Professor Kose John

` Professor Kose John

Spring 2003

Notes on Capital Budgeting and Real Options

These notes contain some brief overview of capital budgeting criteria, examples of the steps involved in capital budgeting and a detailed discussion of real options in capital budgeting.

The net present value rule is a simple application of the valuation rule to take investment (or capital budgeting) decisions optimally in corporate finance. Net present value captures the incremental value that a new capital expenditure provides to the shareholders of the firm. We will discuss the conditions under which NPV rule and the IRR rule comes up with identical decisions and when they do not.

Examples of capital budgeting are included here, including advanced issues of dealing with risk and the presence of real options. The case Super Project Case also gets us into the real word issues of capital budgeting. Another good example of looking at detailed capital budgeting is IM&C’s Fertilizer project in section 6.2 of textbook on pgs 124 to 127. Read the discussion on pg 130 of computing NPV in other countries and currencies.(pg 130, end of section 6.2.).

Example:

GIGO Computer Dating Services is considering replacing its current computer with a new generation model. The ABM salesperson has demonstrated a model which would cost GIGO $750,000 should last 10 years and reduce costs by $100,000 annually. It is expected to have a salvage value of $10,000 at the end of its life. The computer GIGO currently uses has a book value of $450,000 (remaining life of 10 years), a salvage value of $10,000 and a current market value of $10,000. The new machine will permit a $10,000 decrease in working capital when the computer is installed. Assume that all depreciation is straight-line, the marginal corporate tax rate is 40%, and the cost of capital of the project is 16%. Should the replacement be made? Show the relevant computations neatly.

The solution is given on the next page.

The role of risk and risk-adjusted discount rates in capital budgeting is discussed in BM Chapter 9. The following is a simple example of dealing with risk in capital budgeting.

Example:

Consider the following project involving the purchase of a machine for computer- aided manufacture of precision tools. The cost of the machine with installation is $20 million in year 0. The machine will result in increases in depreciation of $5 million per year for the next four years. The machine will produce cost savings of $10 million per year for the next four years. Assume that the other cash flows are not material. $a, the beta of the project is 1.8. The marginal tax rate of the firm is 0.40. The firm has been using a hurdle rate of 14% on almost all of its existing projects. You are also given that rF = 0.09, rm = 0.14. Based on the above information, choose the correct option for the following questions.

(a) Compute the IRR of the project. Choose one below:
I. 24% II. 16% III. 22% IV. 14% V. 9%

(b) Compute the cost of capital of the project. Choose one below:

I. 14% II. 16% III. 18% IV. 24% V. 9%

(c ) What is the net present value of the project? Choose one below:

I. $20.35 million II. $1.53 million III. $3.31 million IV. $2.38 million

For a detailed discussion of real options in capital budgeting we will follow

BM section 10.3 of the book.We will work through option to expand, and option to abandon and option to wait for more information.pgs. 268-278 of section 10.3. Decision Tree analysis of some interesting real option scenarios are given below—we will work through them in class.

Real Options in Capital Budgeting—Another Example

You are considering the introduction of an ever-youth cream using a miracle drug called Compound 2. The initial projections are that the project involves an investment of $150 million in Year 0 and expected after-tax cash flows of $30 million in Years 1 to 10. The current research indicates that there is a 10% probability that the compound 2 may have an unwanted side effect and in this case the expected after-tax cash flows will only be $20 million in Years 1 to 10. Assume that the cost of capital of the project is 10%.

(a) If you have to commit to the project now (i.e., at the beginning of Year 0), should the project be accepted? Show computations.

(b) At a cost of $1 million, a research firm has offered to conduct experiments and determine for you whether or not Compound 2 would, in fact, have the unwanted side effect. The information would be made available to you right away if you buy their services. Would it pay to buy the services of the research firm? Use a decision tree to support your answer.

(c ) Two additional pieces of information have come to your attention. (1) Conclusive information whether or not Compound 2 will have a side reaction will be available to you in a year's time free of charge from related government research. (2) Independently of whether or not Compound 2 has a side reaction, you can sell your "compound 2" operations to a photographic company for $198 million in a year's time, if you choose to do so. Continue to assume that you have to make the initial investment of $150 million in Year 0 and the other cash flows are as stated in (a). What is the net present value of the project incorporating the abandonment option? What is the value of the abandonment option? Would it still pay to purchase the services of the research firm for $1 million mentioned in part (b) before investing in the project in Year 0