Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

7 We did not discuss the possibility that the new product line might cannibalise sales of existing

products. Is that likely to be a problem in this situation? Why or why not?

8 What are three ways that Protect IT might estimate the terminal value of this project?

9 Suppose Parliament passes legislation that allows Protect IT to depreciate its investment in

computers over three years rather than five. In general, what impact would this legislation have on

the project’s NPV?

CONCEPT REVIEW QUESTIONS 10-3

10-4 SPECIAL PrOBLEMS IN CAPITAL

BUDGETING

Though our objective in writing this book was to provide as much real-world focus as possible, real

business situations are more complex and occur in more varieties than any textbook can reasonably

convey. In this section, we examine common business decisions with special characteristics that make

them more difficult to analyse than the examples we have covered thus far. We will see that, whereas

the analysis may require a little more thinking, the principles involved are the same ones discussed

throughout this chapter and Chapter 9. In Chapter 11, we continue this theme when we discuss the

concept of real options and the impact of real options on strategic budgeting.

10- 4a CAPITAL rATIONING

In Chapter 9, we asked the following question: if a company must choose between several investment

opportunities, all worth taking, how does it prioritise projects? We learned that the IRR and PI methods

sometimes rank projects differently than the way NPV does, although properly applied, all three

techniques generate the same accept or reject decisions.

A Fundamental Question

There is a fundamental question that we have avoided until now. If the company has many projects with

positive NPVs (or investments with acceptable IRRs), why not accept all of them? One possibility is

that the company may be constrained by the availability of trained and reliable personnel – especially

managers. This prevents the company from growing extremely rapidly, especially because adding a new

product or project would require managerial talent of the highest order. Another possibility is that the

company simply does not have enough money to finance all its attractive investment opportunities. But

why couldn’t a large, publicly traded company raise money by issuing new shares to investors and using

the proceeds to undertake any and all appealing investments?

If you watch companies closely over time, you notice that most do not often issue new ordinary

shares. As Chapter 12 discusses more fully, companies generally prefer to finance investments with

internally generated cash flow, and will only infrequently raise money in the external capital markets by

issuing new equity. There are several possible reasons for this reluctance to issue new equity. First, when

companies announce their plans to raise new equity capital, they may send an unintended negative signal

to the market. Perhaps investors may interpret the announcement as a sign that the company’s existing

LO10.5

When assessing a particular

company, consider how the

overall budget for capital

investments is established.

thinking cap
question