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Part I
Capital budgeting and valuation under certainty
Well, I come down in the morning and I take up a pencil and I try to think.
(Hans Bethe, quoted by Bob Herbert, New York Times, February 14, 2005, quoting from Timebends by Arthur Miller)
It is useful first to consider capital budgeting with the most simple of assumptions. While the assumption of certainty is not realistic, it does enable us to establish some easily understood and theoretically correct decision rules. Even in these two chapters the presence of uncertainty is implicit in the calculations.
Part I offers very specific and exact solutions to the capital budgeting decision. The basic conclusion is that with independent investments accept all prospects with a positive NPV. With mutually exclusive investments accept the alternative with the largest NPV.
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Chapter 1
The state of the art of capital budgeting
Considering the accidents to which all human Affairs and Projects are subject in such a length of Time, I have perhaps too much flattered myself with a vain Fancy that these Dispositions will be continued without interruption and have the Effects proposed.
(B. Franklin's Will)
In 1790, Franklin made a £2,000 gift to Boston and Philadelphia. £1,000 of the funds were to be spent after 1990. In 1990 the bequest was worth $6.5 million.
(New York Times, April 21,1990. Author's note: Assuming the £1,000 was worth $4,000, the investment earned 0.03766 per year)
Capital budgeting theory keeps evolving. At one point, some felt that net present value (NPV) was so conceptually sound and practically useful that no further improvements were feasible. The basic NPV examples are beautiful (at least to some eyes) in their consistent and easily understood logic.
But we now know that there are important ways of improving the NPV calculation and this book focuses on these techniques.
DECISION-MAKING AND CORPORATE OBJECTIVES
The primary motivation for investing in a corporation is the expectation of making a larger risk-adjusted return than can be earned elsewhere. The managers of a corporation have the responsibility of administering the affairs of the firm in a manner consistent with the expectation of returning the investor's original capital plus the required return on their capital. The common stockholders are the residual owners, and they earn a return only after the investors in the more senior securities (debt and preferred stock) have received their contractual claims. We will assume that the objective of the firm is to maximize its common stockholders' wealth position. But even this narrow, relatively well-defined definition is apt to give rise to misunderstanding and conflict. It is possible that situations will arise in which one group of stockholders will prefer one financial decision while another group of stockholders will prefer another decision.
For example, imagine a situation in which a business undertakes an investment that its management believes to be desirable, but the immediate effect of the investment will be to depress earnings and lower the common stock price today because the market does not have the same information that the management has. In the future, it is expected that the market will realize that the investment is desirable, and at that time the stock price will reflect the enhanced value. But a stockholder expecting to sell the stock in the near future would prefer that the investment had been rejected, whereas a stockholder holding for the long run might be pleased that the investment was undertaken. Theoretically, the problem can be solved by improving the information available to the market. Then the market price would completely reflect the actions and plans of management. However, in practice, the market does not have access to the same information set as management does.
A corporate objective such as “profit maximization” does not adequately or accurately describe the primary objective of the firm, since profits as conventionally computed do not effectively reflect the cost of the stockholders' capital that is tied up in the investment, nor do they reflect the long-run effect of a decision on the shareholder's wealth. Total sales or share of product market objectives are also inadequate normative descriptions of corporate goals, ...
