Project Evaluation

Copyright 1995 by Campbell R. Harvey. All rights reserved. No part of this lecture may be reproduced without the permission of the author.

1. Introduction

We have assumed that the firm selects positive net present value projects. Our concern was with the financing of the investment projects in terms of the capital structure of the firm and the allocation of cash flows via the dividend decision. In this lecture, we examine in some detail what goes into the decision to accept an investment project. We will apply the technique of net present value and develop some rules known as capital budgeting. There are four basic rules for calculating net cash flows. First, use inflows and outflows of cash when they occur -- avoid using "accounting variables". Second, use after-tax net cash flows. Third, use only cash exchanges. In general, it is not appropriate to include opportunity costs. Fourth, discount after-tax cash flows at the after-tax interest rate. Some of the common mistakes in capital budgeting are also highlighted. These include mixing real and nominal cash flows, ignoring embedded options in the project, and ignoring the shadow cost of management time to run or oversee the project. Different appraisal methods are then examined. There is some discussion of decision trees and Monte Carlo simulation in project evaluation. Finally, I close with a brief discussion of mergers and acquistions.

2. The Cash Flows that Should be Included in NPV Calculations

The net present value of a project can be represented as:
      NPV(project) = PV(with project) - PV(without project)

Let's consider an example of this type of calculation.


A large manufacturing firm is considering improving its computer facility. The firm currently has a computer which can be upgraded at a cost of $200,000. The upgraded computer will be useful for 5 years and will provide cost savings of $75,000 per year. The current market value of the computer is $100,000. The cost of capital is 15%. Should the computer be upgraded?
The alternatives available to the manufacturing firm are: (1) do not upgrade the computer or (2) upgrade the computer. The NPV of upgrading is:

The net present value is positive. This means that the firm should go ahead with acquisition. Notice that the market value of the computer is not included. It is irrelevant for the upgrading decision. Further note that a number of simplifying assumptions have been made such as a constant discount rate and zero tax rate. Let's be more precise about the capital budgeting decision. First, we need to introduce some notation.

The net cash flow in period t is:
        X_t= R_t - E_t - TAX_t - I_t + S_t

Taxes are defined to be:
     Tax_t = T × (R_t - E_t - D_t)

Substituting the expression for taxes into the first equation yields:
   X_t = (1-T) × (R_t - E_t) + (T × D_t) - I_t + S_t
Note that we are making a number of simplifying assumptions about the taxation. In an real world application, one would want to consider (1) carry forward and carry back rules, (2) investment tax credits, (3) sufficiency of taxable income, and (4) special tax circumstances (e.g. mining and petroleum).

3. Inflation and Capital Budgeting

Inflation can have a major impact upon the capital budgeting decision. At one level, the expectation of inflation is captured in the nominal interest rate. The discount rate that we use in evaluating the present value of a project is a function of the nominal interest rate as well as the risk of the cash flows. The real rate of interest (nominal interest rate less expected inflation) is less volatile than the nominal rate. At another level, the cash flows of the project could be affected by the inflation rate. If nominal interest rates reflect expected inflation, then we should make sure that the cash flows that we are discounting also reflect expected inflation. There are two alternatives available. First, use nominal cash flows and nominal discount rates for the capital budgeting decision. Second, use real cash flows and real discount rates. It is simple to show that discounting nominal cash flows with the nominal rate is equivalent to discounting real cash flows with a real rate. If you mix real cash flows with the nominal rate or vice versa, then net present value will be incorrect. This could lead one to accept an investment project when you have rejected it. There are some why the net cash flows may not grow at the inflation rate. The first reason has to do with the depreciation tax shield. Remember that:
     X_t = (1 - T) × (R_t - E_t) + (T × D_t) - I_t + S_t

It is possible that R_t, E_t, I_t and S_t all grow at the inflation rate. However, the depreciation, D_t is nominally fixed which means that it does not grow with inflation. As a result, it is unlikely that the cash flows grow at the rate of inflation. The second reason has to do with relative price changes. The inflation rate captured in the interest rate reflects average inflation in the economy. But the prices of different goods change at different rates. As a result, if the prices of the goods that are reflected in the cash flows of the firm could rise faster or slower than the average rate which is captured in the interest rate.

