(BQ) Part 1 book Financial management Concepts and applications has contents Overview of financial management, understanding financial statements, measuring financial performance, projecting financial requirements and managing growth, making investment decisions,...and other contents.
Find more at www.downloadslide.com Find more at www.downloadslide.com Financial Management Concepts and Applications Find more at www.downloadslide.com The Pearson Series in Finance Bekaert/Hodrick International Financial Management Berk/DeMarzo Corporate Finance* Foerster Financial Management: Concepts and Applications* Frasca Personal Finance Berk/DeMarzo Corporate Finance: The Core* Berk/DeMarzo/Harford Fundamentals of Corporate Finance* Brooks Financial Management: Core Concepts* Copeland/Weston/Shastri Financial Theory and Corporate Policy Dorfman/Cather Introduction to Risk Management and Insurance Eakins/McNally Corporate Finance Online* Eiteman/Stonehill/Moffett Multinational Business Finance Fabozzi Bond Markets: Analysis and Strategies Fabozzi/Modigliani Capital Markets: Institutions and Instruments Fabozzi/Modigliani/Jones Foundations of Financial Markets and Institutions Finkler Financial Management for Public, Health, and Not-for-Profit Organizations Gitman/Zutter 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Management and Insurance Smart/Gitman/Joehnk Fundamentals of Investing* Solnik/McLeavey Global Investments Titman/Keown/Martin Financial Management: Principles and Applications* Titman/Martin Valuation: The Art and Science of Corporate Investment Decisions Weston/Mitchel/Mulherin Takeovers, Restructuring, and Corporate Governance Log onto www.myfinancelab.com to learn more Find more at www.downloadslide.com Financial Management Concepts and Applications Stephen Foerster Western University Boston Columbus Indianapolis New York San Francisco Upper Saddle River Amsterdam Cape Town Dubai London Madrid Milan Munich Paris Montreal Toronto Delhi Mexico City São Paulo Sydney Hong Kong Seoul Singapore Taipei Tokyo Find more at www.downloadslide.com Editor in Chief: Donna Battista Editorial Project Manager: Erin McDonagh Editorial Assistant: Elissa Senra-Sargent Marketing Manager: Anne Fahlgren Managing Editor: Jeff Holcomb Sr Production Project Manager: Roberta Sherman Manufacturing Buyer: Carol Melville Cover Design: Jonathan Boylan Interior Design: Cenveo® Publisher Services Content Lead, MyFinanceLab: Miguel Leonarte Senior Media Producer: Melissa Honig Media Project Manager: Lisa Rinaldi Full-Service Project Management: Cenveo® Publisher Services Composition: Cenveo® Publisher Services Printer/Binder: Courier, Kendallville Cover Printer: Lehigh-Phoenix Color/Hagerstown Text Font: 9.75/12 Minion Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on the appropriate page within text Copyright © 2015 by Pearson Education, Inc All rights reserved Manufactured in the United States of America This publication is protected by Copyright, and permission should be obtained from the publisher prior to any prohibited reproduction, storage in a retrieval system, or transmission in any form or by any means, electronic, mechanical, photocopying, recording, or likewise To obtain permission(s) to use material from this work, please submit a written request to Pearson Education, Inc., Permissions Department, One Lake Street, Upper Saddle River, New Jersey 07458, or you may fax your request to 201-236-3290 Many of the designations by manufacturers and sellers to distinguish their products are claimed as trademarks Where those designations appear in this book, and the publisher was aware of a trademark claim, the designations have been printed in initial caps or all caps Library of Congress Cataloging-in-Publication Data Available upon request 10 www.pearsonhighered.com ISBN 10: 0-13-293664-X ISBN 13: 978-0-13-293664-4 Find more at www.downloadslide.com To Linda for her love and support, and to Jennifer, Christopher, Thomas, and Melanie for absorbing unsolicited financial advice and tolerating my attempts at humour over the years Find more at www.downloadslide.com This page intentionally left blank Find more at www.downloadslide.com About the Author Stephen Foerster is a Professor of Finance at the Ivey Business School, Western University in Ontario, Canada He currently teaches corporate finance to Executive MBA students He received his M.A and Ph.D from the University of Pennsylvania (The Wharton School) and also obtained the Chartered Financial Analyst designation Professor Foerster is a member of the Editorial Board of Financial Analysts Journal His research interests include capital markets and household finance Major academic journals such as the Journal of Finance and Journal of Financial Economics have published his research, and he has written over 90 case studies Professor Foerster has won numerous teaching and research awards He has been a consultant and executive training course designer and facilitator in corporate finance, portfolio management, finance for nonfinancial executives, value-based management, risk management, and other investment areas He also serves on a university pension board and a not-for-profit foundation board Born in Sudbury, Ontario, Professor Foerster is married with four children and enjoys golfing, hiking, and biking vii Find more at www.downloadslide.com Brief Content Part 1: Assessing and Managing Performance 1 Overview of Financial Management 2 Sizing-Up a Business: A Nonfinancial Perspective 18 3 Understanding Financial Statements 45 4 Measuring Financial Performance 65 5 Managing Day-to-Day Cash Flow 87 Part 2: Assessing Future Financial Needs 104 6 Projecting Financial Requirements and Managing Growth 104 7 Time Value of Money Basics and Applications 129 8 Making Investment Decisions 151 Part 3: Financing Long-Term Needs 167 9 Overview of Capital Markets: Long-Term Financing Instruments 167 10 Assessing the Cost of Capital: What Return Investors Require 194 viii Find more at www.downloadslide.com Brief Content 11 Understanding Financing and Payout Decisions 215 12 Designing an Optimal Capital Structure 235 Part 4: Creating Value 255 13 Measuring and Creating Value 255 14 Comprehensive Case Study: Wal-Mart Stores, Inc. 281 ix Find more at www.downloadslide.com 152 Part 2 Assessing Future Financial Needs FIG 8.1 Financial Management Framework: Investing Decisions THE ENTERpRISE FINANCING OpERATING INVESTING • Capital expenditures • Long-term projects Growing profits, dividends, cash flow Managing the risk profile GROWTH RISK VALuE CREATION to improve the profitability of its Southwest division There may be a number of short-term and long-term concerns related to this decision For example, in the short-term, Ace might face several issues (including the possible purchase of new equipment) that will result in the need for less labor, and these issues might in turn raise