BF Ch 10 capital budgeting : decision criteria and real option considerations

which capital budgeting criteria are there (which methods can we use)

payback period

net present value

internal rate of return

profitability index

payback period

numbers of years for the cummulative net cash flows to pay back the net investment

payback pariod characteristics

simple

ignores CF after the payback period

ignores the time value of money

may lead to decisions that do not maximize shareholder wealth

Net present value

present value of the net cashflows - net investment

is the estimation of the wealth that the investment porject creates for the stockholders

when is NPV acceptable

NPV > 0 acceptable project

pos NPV increases owner’s wealth

neg NPV decreases owner’s wealth

NPV nadelen

is een absolute maatstaf (grote projecten grotere kans op hogere NPV

the internal rate of return (RR)

the expected return of the project

discount rate that equates the NONV to the OV of NCF’s

rentevoet die ervoor zirgt dat de NPV = 0

= het eigenlijk verwacht rendement

IRR characteristics

IRR > k → acceptable project (with k = cost of capital)

IRR >= k ←> NPV >0

NCF pattern with also negative NCF’s can result in multiple IRR’s → not good, don’t use it

for what type of projects can NPV and IRR disagree + which is preffered

for mutually exclusive projects

→ then NPV is preffered

profitability index

ratio of the PV of NCF by the NINV

relative measure showing wealth creation per dollar of investment

profitability index characteristics

PI >= 1 acceptable

IRR >= k ←> NPV >= 0 ←> PI >= 1

on what type of projects can NPV and PI criteria disagree + which is preferred

mutually exclusive projects

with no capital rationing, the NPV is preferred

PI preferred under capital rationing

capital budgeting under capital rationing

calculate the PI for projects

order the prokects from the highest to the lowest PI

accept projects with the highest PI until the entire capital budget is spent

investment timing option

delaying, to evaluate additional informatioin (invsting now or next year)

abandonment option

permanent, to avoid negative cash flows (when production costs rise due to rising oil price)

shutdown options

temporarely to avoid negative cashflows

growth options

second-stage investment, to generate large positive cashflows (for example first stage R&D investment)

design-in options

input/ output or exansion flexibility

flexibility intentionally built into a project, product, or process during its design phase to adapt to future uncertainties or changes in the environment. This flexibility can apply to inputs, outputs, or capacity.

methods to equate project lives

continue the replacement chain of the shorter life project till the life of the longer life project is reached

transform the NINV - NCF chain into an equivalent NPV

the equivalent annual annuity can be viewd as

the equivalent annual cashflow from the investment project’s replacement chain