01 - Adv Issues in Cap Budgeting

Example - 1: Selling under-valued stocks to finance project
No. of Shares o/s

Value / share
Mkt Price / share
Mkt value of firm
100
100
80
8,000
crores
Rs.
Rs.
Rs. Crore
D
E
DER
4,200 Rs. Crore

3,800 Rs. Crore
1.11
Shares under-valued by the market
The firm faces the following investment opportunity

Initial Investment
100 crore Rs.
NPV
10 crore Rs.
Since DER is already high, the firm decides to fund this by raising fresh equity.
No. of shrs to be
issued by the firm
1.25 =C14/C6
Gain to existing
shareholders due to project
10 =NPV
Loss to existing shareholders for issuing stock

at below true value
25 Rs. Crore
Net gain/loss to existing

Shareholders
(15) Rs. Crore
Net gain/loss to existing

Shareholders per share
(0.15) Rs.
=c20*(Value - Price)
=C23 - C27
=C30/C4
Example - 2A: NPV versus IRR - Projects with Different Scale

Note: These involve RANKING with CONVENTIONAL PROJECTS
There are two projects - A & B - with significant differences in
scale of the project (in terms of investment & cash flows)
WACC
Period
0
1
2
3
4
NPV
IRR
15.00%
15.00%
(Rs. Crore)
CF-A
CF-B
(10.0) (100.0)
3.5
30.0
4.5
35.0
6.0
45.0
7.5
55.0
4.68
33.66%
Note that the conflict disappears

at a higher cost of capital of
19.30% - 19.35% (than 15%).
13.59 SELECT PROJECT B

20.88% SELECT PROJECT A
Example - 2B: NPV versus IRR - Projects with Same Scale

Note: These involve RANKING with CONVENTIONAL PROJECTS
WACC
Period
0
1
2
3
4
NPV
IRR
15.00%
15.00%
(Rs. Crore)
CF-A
CF-B
(100.0)
###
50.0
30.0
40.0
33.0
32.0
45.0
30.0
55.0
11.92
21.41%
12.07 SELECT PROJECT B

20.23% SELECT PROJECT A
Example - 3A: Using the Profitability Index to Choose Projects

A firm (say Bookspace Ltd.) is facing the following seven alternative
projects to choose from during the next one year. The firm has a total
investable capital of Rs. 100 crore that it can that it can pool from
all sources (internal & external, debt & equity).
Project
Initial Invt. NPV

(Rs. Crore) (Rs. Cr.)
A
B
C
D
E
F
G
25
40
5
100
50
70
35
10
20
5
25
15
20
20
Given the information above, how should the firm select the projects,
and which projects should it select?
To resolve this, we compute the PI of each project, and find the rank of each.
Project
A
B
C
D
E
F
G
Initial Invt. NPV

25
10
40
20
5
5
100
25
50
15
70
20
35
20
PI
Rank_PI
0.40
0.50
1.00
0.25
0.30
0.29
0.57
4
3
1
7
5
6
2
Next, we arrange the projects in order of descending /ascendning

magnitude of PI (Rank_PI):
Constraint = Rs. 100 crore
Project
Initial Invt. NPV
PI
Rank_PI Cum_Invt
(Rs. Crore)
C
5
5
1.00
1
5
G
35
20
0.57
2
40
B
40
20
0.50
3
80
A
25
10
0.40
4
105
E
50
15
0.30
5
F
70
20
0.29
6
D
100
25
0.25
7
Given the investable resource of Rs. 100 crore, the firm can adopt
only the first three projects (C, G & B).
Then the firm is left with un-utilized investment capacity of Rs. 20 crore.
Example - 3B: Using the Profitability Index to Choose Projects - with Project Dependence
Since B has to be undertaken, we exclude B's project cost (Rs. 40 crore).
We also reduce the constraints by Rs. 40 crore.
We redraw the list as follows:
Constraint = Rs. 60 crore
Project
Initial Invt. NPV
PI
Rank_PI Cum_Invt
(Rs. Crore)
C
G
A
E
F
D
5
35
25
50
70
100
5
20
10
15
20
25
1.00
0.57
0.40
0.30
0.29
0.25
1
2
3
4
5
6
5
40
65
If it can stretch it's finances a little bit to garner

an additional resource of Rs. 5 crore, it can
adopt project A as well
Question is: what are the trade-offs?
Example - 4: Modified Internal Rate of Return (MIRR) - computation

