Adv Issues in Cap Budgeting

Practical Issues in Capital Budgeting (FM-II)

April 18, 2023

Dr. Triptendu Prakash Ghosh

April 18, 2023

Introduction – 1

• So far, we have analyzed only stand-alone projects• Our job was simple

– Estimate the cash flows from the investment, and

– Discount the same at an appropriate discount rate

• It was assumed that – selecting a good project has no effect on other concurrent or

subsequent projects

– Firms with +ve NPV projects can raise capital at a fair price

• A firm is required to choose between alternatives due to the two following factors– Projects are mutually exclusive – serving the same purpose –

accepting one makes the other proposal redundant, and/or

– Firm has limited capital – it cannot take every project with positive NPV/ high IRR

April 18, 2023

Introduction – 2

• But it is possible that making one investment decision may force the firm to take another one in future (pre-requisite)– Current investment decision should take this into account

• We also assumed that alternative proposals had same life• Though we mentioned a few do’s & don’ts

– We did not deal with the whole range of practical issues

• We also talked about possible conflicts between NPV and IRR– And the ways to resolve the conflict analytically

• But we did not probe whether the choice of NPV versus IRR (as decision rule/criterion) depends on– Firm characteristics, or

– Project settings (e.g., size, life, risk, etc.)

April 18, 2023

Introduction – 3

• It is possible that project dependence (concurrent and future/pre-requisite) may limit ability of managers to select a current project

• It’s also possible that lack of capital may force managers to reject other good (+ve NPV & high IRR) projects– Such, and other situations lead to “Capital Rationing”

April 18, 2023

Capital Rationing Defined

• “Capital Rationing” (CR) occurs when– a firm is unable or unwilling to raise the capital and/or unable to

invest in projects that earn returns higher than the hurdle rate

• CR may arise due to several factors (we discuss four major ones)

• 1) Project Discovery: It is assumed that firms know when they have good (+ve NPV / IRR>WACC) projects at hand

• However, uncertainty and errors of project analysis may lead to a firm feeling undecided about its own project assessment (and the estimated +ve NPV)

• And chose not to pursue the investment

April 18, 2023

Capital Rationing – 1

• 2) Credibility: Theory says that a firm conveys information about its projects to the funding entities (institutions or market)

• Firms attempt to do so in practice as well• Because it is easy for a firm to claim that its future projects

are good, regardless whether such claims are actually true or not

• So funding entities require substantial backing for viability of projects

• Firms that are unable to provide this backing are unable to convince funding entities– This is particularly serious for smaller firms and start-ups

April 18, 2023


• That the projects will create value (on the top of the firm’s own perceived indecisiveness about its own estimation of NPV)

• 3) Market Efficiency: Markets may remain (excessively) optimistic (over-valued) or (extremely) pessimistic (under-valued) for a considerable period of time

• That is, markets are not efficient – since value is not equal to price at all the times

• Managers know the “value” better than anybody else – credibility of communication (or information asymmetry) is another issue

• When markets are undervalued (in times of recession, as in 2012/13 in India), stock prices continue to be depressed

April 18, 2023


• Firms (naturally) tend not to issue fresh equity to finance even the very best of the future projects

• Since they will have to pay high price by selling equity at lower than its value

• See Example-1• The opposite happens when markets are overvalued

– Leading to a tendency of over-investment

– Because existing shareholders gain by issuing shares

• That is a major cause of business cycles

April 18, 2023


• 4) Floatation Costs: – Direct (fees to investment bankers, bankers, legal experts, costs

of complaince, distribution costs, etc.) and

– Indirect (under-pricing or selling at market price below true value for IPOs & FPOs, negative announcement effect for FPOs)

• Total costs may make funds prohibitively costly, reducing NPV substantially

• Implication of Capital Rationing• Firms cannot accept all +ve NPV projects – because they

don’t have unlimited capital• Projects have to be ranked – and we are back into NPV

versus IRR issues

April 18, 2023

Fresh Look at NPV versus IRR under CR – 1

• We know that conflict may arise (between NPV rule & IRR rule) in all situations except for – YES-NO decision (firm has only one investment opportunity),

AND

– Conventional project

• We also know that the conflict occurs over a specific range of values of the discount rate

• Now we probe two further points of difference between NPV & IRR

• See Example – 2A• Implicit assumption – intermediate cash flows get

reinvested at hurdle rate (15%) for NPV and at IRR for computation of IRR

April 18, 2023


• IRR (A: 33.66%, B: 20.88%) of both projects substantially higher than cost of capital [COC] (15%)

