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Capital Budgeting

Financial Appraisal of

Investment Projects

Don Dayananda,

Richard Irons, Steve Harrison,

John Herbohn and Patrick Rowland

PUBLISHED BY THE PRESS SYNDICATE OF THE UNIVERSITY OF CAMBRIDGEThe Pitt Building, Trumpington Street, Cambridge, United Kingdom

CAMBRIDGE UNIVERSITY PRESSThe Edinburgh Building, Cambridge CB2 2RU, UK40 West 20th Street, New York, NY 10011-4211, USA477 Williamstown Road, Port Melbourne, VIC 3207, AustraliaRuiz de Alarc ́on 13, 28014 Madrid, SpainDock House, The Waterfront, Cape Town 8001, South Africacambridge

©CDon Dayananda, Richard Irons, Steve Harrison, John Herbohn and Patrick Rowland 2002

This book is in copyright. Subject to statutory exceptionand to the provisions of relevant collective licensing agreements,no reproduction of any part may take place withoutthe written permission of Cambridge University Press.

First published 2002

Printed in the United Kingdom at the University Press, Cambridge

TypefaceTimes Roman 10/13 pt SystemLATEX2ε [TB]

A catalogue record for this book is available from the British Library

Library of Congress Cataloguing in Publication data

Capital budgeting: financial appraisal of investment projects / Don Dayananda ... [et al.]. p. cm.Includes bibliographical references and index.ISBN 0 521 81782 X (hb) – ISBN 0 521 52098 3 (pb)

