Capital Budgeting

Summaries

Comparing Mutual Exclusive Projects

1)      Least Common Multiple of Lives, repeat the shorter one and compare the NPV or IRR

2)      Equivalent Annual Annuity (EAA), find the equivalent annuity (for the given life of the project) to the NPV

Capital Rationing:

Maximize the overall return for the given available capitals

Hard Rationing: The capital is limited

Soft Rationing: Need to persuade senior management

Rationing violates market efficiency

Sensitivity Analysis: Find the NPV of base case vs one variable change

Scenario Analysis: Multiple input variable analysis with the consideration of input variable probability distribution: best, base and worst case

Simulation Analysis: Monte Carlo: assume input variable probability distributions.

Options:

-          Timing options

-          Abandonment options (~ put) (**** always make sure it is worthy to exercise the put! I.e. the NPV of using put is higher than no using!)

-          Expansion options (~ call)

-          Price setting options

-          Production flexibility options

-          Fundamental options – project itself is an option, e.g. price of the mining output

Always use the following equation to find the option value:

NPV = base case NPV – Option price + option value

Comparing NPV, economic income and accounting income

1)      NPV – pure cash flow, and interest is reflected in WACC

2)      Economic income – pure cash flow – change of the investment value (depreciation of the investment), interest is reflected in WACC

3)      Accounting income – just do income statement (for interest, one can assume the value of the investment is funded by debt in the company’s capital structure ratio)

Economic Profit = EBIT * (1-T) – WACC * capital (i.e. the book value of the capital)

Economic Value Added = MVA = NPV of all Economic Profit discounted at WACC = Basic NPV calculated above!

Company value = Economic value added + initial investment

Residual Income = Net income – required rate of return x beginning equity (asset – liability)

Basic NPV = NPV (use required rate of return for equity) of sum of residual incomes

Claims valuation approach – decomposed into cash flows to debt holders (using interest rate) and equity holders (using cost of equity) to find the value of a company

The company value should be the same regardless of valuation methods (economic profit, residual income or claims valuation approach)