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1、Capital Budgeting Reconsidered,There are two major questions in Corporate Finance: The first regards what long-term investments the firm should make (the capital budgeting question). The second regards the use of equity or debt (the capital structure question).,Corporate Finance, Professor Ho-Mou Wu
2、,1A-1,Spring 2004,The Balance-Sheet Model of the Firm,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,1A-2,Investment Environment,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,1A-3,Capital Budgeting Reconsidered,Example 1: A Black Box Suppose you can put $ 1.00 into a black box and get $1.02
3、 back after one year with absolute certainty. Current interest rates are five percent. How much is the black box worth？,1A-4,Spring 2004,Corporate Finance, Professor Ho-Mou Wu,1. Strategic Values,1A-5,Example 1,：,(Continued),DCF,：,The black box is worthless because you can earn 5%,by putting your mo
4、ney in the bank.,NPV,Valuing Flexibility with ROA (Real Option Analysis):,The black box is valuable because it is an option (gives,you the right, but not the obligation, to use it) and,because interest rates are uncertain.,DCF (Discounted Cash Flows) can become misleading because it does not conside
5、r the option/ flexibility value This box offers.,Spring 2004,Corporate Finance, Professor Ho-Mou Wu,How to Identifying Option? An Ancient Greek Philosopher,Example 2: In the sixth century BC, Thales paid a fee to olive press owners in advance of the olive harvest season. Thales obtained the right to
6、 rent the olive presses during the harvest season at a predetermined price. Thales became a rich man. How did his scheme function？,1A-6,Spring 2004,Corporate Finance, Professor Ho-Mou Wu,Identifying Options and Strategic Values,underlying uncertainty: the harvest of olive, or as shown in the rental
7、value of olive press. expiration date: harvest season. exercise price: normal rental value (predetermined price). option premium: the fee Thales paid to reserve the olive press in advance. option payoffs: if the harvest is bountiful if the harvest is small strategic decision: exercise the right to r
8、ent the olive press,Example 2: (Continued),1A-7,Spring 2004,Corporate Finance, Professor Ho-Mou Wu,Two Crucial Questions for ROA,1A-8,Spring 2004,Corporate Finance, Professor Ho-Mou Wu,1.1 Real Options in Capital Budgeting,Example 3： Company A is considering whether it is worthwhile to purchase and
9、operate an oil field in Alaska. Buying the oil field costs $10m. Once the drilling equipments are in place, which cost $500m, the company can produce 10m barrels each year in perpetuity. With oil prices at $20 per barrel and extraction costs at $16 per barrel, the company receives a net margin of $4
10、 per barrel. Suppose the appropriate discount rate is 10%. Should the company buy and operate this oil field?,1A-9,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,Traditional Capital Budgeting,As we learned before, the DCF method gives us the following NPV： The expected cash flow is 410m per year
11、 forever. NPV According to NPV, company A should not purchase the oil field. Is this analysis correct?,1A-10,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,Find Options in Investment Decisions,1A-11,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,Use the Real Options in Investment Plans,1A-12
12、,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,Real Options and Capital Budgeting,A real options analysis (ROA) is needed in the following situations: When uncertainty is large enough that it is sensible to wait for more information, avoiding regret for irreversible investment. When uncertainty
13、 is large enough to make flexibility a consideration. When the value of investment depends on future growth rather than current cash flow. When there is a contingent investment decision. When there will be mid-course strategy corrections.,1A-13,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,1.2
14、Comparison of DCF and ROA,Example 4：DCFROA Suppose that you have to make an investment of $10m now which requires an amount of $115m to be spent next year. The investment project may generate either $170m or $65m profits next year with equal probabilities. The cost of capital of this project can be
15、calculated by finding a security with the same risk characteristics (or by CAPM). It is estimated to be 17.5%. The risk free-rate of interest is 8%. Would you recommend investing in this project？,1A-14,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,(A) DCF Flexibility Not Valued,Present Value of
16、 Cash Inflows, discounted at 17.5%： PV of benefits $100m Present Value of investment expenditures, discounted at 8% (since you are certain expenditure outlays in year 1)： PV of costs $106.5m Hence, NPV6.5m10m-16.5m0 Do Not Invest.,1A-15,Corporate Finance,Spring 2004, Professor Ho-Mou Wu,(B) ROA Flexibility Valued Correctly,(B1) By the “general principle of the binomial approach”, we can find the r