1. Capital budget. 2. Capital investments. I. Dayananda, Don.HG4028 C346 2002658′242 – dc21 2002019249

ISBN 0 521 81782 X hardbackISBN 0 521 52098 3 paperback

vi Contents

• More complex time series forecasting methods
• Forecasting routes
• Concluding comments
• Review questions
• 4 Forecasting cash flows: qualitative or judgemental techniques
  • Study objectives
  • Obtaining information from individuals
  • Using groups to make forecasts
  • The Delphi technique applied to appraising forestry projects
  • Example 4. Appraising forestry projects involving new species
    • planting systems Example 4. Collecting data for forestry projects involving new
  • Scenario projection
  • Example 4. Using scenario projection to forecast demand
  • Concluding comments: which technique is best?
  • Review questions
• 5Essential formulae in project appraisal
  • Study objectives
  • Symbols used
  • Rate of return
  • Example 5
  • Note on timing and timing symbols
  • Future value of asinglesum
  • Example 5
  • Example 5
  • Present value of asinglesum
  • Example 5
  • Example 5
  • Future value of aseriesof cash flows
  • Example 5
  • Present value of aseriesof cash flows
  • Example 5
  • Example 5
  • Present value when the discount rate varies
  • Example 5
  • Present value of an ordinary annuity
  • Example 5
  • Present value of a deferred annuity
  • Example 5
  • Example 5
  • Perpetuity Contents vii
  • Net present value
  • Example 5
  • Net present value of an infinite chain
  • Internal rate of return
  • Example 5
  • Loan calculations
  • Example 5
  • Loan amortization schedule
  • Concluding comments
  • Review questions
• 6 Project analysis under certainty
  • Study objectives
  • Certainty Assumption
  • Net present value model
  • The net present value model applied
  • Other project appraisal methods
  • Suitability of differentproject evaluation techniques
  • Mutual exclusivity and project ranking
  • Asset replacement investment decisions
  • Project retirement
  • Concluding comments
  • Review questions
• 7 Project analysis under risk
  • Study objectives
  • The concepts of risk and uncertainty
  • Main elements ofthe RADR and CE techniques
  • The risk-adjusted discount rate method
  • Estimating the RADR
  • Estimating the RADR using the firm’s cost of capital
  • Example 7. Computation of the WACC for Costor Company
  • Estimating the RADR using the CAPM
  • The certainty equivalent method
  • Example 7. Computing NPV using CE: Cecorp
  • The relationship between CE and RADR
  • Example 7. Ceradr Company investment project
  • Comparison of RADR and CE
  • Concluding comments
  • Review questions
  • Example 10. Flores Venture Capital Ltd forestry project Contents ix
  • Comparing forestry projects of different harvest rotations
    • harvest options Example 10. FVC Ltd: comparison of one-stage and two-stage
  • Risk analysis or Monte Carlo analysis
  • Example 10. Simulation analysis of FVC Ltd forestry project
  • Concluding comments
  • Review questions
• 11 Resource constraints and linear programming
  • Study objectives
  • LP with two decision variables and three constraints
  • Example 11. Roclap: product mix problem
  • Investment opportunities and by-product constraints
  • Example 11. Capital rationing problem
  • LP and project choice
  • Example 11. Project portfolio selection problem
  • Concluding comments
  • Review questions
• 12 More advanced linear programming concepts and methods
  • Study objectives
  • Basic LP assumptions and their implications for capital budgeting
  • Expanding the number of projects and constraints
  • Example 12. Power generator’s decision problem
  • Indivisible investments and integer activity levels
  • Example 12. Resort development problem
  • Borrowing and capital transfers
  • Example 12. Borrowing and capital transfer problem
  • Contingent or dependent projects
  • Example 12. Infrastructure problem
  • Mutually exclusive projects
  • Example 12. Sports gear problem
  • Some other LP extensions for capital budgeting
  • Concluding comments
  • Review questions
• 13 Financial modelling case study in forestry project evaluation
  • Study objectives
  • Forestry evaluation models: uses and user groups
  • Financial models available to evaluate forestry investments
  • The Australian Cabinet Timbers Financial Model (ACTFM)
  • Review of model development and design options
  • Concluding comments x Contents
  • Review questions
• 14 Property investment analysis
  • Study objectives
  • Income-producing properties
  • Example 14. Property cash flows from the industrial property
  • Example 14. Equity cash flows before tax from the industrial property
  • Example 14. Equity cash flows after tax from the industrial property
  • Corporate real estate
  • Example 14. Acquiring the industrial property for operations
  • Example 14. Leasing or buying the industrial property for operations
  • Development feasibility
  • Example 14. Initial screening of an industrial building project
  • Example 14. Project cash flows from a property development
  • Example 14. Equity cash flows from the development project
  • Concluding comments
  • Review questions
• 1 5Forecasting and analysing risks in property investments
  • Study objectives
  • Forecasting
    • property Example 15. Forecasting operating cash flows for the industrial
  • Example 15. Forecasting resale proceeds for the industrial property
    • residential project Example 15. Forecasting development cash flows for a
  • Risk analysis
    • analysis Example 15. Net present value of the industrial property – sensitivity
    • analysis Example 15. Overbuilding for the industrial property – scenario
  • Example 15. Development risks – Monte Carlo (risk) simulation
  • Concluding comments
  • Review questions
• 16 Multinational corporations and international project appraisal
  • Study objectives
  • Definition of selected terms used in the chapter
  • The parent’s perspective versus the subsidiary’s perspective
  • Example 16. Garment project
  • Exchange rate risk
  • Country risk
  • 1 Corporate goal, financial management and capital budgeting page Figures
  • 1 The capital budgeting process
  • 3 Forecasting techniques and routes
  • 4 Major steps in the survey and data analysis process
  • 4 A simple model for appraising investment in forestry projects
    • survey in Example 4 4 Modified extract of survey form used in stage 1 of Delphi
  • 6 Net present value profiles for projects A and B
  • 7 Main features of RADR and CE techniques
  • 8 Project NPV versus unit selling price
  • 8 Project NPV versus required rate of return
  • 8 Project NPV versus initial outlay
  • 9 Cumulative relative frequency curve for NPV of computer project
• 10 NPV and LEV profiles of FVC Ltd forestry investment- investment for FVC Ltd 10 Cumulative relative frequency distribution for forestry
• 11 Graphical solution to the product mix problem
• 11 Product mix problem: iso-contribution lines and optimal product mix
• 13 Schematic representation of the structure of the ACTFM
• 13 ACTFM: example of plantation output sheet
• 13 Prescriptive costs sheet
• 13 Costs during plantation sheet
• 13 Annual costs sheet
• 15 Trend in industrial rents per square metre
• 15 Distribution of possible net present values- exchange rate and country risks 16 A strategy for an MNC to reduce a host country project’s
  • 2 Delta Corporation’s historical sales page Tables
  • 2 Delta Project: cash flow analysis
  • 2 Repco Replacement Investment Project: initial investment
  • 2 Repco Replacement Investment Project: incremental operatingcashflows
  • 2 Repco Replacement Investment Project: terminal cash flow
  • 2 Repco Replacement Investment Project: overall cash flow
  • 3 Desk sales and number of households
  • 3 Desk sales, number of households and average household income
  • 3 Household and income projections, 2002–2006
  • 3 Desk sales forecastsusing two-variable and multiple regressions
  • 3 Desk sales forecasts using time-trend regression
  • 3 Hypothetical sales data and calculation of simple moving average
  • 3 Forecasts using exponential smoothing model
  • 3 Ticket sales, households and household income
  • 4 Planting and harvesting scenario for a maple and messmate mixture
  • 4 Estimates of model parameters for a maple and messmate mixed plantation
  • 5 First three months of a loan amortization schedule
  • 6 Delta Project: annual net cash flow
  • 6 Cash flows, NPV and IRR for projects Big and Small
  • 6 Cash flows, NPV and IRR for projects Near and Far
  • 6 Cash flows, NPV and IRR for projects Short and Long
  • 6 Replication chain cash flows as an annuity due
  • 6 Cash flows within timed replication chains
    • lengths within a chain 6 Calculated individual NPVs for various replication cycle
    • replication cycle lengths within a chain 6 Calculated total NPVs for perpetual replacement over various
  • 6 Repco Replacement Investment Project: incremental cash flows
• 6 Cash flow forecasts for various retirement lives
• 6 Operational cash flows
  • 7 Stock-market index Value and Delta Company share price
• 12 Tableau after solution for borrowing and capital transfer problem xvi List of tables
• 12 Tableau with solution for coal-miner’s example
• 12 Tableau and solution for sports gear problem
• 12 Capital expenditure for alternative hotel designs
  • eucalypt and cabinet timber species in North Queensland 13 Estimated harvest ages, timber yields and timber prices for
• 13 Modelling options for forestry investments
• 14 Operating cash flows before tax
• 14 Property cash flows before tax
• 14 Equity cash flows before tax
• 14 Equity cash flows after tax (an Australian example)
• 14 Evaluating moving to new premises
• 14 The costs of leasing or buying
• 14 Preliminary analysis of a property development
• 14 Project cash flows from a property development
• 14 Equity cash flows from a property development
• 15 Forecasting rent from leased properties
• 15 Lease rent for the industrial property
• 15 Industrial property market statistics
• 15 Operating cash flows for the industrial property
• 15 Property cash flows before tax for the industrial property
• 15 Development project cash flows before tax
• 15 Sensitivity table for net present value
• 15 Cash flows and returns from contrasting scenarios
• 15 Monte Carlo simulation of office development
• 15 Lease terms for suburban office building
• 15 Market data for suburban offices
• 16 Analysis of the proposed garment project

