CASES 20 AND 21
DIAMOND CHEMICALS PLC (A) AND (B) Teaching Note
Synopsis and Objectives Suggestions fo co!p"e!entay cases egading capita" budgeting: ;,onderia di Torino< Torino< case 1=!& ;4en*yme"4eltex ;4en*yme"4eltex 6harmaceuticals Joint 8enture&< case 22!.
These These two cases cases presen presentt the capit capital al inve investm stment ent decis decisio ions ns under under consid considera erati tion on by executives of a large chemicals firm in January 2001. The A case case 20! presents a go"no#go pro$ect evaluation regarding regarding improvements improvements to a polypropylene polypropylene production plant. The % case case 21! reviews the same pro$ect but from one level higher& where the executive faces an either"or investment decision between two mutually exclusive pro$ects. The ob$ective of the two cases is to expose students to a wide range of capital budgeting issues' issues' A case: go/no-go decision
1. The identifi identification cation of relevant relevant cash flows( flows( in in particular& particular& the treatment of' a. sun) costs b. cash flows flows obtained by cannibali cannibali*in *ing g another activity activity within within the firm c. exploitation exploitation of excess transportation capacity d. corporate overhead allocations allocations e. cash flows of unrelated pro$ects pro$ec ts
This teaching note and t he associated cases were written by +obert +obert ,. %runer& %runer& drawing on the general experience of -r. ,ran) . /cTigue& a consultant in the chemical industry. The author than)s en ades for a number of valuable analytic insights. Any errors remain the authors. -iamond 3hemicals is a fictional company& reflecting the issues facing actual firms. The development of the cases was supported financially by the 3iticorp 4lobal 5cholars 6rogram. 3opyright � 2001 by the 7niversity of 8irginia 8irginia -arden 5chool ,oundation& 3ha rlottesville& 8A. 8A. All rights reserved. reserved. To order copies, send an e-mail to sales9dardenpublishing.com. No part of this publication may be reproduced, stored stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means —electronic, mechanical, photocopying, recording, recording, or otherwise—without otherwise—without the permission of the Darden Darden School Foundation. +ev. 10"0:.
f. inflation. 2. The critical critical assessment assessment of a capital#inv capital#investme estment nt evaluation evaluation system. system. >. The treatment treatment of conflict conflictss of interest interest and other ethical ethical dilem dilemmas mas that that may arise arise in investment decisions. # case: eit$e/o decision
1. The relev relevanc ancee of cash cash flows flows from asset assetss that that may may be separa separabl blee from the core pro$ect. 2. The classic classic crossove crossoverr problem& problem& in which which pro$ect pro$ect ran)ings ran)ings disagr disagree ee on the basis basis of net present value N68! and internal internal rate of return ?++!. >. The asses assessm sment ent of real real option option valu valuee latent latent in manager manageria iall flex flexib ibil ilit ity y to chang changee operating technologies. technologies. @. The identi identifi ficat cation ion of some class classic ic games games or types of human behav behavior ior that can be counterproductive in the resource#allocation resource#allocation process.
Suggested %uestions fo Advance Study
Two xcel spreadsheet files support student analysis of these cases' 3ase -iamond 3hemicals 63. A! -iamond 3hemicals 63. %!
5preadsheet ,ile 3aseB20.xls 3aseB21.xls
/a)ing those files available in advance to students is highly recommended. ?nstructor analysis may rely on TNB20.xls& which should not be shared with students.! A case
1. Chat Chat changes changes&& if any any& should should ucy /orri /orriss as) ,ran) ,ran) 4reysto 4reystoc) c) to ma)e ma)e in his discounted cash flow -3,! analysisD ChyD Chat should /orris be prepared to say to the Transport -ivision& the -irector of 5ales& her assistant plant manager& and the analyst from the Treasury 5taffD
This teaching note and the associated cases were written by 6rofessor +obert ,. %runer& drawing on the general experienc experiencee of -r. ,ran) . /cTigue /cTigue&& a consultant consultant in the chemical chemical industry. industry. The author than)s en ades for a number of valuable analytic analytic insights. Any errors errors remain the authors. -iamond 3hemical is a fictional company& company& reflecti reflecting ng the issues facing facing actual actual firms. firms. The developmen developmentt of cases cases was supported financially financially by the 3iticorp 3iticorp 4loba 4loball 5chola 5cholars rs 6rogr 6rogram. am. 3opy 3opyrig right ht E 2001 2001 by the 7niver 7niversit sity y of 8irg 8irginia inia -arden -arden 5chool 5chool ,oundat ,oundation& ion& 3harlottesville& 8A. To order copies, send an e-mail to dardencases9virginia.edu. No part part of this this publication publication may be reproduced, stored stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means —electronic, mechanical, photocopying, recording, recording, or otherwise—without otherwise—without the permission of the Darden Foundation.
f. inflation. 2. The critical critical assessment assessment of a capital#inv capital#investme estment nt evaluation evaluation system. system. >. The treatment treatment of conflict conflictss of interest interest and other ethical ethical dilem dilemmas mas that that may arise arise in investment decisions. # case: eit$e/o decision
1. The relev relevanc ancee of cash cash flows flows from asset assetss that that may may be separa separabl blee from the core pro$ect. 2. The classic classic crossove crossoverr problem& problem& in which which pro$ect pro$ect ran)ings ran)ings disagr disagree ee on the basis basis of net present value N68! and internal internal rate of return ?++!. >. The asses assessm sment ent of real real option option valu valuee latent latent in manager manageria iall flex flexib ibil ilit ity y to chang changee operating technologies. technologies. @. The identi identifi ficat cation ion of some class classic ic games games or types of human behav behavior ior that can be counterproductive in the resource#allocation resource#allocation process.
Suggested %uestions fo Advance Study
Two xcel spreadsheet files support student analysis of these cases' 3ase -iamond 3hemicals 63. A! -iamond 3hemicals 63. %!
5preadsheet ,ile 3aseB20.xls 3aseB21.xls
/a)ing those files available in advance to students is highly recommended. ?nstructor analysis may rely on TNB20.xls& which should not be shared with students.! A case
1. Chat Chat changes changes&& if any any& should should ucy /orri /orriss as) ,ran) ,ran) 4reysto 4reystoc) c) to ma)e ma)e in his discounted cash flow -3,! analysisD ChyD Chat should /orris be prepared to say to the Transport -ivision& the -irector of 5ales& her assistant plant manager& and the analyst from the Treasury 5taffD
This teaching note and the associated cases were written by 6rofessor +obert ,. %runer& drawing on the general experienc experiencee of -r. ,ran) . /cTigue /cTigue&& a consultant consultant in the chemical chemical industry. industry. The author than)s en ades for a number of valuable analytic analytic insights. Any errors errors remain the authors. -iamond 3hemical is a fictional company& company& reflecti reflecting ng the issues facing facing actual actual firms. firms. The developmen developmentt of cases cases was supported financially financially by the 3iticorp 3iticorp 4loba 4loball 5chola 5cholars rs 6rogr 6rogram. am. 3opy 3opyrig right ht E 2001 2001 by the 7niver 7niversit sity y of 8irg 8irginia inia -arden -arden 5chool 5chool ,oundat ,oundation& ion& 3harlottesville& 8A. To order copies, send an e-mail to dardencases9virginia.edu. No part part of this this publication publication may be reproduced, stored stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means —electronic, mechanical, photocopying, recording, recording, or otherwise—without otherwise—without the permission of the Darden Foundation.
