Capital Budgeting
In Practice
11
Corporate Financial Management 3e
Emery Finnerty Stowe
© Prentice Hall, 2004
Examples of Capital Budgeting
Options
Option to replace an asset.
Option to change selling prices.
Future investment opportunities.
The abandonment option.
The postponement option.
Capital Budgeting Options
A project’s NPV =
Discounted Cash Flow NPV (DCF-NPV)
+ Value of Options – Cost of Options
While it is difficult to place a value on all
capital budgeting options, they should not
be ignored.
The Price-Setting Option
Suregrip Leather Co. (SLC) currently manufactures
and sells 8 million leather belts per year, and is
operating at capacity. Demand is expected to increase
for at least the next five years.
SLC could invest $6 million now in additional
manufacturing facilities. The NPV of this expansion is
$850,000.
SureGrip (cont’d)
Alternative, the current price of a belt ($2.10) could be
increased. The demand curve has been estimated to
be:
D=$82 million / (Price)3
(given by consultant)
Variable cost per unit is $1.20, the cost of capital is
15% and the current tax rate is 40%.
The Price-Setting Option
The two alternatives faced by the SureGrip
Leather Co. (SLC) are:
1. Expand capacity, NPV = $850,000.
2. Increase unit wholesale price.
SLC should choose the alternative that has
the highest positive NPV.
The Price-Setting Option
The maximum unit price which the market will
support can be obtained by setting the quantity
demanded equal to current capacity in the
demand equation and then solving for the
market-clearing price.
$82million
Q Demanded  8,000,000 units 
3
Price
So Price  $2.17
The Price-Setting Option
This new price of $2.17 is $0.07 higher than the
current wholesale price.
By selling 8 million units per year, SLC’s
revenues will increase by (8 million)($0.07) or
$560,000 per year for 5 years, without any
additional investment!
The after-tax revenues will increase by
$560,000×(1 – 0.40) or $336,000 per year for 5
years.
NPV of this (at 15%) is $1,126,324.
The Price-Setting Option
Adding additional production capacity has
an NPV of $850,000 after an investment of
$6 million today.
Increasing the wholesale price has an NPV
of $1,126,324 without any additional
investment.
SLC should go with the latter alternative.
The Price-Setting Option
Since SLC’s current price of $2.10 is below the
maximum price the market will pay per unit and
demand 8 million units, SLC has the option to
increase its unit price.
The expansion proposal increases the operating
leverage of SLC.
If demand declines in the future,


the expansion would be costly to reverse.
price could be cut back to stimulate demand.
Future Investment Opportunities
These are options to identify future, more valuable
investment possibilities resulting from current
opportunities.


Manufacturing and distributing a new product now puts
a marketing/distribution network in place for future use.
Money spent on research and development of a new
idea gives the option to develop the product later on.
Not all future investment possibilities can be
accurately measured in terms of their value.
The Abandonment Option
The abandonment option is the option to
stop the project earlier than originally
planned.
The abandonment value of assets is
enhanced by the presence of active usedequipment markets.

Generic assets versus special purpose assets.
The Abandonment Option
Venda-A-Cart, Inc. is considering a new
project that is expected to last for 4 years. The
cost of capital is 15% and the project’s aftertax cash flows and abandonment values are
given in the table on the next slide.
Should Vend-A-Cart invest in this project?
The Abandonment Option
Year
CFAT
0
1
2
3
4
($40,000)
$13,600
$13,600
$13,600
$13,600
Abandonment
Value
$40,000
$30,000
$15,000
$14,000
$1,500
Abandon in Year 4
–$40,000
$13,600
$13,600
$13,600
$13,600
+$1,500
t=0
t =1
t=2
t=3
t=4
$13,600 $13,600 $13,600 $15,100
NPV  $40,000 



2
3
4
(1.15)
(1.15)
(1.15)
(1.15)
NPV  $314.66
Abandon in Year 3
–$40,000
$13,600
$13,600
$13,600 +
$14,000
t=0
t =1
t=2
t=3
$13,600 $13,600 $27,600
NPV  $40,000 


2
(1.15)
(1.15)
(1.15) 3
NPV  $257.09
t=4
Abandon in Year 2
–$40,000
$13,600
$13,600 +
$15,000
t=0
t =1
t=2
$13,600 $28,600
NPV  $40,000 

