Chapter 10 This chapter has described six techniques (NPV, IRR, MIRR, PI, payback, and discounted payback,) that are used in capital budgeting analysis. Each approach provides a different piece of information, so in this age of computers, managers often look at all of them when evaluating projects. However, NPV is the best single measure, and almost all firms now use NPV. The key concepts covered in this chapter are listed below:• Capital budgeting is the process of analyzing potential projects. Capital budgeting decisions are probably the most important ones managers must make. • The net present value (NPV) method discounts all cash flows at the project’s cost of capital and then sums those cash flows. The project should be accepted if the NPV is positive. • The internal rate of return (IRR) is defined as the discount rate that forces a project’s NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital. IRR is not dependent on the amount of capital used. • The NPV and IRR methods make the same accept/reject decisions for independent projects, but if projects are mutually exclusive, then ranking conflicts can arise. If conflicts arise, the NPV method should be used. The NPV and IRR methods are both superior to the payback, but NPV is superior to IRR. • The NPV method assumes that cash flows will be reinvested at the firm’s cost of capital, while the IRR method assumes reinvestment at the project’s IRR.Reinvestment at the cost of capital is generally a better assumption because it is closer to reality. • The modified IRR (MIRR) method corrects some of the problems with the regular IRR. MIRR involves indexing the terminal value (TV) of the cash inflows, compounded at the firm’s cost of capital, and then determining the discount rate that forces the present value of the TV to equal the present value of the outflows. • The profitability index (PI) shows the dollars of present value divided by the initial cost, so it measures relative profitability. • The payback period is defined as the number of years required to recover a project’s cost. The regular payback method ignores cash flows beyond the payback period, and it does not consider the time value of money. The payback does, however, provide an indication of a project’s risk and liquidity, because it shows how long the invested capital will be “at risk.” • The discounted payback method is similar to the regular payback method except that it discounts cash flows at the project’s cost of capital. It considers the time value of money, but it ignores cash flows beyond the payback period. • If mutually exclusive projects have unequal lives, it may be necessary to adjust the analysis to put the projects on an equal-life basis. This can be done using the replacement chain (common life) approach or the equivalent annual annuity (EAA) approach. • A project’s true value may be greater than the NPV based on its physical life if it can be terminated at the end of its economic life. • Flotation costs and increased riskiness associated with unusually large expansion programs can cause the marginal cost of capital to rise as the size of the capital budget increases. • Capital rationing occurs when management places a constraint on the size of the firm’s capital budget during a particular period.Chapter 11 Throughout the book, we have indicated that the value of any asset depends on the amount, timing, and risk of the cash flows it produces. In this chapter, we developed a framework for analyzing a project’s cash flows and risk. The key concepts covered are listed below.

• The most important (and most difficult) step in analyzing a capital budgeting project is estimating the incremental after-tax cash flows the project will produce. • Project cash flow is different from accounting income. Project cash flow reflects (1) cash outlays for fixed assets, (2) the tax shield provided by depreciation, and (3) cash flows due to changes in net operating working capital.Project cash flow does not include interest payments. • In determining incremental cash flows, opportunity costs (the cash flows forgone by using an asset) must be included, but sunk costs (cash outlays that have been made and that cannot be recouped) are not included. Any externalities (effects of a project on other parts of the firm) should also be reflected in the analysis. • Cannibalization occurs when a new project leads to a reduction in sales of an existing product. • Tax laws affect cash flow analysis in two ways: (1) They reduce operating cash flows, and (2) they determine the depreciation expense that can be taken in each year. • Capital projects often require additional investments in net operating working capital (NOWC). • The incremental cash flows from a typical project can be classified into three categories: (1) initial investment outlay, (2) operating cash flows over the project’s life, and (3) terminal year cash flows. • Inflation effects must be considered in project analysis. The best procedure is to build expected inflation into the cash flow estimates. • Since stockholders are generally diversified, market risk is theoretically the most relevant measure of risk. Market, or beta, risk is important because beta affects the cost of capital, which, in turn, affects stock prices. • Corporate risk is important because it influences the firm’s ability to use lowcost debt, to maintain smooth operations over time, and to avoid crises that might consume management’s energy and disrupt its employees, customers, suppliers, and community. • Sensitivity analysis is a technique that shows how much a project’s NPV will change in response to a given change in an input variable such as sales, other things held constant. • Scenario analysis is a risk analysis technique in which the best- and worstcase NPVs are compared with the project’s expected NPV. • Monte Carlo simulation is a risk analysis technique that uses a computer to simulate future events and thus to estimate the profitability and riskiness of a project. • The risk-adjusted discount rate, or project cost of capital, is the rate used to evaluate a particular project. It is based on the corporate WACC, which is increased for projects that are riskier than the firm’s average project but decreased for less risky projects. • Decision tree analysis shows how different decisions in a project’s life affect its value. • Opportunities to respond to changing circumstances are called managerial options because they give managers the option to influence the outcome of a project. They are also called strategic options because they are often associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called real options because they involve “real,” rather than “financial,” assets. Many projects include a variety of embedded options that can dramatically affect the true NPV. • An investment timing option involves not only the decision of whether to proceed with a project but also the decision of when to proceed with it. This opportunity to affect a project’s timing can dramatically change its estimated value. • Agrowth option occurs if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible. These include (1) options to expand output, (2) options to enter a new geographical market, and (3) options to introduce complementary products or successive generations of products. Chapter 13 - • Corporate assets consist of operating assets and financial, or nonoperating, assets. • Operating assets take two forms: assets-in-place and growth options. • Assets-in-place include the land, buildings, machines, and