2. ow attractive attractive is is the /erse /erseys yside ide pro$ect pro$ectDD %y what what criteria criteriaDD >. 5hould 5hould /orris /orris continue continue to to promote the the pro$ect pro$ect for fundi fundingD ngD
This teaching note and the associated cases were written by 6rofessor +obert ,. %runer& drawing on the general experienc experiencee of -r. ,ran) . /cTigue /cTigue&& a consultant consultant in the chemical chemical industry. industry. The author than)s en ades for a number of valuable analytic analytic insights. Any errors errors remain the authors. -iamond 3hemical is a fictional company& company& reflecti reflecting ng the issues facing facing actual actual firms. firms. The developmen developmentt of cases cases was supported financially financially by the 3iticorp 3iticorp 4loba 4loball 5chola 5cholars rs 6rogr 6rogram. am. 3opy 3opyrig right ht E 2001 2001 by the 7niver 7niversit sity y of 8irg 8irginia inia -arden -arden 5chool 5chool ,oundat ,oundation& ion& 3harlottesville& 8A. To order copies, send an e-mail to dardencases9virginia.edu. No part part of this this publication publication may be reproduced, stored stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means —electronic, mechanical, photocopying, recording, recording, or otherwise—without otherwise—without the permission of the Darden Foundation.
# case
As described below& if the % case is taught on a stand#alone basis& the instructor should distribute the memorandum in E&$ibit 'N1& which presents the -3, analysis for the /erseyside pro$ect& corrected for the issues discussed in the A case. 1. Chy are the /erseyside and +otterdam pro$ects mutually exclusiveD 2. ow do the two pro$ects compare on the basis of -iamond 3hemicals investment criteriaD Chat might account for the differences in ran)ingsD >. ?s it possible to Fuantify the value of managerial flexibility associated with the /erseyside pro$ectD ow& if at all& does this flexibility affect the economic attractiveness of the pro$ectD @. Chat are the differences in the ways li*abeth ustace and ucy /orris have advocated their respective pro$ectsD ow might those differences in style have affected the outcome of the decisionD :. Chich pro$ect should James ,awn propose to the chief executive officer and the board of directorsD
'eac$ing Out"ine
The two cases are meant to be taughtGone eachGin seFuential class sessions. The instructor could& however& teach the A case alone in a straightforward manner& and the % case alone by distributing 4reystoc)s revised discounted cash flow -3,! analysis included here as E&$ibit 'N1! along with the % case. ("an fo t$e A case
1. ow does Diamond !hemicals evaluate its capital-e"penditure proposals# $hy such a complicated scheme# The purpose of this opening is to focus students thin)ing on the hurdles that the /erseyside pro$ect must clear. ?t also affords an opportunity to discuss the relative merits of different investment criteria. 2. $hat is the Transport Division%s suggestion# Does it have any merit# ere the class must grapple with the potential charge for the use of excess capacity in another division. >. $hat is the director of sales% suggestion# Does it have any merit# The focus here should be the cannibali*ation issue.
@. $hy did the assistant plant manager offer his suggested change# Does it have any merit# This Fuestion raises the issue of extraneous cash flows.
:. $hat did the analyst from the Treasury Staff mean by his comment about inflation# Do you agree with it# At this stage of the discussion& students should review the need for internally consistent assumptions about inflation. H. ow should &reystoc' modify his D!F analysis# This Fuestion turns to a summary of the ad$ustments needed to produce an acceptable -3, analysis. I. $hat is the (erseyside pro)ect worth to Diamond !hemicals# 6roducing& in class& a revised -3, analysis helps to provide students with closure on the discussion. ("an fo t$e # case
1. Do you endorse *ustace%s analysis of the pro)ect at +otterdam# ow would you improve on it# This open#ended Fuestion is intended to stimulate a critiFue of ustaces analysis. The )ey point of ob$ection is her inclusion of the right#of#way in the analysis. A brief discussion should establish that the option of the right#of#way should be exercised regardless of whether the pro$ect at the +otterdam plant is underta)en. Therefore& the cash flows associated with the right#of#way should be separated from the rest of the +otterdam pro$ect cash flows. ?t is a simple matter to recast the -3, analysis without the cash flows. The result is that the N68 of the +otterdam pro$ect $ust slightly exceeds the N68 of the /erseyside pro$ect ad$usted to correct for the changes suggested in the A case!. 2. fter eliminating the right-of-way cash flows at +otterdam, how do the (erseyside and +otterdam pro)ects compare financially and along other dimensions# This surfaces the relatively more credible N68 figures on both pro$ects& and exposes the inconsistent ran)ing of pro$ects by N68 and ?++. >. $hy don%t the various investment criteria ran' the two pro)ects identically# The purpose here is to focus on the crossover problem and its cause& which is the massive differences in the time profiles of cash flow. @. $hat should one do when ++ and N/ disagree in ran'ing mutually e"clusive pro)ects# The answer is that one should focus on the ran)ing by N68& because it embodies a more reasonable reinvestment#rate assumption than ?++ and because& in theory& N68 is the amount by which the mar)et value of eFuity will change if the pro$ect is underta)en. 5tudents will need to chew this over a bit( the instructor might be prepared with some comments on this point. :. $hat do you ma'e of Fawn%s concern about 0fle"ibility1# !an we deal with that analytically and, if so, what is its effect on the value of the (erseyside pro)ect# $hat about on the +otterdam pro)ect# ere the students must deal with the value of the option to change technologies.
H. Should Fawn be swayed by *ustace%s rhetoric# ustaces behavior displays a number of classic games used by people attempting to influence the resource#allocation process. 5tudents should see that such games tend to obstruct rather than improve the process. I. $hich pro)ect should Fawn approve# ow should he )ustify his decision to the board of directors, who have already been e"posed to *ustace%s ideas# The instructor can close the discussion with a vote and some summary comments on the wide range of issues that might have driven the decision another way in a different setting.
Supp"e!enta" 'ec$nica" Notes
At the end of this teaching note are three supplemental notes the instructor may choose to distribute to students. Supp"e!enta" Note 'N1' ;+elevant 3ash ,lows&< could be useful to students if distributed in advance of the discussion of the A case. Supp"e!enta" Note 'N2 ' ;8aluing /anagerial ,lexibility and 3ommitment&< could be useful if distributed in advance of the discussion of the % case. Supp"e!enta" Note 'N) ' ;+eflections on the +eal Corld of 3apital %udgeting&< is useful as a wrap#up note for distribution after discussions of both cases.
Co""atea" *eadings fo t$e # Case
The application of option#pricing theory to decisions involving real asset investments may be new to students. Thus& supplementing their study of the % case with some of the following readings might be useful' •
%realey& +ichard A.& /yers& 5tewart 3.& and Allen& ,ran)lin. ;ptions.< 6art H! rinciples of !orporate Finance. =th edition New Kor)' /c4rawLill igher ducation& 200H!.
•
ester& 3arl. ;Todays ptions for Tomorrows 4rowth.< arvard 2usiness +eview /archLApril
[email protected]!' 1:>L1H0.
