Explain the role of real options and the objective and procedures for

LG 6 Explain the role of real options and the objective and procedures for

selecting projects under capital rationing. Real options are opportunities that are embedded in capital projects and that allow managers to alter their cash flow and risk in a way that affects project acceptability (NPV). By explicitly recog- nizing real options, the financial manager can find a project’s strategic NPV. Some of the more common types of real options are abandonment, flexibility, growth, and timing options. The strategic NPV improves the quality of the cap- ital budgeting decision.

Capital rationing exists when firms have more acceptable independent proj- ects than they can fund. Capital rationing commonly occurs in practice. Its objective is to select from all acceptable projects the group that provides the highest overall net present value and does not require more dollars than are budgeted. The two basic approaches for choosing projects under capital rationing are the internal rate of return approach and the net present value approach. The NPV approach better achieves the objective of using the budget to generate the highest present value of inflows.

Opener-in-Review

The chapter opener and the Focus on Ethics box on page 475 described some of the consequences of the accident at BP’s Deepwater Horizon oil rig. The company put up $20 billion to help pay for damages related to the oil spill, yet BP’s market value declined by more than $90 billion. That means that the market assessed BP an additional penalty of roughly $70 billion, above and beyond the direct costs associated with the spill. Describe the effects that an increase in BP’s cost of cap- ital could have on the market value of BP. Oil spills have happened before, so it is plausible that engineers and analysts at BP could have imagined a worst-case sce- nario in which a major spill occurred at one of the firm’s offshore rigs. How might

PART 5

Long-Term Investment Decisions

Self-Test Problems (Solutions in Appendix)

LG 4 ST12–1 Risk-adjusted discount rates CBA Company is considering two mutually exclusive projects, A and B. The following table shows the CAPM-type relationship between a risk index and the required return (RADR) applicable to CBA Company.

Risk index

Required return (RADR)

0.0 7.0% (risk-free rate, R F )

Project data are shown as follows:

Project A

Project B

Initial investment ( CF 0 )

Project life

3 years

3 years

Annual cash inflow ( CF)

Risk index

a. Ignoring any differences in risk and assuming that the firm’s cost of capital is 10%, calculate the net present value (NPV) of each project.

b. Use NPV to evaluate the projects, using risk-adjusted discount rates (RADRs) to

account for risk.

c. Compare, contrast, and explain your findings in parts a and b.

Warm-Up Exercises All problems are available in

LG 2 E12–1 Birkenstock is considering an investment in a nylon-knitting machine. The machine requires an initial investment of $25,000, has a 5-year life, and has no residual value at the end of the 5 years. The company’s cost of capital is 12%. Known with less certainty are the actual after-tax cash inflows for each of the 5 years. The company has estimated expected cash inflows for three scenarios: pessimistic, most likely, and optimistic. These expected cash inflows are listed in the following table. Calculate

CHAPTER 12 Risk and Refinements in Capital Budgeting

Expected cash inflows

Year

Pessimistic

Most likely

LG 2 E12–2 You wish to evaluate a project requiring an initial investment of $45,000 and having a useful life of 5 years. What minimum amount of annual cash inflow do you need if your firm has an 8% cost of capital? If the project is forecast to earn $12,500 per year over the 5 years, what is its IRR? Is the project acceptable?

LG 4 E12–3 Like most firms in its industry, Yeastime Bakeries uses a subjective risk assessment tool of its own design. The tool is a simple index by which projects are ranked by level of perceived risk on a scale of 0–10. The scale is recreated in the following table.

Risk index

Required return

0 4.0% (current risk-free rate) 1 4.5 2 5.0 3 5.5 4 6.0

5 6.5 (current IRR) 6 7.0 7 7.5 8 8.0 9 8.5 10 9.0

The firm is analyzing two projects based on their RADRs. Project Sourdough requires an initial investment of $12,500 and is assigned a risk index of 6. Project Greek Salad requires an initial investment of $7,500 and is assigned a risk index of

8. The two projects have 7-year lives. Sourdough is projected to generate cash inflows of $5,500 per year. Greek Salad is projected to generate cash inflows of $4,000 per year. Use each project’s RADR to select the better project.