Let us consider the following project.
Period
0
1
2
3
4
WACC
(Rs. Million)
CF
(1,000)
300
400
500
600
IRR =
15%
24.89%
The IRR above is based on the assumption that cash flows of years
1, 2 and 3 respectively are re-invested at the same rate (IRR).
MIRR is computed on the basis that intermediate cash flows are
re-invested at the cost of capital. This is worked out below.
Period
Cash Flows
Investment
Thus, MIRR for this project is computed as follows:

MIRR =
21.23%
(IRR = 24.89% )
(1,000)
1
300
Example - 5: Cash Flows of a Service - Installing a Telecom System

The firm must instal a telecom system to carry out its business
It has two alternatives - one with higher initial cost but lesser
maintenance cost. The other alternative involves lower initial
cost but higher annual maintenance cost.
Note that this is a case of minimizing cost.
Discount rate of firm
10%
(Rs. Crore)
Vendor-1
Vendor-2
Investment
CF1
CF2
CF3
CF4
CF5
-20
-8
-8
-8
-8
-8
-30
-3
-3
-3
-3
-3
Vendor-1
(PV)
1
2
3
4
5
NPV
Vendor-2
(PV)
(7.27)
(6.61)
(6.01)
(5.46)
(4.97)
(2.73)
(2.48)
(2.25)
(2.05)
(1.86)
(50.33)
(41.37)
Hence Vendor-2 should be selected.
Example - 6: Equivalent Annuities Method

Investments and cash flows of the two projects are:
Discount Rate
Year
0
1
2
3
4
5
6
7
8
9
10
NPV
Lifetime
Eqv Annuity
15%
Project A
-100
40
40
40
40
40
12%
Project B
-150
35
35
35
35
35
35
35
35
35
35
34.65
5
47.76
10
10.29
8.45
34.65
Equivalent Annuity =NPV
( 1 ( 1+ r )n )
ZOOM TO 145%
2
400
(Rs. Million)
3
4
500
600
PV at Cost of Capital
600.00
575.00
529.00
456.26
PV_at_COC
(Terminal Value)
2,160.26
r
n
( 1+ r )
Call Option - Long & Short

Strike Price (X):
Strike Date
T
Premium
50
7
Spot Price (ST) Pay-Off-LonPay-Off-Short Put Option

30
13
-13
31
12
-12
32
11
-11
33
10
-10
34
9
-9
35
8
-8
36
7
-7
37
6
-6
38
5
-5
39
4
-4
40
3
-3
41
2
-2
42
1
-1
43
0
0
44
-1
1
45
-2
2
46
-3
3
47
-4
4
48
-5
5
49
-6
6
50
-7
7
51
-7
7
52
-7
7
53
-7
7
54
-7
7
Put Option - Long & Short

Strike Price (X):
Strike Date
T
Premium
50
7
Spot Price (ST) Pay-Off-LonPay-Off-Short Call Option

40
-7
7
41
-7
7
42
-7
7
10
8
6
4
2
15
10
5
0
25
30
35
40
45
-5
-10
-15
Pay-Off-Long Put Option
Pay-Off-
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
-7
-7
-7
-7
-7
-7
-7
-7
-6
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
7
7
7
7
7
7
7
7
6
5
4
3
2
1
0
-1
-2
-3
-4
-5
-6
-7
-8
10
8
6
4
2
0
-2 35
-4
-6
-8
-10
40
45
Pay-Off-Long Call Option
50
55
60
65
Pay-Off-Short Call Option
35
40
Long Put Option
45
50
55
Pay-Off-Short Put Option
60
55
60
65
Pay-Off-Short Call Option
70
Cause
Debt limit imposed by outside agreement
Number of firms
10
Percent of total
10.6%
Debt limit placed by management external to firm

