Chapter 15

CAPITAL BUDGETING : EXTENSIONS

The central theme of economics is the allocation of limited resources to various needs in order to maximize our happiness or satisfaction. Similarly, in FINANCE the central theme is the allocation of limited capital to various projects in order to maximize our returns.

OUTLINE
Choice between Projects of Unequal Life Interrelationship between Investment and Financing Aspects

Capital Budgeting under Constraints

Value of Options Sources of Positive NPV Qualitative Influences Corporate Strategy and Capital Budgeting

Organisational Considerations
Capital Budgeting in Public Sector Undertakings
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CHOICE BETWEEN PROJECTS OF UNEQUAL LIFE

Investment
Machine A Rs.75,000 Machine B Rs.50,000

Life 5 years 3 years Annual operating Rs.12,000 Rs.20,000 costs Present Value of All Costs A : 75,000 + 12,000 x PVIFA (5 yrs, 12%) = Rs.118,260 B : 50,000 + 15,000 x PVIFA (3 yrs, 12%) = Rs. 86,030 This comparison is flawed because it overlooks the fact that machine B has a shorter life and has to be replaced earlier
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CHOICE BETWEEN PROJECTS OF UNEQUAL LIFE

For a proper comparison of the two alternatives, that have different lives, we have to convert the present value of costs into a uniform annual equivalent (UAE) figure. PV of Cost UAE = PVIFAr,n 118,260 Machine A : UAE = = 32,804 3.605

Machine B : UAE =

86,030 2.402

= 35,816

Since UAE (A) < UAE (B), A is preferable.

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INTERRELATIONSHIP BETWEEN INVESTMENT

AND FINANCING ASPECTS

Projects tend to differ in their debt capacity and other features like availability of subsidies. Hence financing and investment decisions are likely to be interrelated. When this is so, we must take into account the financing impact of an investment decision. This may be done by calculating the adjusted NPV.
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ADJUSTED NPV Adjusted NPV Base case NPV NPV of financing decisions associated with the project

Base case NPV is the NPV under the assumption that the project is all-equity financed.

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ADJUSTED NPV
Investment Net cash flow Opportunity cost of capital Cost of issuing equity Debt finance Interest rate Repayment period Tax rate : : : : : : : : Rs.5 million Rs.1 million per year for 8 years 15 percent 5 percent Rs.2.4 million 14 percent 8 equal annual instalment 60 percent

Base Case NPV

8

- 5,000,000 +
t=1
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1,000,000 = - Rs.512,700 (1.15)t

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ADJUSTMENT FOR ISSUE COST Equity finance : Rs.2,600,000

Since issue costs would absorb 5 percent of the gross proceeds, the firm will have to issue Rs.2,736,842 (Rs.2,600,000/0.95) of equity stock in order to realise a net amount of Rs.2,600,000. So, issue costs = Rs.136,842.

Adjusted NPV = - Rs.512,700 Rs.136,842

= - Rs.649,542
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ADJUSTMENT FOR TAX SHIELD ASSOCIATED WITH DEBT

(Rs in '000) Year Debt outstanding at the beginning Interest Tax shield Present value of tax shield 14% discount rate

1
2 3 4

2400
2100 1800 1500

336
294 252 210

202
176 151 126

177
135 102 75

5
6 7 8

1200
900 600 300

168
126 84 42

101
76 50 25

52
34 20 9

Total
Adjusted NPV = Base case NPV Issue cost + PV of tax shield = - Rs 512,700 Rs.136,842 + Rs.604,000 = - Rs.45,542
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CAPITAL BUDGETING UNDER CONSTRAINTS

FEASIBLE COMBINATIONS APPROACH

1. Define all combinations of projects which are feasible, given the capital budget restrictions and project interdependencies.

2 Choose the feasible combination that has the highest NPV.

Let us find out most desirable feasible combination out of the following with a capital budget constraint of Rs. 3 million: (what will happen if there are 50 projects?)
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FEASIBLE COMBINATIONS APPROACH

Project
A

Outlay
1,800,000

NPV
750,000

B
C

1,500,000
1,200,000

600,000
500,000

D
E
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750,000
600,000
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360,000
300,000
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CAPITAL BUDGETING UNDER CONSTRAINTS LINEAR PROGRAMMING MODEL

n Maximise NPVj Xj j=1 Subject to m CFjt Xj < Kt (t = 1, 2, , n) j=1 0 < Xj < 1 where NPVj Xj CFjt Kt = = = = net present value of project j proportion of project j accepted cash outflow required for project j in period t capital budget available in period t
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More about Linear Programming (LP)

It is possible to: allow carry forward of cash from one period to another Introduce non financial constraints like availability of material Even though ideally suited for capital budgeting problems with limited resources, LP is not used widely as: 1. It assumes all future investments are known 2. For truly worthwhile opportunities, capital may not be a constraint
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Value of Options 1 Identify Options

In real life, two types of options seen: 1. An incremental option opens opportunities (beachhead) to make profitable investments in future e g Vedanta Group 2. A flexibility option gives wider latitude in manufacturing so that it can cope better with unforeseen changes & exploit future profitable opportunities e g design of RIL refineries
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2 Analyze Environmental Uncertainty