LG 5 E12–4 Outcast, Inc., has hired you to advise the firm on a capital budgeting issue involving two unequal-lived, mutually exclusive projects, M and N. The cash flows for each project are presented in the following table. Calculate the NPV and the annualized net present value (ANPV) for each project using the firm’s cost of capital of 8%.

PART 5

Long-Term Investment Decisions

Project M

Project N

Initial investment

Cash inflows

LG 6 E12–5 Longchamps Electric is faced with a capital budget of $150,000 for the coming year. It is considering six investment projects and has a cost of capital of 7%. The six

projects are listed in the following table, along with their initial investments and their IRRs. Using the data given, prepare an investment opportunities schedule (IOS). Which projects does the IOS suggest should be funded? Does this group of projects maximize NPV? Explain.

Project

Initial investment

Problems All problems are available in

LG 1 P12–1 Recognizing risk Caradine Corp., a media services firm with net earnings of $3,200,000 in the last year, is considering the following projects.

Project

Initial investment

Details

A $ 35,000

Replace existing office furnishings.

B 500,000

Purchase digital film-editing equipment for use with several existing accounts.

C 450,000

Develop proposal to bid for a $2,000,000 per year 10-year contract with the U.S. Navy, not now an account.

D 685,000

Purchase the exclusive rights to market a quality educational television program in syndication to local markets in the European Union, a part of the firm’s existing business activities.

CHAPTER 12 Risk and Refinements in Capital Budgeting

The media services business is cyclical and highly competitive. The board of direc- tors has asked you, as chief financial officer, to do the following:

a. Evaluate the risk of each proposed project and rank it “low,” “medium,” or “high.”

b. Comment on why you chose each ranking. LG 2 P12–2 Breakeven cash inflows Etsitty Arts, Inc., a leading producer of fine cast silver jew-

elry, is considering the purchase of new casting equipment that will allow it to expand the product line into award plaques. The proposed initial investment is $35,000. The company expects that the equipment will produce steady income throughout its 12-year life.

a. If Etsitty requires a 14% return on its investment, what minimum yearly cash inflow will be necessary for the company to go forward with this project?

b. How would the minimum yearly cash inflow change if the company required a 10% return on its investment?

LG 2 P12–3 Breakeven cash inflows and risk Pueblo Enterprises is considering investing in either of two mutually exclusive projects, X and Y. Project X requires an initial investment of $30,000; project Y requires $40,000. Each project’s cash inflows are 5-year annuities: Project X’s inflows are $10,000 per year; project Y’s are $15,000. The firm has unlimited funds and, in the absence of risk differences, accepts the project with the highest NPV. The cost of capital is 15%.

a. Find the NPV for each project. Are the projects acceptable? b. Find the breakeven cash inflow for each project. c. The firm has estimated the probabilities of achieving various ranges of cash

inflows for the two projects, as shown in the following table. What is the proba- bility that each project will achieve the breakeven cash inflow found in part b?

Probability of achieving cash inflow in given range

Range of cash inflow

Project X

Project Y

d. Which project is more risky? Which project has the potentially higher NPV? Discuss the risk–return tradeoffs of the two projects.

e. If the firm wished to minimize losses (that is, NPV 6 $0), which project would you recommend? Which would you recommend if the goal was achieving a higher NPV?

LG 2 P12–4 Basic scenario analysis Murdock Paints is in the process of evaluating two mutu- ally exclusive additions to its processing capacity. The firm’s financial analysts have

PART 5

Long-Term Investment Decisions

inflows associated with each project. These estimates are shown in the following table.

Project A

Project B

Initial investment (CF 0 )

Annual cash inflows (CF)

Most likely

a. Determine the range of annual cash inflows for each of the two projects. b. Assume that the firm’s cost of capital is 10% and that both projects have 20-year

lives. Construct a table similar to this for the NPVs for each project. Include the range of NPVs for each project.

c. Do parts a and b provide consistent views of the two projects? Explain.

d. Which project do you recommend? Why?

LG 2 P12–5 Scenario analysis James Secretarial Services is considering the purchase of one of two new personal computers, P and Q. The company expects both to provide benefits over a 10-year period, and each has a required investment of $3,000. The firm uses a 10% cost of capital. Management has constructed the following table of estimates of annual cash inflows for pessimistic, most likely, and optimistic results.

