EMBA 802 - Session 15

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EMBA 802 - Session 15

• William F. Bentz
• November 10, 1999

Fisher College of Business
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Agenda for Today

• Return Letsgo
• Discuss Operating Leverage
• Overview of capital budgeting
• Answer questions
• Take quiz

another
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• I don't have an attitude problem. You have a
  perception problem.
• Dilbert

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Capital Expenditure Analysis

• Capital expenditure analysis is concerned with a
  class of investment decisions that have several
  characteristics in varying degrees of relative
  importance.
• Capital expenditures involve significant
  expenditures of the available capital of an
  entity (public or private).
• Capital expenditures are recovered through cash
  flows over a period that usually exceeds the
  normal operating cycle.

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Capital Expenditure Analysis

• Capital expenditures by their nature tend to
  involve long-term (multi-period) commitments to
  physical facilities, a project, or the
  development of a product.
• Given the magnitude and duration of capital
  expenditures, they tend to be risk-increasing
  commitments. The risk-reward ratio may offer
  great potential, but there may be significant
  risks as well.

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Capital Expenditure Analysis

• Capital expenditures help support strategic
  plans, but they are not necessarily strategic in
  character.
• Capital expenditure analysis is part of long-term
  planning.
• Capital budgets and operating budgets are
  complimentary financial planning tools.

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Economic Theory

• An economic theory of the firm must explain the
  size of firms the projects and activities
  undertaken payments to suppliers of land, labor,
  and capital and managerial incentives.

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Economic Theory II

• A firm should expand until the marginal return on
  investment is equal to the marginal cost of
  capital. The managerial incentive problem is
  that managers may not expand if it will decrease
  the average return on investment.

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Economic Theory III

• Managers must allocate scarce resources to the
  most profitable opportunities available. The
  value of the firm will be maximized if managers
  discover and fund those projects that will
  maximize the net present value of the firm. To
  do otherwise will result in the firm being
  undersized and undervalued in the marketplace.

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Economic Theory IV

• The maxim to maximize profits is no easy task.
  Crystal balls are about as clear as the Ohio
  river the variables are many customers are
  fickle employees are poorly trained and
  unreliable and complexity grows exponentially.

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Implementing the Theory

• The valuation methods of accounting and economics
  are essentially the same. Economic theory is
  trying to explain economic behavior in a market
  economy, while accounting is concerned with
  implementing the theory in a specific firm.

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Contextual Issues

• Neither economic theory nor capital expenditure
  analysis pretend to capture all of the political,
  equity, managerial, and human resource issues
  that must be considered in actual decisions. But
  I would argue the one always needs to know the
  economic impact of a decision.

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Capital Expenditure Analysis

• Capital expenditure analysis incorporates
• Predetermined approval processes
• Structured methods of analysis
• Project selection techniques
• Post-decision review processes

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Approval processes

• Capital expenditures represent the allocation of
  capital resources among competing business units
  within the firm.
• Since it tends to be corporate capital that is
  being allocated, the more significant capital
  expenditures are approved by the Board of
  Directors.

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Approval processes - II

• Capital expenditures associated with current
  product lines may be approved at the operating
  committee level, rather than by the Board of
  Directors. Size, type, scope, or other factors
  may kick approval up to the Board.

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Structured Methods of Analysis

• While decisions may be unique, there exists a
  generally accepted array of performance measures
  one would be expected to utilize in a given firm.
  Firms differ as to the sets of measures
  utilized, but they tend to be internally
  consistent in their use across projects.

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Structured Methods of Analysis

• The manner in which cash-flow performance
  measures are weighted to arrive at a particular
  decision are apt to vary over time based on the
  individuals involved and the other factors under
  consideration.

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Structured Analysis Elements

• Incremental cash flows regardless of source
  (e.g., revenue increases, cost savings, tax
  savings, etc.)
• All incremental cash flows, regardless of the
  entity impacted by the cost or benefit, should be
  reflected in the decision--including customers
  and suppliers.

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Methods of Analysis - II

• Both projected cash flow performance measures,
  and the projected impact on accounting
  performance measures are relevant to the decision
  process. Risk assessments are necessary as well.
  PRINCIPLE Report on the same basis as used to
  decide.