the possibility of a strike among the division’s unionized workers In the long-term, Ace might need to determine how to keep the Southwest division competitive while better motivating its employees After determining the choice to be made and any related short- and long-term issues, the second step in the decision-making process involves developing a list of c riteria that will be used to evaluate any alternative strategies the firm is considering Returning to our example, let’s say that Ace identifies three main evaluation criteria: maximization of profitability, minimization of risk, and maintenance of good relations with the union In this situation—as in real life—it might not be possible for any one alternative to satisfy every criterion In such cases, a firm must prioritize which criteria are most important The third step of the decision-making framework involves generating alternatives Each of these alternatives should be feasible to achieve One alternative is invariably the “do nothing” or “status quo” alternative Beyond this option, management should FIG 8.2 Decision-Making Framework Define the decision to be made and any related issues Determine the criteria to be used when evaluating alternatives Generate alternatives Analyze and assess the alternatives Decide on an alternative and begin implementation Find more at www.downloadslide.com Chapter 8 Making Investment Decisions 153 typically consider at least two more alternatives, so as not to overlook some possible viable solutions; however, management should not consider so many alternatives that evaluation becomes excessively time consuming Usually three to four distinct alternatives are appropriate Sometimes it is useful to consider some out-of-the-box alternatives in order to stretch one’s thinking For example, when dealing with the issue of raising profitability, Ace’s alternatives might include deciding whether to purchase a new piece of equipment to replace the existing machinery, whether to upgrade the existing equipment, whether to outsource and scrap the existing equipment (which might be a radical departure for Ace), or whether to take no action at all Similarly, Ace’s management would also generate a series of alternatives related to how to deal with the union The fourth step in good decision making involves analysis and assessment of the alternatives This is usually the most critical and most time-consuming step Note that with each alternative, we should be able to quantify the potential benefits, such as increased profitability However, once we quantify these benefits, we need to balance them by considering the possible negative outcomes of each alternative Management plays a key role in this step because it assesses the trade-offs involved in any decision For example, quantitative benefits must be weighed against other qualitative factors Although developing the numbers cannot answer all questions, it does play an important role in articulating the trade-offs involved For example, Ace may have a clear “winning” alternative from the perspective of maximizing profitability—but this alternative might also be the riskiest, or it might involve major layoffs that will damage future relationships with the union Finally, the fifth step in the decision-making framework involves choosing the preferred alternative and developing an implementation plan This requires management to choose among the various alternatives that have been generated using the predetermined criteria For example, Ace management may decide to replace the old equipment with newer and more efficient equipment that will require fewer employees Part of the implementation plan will involve a communication strategy for explaining the impact of this decision on the union We can apply the general decision-making framework specifically to the capital budgeting or investment process Although most of the steps are fairly straightforward, later in this chapter we will provide examples that concentrate on the analysis step In terms of capital budgeting decisions, this step invariably involves an assessment of tradeoffs—namely, the initial cost of investment versus the expected benefits in terms of future cash flows and profitability Thus, with capital budgeting decisions, there is always a quantitative component to the analysis The easiest part of the quantitative analysis involves knowing the initial cost of a potential investment, such as new equipment We can think of this as a cash outflow today, when the decision is being made The next part of the process involves estimating any future costs and benefits, or cash outflows and inflows Here, it is the net cash flow that is relevant In addition, we need to examine the incremental cash flow compared with that of the “do nothing” alternative Finally, the last part of our analysis involves comparing the net cash flows and considering their timing, or what is known as the time value of money 8.2 Capital Budgeting Techniques Now that we have an appreciation of time value of money concepts and understand how these concepts relate to the valuation of bonds, preferred shares, and common shares, we are finally in a position to appreciate the various capital budgeting techniques, because many of them rely on time value of money concepts These capital budgeting techniques are quantitative assessment tools to determine whether a firm should proceed with an Objective 8.2 Describe various capital budgeting techniques, including payback, net present value, and internal rate of return Find more at www.downloadslide.com 154 Part 2 Assessing Future Financial Needs investment in a project We begin with the simplest assessment technique: the payback method This method provides the number of years by which a project’s cash flows cover the initial investment but does not rely on time value of money concepts (which is the major weakness of this technique) We then examine the related techniques of net present value and internal rate of return 8.2.1 Payback payback method: A method for evaluating investment projects that measures the time it takes for an investor to recover his or her initial investment Fig 8.3 Payback Method with Smooth or Even Cash Flows Recall the capital budgeting process described in the previous section As explained in that section, the first step in the process involves determining the initial cost of an investment This is the required cash outflow today, when the decision is being made We then estimate any future costs and benefits, or cash outflows and inflows, focusing specifically on the net cash flows (i.e., cash inflows less cash outflows) On average, these net flows should be cash inflows; otherwise the investment would certainly not be worthwhile Finally, we compare the estimated net cash flows to the initial investment The payback method is the simplest method for assessing capital budgeting decisions We will