CAPITAL BUDGETING - NPV, IRR, MIRR, PAYBACK

There are six different methods used to analyze capital projects. They are net present value (NPV), internal rate of return (IRR), modified internal rate of return (MIRR), profitability index (PI), payback, and discounted payback.

The NPV method estimates the future relevant cash flows and discounts those values to today’s value. The sum of those discounted cash flows less the investment cost is equal to the NPV. If the NPV equals zero than the project will generate enough cash flow to pay off the cost of debt and equity used to finance the project. Positive NPV adds EVA (Economic Value Added) for the company. Using NPV is the most reliable method to determine if a capital project will be profitable.

The IRR method is most commonly used among Fortune 500 companies because it is easy to communicate a project’s profitability in percentage terms. The IRR is that rate that when used to discount relevant cash outflows and inflows equate NPV to equal zero. IRR is not a reliable rate when cash flows change signs more than once.

The modified internal rate of return (MIRR) is a more appropriate method than IRR when a company has Nonnormal cash flows. Nonnormal cash flows exist when a company starts off with positive cash flows then has negative cash flows and then returns to positive cash flows. Using the IRR method for Nonnormal cash flows will result in multiple IRRs. A better indicator of relative profitability is the modified IRR or MIRR. This method discounts future cash outflows and calculates future value of cash inflows using the cost of capital. The discount rate that causes the present value of the future value of cash inflows to equal the present value of costs is defined as the MIRR.

The Profitability Index is another method to value capital projects. The PI takes the present value of future cash flows and divides it by the initial cost. The PI tells us how much cash inflows are being generated for each dollar of investment cost. A project is acceptable if its PI is greater than 1.0 which means the NPV is greater than zero dollars.

The payback period is a method that tells how long it will take to recapture the investment cost without taking into account the time value of money. The payback period also doesn’t give consideration to cash inflows after the initial investment is recovered, and doesn’t tell us by how much the project will increase shareholders wealth or by how much the IRR exceeds the cost of capital.

Some firms use a modified method to the payback period called the discounted payback period which discounts the project’s cash inflows by the project’s cost of capital. The discounted payback corrects the one flaw of the payback period and discounts future cash inflows. However, it still disregards cash inflows after the payback year and, as with regular payback has no connection with wealth maximization.

There are a number of different methods that a company can use to make capital budgeting solutions. No one method by itself is a perfect indicator of value, risk, and shareholder wealth maximization. Each method has its advantages and flaws. NPV which is probably regarded by academia as the most reliable indicator of a capital projects worth doesn’t provide a “safety margin”. When evaluating two mutually exclusive projects using NPV, the results don’t tell you the IRR for each project. Depending on the size of the project and cash inflows one project could have a higher NPV, but a smaller safety margin; meaning a higher NPV could have a smaller IRR, and a change in cash flows from projected could have a more significant impact than the project with a smaller NPV, but higher IRR.

IRR allows an evaluation of the cost of capital rate versus the internal rate of return, but if the project switches back and forth between positive and negative cash flows you end up with multiple IRRs which makes the project difficult to evaluate. In that case the MIRR can be used as a more reliable evaluation tool, but as discussed in the introduction still has its flaws.

Payback and discounted payback provide an indication of the projects liquidity and risk. A project with a long-term payback means that a company’s funds will be tied up for a long period, and secondly, it increases the likelihood that the project will not deliver the projected cash flows and thus, fail.

Since each method provides unique information to the project’s profitability, liquidity, and risk, all methods should be used to make capital budgeting decisions. Management should not use just quantitative methods to make capital budgeting decisions, but take into account qualitative factors such as tax policy, government stability, demographic shifts, etc. Managers should ask tough questions when evaluating capital projects. In a perfect competitive environment there would be no positive NPV because all companies would have the same opportunities, and any positive NPV would quickly be eliminated by the competition. So there has to be some imperfection that gives a company a competitive advantage and creates a positive NPV that will last for a long period of time. Managers need to be able to identify this imperfection that might exist from a patent or advanced technology.
In conclusion, managers need to find competitive advantages that will generate positive NPV that can’t easily be duplicated, and when presented with projects that show a high NPV they need to ask the tough questions and play devils advocate.