Computer P

Computer Q

Initial investment (CF 0 )

Annual cash inflows (CF)

Most likely

a. Determine the range of annual cash inflows for each of the two computers. b. Construct a table similar to this for the NPVs associated with each outcome for

both computers. c. Find the range of NPVs, and subjectively compare the risks associated with pur-

chasing these computers. Personal Finance Problem

LG 2 P12–6 Impact of inflation on investments You are interested in an investment project that costs $7,500 initially. The investment has a 5-year horizon and promises future end- of-year cash inflows of $2,000, $2,000, $2,000, $1,500, and $1,500, respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that

CHAPTER 12 Risk and Refinements in Capital Budgeting

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions. a. What is the net present value (NPV) of the investment under the current required rate of return?

b. What is the net present value (NPV) of the investment under a period of rising inflation?

c. What is the net present value (NPV) of the investment under a period of falling inflation?

d. From your answers in a, b, and c, what relationship do you see emerge between changes in inflation and asset valuation?

LG 2 P12–7 Simulation Ogden Corporation has compiled the following information on a cap- ital expenditure proposal:

(1) The projected cash inflows are normally distributed with a mean of $36,000 and a standard deviation of $9,000. (2) The projected cash outflows are normally distributed with a mean of $30,000 and a standard deviation of $6,000. (3) The firm has an 11% cost of capital. (4) The probability distributions of cash inflows and cash outflows are not expected

to change over the project’s 10-year life. a. Describe how the foregoing data can be used to develop a simulation model for finding the net present value of the project.

b. Discuss the advantages of using a simulation to evaluate the proposed project. LG 4 P12–8 Risk-adjusted discount rates—Basic Country Wallpapers is considering investing in

one of three mutually exclusive projects, E, F, and G. The firm’s cost of capital, r, is 15%, and the risk-free rate, R F , is 10%. The firm has gathered the basic cash flow and risk index data for each project, as shown in the following table.

Project (j)

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

Risk index ( RI j )

a. Find the net present value (NPV) of each project using the firm’s cost of capital. Which project is preferred in this situation?

b. The firm uses the following equation to determine the risk-adjusted discount rate, RADR j , for each project j:

RADR j = R F + 3RI j * ( r-R F ) 4

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Long-Term Investment Decisions

where R F = risk-free rate of return

RI j = risk index for project j r = cost of capital

Substitute each project’s risk index into this equation to determine its RADR. c. Use the RADR for each project to determine its risk-adjusted NPV. Which

project is preferable in this situation? d. Compare and discuss your findings in parts a and c. Which project do you rec-

ommend that the firm accept?

LG 4 P12–9 Risk-adjusted discount rates—Tabular After a careful evaluation of investment alternatives and opportunities, Masters School Supplies has developed a CAPM-type

relationship linking a risk index to the required return (RADR), as shown in the fol- lowing table.

Risk index

Required return (RADR)

0.0 7.0% (risk-free rate, R F )

The firm is considering two mutually exclusive projects, A and B. Following are the data the firm has been able to gather about the projects.

Project A

Project B

Initial investment ( CF 0 )

Project life

5 years

5 years

Annual cash inflow ( CF)

Risk index

All the firm’s cash inflows have already been adjusted for taxes.

a. Evaluate the projects using risk-adjusted discount rates. b. Discuss your findings in part a, and recommend the preferred project.

Personal Finance Problem

LG 4 P12–10 Mutually exclusive investments and risk Lara Fredericks is interested in two mutu- ally exclusive investments. Both investments cover the same time horizon of 6 years.

CHAPTER 12

Risk and Refinements in Capital Budgeting

year-end payments of $3,000. The second investment promises equal and consecu- tive payments of $3,800 with an initial outlay of $12,000 required. The current required return on the first investment is 8.5%, and the second carries a required return of 10.5%.

a. What is the net present value of the first investment? b. What is the net present value of the second investment? c. Being mutually exclusive, which investment should Lara choose? Explain. d. Which investment was relatively more risky? Explain.

LG 4 P12–11 Risk-adjusted rates of return using CAPM Centennial Catering, Inc., is considering two mutually exclusive investments. The company wishes to use a CAPM-type risk-

adjusted discount rate (RADR) in its analysis. Centennial’s managers believe that the appropriate market rate of return is 12%, and they observe that the current risk-free rate of return is 7%. Cash flows associated with the two projects are shown in the following table.

