Download Welcome to EMBA 802 - Fisher College of Business

EMBA 802 - Session 15
William F. Bentz
November 10, 1999
Fisher College of Business
William F. Bentz
EMBA 802
1
Agenda for Today
 Return
Letsgo
 Discuss Operating Leverage
 Overview of capital budgeting
 Answer questions
 Take another quiz
William F. Bentz
EMBA 802
2
I don't have an attitude problem.
You have a perception problem.
Dilbert
William F. Bentz
EMBA 802
3
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.
William F. Bentz
EMBA 802
4
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 riskincreasing commitments. The risk-reward
ratio may offer great potential, but there
may be significant risks as well.
William F. Bentz
EMBA 802
5
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.
William F. Bentz
EMBA 802
6
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.
William F. Bentz
EMBA 802
7
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.
William F. Bentz
EMBA 802
8
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.
William F. Bentz
EMBA 802
9
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.
William F. Bentz
EMBA 802
10
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.
William F. Bentz
EMBA 802
11
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.
William F. Bentz
EMBA 802
12
Capital Expenditure Analysis
 Capital
expenditure analysis
incorporates:
–Predetermined approval
processes
–Structured methods of analysis
–Project selection techniques
–Post-decision review processes
William F. Bentz
EMBA 802
13
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.
William F. Bentz
EMBA 802
14
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.
William F. Bentz
EMBA 802
15
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.
William F. Bentz
EMBA 802
16
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.
William F. Bentz
EMBA 802
17
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.
William F. Bentz
EMBA 802
18
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.
William F. Bentz
EMBA 802
19
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
William F. Bentz
EMBA 802
20
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
William F. Bentz
EMBA 802
21
Analysis Tools (NPV)
 Strengths
– Considers time value of money
– Managers are motivated to invest
until projects earn no more than the
cost of capital--theoretically correct
– Cost of capital measures can be
adjusted easily for different degrees
of risk. Diff. rate for different projects.
William F. Bentz
EMBA 802
22
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.
William F. Bentz
EMBA 802
23
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
William F. Bentz
EMBA 802
24
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
William F. Bentz
EMBA 802
25
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.
William F. Bentz
EMBA 802
26
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 lowreturn projects.
William F. Bentz
EMBA 802
27
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.
William F. Bentz
EMBA 802
28
NPV  Present value of cash flows - present value of investment s
Normally,
NPV and IRR Formulas
n
CFi
1
(1  r )
NPV  
i
 I0
CF1
CF2
CFn




 I0
2
n
(1  r ) (1  r )
(1  r )
The internal rate of return is that rate for which NPV  0 :
NPV 
CF1
CF2
CFn
IRR : CF0 


0
2
n
(1  r ) (1  r )
1  r 
CF1 1  i 
n 1
IRR :
1  r 
n
William F. Bentz
CF2 1  i 
n 2

1  r 
n

EMBA 802
CFn
1  r 
n
 CF0
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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
William F. Bentz
EMBA 802
30
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.
William F. Bentz
EMBA 802
31
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.
William F. Bentz
EMBA 802
32
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.
William F. Bentz
EMBA 802
33
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
William F. Bentz
EMBA 802
34
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
William F. Bentz
EMBA 802
35
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.

William F. Bentz
EMBA 802
36
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.
William F. Bentz
EMBA 802
37
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
William F. Bentz
EMBA 802
38
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.
William F. Bentz
EMBA 802
39
Measuring the Return Part
 What
measure of return would you
recommend?
 What measure of investment would
you recommend?
– Annual measure
– Project average measure
William F. Bentz
EMBA 802
40
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!)
William F. Bentz
EMBA 802
41
William F. Bentz
EMBA 802
42