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Chapter 12 - Strategy and the Analysis of Capital Investments
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Chapter 12 - Strategy and the Analysis of Capital Investments
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Teaching Notes for Readings
Reading 12-1: How Forest Product Companies Analyze Capital Budgets
This article presents the result of a survey on the uses of capital budgeting techniques by forest product
companies. Capital budgeting for this industry has become more challenging and riskier because of
increasing competitiveness and government and environmental pressures. The survey shows that 1) there
has been a significant increase in the use of the DCF method for all capital investment decisions, 2)
quantified risk analysis has taken on increased importance, 3) more firms implement post audit
procedures as a way to both monitor and control their capital investment, and 4) other procedures such as
breakeven analysis, probability analysis, and decision tress are coming into use as relevant capital
budgeting methodologies.
Discussion Questions:
Question 1: The survey result shows that more firms use one or more discounted cash flow methods
in evaluating timber-related investments. However, more firms use payback period to evaluate
plant and equipment purchases. What might be the reasons for these differences?
The survey found the 76% of the firm used a DCF method for time-related investments compared to
consideration for long investments.
Question 2: List changes in the uses of capital budgeting techniques over the years.
Among the changes over the years observed in the survey are:
1. A much higher percentage of the forest products firm uses one of the discounted cash flow
methods as a primary capital budgeting technique in 1998 (64%) than in 1977 (44%)
Question 3: List some of the methods for adjusting risks in capital investments.
Common methods for adjusting capital projects for risk are adjusting the cost of capital used in
Chapter 12 - Strategy and the Analysis of Capital Investments
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Reading 12-2: How ABC Was Used in Capital Budgeting
This article presents a case study on the difference that ABC makes on the investment decision of a new
project. A business forecast signaled “Go” to an interactive TV project, but the ABC analysis said,
“Stop.” The article discusses the utilization and limitations of activity-based costing (ABC) in capital
budgeting including capacity to predict operating and capital costs, benchmarking model and steps in
using ABC in capital investment project.
Discussion Questions:
Question 1: What is the general business case approach to capital budgeting?
A general business case approach generally is done at a broad strategic level with few supporting
level. Figure 1 in the article provides an overview of the business case approach to capital budgeting.
The process starts with broad market assumptions concerning the market size of the total market and
the expected market share of the firm. These assumptions are then converted into general projections
Question 2: How does an ABC model approach to capital budgeting differ from the general
business case approach?
The ABC model approach started with forecasts based on detailed benchmarked data. Using
benchmark assumptions, the ABC approach developed a deployment schedule and a transaction
volume schedule. Both schedules are then used to help generate the revenue, cost, and capital
assumptions and projections. Figure 2 provides an overview of the ABC approach to capital
budgeting.
Question 3: What are the roles of value chain in capital budgeting?
Question 4: List primary advantages and limitations of an ABC approach to capital budgeting.
Among advantages of an ABC approach to capital budgeting are:
1. The pro forma analysis of the business processes and activities with linkages to revenue and cost
structures provided critical information for the final analysis.
2. The ABC analysis can help clarify marketing strategies.
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Reading 12-3: Calculating a Firm’s Cost of Capital
This article provides an overview of the theory and practice associated with the process of estimating a
firm’s discount rate for capital-budgeting purposes. The discount rate for “average-risk” projects is
defined as the firm’s weight-average cost of capital (WACC). The authors present three different methods
for estimating a firm’s WACC. These methods are applied to data from both Microsoft and General
Electric. The authors conclude that careful judgment and the use of sensitivity analysis are important to
the estimation process.
Discussion Questions
1. For what managerial and/or decision-making applications is there a need to generate a firm’s
cost of capital? That is, what are the primary applications of the firm’s cost of capital?
A company’s cost of capital is used in a variety of decision-oriented contexts, such as: to evaluate
financial performance metric); and, for other asset valuations based on a discounted cash flow (DCF)
analysis.
2. Explain the primary components of a firm’s weighted-average cost of capital (WACC).
The term “cost of capital” refers to the cost of obtaining investment capital. In general, funds can be
obtained from two sources: debt and equity. Each of these sources (and subdivisions thereof) has an
associated after-tax financing cost. As the name implies, a weighted-average cost of capital (WACC)
represents an average after-tax financing cost for a given company. The weights in determining the
WACC are based on market (not book) values and theoretically reflect some target capital structure
(i.e., mix between debt and equity capital). Alternatively, as stated in the article the WACC
theoretically represents the average rate of return expected by all investors in the company: creditors of
long-term and short-term interest-bearing debt, preferred shareholders, and common stockholders.
3. What methods are available for estimating a firm’s cost-of-equity component of its WACC?
Explain the elements of each of these two methods.
