Capital Budgeting: Decision Criteria and Real Option Considerations

A Comprehensive Example of Capital Budgeting: Opening a New Bank Branch

The First National Bank and Trust Company has a single banking office located in the downtown business district of a medium -size town. As the population moved to the suburbs, First National has seen its share of both local banking deposits and profits decline. Two of the bank’s vice presidents have proposed that First National try to reverse this trend by building a branch in a new, affluent suburban community. They have presented the bank’s executive committee with the following information.

The initial cost of the bank building and equipment is $1 million. This facility is expected to have a useful life of 20 years. Also, in 20 years at the end of the project the branch building and its equipment are expected to be sold for a $200,000 salvage value. The branch building and its equipment will be depreciated over their 20-year life using straight-line depreciation to a zero balance.We have assumed straight-line depreciation for simplicity.

In actual practice the bank would use MACRS depreciation with a 39-year life on the building and a 7-year life on the equipment. The annual straightline depreciation will be $1,000,000/20 = $50,000. The bank building is to be constructed on land leased for $20,000 per year. In addition to the $1 million investment for the building and equipment, the parent bank’s net working capital must be increased by $100,000 to accommodate the new branch.

Based on customer surveys, population trends, the location of competitor banks, and the experience other area banks have had with their branches, it is estimated that the annual revenues from the new branch will be $400,000. Of this $400,000 in revenues, $50,000 will be drawn away from the bank’s main office. (Assume that the main office will not attempt to cut its expenses because of this loss in revenues.)

In addition to the $20,000 annual expense for the land lease, the new branch will incur about $130,000 per year in other expenses, including personnel costs, utilities, and interest paid on accounts. Both expenses and revenues are expected to remain approximately constant over the branch’s 20-year life. The bank’s marginal tax rate is 40 percent and its cost of capital (required rate of return) is 9 percent after taxes.

Net cash flows are calculated for years 1 through 19 by subtracting branch operating costs and depreciation from the incremental revenues of $350,000. This yields operating earnings before taxes from which taxes (at the 40 percent rate) are deducted to arrive at operating earnings after taxes. By adding back depreciation, the net cash flow equals $140,000 for each year from 1 through. Net cash flows in year 20 are computed by adding the $120,000 estimated after -tax salvage and the $100,000 return of working capital to the annual net cash flow of $140,000 to equal $360,000.14

The $100,000 working capital requirement is added back to the year 20 cash flows because at the end of 20 years, when the project is terminated, there will no longer be a need for this incremental working capital, and thus the working capital of $100,000 can be liquidated and made available to the bank for other uses.

After the project cash flows have been computed and arrayed, the decision of whether to accept or reject the new branch project must be made. Next, the project is evaluated using three of the decision criteria discussed in this chapter, namely, net present value, internal rate of return, and profitability index.

Criterion 1: Net Present Value

The first term in the net present value equation is the present value of an annuity of $140,000 for 19 years at 9 percent, the bank’s cost of capital. Using the present value of an annuity table , an interest factor of 8.950 may be found. The second term is the present value of $360,000 received in 20 years at 9 percent. From the present value table, an interest factor of 0.178 is found. Thus, the net present value of this project at a 9 percent cost of capital is as follows:

Using the net present value criterion and a cost of capital of 9 percent, this project would be acceptable because it has a positive net present value.

Criterion 2: Profitability Index

The profitability index is the ratio of the present value of future net cash flows to the net investment. From the previous net present value calculation, we know that the present value of net cash flows at a percent cost of capital is $1,317,080 ($1,253,000 + $64,080). Thus, the profitability index is computed as follows:

FORMULA

Because the profitability index is greater than 1, the new branch bank project is acceptable according to this criterion.

Criterion 3: Internal Rate of Return

According to this method, a discount rate that makes the net present value of the project equal to zero must be found:

where r is the internal rate of return.

Since the calculated internal rate of return (r), equals 11.56 percent, which is greater than the cost of capital, the project is acceptable by this criterion. Based on these calculations, it appears that the new branch proposal will increase shareholder wealth and therefore should be undertaken. The only step remaining is to monitor the performance of the project to see if it meets, falls short of, or exceeds its projected cash flow estimates. Based on the actual results of this project, the bank’s management will be able to evaluate other new branch bank proposals in a more knowledgeable manner.

INTERNATIONAL ISSUES

A Framework for International Capital Expenditure Decisions

The capital budgeting decision criteria discussed earlier in this chapter can also be used to evaluate international capital expenditure projects. To illustrate, suppose McCormick & Company, a U.S. spice company based in Maryland, is considering expanding its German spice operations.

The company plans to invest $5 million in additional German facilities. Based on this level of investment, McCormick estimates that it proposed German expansion project will generate annual net cash inflows of 1.5 million euros for a period of 10 years and nothing thereafter. Also, based upon its analysis of present German capital market conditions, McCormick has determined that the applicable German cost of capital, k, for the expansion project is 15 percent.The present value of the expected net cash flows from the project, denominated in the foreign currency, is calculated as follows:

Using Equation a present value of approximately 7.53 million euros is obtained for the net cash flows of McCormick’s proposed German expansion:

The present value of the project’s net cash flows from the foreign viewpoint, PVNCFf , is used to calculate the present value of the project’s net cash flows to the parent company in the home country, PVNCFh, as follows:

where S0 is the spot exchange rate expressed in units of home country currency per unit of foreign currency. Using a spot exchange rate of $0.80 per euro, the present value of the net cash flows to the parent company for McCormick’s proposed expansion project is approximately $6.024 million.

PVNCFh = 7.53 million euros _ $0.80/euro
= $6.024 million

The project’s net present value is calculated by subtracting the parent company’s net investment in the project from PVNCFh, the parent company’s present value of the net cash flows:

A net present value of approximately $1.024 million is obtained for the McCormick project.

NPV = $6.024 million – $5.0 million
= $1.024 million

Based on this analysis, McCormick’s proposed German expansion is an acceptable project.

The McCormick example assumes that an efficient capital market exists in the foreign country, as it does in Germany and other developed countries. Assets can be bought and sold and the required rates of return for projects can be determined from prices of other comparable assets in the foreign capital market.

The McCormick example also assumes that the amount and timing of the expected net cash flows to the foreign subsidiary are the same as for the parent company. If the amount and timing of the net cash inflows to the foreign subsidiary and the parent company are not the same, the evaluation of the capital expenditure project is more complex than the example presented in this section. Some of the reasons that the amount and timing of the net cash flows to the foreign subsidiary and parent may differ include the following:

Differential tax rates for foreign and domestic companies in the country in which the project is planned

Legal and political constraints on cash remittances from the foreign country to the home country

Subsidized loans

The example presented in this section shows that the present value of a project’s net cash flows to the parent company is simply the present value of the project’s net cash flows from the foreign viewpoint converted into the home country currency at the current spot exchange rate.