inventory that the firm uses in its operations to produce products and services. • Growth options refer to opportunities the firm has to increase sales. They include opportunities arising from R&D expenditures, customer relationships, and the like. • Financial, or nonoperating, assets are distinguished from operating assets and include items such as investments in marketable securities and noncontrolling interests in the stock of other companies. • The value of nonoperating assets is usually close to the figure reported on the balance sheet. • The value of operations is the present value of all the future free cash flows expected from operations when discounted at the weighted average cost of capital: • The terminal, or horizon, value is the value of operations at the end of the explicit forecast period. It is also called the continuing value, and it is equal to the present value of all free cash flows beyond the forecast period, discounted back to the end of the forecast period at the weighted average cost of capital: • The corporate valuation model can be used to calculate the total value of a company by finding the value of operations plus the value of nonoperating assets. • The value of equity is the total value of the company minus the value of the debt and preferred stock. The price per share is the total value of the equity divided by the number of shares. • Value-based management involves the systematic use of the corporatevaluation model to evaluate a company’s potential decisions. • The four value drivers are (1) the growth rate in sales (g), (2) operating profitability (OP), which is measured by the ratio of NOPAT to sales, (3) capital requirements (CR) as measured by the ratio of operating capital to sales, and (4) the weighted average cost of capital (WACC). • Expected return on invested capital (EROIC) is equal to expected NOPAT divided by the amount of capital that is available at the beginning of the year. • Acompany creates value when the spread between EROIC and WACC is positive, that is, when EROIC - WACC > 0. • Corporate governance involves the manner in which shareholders’ objectives are implemented, and it is reflected in a company’s policies and actions. • The two primary mechanisms used in corporate governance are: (1) the threat of removal of a poorly performing CEO and (2) the type of plan used to compensate executives and managers. • Poorly performing managers can be removed either by a takeover or by the company’s own board of directors. Provisions in the corporate charter affect the difficulty of a successful takeover, and the composition of the board of directors affects the likelihood of a manager being removed by the board. • Managerial entrenchment is most likely when a company has a weak board of directors coupled with strong anti-takeover provisions in its corporate charter. In this situation, the likelihood that badly performing senior managers will be fired is low. • Nonpecuniary benefits are noncash perks such as lavish offices, memberships at country clubs, corporate jets, foreign junkets, and the like. Some of these expenditures may be cost effective, but others are wasteful and simply reduce profits. Such fat is almost always cut after a hostile takeover. • Targeted share repurchases, also known as greenmail, occur when a company buys back stock from a potential acquirer at a higher than fair market price. In return, the potential acquirer agrees not to attempt to take over the company. • Shareholder rights provisions, also known as poison pills, allow existing shareholders to purchase additional shares of stock at a lower than market value if a potential acquirer purchases a controlling stake in the company. • Arestricted voting rights provision automatically deprives a shareholder of voting rights if the shareholder owns more than a specified amount of stock. • Interlocking boards of directors occur when the CEO of Company A sits on the board of Company B, and B’s CEO sits on A’s board. • A stock option provides for the purchase of a share of

stock at a fixed price, called the exercise price, no matter what the actual price of the stock is. Stock options have an expiration date, after which they cannot be exercised. • An Employee Stock Ownership Plan, or ESOP, is a plan that facilitates employees’ ownership of stock in the company for which they work. Chapter 26 (real options) - In this chapter we discussed some topics that go beyond the simple capital budgeting framework, including the following: • Investing in a new project often brings with it a potential increase in the firm’s future opportunities. Opportunities are, in effect, options—the right but not the obligation to take some future action. • Aproject may have an option value that is not accounted for in a conventional NPV analysis. Any project that expands the firm’s set of opportunities has positive option value. • Real options are opportunities for management to respond to changes in market conditions and involve “real” rather than “financial” assets. There are five possible procedures for valuing real options: (1) DCF analysis only, and ignore the real option, (2) DCF analysis and a qualitative assessment of the real option’s value, (3) decision tree analysis, (4) analysis with a standard model for an existing financial option, and (5) financial engineering techniques. Investment timing (such as waiting a year to proceed),