Advanced Capital Budgeting: Refinements in the Economic Analysis of Investment Projects Book

List of illustrations     xiii
Preface     xvii
Capital Budgeting and Valuation Under Certainty     1
The State of the Art of Capital Budgeting     3
Decision-making and corporate objectives     3
The evolution of capital budgeting practice     5
Surveys of practice     5
The discount rate     7
Cash flow components     8
The calculation of the discount rate     8
The time risk interaction     8
Real options     9
Three problems     10
Time discounting     10
Present value addition rule     11
Present value multiplication rule     11
The term structure of interest rates     11
Risk and diversification     13
Strategic considerations     14
Three basic generalizations     16
The capital market     16
Global business aspects     17
Conclusions     17
Problems     18
Discussion question     19
Bibliography     19
Amounts Discounted and Discount Rates     21
The FCF method     23
The CCF method     24
The adjusted present value method     25
Equivalence of the methods     26
The FCF method     27
The CCF calculation: the value to investors     27
Adjusted present value     28
Costs of financial distress     29
The costs of capital     29
The WACC with debt     31
Valuation: a summary     32
With no debt     33
With {dollar}600 of debt substituted for stock     33
With debt (use of APV)     34
The use of r* (the CCF method)     34
Calculation of discount rates     35
Finite-lived assets     36
Global business aspects     36
Conclusions     37
Problems     38
Discussion question     39
Bibliography     39
Appendix derivations     39
Capital Budgeting and Valuation Under Uncertainty     41
Capital Budgeting with Uncertainty     43
Tree diagrams     43
Period-by-period summaries     46
Sensitivity analysis     46
Simulation     48
Risk preferences     50
Certainty equivalents     52
Time and risk     53
Risk adjusted discount rates     54
The required return     55
Default-free rate of discount     55
The borrowing rate     57
Changing the uncertainty     57
Global business aspects     58
Conclusions     58
Problems     59
Discussion question     60
Bibliography     60
Elements of Time and Uncertainty     62
The investment process     63
The discount rate     66
Converting expected cash flows     68
The discount rate assumption     69
Capital budgeting with constant risk aversion     69
Capital budgeting with constant a risk adjusted rate     71
A capital market perspective     73
A qualification of the CAPM decision rule     74
Global business aspects     74
Conclusions     74
Quiz     75
Problems     75
Discussion question     76
Solution to quiz     76
Bibliography     77
The State Preference Approach     79
Prices with certainty     79
Prices with uncertainty      80
The three factors     82
The expected risk-adjustment     84
Countercyclical assets     84
Required rates of return     85
Application of the risk-adjusted present value approach     86
Multiperiod investments     86
Applying the risk-adjusted present value factors     88
Global business aspects     90
Conclusions     90
Problems     91
Discussion question     93
Bibliography     94
Resolution of Uncertainty     95
Risks, returns and the resolution of uncertainty     95
Introducing the three assets     97
Asset values by node     101
Expected rates of return by asset and node     102
Conclusions about the three assets     104
An alternative calculation     106
Introducing the two projects     107
Global business aspects     108
Generalizations     108
Problems     109
Discussion question     111
Bibliography     111
Diversification and Risk Reduction     112
Systematic and unsystematic risk     113
Diversification      114
Introduction to portfolio analysis     115
The portfolio problem in perspective     116
The co-variance     117
The efficient frontier of investment alternatives     120
Perfect positive correlation     120
Perfect negative correlation     121
Imperfect correlation     122
The power of diversification: independent investments     122
Positively correlated investments     124
Observations regarding diversification     126
The risk-free asset     127
The assumptions     127
Portfolio analysis with a riskless security: the capital asset pricing model     128
The expected return     130
Use of the CAPM     131
Systematic and unsystematic risk     131
Implications for corporate investment policy     133
Unsystematic risk     134
Global business aspects     134
Conclusions     135
Review problem 1     136
Review problem 2     136
Review problem 3     136
Problems     137
Discussion question     140
Solution to review problem 1     140
Solution to review problem 2      141
Solution to review problem 3     141
Bibliography     142
Statistical background     143
Projects with Components Having Different Risks     145
A new product project with two different cash flow components     146
Calculating the value of an asset by discounting its net cash flow     147
Increasing the proceeds     150
A new market for an old product     150
Disadvantages of using a single discount rate     152
Finding the composite discount rate for projects with a finite life     152
Buy versus lease     154
Discount rates and corporate income taxes     156
The present value calculation technique used     157
Global business aspects     157
Conclusions     158
Problems     158
Discussion question     160
Bibliography     160
Derivation of the formula for the after-tax discount rate for a cash flow component     160
Practical Solutions to Capital Budgeting with Uncertainty     162
The two basic approaches     162
Using payback, present value profile, and sensitivity analysis     163
Calculate the net present value of the expected cash flows      164
WACC: The weighted average cost of capital     165
The cost of retained earnings     167
Costs of retained earnings and of equity with investor taxes     168
Costs of retained earnings with investor taxes     168
Cost of new equity capital with investor taxes     169
Debt and income taxes     171
The relevant source of funds     171
