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The weighted-average cost of capital is simply a blend of the rates of return expected by
investors in our company. These investors include banks, bond holders, and preferred
stock investors in addition to common stockholders. Of course many of you are, or soon
will be, stockholders of our company.
The following table summarizes the composition of Sea Shore Salt™s financing.
Amount (in millions) Percent of Total Rate of Return
Bank loan $120 20% 8%
Bond issue 80 13.3 7.75
Preferred stock 100 16.7 6
Common stock 300 50 16
$600 100%

The rates of return on the bank loan and bond issue are of course just the interest rates
we pay. However, interest is tax-deductible, so the after-tax interest rates are lower
than shown above. For example, the after-tax cost of our bank financing, given our 35%
tax rate, is 8(1 “ .35) = 5.2%.
The rate of return on preferred stock is 6%. Sea Shore Salt pays a $6 dividend on each
$100 preferred share.
Our target rate of return on equity has been 16% for many years. I know that some
newcomers think this target is too high for the safe and mature salt business. But we
must all aspire to superior profitability.
Once this background is absorbed, the calculation of Sea Shore Salt™s weighted-average
cost of capital (WACC) is elementary:
WACC = 8(1 “ .35)(.2) + 7.75(1 “ .35)(.133) + 6(.167) + 16(.50) = 10.7%
The official corporate hurdle rate is therefore 10.7%.
If you have further questions about these calculations, please direct them to our new
Treasury Analyst, Ms. Bernice Mountaindog. It is a pleasure to have Bernice back at Sea
Shore Salt after a year™s leave of absence to complete her degree in finance.
Section 5
Project Analysis

An Overview of Corporate Financing

How Corporations Issue Securities
PROJECT ANALYSIS

The Option to Expand
How Firms Organize the
Investment Process Abandonment Options
Flexible Production Facilities
Stage 1: The Capital Budget
Investment Timing Options
Stage 2: Project Authorizations
Problems and Some Solutions
Summary
Some “What-If” Questions
Sensitivity Analysis
Scenario Analysis

Break-Even Analysis
Accounting Break-Even Analysis
NPV Break-Even Analysis
Operating Leverage

Flexibility in Capital
Budgeting
Decision Trees




“But Mr. Mitterand, have you thought of sensitivity analysis?”
Prime Minister Margaret Thatcher and President Francois Mitterand meet to sign the treaty
leading to construction of a railway tunnel under the English Channel between England and
France.
AP/Wide World Photos


465
t helps to use discounted cash-flow techniques to value new projects but


I good investment decisions also require good data. Therefore, we start
this material by thinking about how firms organize the capital budgeting
operation to get the kind of information they need. In addition, we look at
how they try to ensure that everyone involved works together toward a common goal.
Project evaluation should never be a mechanical exercise in which the financial man-
ager takes a set of cash-flow forecasts and cranks out a net present value. Cash-flow es-
timates are just that”estimates. Financial managers need to look behind the forecasts
to try to understand what makes the project tick and what could go wrong with it. A
number of techniques have been developed to help managers identify the key assump-
tions in their analysis. These techniques involve asking a number of “what-if ” ques-
tions. What if your market share turns out to be higher or lower than you forecast? What
if interest rates rise during the life of the project? In the second part of this material we
show how managers use the techniques of sensitivity analysis, scenario analysis, and
break-even analysis to help answer these what-if questions.
Books about capital budgeting sometimes create the impression that once the man-
ager has made an investment decision, there is nothing to do but sit back and watch the
cash flows develop. But since cash flows rarely proceed as anticipated, companies con-
stantly need to modify their operations. If cash flows are better than anticipated, the
project may be expanded; if they are worse, it may be scaled back or abandoned alto-
gether. In the third section of this material we describe how good managers take account
of these options when they analyze a project and why they are willing to pay money
today to build in future flexibility.
After studying this material you should be able to
Appreciate the practical problems of capital budgeting in large corporations.
Use sensitivity, scenario, and break-even analysis to see how project profitability
would be affected by an error in your forecasts and understand why an overestimate
of sales is more serious for projects with high operating leverage.
Recognize the importance of managerial flexibility in capital budgeting.




