The Real Importance of Capital Budgeting: Part 2

 

Previously this column discussed the teaching of capital budgeting in the introductory Corpfin course. The gist of that column was that capital budgeting goes far beyond the familiar payback and DCF techniques, and used RCA's "Selectavision" fiasco to illustrate the consequences of poor decisionmaking.

This week, I'd like to pass along another (and more up-to-date) example you might wish to use in class to further illustrate the more advanced aspects of capital budgeting.

Last week, the "Business Briefs" section of The Wall Street Journal included an article entitled "Kodak to Invest in China in a Bid to Improve Its Strategic Position." According to the article, Eastman Kodak has "agreed to invest more than $1 billion in China in a bid to dominate the world's fastest growing market." Kodak's chairman and CEO called this action "probably the most historic and important thing that's happened to Kodak in the last 25 years."

Further, it turns out that Kodak is going to pay $380 million to take over three failing state-owned enterprises (SOEs) in the hope that access to the Chinese market (and, presumably, Kodak's share of that market) will be enhanced. (According to the article, the Chinese market is the third largest in the world, and will eventually overtake Japan.)

This investment raises several question to ask your students. First, at some reasonable discount rate and time horizon estimates, what annual cash flows are necessary to generate a positive NPV?

What strategic issues does this raise?

What morale issues does an investment of this magnitude raise? (Note: Kodak is currently undergoing a "painful restructuring" in the U.S., which has resulted in numerous job losses.)

Are there any "embedded options" in this project? Is management taking any "hidden risks" (or seeking "hidden opportunities") by undertaking this project?

What is political risk? What political risks are relevant to this decision? How might the analyst address the political risk?

I encourage you to scan the "Business Briefs" and "Corporate Focus" columns daily in The WSJ. Rarely does a day go by when I can't find an article relevant to the classroom issue at hand. I require students to subscribe and to bring the previous day's Journal to class each day, then have them read the article in class for discussion. If you don't wish to require subscriptions, you can also clip the articles and distribute copies at the beginning of class. In any event, using real-world events really helps drive the points home!

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