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

Health Care Reform Vote - A Historic Date

Today, the House of Representatives will be voting on whether to pass what is being referred to as Health Care Reform. There has been much controversy surrounding this bill from the rules and procedures used to pass the bill to the claim that this bill will give government control over 1/6 of the country's economy.

I heard something on C-Span for the first time that I found personally disturbing and that I hope millions of Americans would equally find disturbing. In the bill the IRS would be the in control of determining what is an acceptable health insurance plan, tracking and punishing those who don't have coverage, subsidizing individual insurance plans with tax credits, and enforcing the rules on those who attempt to opt out, break the rules, or game the system.

The IRS would require individuals to attest that they have adequate coverage on their 1040 and that would be matched against 1099's that insurers would be required to submit to the IRS. Imagine the additional cost to your plan through this additional requirement. An individual who does not have health insurance for any part of the year will be penalized on a pro rata basis. So if your insurance lapsed and you went three months without insurance you would pay three twelfths of the penalty. The IRS could also offset your refund by this penalty. Think of the amount of time that the IRS and private employers will spend on validating employee coverage. The Congressional Accounting Budget office estimates this will increase the IRS budget by $10 BILLION to oversee health care. Can we really call something health care reform that involves a greater degree of intrusion by our government (IRS). I say no.

Just recently Caterpillar sent a letter to House Speaker Nancy Pelosi and House Minority Leader John Boehner urging them not to pass health care reform. Caterpillar estimates that this biil will drive up health costs by more than 20% or $100 MILLION - in the first year alone. Caterpillar said that while it supports health care reform this bill is not in the best interests of its 150,000 employees, retirees, and dependents they cover.

Caterpillar said the single biggest problem with the bill is that it would tax Medicare Part D. That cost of itself would put at risk the coverage that its current employees and retirees receive. Caterpillar spokesperson Bridget Young says that taxing Medicare Part D "would be a big enough disadvantage that it would likely cause some companies to change the way they provide prescription drug coverage for their retirees".

It seems that when two parties are so adamantly divided on a bill such as this and when so many backroom deals have been made to get votes, that what will get passed has a small chance of improving American lives.

TIME VALUE OF MONEY

Last week I talked about financial ratios and their application depending on who was using them. This week I want to cover the time value of money and how that can be useful in everyday decision making. The most common types of time money calculations that consumers use are auto loans and home mortgages.

When you go to buy an automobile one of the first questions they ask is how much you want your monthly payment to be. Before you buy a vehicle you need to decide what you can afford for a monthly payment, but more importantly you need to shop for the best rate and calculate the present value of those payments over the life of the loan. Then compare the present value to what you believe is a fair purchase price. Never buy a vehicle based just on the payment amount. That gives the dealership the flexibility to play with the price and financing.

The monthly payments over the length of the loan discounted at the interest rate on the loan equal the loan amount or present value. Another way of looking at it is if you were to put the loan amount in a savings account paying the same rate as your auto loan you would be able to make monthly withdrawals equal to your loan payment over the term of the loan. At the end of the term your savings account would have a zero balance.

The other type of present value is Net Present Value (NPV) which is the internal rate of return that a business would generate in order to discount a series of future (monthly, yearly) cash flows that would equal the cost of the investment. Suppose a printing business was fully utilizing all equipment, business was expanding, and needed to buy an additional printer to prevent a back log on orders. What do they need to know in order to make a wise investment? First, the company needs to know the cost of the printing equipment that is necessary to meet demand. Then they would need to know their estimated monthly gross margin which is revenue minus variable costs. Next calculate the interest cost to finance the equipment that you wouldn’t otherwise have to pay. Lastly, there is depreciation which is an expense, but not a cash outlay. If the corporate tax rate is 33%, depreciation only costs the company 67%. Most corporations have a targeted return or payback period that they require before they will make a capital investment. Therefore, if the equipment costs X and I were to invest the projected cash flows at the required rate of return how long would I have to receive those monthly cash flows before the discounted value equals the cost of the investment. If it takes eight years and the company requires a 5 year payback then they would not buy this piece of equipment.

Financial Ratios

In Bus501 and Bus502 we have been learning about financial ratios. There are five categories of financial ratios that tell a story about the companies financial position, management of assets, use of debt to finance assets, profitability and returns, and market value. Keep in mind that users of financial statements look at different ratios depending on their purpose. Each ratio by itself means something, but investors will look at all the ratios to use as one piece of their decision making process. Creditors may only be interested in a companies liquidity for short-term financing, and shareholders likely want to know what is my rate of return and dividend payout. Also, ratios are usually measured against that company's industry standard. In the absence of an industry standard one would compare the ratios against several companies within the same industry.

The first group of ratios is the liquidity ratios which are the current asset, quick, and cash ratio. The current and quick ratios are two of the most commonly referred to with the quick ratio measuring how many dollars of current assets per dollar of current liabilities. The quick ratio subtracts inventory from current assets since inventory isn't readily convertible to cash. The most liquid asset is cash and so a cash ratio of 1:1 says that the company can pay off all their current liabilities with just cash.