Capital Budgeting

Manufacturing businesses require fixed assets to generate revenue and profits. When a company grows it sometimes finds that in order to continue growing it must make some capital budgeting decisions. Capital budgeting is the process of analyzing projects to see if they should be included in the capital budget. A company may face a decision of upgrading equipment or buying new equipment to meet the demand for its products. A company may need to expand their building or build a new plant to allow for continued growth. These two situations I described would be what is called mutually exclusive. You would choose one or the other; upgrade or buy, expand or build, depending on which would be the most profitable.

The next step is taking two alternatives that are mutually exclusive and calculating the profitability of both to decide on the best alternative. Each alternative has a cost and relevant cash flows that have to be calculated. If I upgrade my equipment it is going to cost me X dollars today and provide relevant cash flows of X, Y, and Z over the next three years. I can take those three cash flows and discount them using the Weighted Average Cost of Capital back to day one and subtract the investment cost. That is called Net Present Value (NPV). If that is positive then it would be a profitable investment. The NPV for both alternatives would have to be calculated and the one with the highest NPV would be the most profitable investment.

Most of the Fortune 500 companies use the Internal Rate of Return (IRR) to make capital decisions. The IRR is that rate which when used to discount future relevant cash flows equals the investment cost. That is the equivalent of the NPV being zero. If the IRR is equal to the Cost of Capital then it is a break-even project. One that is probably not worth the time and effort. If the IRR is greater than the Cost of Capital then it is a profitable investment.

Which is a better indicator of a capital project's profitability, NPV or IRR? That is not a simple answer. In summary, the NPV implicitly assumes that cash flows can be reinvested at the cost of capital rate, whereas the IRR assumes that cash flows can be reinvested at the IRR. The better assumption is that cash flows can be reinvested at the cost of capital which means NPV is more reliable.

While NPV may be more reliable, as I mentioned before managers would rather use IRR because it is easier to communicate a project's profitablity in terms of percentage return on investment versus dollars of NPV. There are some inherent limitations with IRR when cash flows are negative and then turn back positive. When this happens you have multiple IRR's which makes it impossible to communicate an investment's return. Given this limitation, the IRR can be modified to provide a better indicator of profitability. The measure is called modified IRR or MIRR. MIRR is caculated by taking the present value of the cash outflows discounted using the WACC, and calculating the compounding future value of cash inflows. The compounded value of future cash inflows is sometimes referred to as Terminal Value, or TV. The discount rate that makes the present value of the TV equal the present value of the cash outflows is referred to as the MIRR.

Next week I will cover some alternative measures for calculating the profitability of capital projects.

Stock Valuation

In Finance we have been studying stock valuation. Equilibrium stock prices represent the present value of a string of future cash flows. The cash flows that you receive when you invest in a company are the stream of dividends and the price you get when you sell the stock. The stock price that you expect to receive in the future is based on the present value of the future dividend. If you were to sell the stock one year from now the stock price would be based on the dividend you would receive in year two. If you were to hold the stock for an infinite period of time the process for calculating the stock price could go on ad infinitum.

There are several different models that can be used to calculate a company's stock price depending on the companies growth pattern. Is the company experiencing zero growth, consistent growth, or super natural growth? The constant dividend growth model is used for mature companies who experience consistent growth over an extended period of time. In order to calculate the stock price you have to know the company's growth rate and their required rate of return. To find the company's growth rate you can go to Yahoo Finance, and find the company's estimated growth rate for the next five years. The required rate of return is calculated using the CAPM model. The required rate of return is equal to the risk free rate (short-term treasury rate) plus the risk premium multiplied times the company's Beta. The risk premium is equal to the market's (S&P 500) average rate of return over at least one business cycle minus the risk free rate of return. The dividend one year from today divided by the difference between the required rate of return and the growth rate would give you the stock price today.

If a company is experiencing zero growth, the stock price today is simply the current dividend divided by the required rate of return. If the company is experiencing super natural growth where the rate of growth is rapid for the first several years with a slower more natural growth rate in future years, the method for calculating the stock price today is different than constant growth model. To calculate the stock's value today you take the sum of the present value of the future dividends during super natural growth plus the present value of the stock at the time the company resumes to a slower more sustainable growth pattern.

Another method for stock valuation is using the Free Cash Flow approach where the most recent free cash flow is discounted by the Weighted Average Cost of Capital minus the growth rate. I will touch on the WACC in next week's blog. You can also use the Market Multiple approach where you take the earnings per share times an average market multiple for similarly traded public companies. This method is more judgemental