Transcripts. Transcript: Welcome. HAME508: Making Capital Investment Decisions Cornell School of Hotel Administration

Transcription

1 Transcripts Transcript: Welcome Any time you're part of the decision to purchase an asset in your company, in your division, the finance team is going to get involved and you're going to have to work together with them to figure out which asset is the best one to purchase, and how it is that that asset is going to help to produce value inside the company. >> And what we're going to do in this course is walk you through all of the key decision making criteria that the finance team is going to use. So, it's no longer going to be the case that you're sitting on the sidelines. You're now going to be able to actively participate and work with the finance team, carry on a dialogue, and go through the different models they use. And you can understand them. And help be part of the solution within the firm as to whether or not to move ahead with this particular project. >> It's going to be common that within the scope of analysis there's going to be multiple types of ways to accomplish the same goal with this project. Different assets. They might have different lives. They may have different types of cash flows leading up into the project itself. And then you will be part of the discussion. After taking this course you can actively be part of the discussion where you will be able to understand and ascertain the choices among the alternatives that the company will be moving toward. >> Good points, Steve. And we'll be presenting a number of frameworks, and we're going to go through the pros an cons of each of those frameworks, when they'll work well when they won't work so well. And you'll be able to bring this knowledge and this array of frameworks to bear when you're looking at presenting your project and working it through the finance team. >> Right. Be more involved. Be more actively involved, engaged and understand better how these decisions are made, and eventually be a motivator toward the decisions that will affect your company and your future. 1

2 Transcript: Capital Budgeting Rules HAME508: Making Capital Investment Decisions Let's talk about capital budgeting rules. Capital budgeting is at the heart of what drives value for any company. Scott, why don't you tell us a little bit about what is capital budgeting, where it comes from, and how do we begin that process? >> Oh sure, Steve. Let me give you the big picture. What I want you do to is think of a balance sheet. And on the right hand side, we have how we're raising our money. It's our debt and our equity. On the left hand side, is the operating assets. And so what we do, is we look over to the right hand side, figure out what our various investors want in the way of a return. Say it's 13%. That becomes what we call the hurdle rate. That is the rate we need to jump over when we invest those funds on the left hand side. So when we invest in a project we have to make sure we're clearing that 13%. So how do we make sure a project is getting us that 13%? Well we use a variety of different capital budgeting rules and we're going to look at those. We're going to look at the NPV, IRR, payback period, discounted payback. We also look at the return on investment, and also the profitability index. All various rules that all bring a little something to the game. They all have their pros and their cons, and we're goning to learn about those pros and cons and when to use each. The whole idea though, is to make sure that we are earning for our investors a return that's going to increase their wealth. That's the idea behind these capital budgeting rules. >> Yeah. It's really critical to understand that when we engage in capital budgeting analysis, when we invest in any project, that we add value to the company. Adding value to the company requires not only creating a positive cash flow, but enough of a positive cash flow, cash flow to add to the value of the business by exceeding the hurdle. >> Yeah, and the financial management team, the finance team. That's what they're trying to do. They're not trying to be difficult when they're shooting down your project. They're trying to work with you to ensure that whatever project that you bring forward bring to the table is contributing to the wealth of the owners of the firm then, that you're achieving that hurdle rate you're exceeding that and that's the whole idea so financial management team, that's the rules they're using but we want you to do is understand those rules, so you can carry on an active dialogue with the finance team. >> Right. It's important to remember, in the end, that almost no business has unlimited funds. And therefore whenever the finance people are evaluating a project, they look to make sure that the opportunity cost of the funds are being maximized in this particular project across the entire company in every division. >> And that's what the capital budgeting rules are going to do for us. >> Right. 2