In uncertain environment, options are valuable e g value of flexi raw crude usage at RIL refineries in a highly volatile crude market. Flexibility options more valuable in an uncertain environment Often such investments motivated by future uncertainty, not current profitability e g Mittal consolidating steel making capacities around the globe
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REAL OPTIONS Investment timing option Expansion option Growth option Shutdown option Abandonment option

Flexibility option
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3 Value the Options

Black-Scholes Options Pricing Model gives these insights: 1. The greater the uncertainty in a project, the higher the value of options embedded in it 2. The longer the duration of a project, the higher the value of options inherent in it
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RELATIVE VALUES OF CASH

P R O J E C T

FLOWS AND OPTIONS

H I G H L O W

Cash flows : 75 Options : 25

Cash flows : 50 Options : 50

D U R A T I O N
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Cash flows : 95 Options :5 LOW

Cash flows : 75 Options : 25 HIGH

Environmental Uncertainty
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SOURCES OF POSITIVE NPV (CEG, MPT)

1.

2 3

Cost advantage Accumulated experience & comparative edge on the learning curve e g Hero Honda, Maruti Monopolistic access to low cost materials e g TISCO A favorable location e g Rs. 60000 / Nano? Economies of scale Increase in the scale of production (RIL), marketing (Godrej) or distribution (HUL) leading to a decline in cost per unit. The greater the Capital requirement for economy of scale, the higher the entry barrier Government policy Govt. Policies that create entry barriers like: Restrictive licensing e g Reliance Communications Import restrictions & / or high tariff walls Environmental controls Special tax relief's e g SEZ
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SOURCES OF POSITIVE NPV

4

Marketing reach

A penetrating marketing reach is an important source of Competitive Advantage e g AVONs worldwide network of 1.2 million independent sales representatives almost impossible to replicate Or, HULs distribution too costly to replicate

Product differentiation

By effective advertising & superior marketing Exceptional service e g pizza in 20 minutes or free Innovative product features e g Nokia High quality and dependability e g Godrej furniture

Technological edge

Examples: IBM, XEROX, Dr Reddys Labs, Lakshmi Machine Works

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QUALITATIVE INFLUENCES Intuition right hemisphere judgment, not analysis Vision serves as super ordinate goal Superstition Astrology They help relieve anxiety, impart a sense of control, encourage necessary activity Politics Internal Political Games Sponsorship decision is a bet on the sponsor, his commitment, track record, ability to overcome obstacles, deliver goods Intangible benefits like enhancing flexibility, technological capability, improving product attractiveness, bringing a sense of pride, pleasing work environment, raising morale
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Some examples of Vision Statements

IBM RIL Honda Bajaj Auto ITC Tata Motors Bell System Ranbaxy Value added leadership position Integrated, world class capacity empire No. 1 world producer of best mobikes Global Player India International Technological competence Our business is service A research based International Pharmaceutical company

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How to strengthen the Links between Corporate Strategy & Capital Budgeting
Long range planning should precede capital budgeting Long Range plans should be formalized & communicated to all involved in capital budgeting Investment proposals should be viewed in the context of the critical premises of Long Range Plans Allocate to missions rather than to activities or divisions
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STRATEGY AND CAPITAL

ALLOCATION
A t t r a c t i v e n e s s

Business Strength
Strong High Invest Average Invest Weak Hold

I N D U S T R Y

Medium
Low

Invest
Hold

Hold
Divest

Divest
Divest

General Electrics Stoplight Matrix

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AN APPROACH TO DECISION-MAKING

Consistency with Strategy ?

No

Yes Yes Accept Positive NPV ? No Reject

Yes

Significant Intangibles ?

No

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ORGANISATIONAL CONSIDERATIONS Compatibility with resources 2

Controllability why pilot needed in a plane?

Executive management endorsement @ LRP, funds planning, development of budgetary controls

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CAPITAL BUDGETING IN PUBLIC SECTOR UNDERTAKINGS Role of the Public Investment Board (1972) headed by

Secretary, Expenditure + secs to Planning Commission,

DEA, PM, DPE, Ministry of Industrial Development, & Administrative ministry bringing up the proposal. Guidelines Provided by the Government 1975 Guidelines for Preparation of Feasibility Repots for

Industrial Projects - 1996 Planning Commission issued A

MANUAL ON FEASIBILITY STUDIES
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SUMMING UP

For a proper comparison of alternate projects with different lives we have to look at the UAE figure.
When investment and financing aspects of a project are inter-related, adjusted NPV is defined as: Base case NPV + NPV of the financing aspects Mathematical programming models are helpful in coping with the problem of capital budgeting under constraints There are several options found in capital projects such as investment timing option, expansion option, growth option, shutdown option, abandonment option and flexibility option.
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 The important entry barriers that result in positive NPV projects are as follows: economies of scale, product differentiation, cost advantage, marketing reach, technological edge, and governmental policy. Intuition, vision, superstition, politics, project sponsorship, and intangible benefits are key qualitative influences bearing on capital expenditure decisions. Since the resource allocation strategy of a firm shapes, guides, and circumscribes individual project decisions, the desirability of a project cannot be assessed without considering the strategy of the firm.

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