The Capital Budgeting Decision

Economic Analysis of Investment Projects

Harold Bierman, Jr., Seymour Smidt

• Publisher: Routledge
• Year: 2012
• ISBN:
  9781135656232
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Fully updated and revised by international authorities on the topic, this new version of a classic and established text returns to its roots as a clear and concise introduction to this complex but essential topic in corporate finance.

Retaining the authority and reputation of previous editions, it now covers several topics in-depth which are frequently under explored, including distribution policy and capital budgeting.

Features new to this edition include:

• 
  
  

• a new chapter on real options
• new material on uncertainty in decision-making.

Easily understandable, and covering the essentials of capital budgeting, this book helps readers to make intelligent capital budgeting decisions for corporations of every type.

Chapter 1 Investment Decisions and Corporate Objectives

One questioner asked Mr. Sloan if he had made any mistakes in 40 years as a top executive of General Motors and added: “Think of one.” “I don’t want to keep you up all night,” Mr. Sloan snapped. “The executive who makes an average of 50–50 is doing pretty good.”

Exchange between Alfred P. Sloan, a long-time

Chairman of General Motors, and a journalist, reported by The New York Times on January 17, 1964

The primary motivation for investing in the common stock of a specific corporation is the expectation of making a larger risk-adjusted return than the investors require. The managers of a corporation have the responsibility of administering the firm’s affairs in a manner consistent with the expectation of returning the investors’ original capital plus the desired return (or more) on their invested capital. The common stockholders are the residual owners, and they earn a return only after the investors holding the more senior securities (debt and preferred stock) have received their contractual claims. We will assume that one of the firm’s primary objectives is to maximize its common stockholders’ wealth position. But even this narrow, relatively well-defined objective is apt to be difficult to execute. Situations frequently arise in which one group of stockholders will prefer one financial decision, while another group of stockholders will prefer another decision. Also, there are many other alternative objectives (e.g. concern for community, the welfare of management and other employees, and satisfying customers) that need to be considered.

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 annual earnings in the short term and thus lower the common stock price today, because the market does not have the same information as management. Management expects that in the future the market will realize the investment is desirable, and the stock price will then reflect the enhanced value. A stockholder expecting to sell the stock in the near future would prefer that the investment had been rejected, whereas an investor holding the stock for the long run might be pleased that the investment was undertaken. The problem might be mitigated to some extent by improving the information available to the market. Then today’s market price would better reflect the actions and plans of management. However, in practice, the market does not have access to the same information set as management does (this is a situation of asymmetric information).

A corporate objective such as “profit maximization” does not adequately describe the primary objective of the firm. Current accounting 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 benefit of a recent decision on the shareholder’s wealth. Total sales or share of product market objectives are also inadequate normative descriptions of corporate goals, although achieving an increase in sales or share of market may also lead to the maximization of the shareholders’ wealth position, by their positive incremental effect on profits.

It is recognized that a complete statement of the organizational goals of a business enterprise beyond maximizing shareholder value might embrace a much wider range of considerations, including such things as the prestige, income, security, freedom, and power of the management group, and the contribution of the corporation to the overall social environment in which it exists and to the welfare of the labor force it employs. Since the managers of a corporation should be acting on behalf of the common stockholders, the managers have a fiduciary responsibility to the stockholders. The common stockholders, the primary suppliers of the risk capital, have entrusted a part of their wealth to the firm’s management. Thus the firm’s success and the appropriateness of management’s decisions must be evaluated in terms of how well this fiduciary responsibility has been met. While we define the firm’s primary objective of the firm to be the maximization of the value of the common stockholder’s ownership rights in the firm, we recognize that any corporation is likely to have other objectives.

Investment Decisions

Business organizations are continually faced with the problem of deciding whether the current commitments of resources are worthwhile in terms of the present value of the expected future benefits. If the benefits are likely to accrue reasonably soon after the expenditure is made, and if both the expenditure and the benefits can be measured in dollars, the analysis of the problem is more simple than if the expected benefits accrue over many years and there is considerable uncertainty as to the amount of these benefits.

We shall use the term investment to refer to commitments of resources made in the hope of realizing benefits that are expected to occur in future periods. Capital budgeting is a many-sided activity that includes searching for new and more profitable investment proposals, investigating engineering and marketing considerations to predict the consequences of accepting the investment, and making economic analyses to determine the profit potential of each investment proposal.

Corporate managers have to decide on the direction their corporation will go (strategic decisions) as well as how to implement the strategic decisions (tactical decisions). We describe both types of decisions with the term capital budgeting decisions. All capital budgeting decisions have time as an important element. Outlays are made today to benefit the future.

Because corporate managers typically do not know the future, there is uncertainty. It is necessary to allocate resources without knowing the exact consequences of the decisions. The objectives of this book are to offer suggestions on how to make informed and intelligent capital budgeting decisions in a reasonable manner and also how to avoid making some subtle but very important errors.

Any good capital budgeting decision process must effectively take into consideration four basic factors:

• time value of money;
• risk considerations;
• alternative investments;
• future opportunities.

A fifth factor falls within risk considerations but is worthy of its own classification. The timing of the information that removes or reduces uncertainty is also of importance in valuation.

Unfortunately, there are several widely used computational methods which seem to consider both time and risk, but have flaws that can readily lead to faulty decisions (decisions in retrospect that should be different from the decision indicated by the calculations). These methods frequently have the virtue of relative simplicity, but they should not be used without supplemental calculations that can confirm or invalidate the conclusions.