• Conflict arises in spite of the facts that– Both are conventional projects, and,

– Since discount rates are same, ranking vis-à-vis Y/N decision is not responsible for the conflict

• The reason is difference in scale of projects – NPV is stated in rupee amount, and hence is affected by scale

– IRR, being a rate, is not affected by scale

• Thus, NPV tends to favor projects with larger scale, while IRR is scale-independent

April 18, 2023


• There is a second (though less important) factor behind this type of conflict (due to difference in scale of projects)

• Both NPV and IRR (implicitly) assumes reinvestment of the cash flows till the maturity– But NPV uses the (much-lower than IRR) COC as the discount rate

– While IRR uses the IRR as the discount rate, which (i.e., the latter, or the IRR) as the discount rate (COC of 15% for NPV, as against IRR of 33.66% for A and 20.88% for B)

• While a smaller rate (of COC than IRR in either case) at the denominator makes NPV larger, the IRR is not dependent on the COC

• The result is: while NPV tends to favour larger projects, IRR is invariant to scale and COC– So long as both have positive NPV and IRR>COC(of A &/or B)

April 18, 2023


• Apart from scale (& difference in implicit discount rates), different timing of cash flows is also a culprit– Demonstrated by the case of comparing NPV for two projects

with similar scale Example – 2B

• NPV-IRR conflict still arises for RANKING of CONVENTIONAL PROJECTS of same scale– Due to difference in (implicitly assumed) reinvestment rates

(COC for NPV and IRR for IRR Rule)

– And when larger portion of CF coming in later years (Project B of Ex-2B) – nullifying the effect of reinvestment assumption

• Timing of cash flows may also be responsible for the NPV-IRR conflict

• It appears from Ex-2A that IRR does a better job in taking into account the timing of cash flows

April 18, 2023


• Consequences are that the NPV Rule– Is biased towards investments of larger scale

– Is biased towards projects for which a larger proportion of CFs come at later stage than otherwise

• Due to lower discount rate

– Does not lead to best use of capital in the presence of capital rationing (limited capital)

• In general, IRR rule is generally better for capital-rationed firms– But its reinvestment assumptions may still skew the investment

decisions

– For example, in those genuine cases where external conditions dictate that the scale of the project is high and/or CFs can only come at later stage

• How do we relate the above to Capital Rationing?

April 18, 2023


• This is how: • If the firm has easy access to capital markets, and/or if the

extent of information asymmetry faced by the firm is low,– Leading to the difference in cost of external and internal finance

low, – It can select both projects– Since both yield positive NPV as well as high IRR (above cost

of capital – even beyond WACC of 19.35%)

• If the firm faces Capital Rationing, – Due to substantial information asymmetry– Causing the cost of external finance to be substantially higher

than internal finance– Choosing the project requiring larger investment (B) may force it

to abandon future projects even with higher NPV and/or IRR than projects A & B now

April 18, 2023


• Thus, if the objective is to maximize shareholder value creation under limited capital (Capital Rationing) – The smaller scale project (A) (of Ex-2A) is a better choice– Since it uses a much smaller capital

• Hence we conclude that firms facing substantial information asymmetry, like those who – Are small in size– Lack physical assets to collateralize– Face riskier operating environment, and so on

• Should rather follow IRR as the decision rule, in stead of NPV

• Thus firms facing lower degree of information asymmetry (e.g., large and long-listed firms) will do better by following the NPV rule

April 18, 2023


• There are three modifications to traditional rules (leading to NPV-IRR conflict due to any of the factors) yielding better decisions– A) Using a scaled version of NPV called Profitability Index (PI)

– B) Using a Modified IRR (MIRR) approach with more reasonable reinvestment rate assumptions

– C) Using a more complex linear programming approach that allows capital constraints across many periods (& not just for the current period)

• The above may be viewed as three alternate attempts to save NPV (from the IRR attack)

April 18, 2023


• A) PI: First Attempt to Save the NPV Rule • This one tries to address the weakness of NPV Rule arising

due to scale effect• PI = NPV / (Initial Investment)• PI for a project measures the total value creation to a firm

per rupee of initial investment (if project accepted)• When there is Capital Rationing and there are several

positive NPV projects,– Rank the projects in descending order of PI, and

– Select the projects from the top that is allowed by available capital

April 18, 2023


• Note: Another version defines the PI ratio as PV of all CF-inflows to PV of all CF-outflows during the life of the project– The resulting ranking will be the same by PI as defined before