review two versions of the payback method First, for projects with an upfront investment and smooth or even annual cash flows, the payback period is estimated as shown in Figure 8.3 To better understand the payback method with smooth or even cash flows, let’s consider an example Suppose Ace Company is considering an investment in new state-ofthe-art equipment that requires an initial outlay of $100,000 The investment is expected to generate average annual net cash flows of $20,000 for the next eight years, primarily related to the superior efficiency of the new equipment as compared to the company’s old equipment Here, the payback period is calculated by dividing $100,000 (the cost of the initial investment) by $20,000 (the average annual net cash inflow) Our result is a payback period of five years In general, the payback period represents the length of time required to repay the initial investment—in other words, how long it takes for Ace to recoup its investment in the new equipment through annual cost savings In a sense, the payback method attempts to capture the riskiness of a project If the payback period is very short, then the project is less risky Thus, some firms have guidelines stating they will only accept projects with payback periods of, say, three years or less Second, let’s examine a more general estimation of payback when net cash flows are uneven In this case we simply cumulate the net cash flows in each year The approximate payback period is the year in which the cumulative net cash flows become positive We will show a more precise measure in the following example Suppose Ace Company made the same equipment purchase for $100,000 today (at year 0) but instead of smooth net cash flows, it had some initial problems that caused a negative net cash flow in year and then lower-than-anticipated net cash flows in earlier years, but higher-than-expected net cash flows in the later years Its net cash flows in years through were as follows: - $10,000, $5,000, $12,000, $18,000, $22,000, $27,000, $33,000, and $35,000 Net cash flows for each year as well as cumulative net cash flows are shown in Figure 8.4 We notice that cumulative net cash flows became positive in year 7, which is the approximate payback period For a more precise estimate we note that at the end of year the cumulative net cash flows were - $26,000 and during year there were net cash flows of $33,000 So partway through year cumulative cash flows turned positive, which implies the actual payback was in less than years We can interpolate by Payback period = initial investment average annual net cash inflow Find more at www.downloadslide.com Chapter 8 Making Investment Decisions Year Net Cash Flow ($) Cumulative Cash Flow ($) (100,000) (100,000) (10,000) (110,000) 5,000 (105,000) 12,000 (93,000) 18,000 (75,000) 22,000 (53,000) 27,000 (26,000) 33,000 7,000 35,000 42,000 155 Fig 8.4 Payback Method with Uneven Cash Flows calculating the fraction $26,000/$33,000 or 0.79 year In other words, given the total year net cash flow of $33,000, by the 0.79 year point, the start-of-year $26,000 cumulative deficit would have been eliminated As such, the precise payback is 6.79 years 8.2.1.1 Strengths and Weaknesses of the Payback Method The main strength of the payback method is its relative ease of calculation It can provide a quick screen of which projects may warrant further in-depth analysis, since if the payback period is quite long it is less likely that any of the other capital budgeting methods would find it acceptable It is a quick measure of the inherent risk of a project, as those with longer payback periods create additional risk of recovering initial investment costs In terms of weaknesses, given our knowledge of the time value of money, we can easily identify the major deficiency with the payback method: There is no attempt to distinguish between cash flows in the earlier years and cash flows in the later years; all are treated the same As well, it does not given any consideration to cash flows expected to occur beyond the payback period Although some firms use internal guidelines—for example requiring any new project to have a payback of less than five years—any such guideline measure of a desired payback period is arbitrary Also, there is no incorporation of opportunity cost 8.2.2 Net Present Value The net present value (NPV) method of capital budgeting attempts to capture the net value added to a firm by taking on a particular project Consider the simple example of a project with a cash outflow today and an anticipated cash inflow in one year In this oneperiod example, NPV is calculated as shown in Figure 8.5 Note that in Chapter 10, we will see that the discount rate used to evaluate projects is directly related to the cost of capital, or the firm’s cost of financing If the particular project is the same risk as the overall firm, then the discount rate should be closely related to the cost of capital In the context of project evaluations, the discount rate is also known as the hurdle rate, and it will be examined in more detail in Chapter 10 as NPV = −C0 + where C1 (1 + r) NPV = net present value −C0 = initial cash outflow today (i.e., time zero) Ct = anticipated net cash inflow in one year r = discount rate (or hurdle rate) in decimal form cost of capital (weighted-average cost of capital or WACC): The weighted average of the cost to a firm of all the forms of long-term financing, including debt, preferred shares, and common shares hurdle rates: The minimum acceptable rate of return for investments, depending on the nature and risk of the investment Fig 8.5 Net Present Value OnePeriod Example Find more at www.downloadslide.com 156 Part 2 Assessing Future Financial Needs Fig 8.6 Net Present Value Multi-Period Example NPV = −C0 + where C1 C2 C3 + + + (1 + r)1 (1 + r)2 (1 + r)3 NPV = net present value −C0 = initial cash outflow Ct = anticipated net cash inflow at time t r net present value rule: A method for evaluating investment projects that states that a firm should accept any project with a net present value greater than or equal to zero = discount rate (in decimal form) well There, we’ll see that the appropriate hurdle rate for a particular project reflects the perceived riskiness of the project: Less risky projects have lower hurdle rates, whereas riskier projects have higher hurdle rates Our focus in this chapter, however, is simply a basic understanding of the mechanics of net present value Suppose Ace is considering a new project The firm’s initial outlay in the project 1C is $80,000, the project’s net cash inflow in one year 1C is anticipated to be $100,000, and the appropriate discount rate (r) is 10 percent The net present value is calculated in two stages First, the present value of the expected cash flow is calculated on the basis of the time value of money concepts described in Chapter Specifically, to