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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:

 


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.

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


Adam Smith
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