ent role of capital budgeting in the arena of financial decision making. This book is intended for both practicing managers who require a thorough knowledge of the principles of making investment decisions in the real world and for students undertaking financial courses, whether at undergraduate, MBA, or professional levels. The subject matter encompasses relevant aspects of the investment decision, varying from a basic introduction, to the appraisal techniques available, to placing investment decisions within both strategic and international contexts, and coverage of recent developments including real options, value at risk, and environmental investments.
Principles and Practice Pogue Corporate Investment Decisions Managerial Accounting Collection Kenneth A Merchant, Editor Michael Pogue Mike Pogue has lectured and examined in the disciplines of accounting and finance at undergraduate, postgraduate, and professional examination levels since 1982 at both Queens University, Belfast, and currently at the University of Ulster For the past 10 years, he has taught on courses for both the CIMA (Chartered Institute of Management Accountants) and the ACCA (Association of Chartered Certified Accountants) professional bodies Other professional activities include current appointments as an assessor for the ACCA examinations at final level and an examiner in management accounting for the ICAI (Institute of Chartered Accountant in Ireland) He has also previously written articles for the CIMA and ACCA professional publications and has recently completed a research project for ACCA examining the impact of defined-benefit pension schemes upon corporate financing In addition, Mike also has substantial experience lecturing in financial management in executive MBA programs at both universities and supervising MBA research projects Consultancy activity outside the university has included projects in the agri-feeds and insurance sectors Corporate Investment Decisions In these turbulent financial and economic times, the importance of sound investment decisions becomes a critical variable in underpinning future business success and, indeed, survival If you’re a practicing manager who needs a thorough knowledge of investment decisions in the real world, this book is for you This outstanding book details the relevant aspects of the investment decision varying from a basic introduction to the appraisal techniques available to placing investment decisions within a strategic context and coverage of recent developments including real options, value at risk, and environmental investments Any professional or MBA student will benefit from both a comprehensive introduction to the subject area and also from the consideration of more advanced aspects and recent innovations for those readers wishing to delve deeper into the fascinating world of investment decisions So many executives and financial managers are feeling overwhelmed by the difficulties currently encountered globally by firms in both raising finance and making predictions concerning the future economic environment Read this book to better understand how this raises the already-prominent role of capital budgeting in the arena of financial decision making Corporate Investment Decisions Principles and Practice Michael Pogue Managerial Accounting Collection Kenneth A Merchant, Editor ISBN: 978-1-60649-064-8 90000 www.businessexpertpress.com 781606 490648 www.businessexpertpress.com Corporate Investment Decisions Corporate Investment Decisions Principles and Practice Michael Pogue Corporate Investment Decisions: Principles and Practice Copyright © Business Expert Press, LLC, 2010 All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means—electronic, mechanical, photocopy, recording, or any other except for brief quotations, not to exceed 400 words, without the prior permission of the publisher First published in 2010 by Business Expert Press, LLC 222 East 46th Street, New York, NY 10017 www.businessexpertpress.com ISBN-13: 978-1-60649-064-8 (paperback) ISBN-10: 1-60649-064-4 (paperback) ISBN-13: 978-1-60649-065-5 (e-book) ISBN-10: 1-60649-065-6 (e-book) DOI 10.4128/9781606490655 A publication in the Business Expert Press Managerial Accounting collection Collection ISSN: 2152-7113 (print) Collection ISSN: 2152-7121 (electronic) Cover design by Jonathan Pennell Interior design by Scribe, Inc