• See Example – 3A • There are several limitations of the PI-based Ranking• A.i) It concentrates on the current period only – but capital

rationing constraint is usually spread over more than one period– Projects chosen this year (using PI) may limit the firm’s ability

to investment in more profitable future projects

• A.ii) PI fails to ensure that projects chosen this year will absorb investable funds available this year

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– See the choice of projects in Ex-3A with a constraint of Rs. 100 crore, and note the amount that cannot be invested

– Now assume that Project B (in Example-3A) is a necessary pre-requisite for any of the other projects, and find out resources that cannot be invested due to capital constraint of current year\

– Compare the two outcomes

– See Ex-3B

• B) MIRR: Second Attempt to Save NPV • Here a reconciliation between NPV and IRR is attempted• One reason of conflict is the different re-investment rate

assumption (IRR at IRR but cost of capital for NPV)• Modified IRR (MIRR) is the IRR for which reinvestment of

intermediate cash flows is done at cost of capital

April 18, 2023


– At cost of equity if cash flows are to equity investors, and

– At cost of capital if cash flows are to the firm

• See Example-4 • Many believe that MIRR is a mix of the NPV and IRR rules

– Not without reason

• In practice, MIRR is a weighted average of returns on individual projects and hurdle rates used by the firm– With weights on each depending on magnitude and timing of

cash flows

– Larger and earlier the cash flows from the project, greater is the weight attached to the CoC (Cost of Capital)

• MIRR leads to removal of NPV-IRR conflict for projects of same scale and lives

April 18, 2023


• C) Multi-period Capital Rationing – the Third Attempt• So far we focused on current period capital rationing• In reality, it applied across time periods• When multi-period constraints are combined with projects

that require investment over many periods,• Our existing toolkit fails to handle the complexity• The solution is to apply linear programming• Problem formulation is as follows:

April 18, 2023


• The objective function is:

k

jjjNPVXMaximize

1

• Subject to the constraints:

• Where Xj=1 if Investment j is taken; 0 otherwise

k

jjj INVX

11, 000,1

k

jjj INVX

12, 200,1

k

jjj INVX

13, 400,1

• INVj,t = Investments (in Rs. Million) required on investment j in period t.

April 18, 2023

Further Issues in Capital Budgeting – 1

• Raising Hurdle rates to Handle Capital Ratoning• Many firms, when faced with CR, simply raise the hurdle

rates• So that fewer projects are available on the drawing board• There are several problems of this approach

– Once adjusted, firms may fail to correct it, especially when the constraint gets relaxed with increase in size and age of firm

– NPV computed by using a discount rate that is higher than the true discount rate does not convey the same information – amount of wealth increase

– Finally, this penalizes all projects – whether capital-intensive or not

April 18, 2023


• Project Dependence• Even in the absence of CR, selection of one project may

lead to rejection of another– For example, a information technology product to do a particular

job, or product distribution service

• See Examlpe-5.• Problem arises when two mutually exclusive projects have

unequal lives• Projects with Unequal Lives• Consider a 5-year and a 10-year project• The 5-year project may be replicated for another 5 years• And now the 10-year project can be compared with

replicated two 5-year projects

April 18, 2023


• Now consider a 5-year and a 4-year project• To compare the two, we must relpicate 5-year project 4

times and 4-year project 5 times– And then compare two 20-year projects

• What if you have to compare 6-year, 7-year and 9-year projects

• after replication, you face the daunting task of estimating cash flows for 126 years !!!

• There is a better method

April 18, 2023


• Equivalent Annuities Method• It is the annual NPV of a multi-period project• Since it is a figure on per annum basis, projects with

unequal lives can be compared• The formula is as follows:

nr

rNPVAnnuityEquivalent

11

*_

• Where– r: project discount rate

– n: project lifetime

• See Example-6.

April 18, 2023

Real Options in Capital Budgeting

• Traditional capital budgeting fails to take into account the myriads of options – That are involved in actual capital budgeting decisions

• There are three major types in capital budgeting– Option to delay a project

– Option to expand – to cover new product and/or market in future

– Option to abandon

• What are options? What are financial options? What are real options? How are they (financial and real options) different?

April 18, 2023

Readings

• AD6 & RWJK8 (see course outline for detailed reference)

Adv Issues in Cap Budgeting

Documents

Transcript of Adv Issues in Cap Budgeting