4. Applications

4.1 Example 1 (Ross-Westerfield)

(a) Suppose a firm is considering an investment of $300,000 in an asset with a useful life of five years. The firm estimates that the annual cash revenues and expenses will be $140,000 and $40,000, respectively. The annual depreciation based on historical cost will be $60,000. The required rate of return on a project of this risk is 13%. The marginal tax rate is 34%. What is the NPV of this project? (b) The 13% required rate of return is a nominal required return including inflation. Suppose the firm has forgotten that revenues and expenses are likely to increase with inflation at a 5% annual rate. Recalculate the NPV. Is this a more attractive proposal now that inflation has been taken into account.
Solution (a)
Calculate the after-tax cash flows:
               Year 1   Year 2   Year 3   Year 4   Year 5

Cash Revenue   140,000  140,000  140,000  140,000  140,000
Cash Expenses   40,000   40,000   40,000   40,000   40,000
Depreciation    60,000   60,000   60,000   60,000   60,000
Taxes Paid      13,600   13,600   13,600   13,600   13,600
After-tax Cash  86,400   86,400   86,400   86,400   86,400

Calculate the PV of the cash flows:

We could also work this out as:

The PV of the cash flows is $303,889. The initial outlay is $300,000 so the NPV of the project is $3,889.

Solution (b)
Calculate the after-tax cash flows:
               Year 1   Year 2   Year 3   Year 4   Year 5

Cash Revenue   147,000  154,350  162,068  170,171  178,679
Cash Expenses   42,000   44,100   46,305   48,620   51,051
Depreciation    60,000   60,000   60,000   60,000   60,000
Taxes Paid      15,300   17,085   18,959   20,927   22,954
After-tax Cash  89,700   93,165   96,804  100,624  104,634

Calculate the PV of the cash flows:

The PV of these cash flows is $337,938. With the initial outlay of $300,000, the NPV is $37,938. The project is far more attractive now.

4.2 Example 2 (Ross-Westerfield)

You have been asked to value orange groves owned by the Roll Corporation. The groves produce 1.6 billion oranges per year. Oranges currently sell for $.10 per 100. With normal maintenance, this level of production can be sustained indefinitely. Variable costs (primarily upkeep and harvesting) are $1.2 million per year. Fixed costs are negligible. The nominal discount rate is 18%, and the inflation rate is 10%. Assuming that orange prices and the variable costs move with inflation, what is the value of the orange groves (ignore taxes and depreciation).
First, the current cash flow is 1.6 billions oranges at $.001 each less $1.2 million in costs, or $.4 million per year. At this point, it is tempting to treat the $.4 million as a perpetuity and divide it by .18 to calculate the value. This would be a mistake. The $.4 million does not reflect future inflation. The 18% discount rate \underbar{does} reflect inflation. The mistake would be dividing a real cash flow by the nominal rate. To be consistent, we need to use either the real cash flows and the real discount rate or the nominal cash flows and the nominal discount rate. Let's do both. The real discount rate is

The value of the perpetuity is:

The nominal discount rate is 18%. The nominal cash flows are growing at a constant rate of 10% per year. Next year's cash flow is .4 × 1.1=$.44 million. The present value is

This uses the formula of the present value of a growing perpetuity. If we are assessing the present value (at time t=0 of some cash flows that grow at a constant rate g and the discount rate is k, the formula is:

4.3 Example 3 (Ross-Westerfield)

The Trout Corporation is deciding whether or not to introduce a new form of aluminum siding. Projected sales, total new net working capital (NWC) requirements and capital investments are:
Year  Sales('000)    NWC('000)    Capital('000)

 0        0            400         20,000
 1     5000            500
 2      600            500
 3     9000            700
 4   10,000            700
 5   10,000            700
 6   10,000            700

Variable costs are 60% of sales, and fixed costs are negligible. The $20 million in production equipment (capital investment CI) will be depreciated straight-line to $0 over 5 years. It will actually be worth $10 million in six years. If 10% is the required return, should Trout proceed. The corporate tax rate is 34%.
         Year 0  Year 1  Year 2  Year 3  Year 4  Year 5  Year 6   

Sales              5000    6000    9000   10000   10000   10000   
Costs              3000    3600    5400    6000    6000    6000   
Deprec.            4000    4000    4000    4000    4000       0   

Cash Flow          2680    2944    3736    4000    4000    2640   

NWC         400     100       0     200       0       0    -700   
CI        20000                                           -6600   

Required  20400     100       0     200       0       0   -7300   

Flows    -20400    2580    2944    3536    4000    4000    9940   

Notice that I am assuming that Trout can take full advantage of the depreciation tax shield. Notice also that the capital equipment is worth $10 million in year 6. When it is sold, the after tax revenue is $6.6 million. The present value of the future cash flows is $18.261 million. The total initial outlays is $20.4 million. So the NPV of this project is -$2.139 million. Hence it should be rejected.

