Notes: FIN 303 Spring 09, Part 7 – Capital Budgeting Professor James P. Dow, Jr. 72Part 7. Capital Budgeting What is Capital Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture with another company. Digital Solutions would provide the software expertise to do the development, while the other company, American Financial Consultants (AFC) would be responsible for the marketing. Nancy Garcia of Digital Solutions would be responsible for assessing the financial viability of the plan. Information about the costs and revenues of the project would come from the accounting, production and marketing groups of the two companies; however, Ms. Garcia would have to put the information together, and provide a preliminary analysis that she would present to the company’s managers. Capital budgeting is the process of making a decision about the financial desirability of a project. The proposed software development project at Digital Solutions is an example of this kind of problem. We will see how Nancy Garcia approaches this problem as a way to learn the techniques of capital budgeting. The Big Picture Businesses are about increasing the wealth of their owners, which means that they should pursue all the profitable projects that they can. Capital budgeting is about deciding which projects are profitable and add to the value of the firm. Sometimes the firm has to choose between two or more projects and can only pick one. For example, you may have a choice between two air-conditioning systems with different installation costs and energy costs. Your decision to install one rules out the installation of the other. Both systems may be wealth improving but you can’t accept both. You want to pick the one that increases wealth by the most. When you have mutually exclusive projects, such as in this situation, you take a ranking approach to decision making, by ranking projects in order from best to worst. Other times, there are independent projects, where the choice to do one project does not affect the returns of the other projects. For example, an airline may be considering proposals to expand into 10 different cities. It could choose to add routes to all cities, to some cities, or to none. This leads to the accept-reject approach to making decisions. You accept all proposals that increase owners’ wealth and reject those that don’t. Of course, even if projects are not technically mutually exclusive, businesses can find themselves limited in the projects they can do by capital rationing. Capital rationing means that there are limits on the amount of funds a company can raise to finance capital expansion. Ideally, capital markets should provide funds for all wealth improving projects, however, in certain circumstances firms may be restricted in what they can do. For example, the airline may not be able to issue enough debt to buy new airplanes to service all ten new cities. Or it may be that a business is reluctant to issue new stock because of concerns of diluting ownership. When there is capital rationing, firms need to treat their new projects like mutually exclusive projects and use aNotes: FIN 303 Spring 09, Part 7 – Capital Budgeting Professor James P. Dow, Jr. 73ranking approach. The airline should rank which cities provide the greatest potential for profits and expand into those cities first. Sometimes the number of projects that can be done may also be limited by other resources of the company such as managerial expertise or specialized machinery. In this case, you also need to rank projects according to desirability, while recognizing that this is probably a short-run constraint. Once some projects are done, the company can move on to other projects; and given time, it can also hire additional employees and equipment. Nancy Garcia’s Plan of Action Nancy’s instructions are, for the moment, to treat this proposal as an independent project, and so not worry about other projects the firm is considering. Given this, she now needs to develop a plan of how to proceed. She (and we) will approach the problem in five steps: 1. Determine the relevant cash flows including different possible outcomes. 2. Assess the rough financial viability of the most-likely outcome. 3. Use more sophisticated capital budgeting techniques to evaluate the project. 4. Provide quantitative measures of risks the project faces. 5 Determine how these risks affect the decision to do the project. The Time-Line of a Capital Project The first step in any capital budgeting decision is to list all the relevant cash flows. This is the hardest part of the process since it depends on having a detailed understanding of the business and requires the manager to forecast what will happen with the project in the future. It is also the most important part of the process, since if the cash flows are wrong, measures of the profitability of the project will be wrong too. Many capital projects have a similar structure: An initial investment by a firm, followed by a number of periods of regular cash inflow, followed by a terminal payment that ends the project. Our methods of evaluating projects don’t depend on this structure, but it can be helpful to think of a project this way when determining cash flows in order to be sure that you don’t forget any beginning or ending payments or costs. Nancy’s project has this kind of structure. The plan is for Digital Solutions to use its own software engineers and some temporary contract workers to develop the software over the next two years. Over the subsequent four years, Digital Solutions and AFC will share the revenue from sales according to a preset formula. At the end of the four years, AFC will have the option of buying all rights to the software at a fixed price. The basic structure of the cash flows for Digital Solutions is as follows: Year 1: outflow: development costs Year 2: outflow: development costs Year 3: inflow: revenue from software sales Year 4: inflow: revenue from software sales Year 5: inflow: revenue from software sales Year 6: inflow: revenue from software sales + inflow: sale of future rights to ACFNotes: FIN 303 Spring 09, Part 7 – Capital Budgeting Professor James P. Dow, Jr. 74 Whenever