find the present value, we divide $100,000 by 1.10, which gives us a result of $90,909 Second, the initial investment of $80,000 is subtracted from this amount, leaving $10,909, or the net present value of the investment The net present value rule states that a firm should accept any project with a net present value greater than or equal to zero Here, we assume that the firm is not facing any capital constraints—in other words, if a project is identified that is shown to add value by providing a return above its cost, then the firm will be able to borrow or to attract new equity investors in order to invest in the project Note that the special case of zero NPV results from a project that provides just enough compensation for its level of riskiness—in other words, enough compensation to satisfy all of its lending or investing stakeholders We can also generalize the net present value calculation to situations that involve cash flows in more than one period, as shown in Figure 8.6 Suppose, for example, that Ace is now considering investing in a new piece of equipment, the Cost-Saver 300, that costs $300,000 The firm anticipates net cash inflows resulting from installing the Cost-Saver 300 in the next three years of $100,000, $150,000, and $200,000, and the appropriate discount rate is again assumed to be 10 percent What is the net present value of this project? Moreover, should Ace purchase the Cost-Saver 300? To answer these questions, we must first calculate the present value of each of the three expected cash flows Upon doing so, we find that the present value of the first inflow is $90,909 (or $100,000>(1.10)1), the present value of the second inflow is $123,967 (or $150,000>(1.10)2), and the present value of the third inflow is $150,263 (or $200,000>(1.10)3) Next, we calculate the sum of the three present values: $365,139 After that, we subtract the initial investment of $300,000, leaving us with a net present value of $65,139 Thus, based on the NPV rule, Ace should purchase the Cost-Saver 300 Net present value can also be calculated using a spreadsheet NPV function, but be forewarned that calling it “NPV” is somewhat of a misnomer and the function should be used carefully In Excel, find the “Insert Function,” then select category “Financial,” then “NPV.” The form of this function is NPV(rate, value1, value2, ), but note carefully that the function assumes “value1” is not the initial cash outflow today but rather the net cash outflow one period from now Thus, in order to an NPV calculation in Excel, you must perform the separate step of subtracting the initial investment Using our notation, rate is the discount rate or r, in decimal form; value1 is the net cash flow one year from now (assuming we are examining annual cash flows); value2 is the net cash flow two years from now; and so on We subtract the initial investment because it is a cash Find more at www.downloadslide.com Chapter 8 Making Investment Decisions A Rate Initial investment value1 value2 value3 B C D Fig 8.7 Spreadsheet Net Present Value Example E 10 –300000 =B2 + NPV(B1,B3,B4,B5) 100000 or =B2 + NPV(B1,B3:B5) 150000 200000 157 65.139 outflow today So, to run the NPV function using the information from our example, choose a particular cell and enter the following: = - 300,000 + NPV(.10,100000,150000,200000) The same answer that we found previously—65,139—should appear We can recreate this example by giving labels to each of the components and then referencing each of the components of the function separately, as indicated in Figure 8.7 8.2.2.1 Strengths and Weaknesses of the Net Present Value Method The major strength of the net present value method is that it takes into account the time value of money through the discount rate It implicitly makes the reasonable assumption that any interim cash flows from the project are reinvested at the firm’s cost of capital One weakness of the net present value method is that it provides an answer in dollar terms while many managers focus on percentage returns when assessing projects The greatest challenges with the net present value approach are determining realistic cash flow estimates and estimating an appropriate hurdle rate real option definition: The alternative or choice, but not obligation, to make a particular business investment decision, often related to timing In-Depth Real Options We have simplified our investment discussions by assuming that, if a manager is deciding whether to invest, a yes-no decision must be made today But what if there is an option to postpone the decision—say, until a project becomes more attractive? This is the notion of a real option or the right (but not obligation) to make a particular business decision.1 Let’s contrast two types of decisions Here is a very simple example of a traditional investment that requires a decision today, and the resulting profits depending on whether there is good or bad news subsequent to our decision good news $100 bad news −$50 invest don’t $0 A broader issue is how to price such a real option, which is beyond the scope of this book Part of the answer requires an understanding of financial options such as call options, and the well-known Black-Scholes model Two finance professors—Myron Scholes and Bob Merton—won Nobel Prizes in Economics for their insights into option pricing, and would almost certainly have shared the award with another finance professor, Fisher Black, who unfortunately passed away before being recognized with the prize (continued) Find more at www.downloadslide.com 158 Part 2 Assessing Future Financial Needs Now let’s suppose we don’t have to decide today but can wait to hear the news first invest $100 good news don’t invest $0 −$50 bad news don’t $0 We can clearly see that there is value in having the option to wait before deciding If news is good then we invest, but if news is bad we don’t Options are usually very specific to the type of project that a firm is facing and are certainly more complex than our simple example However, we can generalize some of the main types of options that managers typically face These include the option to wait until an optimal time before making an investment, the option to grow, and the option to terminate an underperforming project The preceding example showed the value of delaying an investment opportunity As an example of the option to grow, we observe that firms like Google often make acquisitions in businesses that don’t have positive cash flows but are thought to be on the verge of huge growth opportunities Not all acquisitions will work out, but some may be real winners Finally, the abandonment option is valuable when a project requires various stages of investments Managers can reassess the profitability of proceeding further with the investment at each stage and only proceed if future benefits outweigh future costs, regardless of any sunk costs The value