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Issues in Capital BudgetingPowerPoint Presentation

Issues in Capital Budgeting

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### Free Cash Flow to Equity(FCFE)

### Real Options and Capital Budgeting should be discounted at a rate that is a mix of debt and equity

FCFE Whereas FCFF is the cashflow generated for the firm overall (debt + equity), FCFE is the cashflow that goes to shareholders FCFE is what is “left over” from FCFF after paying debtholders

- FCFE is an alternative definition of cashflow
- Related to, but different from, FCFF

FCFE

- NPV can be done using FCFF or FCFE
- If done correctly, should get same answer either way
- FCFF is the more common cashflow definition in capital budgeting
- FCFF is easier to use to calculate NPV (see example coming up)

FCFE

FCFE = Net Income

+ Depreciation

- Change in non-cash Working Capital
- Capital Expenditures
+ Net New Debt

- Preferred Dividends (or + new preferred shares)

- FCFF should be discounted at the weighted average cost of capital (WACC)
- Remember, if no preferred shares:

- Since FCFF represents cashflows to both debt and equity, should be discounted at a rate that is a mix of debt and equity
- FCFE is the cashflow that goes exclusively to shareholders.
- FCFE should be discounted at the required return on equity (cost of equity)

Example: should be discounted at a rate that is a mix of debt and equity

- Firm has target capital structure that is 50% debt, 50% equity
- Interest rate on new debt would be 9%
- Required return on equity is 12%
- Tax rate is 35%
- Project will generate FCFF=$50 per year, forever
- Any debt taken on because of the project will be perpetual, principal never paid back
- Initial investment = $500
- What is NPV using FCFF and using FCFE?

Real Options should be discounted at a rate that is a mix of debt and equity

- Traditional capital budgeting analysis:
- estimates cashflows each period
- discounts to get NPV
- firm decides to invest/not invest

BIG PROBLEM: Traditional analysis assumes that a firm’s

only choice is accept/reject the project.

THIS IS NOT TRUE!!

In a real business situation, firms face many choices with should be discounted at a rate that is a mix of debt and equity

respect to how to operate a project, both before it starts

and after it is underway.

- Eg.
- Flexibility:
- use a production technology that is adaptable
- can produce more than one product
- if market for one product goes down, can switch production
- to the other

- the option to change production if the firm wants
- to (the flexibility) is valuable
- makes the project worth more
- traditional NPV analysis assumes cashflows fixed,
- will not change with future business conditions – ignores
- the value of this option

- Eg. should be discounted at a rate that is a mix of debt and equity
- Abandonment
- firm invests in project
- after a time the firm may be able to shut down production
- if things are not going well
- option to abandon

- traditional analysis assumes that the firm either takes
- the project and runs it for its life, or rejects it
- But…the ability to start a project and shut it down
- (perhaps temporarily) if conditions warrant is valuable

- Eg. should be discounted at a rate that is a mix of debt and equity
- Option to Delay
- traditional analysis assumes firm accepts project now
- or never invests
- But…what if firm has choice to delay making decision?
- Wait and see how things develop and then decide to invest
- or not
- The choice to delay if the firm wants is valuable

- Other examples of valuable options (choices) a firm may have include:
- option to expand/shrink production
- option to move into new market
- R&D gives the option to develop new products if
- they become viable
- development options on natural resources
- et cetera

Real Options should be discounted at a rate that is a mix of debt and equity

- Any time a firm has the ability to make choices, there is a
- value added to the project in question

- traditional NPV analysis ignores this value

- the study of real options attempts to put a dollar value on the
- ability to make choices

How are real options valued? Three major ways: should be discounted at a rate that is a mix of debt and equity

- Use methods developed for pricing financial options
- Black-Scholes Model
- Discussed in “What’s It Worth?” article
- May be problems

- 2) Decision trees
- look at this method here

- 3) Stochastic optimization problems
- like (2) but using far more complicated
- (and realistic) models for the probability
- of different events occurring

Option to Delay should be discounted at a rate that is a mix of debt and equity

- simple example from “Irreversibility, Uncertainty and Investment”,
- Robert Pindyck [Journal of Economic Literature, 1991]

- for $800 a firm can build widget factory
- makes 1 widget per year
- factory is built instantly
- investment is irreversible
- if factory built, first widget produced immediately
- no costs of manufacturing
- no taxes
- appropriate discount rate is 10%

Option to Delay should be discounted at a rate that is a mix of debt and equity

- the price of widgets is currently $100

- next year the price will be either $150 (50% probability) or
- $50 (50% probability)

- whatever price holds next year will hold forever after

year 2 should be discounted at a rate that is a mix of debt and equity

year 0

year 1

Price = $150

Price = $150

prob. = 0.5

Price = $100

prob. = 0.5

Price = $50

Price = $50

Traditional NPV Analysis should be discounted at a rate that is a mix of debt and equity

Expected year 1 price = E[price]

= 0.5($150) + 0.5($50) = $100

Standard analysis says NPV > 0, so start project.

Option to Delay should be discounted at a rate that is a mix of debt and equity

- BUT… firm has another option. Delay the choice of whether
- to invest or not.

- Wait until next year to decide.
- Can see what price turns out to be before making decision.

- If you delay, you lose on the year 0 sales ($100).
- The bad part of delaying – lost sales.

- But, you get to see what price will be before making
- irreversible investment.
- The good part of delaying, reduced uncertainty.

CASE 1: should be discounted at a rate that is a mix of debt and equity

If delay and price turns out to be $50:

- NPV < 0 , so firm will not invest.
- From today’s perspective, NPV = 0 if price turns out to be $50.

CASE 2: should be discounted at a rate that is a mix of debt and equity

If delay and price turns out to be $150:

Firm will invest if the price goes to $150.

- the essence of the option to delay is that it allows the firm to avoid
- the “bad” outcome

- delay deciding until you see what the state of the world is:

- you lose some sales on delay

- if the market turns out to be bad, you do not invest
- and do not take the loss

- does the avoided loss make the foregone sales
- worthwhile?

Price = $150

NPV = 772.73

NPV = ??

Price = $50

NPV = 0

NPV in year 0 of delaying project firm to avoid

= (0.5)(772.73) + (0.5)(0)

= $386.36

- the NPV of delaying ($386.36) is more than the NPV of
- starting immediately ($300)
- therefore, firm should delay start of project

- the flexibility of being able to wait another year to decide
- whether to invest or not is worth an additional $86.36

- Does this mean that firms should always delay projects?
- No, if probability of high price in this example was
- 90% it would be best to start immediately

Option to Abandon firm to avoid

- ability to abandon a project if things are not going well is valuable

- allows firm to avoid bad outcomes

- value of the option to abandon can be calculated in similar
- way to option to delay
- see example handout

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