STRATEGIC FINANCIAL MANAGEMENT MEASURING RETURN ON INVESTMENTS KHURAM RAZA ACMA, MS FINANCE

First Principle and Big Picture

What is a project? Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. Project analyzed in capital budgeting has three criteria:  a large up-front cost,  cash flows for a specific time period, and  a salvage value at the end, which captures the value of the assets of the project when the project ends.

What is a project? Defined broadly then, any of the following decisions would qualify as projects:  Major strategic decisions to enter new areas of business  Acquisitions of new equipment, building or other firms  Decisions on new ventures within existing businesses or markets  Decisions that may change the way existing ventures and projects are run  Decisions on how best to deliver a service that is necessary for the business to run smoothly. Independent Project Mutually Exclusive Projects project to generate revenues project to reduce costs

Hurdle rates for projects Project Characteristics  Project is small and has characteristics similar to the firm  Cost of Equity: Project Risk similar within business, Firm’s beta  Cost of Debit: Firm’s cost of debt  Project is large and has characteristics different from the firm  Cost of Equity: Proxy business Beta, Bottom up Beta  Cost of Debt: cost of debt of the comparable firms  Stand-alone Project  Cost of Equity: Assess the project risk independently, Bottom up Beta  Cost of Debt: cost of debt of the Project

Measuring Returns: The Choices A. Accounting Earnings versus Cash Flows  Why are accounting earnings different from cash flows?  Operating versus Capital Expenditure  Non-Cash Charges  Accrual versus Cash Revenues and Expenses  From Accounting Earnings to Cash flows  Add back all non-cash charges, such as depreciation and amortization, to the operating earnings  Subtract out all cash outflows that represent capital expenditures  Net out the effect of changes in non-cash working capital, i.e. changes in accounts receivable, inventory and accounts payable.

Measuring Returns: The Choices B. Total versus Incremental Cash Flows  Sunk Costs  Allocations of fixed expenses, such as general and administrative costs C. Time-Weighted versus Nominal Cash Flows  Prefer present consumption to future consumption  Inflation  Uncertainty (risk)

Measuring Returns: The Choices Basic characteristics of relevant project flows  Cashflows  Cash (not accounting income) flows  Operatingflows  Operating (not financing) flows  After-tax flows  Incremental flows Principles that must be adhered to in the estimation sunk costs  Ignore sunk costs opportunity costs  Include opportunity costs changes in working capital  Include project-driven changes in working capital net of spontaneous changes in current liabilities effects of inflation  Include effects of inflation

Investment Decision Rules Accounting Income Based Decision Rules Earnings before interest and taxes (1- tax rate) Return on Capital = Average Book Value of Total Investment in Project Net Income Return on Equity= Average Book Value of Equity Investment in Project

Cash Flow Based Decision Rules Payback The payback on a project is a measure of how quickly the cash flows generated by the project cover the initial investment Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40, –40 K 10 K 12 K 15 K 10 K 7 K

(c) 10 K 22 K 37 K 47 K 54 K Payback Solution (#1) PBP 3.3 Years PBP = a + ( b – c ) / d = 3 + (40 – 37) / 10 = 3 + (3) / 10 = 3.3 Years –40 K 10 K 12 K 15 K 10 K 7 K Cumulative Inflows (a) (-b) (d)

Payback Solution (#2) PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. PBP 3.3 Years PBP = 3 + ( 3K ) / 10K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value. Cumulative Cash Flows –40 K 10 K 12 K 15 K 10 K 7 K –40 K –30 K –18 K –3 K 7 K 14 K

PBP Acceptance Criterion Yes! The firm will receive back the initial cash outlay in less than 3.5 years. [3.3 Years < 3.5 Year Max.] The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type. Should this project be accepted?

Limitations  By restricting itself to answering the question “When will this project make its initial investment?” it ignores what happens after the initial investment is recouped.  The payback rule is designed to cover the conventional project that involves a large up-front investment followed by positive operating cash flows.  The payback rule uses nominal cash flows and counts cash flows in the early years the same as cash flows in the later years.

Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. CF 1 CF 2 CF n (1 + IRR) 1 (1 + IRR) 2 (1 + IRR) n ICO =

$15,000 $10,000 $7,000 IRR Solution $10,000 $12,000 (1+IRR) 1 (1+IRR) 2 Find the interest rate (IRR) that causes the discounted cash flows to equal $40, $40,000 = (1+IRR) 3 (1+IRR) 4 (1+IRR) 5

IRR Solution (Try 10%) $40,000 $40,000 = $10,000(PVIF 10%,1 ) + $12,000(PVIF 10%,2 ) + $15,000(PVIF 10%,3 ) + $10,000(PVIF 10%,4 ) + $ 7,000(PVIF 10%,5 ) $40,000 $40,000 = $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621) $40,000 $41,444[Rate is too low!!] $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 =$41,444[Rate is too low!!]

IRR Solution (Try 15%) $40,000 $40,000 = $10,000(PVIF 15%,1 ) + $12,000(PVIF 15%,2 ) + $15,000(PVIF 15%,3 ) + $10,000(PVIF 15%,4 ) + $ 7,000(PVIF 15%,5 ) $40,000 $40,000 = $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497) $40,000 $36,841[Rate is too high!!] $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 =$36,841[Rate is too high!!]

IRR Solution (Interpolate) 10% 15% $41,444 $36,841 $41,444 $36,841 $40,000 $1,444$ 3,159 $1,444 -$ 3,159 5% $ 4,603 5% 4,603 10% + 1,444 x 16% - 3,159 x 11.57%

IRR Acceptance Criterion No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted?

IRR Strengths and Weaknesses Strengths: Strengths: Accounts for TVM Considers all cash flows Strengths: Strengths: Accounts for TVM Considers all cash flows Weaknesses: Assumes all cash flows reinvested at the IRR Difficulties with project rankings and Multiple IRRs

Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF 1 CF 2 CF n (1+k) 1 (1+k) 2 (1+k) n ICO - ICO NPV =

Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. $10,000 $7,000 NPV Solution $10,000 $12,000 $15,000 (1.13) 1 (1.13) 2 (1.13) $40,000 - $40,000 (1.13) 4 (1.13) 5 NPV NPV = +

Solution NPV Solution NPV $40,000 NPV = $10,000(PVIF 13%,1 ) + $12,000(PVIF 13%,2 ) + $15,000(PVIF 13%,3 ) + $10,000(PVIF 13%,4 ) + $ 7,000(PVIF 13%,5 ) – $40,000 NPV $40,000 NPV = $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000 NPV $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 – $40,000 $1,428 =- $1,428

NPV Acceptance Criterion Reject NPV0 No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV < 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?

Limitations  The net present value is stated in absolute rather than relative terms and does not, therefore, factor in the scale of the projects.  The net present value rule does not control for the life of the project. Consequently, when comparing mutually exclusive projects with different lifetimes, the NPV rule is biased towards accepting longer term projects.