IBA, Main Campus

Financial Management
Capital Budgeting
Making Capital Investment Decisions
Ch 10 & 11 - Ross, Westerfield & Jordan

by

M. Yousuf Saudagar
ysaudagar@iba.edu.pk

1
 Learning today
Learning today

• So far, we’ve covered various parts of the capital budgeting decision. Our task in
these sessions is to further bring these pieces together.
• By now, we know well that projected future cash flows are the key element in such
an evaluation. We’ll focus on the process of setting up DCF analysis.
• We’ll see how to “spread the numbers” for a proposed investment or project &
based on those numbers, make an initial assessment about whether the project
should be undertaken.
• Accordingly, we emphasize on working with financial and accounting information
2
to come up with these figures.
 significance
• General Electric (GE), through its “Ecomagination” program, planned
to double R&D spending on green products, from $700 million in
2004 to $1.5 billion in 2010.
• With products such as a hybrid railroad locomotive (a 200-ton,
6,000-horsepower “Prius on rails”), GE’s green initiative paid off.
• Revenue from green products was $14 B in 2007, with a target of $25
B in 2010. The company’s internal commitment to reduced energy
consumption saved it more than $100 M from 2004 to 2007, and the
company was on target to reduce its water consumption by 20% by
2012, another considerable cost savings.
• GE’s decision to develop and market green technology represents a
capital budgeting decision.
• In this chapter, we further investigate such decisions, how they are
made, and how to look at them objectively. 3
 Learning today
First, recall that in the last chapter, we saw that cash flow estimates
are the critical input into a net present value analysis

However, we didn’t say much about where these cash flows come
from; so we will now examine this question in some detail.

• This chapter follows up on our previous one by delving more deeply

into capital budgeting. We have two main tasks:

1. In evaluating a proposed investment, we pay special attention to

deciding what information & costs are relevant to the decision at
hand and what is not.

2. Our second goal is to learn how to critically examine NPV estimates.

In particular, how to evaluate the sensitivity of NPV estimates to

assumptions made about the uncertain future.
4
 RELEVANT & irrelevant CASH FLOWS
• The effect of taking a project is {{{
to change the firm’s overall cash
flows today and in the future.

• To evaluate a proposed investment, we must consider the changes in

the firm’s cash flows and then decide whether they add value to the
firm.

• The first and most important step, therefore, is to decide which cash
flows are relevant.

• A relevant cash flow for a project is a change in the firm’s overall

future cash flow that comes about as a direct consequence of the
decision to take that project.

• Because the relevant cash flows are defined in terms of changes in,
or increments to, the firm’s existing cash flow, they are called the
incremental cash flows associated with the project.
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 incremental CASH FLOWS
• The concept of incremental cash{{{
flow is central to our analysis, so
we state a general definition and refer back to it as needed:

• Incremental cash flows are:

• The difference between a firm’s future cash flows with a project and
those without the project.

• The incremental cash flows for project evaluation consist of any and
all changes in the firm’s future cash flows that are a direct
consequence of taking the project.

• This definition of incremental cash flows has an obvious & important

corollary:

• Any cash flow that exists regardless of whether or not a project is

undertaken is not relevant or irrelevant cash flows.
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 THE STAND-ALONE PRINCIPLE
• In practice, it would be cumbersome to calculate the future total
cash flows to the firm with & without a project, especially for a large
firm.
• Fortunately, it is not really necessary to do so.
• Once we identify the effect of undertaking the proposed project on
the firm’s cash flows, we need focus only on the project’s resulting
incremental cash flows. This is called the stand-alone principle .
• The stand-alone principle says is that once we have determined the
incremental cash flows from undertaking a project, we can view that
project as a kind of “mini-firm” with its own future revenues and
costs, its own assets, and, of course, its own cash flows.
• We will then be primarily interested in comparing the cash flows
from this mini-firm to the cost of acquiring it.
• An important consequence of this approach is that we will be 7
 some pitfalls in Incremental Cash Flows
• We are concerned here with only cash flows that are incremental
and that result from a project.
• Looking back at our general definition, we might think it would be
easy to decide whether a cash flow is incremental.
• Even so, in a few situations it is easy to make mistakes.
• Here, we describe some common pitfalls & how to avoid them:
1. Sunk Costs
2. Opportunity Costs
3. Side Effects, Erosion or Cannibalization
4. Net Working Capital
5. Financing Costs
6. Actual Vs Accruals
7. After Tax 8
 SUNK COSTS

• A sunk cost is a cost we have already paid or have already incurred

the liability to pay. Such a cost cannot be changed by the decision
today to accept or reject a project. Put another way, the firm will
have to pay this cost no matter what.