For listed companies (i.e., companies whose shares are traded on an organized exchange), one approach
to estimating the cost of equity is to use the single-factor capital asset pricing model (CAPM). This
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4. Explain how uncertainties are handling in the process of estimating a firm’s WACC (or, more
generally, its discount rate).
As implied by the above discussion, there is both art and science involved in estimating a company’s
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Reading 12-4: What a University Can Teach You About Choosing Capital
Projects
This article provides a discussion of issues related to the analysis of capital expenditures in a not-for-
profit (i.e., university) setting. Of particular interest is the development of a model that, the authors
maintain, can be used to assess the strategic value of such expenditures. Thus, proposed capital
expenditures are evaluated in terms of their impact on the university’s mission, vision, and strategy. As
such, the model in this paper serves as an alternative to the multi-criteria decision models (such as AHP)
discussed in Chapter 12 of the text.
Discussion Questions
1. What is the primary business (or, managerial) issue addressed by the authors of this article?
The article looks at the capital budgeting decision process as applied by governmental and not-for-profit
(NFP) organizations. In such cases, the use of conventional discounted cash flow (DCF) decision
in certain investments—IT infrastructure, corporate support activities, etc.—made by for-profit
organizations. The handling of these investments via conventional DCF models is difficult at best.)
2. What solution do the authors propose for the business problem you identified above in (1)?
The authors propose a model that they developed and used at the University of Vermont during the
projects, based on an alignment with organizational strategy.
3. Provide an overview of how the model identified above in (2) was actually used in practice (at the
University of Vermont).
The model developed by a small team of MBA students and faculty members is presented as Figure 1
(page 40) and was the basis for the project-ranking system that could be used by university
administrators. This model consists of 13 scoring criteria divided into four categories: Guiding Factors,
Impact on Critical Players, What We Do, and Project Drivers. For example, under category 1, there are
examples). Each question used a scoring scheme of 0 to 3, with 0 = “no impact” and 3 = “high impact.”
As a show of support for the model, the university’s board of trustees accepted the highest-ranked
building proposal: a plant-and-soil science building. (See Exhibit 3 for a sample scoring form and the
final project rankings using the new scoring system.)
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Reading 12-5: Improving Capital Budgeting Decisions with Real Options
This article provides a non-technical introduction to the topic of real options, including how capital
investment analysis can be improved by incorporating the effects of real options that might be embedded
in such projects. For a fuller discussion of this topic, including tips for incorporating real options into the
accounting curriculum, see the following: D. E. Stout, H. Qi, Y. A. Xie, and S. Liu, “Incorporating Real
Options into the Capital Budgeting Process: A Primer for Accounting Educators,” Journal of Accounting
Education, Vol. 26 (2008), pp. 213-230.
Discussion Questions
1. Define the terms financial options, real options, and real assets. In what sense are real options
similar to and distinct from financial options?
Financial options are securities that provide holders with the opportunity to manage risk and capitalize
on new information revealed in the market over time. Financial options associated with new issues of
securities include: stock warrants/options (i.e., options to purchase shares from the company at a
stipulated price prior to an expiration date), convertible bonds (i.e., bonds for which the holder can
exchange for a specified number of shares of stock), and callable bonds (i.e., bonds that the issuing
company can recall, at a specified price, prior to the maturity date of the bonds).
on an organized exchange, real options are not. Conceptually, however, both real options and financial
options can be valued using an asset pricing model, such as the Black-Scholes Option Pricing Model.
2. Describe the primary types of real options that might be embedded in a capital expenditure
project.
For discussion purposes, we might classify real options into four categories, as follows:
a) Expansion options (i.e., the option to make follow-on investments if the immediate investment
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3. What argument do the authors make as to a recommended role of real options analysis for
purposes of evaluating capital investments?
Conventional discounted cash flow (DCF) models used to evaluate capital investment proposals are
static in nature in the sense that they assume management acts passively after an initial investment
decision is made. As such, conventional DCF models effectively assign a value of zero to any real
options that might be embedded in an investment project. From a capital budgeting decision
perspective, this implies the possibility of a less-than-optimal capital budget—some projects that might
be rejected on a DCF basis are actually quite valuable after adjusting the conventional DCF analysis to
4. Provide an overview of the primary example used as the basis for discussion in this article.
The investment decision being contemplated by a business was to purchase a hybrid vehicle or a
gasoline-powered vehicle. When evaluated using a conventional DCF analysis, the purchase of a hybrid
vehicle was rejected because the estimated net present value (NPV) of this alternative was negative (at a
10% discount rate—see Equation 1). The cash inflows associated with this proposed investment were
uncertain (i.e., subject to risk), particularly the income tax benefits, since these are determined
periodically by Congress. Since the NPV of the alternative “purchase gas vehicle now” was positive