1 Capital budgeting: an overview

Financial management is largely concerned withfinancing,dividendandinvestmentdeci-sions of the firm with some overall goal in mind. Corporate finance theory has developedaround a goal of maximizing the market value of the firm to its shareholders. This is alsoknown as shareholder wealth maximization. Although variousobjectives or goals are pos-sible in the field of finance, the most widely accepted objective for the firm is to maximizethe value of the firm to its owners. Financing decisions deal with the firm’s optimalcapital structure in terms of debt andequity. Dividend decisions relate to the form in which returns generated by the firm arepassed on to equity-holders. Investment decisions deal with the way funds raised in financialmarkets are employed in productive activities to achieve the firm’s overall goal; in otherwords, how much should be invested and what assets should be invested in. Throughoutthis book it is assumed that the objective of the investment or capital budgeting decision isto maximize the market value of the firm to its shareholders. The relationship between thefirm’s overall goal, financial management and capital budgeting is depicted in Figure 1.This self-explanatory chart helps the reader to easily visualize and retain a picture of thecapital budgeting function within the broader perspective of corporate finance. Funds are invested in both short-term and long-term assets. Capital budgeting is primar-ily concerned withsizableinvestments inlong-termassets. These assets may be tangibleitems such as property, plant or equipment or intangible ones such as new technology,patents or trademarks. Investments in processes such as research, design, development andtesting – through which new technology and new products are created – may also be viewedas investments in intangible assets. Irrespective of whether the investments are in tangible or intangible assets, a capitalinvestment project can be distinguished from recurrent expenditures by two features. Oneis that such projects are significantlylarge. The other is that they are generallylong-livedprojects with their benefits or cash flows spreading over many years. Sizable,long-terminvestments in tangible or intangible assets have long-term conse-quences. An investment today will determine the firm’s strategic position many years hence.These investments also have a considerable impact on the organization’s future cash flowsand the risk associated with those cash flows. Capital budgeting decisions thus have a long-range impact on the firm’s performance and they are critical to the firm’s success or failure.

1

An overview 3

sketch out a broad overview of the capital budgeting processidentify the financial appraisal of projects as one of the critically important and complex stages in the capital budgeting processappreciate the importance of using computer spreadsheet packages such as Excel for capital budgeting computationsgain a broad overview of how the material in this book is organized.

