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FLEXIBLE PRODUCTION FACILITIES

Companies try to avoid becoming dependent on a single source of raw materials, building flexibility into their production facilities whenever possible. For example, at current prices gas-fired industrial boilers are cheaper to operate than oil-fired ones. Yet most companies prefer to buy boilers that can use either oil or natural gas, even though these dual-fired boilers cost more than a gas-fired boiler.6 The reason is obvious. If gas prices rise relative to oil prices, the dual-fired boiler gives the company a valuable option to switch to low-cost oil. In effect the company has the option to exchange one asset (an oil-fired boiler) for another (a gas-fired boiler).

If the firm is uncertain about the future demand for its products, it may also build in the option to vary the output mix. For example, in recent years automobile manufacturers have made major investments in flexible production facilities that allow them to change their output rapidly in response to consumer demand.

INVESTMENT TIMING OPTIONS

Suppose that you have a project that might be a big winner or a big loser. The project`s upside potential outweighs its downside potential, and it has a positive NPV if undertaken today. However, the project is not БІАААмnow-or-never.БІАААн Should you invest right away or wait? It`s hard to say. If the project truly is a winner, waiting means loss or deferral of its early cash flows. But if it turns out to be a loser, it may pay to wait and get a better fix on the likely demand.

You can think of any project proposal as giving you the option to invest today. You don`t have to exercise that option immediately. Instead you need to weigh the value of the cash flows lost by delaying against the possibility that you will pick up some valuable information.

Think again of those tar sands in Athabasca. Suppose that the price of oil rises to 10 cents a barrel above your cost of production. You can extract the oil profitably at this price, and the required investment has a small positive NPV if the price stays where it is. But it still might be worth delaying production. After all, if the price plummets, you will by waiting avoid a costly mistake. If it rises further, however, you can invest and make a killing.

We repeat, it is because the future is so uncertain that managers value flexibility. Ideally, a project will give the firm an option to expand if things go well and to bail out or switch production if they don`t. In addition, it may pay the firm to postpone the project. Some managers treat capital investment decisions as black boxes; they are handed cash-flow forecasts and they churn out present values without looking inside the black box. But successful firms ask not only what could be wrong with the forecasts but whether there are opportunities to respond to surprises. In other words, they recognize the value of flexibility.

Summary

What are some of the practical problems of capital budgeting in large corporations?

For most large corporations there are two stages in the investment process: the preparation of the capital budget, which is a list of planned investments, and the authorization process for individual projects. This process is usually a cooperative effort. Investment projects should never be selected through a purely mechanical process. Managers need to ask why a project should have a positive NPV. A positive NPV is plausible only if the company has some competitive advantage that prevents its rivals from stealing most of the gains.

How are sensitivity, scenario, and break-even analysis used to see the effect of an error in forecasts on project profitability? Why is an overestimate of sales more serious for projects with high operating leverage?

Good managers realize that the forecasts behind NPV calculations are imperfect. Therefore, they explore the consequences of a poor forecast and check whether it is worth doing some more homework. They use the following principal tools to answer these what-if questions:

Sensitivity analysis, where one variable at a time is changed.

Scenario analysis, where the manager looks at the project under alternative scenarios.

Simulation analysis, an extension of scenario analysis in which a computer generates hundreds or thousands of possible combinations of variables.

Break-even analysis, where the focus is on how far sales could fall before the project begins to lose money. Often the phrase БІАААмlose moneyБІАААн is defined in terms of accounting losses, but it makes more sense to define it as БІАААмfailing to cover the opportunity cost of capitalБІАААнБІАААдin other words, as a negative NPV.

Operating leverage, the degree to which costs are fixed. A project`s break-even point will be affected by the extent to which costs can be reduced as sales decline. If the project has mostly fixed costs, it is said to have high operating leverage. High operating leverage implies that profits are more sensitive to changes in sales.

Why is managerial flexibility important in capital budgeting?

Some projects may take on added value because they give the firm the option to bail out if things go wrong or to capitalize on success by expanding. We showed how decision trees may be used to analyze such flexibility.