• Based on our definition of incremental cash flow, such a cost is

clearly not relevant to the decision at hand. So, we will always be
careful to exclude sunk costs from our analysis.

• For example, suppose General Milk Company hires a financial

consultant to help evaluate whether a line of chocolate milk should
be launched. When the consultant turns in the report, General Milk
objects to the analysis because the consultant did not include the
hefty consulting fee as a cost of the chocolate milk project.

• Who is correct? The consulting fee is a sunk cost: It must be paid

whether or not the chocolate milk line is actually launched 9
 OPPORTUNITY COSTS
• Suppose a firm already owns some of the assets a proposed project
will be using e.g. we might be thinking of converting an old cotton
mill we bought years ago for $100,000 into up-market
condominiums.

• If we undertake this project, there will be no direct cash outflow

because we already own it.

• For purposes of evaluating the condo project, should we then treat

the mill as a relevant or irrelevant cost?

Thee answer is relevant.

The mill is a valuable resource used by the project. We can sell it.

Using the mill for condo complex thus has an opportunity cost.
An opportunity cost is slightly different from out-of-pocket-cost;10it
 OPPORTUNITY COSTS
• There is another issue here.

• Once we agree that the use of the mill has an opportunity cost, how
much should we charge the condo project for this use?

• Given that we paid $100,000, it might seem that we should charge

this amount to the condo project. Is this correct?

• The answer is no.

• The fact that we paid $100,000 some years ago is irrelevant.

• That cost is sunk.

• At a minimum, the opportunity cost that we charge the project is

what the mill would sell for today because this is the amount we
give up by using the mill instead of selling it.
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 SIDE EFFECTS
• Remember that the incremental cash flows for a project include all
the resulting changes in the firm’s future cash flows.
• It would not be unusual for a project to have side, or spillover, effects,
both good and bad.
• Side effects show up in a lot of different ways. For example, one of
Walt Disney Company’s concerns when it built Euro Disney was that
the new park would drain visitors from the Florida park, a popular
vacation destination for Europeans.
• For example, if Imtiaz Super Store or Carrefour, after already having
established a branch in DHA, open up another outlet in Clifton. This
branch would draw a fair number of customers away from DHA
outlet, causing a reduction in DHA sales.
• A negative impact on the cash flows of an existing product from the
introduction of a new product is called side effects, cannibalization
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or erosion .
 SIDE EFFECTS
• In this case, the cash flows from the new line should be adjusted
downward to reflect lost profits on other lines.
• It is important to recognize that any sales lost as a result of launching
a new product might be lost anyway because of future competition.
• Erosion is relevant only when the sales would not otherwise be lost.
• There are beneficial spillover effects, of course.
• When the price of a printer that sold for $500 to $600 in 1994
declined to below $100 by 2009, HP realized that the big money is in
the consumables that printer owners buy to keep their printers going,
such as ink-jet cartridges, laser toner cartridges, and special paper.
• The profit margins for these products proved to be substantial.

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 NET WORKING CAPITAL
• A project will require that the firm invest in net working capital in
addition to long-term assets like cash on hand to pay expenses. In
addition, a project will need an initial investment in inventories &
accounts receivable (to cover credit sales). Some of the financing for
this will be in the form of amounts owed to suppliers (accounts
payable), but the firm will have to supply the balance.
• This balance represents investment in net working capital (NWC).
• It’s easy to overlook this feature of NWC in capital budgeting.
• As a project winds down, inventories are sold, receivables are
collected, bills are paid, and cash balances can be drawn down.
• These activities free up the net working capital originally invested.
• So the investment in net working capital closely resembles a loan.
• The firm supplies working capital at the beginning when it puts up a
project and recovers it toward the end when it winds up. 14
 FINANCING COSTS

• In analyzing a proposed investment, we will not include interest paid

or any financing costs e.g. dividends or principal repaid because we
are interested in the cash flow generated by the assets of the project.