Limit placed on borrowing by internal
management
3.2%
65
69.1%
Restrictive policy imposed on retained earnings

Maintenance of target EPS or PE ratio
2
14
2.1%
14.9%
TOTAL
94
---
Source: Damodaran, Applied Corporate Finance, 3/e, Wiley-India Edition (2011: John Wiley & Sons Inc.; Reprint 2012 by Wil
& Sons Inc.; Reprint 2012 by Wiley India Edition)
Theory
A business uncovers
a good investment
opportunity.
Practice
A business believes,
given the underlying
uncertainty, that it
has a good project.
Source of Rationing
Uncertainty about
true value of
projects may cause
rationing.
2. Information
revelation
The business
conveys information
about the project to
financial markets.
The business
attempts to convey
information to
financial markets.
Difficulty in
conveying
information to
markets may cause
rationing.
3. Market response
Financial markets
believe the firm;
i.e., the information
is conveyed
credibly.
Financial markets
may not believe the
announcement.
The greater the

credibility gap, the
greater the rationing
problem.
4. Market efficiency
The securities
issued by the
business (stocks and
bonds) are fairly
priced.
The securities
issued by the
business may not be
correctly priced.
With underpriced
securities, firms will
be unwilling to raise
funds for projects.
5. Flotation costs
(or Transaction costs)
There are no costs

associated with
raising funds for
projects.
There are significant

costs associated
with raising funds
for projects.
The greater the

flotation costs, the
larger will be the
capital rationing
problem.
1. Project discovery
Source: Damodaran, Applied Corporate Finance, 3/e, Wiley-India Edition (2011: John Wiley & Sons Inc.; Reprint 2012 by Wil
pp. 263
ns Inc.; Reprint 2012 by Wiley India Edition)

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Example - 1: Selling under-valued stocks to finance project

No. of Shares o/s

4,200 Rs. Crore

Shares under-valued by the market

The firm faces the following investment opportunity

Loss to existing shareholders for issuing stock

Net gain/loss to existing

(15) Rs. Crore

Net gain/loss to existing

Example - 2A: NPV versus IRR - Projects with Different Scale

Note that the conflict disappears

13.59 SELECT PROJECT B

Example - 2B: NPV versus IRR - Projects with Same Scale

12.07 SELECT PROJECT B

Example - 3A: Using the Profitability Index to Choose Projects

Initial Invt. NPV

Initial Invt. NPV

Next, we arrange the projects in order of descending /ascendning

If it can stretch it's finances a little bit to garner

Example - 4: Modified Internal Rate of Return (MIRR) - computation

Thus, MIRR for this project is computed as follows:

Example - 5: Cash Flows of a Service - Installing a Telecom System

Hence Vendor-2 should be selected.

Example - 6: Equivalent Annuities Method

Equivalent Annuity =NPV

Call Option - Long & Short

Spot Price (ST) Pay-Off-LonPay-Off-Short Put Option

Put Option - Long & Short

Spot Price (ST) Pay-Off-LonPay-Off-Short Call Option

Pay-Off-Long Call Option

Pay-Off-Short Call Option

Long Put Option

Pay-Off-Short Put Option

Pay-Off-Short Call Option

Debt limit placed by management external to firm

Restrictive policy imposed on retained earnings

& Sons Inc.; Reprint 2012 by Wiley India Edition)

The greater the

There are no costs

There are significant

The greater the

ns Inc.; Reprint 2012 by Wiley India Edition)

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