Capital Budgeting and Investment Analysis / Edition 1

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Overview

The most complete book on this subject available on the market, Capital Budgeting blends theory with practice by providing numerous real-world examples of its applications. It includes a discussion of capital budgeting's link to the corporate strategy for creating value as well as addresses the international aspects of capital budgeting. After a comprehensive introduction to the subject, this book covers capital budgeting principles and techniques; estimating project cash flows; biases in cash flow estimates; foreign investment analysis; real options and project analysis; risk and incorporating risk in a capital budgeting analysis; estimating project cost; financing side effects; discount rates for foreign investments; and corporate strategy and the capital budgeting decision. An excellent handbook for chief financial officers, vice-presidents of finance; treasurers; and comptrollers.

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Product Details

  • ISBN-13: 9780130660909
  • Publisher: Prentice Hall
  • Publication date: 10/13/2004
  • Edition description: New Edition
  • Edition number: 1
  • Pages: 264
  • Product dimensions: 6.92 (w) x 8.89 (h) x 0.78 (d)

Meet the Author

Alan C. Shapiro is the Ivadelle and Theodore Johnson Professor of Banking and Finance and past chairman of the Department of Finance and Business Economics, Marshall School of Business, University of Southern California. Prior to joining USC in 1978, he was an Assistant Professor at the Wharton School of the University of Pennsylvania (1971-1978). He has also been a Visiting Professor at Yale University, UCLA, the Stockholm School of Economics, University of British Columbia, and the U.S. Naval Academy. Professor Shapiro received a B.A. in Mathematics from Rice University (1967) and a Ph.D. in Economics from Carnegie Mellon University (1971).

His specialties are corporate and international financial management. His best-selling textbook Multinational Financial Management (Seventh Edition, 2003) is in use in most of the leading MBA programs around the world. He has also written Modern Corporate Finance (1990), cited by the Journal of Finance as potentially the "standard reference volume in corporate finance," Foundations of Multinational Financial Management (Fifth Edition, 2004), International Corporate Finance (1989), and, with Sheldon Balbirer, Modern Corporate Finance: An Interdisciplinary Approach to Value Creation (Prentice Hall, 2000).

Dr. Shapiro is currently researching the links between corporate finance and corporate strategy. One outcome of this research is the article "Corporate Stakeholders and Corporate Finance," for which he and co-author Brad Cornell received the 1987 Distinguished Applied Research Award from the Financial Management Association and which is the most frequently cited article published in Financial Management since 1985.

Dr. Shapiro has consulted with the FBI, the Federal Home Loan Bank, RTC, the American Law Institute, the Department of Justice, SEC, the Department of Energy, the Internal Revenue Service, FDIC, and numerous firms and banks, including Dow Chemical, Abbott Laboratories, Aetna, Anheuser-Busch, IBM, Caltex, Texas Instruments, Arco Chemical, NCR, GTE, SBC Communications, Scott Paper, Time Warner, Pacific Enterprises, Northrop Grumman, OKC, Computer Sciences Corporation, General Foods, Vulcan Materials, Flying Tiger Line, Wells Fargo, Pepsico, North Broken Hill, BankAmerica, and Citicorp. He frequently serves as an expert witness in cases involving valuation, economic damages, S&Ls, international finance, takeovers, and transfer pricing. In addition, he is a director of Remington Oil and Gas Corp., a government-appointed director of Lincoln S&L, and a past director of OKC Corp.

He has won several teaching awards and has taught in numerous executive education programs, including programs sponsored by Yale University, the Wharton School of Business, University of Southern California, UCLA, UC Berkeley, Columbia University, University of Hawaii, University of Washington, University of Melbourne, Stockholm School of Economics, and the American Management Association. Dr. Shapiro also conducts numerous in-house training and executive programs for banks, corporations, government agencies, consulting firms, and law firms in the areas of corporate finance and international finance and economics. He has lectured on problems of international finance and economics in Munich, Tokyo, Frankfurt, Seoul, Hong Kong, Singapore, Guangzhou, Shanghai, London, Oxford, Sydney, Melbourne, Mexico City, Monterey, Santiago, Rome, Budapest, Vienna, Buenos Aires, and Paris. In October 1993, Business Week recognized him as one of the ten most in-demand business school professors in the United States for teaching in in-house corporate executive education programs.