4.4 Example

The WWW company is cash rich and is looking to take over another firm. The required rate of return that investors in WWW demand is 18%. Three potential takeover possibilities exist. The first firm (code named by its industry group) is Leisure Inc. This firm has the ability to deliever net after tax cash flows of $100,000 in the first year and a growth rate of 6% indefinitely. The second firm is Graphics Inc. Graphics can deliver $140,000 in the first year and a 4% growth rate thereafter. Finally, Paint Inc. will deliver $120,000 in the first year and 5% growth indefinitely. The expected return on the market is 13%. The risk free rate is 7%. The betas for Leisure, Graphics and Paint are 1.16, 1.64 and 0.70 respectively. All of these firm should be able to be taken over for $1 million. Which one do you choose?
First, calculate the expected (required rates) of return on each of these firms. Using the CAPM:
Division    Beta          Required Return

Leisure 1.16 .07 + 1.16[.13 - .07] = 13.96% Graphics 1.64 .07 + 1.64[.13 - .07] = 16.84% Paint 0.70 .07 + 0.70[.13 - .07] = 11.20%

Now calculate the present values of the cash flows.

The highest net present value is found with Paint Inc.

5. Appraisal Rules

Throughout this course, we have stated that the value of the asset is the discounted present value of the asset's cash flows. We have assumed that the net present value rule is the only rule that should be considered. In fact, businesses use many other rules to evaluate investment projects. Sometimes these rules give the correct evaluation (consistent with NPV). But it is possible that these other rules yield an incorrect assessment of the worth of an investment project. There are two type of projects that we will be considering. The first category is independent projects. This means that accepting one project does not affect decisions about the other project. The second category is mutually exclusive projects. This means that only one of a given set of projects can be taken (e.g. different sized factories). The purpose of this lecture is to compare the other techniques to the present value rule. These other techniques are: (1) Internal Rate of Return, (2) Payback, (3) Discounted Payback, (4) Profitability Index. The bottom line is to always use net present value. Given that you work at a firm that uses one of the four alternative techniques, you have to know what is wrong with these techniques if you are going to sell the firm on net present value as the only capital budgeting rule.

5.1 Why Net Present Value is the Dominant Rule

Suppose we are evaluating an investment project. The NPV rule tells us that the project should be accepted. But one of the alternative rules tells us that the project should be rejected. The correct investment decision maximizes the market value of the firm. The initial market value of the firm is:

$$V_0=\sum_{t=0}^{\infty}{X_t-I_t\over (1+r)^t}$$ where X_t represents the gross cash flows from investment projects and I_t represents the costs of the investment projects. All of the variables are after-tax measures. Now consider X_{j,t} and I_{j,t} to be the incremental after-tax net cash flows associated with candidate project j. The value of the firm with the project is:

The candidate project should be accepted if:

Writing this out in terms of the definitions of the values:

This implies:

This is just the Net Present Value rule for project j. Hence, the NPV rule always provides the correct investment decision.

5.2 Internal Rate of Return

The internal rate of return is:

The IRR is the interest rate that makes the value of the discounted cash flows equal to zero. The project selection rule is:

The rate R delivers the net present value. If the discount rate is higher than R and the discounted value is non-negative, then one would think that the IRR rule is delivering a similar evaluation as Net Present Value. In fact, IRR can be consistent with NPV. If the cash flows are normal and the term structure is flat, then the IRR should given the correct evaluation for independent projects. Consider the graphical representation:

Now let's consider when this rule breaks down:

5.2.1 Evaluation of Borrowing

Consider the following investment project.
Period    Cash Flow

  0         1000
  1        -1500

This project can be thought of as borrowing. Now consider solving for the IRR.

We can safely assume that the IRR is greater than R. The rule suggests that we should accept this project. Clearly, this is an incorrect evaluation.

5.2.2 Multiple Rates of Return

It was mentioned earlier that the internal rate of return rule worked for normal cash flows and a flat term structure. Consider an example of non-normal cash flows.
Period    Cash Flow

  0         -100
  1          310
  2         -220

Note that the cash flows switch sign from year to year. Now consider solving for the IRR.

