Chapter 9

CAPITAL BUGDETING
ADITIONAL ASPECTS

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 CAPITAL RATIONING

PROJECT IRR Rm Rm

A 28% 5 5
B 21% 4 9
C 20% 5 14
D 18% 3 17
E 12% 5 22

COST OF CAPITAL 15%

The Company should select Projects A,B,C, D
and reject E. Yet the firm is only able to
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 Why does Capital Rationing
occur?
• Hard Capital Rationing
– Capital Markets. Does this mean
capital markets are not efficient?
• Soft Capital Rationing
– Use of capital limits to ensure
subsidiaries prioritise investments.
Capital limits ensures discipline in
relation to investments by lower level
management.
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 Required Returns for
Individual Projects That
Vary in Risk Levels
• Higher hurdle rates should be
used for projects that are
riskier than the existing firm,
and lower hurdle rates should
be used for lower risk projects.
• Measuring risk and specifying
the tradeoff between required
return and risk, however, are
indeed difficult endeavors

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 Inflation and Capital
Budgeting
• Inflation is an important fact of economic
life and must be considered in capital
budgeting.
• Consider the relationship between interest
rates and inflation, often referred to as the
Fisher relationship:
(1 + Nominal Rate) = (1 + Real Rate) × (1 +
Inflation Rate)
• For low rates of inflation, this is often
approximated as
Real Rate ≅ Nominal Rate – Inflation Rate
• While the nominal rate in the U.S. has
fluctuated with inflation, most of the time
the real rate has exhibited far less variance
than the nominal rate.
• When accounting for inflation in capital
budgeting, one must compare real cash
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cash flows discounted at nominal rates. 5
 Capital Budgeting and
Inflation
• No adjustment for inflation may result
in material errors in capital budgeting
decisions.
• Why? Inflation is included implicitly in
the discount rate
• Nominal rate = (1+ Real rate)
(1+Inflation rate) - 1
• If the expected inflation rate is 7%
and the real rate is 4%, then the
nominal (quoted) rate is 11.3%.

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 Capital Budgeting under
Inflation
NO ADJUSTMENT FO
COST
COST OF CAPITAL
INFLATION
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REAL RETURN 7
 Example of Capital
Budgeting under Inflation
Sony International has an investment opportunity to
produce a new stereo color TV.
The required investment on January 1 of this year is
$32 million. The firm will depreciate the investment
to zero using the straight-line method. The firm is in
the 34% tax bracket.
The price of the product on January 1 will be $400 per
unit. The price will stay constant in real terms.
Labor costs will be $15 per hour on January 1. The will
increase at 2% per year in real terms.
Energy costs will be $5 per TV; they will increase 3%
per year in real terms.
The inflation rate is 5% Revenues are received and
costs are paid at year-end.

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 Profitability Index (Benefit-Cost
Ratio)
• A project’s PI measures the return
of a project relative to cost

• PI = Present Value/Cost
– If PI > 1 = Accept the project
– If PI < 1 = Reject the project

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 Capital Budgeting under
Inflation
CASH FLOWS ADJUS
COST
COST OF CAPITAL
INFLATION
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REAL RETURN 10
 Example of Capital Budgeting under
Inflation
Year 1 Year 2 Year 3 Year 4

Physical 100,000 200,000 200,000 150,000

Production
(units)
Labor Input 2,000,00 2,000,00 2,000,00 2,000,00
(hours) 0 0 0 0

Energy input, 200,000 200,000 200,000 200,000

physical units

The riskless nominal discount rate is 4%.

The real discount rate for costs and revenues is 8%.
Calculate the NPV.
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 Strategic (Real) Options
• Real NPV = NPV + Value of Embedded options

Examples
• Flexibility of Process: Different mixes of inputs to
produce same output
• The Option to abandon the project - exit values
• The Option to Expand the project
• Temporary Closure
• Termination
• The ability to delay the project
• Leasing structures
• Research & Development
• Exploration
• Sequencing of Investments
• Taxation
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 Optimal Economic Lives
• Abandonment Value & Continuing
evaluation of projects
– Compare a project’s economic value
(PV of future cash flows) to its
abandonment value
• Replacement timing
– Use EAC to determine the optimal time
to replace assets

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