of a real option stems mainly from two factors One is the value of time, since by waiting, a more favorable investment outcome may present itself Another source of value relates to the riskiness of the project If there is no risk then a decision is straightforward as future benefits can easily be quantified If a project is much more risky, there may be a chance that there is a huge value at some future date from investing in the project The key message for managers is that there is value in the ability to wait before making an investment decision and we may not capture the value of that real option in our traditional NPV and IRR approaches Real option analysis can supplement our traditional investment analysis 8.2.3 Internal Rate of Return internal rate of return rule: A method for evaluating investment projects that states that a firm should accept any project with an internal rate of return greater than or equal to a prespecified hurdle rate Although the net present value method has tremendous intuitive appeal, a related measure—the internal rate of return (IRR)—is often more popular in practice The IRR measure is similar to the yield to maturity measure for bonds, as examined in Chapter This technique tells us what particular discount rate will result in a zero NPV project Therefore, unlike the NPV method, which gives a dollar figure for the amount of value added, the IRR method gives a percentage return to assess the viability of a project This method also has a “rule” of its own Whereas the NPV rule states that a firm (not facing any capital constraints) should accept any project with a net present value greater than or equal to zero, the IRR rule states that a firm should accept any project with an internal rate of return greater than or equal to a prespecified hurdle rate Note that the hurdle rate should be the same as the discount rate used in the NPV assessment Consequently, Find more at www.downloadslide.com Chapter 8 Making Investment Decisions A Guess Initial investment value1 value2 value3 B C D E 10 –300000 100000 150000 200000 =IRR(B2,B3,B4,B5,B1) or =IRR(B2:B5,B1) Fig 8.8 Spreadsheet Internal Rate of Return Example 20.61% both NPV and IRR decisions should be consistent (at least for most straightforward situations with an initial cash outflow and subsequent cash inflows) In other words, if a project has a positive NPV, it should also have an IRR greater than the hurdle rate To see how the IRR method works, let’s revisit the example described in the latter part of Section 8.2.2 In that example, Ace is considering an investment of $300,000 and anticipates net cash inflows in the next three years of $100,000, $150,000, and $200,000 The appropriate hurdle rate is assumed to be 10 percent What is the internal rate of return for this project, and should Ace accept it? For a multi-period problem like this one, it turns out that there is no easy method to calculate the IRR by hand or even using many standard financial calculators (except for a bruteforce trial-and-error process) However, the process is quite straightforward when using spreadsheets (as well as some more advanced calculators) In Excel, find the “Insert Function,” then select category “Financial,” then “IRR.” Note that the form of this function is IRR(values, [guess]) The values represent an array and must be specified in a particular manner Note also that there is an inconsistency between the NPV and IRR functions in Excel The first value in the IRR function is the initial cash outflow, expressed as a negative number, - 300000 This first value must represent a cash outflow today, unlike the NPV formula that excluded the initial cash outflow in its formula The subsequent values represent the net cash flows, first starting one year from now (100000), then two years from now (150000), then three years from now (200000) This process would continue for as many years as appropriate The “guess” in this formula is optional and represents an estimate of what the IRR might be (Because the spreadsheet function is based on an iterative trial-and-error process, it often needs a reasonable place to start.) In most cases, simply starting with the hurdle rate or even 0.10 should suffice Thus, to use the IRR function for our Ace example, chose a particular cell and enter the following information precisely as shown: = IRR({ - 300000; 100000; 150000; 200000}, 10) An answer of 20.61% should appear This indicates that the internal rate of return for purchasing the equipment is 20.61 percent We can recreate this example by giving labels to each of the components and then referencing each of the components of the function separately, as indicated in Figure 8.8 In this example, consistent with our NPV analysis, the IRR of 20.61 percent is above the hurdle rate of 10 percent, so Ace should take on the project How does the discount rate impact the NPV value? For the Ace example, the relationship between NPV and different discount rates or hurdle rates is shown in Figure 8.9 We see from this figure that when the discount rate is exactly 20.61 percent, then the NPV is zero In other words, we can confirm that the IRR is 20.61 percent, because this is the discount rate that makes the NPV exactly equal to zero In general, the higher the discount rate, the lower the NPV 8.2.3.1 Strengths and Weaknesses of the Internal Rate of Return Method A major strength of the internal rate of return method is that, like the net present value method, it takes into account the time value of money It also has the convenient benefit 159 Find more at www.downloadslide.com 160 Part 2 Assessing Future Financial Needs Fig 8.9 NPV for Different Discount Rates Example $80,000 $60,000 NPV $40,000 $20,000 –$20,000 –$40,000 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 Discount Rate (%) of providing results as a return measure rather than a simple dollar measure If there is an unusual cash flow pattern—for example a mix of positive and negative cash flows throughout the life of the project rather than the usual negative cash flows in early years followed by positive cash flows in later years—it is possible that there is more than one internal rate of return There is one other cautionary note related to the IRR method: An implicit assumption is that any cash inflows generated in the earlier years can be reinvested (for example, in other new projects that Ace is taking on) at the rate of the IRR In many cases, this is not a realistic assumption So, even though the appropriateness of the reinvestment assumption does not affect the “accept” or “reject” decision in our preceding example, the resulting rate of return should be interpreted cautiously 8.2.3.2 Modified Internal Rate of Return In order to overcome some of the weaknesses of the internal rate of return method—in particular the possibility of multiple answers and the assumed reinvestment rate—an alternative