Dr. Shapiro has published more than 50 articles in such leading academic and professional journals as the Journal of Finance, Harvard Business Review, Columbia Journal of World Business, Journal of Financial and Quantitative Analysis, Review of Financial Studies, Journal of Business, Journal of International Money and Finance, Financial Management, Management Science, and Journal of Applied Corporate Finance. In 1988, he was cited as one of the "100 Most Prolific Authors in Finance." Another study published in 1991 ranked him as one of the most prolific contributors to international business literature. He has also published two monographs, International Corporate Finance: Survey and Synthesis and Foreign Exchange Risk Management.

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Read an Excerpt

Capital Budgeting and Investment Analysis is concerned with the most important problem facing management—finding or creating investment projects that are worth more than they cost. This function, also known as the investment decision, involves allocating funds over time in such a way that shareholder wealth is increased. Of the many decisions top management must make, none is likely to have more impact than the decision to invest capital, since this often involves large, extended commitments of money and management time.

The basic philosophy of this book is that deciding what assets to invest in has a far greater bearing on the value created by most companies than does the decision of how to sell claims against those assets (also known as the financing decision). Its purpose is to help develop in students the critical analytical skills required to assess potential investments.

Topics covered include the basics of capital budgeting, the estimation of project cash flows and the project cost of capital, risk analysis in capital budgeting, and corporate strategy and its relationship to the capital-budgeting decision. Throughout, the book emphasizes how management creates value for its shareholders.

TOPIC COVERAGE

This is a short book, containing only seven chapters and several appendices. As such, it is suitable for a mini-course in capital budgeting or for a course that covers capital budgeting as a key but not exclusive topic. These chapters and the topics they cover are as follows:

Chapter 1 examines the basics of capital budgeting, including the criteria by which projects must be evaluated, the capital-budgeting process, and the different types of investment projects that one is likely to encounter. As part of this chapter, we review the basic drivers of shareholder value—cash flow, time, and risk—and see how these drivers affect the basic criteria by which to evaluate capital-budgeting projects.

Chapter 2 presents and compares five alternative methods that companies can use to evaluate prospective investments. These methods include net present value, internal rate of return, profitability index, accounting rate of return, and payback period. It also surveys the capital-budgeting techniques most commonly used by leading U.S. companies. Appendix 2A examines two complex problems that sometimes arise in capital budgeting and shows how to deal with them. These include the existence of capital rationing and mutually exclusive projects with significantly different lives.

Chapter 3 discusses the estimation of project cash flows. It distinguishes between total and incremental cash flows, shows how to calculate the initial investment required, and deals with the estimation of operating cash flows. The chapter also discusses how to incorporate the terminal value and points out some potential sources of bias in the estimation of cash flows. Appendix 3A discusses the general rules for depreciating property, while the effects of inflation on project cash flows are examined in Appendix 3B. Appendix 3C shows how the basic principles of capital budgeting can be modified to deal with the unique aspects of foreign investments, such as differences between project and parent company cash flows, expropriation, blocked funds, and exchange rate changes.

Chapter 4 discusses the analysis of projects whose cash flows are contingent on how management responds to future, unknown events. The contingent nature of these cash flows arises because of the flexibility that companies often have in changing their decisions in response to new information and changing circumstances. This flexibility gives companies what has come to be termed real, or growth, options. Failure to account for the options available to managers to adjust the scope or scale of a project will lead to a downward bias in estimating project cash flows.

Chapter 5 presents and evaluates the techniques that firms use to incorporate risk in the capital-budgeting process. These techniques include adjusting the discount rate, adjusting project cash flows, and using certainty-equivalent cash flows. Other methods of risk analysis are presented as well, including sensitivity analysis, decision-tree analysis, and simulation analysis.

Chapter 6 introduces the issue of cost of capital, the determination of how much projects must yield to make it worthwhile to invest in them. It discusses the relationship between a project's riskiness and its cost of capital and shows how to calculate a firm's overall cost of capital as well as the divisional cost of capital. Appendix 6A discusses some international dimensions to cost of capital estimation.