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Analysis Tools (NPV)

• Net present value criterion
• The net present value is the present value of
  the net cash flows from an investment, minus the
  present value of the cash flows invested.
• Discount rate is the marginal cost of capital

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Analysis Tools (NPV)

• Multiple investments in a project pose no problem
  since we can find the present value of the
  investments as well as the present value of the
  benefits derived from the investment.
• Net present value (NPV) Present value of
  incremental cash flows - present value of the
  investments

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Analysis Tools (NPV)

• Strengths
• Considers time value of money
• Managers are motivated to invest until projects
  earn no more than the cost of capital--theoretical
  ly correct
• Cost of capital measures can be adjusted easily
  for different degrees of risk. Diff. rate for
  different projects.

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Analysis Tools (NPV)

• Consistent with residual income and EVA-type
  analyses
• Weaknesses
• It is difficult to compare projects of different
  size because the net present values are in
  absolute dollar amounts.
• Managers seem to prefer other measures.

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Analysis Tools (IRR)

• Internal rate of return (IRR) computations
• May be implemented with a specific reinvestment
  assumption
• May be implemented with no specific reinvestment
  assumption

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Analysis Tools (IRR)

• Strengths
• Considers time value of money
• easy to compare rates of return with market rates
  earned on assets in different risk classes
• Comparisons with hurdle rates are
  straight-forward.
• required rates of return (hurdle rates) can be
  adjusted up or down for different levels of risk

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Analysis Tools (IRR)

• Strengths (continued)
• consistent with measures of financing cost (e.g.,
  effective interest rates)
• Consistent with the way we think about investment
  performance (rates, not amounts)
• Consistent with the accounting concept of return
  on book value, a common measure of financial
  performance used by external parties.

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Analysis Tools (IRR)

• Weaknesses
• When there are multiple investments in the same
  project over several periods, the computation may
  yield multiple internal rates of return.
• When used without a reinvestment assumption, the
  IRR criterion tends to overstate the
  profitability of high- return projects, and to
  understate that of low-return projects.

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Analysis Tools (IRR)

• More Weaknesses
• Managers have no incentive to invest until the
  marginal return on investment equals the marginal
  cost of capital
• Managers may even withhold projects that would
  bring down the average rate of return on
  investment of their business units.

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NPV and IRR Formulas
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NPV Calculation

• The NPV method requires information or the
  ability to determine information about the cost
  of capital, or the hurdle rate to be used for
  investments in the risk class at hand.
• Once determined, the cash flows are discounted at
  the cost of capital

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NPV Calculation

• A positive NPV means the project is earning more
  than the discount rate (cost of capital).
• A zero NPV means the project is earning exactly
  the discount rate.
• A negative NPV means the projects is not earning
  the cost of capital.

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Calculating the IRR

• When starting with the cash flows and computing
  the IRR, we use an organized trial and error
  process to search for that value of r that makes
  the NPV equal to zero. We can get as close to
  zero as we choose.

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Payback Period

• Number of periods required to recover the dollar
  value of the money invested in the project. It
  is a breakeven inter-temporal cash flow.
• Strengths
• Emphasizes projects that return cash quickly,
  which may be crucial is selected circumstances.

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Payback Period

• Strengths (continued)
• Simple to calculate
• Easily understood
• In very risky situations, stressing payback may
  be reasonable.
• Weaknesses
• Ignores the time value of money
• Ignores the relative profitability of projects
  after payback

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Payback Period

• Weaknesses (continued)
• Provides no basis to evaluate either the minimum
  or the relative profitability of projects
• Inconsistent with economic theory
• Unrelated to accounting measures of profitability

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Discounted Payback Period

• Number of periods required to recover the dollar
  value of the money invested in a project plus a
  return equal to the cost of capital of some other
  hurdle rate.
• Best computed working from time zero. Beginning
  investment new investment interest return -
  net cash inflows unrecovered investment. When
  unrecovered investment turns negative, recovery
  is complete.

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Discounted Payback Period

• Strengths
• Considers the time value of money
• A form of breakeven analysis, which is familiar
  to managers
• Emphasizes those projects that generate cash
  quickly.

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Discounted Payback Period

• Weaknesses
• Ignores the relative profitability of projects
  after payback
• Provides no basis to evaluate either the minimum
  or the relative profitability of projects
• Inconsistent with economic theory
• Unrelated to accounting measures of profitability

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Accounting ROI

• The primary purpose in calculating accounting
  rates of return in this context is to project the
  impact of selecting a project on future measures
  of accounting return. It is not useful for
  making investment decisions.

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Measuring the Return Part

• What measure of return would you recommend?
• What measure of investment would you recommend?
• Annual measure
• Project average measure

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Remember

• Book value historical cost - accumulated
  depreciation
• Gross book value historical cost
• Net book value historical cost - accumulated
  depreciation
• (Nowhere do you see any reference to salvage
  value!)

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I QUIT