Advanced capital budgeting refinements in the economic analysis of investment projects

Advanced Capital Budgeting

This book is a companion volume to the author’s classic The Capital Budgeting Decision
and explores the complexities of capital budgeting as well as the opportunities to
improve the decision process where risk and time are important elements.
There is a long list of contenders for the next breakthrough for making capital budgeting decisions and this book gives in-depth coverage to:
■

■

Real options. The value of a project must take into consideration the flexibility that
it provides management, acknowledging the option of making decisions in the future
when more information is available.This book emphasizes the need to assign a value
to this flexibility, and how option-pricing theory (also known as contingent claims
analysis) sometimes provides a method for valuing flexibility.
Decomposing cash flows. A project consists of many series of cash flows and each
series deserves its own specific risk-adjusted discount rate. Decomposing the cash
flows of an investment highlights the fact that while managers are generally aware
that divisions and projects have different risks, too often they neglect the fact that
the cash flow components may also have different risks, with severe consequences
on the quality of the decision-making.

Designed to assist business decisions at all levels, the emphasis is on the applications of
capital budgeting techniques to a variety of issues. These include the hugely significant
buy versus lease decision which costs corporations billions each year. Current business
decisions also need to be made considering the cross-border implications, and global
business aspects, identifying the specific aspects of international investment decisions,
which appear throughout the book.
Harold Bierman, Jr. is the Nicholas H. Noyes Professor of Business Administration at
the Johnson Graduate School of Management, Cornell University.

Seymour Smidt is Professor Emeritus at the Johnson Graduate School of Management,
Cornell University.


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Advanced
Capital
Budgeting
Refinements in the
economic analysis of
investment projects
Harold Bierman, Jr. and
Seymour Smidt


First published 2007 by Routledge
270 Madison Ave, New York, NY 10016
Simultaneously published in Great Britain
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2007 Harold Bierman, Jr. and Seymour Smidt
Typeset in Perpetua and Bell Gothic by Newgen Imaging Systems (P) Ltd, Chennai, India
Printed and bound in Great Britain by TJ International Ltd, Padstow, Cornwall
All rights reserved. No part of this book may be reprinted or reproduced or utilized in
any form or by any electronic, mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any information storage or
retrieval system, without permission in writing from the publishers.

Library of Congress Cataloging in Publication Data
Bierman, Harold.
Advanced capital budgeting: refinements in the economic analysis of investment projects /
Harold Bierman, Jr. and Seymour Smidt.
p. cm.
Includes bibliographical references and index.
1. Capital budget. 2. Capital investments – Evaluation. I. Smidt, Seymour. II.Title.
HG4028.C4B537 2006
658.15Ј4 – dc22
2006019474
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
ISBN10: 0–415–77205–2 (hbk)
ISBN10: 0–415–77206–0 (pbk)

ISBN13: 978–0–415–77205–1 (hbk)
ISBN13: 978–0–415–77206–8 (pbk)


Contents

List of illustrations
Preface

xiii
xvii

PART I

CAPITAL BUDGETING AND VALUATION UNDER CERTAINTY

1

1 THE STATE OF THE ART OF CAPITAL BUDGETING
Decision-making and corporate objectives
The evolution of capital budgeting practice
Surveys of practice
The discount rate
Cash flow components
The calculation of the discount rate
The time risk interaction
Real options
Three problems
Time discounting
Present value addition rule
Present value multiplication rule
The term structure of interest rates
Risk and diversification
Strategic considerations
Three basic generalizations
The capital market
Global business aspects
Conclusions
Problems
Discussion question
Bibliography
2

3
3

5
5
7
8
8
8
9
10
10
11
11
11
13
14
16
16
17
17
18
19
19

AMOUNTS DISCOUNTED AND DISCOUNT RATES
The FCF method
The CCF method
The adjusted present value method

21
23
24

25

v


CONTENTS
Equivalence of the methods
The FCF method
The CCF calculation: the value to investors
Adjusted present value
Costs of financial distress
The costs of capital
The WACC with debt
Valuation: a summary
With no debt
With $600 of debt substituted for stock
With debt (use of APV)
The use of r* (the CCF method)
Calculation of discount rates
Finite-lived assets
Global business aspects
Conclusions
Problems
Discussion question
Bibliography
Appendix derivations

