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Issues in Capital Budgeting. FINA 4463 (Chapter 12 in text). Free Cash Flow to Equity (FCFE). FCFE. FCFE is an alternative definition of cashflow Related to, but different from, FCFF

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issues in capital budgeting

Issues in Capital Budgeting

FINA 4463

(Chapter 12 in text)

  • FCFE is an alternative definition of cashflow
      • Related to, but different from, FCFF
  • 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
  • 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 = Net Income

+ Depreciation

  • Change in non-cash Working Capital
  • Capital Expenditures

+ Net New Debt

- Preferred Dividends (or + new preferred shares)



– Interest(1-tax)

+ Net New Debt

- Preferred Dividends

For NPV purposes:
  • 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)
  • 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
Real Options
  • 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.



In a real business situation, firms face many choices with

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


    • 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


    • 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 options1
Real Options
  • 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:

  • 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
Option to Delay
  • 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 delay1
Option to Delay
  • 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

year 0

year 1

Price = $150

Price = $150

prob. = 0.5

Price = $100

prob. = 0.5

Price = $50

Price = $50

traditional npv analysis
Traditional NPV Analysis

Expected year 1 price = E[price]

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

Standard analysis says NPV > 0, so start project.

option to delay2
Option to Delay
  • 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.


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.


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

= (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
Option to Abandon
  • 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