Chapter 7 discusses corporate strategy and its relationship to the capital-budgeting decision, focusing on those factors that have contributed to success in the past. Topics covered include the concept of economic rents and what happens to opportunities for positive NPV projects in a competitive industry over time, the nature of market imperfections that give rise to economic rents and how one can design investments to exploit these imperfections, and the evolution of domestic firms into multinational corporations (MNCs). The latter topic incorporates a discussion of the rationale and means whereby MNCs transfer abroad their competitive strengths.

DISTINCTIVE FEATURES

Capital Budgeting and Investment Analysis shows how companies go about creating value by undertaking activities and purchasing or creating assets that are worth more than they cost. Some of the features that distinguish it from its competitors are as follows:

Practical Approach. There is nothing quite so practical as a theory that works. I have tried to reinforce this belief by taking a common sense approach to finance. This involves showing students why the various theories discussed make sense and how to use these theories to solve problems. The book relates the subject matter to material that students are already familiar with or have learned in previous chapters, making it less intimidating and more interesting. Basic intuition is emphasized throughout.

Numerous Applications of Finance Principles. In keeping with its down-to-earth approach, the book contains numerous real-world examples and vignettes that help illustrate the application of financial theories and demonstrate the use of financial analysis and reasoning to address various issues in capital budgeting. No other text has as many or as interesting examples of finance in practice. These examples promote understanding of basic investment principles and add interest to finance.

Appeal to Nonfinance Majors. Since so many of the issues dealt with by nonfinancial executives have financial implications from determining advertising budgets and credit policies to investing in management training programs, it is clear that capital-budgeting theory has broad application to general management as well. Persuading readers who are not interested in pursuing a career in finance of this fact is a different matter. I have attempted to motivate these doubting Thomases by using numerous illustrations, scattered throughout the text, of the application of capital-budgeting principles to nonfinancial problems.

Emphasis on Value Creation. The text emphasizes two related issues: how companies create value and how capital budgeting can facilitate the process of value creation. The focus is on how the financial manager can add value to the firm by smart investment decision making. Its guiding principle is that financial management is subordinate to the "real" business of the firm, which is to produce and sell goods and services. These latter activities all entail decisions regarding investment in real or intangible assets.

Coverage of International Topics. On a more personal note, I believe that managers must view business from a global perspective; international is not just another section of the domestic economy, like office machines or autos, which can be ignored at no cost. Instead, an international orientation has become a business necessity, not a luxury. Those American television manufacturers determined to limit themselves to purely domestic operations learned this lesson the hard way; their greatest competitive threat came from companies located 8,000 miles away, across the Pacific, not from other American producers. To facilitate the development of a global perspective on capital budgeting, I have tried to integrate domestic and international financial topics—such as cost of capital, cash flow estimation when foreign currencies are involved, and corporate strategy and capital budgeting-throughout the book. To the extent I have succeeded, this is one of the distinctive features of the text.

Numerous Questions and Problems. Another distinctive feature of Capital Budgeting and Investment Analysis is the large number of end-of-chapter questions and problems and their close relationship to the material in the chapters. Good conceptual questions are as important as computational problems in promoting understanding and the ones in the book are consistently challenging, interesting, and extremely useful. They provide practical insights into the types of decisions faced by financial executives and offer practice in applying financial concepts and theories.

Additional Features. The book also includes a number of other distinguishing features that relate to the subject matter covered:

  • It features a detailed discussion of estimating project cash flows, including incremental versus total cash flows, the effects of inflation on cash flows, and the valuation of growth options. It gives students hands-on experience in estimating project cash flows and helps them gain an appreciation for the real-world difficulties in valuing projects. (Chapters 3 and 4).
  • It integrates international issues that arise in capital budgeting throughout the text, including estimating foreign project cash flows, determining the appropriate cost of capital for foreign projects, and designing a foreign expansion strategy. (Chapters 4, 6, and 7).
  • It provides a discussion of risk that points out the many ways in which total risk can affect expected future cash flows, even if it does not affect the discount rate (Chapter 5).
  • It features a separate chapter on corporate strategy that helps readers understand the origins and characteristics of positive net present value projects (Chapter 7).
AUDIENCE

Capital Budgeting and Investment Analysis is designed for use in masters-level courses and advanced undergraduate courses in capital budgeting and corporate financial management. It can also be used in bank management courses and executive development programs.

