William F. Bentz1 EMBA 802 EMBA 802 - Session 15 William F. Bentz November 10, 1999 Fisher College of Business

William F. Bentz 1EMBA 802

EMBA 802 - Session 15EMBA 802 - Session 15

William F. BentzWilliam F. BentzNovember 10, 1999November 10, 1999

Fisher College of Business


Agenda for TodayAgenda for Today

Return LetsgoReturn Letsgo Discuss Operating LeverageDiscuss Operating Leverage Overview of capital budgetingOverview of capital budgeting Answer questionsAnswer questions Take quizTake quizanother


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

DilbertDilbert


Capital Expenditure AnalysisCapital Expenditure AnalysisCapital expenditure analysis is concerned Capital expenditure analysis is concerned with a class of investment decisions that with a class of investment decisions that have several characteristics in varying have several characteristics in varying degrees of relative importance.degrees of relative importance.

– Capital expenditures involve Capital expenditures involve significantsignificant expenditures of the available “capital” of an expenditures of the available “capital” of an entity (public or private).entity (public or private).

– Capital expenditures are recovered through Capital expenditures are recovered through cash flows over a period that usually cash flows over a period that usually exceeds the normal operating cycle.exceeds the normal operating cycle.


Capital Expenditure AnalysisCapital Expenditure Analysis– Capital expenditures by their nature tend Capital expenditures by their nature tend

to involve long-term (multi-period) to involve long-term (multi-period) commitments to physical facilities, a commitments to physical facilities, a project, or the development of a product.project, or the development of a product.

– Given the magnitude and duration of Given the magnitude and duration of capital expenditures, they tend to be risk-capital expenditures, they tend to be risk-increasing commitments. The risk-reward increasing commitments. The risk-reward ratio may offer great potential, but there ratio may offer great potential, but there may be significant risks as well.may be significant risks as well.


Capital Expenditure AnalysisCapital Expenditure Analysis Capital expenditures help support Capital expenditures help support

strategic plans, but they are not strategic plans, but they are not necessarily strategic in character.necessarily strategic in character.

Capital expenditure analysis is part Capital expenditure analysis is part of long-term planning.of long-term planning.

Capital budgets and operating Capital budgets and operating budgets are complimentary budgets are complimentary financial planning tools.financial planning tools.


Economic Theory Economic Theory

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


Economic Theory IIEconomic Theory II

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


Economic Theory IIIEconomic Theory III

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


Economic Theory IVEconomic Theory IV

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


Implementing the TheoryImplementing the Theory

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


Contextual IssuesContextual Issues Neither economic theory nor capital Neither economic theory nor capital

expenditure analysis pretend to expenditure analysis pretend to capture all of the political, equity, capture all of the political, equity, managerial, and human resource managerial, and human resource issues that must be considered in issues that must be considered in actual decisions. But I would argue actual decisions. But I would argue the one always needs to know the the one always needs to know the economic impact of a decision.economic impact of a decision.


Capital Expenditure AnalysisCapital Expenditure Analysis

Capital expenditure analysis Capital expenditure analysis incorporates:incorporates:

–Predetermined approval Predetermined approval processes processes

–Structured methods of analysisStructured methods of analysis

–Project selection techniquesProject selection techniques

–Post-decision review processesPost-decision review processes


Approval processesApproval processes

Capital expenditures represent the Capital expenditures represent the allocation of capital resources allocation of capital resources among competing business units among competing business units within the firm.within the firm.

Since it tends to be corporate capital Since it tends to be corporate capital that is being allocated, the more that is being allocated, the more significant capital expenditures are significant capital expenditures are approved by the Board of Directors.approved by the Board of Directors.


Approval processes - IIApproval processes - II

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


Structured Methods of AnalysisStructured Methods of Analysis

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


Structured Methods of AnalysisStructured Methods of Analysis

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


Structured Analysis ElementsStructured Analysis Elements Incremental cash flows regardless Incremental cash flows regardless

of source (e.g., revenue increases, of source (e.g., revenue increases, cost savings, tax savings, etc.)cost savings, tax savings, etc.)