First edition: July 2010 10 9 8 7 6 5 4 3 2 Printed in the United States of America For Aileen and my son Ryan Abstract In these turbulent financial and economic times, the importance of sound investment decisions becomes a critical variable in underpinning future business success and, indeed, survival The difficulties currently encountered globally by firms in both raising finance and making predictions concerning the future economic environment raise the already prominent role of capital budgeting in the arena of financial decision making This book is intended for both practicing managers who require a thorough knowledge of the principles of making investment decisions in the real world and for students undertaking financial courses, whether at undergraduate, MBA, or professional levels The subject matter encompasses relevant aspects of the investment decision, varying from a basic introduction, to the appraisal techniques available, to placing investment decisions within both strategic and international contexts, and coverage of recent developments including real options, value at risk, and environmental investments Keywords Capital expenditure, appraisal techniques, risk, strategic investment decisions, international capital budgeting, recent developments Contents Acknowledgments ix Introduction Chapter The Financial Environment Chapter The Appraisal Process 17 Chapter The Appraisal Techniques 23 Chapter Cash Flows and Discount Rates 41 Chapter Risk and Uncertainty 61 Chapter Capital Rationing 83 Chapter Replacement Decisions and Lease Versus Buy Decisions 91 Chapter Strategic Investment Decisions 105 Chapter International Capital Budgeting 117 Chapter 10 Recent Developments 137 Conclusion 163 Appendix A 165 Appendix B 167 Notes 169 References 173 Index 179 Acknowledgments Thanks to UNCTAD for free permission to reproduce figures 9.1 and 9.2 from the UNCTAD World Investment Report 2008 Thanks to Ken Merchant and David Parker for the opportunity to make this book a reality and to Cindy Durand for her advice and encouragement in completing the manuscript Notes Chapter IAS Plus (2003) Equipment Leasing and Finance Association (2009) Finance and Leasing Association (2009) Chapter Harris, Emmanuel, and Komakech (2009) Kaplan and Norton (1992) Gregory (1995) Roussel et al (1991) Groenveld (1997), p 48 Phaal, Farrukh, and Probert (2004) Garcia and Bray (1997) Miller and O’Leary (2007) Porter (1985) 10 Shank and Govindarajan (1992) 11 Crain and Abraham (2008) 12 Shank and Govindarajan (1992) 13 Hoque (2001) 14 Hoque (2001) 15 Camp (1989) 16 Mayle et al (2002) 17 Putterill et al (1996) 18 Carr and Tomkins (1996) 19 Alkaraan and Northcott (2006) Chapter Eiteman and Stonehill (2010) Block (2000) Holmen and Pramborg (2009) Chapter 10 Dixit and Pindyck (1994) Copeland and Weiner (1990) Luehrman (1988) Lewent (1994) Trigeorgis (1996) 171 172 Notes Broyles (2003) Busby and Pitts (1998) Cottrell and Sick (2001) Copeland and Antikarov (2001) 10 Busby and Pitts (1997) 11 Buckley, Buckley, Langevin, and Tse (1996) 12 Triantis and Borison (2001) 13 Ryan and Ryan (2002); Teach (2003) 14 Block (2007) 15 Macauley (1938) 16 Arnold and 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35 and tax shield benefits, 35 Anglo American Plc, appraisal process, 17–21 appraisal techniques, 23–40 See also accounting rate of return (ARR); adjusted present values (APV); discounted cash flow (DCF) techniques; internal rate of return (IRR); modified internal rate of return (MIRR); net present value (NPV) AT&T, 1, 68 Australia, 37, 38t, 39 B bandwagon effect, 124 binomial option pricing model (BOPM), 139, 142–44, 143f Black-Scholes model, 139–41, 141t, 142, 151 British Petroleum, 7, 120t C Canada, 37, 38t, 39, 57 capex See capital expenditure capital asset pricing model (CAPM), 54–59, 58t capital expenditure, 1–2, 6, 11, 12–15 and capital intensive businesses, 12 and cost commitment, 12 and expected cost savings, 13 and fixed assets, 12 impact on long-term finance, 14 impact on reputation, 15 importance of, 14–15 irreversibility in, 15 and labor intensive businesses, 14 and leasing, 104 and major projects, 12–13 objective of, 12 and outcomes, 12 and postimplementation audits (PIAs), 21 and probabilistic techniques, 81 and replacement expenditure, 13–14 and resource commitment, 12 resource usage and, 14 and routine expenditure, 13 and soft capital