3 Transcript: The Critical Importance of Capital Budgeting Analysis Successful analysis of capital budgeting and, using correct capital budgeting rules is critical to the success of any business. Critical to the value of a business. Critical to adding value to a business and also really important especially at a divisional level for divisional managers to make good decisions. Now of course there is a lot of different types of products that we would use, different types of measures. Scott, you are familiar with the different types of surveys that are used out in the marketplace to see who uses what. >> Yeah right. The survey evidence we saw suggests that in United States the most common capital budgeting rules are the NPV and the internal rate of return, the IRR. But that varies internationally. >> Right so in the U.S., we know that there are more common ones and then globally there's other surveys that are done to see whether or not across the world people use the same types of analysis in the same way. >> For example, we saw in Europe, payback period is relatively more popular than it is in the United States. >> Right, and the level of complexity of the different types of measurements as well as which types of companies are using them, how large they are, those all make a difference. >> Yeah, for example, I've worked with some companies where the return on investment is the most popular rule. They use it for just about everything. But that said they usually calculate the other rules to bring into decision. They all bring something to the table. There's pros and cons with each of the methods. And I would suggest we use all of our capital budgeting rules and look at all of them and understand what they're bringing to the table. >> I think that's a great point. It's important to get different perspectives and each one of these types of rules is going bring a different type of perspective to the table. >> Right. 3

4 Transcript: Net Present Value HAME508: Making Capital Investment Decisions So what is the net present value? It's actually straightforward. What we're going to do is we're looking at a corporation's project. We are going to take the project cash flow. So what is the initial investment and what do we estimate the cash flows to be going out into the future that are associated with this project? Then what we're going to do is get the hurdle rate. Remember the hurdle rate is the rate that investors are going to demand, given the risk that's in the cash flows of the project. And what we're going to do, is we're going to discount, or calculate the present value of those future cash flows. And if the sum of the present value of those future cash flows is greater than that initial investment what we say is that has a positive net present value. The present value of all those future cash flows exceeds that amount or that initial investment. >> Yeah, it's important that financial managers realize that what we're really trying to do is to add, and to add to the incremental value of the business. Every project that we put on the books, every time we use the company's assets, or the money the company has to acquire another part of the business, add to one of our other divisions, they're, of course, needing to add value to the company. The way, the best way for us to value that incremental value is through net present value. Of course financial managers are going to always do this calculation. Non- financial managers, especially those taking this course, need to understand the inputs that they will bring to the table to help make sure that we make good investment decisions. >> Exactly. So the financial management team, when you're going to sit down with them, they're going to be looking through your projections, your capital budget plans that you put together. They're going to be trying to strip out the relevant cash flows going out into to the future. They'll be thinking about the risk of the project. And the hurdle rate that's going to result. And what they're going to do then is take those two ingredients, the cash flows, they're going to take the hurdle rate, use the hurdle rate to discount those cash flows, just add up the present value of those future cash flows, subtract off the initial investment and if it's a positive NPV, that means what the project brings in is worth more than the initial investment. We move ahead. However, if the project cash flows fall short of that initial investment that's what we call a negative NPV. That's actually destroying value, it's destroying the value for our And non- financial managers, whether they be marketing or HR, need to make sure they bring forward the right information to assist financial managers in making that decision to increase the value of the company every time. 4

