Shapiro's most recent finance textbook represents an introductory overview of the capital budgeting problem, i.e. the selection and management of real investments. The book combines a general treatment of basic valuation techniques with capital budgeting principles. It heavily draws on the author's other publications, in particular Multinational Financial Management, for many years the standard reference for the international dimension of corporate finance.
Objective and Target Audience
"Capital Budgeting and Investment Analysis" represents an introductory finance text focusing exclusively on the selection and management of real investment projects. It provides a rather short treatment of the subject (of approx. 240 pages in length) and should therefore be considered as a textbook for a half-term course. A complementary instructors manual is available online with teaching hints and suggested answers for end-of-chapter problems. The author's main objective is to present a general overview of the main capital budgeting concepts rather than to provide a "how to do" recipe collection for practitioners actively involved in the management of real investment projects.
Shapiro's book targets a fairly narrow audience. It is ideally suited for nonbusiness majors (e.g. engineering students) in need of basic project management skills. In contrast, business majors will find that most of the material has been covered in their introductory corporate finance classes and can expect to receive a more in-depth treatment of cross-border aspects in international financial management. As a stand-alone text, the book clearly targets an undergraduate audience with its fairly general treatment of basic capital budgeting concepts and techniques as well as an ample number of short-answer problems provided at the end of each chapter. It can however also be recommended as a supplementary text for a case course on capital budgeting aimed at master-level students.
Structure and Content
The book consists of seven chapters and uses the discounted-cash-flow (DCF) approach to investment valuation and its extensions as an organizing principle. General treatments of the subject can be found in the main body of each chapter while more advanced topics are covered in the various appendices. Following the introductory chapter with an overview of capital budgeting basics (Chapter 1), the author presents alternative methods of evaluating prospective investments (Chapter 2), among them the net present value approach as a decision metric consistent with shareholder value maximization. Subsequent chapters emphasize the determination of individual value drivers, in particular project cash flows (Chapter 3) and project-specific cost of capital (Chapter 6), as well as extensions to the simple DCF model, e.g. accounting for the risk of misjudging net cash flows (Chapter 4) and capturing the managerial degrees of freedom to adjust investment strategies (Chapters 4 and 5). In the final chapter, the author discusses the linkage between corporate strategy and capital budgeting (Chapter 7).
Chapter 1 serves the primary purpose of illustrating the connection between project-level decision-making and the maximization of shareholder value. The author provides a set of general capital-budgeting principles indicative for value-enhancing investment behaviour and classifies capital budgeting projects on the basis of these principles. The description of the capital budgeting process suffers from vagueness and lack of focus. One would have wished to receive the presentation of a generalized decision-flow model coupled with a discussion of typical traps and pit-falls.
Chapter 2 represents a fairly standard treatment of basic valuation concepts found in most corporate finance textbooks. Starting with the net present value rule, the author highlights the relevance of project cash flows, time value of money as well as project risk and presents the internal rate of return as well as profitability index models as variations of the same theme. The DCF-based approaches are contrasted with the payback method and the accounting rate of return as methodologically deficient albeit still widely used decision rules. A review of survey evidence on the popularity of different capital-budgeting methods illustrates the prevalence of the standard DCF approach. While it is typically assumed that all value-generating projects should be accepted, Shapiro addresses the important issue of limited project choice due to capital rationing or mutual exclusivity in the chapter's appendix.
The estimation of project cash flows is the focus of Chapter 3. Shapiro carefully distinguishes between total and incremental cash flows to highlight the relevance of project interdependencies such as cannibalization effects, project complementarities and intra-company dealings. He also provides separate treatments for replacement investments, expansion investments within existing value chains and the introduction of new
products or services. With respect to the formal methodology of calculating cash flows, the author unfortunately chooses a finance-layman approach and therefore fails to draw the connection to the firm's financial accounting system. It would have been much more preferable to start with a typical cash flow statement and then to derive the project's free cash flows as the input variable for the net present value calculation. Shapiro would have then been in the position to introduce standard cash-flow-based performance measures such as EBIT or EBITDA and could have tied project-level decisions into value-based management, for instance on the basis of EVA. Particularly enlightening elements of this chapter are the discussion of typical biases in estimating project cash flows as well as the rich treatments of incorporating inflation into project valuation as well as foreign project appraisal.
As the logical next step, the reader should turn to Chapter 5 to learn more about the full potential of DCF-based investment appraisal. Of particular importance in this context are alternative ways of dealing with input parameter uncertainty. If certain value drivers (e.g. prospective sales or cost of goods sold) cannot be determined with adequate precision, then one can examine the responsiveness of the project value with regard to specific inputs by employing sensitivity analysis. A further extension, not covered by Shapiro, would have been scenario analysis which allows the variation of multiple input variables. By increasing the complexity of scenario modelling, the DCF calculation is effectively converging into simulation analysis. In contrast to the standard DCF calculation, risk is modelled explicitly, including the correlation between different input factors, and future cash flows are discounted at the risk-free rate. The chapter closes with a short treatment of decision trees which are used to account for managerial degrees of freedom, i.e. real options, in a DCF modelling environment. This aspect, compared to the lengthy treatment of real options in Chapter 4, would have deserved much more attention given its greater practical relevance.
The coverage of real option valuation in Chapter 4 merely serves as an overview in order to focus the reader's attention to the relevance of optionalities in real investment projects. More is also not feasible in the context of an introductory textbook given the complexity of the issue. Shapiro conveys the key take-away in a convincing manner--real investments are generally not operated on autopilot as management has the ability to alter strategies before, while and after investing. The general valuation principle is highlighted using a gold mine investment as an example and the binomial model as the option pricing technique. The different levers of real option value as well as the relevance of systematic vs. total risk are subsequently illustrated on the basis of an option to grow (wait).
Chapter 6 is devoted to the estimation of a project's cost of capital. The treatment emphasizes the measurement of the cost of equity using the CAPM and the derivation of benchmark betas by un-leverering/re-leverering the betas of traded assets. The costs of other sources of capital such as debt and preferred stock are touched upon only briefly and subsequently merged using the weighted average cost of capital (WACC). It is also in the context of this chapter that Shapiro compares alternative DCF approaches, in particular the entity/equity method, the adjusted present value (APV) method, the levered equity (LE) method as well as the dividend discount model (in the appendix) as a rationality check for CAPM-based estimates. The determination of the cost of capital for foreign projects is addressed in the appendix.
Chapter 7 presents the linkage between corporate strategy and capital budgeting by touching on a bundle of issues relevant for valuing and managing real investment projects, among them economies of scale and scope, learning curve effects and barriers to entry. Finally, these various loose ends are tied together within a general framework for how to create competitive advantage with real investments.
Recommendation and Critique
Shapiro's newest addition to the collection of finance textbooks is rather unusual and tailored around a course on capital budgeting rarely found in typical finance curricula. The book's main strength is its uniqueness--there does not exist a similar text to the reviewer's knowledge. It can therefore be expected to serve as a standard reference for capital budgeting courses for non-finance majors. Its primary weakness is its level of generality, i.e. the book fails to provide sufficient insight to serve as a stand-alone reference for practitioners struggling with the day-to-day challenges of capital budgeting. It is therefore the reviewer's hope that the inevitable second edition will represent a more in-depth treatment of the subject.
Professor Ulrich Hommel, Ph.D., Chair of Finance, European Business School, Oestrich-Winkel, Germany
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|Title Annotation:||Capital Budgeting and Investment Analysis|
|Publication:||Management International Review|
|Article Type:||Book review|
|Date:||Jan 1, 2006|
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