Capital Budgeting Analysis Research Articles

Preference Trade-Offs In Capital Budgeting Decisions

Abstract Capital budgeting analysis may be characterized as an attempt to satisfy a set of potentially conflicting objectives. Corporate managers may be faced with multiple and conflicting objectives. The wide-spread acceptance of prioritized objectives in capital budgeting has stimulated the adoption of pre-emptive goal programming models. This paper presents a procedure to model a goal programming based capital budgeting model as a polynomial expression where inter-and intra-goal trade-offs can be achieved subject to the marginal rates of substitution between preference levels.

Capital budgeting and optimal timing of investments in flexible manufacturing systems

This paper investigates the financial-economic decision process for investments in flexible manufacturing systems (FMS). Contrary to popular belief, we show that conventional capital budgeting techniques can be used to make such investment decisions. First, we identify theoverall impact of installing an FMS and present guidelines for a cash flow forecasting model. We then present ways in which to incorporate uncertainty in these cash flows within a risk-adjusted discount rate. These expected cash flows and the discount rate are used in calculating the net present value (NPV). Once the capital budgeting analysis is completed, a critical issue facing the firm is the optimal timing of the installation. We reinterpret the general results on optimal timing of investments within the special context of an FMS project. Finally, we illustrate the above technique via a stylized example.

On the Differences between Accrual Accounting Figures and Cash Flows: The Case of Working Capital

'See, for example, Bierman and Smidt [2], pp. 153-154; Levy and Sarat [6], p. 69; and Brealey and Myers [3], p. 85. various accounting procedures to evaluate the level of current assets. Therefore, it would not be surprising if, practical capital budgeting analysis, there would be a wide use of accounting procedures to evaluate the level of working capital. The use of these methods raises many crucial conceptual and practical difficulties. For example, should one use market or cost basis to evaluate inventories and receivables? Should one use FIFO, LIFO, or other methods to evaluate inventories? Which costs should be capitalized: fixed costs, variable costs, out-of-pocket costs, administrative, selling, etc.? The purpose of this paper is not to raise arguments for or against the various accrual accounting methods, but to investigate the relationship between some of these methods and the cash flows of a given project. It is shown here that if the actual cash flows occur only at the beginning and end of the accrual accounting periods, then there is a simple relationship between the

An APV Analysis of Capital Budgeting under Inflation

An APV Analysis of Capital Budgeting under Inflation

Contemporary Financial Management.

Part I: INTRODUCTION. 1. The Role and Objective of Financial Management. 2. The Domestic and International Financial Marketplace. 3. Evaluation of Financial Performance. 4. Financial Planning and Forecasting. Part II: DETERMINANTS OF VALUATION. 5. The Time Value of Money. 6. Fixed Income Securities: Characteristics and Valuation. 7. Common Stock: Characteristics, Valuation, and Issuance. 8. Analysis of Risk and Return. Part III: THE CAPITAL INVESTMENT DECISION. 9. Capital Budgeting and Cash Flow Analysis. 10. Capital Budgeting: Decision Criteria and Real Option Considerations. 11. Capital Budgeting and Risk. Part IV: THE COST OF CAPITAL, CAPITAL STRUCTURE, AND DIVIDEND POLICY. 12. The Cost of Capital. 13. Capital Structure Concepts. 14. Capital Structure Management in Practice. 15. Dividend Policy. Part V: WORKING CAPITAL MANAGEMENT. 16. Working Capital Policy and Short-Term Financing. 17. The Management of Cash and Marketable Securities. 18. The Management of Accounts Receivable and Inventories. Part VI: ADDITIONAL TOPICS IN CONTEMPORARY FINANCIAL MANAGEMENT. 19. LEASE AND INTERMEDIATE-TERM FINANCING. 20. Financing with Derivatives. 21. Risk Management. 22. International Financial Management. 23. Corporate Restructuring. Appendix 2A: Taxes. Appendix 5A: Continuous Compounding and Discounting. Appendix 9A: Depreciation. Appendix 10A: Mutually Exclusive Investments Having Unequal Lives. Appendix 14A: Breakeven Analysis. Appendix 20A: The Black-Scholes Option Pricing Model. Appendix 20B: Bond Refunding Analysis.

Multinational Capital Budgeting: Foreign Investment under Subsidy

Multinational capital budgeting bases foreign direct investment upon ownership, internalization, and locational advantages. These may be linked to a capital-budgeting analysis of an investment's cash flows and profitability. Volkswagen's recent investment in the U.S. is considered.

Basic Financial Management.