There are two solutions to the IRR. At 100%, the IRR tells us to accept the project. At 10%, it is unclear what the IRR is telling us. We need to know what the discount rate for the firm is. If the discount rate is less than 10%, then the IRR is telling us to accept and the NPV is telling us to reject. If the discount rate is greater than 10%, then the NPV is telling us to accept and the IRR is telling us to accept and reject. Now consider a different set of cash flows.

Period    Cash Flow

  0          100
  1         -310
  2          220

Note that the cash flows switch sign from year to year. In this case, they are positive, negative and positive. Now solve for the IRR.

The IRR again gives us two solutions. If the firm's discount rate is less than 10%, then the NPV rule tells us to accept and both the IRRs also tell us to accept. If the firm's discount rate is greater than 10% but less than 100%, the NPV rule tells us to reject but we get conflicting advice from the IRR rule.

5.2.3 Undefined IRR

Consider the following cash flows:
Period    Cash Flow

  0          100
  1         -200
  2          150

To solve for the IRR, set x=1/(1+R). To get the IRR, we need to solve for an x that satisfies:

This is just a quadratic equation. We can solve for the roots with the familiar formula:

where a is the coefficient on x^2 term, b is the coefficient on x and c is the constant.

We cannot solve the square root of a negative number with a real number. The solutions to the IRR are imaginary numbers. This does not help us evaluate the worth of the project. We cannot provide a graphical representation of the differences between NPV and IRR here unless we use the complex plane. Note in this particular case that the NPV is greater than zero for all discount rates.

5.2.4 Non-Uniform Term Structure

Now we consider the possibility of a non-uniform term structure. Suppose we are faced with the following cash flows and one period interest rates:
Period    Cash Flow     Interest Rate

  0        -1000             -
  1           80           .20
  2           80           .10
  3           80           .04
  4           80           .04
  5         1080           .04

This just represents the cash flows from purchasing a five year bond than pays an 8% coupon. The internal rate of return is 8%. Now let's calculate the net present value of cash flows.
Period    Discount               Present Value

  1       80/1.2                   66.67
  2       80/(1.2)(1.1)            60.61
  3       80/(1.2)(1.1)(1.04)      58.27
  4       80/(1.2)(1.1)(1.04)^2    56.03
  5     1080/(1.2)(1.1)(1.04)^3   727.36

Present Value of Inflows         968.94
Investment                      1000.00

Net Present Value                -31.03

In the case of the non-uniform term structure, the IRR is not that meaningful of a measure.

5.2.5 Mutually Exclusive Projects: Scale Differences

Now we will consider the problems with using IRR to evaluate mutually exclusive projects. Suppose you are evaluating the investment project of building a new factory. You have two options on the size the project. Below is a calculation of the NPV and IRR.
Project     Period 0     Period 1    IRR       NPV

  A             -100          200    100%      82
  B          -10,000       15,000     50%    3636

Notice that the IRR rule tells us to accept project A and the NPV rule tells us to accept project B. The IRR rule can not distinguish between a $1 investment and a $1 million dollar investment.


Mutually Exclusive Projects: Cash Flow Timing The IRR is also problematic in that it does not tell us anything about the timing of the cash flows. Consider the following example of cash flows:
Project      Period 0     Period 1     Period 2    NPV(10%)

   A           -1000        1100          0           0
   B           -1000           0       1210           0

The IRR rule will not be able to distinguish between these projects. The IRR is 10%. For any discount rate, below 10% the IRR tells us that both projects are acceptable. But for any discount rate below 10%, project B has a higher NPV than A. Note that project A's cash flows all come in the first year whereas all of project B's cash flows come in the second year. Graphically,

5.3 Payback

The payback is the N^* that satisfies:

The payback rule says to accept independent projects if

where N^c represents the life of the investment project. Similarly, the payback rule says to accept the mutually exclusive project that has the smallest N^*. The most obvious problem with payback is that it ignores the time value of money. Cash flows in year 10 are treated as cash flows today. The rule will not in general give the correct evaluation of a project.

5.4 Discounted Payback

The discounted payback is the N^* that satisfies:

The payback rule says to accept independent projects if

where N^c represents the life of the investment project. Similarly, the payback rule says to accept the mutually exclusive project that has the smallest N^*. Any project with N^* < T has a positive NPV. Let's express the NPV in terms of payback.

The second term in the NPV is ignored in the payback. This term could represent very profitable cash flows. If you are using payback, you may be excluding projects that have positive net present value. Now consider mutually exclusive projects. A lower $N^*$ does not imply a higher NPV. Consider the following example.