rationing, 83 and strategic investments, 12 and taxation, 12 capital rationing, 83–89, 85t, 86t assumptions, 85 hard capital rationing, 84–86 multiperiod capital rationing, 88–89 and mutually exclusive projects, 87, 87t role of managers in, 83–84 soft capital rationing, 83–84 survey evidence, 89 180 Index cash flows, 24t, 41–53, 46t, 48t, 51t assumptions about, 50 beta factor, 35, 55–57 Fisher equation of, 50 incremental, 128, 130, 131t and inflation, 49–53 real versus nominal, 49–50 profit and loss statements, 44t and taxation, 45–48 See also costs; taxation cash flow value at risk (CFaR), 160–61 certainty equivalent (CE), 67–68, 68t China, 117–18, 121t competitive advantage, 5, 18, 110, 111–12, 114, 123 corporate culture, 13, 17 costs and adjusted present value (APV), 34–35 and the capital asset pricing model (CAPM), 57–59, 58t capital expenditure as, 12 cost commitments, 12 cost of capital, 29, 41, 47–49 cost of finance, 33 cost overruns, 20 cost patterns, 42 expected cost savings, 13–14 and financing decisions, fixed costs, 42, 125 flotation costs, 11 and hard capital rationing, 84–86 incremental costs, 42 and inflation, 49–50 initial costs, 28, 43–45, 47, 71–73, 72t, 74t, 75t, 86, 99t, 103t, 128 interest costs, 44t, 45 and internal rate of return (IRR), 29 and irreversibility, 15 issue costs, 9, 35 maintenance costs, 93, 97–98, 98t, 102, 102t nominal cost of capital, 49 opportunity costs, 42–45 in postimplementation audits (PIAs), 20–21 potential costs of failure, 19 relevant costs, 21, 35, 41–42, 43, 45 in sensitivity analysis, 71–73, 72t, 74t, 75t “sunk” costs, 41–42, 43 and taxation, 45–48 training costs, 19 transaction costs, 11 true cost, 47 variable costs, 42–43, 44t, 46t, 71, 72t, 73, 74, 85t, 92, 92t, 125 weighted average cost of capital (WACC), 48, 53–54 D debt financing, 9, 35, 48 decision markets, 154–57 depreciation, 4, 42, 44t, 45, 48, 52, 101, 102, 102t discounted cash flow (DCF) techniques, 23, 27–32, 41 annuity tables, 27 beta factor, 35, 55–57 and conventional analysis, 109, 114, 137 discount factors, 27, 28t discount rates, 27, 29t, 52t, 53 and firm size, 39 and interest costs, 45 and payback period (PB), 33 versus the process of compounding, 27 as a real option, 109, 114, 137 and replacement decisions, 98t, 99t, 100t in simulation analysis, 76 in strategic investment decision making, 105–7 survey evidence about, 36–37, 39, 114, 151 discounted payback index (DPBI), 32–33, 33t dividend decisions, 11 dividend irrelevancy hypothesis, 11 duration analysis, 151–51, 152t, 153t Index 181 E efficient capital markets hypothesis, Eli Lilly, 156 Enron, environmental investing, 13 equations beta factor, 35, 55–57 binomial option pricing model (BOPM), 142–43 Black-Scholes model, 139–40 capital asset pricing model (CAPM), 55–56 capital constraints over time, 88 cash flow value at risk (CFaR), 158 coefficient of variation, 65 discounted payback index (DPBI), 33 duration analysis, 152 estimated annual cost (EAC), 97–100 expected value, 63–64 Fisher equation, 50 interest rate parity, 125–26 internal rate of return (IRR), 29, 30 modified internal rate of return (MIRR), 34 for multiperiod capital rationing, 88 net present value (NPV), 28, 30 nominal rate and rate of inflation, 50 profitability index (PI), 144–46 purchasing power parity (PPP), 124, 126 risk in portfolio analysis, 79–80 sampling distribution (SD), 66 in scenario analysis, 75 in sensitivity analysis, 73 standard error, 66–67 weighted average cost of capital (WACC), 54 Equipment Leasing and Finance Association, 2, 104 equity financing, equivalent annual cost (EAC) method, 96–100, 96t, 97t Europe, 7, 8, 36, 37, 38t, 57, 68, 89, 122, 150 exposure-based cash flow value at risk (CFaR), 161 F financing decision, finite horizon method, 96 foreign direct investment (FDI) See international capital budgeting Fortune 500 companies, 89 France, 37, 38t, 58t, 120t, 121t G gas industry, 3, 61, 112, 120t, 121t, 139 “geared” company, 35 General Motors (GM), Germany, 37, 38t, 58t, 114, 119, 120t, 121t Google, 155 H Hewlett Packard (HP), 155–56 hurdle rate See internal rate of return (IRR) I IBM, 101, 121t inflation, 49–53 assumptions about, 50 Fisher equation, 50 and nominal rate, 50 and rates of return, 50–53 and uncertainty, 49 internal rate of return (IRR), 27, 29–32, 30t and estimated discount rates, 53 estimation tables, 30t example of, 30–31 and inflation, 