method known as the modified internal rate of return (MIRR) has been developed Although the calculation appears to be somewhat complex, the good news is that the MIRR calculation is built in to common spreadsheet applications such as Excel The MIRR method requires the specification of two rates First, we need to specify a hurdle rate or cost of capital the same as with the NPV method, which we can generically refer to as the finance rate Second, we need to specify a reinvestment rate at which we assume the firm can invest any positive net cash flows from the project We then segregate positive cash flows from negative cash flows We take the future value of the positive cash flows compounded at the reinvestment rate We also take the present value of the negative cash flows discounted at the finance rate We then estimate an IRR based on these two values The formula is as follows: modified internal rate of return (MIRR): A modification of IRR that assumes cash flows are reinvested at the financing rate, such as the cost of capital, rather than at the IRR MIRR = FV of positive cash flows compounded at the reinvestment rate -1 B PV of negative cash flows discounted at the finance rate n where n is the number of periods and represents the “root” of the equation (for example, if n is 2, then it is a square root equation, if n is 3, it is a cube root equation, etc.) Find more at www.downloadslide.com Chapter 8 Making Investment Decisions Year Net Cash Flow ($) (100,000) FV of Positive Cash Flows –PV of Negative Cash Flows 161 Fig 8.10 MIRR Example 100,000 9,091 (10,000) 5,000 9,869 12,000 21,148 18,000 28,323 22,000 30,908 27,000 33,869 33,000 36,960 35,000 35,000 Total 196,078 Finance rate 10.00% Reinvestment rate 12.00% Ratio of FVs/–PVs 1.80 MIRR 7.60% 109,091 Let’s consider an example using the same cash flows as in Figure 8.4 The finance rate is 10 percent Let’s assume that the reinvestment rate is 12 percent since Ace is able to find new opportunities slightly above its hurdle rate The MIRR calculation is presented in Figure 8.10 The ratio of the future value of the positive cash flows compounded at the reinvestment rate ($196,078) to the present value of the negative cash flows discounted at the finance rate ($109,091) is 1.80 If we take the eighth root of 1.80, or 21.80 (which is also ( ) the same as writing 1.80 ), we get 1.076 Finally, when we subtract we get 0.076 or 7.60 percent the MIRR 8.3 Capital Budgeting Extensions There are a number of nuances related to capital budgeting that we will explore in this section First, we describe an alternative method for interpreting NPV results and assessing which projects to undertake Second, we consider how to compare projects of different lengths And third, we look at mutually exclusive projects and what happens when a firm is limited to the amount of capital it can spend on projects 8.3.1 Profitability Index In Section 8.2.2, we discussed the NPV approach to evaluating projects and examined a project that Ace Company was considering: purchasing the Cost-Saver 300 Recall that this equipment cost $300,000 and the present value of the first three years of net cash inflows was $365,139 We can evaluate the feasibility of such an investment in a different manner Instead of taking the difference between the benefits and costs, expressed as a Objective 8.3 Describe the profitability index, equivalent annual costs, mutually exclusive projects, and capital rationing Find more at www.downloadslide.com 162 Part 2 Assessing Future Financial Needs dollar amount—the NPV method—we can instead take a ratio of the benefits and costs We refer to this ratio as the profitability index: Profitability index = present value of net cash flows initial investment So, for the Cost-Saver 300, the profitability index measure is simply $365,139>$300,000 = 1.22 According to this method, a project should be undertaken if its profitability index measure is greater than 1.0 because any ratio greater than 1.0 indicates that benefits exceed costs Thus, as we saw with the NPV rule, Ace should purchase the Cost-Saver 300 The profitability index measure is useful for ranking a series of projects based on the notion of getting a “bang for your buck,” or receiving as much value added as possible in excess of each dollar of investment There are limitations to using the profitability index, however Note that a very small project might have a high profitability index, but in dollar terms, it might add only a small amount of value compared with a larger project with a lower profitability index 8.3.2 Equivalent Annual Cost and Project Lengths How can a firm compare projects with different project lengths? The answer is to create an apples-to-apples comparison by estimating and comparing annual costs The equivalent annual cost method measures the annual cost related to a project over the lifetime of that project If we are creating equivalent annual costs, then we are essentially creating an annuity Recall from Chapter the formula for the present value of an annuity (PVA): PVA = PMT c1 d r (1 + r)n where in this context PMT represents the annual annuity payments or equivalent annual costs, r is the discount rate or hurdle rate in the present context, and n is the number of periods of the project To initially simplify matters, if there is a simple one-time initial investment at time and there are no ongoing costs associated with the n years of the project, then we can think of the initial investment as equivalent to the PVA Since we know n (the anticipated length of the project) and r (the hurdle rate), we can solve for PMT In other words, PMT represents an equivalent annual cost we would need to pay during the lifetime of the project (with the first payment at the end of the first year) instead of making the initial upfront investment So rearranging the PVA formula to solve for PMT: PMT = [r * initial investment]/c [1 - profitability index: A method for evaluating investment projects that takes the ratio of present value of net cash flows to the initial investment equivalent annual cost: The annual cost related to a project over the lifetime of that project d (1 + r)n Of course as we’ll see shortly, if we are using a spreadsheet, our lives are much simpler as we can solve for PMT directly using the PMT function Now let’s consider a slightly more complex situation by adding ongoing costs and run some numbers Suppose Ace is considering the purchase of a new machine, and it has two models from which to choose—both of which will generate identical annual cash flows The Super-3 model costs $30,000, is expected to last for three years, and requires annual maintenance of $6,000, whereas the Super-8 model costs $100,000, is expected to last for eight years, and requires annual maintenance of only $1,000 The appropriate hurdle rate is 10 percent Given these factors, which machine should Ace purchase? We