Capital Budgeting: Financial Appraisal of Investment Projects

by Don Dayananda , Richard Irons , Steve Harrison , John Herbohn , Patrick Rowland

• ISBN13: 9780521520980
• ISBN10: 0521520983
• Format: Paperback
• Copyright: 2002-11-18
• Publisher: Cambridge University Press

Summary

This book explains the financial appraisal of capital budgeting projects. The coverage extends from the development of basic concepts, principles and techniques to the application of them in increasingly complex and real-world situations. Identification and estimation (including forecasting) of cash flows, project appraisal formulae, and the application of net present value (NPV), internal rate of return (IRR) and other project evaluation criteria are illustrated with a variety of calculation examples. Risk analysis is extensively covered by the use of risk adjusted discount rate, certainty equivalent, sensitivity, simulation and Monte Carlo analysis. The NPV and IRR models are further applied to forestry, property and international investments. Resource constraints are introduced to the capital budgeting decisions with a variety of worked examples using linear programming technique. All calculations are extensively supported by Excel workbooks on the Web, and each chapter is well reviewed by end of chapter questions.

Table of Contents

List of figures	xiii
List of tables	xiv
Preface	xvii
Capital budgeting: an overview	1	(11)
Study objectives	2	(1)
Shareholder wealth maximization and net present value	3	(1)
Classification of investment projects	4	(1)
The capital budgeting process	5	(4)
Organization of the book	9	(1)
Concluding comments	10	(1)
Review questions	11	(1)
Project cash flows	12	(25)
Study objectives	14	(1)
Essentials in cash flow identification	14	(1)
Example 2.1	15	(1)
Example 2.2	16	(7)
Asset expansion project cash flows	23	(4)
Example 2.3. The Delta Project	27	(4)
Asset replacement project cash flows	31	(1)
Example 2.4. the Repco Replacement Investment Project	32	(2)
Concluding comments	34	(1)
Review questions	35	(2)
Forecasting cash flows: quantitative techniques and routes	37	(18)
Study objectives	39	(1)
Quantitative techniques: forecasting with regression analysis; forecasting with time-trend projections; forecasting using smoothing models	39	(10)
More complex time series forecasting methods	49	(2)
Forecasting routes	51	(1)
Concluding comments	52	(1)
Review questions	53	(2)
Forecasting cash flows: qualitative or judgemental techniques	55	(19)
Study objectives	56	(1)
Obtaining information from individuals	56	(4)
Using groups to make forecasts	60	(4)
The Delphi technique applied to appraising forestry projects	64	(1)
Example 4.1. Appraising forestry projects involving new species	65	(1)
Example 4.2. Collecting data for forestry projects involving new planting systems	66	(3)
Scenario projection	69	(1)
Example 4.3. Using scenario projection to forecast demand	70	(1)
Concluding comments: which technique is best?	71	(2)
Review questions	73	(1)
Essential formulae in project appraisal	74	(17)
Study objectives	75	(1)
Symbols used	75	(1)
Rate of return	76	(1)
Example 5.1	76	(1)
Note on timing and timing symbols	76	(1)
Future value of a single sum	77	(1)
Example 5.2	77	(1)
Example 5.3	78	(1)
Present value of a single sum	78	(1)
Example 5.4	78	(1)
Example 5.5	79	(1)
Future value of a series of cash flows	79	(1)
Example 5.6	79	(1)
Present value of a series of cash flows	80	(1)
Example 5.7	80	(1)
Example 5.8	80	(1)
Present value when the discount rate varies	81	(1)
Example 5.9	81	(1)
Present value of an ordinary annuity	81	(1)
Example 5.10	82	(1)
Present value of a deferred annuity	83	(1)
Example 5.11	83	(1)
Example 5.12	83	(1)
Perpetuity	84	(1)
Net present value	85	(1)
Example 5.13	85	(1)
Net present value of an infinite chain	85	(1)
Internal rate of return	86	(1)
Example 5.14	86	(1)
Loan calculations	87	(1)
Example 5.15	87	(2)
Loan amortization schedule	89	(1)
Concluding comments	89	(1)
Review questions	90	(1)
Project analysis under certainty	91	(23)
Study objectives	92	(1)
Certainty Assumption	92	(1)
Net present value model	93	(2)
The net present value model applied	95	(1)
Other project appraisal methods	96	(1)
Suitability of different project evaluation techniques	97	(5)
Mutual exclusivity and project ranking	102	(6)
Asset replacement investment decisions	108	(1)
Project retirement	109	(2)
Concluding comments	111	(1)
Review questions	111	(3)
Project analysis under risk	114	(19)
Study objectives	115	(1)
The concepts of risk and uncertainty	115	(1)
Main elements of the RADR and CE techniques	116	(2)
The risk-adjusted discount rate method	118	(1)
Estimating the RADR	118	(1)
Estimating the RADR using the firm's cost of capital	119	(1)
Example 7.1. Computation of the WACC for Costor Company	120	(1)
Estimating the RADR using the CAPM	120	(6)
The certainty equivalent method	126	(1)
Example 7.2. Computing NPV using CE: Cecorp	127	(1)
The relationship between CE and RADR	128	(1)
Example 7.3. Ceradr Company investment project	128	(1)
Comparison of RADR and CE	129	(1)
Concluding comments	130	(1)
Review questions	130	(3)
Sensitivity and break-even analysis	133	(20)
Study objectives	133	(1)
Sensitivity analysis	134	(1)
Procedures in sensitivity analysis	135	(1)
Sensitivity analysis example: Delta Project	135	(3)
Developing pessimistic and optimistic forecasts	138	(3)
Pessimistic and optimistic forecasts of variable values for the Delta Project example	141	(3)
Applying the sensitivity tests	144	(1)
