FREE online courses on Capital Budgeting Analysis - The Overall Process -
The Three Stages of Capital Budgeting Analysis
Capital Budgeting Analysis is a process of evaluating how we
invest in capital assets; i.e. assets that provide cash flow benefits for more
than one year. We are trying to answer the following question:
Will the future benefits of this project be large enough to
justify the investment given the risk involved?
It has been said that how we spend our money today determines
what our value will be tomorrow. Therefore, we will focus much of our attention
on present values so that we can understand how expenditures today influence
values in the future. A very popular approach to looking at present values of
projects is discounted cash flows or DCF. However, we will learn that this
approach is too narrow for properly evaluating a project.
We will include three stages within Capital Budgeting
Analysis:
Decision Analysis for Knowledge
Building
Option Pricing to Establish Position
Discounted Cash Flow (DCF) for making the Investment Decision
KEY POINT ®
Do not force decisions to fit into Discounted Cash Flows! You need to go through
a three-stage process: Decision Analysis, Option Pricing, and Discounted Cash
Flow. This is one of the biggest mistakes made in financial management.
Decision-making is increasingly more complex today because of
uncertainty. Additionally, most capital projects will involve numerous variables
and possible outcomes. For example, estimating cash flows associated with a
project involves working capital requirements, project risk, tax considerations,
expected rates of inflation, and disposal values. We have to understand existing
markets to forecast project revenues, assess competitive impacts of the project,
and determine the life cycle of the project. If our capital project involves
production, we have to understand operating costs, additional overheads,
capacity utilization, and start-up costs. Consequently, we can not manage
capital projects by simply looking at the numbers; i.e. discounted cash flows.
We must look at the entire decision and assess all relevant variables and
outcomes within an analytical hierarchy.
In financial management, we refer to this analytical
hierarchy as the Multiple Attribute Decision Model (MADM). Multiple attributes
are involved in capital projects and each attribute in the decision needs to be
weighed differently. We will use an analytical hierarchy to structure the
decision and derive the importance of attributes in relation to one another. We
can think of MADM as a decision tree which breaks down a complex decision into
component parts. This decision tree approach offers several advantages:
We systematically consider both financial and non-financial
criteria.
Judgements and assumptions are included within the decision
based on expected values.
We focus more of our attention on those parts of the decision
that are important.
We include the opinions and ideas of others into the
decision. Group or team decision making is usually much better than one person
analyzing the decision.
Therefore, our first real step in capital budgeting is to
obtain knowledge about the project and organize this knowledge into a decision
tree. We can use software programs such as Expert Choice or Decision Pro to help
us build a decision tree.
Simple Example of a Decision Tree:
The uncertainty about our project is first reduced by
obtaining knowledge and working the decision through a decision tree. The second
stage in this process is to consider all options or choices we have or should
have for the project. Therefore, before we proceed to discounted cash flows we
need to build a set of options into our project for managing unexpected changes.
In financial management, consideration of options within
capital budgeting is called contingent claims analysis or option pricing. For
example, suppose you have a choice between two boiler units for your factory.
Boiler A uses oil and Boiler B can use either oil or natural gas. Based on
traditional approaches to capital budgeting, the least costs boiler was selected
for purchase, namely Boiler A. However, if we consider option pricing Boiler B
may be the best choice because we have a choice or option on what fuel we can
use. Suppose we expect rising oil prices in the next five years. This will
result in higher operating costs for Boiler A, but Boiler B can switch to a
second fuel to better control operating costs. Consequently, we want to assess
the options of capital projects.
Options can take many forms; ability to delay, defer,
postpone, alter, change, etc. These options give us more opportunities for
creating value within capital projects. We need to think of capital projects as
a bundle of options. Three common sources of options are:
Timing Options: The ability to delay our investment in the
project.
Abandonment Options: The ability to abandon or get out of a
project that has gone bad.
Growth Options: The ability of a project to provide long-term
growth despite negative values. For example, a new research program may appear
negative, but it might lead to new product innovations and market growth. We
need to consider the growth options of projects.
Option pricing is the additional value that we recognize
within a project because it has flexibilities over similar projects. These
flexibilities help us manage capital projects and therefore, failure to
recognize option values can result in an under-valuation of a project.
So we have completed the first two stages of capital
budgeting analysis:
(1) Build and organize knowledge within a decision tree and
(2) Recognize and build options within our capital projects.
We can now make an investment decision based on Discounted
Cash Flows or DCF.
Unlike accounting, financial management is concerned with the
values of assets today; i.e. present values. Since capital projects provide
benefits into the future and since we want to determine the present value of the
project, we will discount the future cash flows of a project to the present.
Discounting refers to taking a future amount and finding its
value today. Future values differ from present values because of the time value
of money. Financial management recognizes the time value of money because:
Inflation reduces
values over time; i.e. $ 1,000 today will have less value five years from now
due to rising prices (inflation).
Uncertainty in the
future; i.e. we think we will receive $ 1,000 five years from now, but a lot can
happen over the next five years.
Opportunity Costs of money; $ 1,000 today is worth
more to us than $ 1,000 five years from now because we can invest $ 1,000 today
and earn a return.
Present values are calculated by referring to tables or we
can use calculators and spreadsheets for discounting. The discount rate we will
use is the opportunity costs of the investment; i.e. the rate of return we
require on any other project with similar risks.
Exhibit 1 - Present Value of $ 1.00, year = n, rate = k
|
Year (n)
|
k = 10%
|
k = 11%
|
k = 12%
|
|
1
|
.909
|
.901
|
.893
|
|
2
|
.826
|
.812
|
.797
|
|
3
|
.751
|
.731
|
.712
|
|
4
|
.683
|
.659
|
.636
|
|
5
|
.621
|
.593
|
.567
|
Example 1 - Calculate the Present Value of Cash Flows
You will receive $ 500 at the end of next year. If you could
invest the $ 500 today, you estimate that you could earn 12%.
What is the Present Value of this future cash inflow?
$ 500 x .893 (Exhibit 1) =
$ 446.50
If we were to receive the same cash flows year after year
into the future, then we could use the present value tables for an annuity.
Exhibit 2 - Present Value of Annuity for $ 1.00, year = n, rate = k
|
Year (n)
|
k = 10%
|
k = 11%
|
k = 12%
|
|
1
|
.909
|
.901
|
.893
|
|
2
|
1.736
|
1.713
|
1.690
|
|
3
|
2.487
|
2.444
|
2.402
|
|
4
|
3.170
|
3.102
|
3.037
|
|
5
|
3.791
|
3.696
|
3.605
|
Example 2 - Calculate the Present Value of Annuity Type Cash
Flows
You will receive $ 500 each year for the next five years.
Your opportunity costs for this investment is 10%. What is the present value of
this investment?
$ 500 x 3.791 (Exhibit 2) = $ 1,895.50
We now understand discounting of cash flows (DCF) and the
three reasons why we discount future cash flows: Inflation, Uncertainty, and
Opportunity Costs.
