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Created 7/1/1996
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Business Administration 130:

Capital Budgeting and Performance

http://www.j-bradford-delong.net/Intro_Finance/BAonethirty12.html

Basics:

• Present value of a perpetuity: C/r
• Present value of a growing (or shrinking) perpetuity: C/(r-g)
• Present value of C dollars t years from now: C/[(1+r)^t]
• Present value of a C-dollar t-year annuity: C[(1/r)-(1/[r(1+r)^t])
• "Rule of 72": (1+r)^t = 2 (approximately) whenever rt=.72
• beta = [E((r₁-r*₁)(r_m-r*_m)]/[(r_m-r*_m)²]
• r*_i = r*_f + beta_i(r*_m-r_f)
• Expected return of a portfolio with N securities, a share 1/N invested in each security:
  
• Standard deviation of a portfolio with N securities, a share 1/N invested in each security:
  

Capital Budgets and Project Authorizations:

Who is allowed to do what when; plant managers "identify" opportunties; division managers review them; negotiations; construction of a capital budget.

Formal appropriation requests for each proposal in the capital budget. Scapens and Sale found that any capital expenditure of more than 0.1% of a firm's annual capital budget had to be approved by top management. This is an extraordinarily low ceiling--

Everyone uses DCF, but they use other things as well:

Payback; ease of communication; fear of finance; vulnerability of DCF to things happening far in the future--and distrust of long-run projections.

Controlling capital expenditures--the foot in the door problem, the piecemeal commitment problem.

Problems in Capital Budgeting:

Ensuring that forecasts are consistent (across departments)

Eliminating (reducing) conflicts of interest

Reducing forecast bias: the proportion of proposed projects that have a positive NPV is independent of the estimated opportunity cost of capital.

Bottom-up and top-down planning are necessary.

Control projects in progress

Post-audit afterwards

Try hard to measure incremental cash flows--when you can

Evaluate performance: actual versus projected; actual versus absolute standard of the true cost of capital.

Biases in Accounting Rates of Return:

After tax rates of return:

Pharmaceuticals		Chemicals
J&J	12.8%	du Pont	1.6%
Bristol-Myers	16.8%	Dow	4.4%
Merck	19.0%	Monsanto	4.4%
Abbot	17.6%	Hoechst	2.1%
AHP	20.6%	Grace	1.4%
Pfizer	7.8%	Union Carbide	1.6%
Average:	14.8%	Average:	2.6%

What is going on here? Are all investments in chemical companies absurdly poor? No. Consider a stylized example:

	Pharmaceutical	Chemical
Revenues	$1000	$1000
Operating costs	$500	$500
Investment in P&E	$100	$300
Investment in R&D	$300	$100
Cash Flow:	$100	$100
Book value (10-Yr P&E Life)	$550	$1650
Book ROI	18%	6%

First lesson: businesses with high book ROI's may just hve more "hidden" off balance-sheet assets.

Economic Depreciation: Change in the present value of an asset (market value if there is a good used-sset market)

Because accounting biases are hard to measure, many firms end up asking not "did the widget division earn more than its cost of capital?" but "was the widget division's book ROI typical of a successful widget industry firm?" Makes sense if (a) similar accounting procedures are used by all widget manufacturers and (b) successful widget companies earn their cost of capital.

Book Measures are wrong because:

Errors occur at different stages of project life; when true depreciation is decelerated, book measures understate profitability for new projects (and overstate it for old ones).

Steady-state ROIs are biased unless the growth rate of the company equals the true rate of return even when you have a balanced mix of projects

Errors occur because inflation shows up in revenues faster than in costs

"Creative accounting"

Brealey and Myers wish that managers (and the stock market) didn't worry about accounting earnings so much

Six Lessons of Market Efficiency

You've learned how to spend money. Now let's figure out how to raise it.

Capital structure problems: dividends/retain earnings; issue stock/issue bonds; short/long term debt; normal securities/fancy option securities

We always come back to NPV

We assume that capital markets are efficient.

• that all relevant and ascertainable information is reflected in the market price already because it is widely and cheaply available to investors.

   

• Stock prices are a random walk (with drift)
• Weak efficiency: the past pattern of prices doesn't allow you to make money
• Published information doesn't allow you to make money
• All the hard work in the world doesn't allow you to make money

There are some conspicuously bad portfolio managers. There are few consistently good ones.

The crash of '87 as a challenge to the efficient markets hypothesis. What was the news? Response seems to be (a) the market is better at relative prices than at absolute benchmarks, and (b) with P=D/(r-g) only a small shift in g is necessary to produce big shifts in P.

Anomalies:

Small firm effect

January effect

Long-term patterns

Lesson 1: Markets have no memory

Lesson 2: Trust market prices (more than your own hunches)

Lesson 3: Look at market prices in detail to predict the future (term structure; market's unfavorable assessment of Viacom's takeover of Paramount)

Lesson 4: Do not believe in financial illusions

Lesson 5: Value is lost when the company does something that a shareholder can do on his own for smaller transaction costs

Lesson 6: Demands for stocks should be highly, highly elastic.

Note that the efficient markets hypothesis does not mean that the financing of a corporation will "take care of itself"; it provides a starting point, not an ending point, for analyis.

Exam:

Handout out in your boxes. Some statistics on exam

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