52–53 modifications to, 32–36 multiple solutions, 31 versus net present value (NPV), 27, 29, 30t, 31–32, 36 reinvestment assumption, 31, 36 reliability of, 32 survey evidence about, 36–39, 38t International Accounting Standards Board (IASB), 101 182 Index international capital budgeting, 117–36 additional risks, 124–25 decision making, 125–34 exchange rate risk, 124, 130t inflation risk, 124, 129t interest rate parity, 125–26, 127t motivation for, 119–24, 120t, 121t political risk, 124 purchasing power parity (PPP), 124, 126 remittance risk, 124–25 survey evidence, 134–36 worldwide, 118t investment decisions See strategic investment decisions J Japan, 37, 38t, 39, 119, 120t, 121t, 122 John Deere, 101 joint ventures, 10 L lease versus buy decisions, 100–104, 103t advantages and disadvantages, 104 versus borrowing, 101 impact of economic downturn on, 104 versus installment plans, 101 lowest common multiple method, 94–95, 94t, 95t M Maxwell, modified IRR (MIRR), 34 Monte Carlo simulation, 76 multinationals, 68, 119, 122–25, 127, 134–35, 149 N Netherlands, 37, 38t, 58t, 120t net present value (NPV), 27, 28–32, 29t, 30t, 34, 41, 137, 163 and adjusted present value (APV), 34–36 and adjusting for risk, 67–68, 69 annuity table, 167 and the binomial option pricing model (BOPM), 142, 143, 143f and certainty equivalent (CE), 67–68 and differing discount rates, 29t disadvantages of, 28–29 and discounted payback index (DPBI), 33 in duration analysis, 151, 153t and estimated discount rates, 53 example of, 28–29 expected net present value (ENPV), 69–70, 70t, 71t, 128, 130 and foreign direct investment, 128, 130–31, 133t, 134 and hard capital rationing, 84–86, 86t and inflation, 52–53 and internal rate of return (IRR), 29, 30t, 31–32 and international capital budgeting, 128 and lease versus buy decisions, 102, 103 and modified internal rate of return (MIRR), 34 and multiperiod capital rationing, 88–89 and mutually exclusive projects, 87 versus payback method, 28 present value table, 165 and real options, 109, 137–39 reliability of, 32 and replacement decisions, 93, 98t, 99t, 100t in scenario analysis, 75 in sensitivity analysis, 72–74 in simulations, 76–77, 78t and soft capital rationing, 83–84 survey evidence, 36–40, 38t, 114, 134–36 and taxation, 46–48 and tax shield benefits, 35–36 versus traditional techniques, 28 in valuation techniques, 140 Index 183 O oil industry, 3, 12, 49, 61, 69, 101, 112, 122, 140–41, 149, 150 P Parmalat, payback period (PB), 23–25, 32–33 and adjusting for risk, 66, 68, 135 and cash flow, 24, 24t discounted payback index (DPBI), 32–33, 33t example of, 24 modifications to, 32–33 reduced payback, 68, 135 survey evidence, 36–39, 38t pecking order theory, postimplementation audits (PIAs), 20–21 purchasing power parity (PPP), 124, 126 R real options, 137–51 alternative models of, 144–47 applications of, 147–51 binomial option pricing model (BOPM), 139, 142–44, 143f, 144f Black-Scholes model, 139–41, 141t, 142, 151 versus financial options, 138–39, 138t growth options, 149 scale options, 148 staging options, 148 switching options, 149–50 timing options, 147–48 valuation techniques, 139–47 reinvestment rate, 34 replacement decisions, 91–100, 92t equivalent annual cost (EAC) method, 96–100, 96t, 97t finite horizon method, 96 lowest common multiple method, 94–95, 94t, 95t maintenance costs, 93, 97–98, 98t, 102, 102t resale values, 94t, 95t, 97–98, 98t, 99t and tax benefits, 102t See also lease versus buy decisions research and development (R and D), 91, 122, 141, 145, 146–47, 148, 149, 150–51 retail price index (RPI), 51, 51t return on capital employed See accounting rate of return return on investment (ROI), 69 reward systems, 13, 17 Rio Tinto Alcan, risk and uncertainty, 61–82, 62t, 64t, 65t, 80t adjusting for, 66–69 certainty equivalent (CE), 67–68, 68t coefficient of variation, 65–66 expected values and dispersion, 63–65 independent and conditional events in, 62–63 portfolio theory, 79–80 and probability, 62 in project appraisal, 69–71 reduced payback, 68–69 risk-adjusted discount rates, 66–67 scenario analysis, 75, 75t sensitivity analysis, 71–74 simulation, 76–78, 76t, 77t, 78t standard error, 65–66 survey evidence, 80–82, 81t variable sensitivities, 74t S scenario analysis, 75, 75t sensitivity analysis, 71–74 simulation, 76–78, 76t, 77t, 78t strategic investment decisions, 10, 105–15 strategic investment