5 Transcript: Calculate NPV Fixed Cash Flows Find the NPV - fixed cash flows for Project A using the HP 12C Project A requires an initial investment of 100 dollars. The projected cash flows for years 1, 2 and 3 are fixed, 50 dollars per year. The hurdle rate for this project is 10 percent. What is the NPV for Project A? Your HP12C has five primary financial function keys. Clear the registers [f] [REG] Enter the number of periods: 3 [n] Enter the applicable rate, 10%: 10 [i] Enter the value of the cash flows, $50 annually: 50 [PMT] Calculate the present value of the future cash flows at the applicable rate. The answer is Find the NPV - fixed cash flows for Project A using the TI BA II Plus Project A requires an initial investment of $100. The projected cash flows for years 1, 2, and 3 are fixed, $50 per year. The hurdle rate for this project is 10% What is the NPV for Project A? Your calculator has five primary financial function keys. Clear the TVM register: 2nd [CLR TVM] Enter the number of periods, three years: 3 [n] Enter the applicable rate, 10%: 10 [i/y] Enter the value of the cash flows, $50 annually: 50 [PMT] Calculate the present value of the future cash flows at the applicable rate: [CPT] [PV] The answer is Find the NPV - fixed cash flows for Project B using the HP 12C Project B requires an initial investment of $100. The projected cash flows for years 1 and 2 are $40 per year. The cash flow for year 3 has been rewritten as $40 and the remaining $20 in year 3 has been reassigned as the future value of the project. The hurdle rate for this project is 10%. What is the NPV for project B? Your calculator has five primary financial function keys. Clear register: [f] [REG] Enter the number of periods, three years: 3 [n] Enter the applicable rate, 10 percent: 10 [i] Enter the value of the cash flows, 40 dollars annually: 40 [PMT] Enter the future value, the additional amount available in year three, $20: 20 [FV] Find the NPV - fixed cash flows for Project B using the TI BA II Plus 5

6 Project B requires an initial investment of $100. The projected cash flows for years one and two are $40 per year. The cash flow for year three has been rewritten as $40 and the remaining $20 in three has been reassigned as the future value of the project. The hurdle rate for this project is 10%. What is the NPV for project B? Your calculator has five primary financial function keys. Clear register: 2nd [CLR TVM] Enter the number of periods, three years: 3 [n] Enter the applicable rate, 10%: 10 [i/y] Enter the value of the cash flows 40 dollars annually: 40 [PMT] Enter the future value, the additionally amount available in year three, 20 dollars: 20 [FV] Transcript: Terminal Infinite Cash Flows In this example we are considering a pipeline that will cost $300 million to build. Let's take a look at the future cash flows. In year one we expect $30 million. Year two, $40 million. Year three, $50 million. And then afterwards, the cash flows will go up 4% per year. How are we going to value these future cash flows? Let's break it down and look at the first cash flows individually. Let's take year one, it's a $30 million dollar lump sum. Let's bring it back one year, using the present value of a lump sum formula. The value is $26.79 million dollars. Let's take year two, it's a $40 million dollar cash flow, again we'll use the lump sum formula, bringing it back to the present, we have $31.89 million dollars. Let's take a look at year three, we have a $50 million dollar cash flow, afterwards we expect that to grow at 4% every year. How are we going to put a value on this? If you envision yourself standing at year two, and you look forward, what you'll have is a $50 million cash flow to be received one year from today. That cash flow will draw at 4% each and every year. What does this look like? Well, it's a growing perpetuity. $50 million dollars that's going to grow at 4% each and every year. So, we can value the cash flow using the growing perpetuity formula. Here, the payment amount is $50 million dollars, the growth rate is 4%, and in this example we're using a 12% discount rate. So, if we take the $50 million dollars, divide through by the 12% minus the 4%, we get a value of $625 million dollars. Now that's the value where we're standing today at year two. We don't want the value of year two, we want the value as of today. So we have to shift this $625 million dollars from year two back to today. How do we do that? Well, we use a lump sum valuation once again. $625 million brought back two years at 12% is $ million. Now we have all the pieces to put together. If we add up the present values of the cash flows from year one, two, three on out, let's see what we have. $26.79 million in year one, $31.89 million in year two, and the value of the cash flows in three on out is $

