The Capital Budgeting Decision Book

List of illustrations     xiii
Preface     xvii
Extracts from the preface to the first edition     xix
Investment Decisions and Corporate Objectives     1
Investment decisions     2
The limitations of quantification     3
The state of business practice     4
Time, risk, and the risk-return trade-off     4
Three basic generalizations     4
Relevance of cash flows     5
Cash flows versus earnings     6
The capital market     6
The weighted average cost of capital     7
Tactical and strategic decisions     7
The role of strategic planning     8
The two capital budgeting revolutions     8
Conclusions     9
Pop quiz     10
Problems     10
Answer to pop quiz     11
Bibliography     11
The Time Value of Money     12
Time discounting     12
Future value     13
Present value     15
Computing present value factors     16
Annual equivalent amounts     23
A growing annuity     24
A constant interest bond     25
Present value factors derived from market prices     26
Conclusions     31
Pop quiz     32
Review problem     32
Problems     32
Answer to pop quiz     35
Solution to review problem     35
Bibliography     36
Appendix A     36
Appendix B     37
Capital Budgeting: The Traditional Solutions     43
A capital budgeting decision     43
Rate of discount     43
Classification of cash flows     44
Classifying investments     44
Measures of investment worth     46
Two discounted cash flow methods     48
Net present value profile     53
Payback period     54
Return on investment     55
What firms do     60
Cash flows     61
Working capital     63
Excluding interest payment     64
Conclusions     73
Pop quiz     74
Review problems     75
Problems     75
Answers to pop quiz     83
Solutions to review problems     83
Bibliography     84
Mutually Exclusive Investments     85
Accept or reject decisions     86
Mutually exclusive investment     87
Incremental benefits: the scale problem     87
Timing     88
Reinvestment assumption     91
Reinvestment rate of return     91
Loan-type flows     92
Multiple internal rates of return     93
Interpretation of multiple IRRs     94
A "paradox"     95
Converting multiple IRRs to a single IRR     97
Significance of nonconventional cash flows     99
Ranking independent investments     100
Mutually exclusive alternatives with different risks     101
Duration: a sensitivity measure     102
Why the internal rate of return method is popular     103
Choosing the required rate of return     103
Conclusions     104
Review problem     105
Problems     106
Solution to review problem     111
Bibliography     112
Annual Equivalent Costs and Replacement Decisions     113
Annual equivalent cost     113
Make or buy decisions     114
Comparability     116
Mutually exclusive alternatives with different lives     116
Annual equivalent cost     118
Lowest common multiple life     119
A perpetuity     119
Components of unequal lives     120
Cost of excess capacity     121
The equal cost assumption     122
The replacement decision     122
Replacement chains     125
Conclusions     125
Review problem     126
Problems     127
Solution to review problem     133
Bibliography     134
Capital Budgeting Under Capital Rationing     135
External capital rationing     136
Internal capital rationing     141
Internal capital rationing and dividend policy     141
Ranking of investments     142
Index of present value (or profitability index)     144
Programming solutions     145
Capital rationing and risk     148
Conclusions     148
Problems     148
Bibliography     150
The Use of the Weighted Average Cost of Capital and Other Rates of Discount     152
The sources of cash     153
The cost of retained earnings      153
A theory of stock values     154
Changes in stock prices     157
Accumulated depreciation and the cost of capital     153
Issuing common stock     160
Cost of retained earnings: with investor taxes     160
Cost of new equity capital     161
Issuing common stock: the element of timing     161
Delaying the investment     163
Cost of long-term debt     164
Cost of short term debt     165
Debt and income taxes     166
Weighted average cost of capital     167
The optimum capital structure     168
Summary of weighted average cost of capital     169
Default-free rate of discount     170
Adjusting the default-free rate     171
Comparing average and marginal returns     172
Conclusions     172
Problems     172
Bibliography     178
The Capital Asset Pricing Model     180
The assumptions     181
Introduction to portfolio analysis     182
Forming portfolios     183
The investors     186
Portfolio analysis with a riskless security     187
The efficient frontier      187
The capital market line     190
