Capital Budgeting Decision Rules

1
Capital Budgeting Decision Rules

• What real investments should firms make?

2
Alternative Rules in Use Today

• NPV
• IRR
• Profitability Index
• Payback Period
• Discounted Payback Period
• Accounting Rate of Return

3
What Provides Good Decision-Making?

• Our work has shown that several criteria must be
  satisfied by any good decision rule
• Decision rule should be based upon cash flow.
• The rule should incorporate all the incremental
  cash flows attributable to the project.
• The rule should discount cash flows appropriately
  taking into account the time value of money and
  properly adjusting for the risk inherent in the
  project. - Opportunity cost of capital.
• When forced to choose between projects, the
  choice should be governed by maximizing
  shareholder wealth given any relevant constraints.

4
NPV Analysis

• The recommended approach to any significant
  capital budgeting decision is NPV analysis.
• NPV PV of the incremental benefits PV of
  the incremental costs.
• NPV based decision rule
• When evaluating independent projects, take those
  with positive NPVs, reject those with negative
  NPVs.
• When evaluating interdependent projects, take the
  feasible combination with the highest combined
  NPV.

5
Lockheed Tri-Star

• As an example of the use of NPV analysis we will
  use the Lockheed Tri-Star case.
• To examine the decision to invest in the Tri-Star
  project, we first need to forecast the cash flows
  associated with the Tri-Star project for a volume
  of 210 planes.
• Then we can ask What is a valid estimate of the
  NPV of the Tri-Star project at a volume of 210
  planes as of 1967.

6
Lockheed Tri-Star Key Points

• Pre-production costs estimated at 900 million
  incurred between 1967 and 1971.
• Total of 210 planes delivered from 1972-1977
• Revenues of 16 million per unit, 25 of revenue
  received 2 years in advance of delivery.
• Production costs of 14 million (at 210 units
  could decline to 12.5 million at 300) from
  1971-1976.
• Discount rate of 10 per year.

7
Tri-Star Cash Flows

• 210 planes (1972-1977)
• Planes per year 210/635
• Production Costs (1971-1976)
• 35(14M)490M per year
• Dont forget the preproduction costs of 900M
• Revenues (1970-1977)
• Total Revenues 35(16M)560M per year
• Deposits0.25(560M)140M (2 yrs in advance)
• Net Revenues560-140420M on delivery

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Tri-Star Cash Flows(210 Planes)
9
Tri-Star NPV _at_10 in 1967
10
Accounting Profits at 210

• Production revenues are 16M per plane and
  production costs are 14M per plane. Profit is
  2M per plane.
• 2102M 420M production profits. 420M vs.
  900M preproduction costs is breakeven?
• Suppose production cost is 12.5M per plane
  (learning curve hits early). Profit per plane is
  3.5M. At 210 planes this is 735M production
  profit.
• Now take the extreme low-end of the 800M - 1B
  preproduction cost range.
• Suddenly you have breakeven. Smart huh?

11
Tri-Star NPV 1967 (Millions)
Units Sold Average Unit Cost Accounting Profit NPV
323 12.25 311 -195
400 12.00 700 -12
400 11.75 800 42
500 11.00 1,600 441
12
Tri-Star Cash Flows 1970(210 Planes)
13
1970 Tri-Star NPV _at_10
14
Tri Star Post Mortem

• Accounting breakeven approximately 275 planes
• 16M - 12.5M 3.5M per plane
• 3.5M?275 962M profit versus 960M in actual
  development costs known in 1970
• This more realistic breakeven level announced
  subsequent to the guarantees being granted.
• NPV breakeven approximately 400 planes
• Total free world market demand for wide-body
  aircraft approximately 325 planes
• Optimistic estimate total demand 775 and 40 of
  that is 310
• Lockheed share price
• 64 Jan 1967 drops to 11 Jan 1971
• (64-11)(11.3 Million shares)-599 Million
• Compare to -584 Million NPV