The Limitations of Quantification

This book’s objective is to quantify the investment decision in order to improve the decision process. Measures of value will be determined to indicate whether or not a project (or projects) should be undertaken. Unfortunately, it is a frustrating paradox that the larger and the more important the decision, the more likely it is that relevant reliable quantified measures of value will not be available. The outcomes are more uncertain.

In each industry there are opportunities involving very large outlays with uncertain benefits. Frequently, these decisions must be made based on informed business judgment rather than on a single calculation indicating a “go” or “no-go” decision.

The State of Business Practice

Business practice is very good at taking into consideration the time value of money. The formula (1 + r)⁻ⁿ is universally used to transform future dollars into their present value equivalents. The interest rate (r) either takes into consideration the pure time value (using a risk-free rate), the risk of the corporation (the firm’s weighted average cost of capital), the risk of the operating unit (plant or division), the risk of the specific project being evaluated or the risk of the specific cash flow component. Obviously, all of the above cannot be right. We will attempt to offer suggestions that are both practical and more theoretically correct than current practice.

Time, Risk, and the Risk-Return Trade-Off

The two primary factors that make finance an interesting and complex subject are the elements of time and risk. Because decisions today often affect the cash flows for many future time periods and the outcomes of the actions are uncertain, we need to formulate decision rules that take risk and time value into consideration in a systematic fashion. The capital budgeting decision is as intellectually challenging as any problem that one is likely to encounter in the world of economic activity.

Frequently, the existence of uncertainty means that the decision-maker faces alternatives that involve trade-offs of less return and less risk or more return and more risk. A large part of the study of finance has to do with learning how to address these risk–return trade-off choices.

Three Basic Generalizations

We offer three generalizations that are useful in the types of financial decisions to be discussed. The first generalization is that investors prefer more return (cash and value) to less, all other things being equal (risk is held constant).

The second generalization is that investors are risk averse. They prefer less risk (a possibility of loss) to more risk and have to be paid to undertake risky endeavors. This generalization may seem contrary to common observations, such as the existence of race tracks and gambling casinos (the customers of such establishments are willing to pay for the privilege of undertaking risky investments), but the generalization is useful even if it does not apply to everyone all the time.

The third generalization is that cash to be received today is preferred to the same amount of cash to be received in the future. This generalization is valid because the funds received today can be invested to earn some positive return or can be used to reduce outstanding interest paying debt. Since this is the situation in the real world, the generalization is reasonable.

These three generalizations are used implicitly and explicitly throughout the book.

Relevance of Cash Flows

Given the objective to maximize the stockholder’s wealth, how should individual investment alternatives and other financial decisions be evaluated? For a publicly traded firm, it may be convenient to assume that the market value of the stock is a reasonable measure of its value to the shareholder. The market’s assessment of the firm’s future is incorporated in the stock price, even though this assessment is frequently going to be proven in the future not to be accurate. At any moment, the market’s assessment of the value of some firms is too high, while its assessment of the value of other firms is too low, compared to the values that ultimately occur through time. Unfortunately, there is no means by which even well-informed and astute investors with the best of models can identify with certainty which firms are overvalued and which are undervalued. For most investors, who are not in possession of special inside information (information known only to persons working for or with a firm or talking with such people), the market value of a firm is the best available measure of its value. For the privately held firm, for which there is no regularly reported market value, the wealth position of the owner is even more difficult to assess than where there is a market valuation.

Theoretically, alternative actions should be evaluated based on the extent to which they will improve the market value of the stock, and those ethical and legal actions leading to a maximization of stock value should be chosen. Unfortunately, although this strategy is theoretically correct, we cannot always forecast the consequences of decisions.

Any decision that is expected to alter the anticipated cash flows of the firm is likely to alter the value of the firm’s common stock. Cash is the common element in all decisions. Any decision can be characterized by the set of incremental cash flows that its acceptance is expected to cause. Thus, most decisions can be reduced to evaluating incremental cash flows.

It would be an overstatement to say that all decisions can be characterized and evaluated in terms of incremental cash flow, since some aspects of decisions are wholly nonquantifiable. Yet most business decisions can and should be expressed in cash flow terms. Even decisions that have large elements that do not lend themselves to exact cash flow analysis have segments that can be described in cash flow terms. For example, we may not be able to quantify the expected benefits of a research project, but we should be able to define the cash flows of the costs to be incurred. This information, when compared with rough estimates of gains, if successful, may be sufficient to determine if proceeding with the research is desirable.

Cash Flows Versus Earnings

A decision may be characterized by its effect on accounting earnings, as well as by its incremental cash flows. The forecasted earnings and cash flows would lead to consistent decisions if earnings were computed in accordance with very special rules. Thus, you should not be concerned that cash flows are being used to evaluate decisions in this book. There is no essential conflict with the use of cash flows and the use of good accounting earnings to evaluate investments.

We consider future cash flows to be a relevant measure of the impact of a decision on the firm and will use anticipated cash flows as the primary input in the decision to be analyzed. After the decision has been made, the actual income measures tend to be easier to use than actual cash flows as inputs into performance measurement calculations.

The Capital Market

All corporations at some stage in their life go to the capital market to obtain funds. The market that supplies financial resources is called the capital market and it consists of all savers (banks, insurance companies, pension funds, individuals, etc.). The capital market gathers resources from the savers of society (individuals or organizations consuming less than they earn) and rations these savings to those entities that have a need for new capital and that can pay the price the capital market defines for capital.

The availability of funds (the supply) and the demand for funds det...