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/argrabe& Cilliam. ;The 8alue of an ption to xchange ne Asset for Another.< 3ournal of Finance >> /arch 1MI=!' 1IIL1=H.
•
Trigeorgis& enos& and 5cott 6. /ason. ;8aluing /anagerial ,lexibility.< (idland !orporate Finance 3ournal 5pring 1M=I!'
[email protected]
Ana"ysis of t$e A Case Citi+ue of capita"-invest!ent ana"ysis at Dia!ond C$e!ica"s Case A: -iscussion Fuestion 1
The A case presents information regarding -iamond 3hemicals investment criteria and thus affords opportunities for the students to thin) critically about the incentives and the side effects of the four hurdles. *S growth' This ob$ective is dubious. arnings per share can be easily manipulated by changes in accounting policies& and the figure ignores the investment necessary to produce earnings growth. /oreover& this ob$ective penali*es longer#term pro$ects that may yield a low or even a negative! contribution to earnings in the near term. /ost textboo)s present the considerable volume of academic evidence that the mar)et is not fooled by cosmetic changes in 65 but& instead& the mar)et values cash flows. ,inally& the method of implementing this criterion may penali*e small pro$ects that ma)e a relatively insignificant contribution to the corporation%s 65. aybac' ' The classic flaws of paybac) are that it ignores the time value of money and ignores cash flows occurring after the paybac) hori*on. ne possible reason that firms use this measure is that they feel financially constrained in their ability to finance new pro$ects and wish to underta)e only those pro$ects that do not impose
an unacceptable drag on the firms finances. ne effect of the paybac) criterion is to focus managers attention on near#term performance& possibly to the detriment of longer#term investing. N/ and ++' These measures most closely reflect the interests of investors and fully account for the entire life of a pro$ect. 7nfortunately& they are also somewhat more difficult to use than the other two measures& and may not always agree& as shown in the % case analysis.
Case A: -iscussion Fuestions 2& >& :& and H.
ne virtue of -iamond 3hemicals evaluation approach is the system of varying investment hurdles. 4enerally& the reFuired rates of return rise with the ris) of the pro$ects& which is consistent with the general ris)"return framewor) of finance and is representative of systems presently being adopted at ma$or corporations. Adjust!ents to DC, ana"ysis
4reystoc)s preliminary -3, analysis of the /erseyside pro$ect should be corrected for at least two violations of the principles of relevant costs and could be ad$usted in other ways& depending on ones $udgment. The main issues to be resolved and the possible responses to each are as follows' *ngineering study' %ecause the funds are already spent& they should not be included in the cash#flow analysis. The principle here is' -o not include sun) costs. The text of the case did not highlight this issue& but sharp students will note it. !orporate overhead allocation' These charges are not incremental flows of cash but& rather& accounting allocations. 7nderta)ing the /erseyside pro$ect will not necessarily trigger more headFuarters expense indeed& many students will say that it is unli)ely to trigger more expense!. At issue here is the principle of discounting only incremental cash flows. Again& the text does not highlight this issue& but sharp students will raise it. !annibali4ation of the +otterdam plant ' 5tudents must confront the ;scope of analysis< issue and ta)e into account the investors% perspective. 7nless managers adopt the perspective of the owners of the corporation& they may ma)e suboptimal investment decisions. 6articularly interesting here is the ambiguity about whether +otterdam will inevitably be cannibali*ed. vidently& the director of sales thin)s it will& whereas the mar)eting vice president thin)s it will not if sales can be ta)en away from 5aone#6oulet and"or 8aysol 5.A. the competitors with the next lowest costs!. -ifferent classes of students will have different $udgments about this issue& but the comments in the case about the severity of the current recession are li)ely to suggest to students that cannibali*ation is more probable than not. ?f cannibali*ation is expected to occur& then +otterdams decline in after#tax gross profits must be reflected in the cash flows of the /erseyside pro$ect. 5se of e"cess capacity in tan' cars' 7nderta)ing the /erseyside pro$ect will trigger no purchase of tan) cars today& so some students will argue that the proposed shadow charge for tan)#car capacity is inappropriate to include in the analysis. The counterargument is that
/erseyside will trigger an earlier expenditure than it would have otherwise. The proper ad$ustment here is to reflect the change in timing of expected cash flows. A second issue to consider is whose interests are at sta)e. 4reystoc) seems to suggest that the pro$ect should be evaluated from the narrow perspective of the /erseyside Cor)s or the ?ntermediate 3hemicals 4roup& but a basic principle of capital budgeting is that pro$ects should be evaluated from the standpoint of investors in the entire company. Thus& accounting for secondary effects induced by underta)ing a pro$ect is appropriate no matter how far afield those effects are from the business unit in Fuestion. The final issue regarding the tan) cars has to do with the interdependence of excess capacity and the cannibali*ation issue. ?f the class has decided that /erseyside will erode the volume of +otterdam& some students may be tempted to argue that the spare capacity absorbed by /erseyside will be offset by an increase in spare capacity from the decline in volume at +otterdam. %ut the A case explicitly states that the rolling stoc) is not usable outside %ritain& because of differences in trac) gauge. !hanges in inventory' 5tudents often neglect to reflect in their expenditure analyses the changes in wor)ing capital resulting from a pro$ect. 4reystoc) has shown an increase in raw materials and wor) in process C?6! inventory driven by the increased throughput at the plant. e has ignored the potential recapture of that inventory& however& at the end of the pro$ect life. The buildup of inventory does not simply vanish at the end of year 1:. 3ash in the amount of the inventory buildup is thus shown in E&$ibits 'N1 and 'N2 as being returned during the 1:th year& the last year of the pro$ect. ?nventory ad$ustments must also reflect the reduced wor)ing capital reFuirement at +otterdam brought about by cannibali*ation. Those ad$ustments are reflected as necessary in E&$ibits 'N1 and 'N2. d)ustment for inflation' 4reystoc)s analysis in the A case indeed mismatches cash flows and discount rates. 5tudents should be encouraged to discuss the need for internally consistent assumptions about inflation in both cash flows and discount rate. The modification is straightforward' students should inflate cash flows at > and )eep the current discount rate of 10.1
1 5ome students might assume 0 inflation and use a I discount rate. This is also correct but reFuires more complicated ad$ustments. ?f students want to use real cash flows& they must also deflate the depreciation figures by the annual inflation rate to reflect the loss in purchasing power of the tax savings associated with the depreciation.