26
27
27

28
29
29
31
32
33
33
34
34
35
36
36
37
38
39
39
39

PART II

CAPITAL BUDGETING AND VALUATION UNDER UNCERTAINTY

41

3

CAPITAL BUDGETING WITH UNCERTAINTY
Tree diagrams
Period-by-period summaries
Sensitivity analysis

Simulation
Risk preferences
Certainty equivalents
Time and risk
Risk adjusted discount rates
The required return
Default-free rate of discount
The borrowing rate
Changing the uncertainty
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

43
43
46
46
48
50
52
53
54
55
55
57
57
58
58

59
60
60

4

ELEMENTS OF TIME AND UNCERTAINTY
The investment process
The discount rate
Converting expected cash flows
The discount rate assumption
Capital budgeting with constant risk aversion

62
63
66
68
69
69

vi


CONTENTS
Capital budgeting with a constant risk adjusted rate
A capital market perspective
A qualification of the CAPM decision rule
Global business aspects
Conclusions
Quiz

Problems
Discussion question
Solution to quiz
Bibliography

71
73
74
74
74
75
75
76
76
77

5

THE STATE PREFERENCE APPROACH
Prices with certainty
Prices with uncertainty
The three factors
The expected risk-adjustment
Countercyclical assets
Required rates of return
Application of the risk-adjusted present value approach
Multiperiod investments
Applying the risk-adjusted present value factors
Global business aspects
Conclusions

Problems
Discussion question
Bibliography

79
79
80
82
84
84
85
86
86
88
90
90
91
93
94

6

RESOLUTION OF UNCERTAINTY
Risks, returns and the resolution of uncertainty
Introducing the three assets
Asset values by node
Expected rates of return by asset and node
Conclusions about the three assets
An alternative calculation
Introducing the two projects

Global business aspects
Generalizations
Problems
Discussion question
Bibliography

95
95
97
101
102
104
106
107
108
108
109
111
111

7

DIVERSIFICATION AND RISK REDUCTION
Systematic and unsystematic risk
Diversification
Introduction to portfolio analysis
The portfolio problem in perspective
The co-variance
The efficient frontier of investment alternatives
Perfect positive correlation

112
113
114
115
116
117
120
120

vii


CONTENTS

8

9

Perfect negative correlation
Imperfect correlation
The power of diversification: independent investments
Positively correlated investments
Observations regarding diversification
The risk-free asset
The assumptions
Portfolio analysis with a riskless security: the capital asset pricing model
The expected return
Use of the CAPM
Systematic and unsystematic risk

Implications for corporate investment policy
Unsystematic risk
Global business aspects
Conclusions
Review problem 1
Review problem 2
Review problem 3
Problems
Discussion question
Solution to review problem 1
Solution to review problem 2
Solution to review problem 3
Bibliography
Appendix: Statistical background

121
122
122
124
126
127
127
128
130
131
131
133
134
134
135

136
136
136
137
140
140
141
141
142
143

PROJECTS WITH COMPONENTS HAVING DIFFERENT RISKS
A new product project with two different cash flow components
Calculating the value of an asset by discounting its net cash flow
Increasing the proceeds
A new market for an old product
Disadvantages of using a single discount rate
Finding the composite discount rate for projects with a finite life
Buy versus lease
Discount rates and corporate income taxes
The present value calculation technique used
Global business aspects
Conclusions
Problems
Discussion question
Bibliography
Appendix: Derivation of the formula for the after-tax discount rate for
a cash flow component

145

146
147
150
150
152
152
154
156
157
157
158
158
160
160
160

PRACTICAL SOLUTIONS TO CAPITAL BUDGETING
WITH UNCERTAINTY
The two basic approaches
Approach 1: Using payback, present value profile, and sensitivity analysis
Approach 2: Calculate the net present value of the expected cash flows

