Capital Budgeting in
Practice
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Milestones in Development
of NPV Analysis
F For many years there was just the Payback Period
F 1899: Irving Fischer first articulates concept
NPV = Mkt value of securities minus cost of resources
F 1929: Irving Fischer, Theory of Interest
NPV is key part in theory of optimal resource allocation
F 1951: Joel Dean, Capital Budgeting
Implementation of DCF methodology in current form
F 1964: John Magee, “Decision Trees for Decision
Making”
Incorporates decision tree methods into capital budgeting
F 1964: David Hertz, “Risk Analysis in Capital
Budgeting”
Incorporates computer simulation into capital budgeting
F 1964: William Sharpe introduces CAPM and SML
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Milestones in Development
of NPV Analysis
F 1973: Black, Scholes, and Merton develop 1st Option
Pricing Model
F 1978: Stewart Myers introduces concept of Real
Options
F 1997: 1st Annual International Conference on Real
Options, Columbia University
F 1998: Titman & Grinblatt publish corporate finance
text based entirely upon options analysis
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Readings Package
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Gitman & Forrester
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Shakey Foundations of
Capital Budgeting (1976)
F Begins by criticizing reliance upon forecasting
F Shifts to early-stage discussion of strategic
considerations as basis for capital investment
decisions
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Shakey Foundations of
Capital Budgeting (1976)
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Shakey Foundations of
Capital Budgeting (1976)
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Shakey Foundations of
Capital Budgeting (1976)
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Shakey Foundations of
Capital Budgeting (1976)
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Shakey Foundations of
Capital Budgeting (1976)
Key questions:
F Is it a game worth playing?
F Are my people up to the challenge of playing
the game at this level?
F Can my people adapt?
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Tom Copeland
Capital Investment Decisions Out of Control
Symtoms of Capital Inefficiency
l Blanket Spending
l Unintegrated approach
l Myopic planning
l “Entitled” spending
l Missed budget targets
l Badly aligned incentives
l No post-audit procedure
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F Dave Glassman: EVA
F Stewart Myers: 1984 challenge
F David Luerhman: Adjusted Net Present Value
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Scenario Planning
F Royal Dutch Shell
l
Staff develops two scenarios
—Best Case
—Worst Case
l
All plans must be flexible
enough to work in either
scenario
F ARCO
l
Staff develops five scenarios
—Best Case
—Good Case
—Middle
—Bad Case
—Worst Case
l
People tend to plan for middle
“most likely” case
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Quote from Pierre Wack
“Despite all Shell’s efforts to develop the use of
scenario planning, it is well known that theory
and practice are usually very far apart in
management.”
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Other Milestones in
Business Strategy
F 1980: Michael Porter, Competitive Strategy
F 1985: Michael Porter, Competitive Advantage
F 1990: Prahalid & Hamel, “Core Competence of
the Corporation”
F 1992: Stalk, Evans, and Shulman, “Competing
on Capabilities”
F 1994: Rosabeth Moss Kanter, “Collaborative
Advantage”
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Tracy O’Rourke on
CIM
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Tracy O’Rourke on
CIM
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Tracy O’Rourke on
CIM
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Mahoney Reshapes
Monsanto for the Future
F Things a company should do
l
l
l
Stop doing what it can’t do well
Find out what it does well and try
to do it a lot better
Start some new things to replace
the old
F Research at Monsanto
l
l
Old way: complete line of
capabilities
New way: work with best
independent labs in the world
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Monsanto
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Monsanto
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Strategy Meets Finance
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The Greatest
Capitalist in History
Thomas J. Watson Jr.
F IBM stock increased in
value by $36 billion during
his 15 year tenure (1956 to
1971)
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What are the Value
Drivers?
F Market value of physical
assets
l
l
Consider change in net worth
when new assets and liabilities
are included in the balance sheet
—When would impact on net
worth be neutral? …
Negative? … Positive?
You may be able to stop here
if neutral or positive
F Added earning power
derived from new assets
l
l
F Option approaches continue from
here
l
l
Value of new opportunities
Enhanced value of human capital
— Stronger organizational capital
via enhanced flexibility
— New incentives offered to key
decision makers
l
l
Enhanced technology
Enhanced competitive advantage
DCF methods focus on these
earnings
You may be able to stop here, too
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How are Real
Options Different?
FFinancial Options
assets
are financial assets
FReal Options
l Underlying
l Underlying
l Rules
l Rules
governing
exercise are stated
in contract
assets
are physical items
governing
exercise reflect
realities in the
physical realm
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Score Card
FDCF significantly underestimates value
by ignoring real options
FRO also underestimates value
FRO doesn’t cover important parts of the
value chain
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The physical value chain from a
global perspective:How much of it
have we covered so far?
Support Activities:
•Technology Development
•Human Resources
Development
Service
Distribution&
Marketing
Fabrication
Refining
Basic Extraction
Physical
Realm
Value Added at
Each Step
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Score Card
FVirtual option analysis helps fill the gap
even further
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How are Virtual
Options Different?
F Real Options
l
Underlying assets are
physical items
l
Rules governing exercise
reflect realities in the
physical realm
F Virtual Options
l
Underlying assets are
information items
l
Rules governing exercise
reflect realities in the
information realm
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Transition-Phase
Virtual Options
FDerive from information products
FUnderlying assets are real options
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Virtual Value Chain &
Information Operations
GATHER AND APPLY IN THE PHYSICAL REALM
STORE AND TRANSFORM IN THE INFORMATION REALM
APPLY
PRESENT
DISTRIBUTE
SYNTHESIZE
Infosphere
SELECT
ORGANIZE
GATHER
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Option Applications
F
Growth options
l See
F
Options to abandon
l See
F
Black/Scholes (1973), Myers (1977)
Kensinger (1980), Myers & Majd (1984)
Options to shut down temporarily
l See
McDonald and Siegel (1985)
l See Brennan & Schwartz (1985)
l See Siegle, Smith, & Paddock (1988)
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Option Applications
F
Options to choose the most profitable of
several activities
l See
F
Chen, Conover, and Kensinger (1998)
Strategic Options
l See
Grinblatt & Titman (1998)
l See Luerhman (1998)
l Amram & Kulatilaka (2000)
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