Global business aspects     172
Computing the firm's weighted average cost of capital     172
Capital structure and the effect on the WACC     173
The optimum capital structure     174
The firm's WACC and investments     175
The project's WACC     177
The pure play     177
Default-free rate of discount     178
Discounting stock equity flows     179
Simulation and the Monte Carlo method     181
Value-at-risk     183
Conclusions     183
Problems     184
Discussion question     185
Bibliography     186
Option Theory as a Capital Budgeting Tool     187
Real Options and Capital Budgeting     189
Two types of stock options     192
Valuing call options on common stock      193
The value of a call option on common stock: a numerical example     193
Formulas for call option valuation     195
Formulas for composition of the replicating portfolio     196
Certainty equivalent formulas for the value of an option     198
A multi-period call option     199
The replicating portfolio method for a two-period option     199
The certainty equivalent method for a two-period option     201
Number of periods     202
Valuing real options     202
Description and valuation of the underlying asset without flexibility     203
An option to abandon     206
An option to expand     209
Multiple options on the same asset     210
Conclusions     210
Problems     211
Discussion question     211
Bibliography     212
Increasing accuracy by using a large number of short periods     213
Valuation with multiple options on an asset     215
Applications of Capital Budgeting     219
Growth Constraints     221
External capital rationing     221
Internal capital rationing     222
Scarce factors of production     223
Ranking of investments     223
Programming solutions     224
Global business aspects     224
Conclusions     224
Problems     225
Discussion question     227
Bibliography     227
The Valuation of a Firm     228
Present value of dividends     229
Present value of earnings minus new investment     230
Present value of growth opportunities     230
A terminal value model     231
Multipliers     231
Free cash flow     232
Book value     233
Value with zero debt     233
Market capitalization     236
Substitution of debt for equity     236
Option theory     237
Present value of economic income     237
Valuation for acquisition     238
DCF versus comparables     238
Mergers and acquisitions     238
Forecasting the post-acquisition price     239
Global business aspects     241
Conclusions     241
Problems     241
Discussion question     242
Bibliography     242
Using Economic Income (Residual Income) for Valuation      243
The discounted cash flow model accepted by finance theorists     244
The economic income model     244
Valuation using economic income     246
Other methods of valuation     248
Comparing ROI and economic income     249
Global business aspects     250
Conclusions     250
Problems     250
Discussion question     254
Bibliography     254
Present Value Accounting     255
A management seminar     255
Basic concepts     256
Economic depreciation, income, and return on investment     256
Application to assets with zero present value     257
An investment with a positive net present value     258
Combining investments     259
Two investments with different risks     260
Better income measures     262
Internal rate of return and taxes     263
Global business aspects     265
Conclusions     265
Problems     266
Discussion question     270
Bibliography     270
Performance Measurement and Managerial Compensation     272
Problems of agency      273
Performance measurement and managerial compensation     274
Accounting measures     274
Income     275
Return on investment (ROI)     275
ROI and investment decision-making     277
The case of the resource benefiting the future     277
The computation of income and ROI     278
Comparing ROI and economic income     280
Summary of complexities     280
Summary of economic income advantages     282
Time adjusted revenues     282
A non-zero net present value     283
Incentive consideration     284
PVA     286
Cash flow return on investment     286
Planning implications     287
In conclusion: To measure performance     288
Some generalizations regarding compensation     290
Rewarding bad performance     290
Global business aspects     290
Conclusions     290
Problems     291
Discussion question     295
Bibliography     296
Fluctuating Rates of Output     297
A plant limited to one type of equipment and two alternatives     298
Optimum equipment mix      301
More periods or more equipment types     304
Conclusions     305
Problems     305
Bibliography     310
Investment Decisions with Additional Information     311
The opportunity to replicate     312
The basic model     312
Delaying other investments     315
The winner's curse     316
Conclusions     317
Problems     317
Discussion question     318
Bibliography     318
Investment Timing     320
Basic principles of when to start and stop a process     321
Growth-type investments     322
Example: The tree farm     325
Equipment replacement     328
The strategy of capacity decisions     329
The basic decision     329
Performance measurement and the timing decision     330
Competitors: Preempting the market     331
Perfect predictions of interest rates     333
Conclusions     334
Problems     334
Discussion question     338
Bibliography     338
Buy Versus Lease     339
Borrow or lease: The financing decision      340
A lease is debt     341
Buy or lease with taxes: using the after-tax borrowing rate (method 1)     342
Using a risk-adjusted discount rate (method 2)     345
Computing the implied interest rate on the lease (method 3)     346
Risk considerations in lease-versus-borrow decisions     347
The rate of discount     347
Recommendations     349
Leases and purchase options     349
Importance of terminal value     350
Leveraged leases     352
Cancelable leases     354
The alternative minimum tax     355
Global business aspects     355
Conclusions     355
Problems     356
Discussion question     359
Bibliography     360
Name index     361
Subject index     363