• As we saw earlier, interest paid, is a component of cash flow to

creditors.

• More generally, our goal in project evaluation is to compare the cash

flow from a project/firm to the cost of acquiring that project in
order to estimate NPV.

• Particular mixture of debt & equity a firm actually chooses to use in

financing a project is managerial variable & primarily determines
how project cash flow is divided between owners & creditors.

• This is not to say that financing arrangements are unimportant.

They are just something to be analyzed separately.
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 OTHER ISSUES - Actual Vs Accruals & After Tax
• There are some other things to watch out for.

Actual Vs Accruals:
• First, we are interested only in measuring cash flow.
• Moreover, we are interested in measuring it when it actually occurs,
not when it accrues in an accounting sense.
After-tax Cash Flow:
• Second, we are always interested in after-tax cash flow because taxes
are definitely a cash outflow.
• Whenever we write incremental cash flows , we mean after-tax
incremental cash flows.

• Remember, however, that after-tax cash flow and accounting profit,

or net income, are entirely different things.
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 Pro Forma Financial Statements and Project Cash Flows
• The first thing we need when we begin evaluating a proposed
investment is a set of pro forma, or projected, financial statements.
Given these, we can develop the projected cash flows. Once we have
the cash flows, we can estimate the value of the project using the
techniques we described in the previous sessions.
• Pro forma financial statements are a convenient and easily
understood means of summarizing much of the relevant information
for a project. To prepare these statements, we will need estimates of:
a) Quantities such as unit sales
b) The selling price per unit
c) The variable cost per unit, and
d) Total fixed costs.
We will also need to know:
e) The total investment required
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 Illustration –finding net income
• Suppose we think we can sell 50,000 cans of shark attractant per year
at a price of $4 per can.
• It costs us $2.50 per can to make the attractant
• New product such as this one typically has only a three-year life.
• We require a 20% return on new products i.e. required rate of return.
• The project will incur Fixed costs of $12,000 per year, including rent.
• Further, we will need to invest $90,000 in manufacturing equipment.
• For simplicity, we will assume that this $90,000 will be depreciated
100% over the three-year life of the project.
• Furthermore, the cost of removing the equipment will roughly equal
its actual value in three years, so it will be essentially worthless on a
market value basis as well. So no salvage value.
• Finally, the project will require an initial $20,000 investment in net
working capital, and the Tax rate is 34%. 18
 Income Statement & Capital Requirements

(Outstanding)

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 PROJECT CASH FLOWS
• At this point, we need to start converting this accounting information
into cash flows.

• To develop the cash flows from a project, we need to recall that cash
flow from assets has three components:
1. Operating cash flow
2. Capital spending, and
3. Changes in net working capital.
• To evaluate a project or mini-firm, we need to estimate each of these.

• Once we have estimates of the components of cash flow, we will

calculate cash flow for our mini-firm just as we did earlier for an
entire firm.

• Project cash flow = Project operating cash flow - Project change in

net working capital - Project capital spending 20
 Cash Flow
• Operating cash flow = EBIT + Depreciation - Taxes
• To illustrate the calculation we’ll use the projections from the project.

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 PROJECTED TOTAL CASH FLOW AND VALUE
Now that we have cash flow projections, we are ready to apply the various
criteria we discussed in the last chapter.
2 3
1. NPV(@r 20%) = -110,000+51,780/1.2+51,780/1.2+71,780/1.2=10,648

Thus, the project creates over $10,000 in value and should be accepted.
Also, the return on this investment obviously exceeds 20% (because the
NPV is positive at 20%).