Project      Period 0     Period 1     Period 2    NPV(10%)   N*

   A           -1000        1100          0             0     1
   B           -1000           0       1300         74.38     2

In this example, the discounted payback tells us to accept project A but project B has a higher NPV.

5.5 Profitability Index

The profitability index is defined as:

The rule says to accept projects that have:

Among mutually exclusive projects, accept the project with the highest index which is greater than one. There are no problems in using this rule for independent projects.

which is just another way to express net present value:

There are problems in using the profitability index to evaluate mutually exclusive projects. The index ignores scale. Consider the following example.

Project   Period 0   Period 1   PI(10%)   NPV(10%)

  A         -100       200       1.82       82
  B      -10,000    15,000       1.36     3636

The profitability index suggests that project A is superior to project B. However, the net present value of B far exceeds that of A.

6. Tax Considerations

We have already learned how to make capital budgeting decisions for both riskless and risky projects: Discount all the cash flows by using appropriate discount rates. For riskless or almost riskless projects, the interest rates are sufficient. For risky projects, we pair them with stocks that are of the same risk levels and use the expected returns on the stocks as the discount rates. However, this method works only to all-equity financed firms, an assumption we have implicitly made. This assumption is not true in the real world. What happens when firms do have debt?

6.1 Weighted Average Cost of Capital

When a firm has debt and equity, it has a cost of equity capital and a cost of debt capital. Let R_S be the cost of equity capital and R_B be the cost of debt capital. Let T be the tax rate. The weighted average cost of capital (WACC) is a weighted average of the after-tax rates

We use the WACC for discounting a project's cashflow if and only if:
  1. The project and the firm have the same systematic risk
  2. The project and the firm have the same debt capacity

6.2 The adjusted-present-value (APV)

To capture the effect of debt-financing, the WACC finds a new appropriate discount rate. There is an alternative approach which computes the NPV under all-equity assumption and then adjusts it by the debt-financing effect. As a result, this approach is called adjusted-present-value technique or APV. In formula, it states:
Adjusted PV = All-equity value + Additional effects of debt APV is perhaps best understood by an example:
A firm, with debt and equity half each, has an investment project that costs $10 million today but generates after-tax $2 million in perpetuity starting from next year. Assume the firm's tax rate is 34% and the cost of unlevered equity is 20%. If the firm can finance the project by borrowing $5 million at 10%. What is the APV? The NPV of the project if the firm were all-equity:
All-equity value = -10 +  --- = 0 
Now the PV of tax-shield is:
                              T × B × R_B
 Additional effects of debt = ----------- = T × B = $1.7 million

Hence, the adjusted present value is
   APV = 0 + 1.7 = $1.7 million

In general, the additional effects of debt include:
  1. floatation costs,
  2. tax shield from debt,
  3. effects of subsidized financing.
They can be adjusted one by one in the APV computation. Often in the real applications, we

7. Additional Decision Tools

Decision trees are a convenient way of representing sequential decisions over time in an uncertain environment. This is best understood by the attached example. To make any estimate of cash flows over the uncertain future periods, certain assumptions have to be made. Optimistic assumptions often lead high cash flow estimates whereas pessimistic assumptions often lead low estimates. Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions. Similarly, Scenario analysis examines how sensitive the NPV calculation is to changes in different likely scenarios. Traditional NPV analysis identifies the expected cash flows and discount them according to their systematic risk. An alternative and increasing popular approach to project evaluation is Monte Carlo simulation.


Suppose you are facing an investment which cost $100 today, but generates cash flows for the next two years. Assume the discount rate is 10%.

Step 1. Modeling

Step 2. Specifying Distributions for Cash Flows
We do not know the cash flows for sure, but we can forecast them or make our best guesses. Assume CF_1 and CF_2 follows normal distributions, CF_1 has mean $70 with standard error $7 and CF_2 has mean $60 and standard error $12. This implies that $70 is the expected cash flow next year. However, due to some uncertain economic conditions, the actual cash flow next year will be different from $70. But we believe it has about 68.26% chance to be in $70 plus or minus $7 and 95.44% chance to be in $70 plus or minus $14. Or if we take $70 as the forecasting value of CF_1, we have 68.26% chance of making 10% forecasting error and 95.44% of making 20% error.

Step 3. Draw Cash Flows from the Specified Distributions
A computer can be used to easily draw CF_1 and CF_2 from two normal distributions with means 70 and 60, standard errors 7 and 12 respectively.