7 million. The total present value of all the future cash flows in this case is million. If we subtract off the $300 million construction cost, we have a positive net present value for our pipeline project of million. The project looks like a winner. The valuation we just made of the growing perpetuity, beginning three years from now, is known as a terminal value calculation. Terminal value calculations are often made in situations where the project cash flows are expected to continue into the indefinite future. Terminal valuation calculations are also used to value whole businesses where clearly the cash flows are expected to continue into the indefinite future. Typically in these situations, cash flows are projected out three to seven years, on a year- by- year basis. The cash flows afterwards that extend out into the future are assumed to take the form of growing perpetuity, just as in the pipeline example that we just worked through. Transcript: One Key Limitation to NPV So recognizing that Net Present Value is one of the predominant types of valuation techniques that we do when we engage in a capital budgeting analysis, we do recognize that it has some, fundamental challenges associated with it. What do you think some of those are, Scott? >> Well, the key thing and this is important when you get to how it's used in business, is that all of the calculations we made rely on the hurdle rate. Well what is the hurdle rate? Well the hurdle rate is what our investors require to account for the risk that's in the project. And in practice, you're kind of holding your finger up here trying to figure out what is this. It's really a guesstimate. The textbooks that you may have read, if you've ever taken a finance class, chances are you never have, but, if you ever do read these finance textbooks, what they all do is they hold out the NPV as the king of the capital budget rules. That is what you want to use. And in practice, that is not always the case, because it requires the hurdle rate. And in practice, often times we have to take an educated guess as to what that hurdle rate is. >> Right, don't forget, you have sometimes where a individual project will be more risky or less risky then the overall company. The overall company may have a hurdle rate that's not necessarily going to be the same as the hurdle rate for the project. >> Yeah, and you might know it's higher or lower but the question is how much higher or lower, so we don't know exactly. So, but again, NPV, always want to calculate it, bring it to the table when you're making your capital budgeting decisions. But there are others that also bring other factors to the table. If you read a textbook sometimes you'll be left with the impression NPV, just do that and you're fine. But you know, there's more. 7

8 >> And some of the other mechanisms don't require as much reliance on knowing the hurdle rate in advance like the NPV does. >> Exactly. Transcript: Internal Rate of Return So NPV is not the only type of capital budgeting rule commonly used by companies. There are others. One in particular, the internal rate of return, is very common and widely used and actually quite important to the process of figuring out a project's viability and process of adding value to a business. Now, an IRR of course has some of its own challenges, but one of the things it doesn't do is rely on a hurdle rate, in order to be able to make that calculation. So, it's all internal to the company. All we have to know is that the company has cash flow estimates, and knows when it's going to receive them. And then looks at them over time, and then values them. >> Right, Steve, an intuitive way to think about the IRR, it's what you're earning as far as the rate of return on money you invest in the project. You know, very, very intuitive. And you're right. It does not rely on the hurdle rate, as we'll see, and that's important. So let's for example assume that our hurdle rate is 10%, that's what our investors require. We go through the work and we estimate the IRR for this particular project, comes out at say 20%. This 20% is so far ahead of the 10%, this price is clearly a slam dunk. Let's just move ahead we don't really have to spend much more time you know, belaboring whether we're going to go ahead or not. Let's say a different project, we work through the calculation. The IRR is 5%. Our hurdle rate is 10%. Clearly this is a loser. Let's just you know, shut this one down and look for the next opportunity. However if we run through the calculation, the IRR is, say 10%, or maybe 10 1/2%, our hurdle rate is 10%, well, we have to roll up our sleeves, sharpen our pencils, and, and look at it a bit more. This is how it's actually worked with, and used in practice, in this fashion. So it's a very valuable decision tool to bring along with the NPV. NPV, IRR work very well together, in highlighting some of the issues, which ones we'll move ahead with, look elsewhere, or need to roll up the sleeves. >> On an intuitive basis, especially for non- financial managers, the IRR has one real great benefit, and that's that it's stated in percentage terms, as you just said >> Sure. As opposed to saying is it good to have an NPV of $8 million versus $2 million. Many people understand intuitively percentages and where percentages lie within our hurdle rate. >> Sure, one of the great advantages of the IRR. 8

