0 оценок0% нашли этот документ полезным (0 голосов)

12 просмотров29 страницefsgedf

Apr 07, 2016

01_Adv Issues in Cap Budgeting

© © All Rights Reserved

PPT, PDF, TXT или читайте онлайн в Scribd

efsgedf

© All Rights Reserved

0 оценок0% нашли этот документ полезным (0 голосов)

12 просмотров29 страниц01_Adv Issues in Cap Budgeting

efsgedf

© All Rights Reserved

Вы находитесь на странице: 1из 29

Budgeting (FM-II)

April 7, 2016

Introduction 1

Our job was simple

Estimate the cash flows from the investment, and

Discount the same at an appropriate discount rate

selecting a good project has no effect on other concurrent or

subsequent projects

Firms with +ve NPV projects can raise capital at a fair price

two following factors

Projects are mutually exclusive serving the same purpose

accepting one makes the other proposal redundant, and/or

Firm has limited capital it cannot take every project with

positive NPV/ high IRR

April 7, 2016

Introduction 2

force the firm to take another one in future (pre-requisite)

Current investment decision should take this into account

Though we mentioned a few dos & donts

We did not deal with the whole range of practical issues

IRR

And the ways to resolve the conflict analytically

But we did not probe whether the choice of NPV versus IRR

(as decision rule/criterion) depends on

Firm characteristics, or

Project settings (e.g., size, life, risk, etc.)

April 7, 2016

Introduction 3

future/pre-requisite) may limit ability of managers to select

a current project

Its also possible that lack of capital may force managers to

reject other good (+ve NPV & high IRR) projects

Such, and other situations lead to Capital Rationing

April 7, 2016

a firm is unable or unwilling to raise the capital and/or unable to

invest in projects that earn returns higher than the hurdle rate

ones)

1) Project Discovery: It is assumed that firms know when

they have good (+ve NPV / IRR>WACC) projects at hand

However, uncertainty and errors of project analysis may

lead to a firm feeling undecided about its own project

assessment (and the estimated +ve NPV)

And chose not to pursue the investment

April 7, 2016

Capital Rationing 1

about its projects to the funding entities (institutions or

market)

Firms attempt to do so in practice as well

Because it is easy for a firm to claim that its future projects

are good, regardless whether such claims are actually true or

not

So funding entities require substantial backing for viability

of projects

Firms that are unable to provide this backing are unable to

convince funding entities

This is particularly serious for smaller firms and start-ups

April 7, 2016

Capital Rationing 2

That the projects will create value (on the top of the firms

own perceived indecisiveness about its own estimation of

NPV)

3) Market Efficiency: Markets may remain (excessively)

optimistic (over-valued) or (extremely) pessimistic (undervalued) for a considerable period of time

That is, markets are not efficient since value is not equal

to price at all the times

Managers know the value better than anybody else

credibility of communication (or information asymmetry) is

another issue

When markets are undervalued (in times of recession, as in

2012/13 in India), stock prices continue to be depressed

April 7, 2016

Capital Rationing 3

even the very best of the future projects

Since they will have to pay high price by selling equity at

lower than its value

See Example-1

The opposite happens when markets are overvalued

Leading to a tendency of over-investment

Because existing shareholders gain by issuing shares

April 7, 2016

Capital Rationing 4

4) Floatation Costs:

Direct (fees to investment bankers, bankers, legal experts, costs

of complaince, distribution costs, etc.) and

Indirect (under-pricing or selling at market price below true

value for IPOs & FPOs, negative announcement effect for FPOs)

NPV substantially

Implication of Capital Rationing

Firms cannot accept all +ve NPV projects because they

dont have unlimited capital

Projects have to be ranked and we are back into NPV

versus IRR issues

April 7, 2016

We know that conflict may arise (between NPV rule & IRR

rule) in all situations except for

YES-NO decision (firm has only one investment opportunity),

AND

Conventional project

of values of the discount rate

Now we probe two further points of difference between

NPV & IRR

See Example 2A

Implicit assumption intermediate cash flows get

reinvested at hurdle rate (15%) for NPV and at IRR for

computation of IRR

April 7, 2016

higher than cost of capital [COC] (15%)

Conflict arises in spite of the facts that

Both are conventional projects, and,

Since discount rates are same, ranking vis--vis Y/N decision is

not responsible for the conflict

NPV is stated in rupee amount, and hence is affected by scale

IRR, being a rate, is not affected by scale

IRR is scale-independent

April 7, 2016

type of conflict (due to difference in scale of projects)

Both NPV and IRR (implicitly) assumes reinvestment of the

cash flows till the maturity

But NPV uses the (much-lower than IRR) COC as the discount rate

While IRR uses the IRR as the discount rate, which (i.e., the latter,

or the IRR) as the discount rate (COC of 15% for NPV, as against

IRR of 33.66% for A and 20.88% for B)

While a smaller rate (of COC than IRR in either case) at the

denominator makes NPV larger, the IRR is not dependent on

the COC

The result is: while NPV tends to favour larger projects, IRR is

invariant to scale and COC

So long as both have positive NPV and IRR>COC(of A &/or B)

April 7, 2016

different timing of cash flows is also a culprit

Demonstrated by the case of comparing NPV for two projects

with similar scale Example 2B

CONVENTIONAL PROJECTS of same scale

of

(COC for NPV and IRR for IRR Rule)

And when larger portion of CF coming in later years (Project B

of Ex-2B) nullifying the effect of reinvestment assumption

Timing of cash flows may also be responsible for the NPVIRR conflict

It appears from Ex-2A that IRR does a better job in taking

into account the timing of cash flows

April 7, 2016

Is biased towards investments of larger scale

Is biased towards projects for which a larger proportion of CFs

come at later stage than otherwise

Due to lower discount rate

rationing (limited capital)

firms

But its reinvestment assumptions may still skew the investment

decisions

For example, in those genuine cases where external conditions

dictate that the scale of the project is high and/or CFs can only

come at later stage

April 7, 2016

This is how:

If the firm has easy access to capital markets, and/or if the

extent of information asymmetry faced by the firm is low,

Leading to the difference in cost of external and internal finance

low,

It can select both projects

Since both yield positive NPV as well as high IRR (above cost

of capital even beyond WACC of 19.35%)

Due to substantial information asymmetry

Causing the cost of external finance to be substantially higher

than internal finance

Choosing the project requiring larger investment (B) may force it

to abandon future projects even with higher NPV and/or IRR

than projects A & B now

April 7, 2016

creation under limited capital (Capital Rationing)

The smaller scale project (A) (of Ex-2A) is a better choice

Since it uses a much smaller capital

asymmetry, like those who

Are small in size

Lack physical assets to collateralize

Face riskier operating environment, and so on

NPV

Thus firms facing lower degree of information asymmetry

(e.g., large and long-listed firms) will do better by following

the NPV rule

April 7, 2016

NPV-IRR conflict due to any of the factors) yielding better

decisions

A) Using a scaled version of NPV called Profitability Index (PI)

B) Using a Modified IRR (MIRR) approach with more

reasonable reinvestment rate assumptions

C) Using a more complex linear programming approach that

allows capital constraints across many periods (& not just for the

current period)

NPV (from the IRR attack)

April 7, 2016

This one tries to address the weakness of NPV Rule arising

due to scale effect

PI = NPV / (Initial Investment)

PI for a project measures the total value creation to a firm

per rupee of initial investment (if project accepted)

When there is Capital Rationing and there are several

positive NPV projects,

Rank the projects in descending order of PI, and

Select the projects from the top that is allowed by available

capital

April 7, 2016

Note: Another version defines the PI ratio as PV of all CFinflows to PV of all CF-outflows during the life of the

project

The resulting ranking will be the same by PI as defined before

See Example 3A

There are several limitations of the PI-based Ranking

A.i) It concentrates on the current period only but capital

rationing constraint is usually spread over more than one

period

Projects chosen this year (using PI) may limit the firms ability

to investment in more profitable future projects

absorb investable funds available this year

April 7, 2016

See the choice of projects in Ex-3A with a constraint of Rs. 100

crore, and note the amount that cannot be invested

Now assume that Project B (in Example-3A) is a necessary prerequisite for any of the other projects, and find out resources that

cannot be invested due to capital constraint of current year

Compare the two outcomes

See Ex-3B

Here a reconciliation between NPV and IRR is attempted

One reason of conflict is the different re-investment rate

assumption (IRR at IRR but cost of capital for NPV)

Modified IRR (MIRR) is the IRR for which reinvestment of

intermediate cash flows is done at cost of capital

April 7, 2016

At cost of equity if cash flows are to equity investors, and

At cost of capital if cash flows are to the firm

See Example-4

Many believe that MIRR is a mix of the NPV and IRR rules

Not without reason

individual projects (IRR) and hurdle rates (CoC) used by the

firm

With weights on each depending on magnitude and timing of cash

flows

Larger and earlier the cash flows from the project, greater is the

weight attached to the CoC (Cost of Capital)

same scale and lives

April 7, 2016

So far we focused on current period capital rationing

In reality, it applied across time periods

When multi-period constraints are combined with projects

that require investment over many periods,

Our existing toolkit fails to handle the complexity

The solution is to apply linear programming

Problem formulation is as follows:

April 7, 2016

Maximize

X

j 1

NPV j

Subject to the constraints:

k

X

j 1

INV j ,1 1,000

X

j 1

X

j 1

April 7, 2016

INV j , 2 1,200

INV j ,3 1,400

Rs. Million) required on

investment j in period t.

Many firms, when faced with CR, simply raise the hurdle

rates

So that fewer projects are available on the drawing board

There are several problems with this approach

Once adjusted, firms may fail to correct it, especially when the

constraint gets relaxed with increase in size and age of firm

NPV computed by using a discount rate that is higher than the

true discount rate does not convey the same information

amount of wealth increase

Finally, this penalizes all projects whether capital-intensive or

not

Even PI does a better job in conserving scarce capital

April 7, 2016

Project Dependence

Even in the absence of CR, selection of one project may

lead to rejection of another

For example, an information technology product to do a

particular job, or product distribution service

See Examlpe-5.

Problem arises when two mutually exclusive projects have

unequal lives

Projects with Unequal Lives

Consider a 5-year and a 10-year project

The 5-year project may be replicated for another 5 years

And now the 10-year project can be compared with

replicated two 5-year projects

April 7, 2016

To compare the two, we must relpicate 5-year project 4

times and 4-year project 5 times

And then compare two 20-year projects

projects

after replication, you face the daunting task of estimating

cash flows for 126 years !!!

There is a better method

April 7, 2016

It is the annualized NPV of a multi-period project

Since it is a figure on per annum basis, projects with

unequal lives can be compared

The formula is as follows:

r

Equivalent _ Annuity NPV *

n

1 1 r

Where

r: project discount rate

n: project lifetime

See Example-6.

April 7, 2016

myriads of options

That are involved in actual capital budgeting decisions

Option to delay a project

Option to expand to cover new product and/or market in future

Option to abandon

What are options? What are financial options? What are real

options? How are they (financial and real options) different?

April 7, 2016

Readings

April 7, 2016

## Гораздо больше, чем просто документы.

Откройте для себя все, что может предложить Scribd, включая книги и аудиокниги от крупных издательств.

Отменить можно в любой момент.