Online Financial Courses - Capital Budgeting AnalysisProvided by : Matt H. Evans
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Course 2: Capital Budgeting Analysis
Chapter 1: The Overall Process
Capital ExpendituresWhenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase of new equipment, expansion of production facilities, buying another company, acquiring new technologies, launching a research & development program, etc., etc., etc. Capital expenditures often involve large cash outlays with major implications on the future values of the company. Additionally, once we commit to making a capital expenditure it is sometimes difficult to back-out. Therefore, we need to carefully analyze and evaluate proposed capital expenditures.
The Three Stages of Capital Budgeting AnalysisCapital Budgeting Analysis is a process of evaluating how we invest in capital assets; i.e. assets that provide cash flow benefits for more than one year. We are trying to answer the following question:
Will the future benefits of this project be large enough to justify the investment given the risk involved?
It has been said that how we spend our money today determines what our value will be tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project. We will include three stages within Capital Budgeting Analysis:
- Decision Analysis for Knowledge Building
- Option Pricing to Establish Position
- Discounted Cash Flow (DCF) for making the Investment Decision
Stage 1: Decision AnalysisDecision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcomes. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and start-up costs. Consequently, we can not manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and assess all relevant variables and outcomes within an analytical hierarchy.
In financial management, we refer to this analytical hierarchy as the Multiple Attribute Decision Model (MADM). Multiple attributes are involved in capital projects and each attribute in the decision needs to be weighed differently. We will use an analytical hierarchy to structure the decision and derive the importance of attributes in relation to one another. We can think of MADM as a decision tree which breaks down a complex decision into component parts. This decision tree approach offers several advantages:
- We systematically consider both financial and non-financial criteria.
- Judgements and assumptions are included within the decision based on expected values.
- We focus more of our attention on those parts of the decision that are important.
- We include the opinions and ideas of others into the decision. Group or team decision making is usually much better than one person analyzing the decision.
Simple Example of a Decision Tree:
Stage 2: Option PricingThe uncertainty about our project is first reduced by obtaining knowledge and working the decision through a decision tree. The second stage in this process is to consider all options or choices we have or should have for the project. Therefore, before we proceed to discounted cash flows we need to build a set of options into our project for managing unexpected changes.
In financial management, consideration of options within capital budgeting is called contingent claims analysis or option pricing. For example, suppose you have a choice between two boiler units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on traditional approaches to capital budgeting, the least costs boiler was selected for purchase, namely Boiler A. However, if we consider option pricing Boiler B may be the best choice because we have a choice or option on what fuel we can use. Suppose we expect rising oil prices in the next five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a second fuel to better control operating costs. Consequently, we want to assess the options of capital projects.
Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options give us more opportunities for creating value within capital projects. We need to think of capital projects as a bundle of options. Three common sources of options are:
1. Timing Options: The ability to delay our investment in the project.
2. Abandonment Options: The ability to abandon or get out of a project that has gone bad.
3. Growth Options: The ability of a project to provide long-term growth despite negative values. For example, a new research program may appear negative, but it might lead to new product innovations and market growth. We need to consider the growth options of projects.
Option pricing is the additional value that we recognize within a project because it has flexibilities over similar projects. These flexibilities help us manage capital projects and therefore, failure to recognize option values can result in an under-valuation of a project.
Stage 3: Discounted Cash FlowsSo we have completed the first two stages of capital budgeting analysis: (1) Build and organize knowledge within a decision tree and (2) Recognize and build options within our capital projects. We can now make an investment decision based on Discounted Cash Flows or DCF.
Unlike accounting, financial management is concerned with the values of assets today; i.e. present values. Since capital projects provide benefits into the future and since we want to determine the present value of the project, we will discount the future cash flows of a project to the present.
Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because:
1. Inflation reduces values over time; i.e. $ 1,000 today will have less value five years from now due to rising prices (inflation).
2. Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now, but a lot can happen over the next five years.
3. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return.
Present values are calculated by referring to tables or we can use calculators and spreadsheets for discounting. The discount rate we will use is the opportunity costs of the investment; i.e. the rate of return we require on any other project with similar risks.
If we were to receive the same cash flows year after year into the future, then we could use the present value tables for an annuity.
We now understand discounting of cash flows (DCF) and the three reasons why we discount future cash flows: Inflation, Uncertainty, and Opportunity Costs.
Chapter 1 pointsCapital Expenditures
The Three Stages of Capital Budgeting Analysis
Stage 1: Decision Analysis
Stage 2: Option Pricing
Stage 3: Discounted Cash Flows