162
162
163
164

viii

CONTENTS
WACC: The weighted average cost of capital
The cost of retained earnings
Costs of retained earnings and of equity with investor taxes
Costs of retained earnings with investor taxes
Cost of new equity capital with investor taxes
Debt and income taxes
The relevant source of funds
Global business aspects
Computing the firm’s weighted average cost of capital
Capital structure and the effect on the WACC
The optimum capital structure
The firm’s WACC and investments
The project’s WACC
The pure play
Default-free rate of discount
Discounting stock equity flows
Simulation and the Monte Carlo method
Value-at-risk
Conclusions
Problems
Discussion question
Bibliography

165
167
168
168
169
171

171
172
172
173
174
175
177
177
178
179
181
183
183
184
185
186

PART III

OPTION THEORY AS A CAPITAL BUDGETING TOOL

187

10 REAL OPTIONS AND CAPITAL BUDGETING
Two types of stock options
Valuing call options on common stock
The value of a call option on common stock: a numerical example
Formulas for call option valuation
Formulas for composition of the replicating portfolio
Certainty equivalent formulas for the value of an option

A multi-period call option
The replicating portfolio method for a two-period option
The certainty equivalent method for a two-period option
Number of periods
Valuing real options
Description and valuation of the underlying asset without flexibility
An option to abandon
An option to expand
Multiple options on the same asset
Conclusions
Problems
Discussion question
Bibliography
Appendix A: Increasing accuracy by using a large number of short periods
Appendix B: Valuation with multiple options on an asset

189
192
193
193
195
196
198
199
199
201
202
202
203
206

209
210
210
211
211
212
213
215

ix


CONTENTS
PART IV

APPLICATIONS OF CAPITAL BUDGETING

219

11 GROWTH CONSTRAINTS
External capital rationing
Internal capital rationing
Scarce factors of production
Ranking of investments
Programming solutions
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

221
221
222
223
223
224
224
224
225
227
227

12 THE VALUATION OF A FIRM
Present value of dividends
Present value of earnings minus new investment
Present value of growth opportunities
A terminal value model
Multipliers
Free cash flow
Book value
Value with zero debt
Market capitalization
Substitution of debt for equity
Option theory
Present value of economic income
Valuation for acquisition
DCF versus comparables
Mergers and acquisitions
Forecasting the post-acquisition price

Global business aspects
Conclusions
Problems
Discussion question
Bibliography

228
229
230
230
231
231
232
233
233
236
236
237
237
238
238
238
239
241
241
241
242
242

13 USING ECONOMIC INCOME (RESIDUAL INCOME)

FOR VALUATION
The discounted cash flow model accepted by finance theorists
The economic income model
Valuation using economic income
Other methods of valuation
Comparing ROI and economic income
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

243
244
244
246
248
249
250
250
250
254
254

x


CONTENTS
14 PRESENT VALUE ACCOUNTING
A management seminar

Basic concepts
Economic depreciation, income, and return on investment
Application to assets with zero present value
An investment with a positive net present value
Combining investments
Two investments with different risks
Better income measures
Internal rate of return and taxes
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

255
255
256
256
257
258
259
260
262
263
265
265
266
270
270

15 PERFORMANCE MEASUREMENT AND MANAGERIAL
COMPENSATION
Problems of agency
Performance measurement and managerial compensation
Accounting measures
Income
Return on investment (ROI)
ROI and investment decision-making
The case of the resource benefiting the future
The computation of income and ROI
Comparing ROI and economic income
Summary of complexities
Summary of economic income advantages
Time adjusted revenues
A non-zero net present value
Incentive consideration
PVA
Cash flow return on investment
Planning implications
In conclusion: To measure performance
Some generalizations regarding compensation
Rewarding bad performance
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

272
273

274
274
275
275
277
277
278
280
280
282
282
283
284
286
286
287
288
290
290
290
290
291
295
296

16 FLUCTUATING RATES OF OUTPUT
A plant limited to one type of equipment and two alternatives
Optimum equipment mix
More periods or more equipment types
Conclusions

Problems
Bibliography

297
298
301
304
305
305
310

xi


CONTENTS
17 INVESTMENT DECISIONS WITH ADDITIONAL INFORMATION
The opportunity to replicate
The basic model
Delaying other investments
The winner’s curse
Conclusions
Problems
Discussion question
Bibliography