How Firms Organize
the Investment Process
For most sizable firms, investments are evaluated in two separate stages.


466
Project Analysis 467


STAGE 1: THE CAPITAL BUDGET
Once a year, the head office generally asks each of its divisions and plants to provide a
list of the investments that they would like to make.1 These are gathered together into a
ACAPITAL BUDGET proposed capital budget.
List of planned investment This budget is then reviewed and pruned by senior management and staff specializ-
projects. ing in planning and financial analysis. Usually there are negotiations between the firm™s
senior management and its divisional management, and there may also be special analy-
ses of major outlays or ventures into new areas. Once the budget has been approved, it
generally remains the basis for planning over the ensuing year.
Many investment proposals bubble up from the bottom of the organization. But
sometimes the ideas are likely to come from higher up. For example, the managers of
plants A and B cannot be expected to see the potential benefits of closing their plants
and consolidating production at a new plant C. We expect divisional management to
propose plant C. Similarly, divisions 1 and 2 may not be eager to give up their own data
processing operations to a large central computer. That proposal would come from sen-
ior management.
Senior management™s concern is to see that the capital budget matches the firm™s
strategic plans. It needs to ensure that the firm is concentrating its efforts in areas where
it has a real competitive advantage. As part of this effort, management must also iden-
tify declining businesses that should be sold or allowed to run down.
The firm™s capital investment choices should reflect both “bottom-up” and “top-
down” processes”capital budgeting and strategic planning, respectively. The two
processes should complement each other. Plant and division managers, who do most of
the work in bottom-up capital budgeting, may not see the forest for the trees. Strategic
planners may have a mistaken view of the forest because they do not look at the trees.

STAGE 2: PROJECT AUTHORIZATIONS
The annual budget is important because it allows everybody to exchange ideas before
attitudes have hardened and personal commitments have been made. However, the fact
that your pet project has been included in the annual budget doesn™t mean you have per-
mission to go ahead with it. At a later stage you will need to draw up a detailed proposal
describing particulars of the project, engineering analyses, cash-flow forecasts, and
present value calculations. If your project is large, this proposal may have to pass a
number of hurdles before it is finally approved.
The type of backup information that you need to provide depends on the project cat-
egory. For example, some firms use a fourfold breakdown:
1. Outlays required by law or company policy, for example, for pollution control equip-
ment. These outlays do not need to be justified on financial grounds. The main issue
is whether requirements are satisfied at the lowest possible cost. The decision is
therefore likely to hinge on engineering analyses of alternative technologies.
2. Maintenance or cost reduction, such as machine replacement. Engineering analysis
is also important in machine replacement, but new machines have to pay their own
way.
3. Capacity expansion in existing businesses. Projects in this category are less straight-

1 Large firms may be divided into several divisions. For example, International Paper has divisions that spe-
cialize in printing paper, packaging, specialty products, and forest products. Each of these divisions may be
responsible for a number of plants.
468 SECTION FIVE


forward; these decisions may hinge on forecasts of demand, possible shifts in tech-
nology, and the reactions of competitors.
4. Investment for new products. Projects in this category are most likely to depend on
strategic decisions. The first projects in a new area may not have positive NPVs if
considered in isolation, but they may give the firm a valuable option to undertake
follow-up projects. More about this later.

PROBLEMS AND SOME SOLUTIONS
Valuing capital investment opportunities is hard enough when you can do the entire job
yourself. In most firms, however, capital budgeting is a cooperative effort, and this
brings with it some challenges.

Ensuring that Forecasts Are Consistent. Inconsistent assumptions often creep into
investment proposals. For example, suppose that the manager of the furniture division
is bullish (optimistic) on housing starts but the manager of the appliance division is
bearish (pessimistic). This inconsistency makes the projects proposed by the furniture
division look more attractive than those of the appliance division.
To ensure consistency, many firms begin the capital budgeting process by establish-
ing forecasts of economic indicators, such as inflation and the growth in national in-
come, as well as forecasts of particular items that are important to the firm™s business,
such as housing starts or the price of raw materials. These forecasts can then be used as
the basis for all project analyses.