2. IRR With trial & error, we find that the IRR = 25.8%.

3. Payback period = 2.1 years.

4. AAR = average net income divided by average book value. The net income
= $21,780. The average of 4 book values for total investment is ($110 + 80
+ 50 + 20)/4 = $65 or $21,780/65,000 = 33.51%.

We’ve seen that the return on this investment (the IRR) is about 26%. The
fact that the AAR is larger illustrates again why the AAR cannot be 22
 EXAMPLE: THE MAJESTIC MULCH AND COMPOST COMPANY
• MMCC is investigating the feasibility of a new line of power mulching tools for growing
number of homes. MMCC projects unit sales as follows:

• The new product will sell for $120 per unit to start. When the competition catches up
after 3 years, MMCC anticipates that the price will drop to $110.
• Project will require $20,000 in NWC at start. Subsequently, total net working capital
at the end of each year will be 15% of sales for that year.
• The variable cost per unit is $60, and total fixed costs are $25,000 per year.
• It will cost $800,000 to buy the equipment necessary to begin production.
• This investment is an industrial equipment & qualifies as seven-year MACRS.
• The equipment will be worth 20% of its cost in eight years i.e. $160,000.
• The relevant tax rate is 34% & the required return is 15%.
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Based on this information, should MMCC proceed?
 Operating Cash Flows
• At this point, we want to go through a somewhat more involved
capital budgeting analysis.
• Keep in mind as you proceed that the basic approach here is exactly
the same as that in the shark attractant example used earlier.
• We have just added some real-world detail (and a lot more numbers)
• There is a lot of information that we need to organize.
• The first thing we can do is calculate projected sales revenue.

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 DEPRECIATION, modified accelerated cost recovery system (mACRS)
• Next, we compute the depreciation on the $800,000 investment

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 Operating Cash Flows
With this information, we can prepare the income statements

From here, computing the operating cash flows is straightforward.

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 Change in Net Working Capital
• Now that we have the operating cash flows, we need to determine changes
in NWC which is assumed to change as sales change.
• Recalling that NWC starts out at $20,000 and then rises to 15% of sales, we
can calculate the amount of NWC for each year as

• Total change in NWC for each year are shown below:

0 1 2 3 4 5 6 7 8

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 Capital Spending
• Finally, we have to account for the long-term capital invested. MMCC
invests $800,000 at year 0. This equipment will be worth $160,000 at
the end & will have BV = 0. This $160,000 excess of MV over BV is
taxable, so the after-tax proceeds will be $160,000 x (1 - .34) =
$105,600.

0 1 2 3 4 5 6 7 8

• Total Cash Flow: We now have all the cash flow pieces, put them
together
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Valuation:

29
 Valuation
• There is no further analysis to be done.
• MMCC should begin production and marketing immediately.
• No; it is important to remember that the result of our analysis is an
estimate of NPV & we’ll usually have less than complete confidence
in our projections.
• This means we have more work to do.
• We need to spend some time evaluating the quality of our estimates.
• All the inputs are expected/estimated values, and actual values can
vary from expected values.
• Three techniques are used to assess stand-alone risk: (1) sensitivity
analysis, (2) scenario analysis, and (3) Monte Carlo simulation.
• We discuss them in the following sections.
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 Sensitivity Analysis
• Sensitivity analysis measures the percentage change in NPV that
results from a given percentage change in input variable
• The input variables can be changed one at a time to alter the
calculated project cash flows & thus the NPV & other capital
budgeting decision criteria may be applied. We could increase or
decrease
a) the projected unit sales,
b) the sales price,
c) the variable and/or the fixed costs,
d) the initial investment cost,
e) the net working capital requirements,
f) the salvage value,
g) the tax rate OR
h) Any other variable
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 Sensitivity analysis
• Such changes can be made easily in an Excel model, making it
possible to immediately see the resulting changes in the decision
criteria.
• This is called sensitivity analysis
• Ask yourself a series of “what if” questions: “What if unit sales fall
from 550 to 385?” What if market forces us to price the product at
$8.12, not $11.60?” “What if variable costs are higher?”

• Sensitivity analysis provides answers to such questions.

• Each variable is increased or decreased by a specified %age from its

expected value, holding other variables constant at base-case levels.

