Benefit-cost ratio – The ratio of the present value of the benefits from a project or program (discounted at the social discount rate) to the present value of the costs (similarly discounted)

See Table 17.3

Table 17.3 – Net Cost-Benefit Analysis

Ch 17 – Cost-Benefit Analysis Program-Level Analysis (1 of 1)

Cost-benefit analysis can also determine whether the size of an existing program should be increased (or reduced), and if so, by what amount

This determination may be made using traditional marginal analysis as developed earlier in the text

Return again to the tuberculosis control program, and assume that a number of expenditure levels beyond the originally proposed $250 million are being considered

Table 17.4 summarizes these proposed programs and their expected benefits; each proposal generates positive expected net program benefits

However, Table 17.5 shows that when analyzed as a group, these program levels show a limit to the economically justifiable expenditure of funds for tuberculosis control

Table 17.4 – Schedule of Program Benefits for Various Cost Levels

Table 17.5 – Marginal Analysis of Benefits and Costs

Ch 17 – Steps in Cost-Benefit Analysis (1 of 1)

The general principles of cost-benefit analysis may be summarized by answering the following questions:

1. What is the objective function to be maximized?

2. What are the constraints placed on the analysis?

3. What costs and benefits are to be included, and how may they be valued?

4. What investment evaluation criterion should be used?

5. What is the appropriate discount rate?

The decision-making process may be traced in the flowchart of Figure 17.2

Figure 17.2 Schematic of the Cost-Benefit Analysis Process

Ch 17 – Objectives and Constraints in Cost-Benefit Analysis (1 of 1)

Not all projects with benefits that exceed costs will necessarily be adopted because of the following:

1. Physical constraints

2. Legal constraints

3. Administrative constraints

4. Distributional constraints

5. Political constraints

6. Financial or budget constraints

7. Social and religious constraints

Ch 17 – Analysis & Valuation of Benefits and Costs (1 of 1)

Direct Benefits

Primary or direct benefits of a project consist of the value of goods or services produced if the project is undertaken, compared to conditions without the project

Direct Costs

Direct or primary costs are easier to measure than direct benefits, and include the capital costs necessary to undertake the project, operating and maintenance costs incurred over the life of the project, and personnel expenses

Indirect Costs or Benefits and Intangibles

These may be of two types: real effects and pecuniary effects; real effects should be counted; pecuniary effects should not be counted

It is very difficult to calculate a value for intangible effects

Ch 17 – The Appropriate Rate of Discount (1 of 1)

When the benefits or costs of a program extend beyond a 1-year time limit, they must be discounted back to some common point in time for purposes of comparison

Most people prefer current consumption to future consumption, so the social discount rate is used to adjust for this preference

The choice of the appropriate discount rate to evaluate public investments is critical; projects that may appear to be justified at a low discount rate may seem to be a gross misallocation of resource at a higher rate

The correct discount rate for the evaluation of a government project is the percentage rate of return that the resources utilized would otherwise provide in the private sector

Ch 17 – Cost-Effectiveness Analysis (1 of 1)

Cost-effectiveness analysis – An analytical tool designed to assist public decision makers in their resource allocation decisions when benefits cannot be easily measured in terms of dollars but costs can be monetarily quantified

Lease-Cost Studies

These are the most frequent type of cost-effectiveness analysis

The object is to identify the least expensive way of generating some quantity of an output

Objective-Level Studies

These attempt to estimate the costs of achieving several alternative performance levels of the same objective

Table 17.6 provides some hypothetical data regarding emission-control standards

As the level of objective achievement increase, the associated costs may increase at a faster rate

Table 17.6 – Hypothetical Data Relating to the Cost of Achieving Various Levels of Auto Emission Reductions