1. An Introduction to Financial Management.Appendix: Methods of Depreciation. 2. The Role of Financial Markets and Interest Rates in Financial Management. 3. Evaluating a Firms Financial Performance and Measuring Cash Flow. 4. Financial Forecasting, Planning, and Budgeting. 5. The Time Value of Money. 6. Risk and Rates of Return.Appendix: Measuring the Required Rate of Return: The Arbitrage Pricing Model. 7. Bond Valuation. 8. Stock Valuation.Appendix: The Relationship Between Value and Earnings. 9. Capital-Budgeting Decision Criteria. 10. Cash Flows and Other Topics in Capital Budgeting. 11. Capital Budgeting and Risk Analysis. 12. Cost of Capital. 13. Analysis and Impact of Leverage. 14. Planning the Firms Financing Mix. 15. Dividend Policy and Internal Financing. 16. Working-Capital Management and Short-Term Financing. 17. Cash and Marketable Securities Management.Appendix: Cash-Management Models: Split Between Cash and Near Cash. 18. Accounts Receivable, Inventory, and Total Quality Management. 19. Term Loans and Leases. 20. The Use of Futures, Options, and Currency Swaps to Reduce Risk.Appendix: Convertible Securities and Warrants. 21. Corporate Restructuring: Combinations and Divestitures. 22. International Business Finance. Appendix A: Using a Calculator. Appendix B: Compound Sum of $1. Appendix C: Present Value of $1. Appendix D: Sum of an Annuity of $1 for n Periods. Appendix E: Present Value of an Annuity of $1 for n Periods. Appendix F: Solutions for Selected End-of-Chapter Problems. Glossary. Organization Index. Subject Index.

The Weighted Average Cost of Capital, Perfect Capital Markets, and Project Life: A Clarification

For financial management to make wealth maximizing capital budgeting decisions, a model that will determine correctly the market value of a project's levered cash flows is required. A capital budgeting model should account not only for the effects of the investment decision, but also for the effects of the financing decision and the interactions between the two decisions. In perfect capital markets all the effects of the financing decision pertain to the tax shield created by debt financing. Thus, as originally shown by Modigliani and Miller [8], the value of a project's levered cash flow stream equals the market value the stream would have if it were unlevered plus the market value of the stream of tax savings on interest payments associated with the debt employed to finance the project. While this result is completely general with respect to the specific processes utilized by the market to value the two components, MM specified the value of the unlevered component as the present value of the unlevered cash flows discounted at the appropriate risk adjusted unlevered cost of capital and they specified the value of the tax savings component as the present value of the tax shield on interest discounted at the cost of debt. Accordingly, the value of a project's levered cash flows is specified as the sum of these two present values, one representing the effects of the investment decision and the other capturing the effects of the financing decision. The MM valuation model has been extended to normative capital budgeting analysis by Myers [9] in terms of the adjusted present value (APV) model.

Debt Capacity and the Capital Budgeting Decision: A Revisitation

* Our earlier Financial Management paper, Debt Capacity and the Capital Budgeting Decision [15], had as its objectives: 1) To propose a conceptual basis for assessing project debt capacity utilizing a cash flow adequacy criterion, and 2) to link this methodology with the Bower-Jenks [2] framework for project evaluations. Since the appearance of that paper, two refinements have been offered to the proposed methodology. Hong and Rappaport [8] have suggested the incorporation of bankruptcy into the model. This would, they contend, provide an improved approach to project evaluation, since the resulting model would provide the basis for determining the value maximizing financial structure. Specifically, their model gives explicit consideration to the costs of insolvency. In the current issue of this journal, Conine [3] suggests that a technical problem arises in attempting to link the use of the CAPM to the debt capacity scheme we proposed. Specifically, in a CAPM world where risky debt is issued, the simple Hamada [5] adjustment we used to produce an estimate of the beta coefficient for an unlevered firm is biased. In fact, where debt is risky, in a CAPM sense, the adjustment involves a more involved calculation that considers both the beta coefficient for the levered firm's equity and that of its risky debt. In the pages that follow we take this opportunity to share what we have learned from these authors' refinements and provide some comments as to how far the finance discipline has come in dealing with the debt capacity issue in capital budgeting analysis.

Debt Capacity, Optimal Capital Structure, and Capital Budgeting Analysis

* As far back as 1955, Solomon [9] recognized that capital budgeting decisions should consider the debtcarrying capacity that a proposed capital project adds to the firm. Since then, much work has been done on the nature of debt capacity and its value to the firm. The value of carrying debt was quantified by Modigliani and Miller (MM) [7] in the context of a competitive market with corporate taxes and no insolvency costs. Lewellen [5] further clarified the analysis of debt capacity by considering portfolio effects of an acquisition whose cash flows are less than perfectly correlated with those of the acquiring firm. Building on the MM framework and the capital asset pricing model, Bower and Jenks [1] explicitly incorporated the tax benefits of debt capacity in setting discount rates for individual projects. Martin and Scott [6] extended the Bower-Jenks analysis by expressing debt capacity in terms of a target probability risk of insolvency for the firm. The capital budgeting literature cited does not deal explicitly with the firm's optimal capital structure. This paper seeks to do this and to analyze the implications of optimal structure in capital budgeting decisions.