9 >> Right. So the IRR has some advantages that make it real unique and valuable. Transcript: The Art of IRR for Non-Financial Managers Non- financial managers who engage in financial decision making with their firms often will be given cash flows and will be asked to attend meetings and discuss what's going on and add flavor to the discussion. It's important for them to understand how IRR is calculated in that environment, because they're going to be part of the decision making process. But often, they're going be asked to come up with some of these calculations themselves. >> Right, Steve. And, and as we see, the IRR involves two key ingredients. The first, as you mentioned is the cash flow. So, either you'll be given those, and asked to comment on those. Or you'll be given kind of the raw financial statements. They call it the P&L, or profit and loss sometimes they'll call it an internal budget. That's really beyond the scope, is taking those financial statements and pulling out the relative cash flows, that's our first key ingredient. The second key ingredient is the hurdle rate. Again, typically the finance team will give you that hurdle rate. And, you'll be asked to, maybe, comment on whether you think this is particularly risky, or not, relative to other things you've done. And they might take that and adjust it for you. But again, the full calculation of that hurdle rate is beyond the scope of this class. Those are the two key ingredients. But what we're learning here is when we have those two key ingredients, what we do with them, that is calculate the IRR. Again, it's very appealing in that it is a percentage. And this is really where that art of the capital budgeting decision comes in. If the IRR is very high relative to that hurdle rate and that's what your gut is telling you, that's what you know. Everything looks good. You move ahead and that's the way it's done in practice. But again if it falls short you're probably going to back off from the project. >> I like the idea of art. It is a lot of an art form. Especially again for a non- financial manager participating in this discussion. They're going to be providing a lot of the background art to the scientist of the finance person. >> Right. >> Finance people aren't there to figure out, necessarily, whether or not a product is going to sell well, what its demographics are going to be. That's the marketing department's job. So they'll still have to participate. On top of it, even after we calculate the IRR, we understand that the IRR has its own drawbacks. >> Oh sure, absolutely, and so as we've discussed, we have the borrowing lending problem scale problem, or projects with different sizes. If the time horizons are different, and when we have a cash flow switch, that will create problems too. So, the IRR does have its drawbacks. And again, it's always my advice, and I think you would advise as well, Steve, aways calculate the NPV and the IRR. Learn what they say, what the drawbacks are, the pros and cons, and use them together to make capital budget decisions. 9

10 >> We need to have multiple dimensions in order to make good decisions. >> Absolutely. Transcript: Calculate IRR Fixed Cash Flows Find IRR - fixed cash flows for Project A using the HP 12C Project A requires an initial investment of 100 dollars. The projected cash flows for years 1, 2 and 3 are fixed, 50 dollars per year. The hurdle rate for this project is 10 percent. What is the IRR for Project A? Your HP12C has five primary financial function keys. Clear the registers [f] [REG] Enter the number of periods: 3 [n] Enter the initial investment, $100: 100 [CHS] [PV] Enter the value of the cash flows, $50 annually: 50 [PMT] Calculate the internal rate of return: [i] Find IRR - fixed cash flows for Project A using the TI BA II Plus Project A requires an initial investment of 100 dollars. The projected cash flows for years 1, 2 and 3 are fixed, 50 dollars per year. The hurdle rate for this project is 10 percent. What is the IRR for Project A? Your calculator has five primary financial function keys. Clear the registers: 2nd [CLR TVM] Enter the number of periods, three years: 3 [n] Enter the initial investment, $100: 100 [+/- ] [PV] Enter the value of the cash flows, $50 annually: 50 [PMT] Calculate the internal rate of return: [CPT] [i/y] Find IRR - fixed cash flows for Project B using the HP 12C Project B requires an initial investment of $100. The projected cash flows for years 1 and 2 are $40 per year. The cash flow for year 3 has been rewritten as $40 and the remaining $20 in year 3 has been reassigned as the future value of the project. The hurdle rate for this project is 10%. What is the IRR for project B? Your calculator has five primary financial function keys. Clear register: [f] [REG] Enter the number of periods, three years: 3 [n] Enter the initial investment, $100: 100 [CHS][PV] Enter the value of the cash flows, 40 dollars annually: 40 [PMT] 10