E&taneous cas$ f"os and et$ics Case A: -iscussion Fuestion @
4riffin Tewitts proposal to include the 63 ethylene#propylene#copolymer rubber! pro$ect is characteristic of the )inds of adverse games that operating managers can play with capital budgeting. ,or another example& Joseph %ower recounts how one manager built almost an entire plant on the basis of small investment authori*ations that were within a managers own power to approve.2 The manager was caught when he submitted an investment proposal for a chimney the cost of which exceeded his personal authori*ation limit!. 4reystoc)s analysis should not be modified to include the 63 pro$ect for two reasons' 1. To do so is to violate the basic axiom of relevant cash flows' ne should include only those flows of cash that are incremental to the pro$ect being valued. As the case states& the 63 pro$ect is ;separate and independent< from the polypropylene#line renovation( its flows simply do not belong in this valuation analysis. 2. To do so is at the least surreptitious and practically amounts to lying about the nature of the pro$ect. 5enior executives have already re$ected the pro$ect. To include it in the polypropylene pro$ect is to willfully undercut ones own leaders& a failure of ones responsibility as an agent. The conflict of interest underlying this principal#agent brea)down is clear in Tewitts own comments to maximi*e plant si*e& to maximi*e personal bonuses& and to avoid layoffs because they are painful to ma)e. e advocates this step despite the implication that the shareholders will be worse off from this investment. ,inally& the potential personal ris)s to /orris are disproportionately greater than any benefits she might receive. ,ailures of ones duties as an agent tend not to be well received in large& bureaucratic organi*ations. Su!!ay of evisions and t$ei i!pact Case A: -iscussion Fuestion I
3ontained in E&$ibit 'N1 is a memo from 4reystoc) and /orris to ,awn& the )ey decision ma)er& in which changes have been made to reflect ad$ustments based on these five issues. 5pecifically& the costs of the engineering study and overhead allocation have been dropped from the cash flows. The forecast is given for cases of no erosion and full erosion of business at the sibling plant. The cash#flow effect from the change in timing of new tan) cars is reflected& as are the changes in inventory. The cash flows are discounted at the nominal rate of 10& and 2 5ee Joseph . %ower& (anaging the +esource llocation rocess6 Study of !orporate lanning and nvestment %oston' -ivision of +esearch& arvard %usiness 5chool& 1MI0!.
inflation of > is incorporated into the models. ?n sum& the pro$ect offers a N68 of %ritish pounds! OI.2M million and an ?++ of 22.: or& if no ad$ustment were made for erosion& O1>.M2 million and >1.2!. ?f the /erseyside pro$ect were to be evaluated now on a stand#alone& go"no# go basis& it should be accepted.
Case #: -iscussion Fuestion 1
The revised estimates in E&$ibit 'N1 afford a focal point for the students with which to continue the analysis in the % case. ?deally& the instructor would hand out copies of E&$ibit 'N1 with little or no comment other than to say& ;This is how ,ran) 4reystoc) finally decided to model the pro$ect.< The instructor should ta)e care not to hand out the memo as a ;solution< to the case& because that might dampen any emphasis made earlier in the class about the large gray area for $udgment in capital#expenditure analysis. ?n other words& E&$ibit 'N1 should not be presented as the ;right< answer to the A case. An added caution is that once distributed& E&$ibit 'N1 may enter the body of solutions that students at some schools pass along to succeeding classes. Thus& distribution of this exhibit may impair the Fuality of discussion the next time the case is taught. An alternative approach is for the instructor to allow the students to revise their own analyses of the A case& consistent with the class discussions& and then to use those analyses as a basis for discussion of the % case. This approach encourages variability in student analyses.
Ana"ysis of t$e # Case Citi+uing E"i.abet$ Eustaces ana"ysis: t$e ig$t-of-ay
As with the A case& students should be encouraged to scrutini*e the -3, analysis and offer suggestions for possible improvement. ?n most respects& ustaces analysis seems appropriate& although as in the case with /erseyside& this teaching note recommends that nominal cash flows and nominal discount rates be used. ?n addition& a close reading of the nature of the investment in the right#of#way suggests that the right#of#way should be purchased& regardless of whether the +otterdam pro$ect is underta)en. -iamond holds an in#the#money option to purchase for O>.: million the right#of#way& which has a current mar)et value of OH million. This option is to expire in six months. ven if the +otterdam pro$ect is not underta)en& -iamond should exercise the option and sell the right#of#way at a profit& despite the fact that& in the % case& a director of the company is Fuoted as asserting that land speculation is not -iamonds business. ?f there were any speculation& it occurred when -iamond bought the option in the first place( now it is time to harvest a luc)y profit. ?n short& the exercise of the option is not incremental to the pro$ect( the O>.: million outlay today& and the O>: million terminal value in 200H should be removed from the cash flows of the +otterdam pro$ect.> ?n my experience teaching this case& many students will ob$ect to ustaces inclusion of the right#of#way in the analysis for another reason' The lump#sum terminal value& which significantly influences the N68 of the pro$ect& is uncertain. The consultants unsubstantiated estimate of a terminal value of O>: million 1: years into the future is easy to challenge. Chile it is appropriate > ustaces analysis is incorrect for another reason. 5he used the O>.: million cash outlay the exercise price of the option! rather than the OH million value of the land as the ;investment< in land. The OH million value is correct& as it reflects the true opportunity cost of the land invested in the pro$ect. %ut this error is moot anyway since the investment flows for the righ t#of#way should be removed from the p ro$ect analysis.
Case #: Case #: -iscussion -iscussion Fuestion 2> Fuestions and @
to scrutini*e ;)ey value drivers&< the instructor should ta)e care not to let students dispense with the right#of#way simply because of its si*e or difficulty to value. ?f the problem is credibility& then the answer is to get better information. ?t remains that the )ey intellectual test of whether to include a flow of cash in a -3, analysis is whether that flow is incremental to the pro$ect. E&$ibit 'N2 ad$usts the -3, valuation of the +otterdam pro$ect by excluding the cash flows associated with the right#of#way& and by using nominal cash flows and discount rates. The result is an N68 for the +otterdam pro$ect that is considerably lower than initially pro$ected. Also& comparing the ?++s and N68s of +otterdam and /erseyside under the assumption of full erosion yields inconsistent ran)ings. 'ab"e 'N1 shows the situation facing James ,awn in the % case'
Table TN1.
*otteda! (oject without right#of#way!
eseyside (oject
Assumes N +5?N at the sibling plant
N68 P
[email protected] m ?++ P 22.2 see E&$ibit 'N2!
N68 P O1>.M2 m ?++ P >1.2 see E&$ibit 'N1-#!
Assumes ,7 +5?N at the sibling plant
N68 P O10.01 m ?++ P 1=.I see E&$ibit 'N2!
N68 P OI.2M m ?++ P 22.: see E&$ibit 'N1-A!
The analysis suggests that on an N68 basis& the +otterdam pro$ect dominates /erseyside in both the full and non#erosion scenarios. ?n terms of ?++& however& /erseyside dominates +otterdam. 3learly& N68 and ?++ disagree in their ran)ings. 4enerally& ones preference for either pro$ect depends on the discount rate one assumes& as shown in the table in E&$ibit 'N) and in the graphs given in E&$ibits 'N and 'N. The disagreement in ran)ings offers two important learning opportunities' 1! why the differences arise& and 2! what to do about the situation. ?n essence& this ran)ing problem arises because of the highly different time profiles of the two pro$ects free cash flowsGthese are compared graphically in E&$ibit 'N3. +otterdams cash flows are large later on( /erseysides are comparatively large in the near term. 8arying the discount rate affects the attractiveness of the two pro$ects differently. %oth pro$ects have positive N68s& and in a ;go"no#go< decision setting& both should be accepted. Apparently& -iamond 3hemicals can use I more capacity in polypropylene production& but not
[email protected] more. Thus& only one of the two pro$ects may be accepted& no matter how good the other pro$ect loo)s independently.