Project X

Project Y

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Use a risk-adjusted discount rate approach to calculate the net present value of each project, given that project X has an RADR factor of 1.20 and project Y has an RADR factor of 1.40. The RADR factors are similar to project betas. (Use Equation 12.5 to calculate the required project return for each.)

b. Discuss your findings in part a, and recommend the preferred project. LG 4 P12–12 Risk classes and RADR Moses Manufacturing is attempting to select the best of

three mutually exclusive projects, X, Y, and Z. Although all the projects have 5-year lives, they possess differing degrees of risk. Project X is in class V, the highest-risk class; project Y is in class II, the below-average-risk class; and project Z is in class III, the average-risk class. The basic cash flow data for each project and the risk classes and risk-adjusted discount rates (RADRs) used by the firm are shown in the fol- lowing tables.

Project X

Project Y

Project Z

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

PART 5

Long-Term Investment Decisions

Risk Classes and RADRs

Risk-adjusted

Risk class

Description

discount rate (RADR)

I Lowest risk

II Below-average risk

III

Average risk

IV Above-average risk

V Highest risk

a. Find the risk-adjusted NPV for each project. b. Which project, if any, would you recommend that the firm undertake?

LG 5 P12–13 Unequal lives—ANPV approach Evans Industries wishes to select the best of three possible machines, each of which is expected to satisfy the firm’s ongoing need for additional aluminum-extrusion capacity. The three machines—A, B, and C—are equally risky. The firm plans to use a 12% cost of capital to evaluate each of them. The initial investment and annual cash inflows over the life of each machine are shown in the following table.

Machine A

Machine B

Machine C

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the NPV for each machine over its life. Rank the machines in

descending order on the basis of NPV. b. Use the annualized net present value (ANPV) approach to evaluate and rank the

machines in descending order on the basis of ANPV. c. Compare and contrast your findings in parts a and b. Which machine would you

recommend that the firm acquire? Why?

LG 5 P12–14 Unequal lives—ANPV approach Portland Products is considering the purchase of one of three mutually exclusive projects for increasing production efficiency. The firm plans to use a 14% cost of capital to evaluate these equal-risk projects. The ini- tial investment and annual cash inflows over the life of each project are shown in the following table.

CHAPTER 12

Risk and Refinements in Capital Budgeting

Project X

Project Y

Project Z

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the NPV for each project over its life. Rank the projects in descending order on the basis of NPV.

b. Use the annualized net present value (ANPV) approach to evaluate and rank the projects in descending order on the basis of ANPV.

c. Compare and contrast your findings in parts a and b. Which project would you recommend that the firm purchase? Why?

LG 5 P12–15 Unequal lives—ANPV approach JBL Co. has designed a new conveyor system. Management must choose among three alternative courses of action: (1) The firm

can sell the design outright to another corporation with payment over 2 years. (2) It can license the design to another manufacturer for a period of 5 years, its likely product life. (3) It can manufacture and market the system itself; this alternative will result in 6 years of cash inflows. The company has a cost of capital of 12%. Cash flows associated with each alternative are as shown in the following table.

Initial investment (CF 0 )

Year (t)

Cash inflows (CF t )

a. Calculate the net present value of each alternative and rank the alternatives on the basis of NPV.

b. Calculate the annualized net present value (ANPV) of each alternative and rank them accordingly.

c. Why is ANPV preferred over NPV when ranking projects with unequal lives?

PART 5

Long-Term Investment Decisions

Personal Finance Problem

LG 5 P12–16 NPV and ANPV decisions Richard and Linda Butler decide that it is time to pur- chase a high-definition (HD) television because the technology has improved and prices have fallen over the past 3 years. From their research, they narrow their choices to two sets, the Samsung 42-inch LCD with 1080p capability and the Sony 42-inch LCD with 1080p features. The price of the Samsung is $2,350 and the Sony will cost $2,700. They expect to keep the Samsung for 3 years; if they buy the more expensive Sony unit, they will keep the Sony for 4 years. They expect to be able to sell the Samsung for $400 by the end of 3 years; they expect they could sell the Sony for $350 at the end of year 4. Richard and Linda estimate the end-of-year entertainment bene- fits (that is, not going to movies or events and watching at home) from the Samsung to

be $900 and for the Sony to be $1,000. Both sets can be viewed as quality units and are equally risky purchases. They estimate their opportunity cost to be 9%. The Butlers wish to choose the better alternative from a purely financial per- spective. To perform this analysis they wish to do the following:

a. Determine the NPV of the Samsung HD LCD. b. Determine the ANPV of the Samsung HD LCD. c. Determine the NPV of the Sony HD LCD. d. Determine the ANPV of the Sony HD LCD. e. Which set should the Butlers purchase and why?