know the annual maintenance cost for each machine, and on that basis, the Super-8 looks better because its annual costs are much lower However, to make a fully informed decision, we also need to amortize each machine’s purchase price over the life of the machine The easiest way to this is to use a spreadsheet function that solves for Find more at www.downloadslide.com Chapter 8 Making Investment Decisions 163 the annual payment, or PMT, given the initial price or present value of each machine In Excel, find the “Insert Function,” then select category “Financial,” then “PMT.” The form of this function is PMT(rate, Nper, PV, [FV ], [type]) For the Super-3 machine, rate is the hurdle rate or 10 percent; Nper is the life of the machine, or three years; and PV is the initial investment in the machine, or –30,000 (Because it represents a cash outflow, the initial investment is expressed as a negative number.) We don’t need to enter any information for FV, or future value, and would only so if there was any salvage value at the end of the life of the machine We also don’t need to enter any information for type, because the default assumption is that the annual cash outflows occur at the end of each year So, we would enter the following values in our function in order to assist in estimating the equivalent annual cost: = PMT(.10, 3, - 30000) or = PMT(.10, 3, - 30000,0,0) The function returns a result of $12,063.44 Or using a financial calculator: 30,000 S S 10 PMT S PV i [or r] n Answer is 12,063.44 If we add this amount to the annual maintenance cost of $6,000, we have the equivalent annual cost of the Super-3 machine: $18,063.44 We can then repeat this procedure for the Super-8 machine using the function PMT(.10, 8, –100000) This function yields a result of $18,744.40, which is the amortized cost of the machine When this amount is added to the annual maintenance of $1,000, we arrive at the equivalent annual cost of the Super-8 machine: $19,744.40 Because the equivalent annual cost of the Super-3 machine is lower than that of the Super-8 machine, Ace should purchase the Super-3 machine Notice that we are making some important assumptions in this example If we anticipate needing the machine for at least eight years—the anticipated life of the Super-8 machine—then we will need to replace the Super-3 machine at least two times We are making an implicit assumption that the cost of a new Super-3 machine three and six years from now will be the same as today’s $30,000 cost We’re also assuming that a new machine purchased three or six years in the future will have the same annual maintenance costs If these assumptions are not valid, then we need to be careful in the decision we make 8.3.3 Mutually Exclusive Projects and Capital Rationing A firm may face some complicating factors when it is making investment decisions In most of the examples in the chapter, we’ve implicitly assumed that every project Ace was considering was independent of other projects In other words, we assumed that Ace could make “accept” or “reject” decisions for every project without considering the effects of these decisions on other projects The one exception was the consideration of whether to purchase either the Super-3 machine or the Super-8 machine We refer to those two machine purchases as being mutually exclusive projects In other words, if Ace purchases the Super-3 machine, it will not purchase the Super-8 machine, and vice versa If all projects are independent, then both the NPV and IRR methods should result in consistent “accept” or “reject” decisions If projects are mutually exclusive, then the NPV rule still applies: Invest in the project with the highest positive net present value However, trying to rely on IRR and simply choosing the project with the highest IRR above the hurdle rate may be inconsistent with the NPV rule For example, a 30 percent return on a $1,000 investment is $300, whereas a 20 percent return on a $1 million investment is much greater $200,000 Thus, while the 30 percent IRR is clearly greater than the mutually exclusive projects: Projects that are similar—however, if one is chosen the other cannot be Find more at www.downloadslide.com 164 Part 2 Assessing Future Financial Needs capital rationing: The act of placing restrictions on the amount of money available for investments, forcing firms to choose among worthwhile projects 20 percent IRR, the $1,000 return is a much lower dollar amount than the $200,000 return This critique—that we need to be careful when interpreting which project is “better” simply by relying on which one has the highest IRR—can be applied to evaluating projects solely on the basis of the profitability index as well One suggested solution, particularly for comparing two mutually exclusive projects with identical lives, is to focus on the incremental initial outlays and incremental cash flows of the two projects Still, there are limitations in practice based on implicit assumptions related to the IRR method For example, there may be more than one IRR (i.e., more than one value that makes the NPV equal to zero) depending on the complexity of the resulting incremental cash flow stream Another complicating factor when a firm is making investment decisions relates to the amount of money that the firm has available for investing Capital rationing occurs when a firm puts a limit on the amount of its investments—for example, by having a fixed budget for capital expenditures in a particular year Capital rationing may also occur when a firm imposes a higher hurdle rate, which is associated with a higher cost of capital—for example, if a firm decides to reduce its borrowing Capital rationing may be imposed externally—for example, loan provisions may limit the issuance of additional debt, or it may be imposed internally Capital rationing may be imposed within firms that have had a poor track record of overinvesting in underperforming assets—even though a more logical response might be to review the capital expenditure process Or it may be imposed because a firm’s senior managers are reluctant to issue external debt For example, Ace may decide that it is investing a total of only $50 million next year in new equipment, so it will undertake only the “best” equipment investments But what does “best” mean? Ace should compare the initial cost of various investments, the NPV of each, the IRR, and the profitability index Selecting projects based on NPV might not be optimal since a particular project might have a very high initial cost compared to another but only marginally higher NPV than other projects with much lower initial investments For example, Project A might require an initial investment of $40 million and provide an NPV of $1 million, the highest NPV among all projects under consideration However, Project B might have an initial investment of only $5 million with an NPV of $900,000, and Project C might have an initial investment of only $4 million with an NPV of $800,000 Other projects might cost less than $4 million but with still sizeable NPVs Therefore Ace might be better off foregoing Project A and instead take on a series of smaller projects that cumulatively have a much higher NPV than Project A So how should Ace determine which projects to take on? Usually, the IRR method and the profitability index will be more informative than the NPV method when facing capital rationing and should provide identical rankings In time, if there are conflicts, the profitability index should provide the best rank order in a capital rationing situation Ultimately, Ace should consider the combination of projects that provide the highest NPV, and the profitability index will be a useful tool to assist 8.4 Relevance for Managers Objective 8.4 Explain why making investment decisions is relevant for managers Making investment decisions is a critical function of almost every operating manager Thus, it’s important for all managers to have a framework for effective decision making Such a framework involves defining the decisions to be made, developing criteria for evaluating alternatives, generating and assessing alternatives, and finally, choosing an alternative and implementing an action plan Time value of money concepts are also the foundational building blocks on which to make effective investment decisions In particular, investment in any project relies on Find more at www.downloadslide.com Chapter 8 Making Investment Decisions 165 basic present value calculations—in other words, comparing initial investments with the present value of anticipated net cash flows, discounted at an appropriate hurdle rate to reflect the perceived riskiness of the project Managers strive to add value to their firms, and they can accomplish this goal by undertaking positive net present value projects It is critical for managers to understand the pros and cons of a variety of capital budgeting metrics, including those that rely on time value of money concepts such net present value, internal rate of return, and the profitability index, and those that don’t, such as payback To what extent managers rely on the capital budgeting techniques described in this chapter? A survey of American CFOs conducted by academics John Graham and Campbell Harvey asked the CFOs to rate the frequency of their use of various capital budgeting techniques Graham and Harvey found that 75.7 percent of CFOs always or almost always relied on IRR to make capital budgeting decisions, and 74.9 percent relied on NPV In particular, larger firms were more likely to rely on these techniques, as were firms with proportionately more debt Perhaps surprisingly, payback was used by 56.7 percent of survey CFOs despite the obvious limitations of this method Only around 12 percent of the surveyed CFOs used the profitability index method Thus, we see that it is important for all managers to be aware of and utilize sound capital budgeting techniques Summary The business decision-making framework involves five steps: definition of the decision to be made; identification of criteria to be used when evaluating alternatives; generation of alternatives; analysis and assessment of alternatives; and decision and implementation The payback method is the simplest capital budgeting technique, but it ignores the time value of money The net present value method of capital budgeting estimates how much value a firm will gain or lose by accepting a project with a particular initial investment and projected net cash flows A real option is the right but not obligation to make a particular business decision The internal rate of return method of capital budgeting estimates the discount rate such that the net present value of a project is just equal to zero The profitability index compares the present value of net cash flows to the initial investment Capital budgeting decisions are more complex when projects are mutually exclusive, when comparison projects are not of equal length, and when capital is rationed Additional Readings and Information See any of the corporate finance textbooks listed at the end of Chapter that contain extensive sections related to capital budgeting Some books that focus exclusively on capital budgeting include: Peterson, Pamela, and Frank Fabozzi, Capital Budgeting: Theory and Practice New York: John Wiley & Sons, 2002 Bierman, Harold, and Seymour Smidt The Capital Budgeting Decision: Economic Analysis of Investment Projects, 9th ed New York: Routledge The capital budgeting survey described in this chapter is from: Graham, John, and Campbell Harvey “How Do CFOs Make Capital Budgeting and Capital Structure Decisions?” Journal of Applied Corporate Finance 15 (Spring 2002): 8–23 Find more at www.downloadslide.com 166 Part 2 Assessing Future Financial Needs Problems What is the payback period of a project with average annual cash outflows of $8,000, average annual cash inflows of $10,000, and an initial investment of $13,000? What is the net present value of a simple one-period project with an initial investment of $12,000 and an expected net cash flow in one year of $15,000, assuming a discount rate of percent? What is the internal rate of return for the project in question 2? What is the profitability index for the project in question 2? What is the highest discount rate at which the project would still be acceptable (i.e., a zero NPV)? What is the net present value of a project with a $40,000 initial investment and expected net cash flows of $15,000, $20,000, and $25,000 in each of the next three years, assuming an appropriate discount rate of 10 percent? What is the internal rate of return for the project in question 6? What is the profitability index for the project in question 6? What is the payback period for the project in question 6? 10 What is the modified internal rate of return for the project in question if the finance rate is 10 percent and the reinvestment rate is 13 percent? 11 What is the equivalent annual cost of a piece of equipment that requires an initial investment of $50,000, is expected to last seven years, and requires annual maintenance costs of $4,000 if the appropriate discount rate is percent? ... Value of Money Concepts 12 9 7 .1. 1 Future Values 13 1 7 .1. 2 Present Values 13 3 7 .1. 3 Annuities 13 5 7 .1. 4 Perpetuities 13 6 In-Depth: Spreadsheet and Financial Calculator Tips 13 7 7.2 Applying... amd-faces-looming-cash-crunch-amid-quest-for-new-markets-tech#p1 (accessed December 10 , 2 012 ) Fig 1. 1 Cash-Related Activities and the Financial Manager financing operating financial Manager investing... www.pearsonhighered.com ISBN 10 : 0 -1 3-2 93664-X ISBN 13 : 97 8-0 -1 3-2 9366 4-4 Find more at www.downloadslide.com To Linda for her love and support, and to Jennifer, Christopher, Thomas, and Melanie for absorbing