Step 4. Compute the NPV
With cash flows drawn in Step 3, the NPV is computed from the model of Step 1.

Step 5. Repeat 3 and 4 for a Specified Number of Times
Generally, hundreds or thousands repeated computations of 3 and 4 are required. 10,000 times would be a good choice for many problems.

Step 6. Determine the Distribution of NPV
With the hundreds or thousands repeated computed values of NPV from Step 5, we are able to determine the distribution of NPV, in particular the mean and standard error. All this is what we need for our decision making.

8. Real Options in Project Evaluation

8.1 Overview

These options available to management as part of the project. They sometimes known as an operating options.


Electric utility has choice of building a power plant that:
  1. Burns oil
  2. Burns either oil or coal
Plant (1) is cheaper to construct. Naive implementation of present value might suggest that plant (1) be constructed. But while (2) costs more, it also provides greater flexibility. Management has the ability to select which fuel to use and can switch back and forth depending on energy conditions. Proper implementation of present value analysis (or discounted cash flow, DCF) must take the value of this operating option into account.

8.2 Input Mix Options:

Electric utility problem is one example of an input mix option. Many operating facilities (such as oil refineries and chemical plants) can use different mixes of inputs to produce same output.

8.3 Output Mix Options:

Some facilities can use the same inputs to produce different arrays of outputs.

8.4 Abandonment Options (or Termination Options)

Traditional capital budgeting assumes that a project will operate in each year of its lifetime. There are two type of options:
8.4.1 Temporary Stop Options
For many projects with production facilities, it may not be optimal to operate a plant in a given year -- because revenue will not cover variable cost. Explicit recognition of this type of flexibility is critical when choosing among alternative production technologies with different ratios of variable-to-fixed costs.
8.4.2 Permanent Stop Options
Abandonment option (or option to sell) is like an American put option. When present value of the asset falls below the liquidation value, then sell asset. Abandonment is like exercising the put option. These options are particularly important for large capital intensive projects (such as nuclear plants). They are also important for projects involving new products where their acceptance in the market is uncertain.

In short a project with liquidation possibility is worth more than project without possibility of abandonment.

8.5 Intensity Options:

Closely related to the Abandonment Options. Intensity Options are the flexibility to expand or contract the scale of the project. Examples--
8.5.1 Option to Expand
Build production capacity in excess of expected level of output (so it can produce at higher rate if needed). Management has the right (not the obligation to expand). If project conditions turn out to be favorable, management will exercise this option.

Project with option to expand is worth more than project without possibility of expansion.

8.5.2 Option to Contract
This is the equivalent to a put option. Many projects can be engineered in such a way that output can be contracted in future. Example--modularization of project. Forgoing future expenditures is equivalent to exercising the put option.

Project with option to contract is worth more than project without possibility of contraction.

8.5.3 Option to Expand or Contract (Switching Option).
This is the most general situation. It is equivalent to the firm having a portfolio of call and put options. Restarting operations when project currently shut down is a call option. Shutting down is a put option.

Project whose operation can be dynamically turned on and off (or switched to two distinct locations) is worth more than the same project without the flexibility to switch. A flexible manufacturing system (FMS) is a good example of this type of option. Other examples--

8.6 Initiation Options

Just as Abandonment Option is valuable, so is the option to initiate the project. Example: Purchaser of off-shore lease can choose when, if at all, to develop property. This option has significant value. If U.S. government required immediate development of leases:
  1. Prices paid for leases would decline
  2. Some leases would not be purchased at all.
Also, true for exploration in general. If natural resource companies were committed to produce all resources discovered, then they would never explore in areas where the estimated extraction cost exceeded the expected future price at which the resource could be sold.

8.7 Sequencing Options

Important strategic issue is the sequencing of projects. For example, Successful marketing of consumer products often requires "brand name." Suppose a firm is evaluating projects to produce a number of consumer products. It may be advantageous to implement projects sequentially rather than in parallel. Pursuing the development of a single product, the firm can resolve some of the uncertainty surrounding its ability to establish "brand name." Once resolved, management has the option to proceed or not with the development of the other projects. If taken in parallel, management would have already spent the resources and the value of the option not to spend them is lost.

8.8 Intra vs. Interproject Options:

The sequencing option was an interproject option. That is, the sequencing of projects creates options on one or more projects as the direct result of undertaking another project. Old-style capital budgeting will miss this option because projects evaluated on stand-alone basis. Ignoring interproject options, could lead to significant undervaluation of projects. Extreme case example is R&D: The source of value is the options created to undertake other projects. Interproject options are created whenever management makes an investment that places the firm in a position to use new technology to enter a different industry.