• Then the NPV is calculated using the changed input.

• Finally, the resulting set of NPVs is plotted to show how sensitive NPV
is to changes in the different variables.
33
Input Variables

NPV = $36
 Using Tornado Diagrams for Sensitivity Analysis
• It is another way to present results from sensitivity analysis.
• First rank the range of possible NPVs for each of the input variables
& place the widest at the top and smallest at the bottom.
 Interpreting Sensitivity Analysis
• The slopes of the lines in the graph and the ranges in the table indicate
how sensitive NPV is to each input.
• The larger the range, the steeper the variable’s slope and the more
sensitive the NPV is to this variable.
• NPV is extremely sensitive to changes in the sales price; fairly sensitive
to changes in variable costs, units sold, and fixed costs; and not
especially sensitive to changes in the equipment’s cost and the WACC.
• We should try to obtain accurate estimates of the variables that have
the greatest impact on the NPV (i.e. steep slope & high range).
• Even though NPV may be highly sensitive to certain variables, if those
variables are not likely to change much from their expected values,
then the project may not be very risky in spite of its high sensitivity.
• If we were comparing two projects, then the one with the steeper
sensitivity lines would be riskier, because relatively small changes in the
input variables would produce large changes in the NPV
 Scenario Analysis
• In sensitivity analysis, we change one variable at a time.

• However, it is useful to know what would happen to the project’s

NPV if several of the inputs turn out to be better or worse than
expected, and this is what we do in a scenario analysis.

• Scenario analysis allows us to assign probabilities to the base case,

the best case, and the worst case; then we can find the expected
value of the project’s NPV.

• Always ask marketing, engineering, and other operating managers

to specify a worst-case scenario (low unit sales, low sales price, high
variable costs, and so on) and a best-case scenario.
Scenario Analysis
Scenario Analysis
 MONTE CARLO SIMULATION
• Monte Carlo simulation, so named because this analysis grew out of
work on the mathematics of casino gambling, is a sophisticated
version of scenario analysis. Here the project is analyzed under a
large number of scenarios, or “runs.” In the first run, the computer
randomly picks a value for each variable—units sold, sales price,
variable costs per unit, and so forth. Those values are then used to
calculate an NPV, and that NPV is stored in the computer’s memory.
• Next, a second set of input values is selected at random & a second
NPV is calculated. This process is repeated perhaps 1,000 times,
generating 1,000 NPVs. The mean of the 1,000 NPVs is determined
and used as a measure of the project’s expected profitability, and the
standard deviation (or perhaps the coefficient of variation) of the
NPVs is used as a measure of risk.
• Monte Carlo simulation is technically more complex than scenario
analysis, but simulation software makes the process manageable.
Simulation is useful; but because of its complexity, a detailed
discussion is best left for advanced finance courses.
 common cases involving discounted cash flow analysis
• The analysis we went through in the previous section is quite general
and can be adapted to just about any capital investment problem.
• In the next section, we illustrate some particularly useful variations.
• To finish our chapter, we look at three common cases involving
discounted cash flow analysis.
1. First case involves new & expansion of existing projects, which
we are done with.
2. Second case involves replacement that are primarily aimed at
improving efficiency and thereby cutting costs.
3. Fourth and final case arises in choosing between equipment
options with different economic lives.
• There are many other special cases, but these four are particularly
important because problems similar to these are so common.
• Also, they illustrate some diverse applications of cash flow analysis
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 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• One decision we frequently face is whether to upgrade existing
facilities to make them more cost-effective.
• The issue is whether the cost savings are large enough to justify the
necessary capital expenditure.
• For example, suppose we are considering automating some part of
an existing production process.
• The necessary equipment costs $80,000 to buy and install.
• The automation will save $22,000 per year (before taxes) by reducing
labor and material costs.
• For simplicity, assume that the equipment has a five-year life and is
depreciated to zero on a straight line basis over that period. It will
actually be worth $20,000 in 5 years.
• Tax rate is 34%, and the discount rate is 10%. Should we automate?
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 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• As always, the first step in making such a decision is to identify the relevant
incremental cash flows.
• First, determining the relevant capital spending is easy enough. The initial
cost is $80,000. The after-tax salvage value is $20,000 x (1- 0.34) = $13,200
because the book value will be zero in five years.
• Second, there are no working capital consequences here, so we don’t need
to worry about changes in net working capital.
• Third, Operating cash flows. Buying the new equipment affects our
operating cash flows in two ways.
• First, we save $22,000 before taxes every year. In other words, the firm’s
operating income increases by $22,000, so this is the relevant incremental
project operating income.
• Second, we have an additional depreciation. In this case, depreciation is
$80,000/5 = $16,000 per year.
• Because the project has an operating income of $22,000 (the annual pretax
cost saving) and a depreciation deduction of $16,000, taking the project will
increase it’s EBIT by $22,000 - 16,000 = $6,000. So this is the project’s EBIT.
44
 Replacement Analysis – EVALUATING COST-CUTTING PROPOSALS
• Finally, because EBIT will rise for the firm, taxes will increase. This
increase in taxes will be $6,000 x .34 = $2,040. With this information,
we can compute operating cash flow in the usual way:

• We can now finish our analysis. Based on our discussion, here are the
relevant cash flows:

• At 10%, it’s straightforward to verify that the NPV here is $3,860, so

we should go ahead and automate. 45
 EVALUATING OPTIONS WITH DIFFERENT LIVES
• Here the problem we consider involves choosing among different
possible systems, equipment setups, or procedures.
• Our goal is to choose the most cost-effective option. The approach we
consider here is only when following 2 special circumstances exist.
1. The possibilities under evaluation have different economic lives.
2. Just as important, we will need whatever we buy indefinitely. As a
result, when it wears out, we will buy another one.
• We can illustrate this problem with a simple example. Imagine we are
in the business of manufacturing stamped metal subassemblies.
Whenever a stamping mechanism wears out, we have to replace it
with a new one to stay in business. We are considering which of two
stamping mechanisms to buy.
• For this we use 2 approaches:
• (1) LCM Approach and (2) Equivalent Annual Cost 46
EVALUATING OPTIONS WITH DIFFERENT LIVES – LCM approach

r = 10%
NPV = 28.93

NPV = 35.66

47
EVALUATING OPTIONS WITH DIFFERENT LIVES – LCM approach

NPV = 72.59

NPV = 62.45

48
 EVAL. OPTIONS WITH DIFFERENT LIVES – Eqv Annual cost approach
• Machine A costs $100 to buy and $10/year to operate. It wears out
and must be replaced every two years.
• Machine B costs $140 to buy and $8/year to operate. It wears out
and must be replaced every three years.
• Ignoring tax which one should we choose using 10% discount rate?
• In comparing the two machines, we notice that the first is cheaper to
buy, but it costs more to operate and it also wears out more quickly.
How can we evaluate these trade-offs?
• We can start by computing the present value of the costs for each:
2
• Machine A: PV -$100 - 10/1.1 - 10/1.1 = -$117.36
2 3
• Machine B: PV -$140 - 8/1.1 - 8/1.1 - 8/1.1 = -$159.89
• Note: All the numbers here are costs, so they all have negative signs.
49
 EVALUATING OPTIONS WITH DIFFERENT LIVES - EAC approach
• If we stopped here, it might appear that A is more attractive because
the PV of the costs is less.
• Actually, all we have really discovered so far is that A effectively
provides two years’ worth of stamping service for $117.36, whereas
B effectively provides three years’ worth of same service for $159.89.
• These costs are not comparable because of different service periods.
• We need to work out a cost per year for these two alternatives.
• To do this, we ask: What amount, paid each year over the life of the
machine, has the same PV of costs? This amount is called the
equivalent annual cost (EAC) .
• Calculating EAC involves finding unknown payment amount e.g. for
machine A, we need to find 2 year ordinary annuity with PV of $117.36
at 10%.
• Similarly , for B we need to find 3 year ordinary annuity with PV
50
of
$159.89 at 10%
 EVALUATING OPTIONS WITH DIFFERENT LIVES - EAC approach
• In IBF, we learnt that Annuity PV Factor
2

