1 / 42

EMBA 802 - Session 15

EMBA 802 - Session 15. William F. Bentz November 10, 1999. Fisher College of Business. Agenda for Today. Return Letsgo Discuss Operating Leverage Overview of capital budgeting Answer questions Take quiz. another.

rowena
Download Presentation

EMBA 802 - Session 15

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

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

  2. Agenda for Today • Return Letsgo • Discuss Operating Leverage • Overview of capital budgeting • Answer questions • Take quiz another EMBA 802

  3. I don't have an attitude problem. You have a perception problem. Dilbert EMBA 802

  4. 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. EMBA 802

  5. 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 risk-increasing commitments. The risk-reward ratio may offer great potential, but there may be significant risks as well. EMBA 802

  6. 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. EMBA 802

  7. 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. EMBA 802

  8. 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. EMBA 802

  9. 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. EMBA 802

  10. 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. EMBA 802

  11. 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. EMBA 802

  12. 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. EMBA 802

  13. Capital Expenditure Analysis • Capital expenditure analysis incorporates: • Predetermined approval processes • Structured methods of analysis • Project selection techniques • Post-decision review processes EMBA 802

  14. 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. EMBA 802

  15. 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. EMBA 802

  16. 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. EMBA 802

  17. 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. EMBA 802

  18. 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. EMBA 802

  19. 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. EMBA 802

  20. 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 EMBA 802

  21. 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 EMBA 802

  22. 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. EMBA 802

  23. 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. EMBA 802

  24. 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 EMBA 802

  25. 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 EMBA 802

  26. 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. EMBA 802

  27. 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 low-return projects. EMBA 802

  28. 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. EMBA 802

  29. NPV and IRR Formulas EMBA 802

  30. 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 EMBA 802

  31. 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. EMBA 802

  32. 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. EMBA 802

  33. 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. EMBA 802

  34. 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 EMBA 802

  35. 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 EMBA 802

  36. 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. EMBA 802

  37. 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. EMBA 802

  38. 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 EMBA 802

  39. 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. EMBA 802

  40. Measuring the Return Part • What measure of return would you recommend? • What measure of investment would you recommend? • Annual measure • Project average measure EMBA 802

  41. 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!) EMBA 802

  42. I QUIT EMBA 802

More Related