Getting Creative with Capital Budgeting
From the past few articles, it may seem like capital budgeting has a pre-determined procedure. All the possible scenarios that can occur have been thought of and appropriate solutions for all of them have already been developed. While this makes capital budgeting a good subject, it also removes the creativity from it. There is a general perception that jobs pertaining to finance and capital budgeting are boring and lack creative potential. As we shall see in this article, this is definitely not the case. The subject does provide room for ample creativity. Here are some examples:
Timing of the Project
Our NPV rule says that if a project has a positive NPV, it is financially viable. The NPV rule does not say that the project needs to be undertaken immediately. As many creative professionals have shown before, the NPV of a project can be magnified just by waiting for sometime before you execute it.
Consider the case of a building construction. You have conducted your analysis and it shows that given the cash inflows and outflows listed on your schedule, the project is a good bet. Does that mean you should execute it immediately? Well, this wouldnt be the case if you found out additional information.
What if you found out that the government was about to declare an area near your proposed building site to be a tax-free zone for corporations. You would obviously expect a lot of companies to set up their shop there and this would increase the property prices, isnt it?
Also, what if you find out that the government is about to create an underground train line linking that area to the centre of the city. Now, obviously it would make sense to wait, right? The NPV of the project is positive now. But it will be many times larger, if we waited for some more time. (Assuming that the information is credible)
So, a positive NPV does not mean that the project should be executed immediately. Any project always has two implicit options. One is to execute it right away and the other is to execute it at a later date. Many times projects with negative NPV turn around positive in a few years. The real task of the financial manager therefore is to be aware of this information that could affect their project and look into the future. What is in the present can be easily seen and discounted even by a computer!
Many times companies are faced with this decision regarding whether or not they must re-engineer the way in which they operate. This may include shutting down for a few days and then re-opening with completely different equipment, processes etc. These projects are usually viewed by financial managers as an all or nothing game. They will calculate the NPV for the entire project as a whole before they make a decision.
Now, creative financial managers on the other hand realize that it doesnt have to be an all or nothing game. They pick and choose parts of the project and work out with combinations. They will try and find out if it is in the best interest to execute the entire project now or would executing 25% at a time for the next 4 years lead to a higher NPV.
The real point here is that the goal is to maximize the NPV. There will be given scenarios which are known to everyone. The trick is to think about the project in terms of time, partial implementation etc which are not the scenarios people would commonly think of. Like in all other professions, a good financial manager is a creative financial manager. He/she will find ways and means of maximizing the NPV.
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- The Consequences of Negative Interest Rates
- Opportunity Cost of Capital
- Valuing Cash Flows in Different Periods
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- Types of Annuity Calculations
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- Estimating Project Cash Flows: Part 2
- Estimating Project Cash Flows: Part 3
- Capital Budgeting and Inflation
- Capital Budgeting and Depreciation
- Equivalent Annual Costs
- Investing and Financing Decisions
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- The Fallacy of Creative Destruction
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