The textboo) solution to this ran)ing problem is to ta)e the pro$ect with the highest N68. ,irst& N68 assumes the firm reinvests cash at a rate eFual to the discount rate 10!& whereas ?++ assumes higher reinvestment rates& which may not be replicable. 5econd& N68 has a straightforward interpretation' ?t is the amount by which the mar)et value of the firm will change if the pro$ect is underta)en. ?f we are ta)ing the investors point of view& such a statistic is extremely relevant. n the basis of N68 calculated on the two pro$ects cash flows& James ,awn would probably find the selection too close to call. %ut perhaps the N68 analysis ignores hidden real options. '$e i!pact of ea" options Case #: -iscussion Fuestion :
This consideration is appropriate to explore with students who have been exposed to option#pricing theory and the concept of real options. ? li)e to emphasi*e to students that the value of a pro$ect consists of the -3, value of determinate cash flows plus the value of options the pro$ect may containGrather li)e valuing a convertible bond in which we value the bond and option pieces separatelyG and then sum. 3onceivably& there are many options latent in both pro$ects. 5ince the plants in +otterdam and /erseyside are identical and since the choice between them is mutually exclusive& ? prefer to assume away most of the latent options by saying that they dont help us differentiate between the two investment alternatives. owever& the % case highlights options associated with technological change that may help us differentiate between the two. 'ab"e 'N2 summari*es the technology choice options latent in the two proposals' Table TN2. *otteda!
New technology commitment at initiation of pro$ect ptions! present
eseyside
Japanese process controls
No initial new technology commitment
ption to switch from Japanese to 4erman technologies
1. 3all option on the Japanese technology 2. ption to switch from Japanese to 4erman technologies >. ption to delay
The Fuestion here is whether the values of the real options are significant enough to influence the managerial decision in this case. The learning point for students here is to see that the N68
analyses ignore the creation or destruction! of options( they focus only on the flows of cash. An appropriate approach is to frame the investment decision as a comparison between the N68s of the two pro$ects incremental cash flows plus the values of the call options on process#control technology at each of the two plants. ?n other words& the simple comparison of N68s ignores an important component of value. 'eac$ing stategies fo t$e ea" options issue
-iscussion of the real options issue should be tailored carefully to the capabilities of the class. Novices' Cith degree students who have had little or no prior exposure to option theory& the options could be treated as Fualitative considerations. ere& the approach would be to help students see that the two pro$ects have very different stances toward the new technologies. Then the instructor could as)& 0n your opinion, does (erseyside%s 7wait-and-see% approach have any merit over +otterdam%s commitment to one technology today#1 This type of Fuestion can prompt students to reflect on the potential value of flexibility. Students familiar with option-pricing theory' Those who can appreciate the challenges in estimating option values might benefit from a more detailed presentation of the real option aspect. ere& the instructor can choose between at least two approaches& depending on the teaching ob$ectives for the day. •
ntuitive presentation' To gain some degree of closure on the real option issue at the intuitive level& the instructor must help the students reason through the types of options embedded in each pro$ect& assess whether they are in# or out#of#the# money& and assess the ris) of the underlying asset. The discussion that follows argues that the +otterdam pro$ect contains an option to switch that is deeply out# of#the#money& and unli)ely to be exercised. /erseyside contains 1! a call option on the Japanese technology& 2! an option to switch from Japanese to 4erman technologies& and >! an option to continue to delay further without ma)ing any investment at all. The Japanese technology option is probably in#the#money. The 4erman option is less clear& but one could reason that& at worst& it is probably not far out#of#the#money. ?n short& the /erseyside options are probably more valuable than the +otterdam options. 5ince the N68s are close& the relative option values may be enough to tip the financial evaluation in /erseysides favor.
•
Numeric presentation' The actual estimation of the technology option values associated with each pro$ect is the most time#consuming approach& and should be supplemented with transparencies or handouts. ?n my experience& students left on their own rarely address all the reFuired issues in the numeric estimation of the pro$ects options. The teacher will need to add some structure to the unfolding of this aspect of the discussion. The structure of this presentation is similar to the intuitive approach& but employs assumptions given in the case and an option# pricing model to arrive at numeric estimates. The sections that follow provide a foundation for this presentation.
Nu!eic esti!ates of option va"ue at eseyside and *otteda!
The /erseyside pro$ect contains rights to invest later in the Japanese or the 4erman control systems& as well as the right to do nothing. This is a trinomial problem& the formal solution of which goes well beyond the mastery of most /%A finance students. %ut one simplifying assumption can reduce the situation to a more tractable solution' one can be optimistic that either the 4erman or the Japanese technology will so dominate the ;do#nothing< alternative that the option value of continuing to wait indefinitely is Fuite small. The evidence for this optimistic assumption is that the N68 of the Japanese technology is positive( the option on the Japanese technology is already in#the#money. ?f the 4erman technology is successfully commerciali*ed& one can assume that it will have a positive N68& too. ,rom this perspective& investing in either of the new technologies is li)ely to dominate doing nothing. This reduces the choice to two alternatives' 4erman or Japanese technology. 5ome students will suggest that /erseyside retain two call options& one on each technologyGbut this overstates the option value at /erseyside& since one would logically not exercise both call options. ?nstead& /erseyside really contains the option to call on one of the new technologies& and then to switch to the other. 4iven what we )now about the uncertain commerciali*ation of the 4erman technology& the logical inference is that /erseyside contains a call on the Japanese technology& with an option to switch to the 4erman technology once the viability of the 4erman technology becomes )nown. The +otterdam pro$ect ta)es a very different posture toward the new technology. ?t commits to the Japanese technology now& but retains the flexibility to switch to the 4erman technology later. 5ome students will resist the notion that +otterdam would ever be re#engineered to the 4erman technology& as suggested by the statements in the % case. Their intuition is not unreasonable. oo)ing forward from the date of the case& it is uneconomical to install the Japanese technology and use it for only five years. %y then& executives will face positive cash flows and a relatively high N68 by not switching& since the investment in the Japanese technology will have been a sun) cost. ?t would be unli)ely for the new 4erman technology to be attractive enough to replace what is already operating. The rights on new technology at both /erseyside and +otterdam include switching options. Cilliam /argrabe has modeled the option to switch as a uropean option to exchange one asset for
[email protected] The analysis here follows his presentation' 8alue of option to switch P 64 NQd1R S 6 JNQd2R 64 P exercise price of the 4erman technology O>.=: million:! 6J P exercise price of the Japanese technology O>.=:H million for /erseyside& and O2:.MM millionI for +otterdam! @ Cilliam /argrabe& ;The 8alue of an ption to xchange ne Asset for Another&< 3ournal of Finance >> /arch 1MI=!' 1IIL1=H. : O>.=: million is the present value of investment outlays at +otterdam i.e.& without the right#of#way!& discounted at 10. The assumption is that the 4erman and Japanese systems are comparable in cost. H 6resent value of investment outlays at +otterdam i.e.& without the right#of#way!& discounted at 10. I This consists of the sum of the forgone benefits of the Japanese technology and the cost of installing the
84 P standard deviation of the 4erman#technology returns 0.0=!& % case footnote > 8J P standard deviation of the Japanese#technology returns 0.0=!& % case footnote > P correlation of N684 and N68J 0.=0!& % case footnote > 82 P 8J2 U 842 S 2848J VP
[email protected] U
[email protected] S 2 × 0.0= × 0.0= × 0.=0! P 0.002:HW= 8 P expected standard deviation of switching returns P 0.0:0H + f P 0M T P term to maturity : years! ?nserting those parameters into the %lac)#5choles option#pricing model gives' /erseyside option to switch' +otterdam option to switch'
[email protected] million O0.000 million
/erseysides option to switch is positive but relatively small and because of the simplifying10 assumptions& it should be regarded as a conservative estimate. The surprisingly low option value reflects the high covariance between the returns on the Japanese and 4erman technologies. +otterdams option to switch is virtually worthless. The huge N68 forgone O2:.MM million& the ;lost< cash flows from the Japanese system in years HL1:! renders the switching option deeply out#of#the#money. ence& the flexibility to change technology at +otterdam is worth little. /erseyside also contains a call option on the Japanese technology. The case and student analysis can provide parameters to insert in a standard %lac)#5choles option#pricing model shown in 'ab"e 'N)' Table TN>.