All incremental cash flows, All incremental cash flows, regardless of the entity impacted by regardless of the entity impacted by the cost or benefit, should be the cost or benefit, should be reflected in the decision--including reflected in the decision--including customers and suppliers.customers and suppliers.


Methods of Analysis - IIMethods of Analysis - II

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


Analysis Tools (NPV)Analysis Tools (NPV) Net present value criterionNet present value criterion

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

capitalcapital


Analysis Tools (NPV)Analysis Tools (NPV)

– Multiple investments in a project pose Multiple investments in a project pose no problem since we can find the no problem since we can find the present value of the investments as present value of the investments as well as the present value of the well as the present value of the benefits derived from the investment.benefits derived from the investment.

– Net present value (NPV) = Present Net present value (NPV) = Present value of incremental cash flows - value of incremental cash flows - present value of the investmentspresent value of the investments



StrengthsStrengths– Considers time value of moneyConsiders time value of money

– Managers are motivated to invest Managers are motivated to invest until projects earn no more than the until projects earn no more than the cost of capital--theoretically correctcost of capital--theoretically correct

– Cost of capital measures can be Cost of capital measures can be adjusted easily for different degrees adjusted easily for different degrees of risk. Diff. rate for different projects.of risk. Diff. rate for different projects.



– Consistent with residual income and Consistent with residual income and EVA-type analysesEVA-type analyses

WeaknessesWeaknesses– It is difficult to compare projects of It is difficult to compare projects of

different size because the net present different size because the net present values are in absolute dollar amounts.values are in absolute dollar amounts.

– Managers seem to prefer other Managers seem to prefer other measures.measures.


Analysis Tools (IRR)Analysis Tools (IRR)

Internal rate of return (IRR) Internal rate of return (IRR) computationscomputations– May be implemented with a specific May be implemented with a specific

reinvestment assumptionreinvestment assumption

– May be implemented with no specific May be implemented with no specific reinvestment assumptionreinvestment assumption


Analysis Tools (IRR)Analysis Tools (IRR)– StrengthsStrengths

»Considers time value of moneyConsiders time value of money»easy to compare rates of return with easy to compare rates of return with

market rates earned on assets in market rates earned on assets in different risk classesdifferent risk classes

»Comparisons with hurdle rates are Comparisons with hurdle rates are straight-forward.straight-forward.

» required rates of return (hurdle rates) required rates of return (hurdle rates) can be adjusted up or down for different can be adjusted up or down for different levels of risklevels of risk



–Strengths (continued)Strengths (continued)»consistent with measures of financing cost consistent with measures of financing cost

(e.g., effective interest rates)(e.g., effective interest rates)»Consistent with the way we think about Consistent with the way we think about

investment performance (rates, not amounts)investment performance (rates, not amounts)»Consistent with the accounting concept of Consistent with the accounting concept of

return on book value, a common measure of return on book value, a common measure of financial performance used by external financial performance used by external parties.parties.


Analysis Tools (IRR)Analysis Tools (IRR)–WeaknessesWeaknesses

» When there are multiple investments in When there are multiple investments in the same project over several periods, the same project over several periods, the computation may yield multiple the computation may yield multiple internal rates of return.internal rates of return.

» When used without a reinvestment When used without a reinvestment assumption, the IRR criterion tends to assumption, the IRR criterion tends to overstate the profitability of high- return overstate the profitability of high- return projects, and to understate that of low-projects, and to understate that of low-return projects.return projects.



– More WeaknessesMore Weaknesses» Managers have no incentive to invest Managers have no incentive to invest

until the marginal return on investment until the marginal return on investment equals the marginal cost of capitalequals the marginal cost of capital

» Managers may even withhold projects Managers may even withhold projects that would bring down the average rate that would bring down the average rate of return on investment of their business of return on investment of their business units.units.


NPV and IRR FormulasNPV and IRR Formulas

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NPV CalculationNPV Calculation

The NPV method requires The NPV method requires information or the ability to information or the ability to determine information about the determine information about the cost of capital, or the hurdle rate to cost of capital, or the hurdle rate to be used for investments in the risk be used for investments in the risk class at hand.class at hand.