Capital cost and adjusted present value: Reconciliation and amplification

In recent years the adjusted present value method has been propounded for capital budgeting analysis. A comparison of the standard cost of capital approach to the adjusted present value method indicates that the two analyses produce exactly equivalent present value appraisals, as long as the enterprise contemplating the asset has a policy of keeping the degree of leverage constant. The conclusions reached are independent of the firm's target leverage position matching its present posture.

Sales Forecasting Practices of Large U.S. Industrial Firms

* Sales forecasting is a crucial part of many financial management activities, including profit planning, capital expenditure analysis, capital structure planning, cash budgeting and merger analysis. In all of these and other financial management areas, accurate sales projections are extremely important. Because of this importance, any prescriptive finance theory should be cognizant of and influenced by the projection and forecasting practices of the firms we prescribe for. Very little is known today about sales forecasting practices in industry, however, and a systematic cataloguing of current sales forecasting practices would assist in documenting and comparing current practices. The purpose of this study is to present some evidence regarding the current state of the art of business sales forecasting practices. Because of the nature of the topic, we necessarily use data from a questionnaire. In the following sections we present this questionnaire, the nature of the data obtained from it and draw some conclusions about the evidence. Data

MATHEMATICAL PROGRAMMING, THE CAPITAL ASSET PRICING MODEL AND CAPITAL BUDGETING OF INTERRELATED PROJECTS

THE PROBLEMS OF CAPITAL BUDGETING seem to be, figuratively speaking, everyone's concern. Industrial engineers, economists, operations research analysts and finance specialists claim the subject matter as their domain. Each has a unique perspective and point of view; each tends to concentrate attention on a different type of problem because of slightly different goals; each tends to use a different set of tools and techniques; and each tends to talk among themselves. The literature has grown rapidly in each field and has tended to diverge from, rather than to converge to, a unified whole. The analysis of uncertainty in capital budgeting is a good example. With some oversimplification, it is convenient to characterize the engineeringmanagement science approach as one concerned primarily with norinative. models for decision making and to be primarily concerned with computing solutions. Weingartner [17], Naslund [13], Hillier [7], Oakford [14] and Bernhard [2] are examples. These approaches place minimum emphasis on the development of criteria and maximum emphasis on solution technique. Mathematical programming holds sway in these approaches. The economics-finance approach tends to pay little attention to computing technique and a great deal of attention to the development of general criteria and rules. Here the theoretical ideas of capital asset pricing of Sharpe [15], Lintner [8], and Mossin [1 1] serve as background for capital budgeting analysis by Litzenburger and Budd [9], Hamada [6], Stapleton [16] and Bierman and Hass [3], to name a few. One could further classify the approaches as being concerned with the selection of sets of projects under inter-relationships in the engineering-management science approach and with single projects in the economics-finance approach. Mutually exclusive, contingent, competitive and complementary projects are significant in the writings of the former, while they play a lesser role in the latter. What is the appropriate discount rate or the hurdle rate that projects must clear is usually the goal of the economics-finance approach, while this rate is taken for granted in the engineering-management science approach. The classifications that have been made are not perfect, to be sure. Weingartner [17], Baumol and Quandt [1], Naslund [13] and Bernhard [2], represent programming approaches which tie in with the criterion problem. Hamada [6] on the opposite side makes reference to programming analysis in his development of general criterion and rules for capital budgeting. However, explicit recognition of the role of programming in the general criterion of market value maximization using the capital asset pricing model has not been detailed.

On the Explicit Solution of a Special Class of Linear Economic Models

This paper derives explicit solutions for a class of linear (inequality) economic models heretofore treated by linear programming. These solutions are quite elementary and the decision criteria given are easily interpreted. The explicit solutions may involve the inversion of a single matrix, but even this is not necessary for the three applications in capital budgeting, production planning, and input-output analysis given in the paper.

Shareholder Wealth Maximization Under Non-Constant Marginal Cost of Capital: Lifeway Science, Inc.