Ca"" Option on 4apanese 'ec$no"ogy
6rice
O10.01
Souce
N68 full erosion!& E&$ibit 'N2
4erman technology. The present value of the +otterdam pro$ects free cash flows under the Japanese technology from years H to 1:& discounted at the 10 hurdle rate& is O2>.H million. The assumed outlay for the 4erman technology is O2.>M million. As mentioned in footnote :& the assumption is that the 4erman and Japanese systems are comparable in cost. O2.>M million is the present value of the investment outlays at +otterdam& with those outlays situated in years H through = rather than in 1 through >. = ?n /argrabes analysis& the variance of the underlying must account for the covariance between the two exchangeable assetsGthe third term in the variance calculation accounts for this covariance. The odds of the return on one asset greatly exceeding the other are greatly reduced when the returns on the two assets are positively correlated as they are in this case. M According to /argrabe& the ris)#free rate applicable in estimating the option to exchange is *ero. The ;stri)e price< earns a fair rate of return already because it is a fairly priced asset. 10 The analysis assumes away any value to the option to delay further investing in new technology.
Ca"" Option on 4apanese 'ec$no"ogy
Souce
xercise
O>.=:
68 outlays& E&$ibit 'N2
Term
: yrs.
% case
8olatility
0.0=
% case footnote >
?nterest rate
0.0::
Nominal rate in % case footnote >
Ca""-option va"ue
OI.0M mm
ne final ad$ustment to the real option analysis is necessary. The calculations thus far assume that the 4erman technology wor)s& that it moves successfully from pilot operation to full# scale commercial application. ,ootnote > of the % case indicates a :0 probability of successful commerciali*ation. ,or /erseyside& there is a :0 chance that the option to switch will have any value and a :0 chance that they have a simple call option on Japanese technology. Thus& the option value at /erseyside is a probabilistically weighted average of the two option outcomes as shown in 'ab"e 'N'
Table
[email protected] *e"evant Option 5a"ue
(obabi"ity
6eig$ted 5a"ue
4erman technology is successfully commerciali*ed
[email protected] m switch! O I.0M m call!
[email protected] million
0.:0
O>.H> m
4erman technology is not successfully commerciali*ed.
OI.0M million simple call option!
0.:0
O>.:: m
'ota" 6eig$ted Option 5a"ue at eseyside
OI.1= m
Ana"ytica" conc"usions
To summari*e' The value of each of the pro$ects is regarded as the sum of the N68s of the cash flows and option values as shown in 'ab"e 'N' Table TN:.
,u"" Eosion
No Eosion
/erseyside
+otterdam
/erseyside
+otterdam
N68 cash flows as ad$usted
OI.2M m
O10.01 m
O1>.M2 m
[email protected] m
ption value
OI.1= m
O0.00 m
OI.1= m
O0.00 m
Total value
7189 !
710801 !
721810 !
7180 !
Chen the value of the technology options is added to the analysis& the ran)ing of the two pro$ects reverses from the simple N68#based ran)ing. This reversal& combined with the li)elihood that the value of options at /erseyside is greater after accounting for the option to wait indefinitely!& will lead many students to conclude that ,awn should accept the /erseyside pro$ect. ?f time permits& the class discussion might touch on two final Fualitative considerations.
%ua"itative ;ssues ;nte""ectua" capita"
li*abeth ustace ma)es the argument that the +otterdam pro$ect moves -iamond 3hemicals down the learning curve in the deployment of advanced control systems. earning or intellectual capital! is valuable& though it is not an asset that is readily valued. rgani*ations that truly value this learning would attach some worth to ustaces claim. 5tudents can reflect on whether 5ir -avid %en$amin& the raider who threatened -iamond with a ta)eover& would be patient enough to see the value of that learning reflected in the firms share price. #udget ga!es Case #: -iscussion Fuestion H
ustace has framed the political landscape in an effort to affect the economic decision. The )ey issue is whether ,awn should be influenced by them. These include a variety of gambits previously identified by 3hris Argyris.11 1. 5ee)ing approval or support for a budget reFuest from more than one supervisor. The assistant plant manager in the A case illustrated a related game' circumventing ones leaders altogether.! 2. 5upporting the reFuest with voluminous data the M0#page proposal!& but with the data arranged in such a way that their significance is not clear. >. Justifying the analysis in terms of sub$ective and lofty benefits for example& technological ;learning
Su!!ay E&$ibit 'N9 summari*es the structure of the decision problem facing James ,awn& the decision ma)er in the % case. The diagram shows that uncertainties about the commerciali*ation and the returns from the process technologies add considerable complexity to the either#or decision in the % case.
11 3hris Argyris& 8vercoming 8rgani4ational Defenses %oston' Allyn and %acon& 1MM0!& =.
An analysis of the two cases reveals ma$or issues to which the analyst of capital investment proposals should be attuned' •
The identification of relevant cash flows
•
The need for internal consistency in the estimation of cash flows and the discount rate
•
The possible influence of hidden real options& the option to switch& and the option to wait
•
The impact of unFuantifiable effects and of behaviors that see) to influence the wor)ing of the proposal#review process
At its most basic level& this has been an exercise in critical thin)ing& aimed at impressing the student with the importance of reflecting on basic economic notions.
xhibit TN1 D;AOND C
A? AND >#?
xcerpts from /orriss xpenditure 6roposal /emo +egarding the /erseyside 6ro$ect
To' ,rom' 5ub$ect'
James ,awn ucy /orris and ,ran) 4reystoc) 3apital xpenditure 6roposal' 6olypropylene ine nhancements /erseyside!
This memo summari*es the rationale and financial impact of capital improvements to the polypropylene line at /erseyside. The investment reFuested is OM million. 5trategic and operating benefits were summari*ed in our previous memo to you. Ce have made& however& some changes to our investment analyses& which appear below. Two discounted cash flow analyses accompany this memo. 6art A contains an ad$ustment for possible business erosion at +otterdam& while part % does not ma)e that ad$ustment. X
The results are'
N68 ?++
rosion OI.2M m 22.:
No rosion O1>.M2 m >1.2
X
The costs of the engineering study and corporate overhead allocation have been excluded from the analysis& per discussions with John 3amperdown.