Read More Show Less

Table of Contents

CONTENTS

1. Introduction to Capital Budgeting.

2. Capital-Budgeting Principles and Techniques.

3. Estimating Project Cash Flows.

4. Real Options and Project Analysis.

5. Risk in Capital Budgeting.

6. Estimating the Project Cost of Capital.

7. Corporate Strategy and the Capital Budgeting Decision.

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Preface

Capital Budgeting and Investment Analysis is concerned with the most important problem facing management—finding or creating investment projects that are worth more than they cost. This function, also known as the investment decision, involves allocating funds over time in such a way that shareholder wealth is increased. Of the many decisions top management must make, none is likely to have more impact than the decision to invest capital, since this often involves large, extended commitments of money and management time.

The basic philosophy of this book is that deciding what assets to invest in has a far greater bearing on the value created by most companies than does the decision of how to sell claims against those assets (also known as the financing decision). Its purpose is to help develop in students the critical analytical skills required to assess potential investments.

Topics covered include the basics of capital budgeting, the estimation of project cash flows and the project cost of capital, risk analysis in capital budgeting, and corporate strategy and its relationship to the capital-budgeting decision. Throughout, the book emphasizes how management creates value for its shareholders.

TOPIC COVERAGE

This is a short book, containing only seven chapters and several appendices. As such, it is suitable for a mini-course in capital budgeting or for a course that covers capital budgeting as a key but not exclusive topic. These chapters and the topics they cover are as follows:

Chapter 1 examines the basics of capital budgeting, including the criteria by which projects must be evaluated, the capital-budgeting process, and the different types of investment projects that one is likely to encounter. As part of this chapter, we review the basic drivers of shareholder value—cash flow, time, and risk—and see how these drivers affect the basic criteria by which to evaluate capital-budgeting projects.

Chapter 2 presents and compares five alternative methods that companies can use to evaluate prospective investments. These methods include net present value, internal rate of return, profitability index, accounting rate of return, and payback period. It also surveys the capital-budgeting techniques most commonly used by leading U.S. companies. Appendix 2A examines two complex problems that sometimes arise in capital budgeting and shows how to deal with them. These include the existence of capital rationing and mutually exclusive projects with significantly different lives.

Chapter 3 discusses the estimation of project cash flows. It distinguishes between total and incremental cash flows, shows how to calculate the initial investment required, and deals with the estimation of operating cash flows. The chapter also discusses how to incorporate the terminal value and points out some potential sources of bias in the estimation of cash flows. Appendix 3A discusses the general rules for depreciating property, while the effects of inflation on project cash flows are examined in Appendix 3B. Appendix 3C shows how the basic principles of capital budgeting can be modified to deal with the unique aspects of foreign investments, such as differences between project and parent company cash flows, expropriation, blocked funds, and exchange rate changes.

Chapter 4 discusses the analysis of projects whose cash flows are contingent on how management responds to future, unknown events. The contingent nature of these cash flows arises because of the flexibility that companies often have in changing their decisions in response to new information and changing circumstances. This flexibility gives companies what has come to be termed real, or growth, options. Failure to account for the options available to managers to adjust the scope or scale of a project will lead to a downward bias in estimating project cash flows.

Chapter 5 presents and evaluates the techniques that firms use to incorporate risk in the capital-budgeting process. These techniques include adjusting the discount rate, adjusting project cash flows, and using certainty-equivalent cash flows. Other methods of risk analysis are presented as well, including sensitivity analysis, decision-tree analysis, and simulation analysis.

Chapter 6 introduces the issue of cost of capital, the determination of how much projects must yield to make it worthwhile to invest in them. It discusses the relationship between a project's riskiness and its cost of capital and shows how to calculate a firm's overall cost of capital as well as the divisional cost of capital. Appendix 6A discusses some international dimensions to cost of capital estimation.