11 Enter the future value, the additional amount available in year three, $20: 20 [FV] Find IRR - fixed cash flows for Project B using the TI BA II Plus Project B requires an initial investment of $100. The projected cash flows for years one and two are $40 per year. The cash flow for year three has been rewritten as $40 and the remaining $20 in three has been reassigned as the future value of the project. The hurdle rate for this project is 10%. What is the IRR for project B? Your calculator has five primary financial function keys. Clear register: 2nd [CLR TVM] Enter the number of periods, three years: 3 [n] Enter the initial investment, $100: 100 [+/- ] [PV] Enter the value of the cash flows 40 dollars annually: 40 [PMT] Enter the future value, the additionally amount available in year three, 20 dollars: 20 [FV] Transcript: Borrowing/Lending IRR Pitfall So the first IRR pitfall we'll look at is something called the borrowing lending problem. Let's look carefully at the cash flows for two projects. We have project C, and in project C we have a $10,000 initial investment, and a year from now we get $12,000 dollars back. In project D, we have a $10,000 inflow. And then a year from now we have a $12,000 outflow. Now let's think about project C for a moment. If we have 10,000 going out and 12,000 coming back, we can probably figure out the internal rate of return, the IRR, in our head, it's 20%. But if we work through the formula we see that we get 20%. If we make that same calculation for project D, we also get 20%. So if we use the IRR rule, it says project C, project D, they're equally good. We're indifferent between the two. Now let's take a look at the NPV for project C. If we run through the calculation, we get a positive $434. That one looks good according to the NPV criteria. Now Project D, if we calculate the NPV, it's a negative $434. Clearly, this is a negative NPV. This is a bad deal according to the NPV rule. So what do we do here? I'm going to give you a hint, this is called IRR pitfalls, so if you guessed project C is the one we want to go with, you would be correct. So what is wrong with the IRR here? Well, if you look carefully at cash flows in project D, really what we're doing is we're getting 10,000. And then we're paying out 12,000. In effect, what we're doing is, we are borrowing at a 20% rate. So, clearly with an IRR of 20% here, it's really saying we're borrowing at a 20% rate. And because our hurdle rate is much less here, that would be a bad deal. Now, the NPV correctly tells us that, but the IRR fails. So whenever you have cash flows coming in and going out, you have to be very careful, and in a case where you have cash flows coming in followed by cash flows coming out, the IRR may not work because you're going to run into this borrow lending problem. So always calculate the 11