Sensitivity test results	145	(4)
Break-even analysis	149	(1)
Break-even analysis and decision-making	150	(1)
Concluding comments	150	(1)
Review questions	151	(2)
Simulation concepts and methods	153	(32)
Study objectives	154	(1)
What is simulation?	154	(2)
Elements of simulation models for capital budgeting	156	(2)
Steps in simulation modelling and experimentation	158	(4)
Risk analysis or Monte Carlo simulation	162	(1)
Example 9.1. Computer project	163	(8)
Design and development of a more complex simulation model	171	(1)
Example 9.2. FlyByNight project	171	(4)
Deterministic simulation of financial performance	175	(1)
Example 9.3. FlyByNight deterministic model	175	(2)
Stochastic simulation of financial performance	177	(1)
Example 9.4. FlyByNight stochastic simulation	177	(2)
Choice of experimental design	179	(1)
Advantages and disadvantages of simulation compared with other techniques in capital budgeting	179	(1)
Concluding comments	180	(1)
Review questions	180	(1)
Appendix:Generation of random variates	181	(4)
Case study in financial modelling and simulation of a forestry investment	185	(19)
Study objectives	185	(1)
Key parameters for forestry models	186	(1)
Sources of variability in forestry investment performance	187	(2)
Methods of allowing for risk in the evaluation of forestry investments	189	(1)
Problems faced in developing forestry financial models	190	(1)
Developing a financial model: a step-by-step approach	191	(1)
Example 10.1. Flores Venture Capital Ltd forestry project	192	(7)
Comparing forestry projects of different harvest rotations	199	(1)
Example 10.2. FVC Ltd: comparison of one-stage and two-stage harvest options	199	(1)
Risk analysis or Monte Carlo analysis	200	(1)
Example 10.3. Simulation analysis of FVC Ltd forestry project	200	(2)
Concluding comments	202	(1)
Review questions	203	(1)
Resource constraints and linear programming	204	(15)
Study objectives	206	(1)
LP with two decision variables and three constraints	206	(1)
Example 11.1. Roclap: product mix problem	206	(6)
Investment opportunities and by-product constraints	212	(1)
Example 11.2. Capital rationing problem	212	(2)
LP and project choice	214	(1)
Example 11.3. Project portfolio selection problem	215	(2)
Concluding comments	217	(1)
Review questions	217	(2)
More advanced linear programming concepts and methods	219	(17)
Study objectives	219	(1)
Basic LP assumptions and their implications for capital budgeting	220	(1)
Expanding the number of projects and constraints	221	(1)
Example 12.1. Power generator's decision problem	222	(2)
Indivisible investments and integer activity levels	224	(1)
Example 12.2. Resort development problem	225	(1)
Borrowing and capital transfers	226	(1)
Example 12.3. Borrowing and capital transfer problem	226	(2)
Contingent or dependent projects	228	(1)
Example 12.4. Infrastructure problem	228	(1)
Mutually exclusive projects	229	(1)
Example 12.5. Sports gear problem	230	(1)
Some other LP extensions for capital budgeting	231	(2)
Concluding comments	233	(1)
Review questions	234	(2)
Financial modelling case study in forestry project evaluation	236	(15)
Study objectives	237	(1)
Forestry evaluation models: uses and user groups	237	(1)
Financial models available to evaluate forestry investments	238	(1)
The Australian Cabinet Timbers Financial Model (ACTFM)	239	(7)
Review of model development and design options	246	(3)
Concluding comments	249	(1)
Review questions	250	(1)
Property investment analysis	251	(23)
Study objectives	252	(1)
Income-producing properties	252	(4)
Example 14.1. Property cash flows from the industrial property	256	(2)
Example 14.2. Equity cash flows before tax from the industrial property	258	(3)
Example 14.3. Equity cash flows after tax from the industrial property	261	(2)
Corporate real estate	263	(1)
Example 14.4. Acquiring the industrial property for operations	263	(3)
Example 14.5. Leasing or buying the industrial property for operations	266	(2)
Development feasibility	268	(1)
Example 14.6. Initial screening of an industrial building project	268	(2)
Example 14.7. Project cash flows from a property development	270	(1)
Example 14.8. Equity cash flows from the development project	271	(1)
Concluding comments	272	(1)
Review questions	272	(2)
Forecasting and analysing risks in property investments	274	(23)
Study objectives	275	(1)
Forecasting	275	(3)
Example 15.1. Forecasting operating cash flows for the industrial property	278	(5)
Example 15.2. Forecasting resale proceeds for the industrial property	283	(2)
Example 15.3. Forecasting development cash flows for a residential project	285	(3)
Risk analysis	288	(1)
Example 15.4. Net present value of the industrial property-sensitivity analysis	289	(1)
Example 15.5. Overbuilding for the industrial property-scenario analysis	290	(3)
Example 15.6. Development risks-Monte Carlo (risk) simulation	293	(1)
Concluding comments	293	(2)
Review questions	295	(2)
Multinational corporations and international project appraisal	297	(16)
Study objectives	298	(1)
Definition of selected terms used in the chapter	298	(1)
The parent's perspective versus the subsidiary's perspective	299	(2)
Example 16.1. Garment project	301	(2)
Exchange rate risk	303	(1)
Country risk	304	(1)
A strategy to reduce a project's exchange rate and country risks	305	(4)
Other country risk reduction measures	309	(1)
Incorporating exchange rate and country risk in project analysis	310	(1)
Concluding comments	311	(1)
Review questions	311	(2)
References	313	(3)
Index	316