311
312
312
315
316

317
317
318
318

18 INVESTMENT TIMING
Basic principles of when to start and stop a process
Growth-type investments
Example: The tree farm
Equipment replacement
The strategy of capacity decisions
The basic decision
Performance measurement and the timing decision
Competitors: Preempting the market
Perfect predictions of interest rates
Conclusions
Problems
Discussion question
Bibliography

320
321
322
325
328
329
329
330
331
333

334
334
338
338

19 BUY VERSUS LEASE
Borrow or lease: The financing decision
A lease is debt
Buy or lease with taxes : using the after-tax borrowing rate (method 1)
Using a risk-adjusted discount rate (method 2)
Computing the implied interest rate on the lease (method 3)
Risk considerations in lease-versus-borrow decisions
The rate of discount
Recommendations
Leases and purchase options
Importance of terminal value
Leveraged leases
Cancelable leases
The alternative minimum tax
Global business aspects
Conclusions
Problems
Discussion question
Bibliography

339
340
341
342
345

346
347
347
349
349
350
352
354
355
355
355
356
359
360

Name index
Subject index

xii

361
363


Illustrations

FIGURES
3.1
3.2
3.3

5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
6.1
6.2
6.3
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
7.12
9.1
10.1
10.2
10.3
16.1

Tree diagrams

Two choices and two outcomes
Risk-adjusted required rate of return
Tree diagram of cash flow
Cash-flow pattern of countercyclical asset
Probabilities for a two-period investment (tree diagram)
Cash flows of an investment that costs $300 (tree diagram)
Investment cash flows (tree diagram)
Value of the asset one period from now (tree diagram)
Tree diagram of investment
Tree diagram of single-period RAPVFs
Assets A, B and C and their cash flows
Asset values by asset and node
Expected rates of return by asset and node
Available investments
Examples of co-variation
Choosing portfolios
Perfect linear dependence
Perfect negative correlation
Two securities and different values of ␳
One investment: investment E
Two independent investments (half of E and half of F)
Risk and number of securities
The capital market line
Risk reduction by diversification
Expected return and risks for different portfolios
Relationship between amount of risk, the required return, and the
weighted average cost of capital (WACC)
The underlying stock prices over two periods
Underlying asset
Decision tree for the option to abandon

Total costs for the two alternatives

45
51
54
80
85
87
88
89
89
92
93
98
103
105
115
117
120
121
121
122
123
123
124
128
132
138
177
200

204
206
301

xiii


ILLUSTRATIONS
17.1
17.2
18.1
18.2

The basic decision model
Investment decision tree
Contribution to overhead at time t
Determination of optimum time to harvest trees

313
314
321
323

TABLES
1.1
1.2
1.3
14

What firms do: a survey in 1976 of capital budgeting techniques in use

Percentage of firms using method
Use of DCF (IRR or NPV) as primary or secondary methods
Distribution of responses: the five investment evaluation methods
used as primary or secondary methods
An investment with uncertainty
Period-by-period summary of the cash flow of an uncertain investment
Summary measures of the worth of an uncertain investment,based
on best estimate of cash flows
Sensitivity analysis
Frequency distribution of net present value of an uncertain investment
Risk analyses of an uncertain investment based on net present
value using a 10% discount rate
Values of rn given constant values of j; values of rn if j ϭ 1.10,
rf ϭ 0.04
With implied values of the risk conversion factors (jn);
constant discount rate (rn ϭ 0.144) and rf ϭ 0. 04
Common economic environment for assets A, B and C
Asset values by asset and node ($)
Expected rates of return by asset and node (%)
Uncertainty resolution and expected rate of return
for assets A, B and C
Project values by project and node ($)
Expected rates of return by project and node (%)
Uncertainty resolution and expected rate of return for
projects 1 and 2
Portfolio variance as fraction of individual security variance where
var(R) ϭ 1 and the number of securities is changed
Project A: cash flow
Project A: present value using the component cash flow procedure
Present value of project A using the project cash flow procedure

with a 10% hurdle rate
Comparison of the project A NPVs that result from using the project
cash flow procedure (PCFP) and the component cash flow
procedure (CCFP) ($)
Project A present value using the project cash flow procedure
with a 13.88% hurdle rate
Project B cash flows
Project B present value using the component cash flow procedure
mutually exclusive alternative to project B