The next set of ratios tell the story about how a company manages their assets which would be inventory, accounts receivable, and total assets. All three of these assets are measured against sales. The inventory ratio tells how fast they are turning over their inventory. A company with a low turnover ratio in comparison may indicate stagnant inventory which may have to be written down. The accounts receivable ratio measures how quickly the company collects from their customers. It is measured by taking accounts receivable and dividing it by the average daily sales. A high receivables turnover ratio in comparison would likely indicate that the company was ineffective in managing the collection of accounts receivable. The ineffective management of accounts receivable and inventory would lead to higher working capital and the need for increasing short-term debt. The total asset turnover ratio measures the effectiveness of asset utilization in generating sales. The ratio measures the amount of sales generated for each dollar of assets.

Another area that a company is evaluated on is long-term debt. Long-term debt is a necessary source of funds to finance the purchase of long-term assets which will be used to generate sales and profit. There needs to be a balance between debt and equity. A company that is highly leveraged which means they are principally using debt to finance their assets is susceptible to the negative impact of high interest costs especially so when the company goes through a recession or cyclical downturn. The long-term debt ratio measures how many dollars of debt for each dollar of assets. This ratio should not be over one and should probably be around 50%.

The next set of ratios measure a company's profitability. Profit margin, return on assets, and return on equity are three of the more common ratios used to measure a company's profitability. Return on assets (ROA) measures the percent of profit for each dollar of assets. Corporations are often interested in this statistic which is referred to as RONA (Return on net assets)which is slightly different than ROA. Companies that are considering an acquisition or major capital expenditure will calculate a payback or return on investment that must meet the companies required rate of return before they will consider the investment. Shareholders will additionally want to look at profit margin and return on equity. Profit margin is especially meaningful because it tells what percent of sales is net income which is used to calculate earnings per share. A quarterly upward trend in profit margin is a strong indicator that a company is improving their gross margin and controlling their SG&A expenses. Return on equity tells an investor what their rate of return is on their investment. ROE measures the rate of return generated by the shareholders' net worth which is assets minus liabilities.

The last set of ratios is market value ratios. These ratios often tell how a company is perceived by investors. Several profitability ratios would be Price Earnings (PE), PEG (Price Earnings Growth), and cash flow. The PE ratio measures how many dollars of the market price for each dollar of earnings an investor is willing to pay. Corporations forecasting strong growth in revenue and earnings will demand a higher earnings per share price than a mature company with stable earnings but low growth. The PEG measures the ratio of the price (trading price) an investor is willing to pay for each dollar of earnings for each percent of sales growth. A high PEG ratio can be a good indicator for companies perceived to be growing quickly. A low PEG ratio of one or below could indicate that investors have overlooked the value of the company or they aren't very positive about the company's future growth prospects.

This was a good exercise for me to see how much I have learned about financial ratios, and hopefully it was helpful to those who read this.

Toyota Loses Focus of Customer Satisfaction

Rivals beware. What happened to Toyota should be a warning to all auto manufacturers. According to an article in the Economist there is not one auto manufacturer who has not patterned its manufacturing and supply-chain management after Toyota. Mr. Toyoda gave testimony to the House oversight committee on February 24th, and acknowledged that Toyota stretched its lean philosophy to the breaking point and lost focus on what made their company great: putting customer satisfaction above everything else and their ability to stop, think, and improve.

James Womack one of the authors of "The Machine that Changed the World", a book about Toyota's innovations in manufacturing believes that the company's misfortunes date back to 2002, when the firm set a goal to expand its market share from 11% to 15%. According to Mr. Womack the rapid expansion was not connected to customer satisfaction and was driven by ego. When customer recalls started mounting in the middle of the decade, Toyota's president asked that there be a renewed focus on quality. However, nothing was allowed to get in the way of another goal which was to overtake GM as the biggest car maker in the world.

The article goes on to say that Toyota's problems were not in their factories, but those of their suppliers. As they adopted an aggressive expansion strategy they started using a lot of unfamiliar suppliers. In the auto manufacturing world you have the car makers referred to as OEM's. Then you have tier-one, tier-two, and tier-three suppliers. Tier-one suppliers are responsible for making the big integrated systems, tier-two suppliers make and ship components to tier-one suppliers, and tier-three suppliers may make a single component for tier-two suppliers. The supplier who made the faulty gas pedals is a tier-two supplier.

Before Toyota's expansion efforts, they had designated certain suppliers as the sole provider of certain components leading to a close and long-term relationship and a sense of mutual benefit. However, as the company rapidly expanded their production capacity they became more dependent on suppliers outside of Japan with whom they did not have years of working experience. Also, Toyota did not have enough senior engineers to keep track of how new suppliers were doing. Toyota continued to trust in its sole-sourcing method, and gained economies of scale not seen before by contracting single suppliers for entire ranges of its cars across multiple markets.

A senior executive at one of the tier-one suppliers stresses that Toyota's single supplier source philosophy was taken to risky extremes especially when mixed with the company's highly centralised decision-making in Japan. There was not close enough monitoring. They didn't have transparency with their supplier base.

So the industry faces a question. Is sole-sourcing the way to go. Should you put all your eggs in one basket. The article suggest that perhaps by having multiple suppliers for big components they could benchmark each other.