The expected rate of return of a security     192
The security characteristic line     192
Systematic and unsystematic risks     194
The security market line     295
Required rate of return versus WACC     197
Making investment decisions     198
Conclusions     199
Review problem     200
Problems     201
Solution to review problem     204
Bibliography     204
The Cost of Capital and Capital Structure     206
The weighted average cost of capital     206
Definition     207
The weights     209
Capital budgeting decisions     210
Investments and taxes     210
Existence of a unique optimal financial structure     211
No taxes     213
A constant WACC (no taxes)     216
A constant value     217
Levering a firm     217
Taxes     218
Implications of the zero corporate tax model     219
The value of a levered firm with taxes     219
Valuing a firm: capital structure and corporate taxes     220
Personal taxes      221
Conclusions     222
Problems     224
Bibliography     229
Distribution Policy and Capital Budgeting     231
A cash dividend: from retained earnings     231
Investment: new capital     232
Share repurchase versus real investment     233
A different required return     234
Model     234
Maintenance cap-ex     236
The capital structure     236
Risk assumptions     236
The derivation of 1/(M-1)     237
Conclusions     240
Problems     240
Bibliography     241
A Firm Investing in a Second Firm     242
Tax implications     243
Anti-raiding maneuver     244
Antitrust considerations     244
An acquisition for cash     244
Determining the premium     245
Analysis with capital gains     247
A holding company     249
Valuation for acquisition     249
The P/E ratio     251
Dilution of earnings: the period of dilution     254
Elimination of dilution     254
Forecasting the post-acquisition price      256
Dividend versus an acquisition of shares     257
Conclusions     259
Problems     259
Bibliography     261
Investing in Current Assets     262
Decisions affecting cash     263
Timing strategies     264
Acquiring the cash from long-term sources     266
A reformulation     268
Timing considerations     271
Near-cash securities     271
Managing accounts receivable     273
Calculation of costs     275
One-period case with time discounting     275
Multiperiod case     277
Systematic revision of probabilities     278
Problems in application     280
Inventory and finance     281
Inventory models versus "just in time"     282
Inventory models     282
Conclusions     285
Problems     287
Bibliography     289
Foreign Investments     290
Currency translation     290
A different approach     291
The irrelevance of future plans     292
The leverage consideration     293
Taxes     295
One-period example      295
Multiperiod case     296
Remission of funds     297
Foreign investment and risk     297
Conclusions     298
Problems     298
Bibliography     301
The Buy Versus Lease Decision     303
Three basic problems of analysis     303
One incorrect method     304
The two correct methods     306
Residual value     306
The investment decision     307
The lease decision with taxes     309
Risk-adjusted discount rates     311
The calculation that is not made     311
Cash flows and discount rate: debt     312
Pros and cons of leasing     313
Three decisions     315
Conclusions     316
Problems     316
Bibliography     318
An Introduction to Real Options     319
Black-Scholes     320
Option valuation when there is no hedge portfolio     321
The value of waiting     323
An option to expand     324
Put options on real assets: an opportunity to sell     326
Embedded options: the value of future uses     327
Valuation: expected value less than liabilities     327
Advantages of the option approach     328
Disadvantages of the option approach     329
Conclusions     330
Problems     331
Discussion question     332
Bibliography     332
Capital Budgeting and Inflation     334
What is inflation?     334
Real cash flows     335
Real cash flows and nominal flows     335
The use of specific prices     336
Real and nominal discount rates     338
Inflation analysis: a simplified approach     340
Tax effects     342
A tax-exempt alternative     343
The real return and the rate of inflation     343
Conclusions     346
Problems     346
Bibliography     348
Reflections on the Capital Budgeting Decision     350
The criticisms of NPV     350
Cash on cash     351
Real options     352
Cash flow components     353
The compounding of risk     353
Investing in other countries     353
Conclusions     354
Problems     354
Cases      356
Appendices     380
Present value of {dollar}1.00     380
Present value of {dollar}1.00 received per period     384
Name index     389
Subject index     393