8.9 Present Value of Growth Opportunities:

Value of the firm can exceed the market value of the projects currently in place because the firm may have the opportunity to undertake positive NPV projects in the future. Standard method is to establish the present value of these projects based on anticipated implementation dates. But this implicitly assumes that the firm is committed to go ahead with the projects! However, management need not make such a commitment. Standard valuation methods ignore the option not to go forward.

8.11 Shadow Costs:

Ignoring options usually causes undervaluation of projects. Some projects may have little or no option component. However, standard valuation techniques may overvalue these projects by failing to recognize losses in flexibility to the firm that result from implementation.

8.12 Financial Flexibility:

Choice of capital structure can affect value of project. Like operating flexibility, financial flexibility can be measured by the value of the financial options made available to the firm by its choice of capital structure. Interaction between financial and operating options can be strong -- especially for long-term investment projects with a lot of uncertainty. The option valuation framework is particularly useful to the corporate strategist because it provides an integrative analysis of both operating and financial options associated with the combined investment and financing decisions.
Practical Examples 1: Oil Extraction
Valuation of heavy oil asset. Deferral options are critical. In addition, production could be phased in over time. Conventional NPV will significantly undervalue these assets. Two operating options important: Option to defer and the option of deferring expansion program. In this case, the strike price was $20 per barrel.
Practical Examples 2: Precious Metal Mining
Four silver production sites, each with different layout and extraction technologies. Price of silver has been very volatile. To value firm based upon forecasts of silver prices (traditional NPV approach) could grossly underestimate the value. Value enhanced by: (i) Operational flexibilities and (ii) Switching options (shut down, reopening, abandonment). Insight gained into the opening-up and shutting-down decision. Given the mine was open, it was optimal to keep it open even when the marginal revenue from a ton of output was less than the marginal cost of extraction. Intuitively, the fixed cost of closing an operation might be needlessly incurred if the price rose in the future. Opposite for the closing-down decision. Due to the cost of reopening the mine, the optimal decision might be to keep it closed until the commodity price rose substantially above the marginal cost of production.
Practical Examples 3: Pharmaceutical R&D
A drug company needed to value a new drug research and development project. Four development phases:
  1. initial R&D with 20% chance of success
  2. clinical testing, with 50% chance of success
  3. ing I, with 40% chance of success
  4. ing II, with a 90% chance of success.

Lessons from Real Options

9. Mergers and Acquisitions

9.1 The Basic Forms and Types of Acquisitions

There are three basic legal forms about corporate acquisitions:
  1. Merger or Consolidation
    • With a merger, one firm absorbs another. The acquiring firm retains its name and identity, but the acquired firm ceases to exist.
    • With a consolidation, a new firm is created. Both firms involved terminate their previous legal existence.
  2. Acquisitions of Stock
    • A firm buys another firm's voting stock in exchange for cash, stock, or other securities. This is often done by a tender offer, a public offer to buy the stocks directly from shareholders.
  3. Acquisitions of Assets
    • A firm can buy another firm by purchasing the assets of the target firm.
Given that we have three approaches to acquire a firm, which one should we use? What are the advantages and disadvantages?
  1. Merger or Consolidation
    • + legally simple.
    • + Relatively inexpensive, no transfers of titles necessary.
    • - All liabilities assumed, including potential litigation.
    • - 2/3 of shareholders (most states) of both firms must approve.
    • - Dissenting shareholders can sue to receive their `fair' value (`appraisal rights')
  2. Acquisitions of Stock (tender offer)
    • + No shareholder meetings or votes necessary
    • + Bidder can bypass management and go directly to shareholders.
    • - Resistance by the target firm's management makes the process costly.
    • - Often a minority of shareholders hold out.
  3. Acquisitions of Assets
    • + Only needs 50% of shareholders' approval, thus avoiding dissident minority shareholders.
    • - transfers of assets may be costly in legal fees.
Corporate acquisitions not only have the above three legal forms, but also have three economic types:
  1. Horizontal Acquisition
    • Acquisition of a firm in the same industry as the acquiring firm.
  2. Vertical Acquisition
    • Acquisition of a firm at a different step of production from the acquiring firm. For example, the ill-fated strategy of Kodak acquiring Sterling Drugs.
  3. Conglomerate Acquisition
    • Acquisition of a firm in unrelated business.
Now we make a remark on a more general concept, takeovers. A takeover is the transfer of control of a firm from one group to another. It can occur by an acquisition (as described above), a proxy contest, or a going-private transaction. In a proxy contest, a group of dissident shareholders seeks to obtain enough proxies from the firm's existing shareholders in order to gain control of the board of directors. In a going-private transaction, a small group of investors buys all of the firm's common stocks, which later are delisted and are no longer be purchased in the open market.