(1.15)
(1.15) 2
NPV  $6,548.20
t=3
t=4
Abandon in Year 1
–$40,000
$13,600 +
$30,000
t=0
t =1
t=2
$43,600
NPV  $40,000 
(1.15)
NPV  $40,000  $37,913.04
NPV  $2,086.96
t=3
t=4
The Abandonment Option
The NPV of the project, if kept for 4 years
is ($315).
If abandoned after 3 years, the NPV is $257.
Thus, the value of the abandonment option
is $257 - ($315) or $572.
The Postponement Option
Suppose that your firm owns a forest.
If you were to open a logging camp, the start-up
costs would be $50,000.
The amount of lumber that could be logged would
result in a $75,000 after-tax inflow at the end of
one year. Then the project is over. The discount
rate is 10%
The forest is growing such that for each year we
wait to start, the after-tax cash inflow grows by 5
percent per year.
This growth will stop after 3 years.
When should they start the project?
The Postponement Option
Evaluate three mutually exclusive
projects:
1. Start the project today.
2. Start the project in one year.
3. Start the project in two years.
Calculate the NPV at time zero for each
one and pick the highest
$75,000
NPV  $50,000 
1.10
Start t = 0
 $18,181.82
Start t = 1
$50,000 $75,000 1.05
NPV  

1.10
1.10 2
 $19,628.10
wait
Start t = 2
$50,000 $75,000 1.052
NPV  

2
1.10
1.103
 $20,802.03
Problems in Defining
Incremental Cash Flows
If two alternative manufacturing processes differ
only in their levels of operating leverage, sales
revenues are not affected by the choice of the
process.
This does not imply that sales revenues can be
ignored in the analysis.
The high-risk project’s total cash flows are riskier
than the low-risk project’s:

With lower sales, the project with the lower operating
leverage will also have lower cost.
Capital Rationing
Capital rationing limits the firm’s capital
expenditures during a given time period.
Capital rationing can be imposed by:


using a discount rate that is higher than the project’s
cost of capital, or
setting an explicit upper limit on the total dollar
investment.
The first method reflects managerial desire to be
conservative:

It understates the true NPV of the project.
Capital Rationing
In a perfect capital market, a firm can always
obtain the necessary funds for a positive NPV
project.
In practice, obtaining necessary funds may be
difficult due to:

asymmetric information (about the true value of the
project) between the investors and the firm.


the adverse selection problem.
transaction costs associated with raising funds.

These costs reduce the NPV of the project.
Hard versus Soft Capital
Rationing
With hard capital rationing, the limit on
total capital spending is strictly enforced.
With soft capital rationing, the firm sets a
target limit on capital expenditures.
Exceptions may be made if a particularly
desirable project becomes available.
 Alternatively, the firm might under-spend if
conditions warrant.

Project Choice Under Capital
Rationing
The objective is to select the set of projects
that maximize the total NPV of the capital
budget, subject to the constraints on the
invested capital.
The Profitability Index (PI) can help in this
process.
PI measures the NPV per dollar invested.
Project Choice Under Capital
Rationing
The Venda-A-Cart Co. has the following
projects available. Total investment is limited to
$3.4 million. Which projects should it select?
Project
Cost
NPV
A
B
C
D
E
F
$1,200,000
$900,000
$700,000
$600,000
$600,000
$300,000
$864,000
$360,000
$784,000
$570,000
$270,000
$60,000
Project Choice Under Capital
Rationing
Projects ranked by their Profitability Index
Project
C
D
A
E
B
F
Cost
NPV
PI
$700,000
$600,000
$1,200,000
$600,000
$900,000
$300,000
$784,000
$570,000
$864,000
$270,000
$360,000
$60,000
2.12
1.95
1.72
1.45
1.40
1.20
Project Choice Under Capital
Rationing
If the firm chooses projects C, D, A, E, and
F (in descending order of their PI values):
the total investment is $3.4 million.
 the total NPV is $2,548,000.

Suppose the firm chooses B instead of both
E and F.
The total investment is $3.4 million.
 The total NPV is $2,578,000.

Managing the Firm’s Capital
Budget
Capital rationing can be used as a planning
tool for capital expenditures.
Managerial authority and responsibility:
A divisional manager must have some leeway
in approving capital projects.
 Managers from different functional areas must
work cooperatively for the good of the firm.

Managing the Firm’s Capital
Budget
Managerial Incentives and Performance
Evaluation

If managers are evaluated and rewarded for their
performance, self-interested behavior leads to optimal
performance for the good of the firm.
Post-Audits



A post-audit is a procedure for evaluating the
performance of a capital budgeting decision after its
implementation.
Abandonment option.
Advantage of hindsight.
Applying the Principles of
Finance
Valuable New Ideas


Pursuing valuable investment ideas is the best way to
achieve extraordinary returns.
New ideas are not limited to new products.
Comparative Advantage

Make use of current expertise.
Market Efficiency


There is useful information in a physical asset’s markettraded price.
You should think long and hard before you conclude
that a market price is “wrong.”