Download Capital rationing

Investment Decision
Rules
04/30/07
Ch. 10 and Ch. 12
Investment decision revisited
 Acceptable projects are those that yield a return
greater than the minimum acceptable hurdle rate with
adjustments for project riskiness.
 We know now how to calculate the acceptable hurdle
rate (cost of capital), and relevant project cash flows.
 The final step in the process is to evaluate the
project. This entails understanding and applying the
appropriate investment decision tools. We must also
understand their benefits and drawbacks.
Accounting income-based investment
decision rules
 Return on Capital

This measures the return to all capital providers (equity and debt)

For a given year, this return can be measured as:
ROC = EBIT(1-t) / (avg. BV of total investment + total working capital investment)
where average BV is calculated as the
(ending BV + beginning BV) / 2

Decision rule: If ROC > cost of capital, then project is acceptable
Note: You can assess the collective quality of a firm’s investments by
measuring ROC as:
ROC = EBIT(1-t) / (BV of equity + BV of debt)
Problems with accounting return
approaches
 Changing depreciation methods may result in
different decisions
 Ignores the time value of money
 For projects without a significant investment,
these measures have less meaning
Payback period
 The payback on a project is a measure of
how quickly the cash flows generated by the
project cover the initial investment.
 Decision rule: Projects are considered
acceptable if the payback period is shorter
than some arbitrarily determined period by
the firm.
Problems with the payback period
method
 It ignores the time value of money.
 It ignores all cash flows after the arbitrary cut
off date.
Discounted cash flow measures of
return
 Net Present Value (NPV): Sum of the present values of all cash flows
on the project, including the initial investment, with the cash flows
being discounted at the appropriate hurdle rate (cost of capital, if cash
flow is cash flow to the firm, and cost of equity, if cash flow is to equity
investors)
n
CFt
NPV  
t


1

hurdlerate
t 0

Decision Rule: Accept if NPV > 0
Discounted cash flow measures of
return
 Attractive properties of NPV

NPVs are additive


value of the firm is the NPV of all projects adopted by the firm
The additional value to the firm of divestitures and acquisitions
can be calculated as Price – expected NPV
Intermediate CFs are reinvested at the
hurdle rate
 NPV calculations allow for changes in
interest rates and hurdle rates

Discounted cash flow measures of
return
 Why is NPV not used exclusively?

Managers are more comfortable talking about
percentage returns than absolute returns

Capital rationing, the inability of firms to
invest in all positive NPV projects,
necessitates managers choosing the projects
that add most value to the firm
Discounted cash flow measures of
return
 Internal Rate of Return (IRR): The internal rate of return is the
discount rate that sets the net present value equal to zero. It is the
percentage rate of return, based upon incremental time-weighted
cash flows.
n
CFt
NPV  0  
t
t 0 1  IRR 

Decision Rule: Accept if IRR > hurdle rate
Where the hurdle rate is the cost of capital if cash flow is
cash flow to the firm, and cost of equity if cash flow is to
equity investors
Discounted cash flow measures of
return
 The multiple IRR problem


The number of IRRs equals the number of
sign changes in cash flows
Therefore, if the sign of cash flows changes
more than once during the life of the project,
multiple IRRs will result
Discounted cash flow measures of
return
 NPV and IRR generally result in the same
decision about projects.
 However, when the projects are mutually
exclusive, differences can arise

Differences in scale


Capital rationing may be a factor
Difference in reinvestment rate assumption
Capital rationing and choosing a
rule
 If a business has limited access to capital and has a stream of
surplus value projects, it is much more likely to use IRR as its
decision rule.
Small, high-growth companies and private businesses are much
more likely to use IRR.
 If a business has substantial funds on hand, access to capital
and limited surplus value projects, it is much more likely to use
NPV as its decision rule.
As firms go public and grow, they are much more likely to gain from
using NPV.
NPV, IRR and the reinvestment
rate assumption
 The NPV rule assumes that intermediate cash flows on the
project get reinvested at the hurdle rate (which is based upon
what projects of comparable risk should earn).
 The IRR rule assumes that intermediate cash flows on the
project get reinvested at the IRR.
Conclusion: When the IRR is high (the project is creating significant
surplus value) and the project life is long, the IRR will overstate
the true return on the project.
Modified IRR
 The modified IRR (MIRR) calculates a project’s rate of return assuming
that intermediate cash flows get reinvested at the hurdle rate.
 The MIRR is calculated as follows:
 Calculate the terminal value, which is the future value of cash flows
after initial investment compounded at the hurdle rate
n
TermValue   CFt * 1  hurdlerate 
n t
t 1

Calculate the MIRR assuming the terminal value equals the future
value and initial investment equals the present value
1/ n
 TermValue 
MIRR  

 InitialInv estment 

Decision Rule: Accept if MIRR > hurdle rate
1
Mutually exclusive projects with
different lives
 In our discussions of ranking mutually exclusive
projects, we assumed that the projects being
considered had equal lives.
 We now expand our analyses to incorporate
differences in project lives.
Ranking mutually exclusive projects
with different lives
 The net present values of mutually exclusive projects
with different lives cannot be compared, since there
is a bias towards longer-life projects.
 To do the ranking, we have to either


replicate the projects till they have the same life or;
convert the net present values into equivalent annuities
where
NPV
equiv.annuity 
1  1

n
1  r  



r


Capital rationing
 Capital rationing occurs when a firm is unable to
invest in projects that earn returns greater than
hurdle rates.
 Sources of capital rationing:
 Firm’s lack of credibility with financial markets
 Underpricing of securities
 Costs (flotation) of external financing
 These sources are typically more severe for smaller
firms and for firms seeking equity financing.
An alternative to IRR with capital
rationing
 The problem with the NPV rule, when there is capital
rationing, is that it is a dollar value. It measures
success in absolute terms.
 The NPV can be converted into a relative measure by
dividing by the investment required in the project.
This is called the profitability index (PI).
PV of cash inflows
PI  PV
of cash outflows
 Decision rule: If PI > 1, the project is acceptable.
A summary of decision-making in
capital budgeting
 For independent projects, NPV is the best method of evaluation as it
provides an indication of how much wealth the project will add to the
firm. The MIRR and PI methods will also provide you with the correct
decision. The IRR method will too, as long as cash flows are
conventional.
 For mutually exclusive projects without capital rationing constraints,
NPV is the best method for ranking projects. The PI method will also
provide you with the same rankings. The IRR method rankings will be
biased towards projects with larger early cash flows. The MIRR method
may not rank the project that generates the most wealth for the firm
first.
 For mutually exclusive projects with capital rationing constraints, the
MIRR method tends to work the best. The value tends to be more
meaningful than the PI method value, which also will provide accurate
rankings in this case.
What firms actually use ..
Decision Rule
IRR
Accounting Return
NPV
PI
Payback Period
% of Firms using as primary decision
rule in
1976
1986
2000
53.6%
25.0%
9.8%
2.7%
8.9%
49.0%
8.0%
21.0%
3.0%
19.0%
47.0%
8.1%
23.3%
6.0%
15.0%
Chapter 10 and 12 sections NOT
covered
 Chapter 10
 Return on Equity
 Cash Flow Returns on Equity and Capital
 Chapter 12
 Projects with Equal Lives
 Calculating Breakeven
 The Replacement Decision: A Special Case of Mutually
Exclusive Projects
 Side Costs of Projects and all sections thereafter