X
Tan)#car expenditure occurs earlier in time& and changes in depreciation tax shields are reflected herein.
X
The discount rate used is 10& and the cash flows used are nominal& rather than real cash flows. Ce would be happy to respond to any remaining Fuestions you or the board may have.
xhibit TN1 continued!G6art A +evised and ,inal -3, Analysis' /erseyside 3apital xpenditure 6rogram reflects charge for ,7 +5?N of +otterdam business volume!
xhibit TN1 continued!G6art % +evised and ,inal -3, Analysis' /erseyside 3apital xpenditure 6rogram reflects N 3A+4 ,+ +5?N of +otterdam business volume!
xhibit TN1 continued!G6art % +evised and ,inal -3, Analysis' /erseyside 3apital xpenditure 6rogram reflects N 3A+4 ,+ +5?N of +otterdam business volume!
xhibit TN2 D;AOND CA? AND >#?
Analysis of +otterdam 6ro$ect& xcluding ?mpact of the +ight#of#Cay ?nvestment financial values in millions of %ritish pounds!
xhibit TN2 D;AOND CA? AND >#?
Analysis of +otterdam 6ro$ect& xcluding ?mpact of the +ight#of#Cay ?nvestment financial values in millions of %ritish pounds!
xhibit TN> D;AOND CA? AND >#?
-iscounted 3ash ,low +esults 3omparison
xhibit TN> D;AOND CA? AND >#?
-iscounted 3ash ,low +esults 3omparison
N.%. 4rey highlights region of ;crossover.< 5ource' case writer analysis.
xhibit [email protected] D;AOND CA? AND >#?
xhibit [email protected] D;AOND CA? AND >#?
5ource' 3ase writers analysis.
xhibit TN: D;AOND CA? AND >#?
xhibit TN: D;AOND CA? AND >#?
5ource' 3ase writers analysis.
xhibit TNH D;AOND CA? AND >#?
xhibit TNH D;AOND CA? AND >#?
5ource' 3ase writers analysis.
xhibit TNI D;AOND CA? AND >#?
5ummary of the -ecision 6roblem ,acing James ,awn
xhibit TNI D;AOND CA? AND >#?
5ummary of the -ecision 6roblem ,acing James ,awn
5upplemental Note TN1 DIAMOND CHEMICALS PLC (A) AND (B)
+elevant 3ash ,lows
The basic axiom in capital#expenditure analysis is ;3ash is ingY< i)e most slogans& however& adhering to this maxim is easier said than done. The thoughtful analyst will routinely encounter subtle and sophisticated challenges to the basic focus on cash flow. To provide a more operational form of the basic axiom& here are some guidelines for use in determining which cash flows are relevant for capital#investment analysis' X gnore sun' costs' All investment analysis should be marginal and forward loo)ing. ?f we include past cash flows in our analysis& we might overburden good pro$ects with the sins of the past or ma)e bad pro$ects seem attractive simply on the basis of past success. Ce want to stand at the margin. X gnore fictional accrual accounting flows' Accountants aim to answer Fuestions that are different although important! from whether a prospective investment is attractive.1 The capital#expenditure analyst necessarily loo)s forward& rather than bac)& and see)s to consider the real economic events. ne should not mix the two perspectives. ne should be suspicious of any item called a ;charge< or an ;allocation.< X gnore cash flows of unrelated pro)ects' To analy*e a capital#expenditure proposal fairly reFuires that one focus only on the cash flows that are incremental to the pro)ect. To do otherwise would confound the analysis and may very well be unethical. X +eflect the impact of the pro)ect anywhere it may occur in the company' /anagers are called upon to account for the investors perspective in ma)ing their investment decisions. ne should be extremely suspicious of analyses that ignore possible side effects on other divisions of the company.
1 Accounting Fuestions include& 1! ow did the firm do last year as opposed to the year beforeD 2! Cere the accounting statements fairly )eptD >! ow should the costs and revenues be allocated between one year and the nextD @! Chat does it cost us to ma)e a unit of our product& and so on.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case study ;-iamond 3hemicals 63. A!&< 78A#,#1>:1!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals A!&< and instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.
5upplemental Note TN1 continued!
X +eflect the e"pected timing of the cash flows' Cith the focus on real economic events& it is inappropriate to accelerate or delay cash flows or to lump them to one point in time. X Don%t forget terminal values and abandonment costs' These costs may be material flows of cash. Cith the increasing attention to environmental issues& abandonment costs can be huge for example& in nuclear power or pesticide production!. ?f a pro$ect reFuires a buildup of inventory& it ma)es sense to assume a recapture of that investment at the end or to $ustify the failure to recapture it. 5imilarly& intangible assets may have a value that carries past the forecast hori*on and can be recaptured. ,inally& to assume that the business simply continues to operate may ma)e sense( doing so will reFuire an estimate of the ;going#concern< value of the business to be reflected at the terminus of the cash flows. Two other related issues are most often not scrutini*ed in a capital#expenditure setting' X 5se investment criteria that are tied to cash flow, are ris' ad)usted, and reflect the time value of money' Throughout the business economy& the best techniFues are still underutili*ed. X The best capital-e"penditure analysis practices will not guarantee that the right decisions get made' The real challenge is to get managers to thin) li)e investors. 4ood analytical practices can help& but fundamentally& the problem is one of compensation and incentives. 7nfortunately& good finance cannot be practiced apart from the messy world of human behavior.
5upplemental Note TN2 DIAMOND CHEMICALS PLC (A) AND (B)
8aluing /anagerial ,lexibility and 3ommitment
ne of the limitations of discounted cash flow is that it does not capture well the strategic aspects of capital investment. 5uch strategic elements include the right to ma)e future investments& the right to sell or liFuidate in the future& the right to abandon& and the right to switch investments. All of these rights are indicators of managerial fle"ibility. Another class of strategic elements appears when managers promise to do certain things in response to others for example& invest more heavily if a competitor enters a mar)et or acFuires a new technology& buy if others choose to sell& sell if others choose to buy!. Those promises amount to managerial commitment. ne almost never sees those contingent elements reflected in -3, analyses& and for good reason' They are very uncertain. Nevertheless& they are also so important in the thin)ing of general managers that flexibility and commitment can often override the decision dictated by -3,. Chat is the careful analyst to doD The answer is that one should define the capital#investment decision broadly to include flexibility and commitment& and then value the strategic element of the investment. ?n other words& one must see that the value of an investment is the sum of its discounted cash flow and the value of its fle"ibility or commitment . The challenge in thin)ing about capital investments this way lies in placing a value on flexibility and commitment. ,ortunately& option#pricing theory can help with this challenge.
Si!p"e Options
The )ey tas) is to define elements of flexibility or commitment in terms of options& and then use the theory to estimate a value. As a general rule& flexibility is analogous to a long position in call or put options. 3onversely& commitment is analogous to a short position in call or put options. ere is a brief taxonomy of options latent in capital investments'
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case study ;-iamond 3hemicals 63. %!&<78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals %!&< and instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.