Introduction Traditional capital budgeting methods used in capital expenditure decisions are routinely applied to managerial decisions. Each method has its own strengths and weaknesses, and is often positioned in relation to another in assessments of the validity of the method. The capital expenditure decision is also traditionally thought of as separate from the funding of capital projects; that is, the cost of capital is considered a given in expositions of capital budgeting decision criteria. Most finance textbooks, and indeed, most managers, accept simplifying assumptions in order to avoid the complications associated with a true business environment. For example, while a manager might wish to consider the funding of capital expenditures a separate and distinct decision, funds providers, particularly creditors, certainly consider the two decisions intertwined. In fact, creditors funding capital assets often require specific assets to be pledged as security in order to have a secondary repayment conduit if the primary means of repayment fails. While the pledging of collateral may not materially affect a capital budgeting decision in some cases, other elements of capital budgeting complexities might. The presence of mutually exclusive projects, projects with unequal lives, and presence of multiple divisions are all possible complicating factors in the decision process. One complexity present in virtually all capital budgeting analyses, yet assumed away or ignored by both finance educators and practicing managers is the presence of non-constant marginal cost of capital. Assuming some benchmark discount rate for use with capital budgeting techniques may simplify the analysis of projects, but can lead to over- or under-investment, inclusion and exclusion errors, and substantive errors in estimating the shareholder wealth consequences of accepting or rejecting a capital project. It is difficult to determine a correct business strategy if a key element of the business reality is ignored or assumed away. There are, however, few resources available to educators or practicing managers that highlight the decision errors that can result from not recognizing the effects of the non-constant marginal cost of capital. It is in this spirit that anecdotal scenarios, or cases, can be of help to both educators and practicing managers in understanding the proper application of capital budgeting methods. The case featured in this paper concerns a small company considering five investment projects. The question posed in the case appears simple at first glance: assess the independent projects under consideration and come up with an optimal investment decision. The non-constant marginal cost of capital faced by the company, however, requires a solution that is more complex than decision methods presented in textbooks, usually the case when real business situations are addressed. The reader is tasked with figuring out and performing the appropriate solution, given the typical analytical tools (Excel, and perhaps other software) and time pressures of a professional management environment. The case is appropriate for senior level finance majors, or perhaps administrative problems courses at the MBA level. In a group setting, students should expect to spend 10-20 hours on the solution, depending on the degree of automation they can achieve with analytical software. Case Assignment For Distribution To Students LIFEWAY SCIENCE, INC.: A CAPITAL BUDGETING CHALLENGE Nathan Young, a recently hired financial manager for Lifeway Science, Inc. (LSI), had been with the company for only three months. He had been given responsibility for the firm's capital budget for the current year. The Chief Financial Officer (CFO), Natalie Miller (Nathan's direct supervisor), had given Nathan a brief history on her past capital budgeting methods and project selections. Natalie had been the sole financial manager for the firm for the past four years, and had brought in some personal biases four years ago, and had developed several more since. …

An optimal allocation of resources for the capital budgeting problem

As the channels to which money can be allocated become greater in number, and their interrelationships become more complex, a systematic approach to budgetary decision making becomes essential. Such an approach is developed in this paper, assuming that the program under consideration has a fixed sum of money for allocation, which is insufficient to finance all of the alternative activities under consideration. A sequential procedure, utilizing the PPBS approach, is developed to evaluate the comparative worth of interacting alternatives in the capital budgeting analysis, and to maximize their combined benefit or effectiveness. While certain mathematical techniques are incorporated in the model, the general mathematical intractibility of this problem is recognized. The need for open discussion, subjective opinion, intuitive insight and competitive bargaining are essential ingredients in the proposed systematic procedure. The mathematical formulations are designed to be an aid to the intellectual and experimental capabilities of the individuals involved in the study. Some applications of this procedure are also presented.

Book Reviews

Abstract Mathematical Programming and the Analysis of Capital Budgeting Problems.: Weingartner, Martin H. (Englewood Cliffs, N. J.: Prentice-Hall, Inc., 1963), 200 pages. Reviewed by Alexander A. Robichek Introduction to Statistical Method.: Sylvain Ehrenfeld and Sebastian Littauer. New York: McGraw-Hill Book Company, Inc. 1964. Pp. x, 533. $9.75. Reviewed by T. A. Willke Applications of Characteristic Functions.: E. Lukacs and R. G. Laha. New York, New York: Hafner Publishing Co., 1964, Number 14 of Griffin's Statistical Monographs and Courses, Edited by M. G. Kendall. Pp. 202. $7.25. Reviewed by Solomon Kullback Statistics, an Introductory Analysis.: Taro Yamane. New York: Harper & Row, 1964, pp. xvi, 734. $8.75. Reviewed by Jules Joskow Research Design and Analysis.: Raymond O. Collier, Jr. and Stanley M. Elam, Editors. Bloomington, Indiana: Phi Delta Kappa, 1961. Pp. viii, 208. $3.50. Reviewed by Henry F. Kaiser Statistical Assessment of the Life Characteristic: a bibliographic guide.: (Griffin's Statistical Monograph 13). W. R. Buckland. Hafner Publishing Co., 1964. New York, 125 pp. $4.25. Reviewed by Marvin Zelen Statistically Speaking.: Warren K. Garington and Helen E. Shimota. Springfield, Illinois: Charles C Thomas, 1964. Pp. vii, 110. Reviewed by Michael J. Hamburger