3.1
3.2
3.3
3.4
3.5
3.6
4.1
4.2
6.1
6.2
6.3
6.4
6.5
6.6
6.7
7.1
8.1
8.2
8.3
8.4

8.5
8.6
8.7

xiv

6
6
7
7
44
47
47
47
49
49
71
71
99
101
103
106
107
107
108
125
146
147
148

148
149
151
151


ILLUSTRATIONS
8.8
8.9
8.10
9.1
9.2
10.1
10.2
10.3
10.4
10.5
10.6
14.1
14.2
14.3
14.4
14.5
14.6
15.1
15.2
16.1
16.2
16.3

16.4
16.5
16.6

16.7
16.8
16.9
16.10
16.11
16.12
16.13
18.1
18.2
18.3
18.4
18.5
18.6
18.7
18.8

Project B-1 present value using the component cash flow procedure.
Project B-1 is a mutually exclusive alternative to Project B
Project C present value using the component cash flow procedure
Buy versus lease: summary of recommended analysis
Estimate of weighted average cost of capital
Frequency distribution of net present value of an uncertain investment
Variables for stock option valuation example
Calculation of the certainty equivalent at time 2
Variables for real option valuation example
Valuing the investment with the abandonment option

Calculating factory values at the expiration with an expansion option
Calculating factor values prior to expiration with an expansion option
Calculation of the net present value of asset A at times 0 and 1
(r ϭ 10%)
Computation of net present value for asset B at 10%
Computation of internal rate of return for investment B (r ϭ 20%)
Calculation of the net present value of asset E at times 1 and 2
(r ϭ 10%)
Cash flows of asset F
Calculation of NPV of asset D at times 0 and 1 (r ϭ 0.20)
Income and investments for each of the three years in use
Present value of the investment at three moments in time
Basic data on equipment types
Seasonal production pattern
Seasonal production schedule form for multiple equipment
plant – analysis for first increment (thousands)
Step 2: seasonal production schedule for multiple equipment
plant – analysis for first two increments (thousands)
Final version seasonal production schedule for multiple equipment
plant – analysis for all three increments (thousands)
Final version seasonal combining quarters with equal production –
seasonal production schedule for multiple equipment
plant (thousands)
Cost characteristics of alternative types of widget
production facilities
Estimated demand for widgets
Cost data
Two alternative sizes
Predicted demand for automobiles
Types of generating equipment and costs

Generating units and characteristics
Net realizable value from one growth cycle
Calculations when land value is $500
Value of land when crops are harvested at various ages
Return earned
Data for years 1 and 2 of the two investments
Values and depreciation expenses
Incomes and returns on investment B
Firm A’s net present value conditional on B’s actions

xv

151
153
156
173
182
196
202
205
208
209
209
257
258
258
260
261
261
279

279
298
300
302
303
304

305
306
306
308
308
309
309
309
326
327
327
328
330
331
331
332


ILLUSTRATIONS
18.9
18.10
18.11
19.1

19.2
19.3
19.4
19.5
19.6

xvi

Firm B’s net present value conditional on A’s actions
York State Electric refunding calculations
Analysis of Bi-State Electric position
Cash flows
Balloon payment debt and after-tax cash flows
Cash flows
Debt amortization
Lease analysis (1)
Lease analysis (2)

