Page 214 - DMGT521_PROJECT_MANAGEMENT

Unit 12: Work Break Down Structure

12.2 Other Factors Affecting the Optimal Capital Budget Notes

So far, we have discussed how a firm determines its optimal capital budget by looking at its IOS
and MCC schedules. In addition, we have also discussed briefly how a firm’s optimal capital
budget will be influenced when it faces capital rationing. There are other factors that will also
affect a firm’s optimal budget: (1) earnings growth, (2) project maturity, and (3) strategic
considerations.
1. Earnings growth: If you recalled from our earlier discussions on the valuation of common
stocks and determination of the cost of common equity (using the dividend growth model),
we have mentioned that shareholders “expect” a certain growth rate in dividends (which
is tied to the growth rate of a firm’s earnings). As a result, a financial manager sometimes
needs to pick less “superior” projects that will meet this short-term “goal”. We will
illustrate this with the following example.

Example: The CFO of Morning Glory, Inc. is presented with two potential projects, A
and B, with the following financial information:

0 1 2 3 4 5
Project A -$100,000 $30,000 $30,000 $25,000 $25,000 $20,000
Project B -$100,000 -$40,000 $60,000 $60,000 $60,000 $60,000

Suppose the firm is facing a cost of capital of 10%. In that case, we know the NPVs of
Projects A and B will be $342.75 and $36,538.12, respectively. If the two projects are
independent, then both projects will be accepted (assuming that the firm faces no capital
rationing). On the other hand, if they are mutually exclusive, then Project B will be chosen
because it has a much higher NPV. However, if we look at the very immediate future after
undertaking the project(s) (i.e. time 1), we know that Project A will lead to an increase in
cash flow (and possibly an increase in earnings) while Project B will lead to a decrease in
cash flow (and possibly a decrease in earnings). As a result, Project B will lead to a drop in
earnings growth initially (because of the negative cash flow at time 1), and this is not
going to make the shareholders happy (even though the situation improves later on in the
life of the project). In this case, the shareholders will require a higher return on the firm’s
stocks, which translates into a higher cost of common equity for the firm. Facing the
pressure of a rising cost of common equity, the financial manager will opt for Project A
rather than Project B.
We know that ultimately Project B will bring in a much higher value to the firm than
Project A, why would the shareholders not want the financial manager to pick Project B?
That is because there is asymmetric information between the shareholders and the
management. Technically, the shareholders are the owners of the firm, but most of them
do not pay attention to the operations of the firm. In other words, the shareholders do not
really have much information about the firm. In addition, there are certain types of inside
information (such as the projected cash flows of all the projects under review) that are
available only to the management and not the shareholders. As a result, shareholders
usually make decisions without having the same set of information the management has.

Did u know? When the managers face an investment budget that is set for several periods,
the actions taken in the first period will affect the actions taken in the subsequent periods.
Similarly, actions taken in the second period will affect the actions taken in other periods.

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