Once determined, the cash flows Once determined, the cash flows are discounted at the cost of capitalare discounted at the cost of capital


NPV CalculationNPV Calculation

A positive NPV means the project A positive NPV means the project is earning more than the discount is earning more than the discount rate (cost of capital).rate (cost of capital).

A zero NPV means the project is A zero NPV means the project is earning exactly the discount rate.earning exactly the discount rate.

A negative NPV means the projects A negative NPV means the projects is not earning the cost of capital.is not earning the cost of capital.


Calculating the IRRCalculating the IRR

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


Payback PeriodPayback Period Number of periods required to Number of periods required to

recover the dollar value of the recover the dollar value of the money invested in the project. It is money invested in the project. It is a breakeven inter-temporal cash a breakeven inter-temporal cash flow.flow.– StrengthsStrengths

»Emphasizes projects that return cash Emphasizes projects that return cash quickly, which may be crucial is selected quickly, which may be crucial is selected circumstances. circumstances.


Payback PeriodPayback Period

– Strengths (continued)Strengths (continued)»Simple to calculateSimple to calculate»Easily understoodEasily understood» In very risky situations, stressing In very risky situations, stressing

payback may be reasonable.payback may be reasonable.

– WeaknessesWeaknesses» Ignores the time value of moneyIgnores the time value of money» Ignores the relative profitability of Ignores the relative profitability of

projects after paybackprojects after payback


Payback PeriodPayback Period

– Weaknesses (continued)Weaknesses (continued)»Provides no basis to evaluate either the Provides no basis to evaluate either the

minimum or the relative profitability of minimum or the relative profitability of projectsprojects

» Inconsistent with economic theoryInconsistent with economic theory»Unrelated to accounting measures of Unrelated to accounting measures of

profitabilityprofitability


Discounted Payback PeriodDiscounted Payback Period Number of periods required to recover the Number of periods required to recover the

dollar value of the money invested in a dollar value of the money invested in a project plus a return equal to the cost of project plus a return equal to the cost of capital of some other hurdle rate.capital of some other hurdle rate.

Best computed working from time zero. Best computed working from time zero. Beginning investment + new investment + Beginning investment + new investment + interest return - net cash inflows = interest return - net cash inflows = unrecovered investment. When unrecovered investment. When unrecovered investment turns negative, unrecovered investment turns negative, recovery is complete.recovery is complete.


Discounted Payback PeriodDiscounted Payback Period

–StrengthsStrengths

»Considers the time value of Considers the time value of moneymoney

»A form of breakeven analysis, A form of breakeven analysis, which is familiar to managerswhich is familiar to managers

»Emphasizes those projects that Emphasizes those projects that generate cash quickly.generate cash quickly.


Discounted Payback PeriodDiscounted Payback Period– WeaknessesWeaknesses

» Ignores the relative profitability of Ignores the relative profitability of projects after payback projects after payback

»Provides no basis to evaluate either the Provides no basis to evaluate either the minimum or the relative profitability of minimum or the relative profitability of projectsprojects

» Inconsistent with economic theoryInconsistent with economic theory»Unrelated to accounting measures of Unrelated to accounting measures of

profitabilityprofitability


Accounting ROIAccounting ROI

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


Measuring the Return PartMeasuring the Return Part

What measure of return would you What measure of return would you recommend?recommend?

What measure of investment would What measure of investment would you recommend?you recommend?– Annual measureAnnual measure

– Project average measureProject average measure


RememberRemember

Book value = historical cost - Book value = historical cost - accumulated depreciationaccumulated depreciation

Gross book value = historical costGross book value = historical cost Net book value = historical cost - Net book value = historical cost -

accumulated depreciationaccumulated depreciation

(Nowhere do you see any reference (Nowhere do you see any reference to salvage value!)to salvage value!)


Documents

William F. Bentz1 EMBA 802 EMBA 802 - Session 15 William F. Bentz November 10, 1999 Fisher College of Business