332
337
337
347
351
353
353
358
359


Preface

The history of capital budgeting is a series of time periods where managers
thought they had found exact solutions to making investment decisions only to
find that new improved methods of thinking of the issues introduced complexities and solutions.Thus until early in the 1950s the payback and accounting return
on investment were the primary methods used by business. The internal rate of
return (called by different names) then reigned for a brief time in the mid fifties
only to be replaced by the net present value method. Both of these discounted
cash flow methods initially used the firm’s weighted average cost of capital either
as the rate of discount for computing present values or as the required return. It
was then recognized that not only did a corporation have a risk measure, but so
did divisions, and individual projects.We argue in this book that investments have
cash flow components that might require different discount rates.
Now there is a long list of contenders for the next break-through for making
capital budgeting decisions. Leading the list are real options.The value of a project
must take into consideration the flexibility that it provides management. One
project may commit management to a definite course of action; another may
provide flexibility by giving managers the alternative of making decisions in the
future when more information is available.We emphasize the need to assign a value
to this flexibility. We point out that option-pricing theory (also known as contingent claims analysis) sometimes provides a method for valuing flexibility. But even
though many knowledgeable managers already incorporate the basic concepts, it is
useful to acknowledge formally the necessity of considering all decision alternatives and of using option theory where appropriate and feasible.
Close behind options in importance is the thought that a project consists of
many series of cash flows and that each series deserves its own specific risk
adjusted discount rate. Decomposing the cash flows of an investment may lead to
significantly different results than the calculation of the net present value of an
investment’s net cash flow.We expand on this conjecture in this book.

xvii

PREFACE

Even the use of one risk adjusted rate for a series of cash flows must be
questioned. Under what conditions is it correct to use (l ϩ r)Ϫn with the same r for
all values of n to compute the present value of a cash flow?
This book explores the complexities of capital budgeting as well as the opportunities to improve the decision process where risk and time are important elements.
We assume that the reader of this book has read and understood the core chapters
of The Capital Budgeting Decision or the equivalent material in a basic corporate finance
text. In this book, we have not gone over the basic concepts of time value, NPV, or
IRR. If you are not familiar with these concepts, we strongly recommend that you do
some reading to establish a necessary foundation before starting this book.
This book assumes the reader has an appreciation for the usefulness of net present
value (NPV) and the cases where NPV is superior to alternative measures of investment worth. Part I of this book summarizes the basic elements of time discounting but
the two chapters do not attempt to replicate the essentials of capital budgeting.
Part II expands on Capital Budgeting under conditions of uncertainty. Chapter 8,
“Projects with Components Having Different Risk,” highlights the fact that while
management is generally aware that divisions and projects have different risks, too
often they neglect the fact that the cash flow components may also have different risks.
Chapter 6 contains complex examples that can be omitted on first reading.
Part III deals with the application of option theory to capital budgeting. The
topic is set aside in its own section to highlight the importance of option theory.
Part IV consists of applications of capital budgeting techniques to a variety of decisions.While present value accounting is not likely to be accepted by the FASB in the
near future, the basic concepts are important to a wide range of managerial decisions.
One of the more important chapters to a business manager is “Buy versus Lease.” The
leases of corporations amount in the trillions. Unfortunately, a widely used calculation
of the cost of leasing is wrong and understates the cost of leasing.This calculation is
exploited by lessors to sell leasing to managements.
Current business decisions should be made considering the international implications of the decisions. Throughout the book we have scattered sections titled
“Global Business Aspects.” The objective of these sections is to identify the specific
aspects of international investment decisions that expand the domestic decisions.

We decided to avoid limiting our discussion of international aspects to one chapter since we believe that decisions involving cross border factors is of a general
nature and the reader should be reminded of this throughout the book.
Lauren McEnery read an early version of The Capital Budgeting Decision and the
first chapter of this book and offered many useful suggestions.We thank her.
The tree diagrams in this text were drawn with the help of PrecisionTree, a
software product of Palisade Corporation, Ithaca, NY. For more information visit
their website at www.palisade.com, or call 800-432-RISK (7475).
Harold Bierman, Jr.
Ithaca, New York
Seymour Smidt

xviii


Part I

Capital budgeting and
valuation under certainty

Well, I come down in the morning and I take up a pencil and I try to think.
(Hans Bethe, quoted by Bob Herbert, New York Times, February 14,
2005, quoting from Timebends by Arthur Miller)

It is useful first to consider capital budgeting with the most simple of assumptions.
While the assumption of certainty is not realistic, it does enable us to establish
some easily understood and theoretically correct decision rules. Even in these two
chapters the presence of uncertainty is implicit in the calculations.
Part I offers very specific and exact solutions to the capital budgeting decision.
The basic conclusion is that with independent investments accept all prospects
with a positive NPV. With mutually exclusive investments accept the alternative

with the largest NPV.