2
• 2 year annuity PV = EAC x (1 – 1/(1.10 )) /.10 = EAC x 1.7355
• For machine A, then, we have: PV of costs = -$117.36 = EAC x 1.7355
• Equivalent Annual Cost (EAC) = -$117.36/1.7355 = -$67.62
• For machine B, life is 3 yrs, so we first need the 3 year annuity factor:
3
• 3 year annuity factor = EAC x (1 – 1/1.10 ) /.10 = EAC x 2.4869
• PV of costs = -$159.89 = EAC x 2.4869
• EAC = -$159.89/2.4869 = -$64.29
• Based on this analysis, we should purchase B because it effectively costs
$64.29 per year versus $67.62/year for A. So B is cheaper. In this case, the
longer life and lower operating cost are more than enough to offset the51
higher initial purchase price
 real options
• DCF techniques were originally developed to value securities such as
stocks and bonds. These are passive investments—once the
investment has been made, most investors can take no actions that
influence the cash flows they produce.
• However, capital budgeting projects are not passive investments—
managers can often take positive actions after the investment has
been made that alter the cash flow stream.
• Opportunities for such actions are called real options—“real” to
distinguish them from financial options like an option to purchase
shares of Boeing stock, and “options” because they offer the right but
not the obligation to take the future action to increase cash flows.
• Real options are valuable, but this value is not captured by
conventional NPV analysis.
• Therefore, a project’s real options must be considered separately.
52
 TYPES OF REAL OPTIONS
• There are several types of real options, including
1. Input flexibility, where the inputs used in the production process
(say, coal vs natural gas vs oil for generating electricity) can be
changed if input prices and/or availability change.
2. Abandonment, where the project can be shut down if its cash
flows are low
3. Timing, where a project can be delayed until more information
about demand and/or costs can be obtained
4. Expansion, where the project can be expanded if demand turns
out to be stronger than expected
5. Output flexibility, where the output can be changed if market
conditions change; and
• In the following slides we shall illustrate flexibility options and
abandonment options.

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 Production flexibility option

Solution

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 ABANDONMENT OPTIONS
• In capital budgeting we generally assume that a project will be
operated for its full physical life.
• However, this is not always the best course of action. If the firm has
the option to abandon a project during its operating life, this can
lower its risk, increase its expected profitability, and raise its
calculated NPV.
• Table below gives a picture of the decision tree for a Project S.
• Scenario analysis for the Project S under the Best Case, Base Case,
and Worst Case assumptions are given in the table.
• In the worst-case situation, the project has negative cash flows for
its full 4-year life.
• However, if the company can abandon the project after Year 1,
when it sees that it is not a success, then its expected NPV can be
improved.
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ABANDONMENT OPTIONS