Shareholder wealth maximization and net present value

The efficiency of financial management is judged by the success in achieving the firm’sgoal. The shareholder wealth maximization goal states that management should endeavourto maximize the net present (or current) value of the expected future cash flows to theshareholders of the firm present valuerefers to the discountedsumof the expectednet cash flows. Some of the cash flows, such as capital outlays, are cash outflows, whilesome, such as cash proceeds from sales, are cash inflows. Net cash flows are obtained bysubtracting a given period’s cash outflows from that period’s cash inflows. Thediscountratetakes into account thetimingandriskof the future cash flows that are available froman investment. The longer it takes to receive a cash flow, the lower the value investors placeon that cash flow now. The greater the risk associated with receiving a future cash flow, thelower the value investors place on that cash flow. The shareholder wealth maximization goal, thus, reflects themagnitude,timingandriskassociated with the cash flows expected to be received in the future by shareholders. In termsof the firm’s objective, shareholder wealth maximization has been emphasized because thisbook has a corporate focus. For a simplified case where there is only one capital outlay which occurs at the beginningof the first year of the project, the net present value (NPV) is calculated by subtracting thiscapital outlay from the present value of the annual net operating cash flows (and the netterminal cash flows). If the capital outlay occurs only at the beginning of the first year ofthe project then it is already a present value and it is not necessary to discount it any further.The formula for the NPV in such a simplified situation is:

NPV=

∑n

t= 1

Ct(1+r)t

−CO

whereCOis the capital outlay at the beginning of year one (or wheret=0),ris the discountrate andCtis the net cash flow at end of yeart. For example, suppose project Alpha requires an initial capital outlay of $900 and willhave net cash inflows of $300, $400 and $600 at the end of years 1, 2 and 3, respectively.The discount rate is 8% per annum. The net present value is:

NPV=

300

(1)

+

400

(1) 2

+

600

(1) 3

− 900 = 197. 01

Project Alpha will add $197 to the firm’s value.

4 Capital Budgeting

Classification of investment projects

Investment projects can be classified into three categories on the basis of how they influencethe investment decision process: independent projects, mutually exclusive projects andcontingent projects. Anindependent projectis one the acceptance or rejection of which does not directlyeliminate other projects from consideration or affect the likelihood of their selection. Forexample, management may want to introduce a new product line and at the same time maywant to replace a machine which is currently producing a different product. These twoprojects can be consideredindependently of each other if there are sufficient resources toadoptboth,providedtheymeetthefirm’sinvestmentcriteriaindependently and a decision made to accept or reject them depending upon whether theyadd value to the firm. Two or more projects that cannot be pursued simultaneously are calledmutually exclusiveprojects– the acceptance of one prevents the acceptance of the alternative proposal. There-fore, mutually exclusive projects involve ‘either-or’ decisions – alternative proposals cannotbe pursued simultaneously. For example, a firm may own a block of land which is largeenough to establish a shoe manufacturing business or a steel fabrication plant. If shoemanufacturing is chosen the alternative of steel fabrication is eliminated. A car manufac-turing company can locate its manufacturing complex in Sydney, Brisbane or Adelaide. Ifit chooses Adelaide, the alternatives of Sydney and Brisbane are precluded. Mutually exclusive projects can be evaluated separately to select the one which yieldsthe highest net presentvalue to thefirm. The early identification of mutuallyexclusivealternatives is crucial for a logical screening of investments. Otherwise, a lot of hard workand resources can be wasted if two divisions independently investigate, develop and initiateprojects which are later recognized to be mutually exclusive. Acontingent projectis one the acceptance or rejection of which is dependent on thedecision to accept or reject one or more other projects. Contingent projects may be com-plementary or substitutes. For example, the decision to start a pharmacy may be contingentupon a decision to establish a doctors’ surgery in an adjacent building. In this case theprojects are complementary to each other. The cash flows of the pharmacy will be enhancedby the existence of a nearby surgery and conversely the cash flows of the surgery will beenhanced by the existence of a nearby pharmacy. In contrast, substitute projects are ones where the degree of success (or even the suc-cess or failure) of one project is increased by the decision to reject the other project.For example, market research indicates demand sufficient to justify two restaurants ina shopping complex and the firm is considering one Chinese and one Thai restaurant.Customers visiting this shopping complex seem to treat Chinese and Thai food as closesubstitutes and have a slight preference for Thai food over Chinese. Consequently, ifthe firm establishes both restaurants, the Chinese restaurant’s cash flows are likely tobe adversely affected. This may result in negative net present value for the Chineserestaurant. In this situation, the success of the Chinese restaurant project will dependon the decision to reject the Thai restaurant proposal. Since they are close substi-tutes, the rejection of one will definitely boost the cash flows of the other. Contingent

6 Capital Budgeting

strategic and tactical areas of business development, and guides the planning process inthe pursuit of solid objectives. A firm’s vision and mission is encapsulated in its strategicplanning framework. There are feedback loops at different stages, and the feedback to ‘strategic planning’ atthe project evaluation and decision stages – indicated by upward arrows in Figure 1 – iscritically important. This feedback may suggest changes to the future direction of the firmwhich may cause changes to the firm’s strategic plan.