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Chapter 1

The state of the art of
capital budgeting

Considering the accidents to which all human Affairs and Projects are
subject in such a length of Time, I have perhaps too much flattered myself
with a vain Fancy that these Dispositions will be continued without
interruption and have the Effects proposed.
(B. Franklin’s Will)
In 1790, Franklin made a £2,000 gift to Boston and Philadelphia.
£1,000 of the funds were to be spent after 1990. In 1990 the bequest
was worth $6.5 million.
(New York Times, April 21, 1990. Author’s note: Assuming the
£1,000 was worth $4,000, the investment
earned 0.03766 per year)

Capital budgeting theory keeps evolving. At one point, some felt that net present
value (NPV) was so conceptually sound and practically useful that no further
improvements were feasible. The basic NPV examples are beautiful (at least to
some eyes) in their consistent and easily understood logic.
But we now know that there are important ways of improving the NPV calculation and this book focuses on these techniques.

DECISION-MAKING AND CORPORATE OBJECTIVES

The primary motivation for investing in a corporation is the expectation of making a
larger risk-adjusted return than can be earned elsewhere.The managers of a corporation have the responsibility of administering the affairs of the firm in a manner
consistent with the expectation of returning the investor’s original capital plus the
required return on their capital.The common stockholders are the residual owners,

3


CAPITAL BUDGETING UNDER CERTAINTY

and they earn a return only after the investors in the more senior securities
(debt and preferred stock) have received their contractual claims. We will assume
that the objective of the firm is to maximize its common stockholders’ wealth
position. But even this narrow, relatively well-defined definition is apt to give rise to
misunderstanding and conflict. It is possible that situations will arise in which one
group of stockholders will prefer one financial decision while another group of
stockholders will prefer another decision.
For example, imagine a situation in which a business undertakes an investment
that its management believes to be desirable, but the immediate effect of the investment will be to depress earnings and lower the common stock price today because
the market does not have the same information that the management has. In the
future, it is expected that the market will realize that the investment is desirable, and
at that time the stock price will reflect the enhanced value. But a stockholder expecting to sell the stock in the near future would prefer that the investment had been
rejected, whereas a stockholder holding for the long run might be pleased that the
investment was undertaken.Theoretically, the problem can be solved by improving
the information available to the market. Then the market price would completely
reflect the actions and plans of management. However, in practice, the market does
not have access to the same information set as management does.
A corporate objective such as “profit maximization” does not adequately or
accurately describe the primary objective of the firm, since profits as conventionally
computed do not effectively reflect the cost of the stockholders’ capital that is tied up

in the investment, nor do they reflect the long-run effect of a decision on the shareholder’s wealth.Total sales or share of product market objectives are also inadequate
normative descriptions of corporate goals, although achieving these goals may also lead
to maximization of the shareholders’ wealth position by their positive effect on profits.
It is recognized that a complete statement of the organizational goals of a business
enterprise embraces a much wider range of considerations, including such things as
the prestige, income, security, and power of management, and the contribution of
the corporation to the economic and social environment in which it exists and to the
welfare of the labor force it employs. Since the managers of a corporation are acting
on behalf of the common stockholders, there is a fiduciary relationship between the
managers (and the board of directors) and the stockholders. The common stockholders, the suppliers of the risk capital, have entrusted a part of their wealth position to the firm’s management.Thus the success of the firm and the appropriateness
of management’s decisions must be evaluated in terms of how well this fiduciary
responsibility has been met. We define the primary objective of the firm to be the
maximization of the value of the common stockholder’s ownership rights in the firm
but recognize that there are other objectives.
Business organizations are continually faced with the problem of deciding
whether the commitments of resources – time or money – are worthwhile in terms
of the expected benefits. If the benefits are likely to accrue reasonably soon after the

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THE STATE OF THE ART OF CAPITAL BUDGETING

expenditure is made, and if both the expenditure and the benefits can be measured
in dollars, the solution to such a problem is relatively simple. If the expected benefits are likely to accrue over several years, the solution is more complex.
We shall use the term investment to refer to commitments of resources made in the
hope of realizing benefits that are expected to occur over a reasonably long period of
time in the future. Capital budgeting is a many-sided activity that includes searching
for new and more profitable investment proposals, investigating engineering and
marketing considerations to predict the consequences of accepting the investment,

and making economic analyses to determine the profit potential of each investment
proposal.While the specific calculations use the investment’s expected cash flows to
compute the net present value, the implicit assumption is that a positive net present
value will add the same amount to the firm’s value.

