Practical Issues in Capital Budgeting (Chs. 11, 12)
These chapters discuss various things that can be done to
reduce the error in NPV estimates and avoid costly mistakes in making investment
decisions.
·
Trust market values; avoid unnecessary estimation.
Gold mine example in 11.1:
o
You
could get PV of future revenues by estimating the future price of gold,
computing future revenue, and then discounting it back
o
However,
this unnecessarily introduces estimation error
o
Instead
of trying to estimate future gold prices yourself, you can just use the info
contained in the market price of gold
§
Gold
is just a risky asset which pays no dividends
§
Expected
return from investing in gold for one year = E(P1)/P0 –
1
§
Setting
E(R) equal to the required return, r, we get E(P1) = P0(1+r)
§
This
simply says that, since your entire return comes through price appreciation, the
expected rate of growth in the gold price must be the required return
§
In
general, E(P2) = P0(1+r)2, E(P3) = P0(1+r)3,
etc
§
P0
= PV0(P1) or PV0(P2), etc
=> Today’s gold price is the PV of all future gold prices
o
The
market is giving you a ready-made estimate of the PV of gold that will be
produced in the future. Use that
instead of trying to come up with your own estimate
·
Perform a reality check: ask yourself where the NPV is coming
from
o
Think
back to the first class: NPV of a project = value of assets – cost of assets
o
Cost
is the same for everyone; any company can buy these assets for the same price
o
Value
is use-dependent; the more efficiently you use those assets, the higher your
value will be
o
Your
project has a positive NPV only if you can use these assets more efficiently
than others
o
If
a project truly has a positive NPV, you should be able to identify the source of
the efficiency (or competitive edge or distinctive competency or whatever term
you want to use). What allows you
to generate higher cashflows than others? Good
answers would include:
§
First mover advantage
§
Patents or proprietary technology or other barriers to entry
§
Monopoly power
o
If
you can’t for the life of you figure out why you should earn a positive NPV
from a project, chances are it’s just an estimation error, and the true NPV is
negative.
·
Don’t underestimate your competitors.
In forecasting future sales and profitability, factor in the likely
competitive response (e.g. polyzone project in 11.2)
Agency problems between s/h and managers
· The investment decision is one area where there is likely to
be a conflict of interest between s/h and managers. For example:
o
Consider
a
project which has a large positive NPV but also exposes the firm to a sizable
risk of bankruptcy. The project is
good for s/h and they would like to see it accepted.
For obvious reasons, managers will shy away from such projects.
o
Or
a project has a slightly negative NPV but will double the size of your division.
Manager may fudge the NPV estimate to get the project accepted.
·
solution: managers have to be given incentives to act in the
interest of s/h
·
=> you have
to make them care about the same thing s/h care about: maximizing stock price
·
hence:
o
bonuses
linked to stock price
o
Employee
stock option plans (ESOPs)