decisions (continued ) assets in place, 10 assumptions, 107 asymmetric information, 10 balanced scorecard, 107–8 benchmarking, 113 184 Index and capital expenditure, 14 consistency in decision making, 3, 10, 18, 28, 36, 50 duration analysis, 151–51, 152t, 153t emergent techniques, 107–15 growth assets, 10 and maximizing shareholder wealth through, 2, 8, 10, 11, 28, 36, 83, 88, 119 overinvestment, 10, 59 profitability index (PI), 144–45, 145t real options, 108–9 recent developments, 137–61 survey evidence, 113–15 technology roadmapping, 110–11 value chain analysis, 111–12 subcontracting, 19 T taxation, 45–48 after–tax cost of debt, 48 American Recovery and Reinvestment Act, 48 and discount rate, 48 first year allowance (FDA), 45 and investment decisions, 48 pretax cash flows, 47, 47t in the United Kingdom, 45–46 in the United States, 48 and weighted average cost of capital (WACC), 48 writing-down allowance (WDA), 45–47, 47t terminal values (TV), 34, 34t Toyota, U underinvestment, 10, 59 “ungeared” company, 35 United Kingdom, 8–9, 106–7, 114 and appraisal techniques, 37–39, 37t, 57–58, 58t calculating risk, 81–82, 81t Combined Code, first year allowance (FYA), 45 and inflation, 49 and international capital budgeting, 120t, 121t, 126–27 and leasing decisions, 104 and taxation, 45, 48, 49 writing-down allowance (WDA), 45–47, 47t United Nations, 118 United States, 2, 7–9, 37–39, 80–81, 89, 114, 129t, 150, 163 American Recovery and Reinvestment Act (2009), 48 and appraisal techniques, 37–39, 37t, 57–58, 58t calculating risk, 80–82 and capital rationing, 89 and foreign direct investment, 119, 120t, 121t, 122, 126–27, 134 and leasing decisions, 104 Sarbanes-Oxley Act (SOX), V valuation techniques, 139–47 value at risk (VAR), 157–60 value chain analysis, 111–12 W weighted average cost of capital (WACC), 48, 53–54 Worldcom, world gross product (WGP), Principles and Practice Pogue Corporate Investment Decisions Managerial Accounting Collection Kenneth A Merchant, Editor Michael Pogue Mike Pogue has lectured and examined in the disciplines of accounting and finance at undergraduate, postgraduate, and professional examination levels since 1982 at both Queens University, Belfast, and currently at the University of Ulster For the past 10 years, he has taught on courses for both the CIMA (Chartered Institute of Management Accountants) and the ACCA (Association of Chartered Certified Accountants) professional bodies Other professional activities include current appointments as an assessor for the ACCA examinations at final level and an examiner in management accounting for the ICAI (Institute of Chartered Accountant in Ireland) He has also previously written articles for the CIMA and ACCA professional publications and has recently completed a research project for ACCA examining the impact of defined-benefit pension schemes upon corporate financing In addition, Mike also has substantial experience lecturing in financial management in executive MBA programs at both universities and supervising MBA research projects Consultancy activity outside the university has included projects in the agri-feeds and insurance sectors Corporate Investment Decisions In these turbulent financial and economic times, the importance of sound investment decisions becomes a critical variable in underpinning future business success and, indeed, survival If you’re a practicing manager who needs a thorough knowledge of investment decisions in the real world, this book is for you This outstanding book details the relevant aspects of the investment decision varying from a basic introduction to the appraisal techniques available to placing investment decisions within a strategic context and coverage of recent developments including real options, value at risk, and environmental investments Any professional or MBA student will benefit from both a comprehensive introduction to the subject area and also from the consideration of more advanced aspects and recent innovations for those readers wishing to delve deeper into the fascinating world of investment decisions So many executives and financial managers are feeling overwhelmed by the difficulties currently encountered globally by firms in both raising finance and making predictions concerning the future economic environment Read this book to better understand how this raises the already-prominent role of capital budgeting in the arena of financial decision making Corporate Investment Decisions Principles and Practice Michael Pogue Managerial Accounting Collection Kenneth A Merchant, Editor ISBN: 978-1-60649-064-8 90000 www.businessexpertpress.com 781606 490648 www.businessexpertpress.com [...]