56
 ABANDONMENT OPTIONS
• The earlier analysis is reproduced in the top section of the table
labeled “No Abandonment.”
• In Column C, which is Time 0, we see that the firm must invest
between $750 and $1,250. Columns D through G show the annual
cash flows under each scenario, and in Column H we show the
WACCs for each scenario.
• Then, in Column I, we show the NPV under each scenario when the
cash flows are discounted at their respective WACCs.
• The sum of the products obtained by multiplying each probability
times each branch NPV is the expected NPV, which is $706.40. The
standard deviation and the coefficient of variation are also calculated
to provide an idea of the project’s risk.
• This project has a positive expected NPV; hence, by the NPV criterion
it should be accepted.
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 ABANDONMENT OPTIONS
• Now suppose the company could make a second decision, at t1, to
abandon (or shut down) the project if things go badly during Year 1.
• To see what would happen then, we add another branch, as shown in
the Worst #2 row in the table under the “Can Abandon” situation.
• Here we assume that the company abandons the project at the end
of Year 1, when information about the actual production costs and
demand conditions become available.
• If things were going well, the project would be continued. However, if
things were going badly, the firm would close the operation and not
suffer the indicated losses during the next 3 years.
• Given the “Can Abandon” option, the firm would prefer to abandon
the project than to continue it under the worst-case scenario.
• Therefore, we assign a zero probability to continuing after a bad start.
Therefore, the 25% probability associated with the worst case is used
for “Worst #2” and a 0% probability is assigned to “Worst #1.” 58
 ABANDONMENT OPTIONS
• The option to abandon raises the expected NPV from $706 40 to
$1,350 09, and it also lowers the standard deviation. Those changes
combine to lower the coefficient of variation from 6.19 to 2.70. The
coefficient of variation is still above the company’s average CV of 2.0,
which indicates that the project is still more risky than most, even
after the abandonment option has been considered.
• Therefore, the 12.50% WACC is still appropriate for discounting this
project’s free cash flows.
• Also, note that the difference between the expected NPVs with and
without abandonment represents the option value to abandon this
project.
• As shown in the lower part of the table. this option is worth $643.68.
• If the NPV of the “No Abandonment” situation had been negative,
then the value of the option would simply have been the NPV of the
“Can Abandon” situation. 59
 ABANDONMENT OPTIONS
• With this project, the ability to abandon it makes the NPV look better,
but it does not reverse the accept/reject decision. However, it often
turns out that if we fail to consider abandonment, the bad case is so
bad that the expected NPV is negative, but when abandonment is
considered, the expected NPV becomes positive.
• Clearly, abandonment must be considered to obtain valid assessment
for different projects, and the opportunity to abandon a project is an
important way to limit downside losses.
• Note too that it might be necessary for the firm to arrange things so
that it has the possibility of abandonment when it is making the
initial decision about a project.
• This might require contractual arrangements with suppliers,
customers, and its union, and there might be some costs to obtaining
these advance permissions. Any such costs could be compared with
the value of the option as we calculated it, and this could enter into
the initial decision. 60
 THE POST-AUDIT
• Final aspect of capital budgeting process is post-audit, which involves:
1. Comparing actual results with those predicted and
2. Explaining why any differences occurred.
• For example, many firms require that the operating divisions send a
monthly report for the first 6 months after a project goes into
operation & a quarterly report thereafter, until the project’s results
meet expectations. From then on, reports on the operation are
reviewed on a regular basis like those of other operations.
• The post-audit has two main purposes:
1. Improve forecasts. When decision makers are forced to compare
their projections with actual outcomes, there is a tendency for
estimates to improve. Conscious or unconscious biases are
observed and eliminated; new forecasting methods are sought as
the need for them becomes apparent; and people simply tend to
do everything better, including forecasting, if they know that their
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actions are being monitored.
 THE POST-AUDIT
2. Improve operations. Businesses are run by people, and people can
perform at higher or lower levels of efficiency. When a divisional
team has made a forecast about an investment, the team members
are, in a sense, putting their reputations on the line. Accordingly, if
costs are above and sales below predicted levels, then executives in
production, marketing, and other areas will strive to improve
operations and to bring results into line with forecasts.
• In a discussion related to this point, one executive made this
statement: “You academicians only worry about making good
decisions. In business, we also worry about making decisions good.”
• The post-audit is not a simple process.
a) First, we must recognize that each element of the cash flow
forecast is subject to uncertainty, so a percentage of all projects
undertaken by any reasonably aggressive firm will necessarily go
awry. This fact must be considered when appraising the
performances of the operating executives who sponsor projects. 62
 THE POST-AUDIT
b) Second, projects sometimes fail to meet expectations for reasons
beyond the control of their sponsors and for reasons that no one
could be expected to anticipate.
c) Third, it is often difficult to separate the operating results of one
investment from those of a larger system. Although some projects
stand alone and permit ready identification of costs and revenues,
the cost savings that result from assets like new computers may be
very hard to measure.
d) Fourth, it is often hard to hand out blame or praise because the
executives who were responsible for launching a given investment
have moved on by the time the results are known.
• Because of this, some firms play down the importance of the post-
audit. However, observations of both businesses & governmental
units suggest that the best-run & most successful organizations put a
lot of emphasis on post-audits. Accordingly, we regard the post-audit
as an important element in a good capital budgeting system. 63