9.2 Reasons for Mergers and Acquisitions

The primary motivation for most mergers and acquisitions is to increase the value of the combined enterprise. That is the whole is worth more that the sum of the parts. This is often called "synergy". Where does the synergy profits come from?
  1. Economies of scale
    • Share costly equipment, facilities and personnel, reduce the cost of flotation.
  2. Acquire valuable technologies and resources
    • For example, many oil company acquisitions took place because it was cheaper to buy existing reserves than to explore new ones.
  3. The target company is undervalued
    • The target firm's management may not operating the firm to its full potential, leaving room for another firm to takeover and realize the value. Alternatively, the acquiring firm may have insider information on the target firm which leads them to believe the firm has a value higher than the current market value. For example, it is now common to see `expert' on TV giving estimates of a company's break up value. If this exceeds the company's market value, a takeover specialist could acquire the firm at or somewhat above the current market value, sell it off in pieces, and earn a substantial profit.
  4. Tax considerations
    • A firm with large tax loss carry-forwards may be attractive to another firm that can use the tax benefits. However, IRS may disallow the use of tax loss carry-forwards if no business purpose for the acquisition is demonstrated. Furthermore, under 1986 Tax Reform Act, the carry-forwards is limited.
    • Some firms which have unused debt capacity may make them acquisition candidates. The acquiring firm can deduct more interest payments and reduce taxes. For example, this was cited as the logic behind the proposed merger of Hospital Corporation of American and American Hospital Supply in 1985. Insiders said the combined company could increase debt by $1 billion.
  5. Inefficient management of the target company
    • Management could be bad relative to others in the same industry, leading to a horizontal merger. Or, it could be bad in absolute sense, leading to a conglomerate merger. Anybody can come in and do better.
  6. Market power
    • One firm may acquire another to reduce competition. If so, prices can be increased and monopoly rents obtained. However, mergers that reduce competition may be challenged by the US Department of Justice and the Federal Trade Commission.
  7. Diversification
    • A cash rich company may use the cash for acquisitions rather than to pay it out as dividends. A frequent argument for this is that it reduces the investor's risk in the company, thus achieving diversification. However, investors can diversify on their own, likely more easily and cheaply than can the company.
After mentioning so many possible sources for synergy, in practice, what are the gains or losses from acquisitions? According to a study by Jensen and Ruback, shareholders earn 30% abnormal returns for successful tender offers. In general, successful takeovers lead to gains for shareholders of both firms, but those of the target firm obtain substantially more; for unsuccessful takeovers, shareholders on both sides lose.

9.3 Tactics which deter unfriendly takeovers

Many takeovers are agreed upon by both parties. These are called friendly takeovers. But there are also many that go over the management directly to shareholders. These are hostile takeovers. They can be done by a proxy fight, seeking the right to vote someone else's shares in a shareholders' annual meeting. Alternatively, the acquirer can make a tender offer directly to the shareholders. The management of the target firm may advise its shareholders to accept the tender or it may attempt to fight the bid. This process resembles a complex game of poker, playing under the rules set largely by the Williams Act of 1968 and by the courts. What are the strategies the management can take to fight the battle?
  1. Pac-man Defense
  2. White Knight
  3. Lockup Defense
  4. Scorched Earth Defense
  5. Golden Parachutes
  6. Poison Pills
  7. Greenmail
  8. Create an Antitrust Problem
  9. Change the state of incorporation
  10. Stalling tactics
  11. Shark repellent charter amendements
  12. Dual class recapitalization
Of course, the best method to prevent an unfriendly takeover to take actions to maximize shareholder value such as accepting positive NPV projects and running the corporation as efficiently as possible. Indeed, the benefit of an unfriendly takeover is often to purge the inefficient management. Any of these antitakeover tactics could destroy shareholder value if they are used to prolong the tenure of low quality management.


Some of the material for this lecture is drawn from Richard Ruback's note, "Applications of the Net Present Value Rule" and Guofu Zhou's "Capital Budgeting".

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