... attempting to identify and evaluate long-term projects While recognizing that practical investment decisions could be deemed to be “as much art as science,” and sophisticated 4 Corporate Investment Decisions valuation techniques cannot be viewed as a substitute for intuition and experience, the primary objective of this book is to provide an appropriate combination of theory and practice In the pursuit... appraisal To assist in making investment decisions and ensure consistency, methods of investment appraisal are required that can be applied to the whole spectrum of investment decisions, and that should help to decide whether any individual investment will enhance shareholder wealth The results of the appraisal will heavily influence the project selection for investment decisions However, appraisal... its economic life and is unlikely to have a significant impact upon current activities In contrast, successful strategic investment decisions are likely to impinge heavily on competitive advantage and will influence what the company does, where it does it, and how it does it We consider strategic investment decisions in chapter 8 and assess the emerging techniques to assist strategic decisions prior... financing is a futile exercise 10 Corporate Investment Decisions The Investment Decision In its simplest form, an investment decision can be defined as involving the company making a cash outlay with the aim of receiving future cash inflows Capital investment decisions are generally long-term corporate finance decisions relating to fixed assets, and management must allocate limited resources among competing... through which a typical investment proposal may pass, commencing with the identification of the investment opportunity and concluding with an assessment of the postimplementation performance of the chosen projects Investment decisions can be considerably enriched by the experience and intuition of the managers involved Given our assertion that the process of making investment decisions is “as much art... theory4 predicts that asymmetric information between informed managers and the public market causes underinvestment The Financial Environment 11 The Dividend Decision The dividend decision is the third major category of corporate long-term financial decision and perhaps the most elusive and controversial As with the financing and investment decisions, the main research question is whether the pattern (not... debt and have an insignificant impact on capital investment Similarly, a decision to increase investment can only be accommodated by either reducing dividend payments or raising additional finance Less obviously, the source of new finance raised may influence the discount rate used in the appraisal and may impinge on the acceptance or rejection of the investment project 12 Corporate Investment Decisions. .. and political uncertainty In chapter 9, we attempt to provide a brief overview of the motives underlying foreign expansion and an appreciation of the additional risk factors requiring consideration when contemplating foreign expansion The current frontiers of investment decision theory are discussed and evaluated in chapter 10 Although the concept of real options originated 6 Corporate Investment Decisions. .. independently, in practice they are closely linked A company’s investment, financing, and distribution decisions are necessarily interrelated by the fact that sources of cash equal uses of cash An increase in operating cash flow could be used to increase capital expenditure Alternatively, it could be employed to reduce debt, increase dividends, or finance any combination of investment and financing decisions. .. being economically inefficient, losing the spread between debt and investment, to being a vital element in the battle to maintain liquidity at times of capital market disruptions.” 8 Corporate Investment Decisions The role of the corporate treasurer has never been more important as the attention of company boards is dominated by risk management and cash Moreover, even if eventual economic recovery is likely,