THE EVOLUTION OF CAPITAL BUDGETING PRACTICE
Capital budgeting theory and practice received a major thrust in 1951. In that
year, two books were published that opened the door to new managerial techniques for making capital budgeting decisions using discounted cash flow methods
of evaluating investments. Capital Budgeting was written by Joel Dean and The
Theory of Investment of the Firm by Vera and Friedrich Lutz.
Dean, a respected academician who did a large amount of business consulting,
wrote his book for business teachers and managers. The Lutzes were economists
interested in capital theory, and wrote their book for the economic academic
community. Both books were extremely well written and are understandable.
They initially caused academics and subsequently business managers to rethink
how investments should be reevaluated. Up to the late 1950s payback and accounting return on investment were the two primary capital budgeting methods used by
large firms, with less than 5 percent of the largest firms using a DCF method.
Today, almost all large corporations use at least one DCF method.
The two books were followed by a series of articles on capital budgeting in 1955
in The Journal of Business (University of Chicago). In 1960, The Capital Budgeting
Decision by Bierman and Smidt was published by Macmillan.This book established
the clear superiority of net present value (NPV) but also described how internal
rate of return (IRR) could be used correctly. The limitations of alternative
methods were also defined.

SURVEYS OF PRACTICE
Prior to 1960, very few corporations used discounted cash flow methods for
evaluating investments. Surveys indicate that the situation has changed. Gitman
and Forrester showed in a 1976 study that 67.6 percent of the major US firms

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CAPITAL BUDGETING UNDER CERTAINTY

responding used internal rate of return as either the primary or secondary method
and that 35.7 percent used net present value (see Table 1.1).
In a second study (see Table 1.2), Scholl, Sundem, and Gaijsbeck found that
86 percent of the major firms responding used internal rate of return or present
value, thus confirming the magnitudes of the Gitman–Forrester study.
In 1992, Bierman made a survey of the capital budgeting practices of the 100
largest of the Fortune 500 Industrial firms. Sixty-eight firms supplied usable information (see Tables 1.3 and 1.4).The survey results indicate that all the firms used
time discounting, and sixty-seven of the firms used either NPV or IRR. However,
despite the academic literature conclusions that ROI is not useful, close to 50 percent
still used ROI to evaluate investments.WACC was the most popular discount rate,
but the risk adjusted rate for the project, was also extensively used.
Graham and Harvey (2001 and 2002) sought responses from approximately 4,440
companies and received 392 completed surveys.They found that 74.9 percent of the

Table 1.1 What firms do: a survey in 1976 of capital budgeting techniques
in use
Method
Internal rate of return
Rate of return (average)
Net present value
Payback period
Benefit/cost ratio
Total responses

Primary

number of firms

%

Secondary
number of firms

%

60
28
11
10
003
112

53.6
25.0
9.8
8.9
002.7
100.0

13
13
24
41
02
93

14.0
14.0
25.8
44.0
002.2
100.0

Source: L. J. Gitman and J. R. Forrester, Jr., “A Survey of Capital Budgeting Techniques Used by
Major Firms,” Financial Management, fall 1977, pp. 66–71.

Table 1.2 Percentage of firms using method
Method

% of firms

Payback
Accounting return on investment
Internal rate of return
Net present value
Internal rate of return or present value
Use only one method (of which 8% is a DCF method)

74
58
65
56
86
14

Source: L. D. Scholl, G. L. Sundem, and W. R. Gaijsbeck, “Survey and Analysis of

Capital Budgeting Methods,” Journal of Finance, March 1978, pp. 281–7. There were
429 firms selected and 189 responses. The firms were large and stable. Major financial
officers were sent the survey.

6