FINANCE IN A CANADIAN SETTING Sixth Canadian Edition

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FINANCE IN A CANADIAN SETTING Sixth Canadian
Edition

• Lusztig, Cleary, Schwab

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• CHAPTER TWELVE
• Capital Budgeting Additional Topics

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Learning Objectives

• 1. Discuss why cash flows need to be projected
  in nominal terms when market discount rates are
  used.
• 2. Explain what discount is used and why, when a
  business faces capital rationing.
• 3. Explain why projects should be ranked
  according to their benefit-cost ratio.

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Learning Objectives

• 4. Discuss the additional considerations of
  international capital budgeting.
• 5. Describe and define the relationship between
  capital budgeting, general corporate planning,
  strategic planning, and operating budgets.

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Discounted Cash Flow Analysis and Inflation

• The standard process of measuring inflation is
  called the current dollar discounting
• Inflation influences two aspects of capital
  budgeting
• 1. The general level of future cash flows
  generated by a project
• 2. The cost of capital that is used as a
  discount rate

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Discounted Cash Flow Analysis and Inflation

• Forecasting the inflation rate over extended time
  periods is extremely difficult
• Constant dollar discounting method is
  alternative method used to forecast the general
  level of inflation explicitly by removing the
  inflation component out of the cost of capital
• Constant dollar discounting is used in the public
  sector but not in private sector project
  evaluation because there are interactions between
  the tax code and inflation

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Project Interdependencies

• Interdependencies occur when the cash flow
  generated from one project depends on other
  investments that the firm may consider
• Extreme examples include
• Mutually exclusive
• Contingent projects
• Generally the interdependence of projects may be
  either complementary or negative

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Capital Rationing

• Capital rationing when money has to be rationed
  among projects that compete for scarce funds
• Under normal circumstances all positive NPV
  projects should be accepted
• Project ranking based on NPV becomes the practice
  when firms face a capital constraint

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International Aspects of Capital Budgeting

• Large multinational firms view it as essential to
  be active in the major industrial areas of North
  America, Europe, and Asia-Pacific
• Firms invest abroad to
• minimize the cost of production
• achieve economies of scale
• circumvent trade barriers or regulations
• exploit future opportunities

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International Aspects of Capital Budgeting

• Expected cash flows of international projects can
  be affected by
• economic incentives
• different tax rates and regulations
• different business conduct
• repatriation of profits
• Factors affecting project risk in international
  projects include
• political uncertainty
• foreign exchange rates

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International Aspects of Capital Budgeting

• Factors affecting the discount rate in the
  international markets include
• underdeveloped financial markets
• favourable government financing offers
• exchange rate risk

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Organizational Issues

• Investment planning is within general corporate
  planning
• Capital budgeting has both a top down and a
  bottom up component
• Approval of investment proposals proceeds in
  several stages depending on the type, size, and
  complexity of the proposal

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Organizational Issues

• Firms often group investment proposals into
  distinctive categories such as
• 1. projects required by law
• 2. safety and working condition
  improvements
• 3. essential replacements and additions
• 4. cost reduction and quality improvements
• 5. capacity expansion for existing products
• 6. new products or markets

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Organizational Issues

• Management is often faced with distortions from
  divisions and departments competing with each
  other for scarce corporate resources
• Management can deal with distortions by
• requesting additional information about the
  proposed project
• systemic post-audits of projects
• An approach to avoid competitive bidding for
  projects is for management to decentralize
  decision-making

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Organizational Issues

• There are two types of errors that can be made in
  investment decisions
• accept a bad project (type 1 error)
• reject a good project (type 2 error)
• Trade-offs occur in trying to manage both types
  of errors

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Summary

• 1. Given inflation, it is important that in both
  the cash flow projections and choice of the
  discount rate, general price-level changes be
  reflected in a consistent manner.
• 2. Interrelations between projects can become
  important in affecting diversification and risk.
  Any direct interdependencies between investments
  need to be recognized. In extreme cases, projects
  may be either mutually exclusive or contingent.

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Summary

• 3. When a firm faces capital rationing the
  discount rate to be used is the opportunity cost
  of funds, which equals the yield on the most
  attractive investment opportunity foregone.
• 4. Projects should be ranked on the basis of
  their benefit-cost ratio, which equals the net
  present value per unit of capital invested. The
  larger ratios are the more attractive.

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Summary

• 5. International capital budgeting uses the same
  basic concepts and technologies, but added
  considerations affecting expected cash flows,
  risk, and the discount rate may exist.
• 6. Capital budgeting is linked to both strategic
  planning and to operating budgets. Ultimately,
  positive net present values are only created when
  a firm can do things better or cheaper than its
  competitors.