Identification of investment opportunities

The identification of investment opportunities and generation of investment project pro-posals is an important step in the capital budgeting process. Project proposals cannot begenerated in isolation. They have to fit in with a firm’s corporate goals, its vision, missionand long-term strategic plan. Of course, if an excellent investment opportunity presentsitself the corporate vision and strategy may be changed to accommodate it. Thus, there is atwo-way traffic between strategic planning and investment opportunities. Some investments are mandatory – for instance, those investments required to satisfyparticular regulatory, health and safety requirements – and they are essential for the firm toremain in business. Other investments are discretionary and are generated by growth oppor-tunities, competition, cost reduction opportunities and so on. These investments normallyrepresent the strategic plan of the business firm and, in turn, these investments can set newdirections for the firm’s strategic plan. These discretionary investments form the basis ofthe business of the corporation and, therefore, the capital budgeting process is viewed inthis book mainly with these discretionary investments in mind. A profitable investment proposal is not just born; someone has to suggest it. The firmshould ensure that it has searched and identified potentially lucrative investment opportuni-ties and proposals, because the remainder of the capital budgeting process can only assurethat the best of the proposed investments are evaluated, selected and implemented. Thereshould be a mechanism such that investment suggestions coming from inside the firm, suchas from its employees, or from outside the firm, such as from advisors to the firm, are‘listened to’ by management. Some firms have research and development (R&D) divisions constantly searching forand researching into new products, services and processes and identifying attractive invest-ment opportunities. Sometimes, excellent investment suggestions come through informalprocesses such as employee chats in a staff room or corridor.

Preliminary screening of projects

Generally, in any organization, there will be many potential investment proposals generated.Obviously, they cannot all go through the rigorous project analysis process. Therefore, theidentified investment opportunities have to be subjected to a preliminary screening processby management to isolate the marginal and unsound proposals, because it is not worthspending resources to thoroughly evaluate such proposals. The preliminary screening may

An overview 7

involve some preliminary quantitative analysis and judgements based on intuitive feelingsand experience.

Financial appraisal of projects

Projects which pass through the preliminary screening phase become candidates for rigorousfinancial appraisal to ascertain if they would add value to the firm. This stage is also calledquantitative analysis, economic and financial appraisal, project evaluation, or simply projectanalysis. This project analysis may predict the expected future cash flows of the project, analysethe risk associated with those cash flows, develop alternative cash flow forecasts, examinethe sensitivity of the results to possible changes in the predicted cash flows, subject the cashflows to simulation and prepare alternative estimates of the project’s net present value. Thus, the project analysis can involve the application of forecasting techniques, projectevaluation techniques, risk analysis and mathematical programming techniques such as lin-ear programming. While the basic concepts, principles and techniques of project evaluationare the same for different projects, their application to particular types of projects requiresspecial knowledge and expertise. For example, asset expansion projects, asset replacementprojects, forestry investments, property investments and international investments have theirown special features and peculiarities. Financial appraisal will provide the estimated addition to the firm’s value in terms of theprojects’ net present values. If the projects identified within the current strategic frameworkof the firm repeatedly produce negative NPVs in the analysis stage, these results send amessage to the management to review its strategic plan. Thus, the feedback from projectanalysis to strategic planning plays an important role in the overall capital budgeting process. The results of the quantitative project analyses heavily influence the project selection orinvestment decisions. These decisions clearly affect the success or failure of the firm and itsfuture direction. Therefore, project analysis is critically important for the firm. This bookfocuses on this complex analytical stage of the capital budgeting process, that is, financialappraisal of projects (or simply, project analysis).

Qualitative factors in project evaluation

When a project passes through the quantitative analysis test, it has to be further evaluatedtaking into consideration qualitative factors. Qualitative factors are those which will have animpact on the project, but which are virtually impossible to evaluate accurately in monetaryterms. They are factors such as:

the societal impact of an increase or decrease in employee numbersthe environmental impact of the projectpossible positive or negative governmental political attitudes towards the projectthe strategic consequences of consumption of scarce raw materialspositive or negative relationships with labour unions about the project