Eliminating Conflicts of Interest. Earlier we pointed out that while managers want
to do a good job, they are also concerned about their own futures. If the interests of
managers conflict with those of stockholders, the result is likely to be poor investment
decisions. For example, new plant managers naturally want to demonstrate good per-
formance right away. To this end, they might propose quick-payback projects even if
NPV is sacrificed. Unfortunately, many firms measure performance and reward man-
agers in ways that encourage such behavior. If the firm always demands quick results,
it is unlikely that plant managers will concentrate only on NPV .

Reducing Forecast Bias. Someone who is keen to get a project proposal accepted is
also likely to look on the bright side when forecasting the project™s cash flows. Such
overoptimism is a common feature in financial forecasts. For example, think of large
public expenditure proposals. How often have you heard of a new missile, dam, or high-
way that actually cost less than was originally forecast? Think back to the Eurotunnel
project. The final cost of the project was about 50 percent higher than initial forecasts.
It is probably impossible to ever eliminate bias completely, but if senior management is
aware of why bias occurs, it is at least partway to solving the problem.
Project sponsors are likely to overstate their case deliberately only if the head office
encourages them to do so. For example, if middle managers believe that success de-
pends on having the largest division rather than the most profitable one, they will pro-
pose large expansion projects that they do not believe have the largest possible net pres-
ent value. Or if divisions must compete for limited resources, they will try to outbid
each other for those resources. The fault in such cases is top management™s”if lower
level managers are not rewarded based on net present value and contribution to firm
value, it should not be surprising that they focus their efforts elsewhere.
Other problems stem from sponsors™ eagerness to obtain approval for their favorite
Project Analysis 469


projects. As the proposal travels up the organization, alliances are formed. Thus once a
division has screened its own plants™ proposals, the plants in that division unite in com-
peting against outsiders. The result is that the head office may receive several thousand
investment proposals each year, all essentially sales documents presented by united
fronts and designed to persuade. The forecasts have been doctored to ensure that NPV
appears positive.
Since it is difficult for senior management to evaluate each specific assumption in
an investment proposal, capital investment decisions are effectively decentralized what-
ever the rules say. Some firms accept this; others rely on head office staff to check cap-
ital investment proposals.

Sorting the Wheat from the Chaff. Senior managers are continually bombarded
with requests for funds for capital expenditures. All these requests are supported with
detailed analyses showing that the projects have positive NPVs. How then can managers
ensure that only worthwhile projects make the grade? One response of senior managers
to this problem of poor information is to impose rigid expenditure limits on individual
plants or divisions. These limits force the subunits to choose among projects. The firm
ends up using capital rationing not because capital is unobtainable but as a way of de-
centralizing decisions.2
Senior managers might also ask some searching questions about why the project has
a positive NPV After all, if the project is so attractive, why hasn™t someone already un-
.
dertaken it? Will others copy your idea if it is so profitable? Positive NPVs are plausi-
ble only if your company has some competitive advantage.
Such an advantage can arise in several ways. You may be smart or lucky enough to
be the first to the market with a new or improved product for which customers will pay
premium prices. Your competitors eventually will enter the market and squeeze out ex-
cess profits, but it may take them several years to do so. Or you may have a proprietary
technology or production cost advantage that competitors cannot easily match. You may
have a contractual advantage such as the distributorship for a particular region. Or your
advantage may be as simple as a good reputation and an established customer list.
Analyzing competitive advantage can also help ferret out projects that incorrectly
appear to have a negative NPV If you are the lowest cost producer of a profitable prod-
.
uct in a growing market, then you should invest to expand along with the market. If your
calculations show a negative NPV for such an expansion, then you probably have made
a mistake.



Some “What-If” Questions
SENSITIVITY ANALYSIS
Uncertainty means that more things can happen than will happen. Therefore, whenever
managers are given a cash-flow forecast, they try to determine what else might happen
and the implications of those possible events. This is called sensitivity analysis.
SENSITIVITY
ANALYSIS Analysis of Put yourself in the well-heeled shoes of the financial manager of the Finefodder su-
the effects on project permarket chain. Finefodder is considering opening a new superstore in Gravenstein
profitability of changes in
sales, costs, and so on. 2 We discussed capital rationing earlier.
470 SECTION FIVE


TABLE 5.1

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