LG 6 P12–17 Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment

that would expand the firm’s manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because

NPV traditional =- $1,700 6 $0

Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm’s cash flows. Her evalua- tion uncovered three options:

Option 1: Abandonment—The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,200.

Option 2: Growth—If the projected outcomes occurred, an opportunity to expand the firm’s product offerings further would become available at the end of

4 years. Exercise of this option is estimated to add $3,000 to the project’s NPV. Option 3: Timing—Certain phases of the proposed project could be delayed if

market and competitive conditions caused the firm’s forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $10,000.

Jenny estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the growth option would be exer- cised, and only a 10% chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategic NPV, NPV strategic , for Asor Products’ proposed equipment expenditure.

b. Judging on the basis of your findings in part a, what action should Jenny recom- mend to management with regard to the proposed equipment expenditure?

CHAPTER 12

Risk and Refinements in Capital Budgeting

LG 6 P12–18 Capital rationing—IRR and NPV approaches Valley Corporation is attempting to select the best of a group of independent projects competing for the firm’s fixed

capital budget of $4.5 million. The firm recognizes that any unused portion of this budget will earn less than its 15% cost of capital, thereby resulting in a present value of inflows that is less than the initial investment. The firm has summarized, in the following table, the key data to be used in selecting the best group of projects.

Present value of

Project

Initial investment

IRR

inflows at 15%

a. Use the internal rate of return (IRR) approach to select the best group of projects. b. Use the net present value (NPV) approach to select the best group of projects.

c. Compare, contrast, and discuss your findings in parts a and b.

d. Which projects should the firm implement? Why?

LG 6 P12–19 Capital rationing—NPV approach

A firm with a 13% cost of capital must select the optimal group of projects from those shown in the following table, given its cap- ital budget of $1 million.

NPV at 13%

Project

Initial investment

cost of capital

a. Calculate the present value of cash inflows associated with each project. b. Select the optimal group of projects, keeping in mind that unused funds are costly.

LG 4 P12–20 ETHICS PROBLEM The Environmental Protection Agency sometimes imposes penalties on firms that pollute the environment (see the Focus on Ethics box on page

475 ). But did you know that there is a legal market for pollution? A mechanism that has been developed to limit excessive air pollution is to use carbon credits. Carbon credits are a tradable permit scheme that allows businesses that cannot meet their greenhouse- gas-emissions limits to purchase carbon credits from businesses that are below their quota. By allowing credits to be bought and sold, a business for which reducing its emis- sions would be expensive or prohibitive can pay another business to make the reduction

PART 5

Long-Term Investment Decisions

Spreadsheet Exercise

Isis Corporation has two projects that it would like to undertake. However, due to capital restraints, the two projects—Alpha and Beta—must be treated as mutually exclusive. Both projects are equally risky, and the firm plans to use a 10% cost of cap- ital to evaluate each. Project Alpha has an estimated life of 12 years, and project Beta has an estimated life of 9 years. The cash flow data have been prepared as shown in the following table.

Cash flows Project alpha

Project beta

CF 10 1,500,000 CF 11 2,000,000 CF 12 2,500,000

TO DO Create a spreadsheet to answer the following questions.

a. Calculate the NPV for each project over its respective life. Rank the projects in descending order on the basis of NPV. Which one would you choose?

b. Use the annualized net present value (ANPV) approach to evaluate and rank the projects in descending order on the basis of ANPV. Which one would you choose?

c. Compare and contrast your findings in parts a and b. Which project would you

recommend that the firm choose? Explain.

Visit www.myfinancelab.com for Chapter Case: Evaluating Cherone Equipment’s Risky Plans for Increasing Its Production Capacity, Group Exercises, and numerous online resources.

Integrative Case 5

Lasting Impressions Company