Chapter 7 discusses corporate strategy and its relationship to the capital-budgeting decision, focusing on those factors that have contributed to success in the past. Topics covered include the concept of economic rents and what happens to opportunities for positive NPV projects in a competitive industry over time, the nature of market imperfections that give rise to economic rents and how one can design investments to exploit these imperfections, and the evolution of domestic firms into multinational corporations (MNCs). The latter topic incorporates a discussion of the rationale and means whereby MNCs transfer abroad their competitive strengths.

DISTINCTIVE FEATURES

Capital Budgeting and Investment Analysis shows how companies go about creating value by undertaking activities and purchasing or creating assets that are worth more than they cost. Some of the features that distinguish it from its competitors are as follows:

Practical Approach. There is nothing quite so practical as a theory that works. I have tried to reinforce this belief by taking a common sense approach to finance. This involves showing students why the various theories discussed make sense and how to use these theories to solve problems. The book relates the subject matter to material that students are already familiar with or have learned in previous chapters, making it less intimidating and more interesting. Basic intuition is emphasized throughout.

Numerous Applications of Finance Principles. In keeping with its down-to-earth approach, the book contains numerous real-world examples and vignettes that help illustrate the application of financial theories and demonstrate the use of financial analysis and reasoning to address various issues in capital budgeting. No other text has as many or as interesting examples of finance in practice. These examples promote understanding of basic investment principles and add interest to finance.

Appeal to Nonfinance Majors. Since so many of the issues dealt with by nonfinancial executives have financial implications from determining advertising budgets and credit policies to investing in management training programs, it is clear that capital-budgeting theory has broad application to general management as well. Persuading readers who are not interested in pursuing a career in finance of this fact is a different matter. I have attempted to motivate these doubting Thomases by using numerous illustrations, scattered throughout the text, of the application of capital-budgeting principles to nonfinancial problems.

Emphasis on Value Creation. The text emphasizes two related issues: how companies create value and how capital budgeting can facilitate the process of value creation. The focus is on how the financial manager can add value to the firm by smart investment decision making. Its guiding principle is that financial management is subordinate to the "real" business of the firm, which is to produce and sell goods and services. These latter activities all entail decisions regarding investment in real or intangible assets.

Coverage of International Topics. On a more personal note, I believe that managers must view business from a global perspective; international is not just another section of the domestic economy, like office machines or autos, which can be ignored at no cost. Instead, an international orientation has become a business necessity, not a luxury. Those American television manufacturers determined to limit themselves to purely domestic operations learned this lesson the hard way; their greatest competitive threat came from companies located 8,000 miles away, across the Pacific, not from other American producers. To facilitate the development of a global perspective on capital budgeting, I have tried to integrate domestic and international financial topics—such as cost of capital, cash flow estimation when foreign currencies are involved, and corporate strategy and capital budgeting-throughout the book. To the extent I have succeeded, this is one of the distinctive features of the text.

Numerous Questions and Problems. Another distinctive feature of Capital Budgeting and Investment Analysis is the large number of end-of-chapter questions and problems and their close relationship to the material in the chapters. Good conceptual questions are as important as computational problems in promoting understanding and the ones in the book are consistently challenging, interesting, and extremely useful. They provide practical insights into the types of decisions faced by financial executives and offer practice in applying financial concepts and theories.

Additional Features. The book also includes a number of other distinguishing features that relate to the subject matter covered:

  • It features a detailed discussion of estimating project cash flows, including incremental versus total cash flows, the effects of inflation on cash flows, and the valuation of growth options. It gives students hands-on experience in estimating project cash flows and helps them gain an appreciation for the real-world difficulties in valuing projects. (Chapters 3 and 4).
  • It integrates international issues that arise in capital budgeting throughout the text, including estimating foreign project cash flows, determining the appropriate cost of capital for foreign projects, and designing a foreign expansion strategy. (Chapters 4, 6, and 7).
  • It provides a discussion of risk that points out the many ways in which total risk can affect expected future cash flows, even if it does not affect the discount rate (Chapter 5).
  • It features a separate chapter on corporate strategy that helps readers understand the origins and characteristics of positive net present value projects (Chapter 7).

AUDIENCE

Capital Budgeting and Investment Analysis is designed for use in masters-level courses and advanced undergraduate courses in capital budgeting and corporate financial management. It can also be used in bank management courses and executive development programs.

Read More Show Less

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