Capital Budgeting Decision Rules

What real investments should firms make?

Alternative Rules in Use Today NPV IRR Profitability Index

Payback Period Discounted Payback Period

Accounting Rate of Return

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.

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.

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.

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.

Tri-Star Cash Flows 210 planes (1972-1977)

Planes per year = 210/6=35 Production Costs (1971-1976)

35($14M)=$490M per year Don’t forget the preproduction costs of $900M

Revenues (1970-1977) Total Revenues 35($16M)=$560M per year Deposits=0.25($560M)=$140M (2 yrs in

advance) Net Revenues=$560-$140=$420M on delivery

Year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Pre Prod.

-100 -200 -200 -200 -200

Costs -490 -490 -490 -490 -490 -490 Dep. 140 140 140 140 140 140 Revs. 420 420 420 420 420 420 Total Cash Flow

-100 -200 -200 -60 -550 70 70 70 70 -70 420

Tri-Star Cash FlowsTri-Star Cash Flows(210 Planes)(210 Planes)

Tri-Star NPV @10% in 1967

Million

NPV

584$)10.1(

420)10.1(

70)10.1(

70)10.1(

70)10.1(

70)10.1(

70)10.1(

550)10.1(

60)10.1(

200)10.1(

200100

109876

5432

Accounting Profits at 210 Production revenues are $16M per plane and

production costs are $14M per plane. Profit is $2M per plane.

210×$2M = $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?

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

Year 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 Pre Prod.

-200

Costs -490 -490 -490 -490 -490 -490 Dep. 140 140 140 140 140 140 Revs. 420 420 420 420 420 420 Total Cash Flow

0 0 0 140 -550 70 70 70 70 -70 420

Tri-Star Cash Flows 1970Tri-Star Cash Flows 1970(210 Planes)(210 Planes)

1970 Tri-Star NPV @10%1970 Tri-Star NPV @10%

Million

NPV

18$

)10.1(420

)10.1(70

)10.1(70

)10.1(70

)10.1(70

)10.1(70

)10.1(550140

76

5432

Tri Star Post Mortem Accounting breakeven approximately 275 planes

$16M - $12.5M = $3.5M per plane $3.5M275 = $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