5upplemental Note TN2 continued! 9ong call ' X +ight to invest at some future date& at a certain price X +ight to harvest1 at some future date X 4enerally& any flexibility to invest& to enter a business& or to delay harvesting 9ong put '
X +ight to sell at some future date at a certain price X +ight to abandon at some future date at *ero or some certain price X +ight to force someone else to harvest X 4enerally& any flexibility to disinvest& to exit from a business& or to accelerate harvesting
Short call ' X 6romise to sell if the counterparty wants to buy X 4enerally& any commitment to disinvest or accelerate harvesting upon the action of another party Short put '
X 6romise to buy if the counterparty wants to sell X 4enerally& any commitment to invest or delay harvesting upon the action of another party
Co!p"e& Options
/ost large capital investments are a bundle of strategic options. The simple treatment of this bundle is to value the individual parts or options! and then to sum them. This simple approach brea)s down when the options are interdependent or mutually exclusive. The classic example involves the flexibility to switch investments or to choose investments! at some future date. ,or problems that include the flexibility to switch& one needs to rely on the elegant models of option#pricing theory.
1 The word harvest is meant both literally and to stimulate the readers thin)ing. ,or instance& consider that you have an option on a tree farm. The trees are immature now but will certainly grow to have commercial value. The right to extend your commercial claim on the trees is a call option. Analy*ing the trees value is Fuite similar to analy*ing the investment in an +Z- program& where each years investment extends the harvesting hori*on by one year.
5upplemental Note TN2 continued!
,or instance& Cilliam /argrabe has modeled the right to switch as a uropean option to exchange one asset for another .2 The analysis here follows his presentation' 8alue of the option to switch P 6 4 NQd1R S 6 JNQd2R where' 64 P exercise price of ma)ing investment 4 6J P exercise price of ma)ing investment J 84 P standard deviation of the uncertain returns on investment 4 8J P standard deviation of the uncertain returns on investment J 6 P correlation of N684 and N68J 82 P 8J2 U 842 S 2848J6!.: P variance of returns in the exchange T P term to maturity This eFuation is nothing more than the familiar %lac)#5choles option#pricing model& the values for which may be estimated from tables in textboo)s or programs in personal computers.
Conc"usion
ptions are always valuable& even if deeply out#of#the#money. Therefore& the options latent in capital#expenditure decisions can prove to be of great economic significance. The financial analyst should& when possible& attempt to estimate the value of those options and consider them in ma)ing final recommendations.
2 Cilliam /argrabe& ;The 8alue of an ption to xchange ne Asset for Another&< 3ournal of Finance >> /arch 1MI=!' 1IIS1=H.
5upplemental Note TN> DIAMOND CHEMICALS PLC. (A) AND (B)
+eflections on the +eal Corld of 3apital %udgeting
3apital#budgeting analysts struggle to apply such axioms of modern finance as 1! cash flow! is )ing& 2! discount cash flows at rates consistent with their ris)& and >! N68 and -3, are sufficient summaries of value. The -iamond 3hemicals cases illustrate the sorts of difficulties that can arise' 1. ncluding real options' The value created or destroyed by an investment is the sum of the present value of expected cash flows plus the value of latent options. ptions permeate most capital#investment problems for example& see Supp"e!enta" Note 'N2!. 8aluing real options& however& is Fuite difficult. ,irst& one needs to ta)e care to incorporate all options in the analysis( simply identifying the latent options can be a challenge. 5econd& the volatilities on which the value estimates depend are daunting to estimate. Nonetheless& as ;-iamond 3hemicals 63. %!&< case 21! shows& the values of latent options can overshadow the present values of expected cash flows. 2. !hoosing the right investment criteria and designing a good evaluation system' /anagers are responsive to the incentives and constraints that surround them. A capital#budgeting system sends signals to managers that define what a good pro$ect is. ne needs to be extraordinarily careful in the design of these systems in order not to send the wrong signals. -iamond 3hemicals used four criteria& of which earnings per share 65! growth and paybac) have obvious defects see Supp"e!enta" Note 'N1 !. The flaws of ?++ emerge in instances where ?++ and N68 disagree about the ran)ing of two mutually exclusive pro$ects. The reason they disagree has to do with the dramatically different time profiles of cash flows& as indicated in ,igue 'N1( the +otterdam proposal with its huge terminal value was much more sensitive to changes in discount rates than was the /erseyside proposal.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case study ;-iamond 3hemicals 63. %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 63. %!&< and instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.
5upplemental Note TN> continued! ,igure TN1
,igue 'N1 shows that the pro$ect ran)ings cross over as the discount rate grows from *ero to a high value. This is due to differences in the time profile of cash flows for the two pro$ects. /erseysides cash flows are relatively large earlier in time( +otterdams are relatively large later. $hen ++ and N/ disagree, rely on the recommendation indicated by N/. There are two reasons for following this rule'
1. ?mplicit in the mathematics of discounting is the assumption that earnings on the pro$ects will be reinvested to yield a return eFualing the discount rate. ?n N68 calculations& this reinvestment rate of return is the weighted#average cost of capital& which is not an unreasonable assumption if chosen thoughtfully. +einvesting to yield the ?++& however& may not be reasonable to assume. 2. %asically& the analyst wants to create value for investors. N68 explicitly estimates how much value the pro$ects create at the investors% re:uired rate of return.
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case study ;-iamond 3hemicals 63 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 63 %!&< and instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.
5upplemental Note TN> continued!
5tated differently& whenever you suspect that a ;crossover problem< might exist& use N68 for decision#ma)ing. Another prominent issue under the panoply of system design is choice of discount rate. -iamond 3hemicals used a ris)#ad$usted system by functional type of pro$ect. ,inance theory would applaud this approach as far as it goes. ne must be prepared to adapt the system to unusual proposals& however& such as +otterdams& which could be viewed as a combination of plant maintenance and real estate arbitrage. This instance might profit from decomposing the bundle and valuing the two pieces at their respective appropriate ris)#ad$usted discount rates. 5ltimately& no capital-e"penditure evaluation system can fully anticipate the variety of assets and pro)ects to be valued; where the educated analyst adds value is in tailoring the system to the characteristics of the asset being valued. f course& the analyst and the company run a ris) every time the system is tailored' 3hanges in the rules send signals to managers& and one wants to avoid inadvertently sending the wrong signals. /oreover& a system that is tailored for every pro$ect may be seen as being completely arbitrary and able to be manipulated. ,inally& decision ma)ers will filter the output of such a system in their own ways. ,or many senior corporate executives& the trac) record of the executive sponsoring the proposal is about as influential as N68. The practical implication of this example is that N68 is a necessary& but not sufficient& condition for pro$ect approval. The human#behavioral side of resource allocation potentially overshadows all attempts at rigorous Fuantitative analysis. This reminder leads to the third and final barrier. >. Dealing with political 0games1' ?n ;-iamond 3hemicals 63 %!&< li*abeth ustace has framed the political landscape in ways that may prevent the proper economic decisions from being made. ustaces behavior included the following'
This supplemental note was prepared by 6rofessor +obert ,. %runer to support classroom discussion of the case study ;-iamond 3hemicals 63 %!&< 78A#,#1>:2!. 3opyright E 1MM2 by the -arden 4raduate %usiness 5chool ,oundation& 3harlottesville& 8A. 6urchasers of loose#leaf copies of ;-iamond 3hemicals 63 %!&< and instructors who have adopted !ase Studies in Finance by +obert ,. %runer for course use may ma)e copies of this note for classroom use.