12 NPV and the IRR together. And when they give a different answer, chances are it's one of the IRR pitfalls, so look for this borrowing lending problem. Transcript: Mutually Exclusive Projects Pitfall Size of Investment Our next IRR pitfall occurs when we have mutually exclusive projects. That means we have several projects and we can choose only one. Maybe it's a single piece of property. And there's different ways that we can develop that property. So I want to show you two more projects. We have project E and project F. Let's look first at project E. So for project E we have a $10,000 cash outflow, followed one year later by a $20,000 cash inflow. We're doubling our money. So here the IRR is 100%. And if we calculate the NPV using our 10% hurdle rate. We get $8,182. Now let's look at Project F. Here we're investing $20,000, and we get back $35,000 one year from now. So we're going from 20 to 35,000. That's a 75% return on our money, so that is the IRR. And if we calculate the NPV again using that 10% hurdle rate. We get an NVP of $11,818. Now let's take a look. IRR says which project is better, well it's project E, it has the IRR, 100% is better than seventy- five. And if we look at the NPV, it is project F, it has the higher NPV. Now which project should we be taking here? IRR, the NPV disagree. Again let me give you a hint. It has to, the title of this section is called IRR Pitfalls, so you're right, we want to go with project F. Now, why do we want to go with project F? Look carefully at the cash flows, and let me give you some intuition. I'm going to offer you a deal. The first deal is, I'm going to give you $1 today, you give me back $2 tomorrow. Let's presume that I'm good for it. Another alternative is I will give you $100 today, you give me back $150 tomorrow. Again, presume I am good for it.which would you like to take? $1 to $2 or $100 to $150 one day later? Use your intuition, your common sense. Chances are, you're going to wanna go the 100 to the 150, cause you make $50. But wait a minute, do you really want to do that? 1 to $2, that's a 100% return on your money, 100 to 150 is only 50% return on your money. You still want to take 100 to 150? Well chances are that you do even though the return for that one day is lower. The important thing to consider here is the amount of money you're earning interest on. A $100 is a hundred times that one dollar. The project scale here or the initial investment is much larger on the $100. The same is true if we looked at project E and F. $20,000 is twice as large as the 10,000. So for project E we're earning 100% return on the 10,000. For project F, 75%, still a great return, not quite 100 but we're earning double the amount of money the 20,000. So the IRR actually does not take into consideration. The initial investment or the scale of the project 12

13 only tells us the rate of return. The NPV properly takes into consideration the project's scale of our initial investment. So, again, always calculate the NPV and the IRR together. And when they give you a different answer, chances are, it's the project scale. It's one of the things to look for. Transcript: Mutually Exclusive Projects Pitfall Timing One more IRR pitfall, again this is going to deal with mutually exclusive projects, remember we have many projects we can only choose one. Now this has to do when we have different time horizons. We have two projects now we're going to look at. We have project G and H, both require a $9000 initial investment, and for G we're going to get paid back cash flows of 6, then 5 and then $4000 in the next three years. For H we're going to get back $1800 per year, going on out forever. Now, if we calculate the IRRs for project G it is 33%, for project H it is 20%. So the IRR rule says G is the better way to go. However, if we look at the NPVs and we use a 10% hurdle rate, for project G it's $3,592 and for H, it is $9,000. So the NPV rule says H is the better way to go. So which is it? The IRR and NPV disagree. Now again, you might be clued into this, it's IRR Pitfalls. So H is the winner here. NPV dominates the IRR here. But what is the intuition? Let's work through a little scenario. Suppose you give me $100 today, and I promise to give you back $150 tomorrow. Alternatively, you give me $100 today and I'll give you back $180 two days from now, and presume I'm good for it. Which do you prefer? $100 to $150 tomorrow, or you give me $100 and I give you back $180 two days from now? Well, chances are, you're going to want to go with the $180. That's an $80 profit versus a $50 profit. But think of the IRRs now. 100 to 150, that's a 50% return per day. 100 to 180, that's something less than 40% when we figure in compounding. So 50% is a great return, but you're only earning it for one day. Something a little south of 40% is also a good return, but not as good as 50, but you're earning it for twice as long, for two days. So the key here is, what the IRR misses is, how long your money's tied up, and how long you're earning that return. It doesn't take into account the timing difference. The net present value, the NPV, properly does. So again, always calculate the IRR and the NPV, and when you see them giving different answers, one thing to look for is timing of the cash flows if they differ. 13

14 Transcript: Multiple IRR Pitfall HAME508: Making Capital Investment Decisions One more problem with the IRR, one more pitfall, and this has to do when we have a project, and the cash flows flip at some point over the life of the project. So we might have an outflow, followed by an inflow, followed by another outflow. Or we could have an inflow, then an outflow, and then an inflow. So there you get the switch in the signs of the direction of the cash flows. So, here let's look at project where we have a $4,000 initial investment. We have a $25,000 inflow, and then a $25,000 outflow. Now, when you set up the equation for the IRR, we're going to get what we call a quadratic equation. Now, some of you may have, earlier in your schooling, been exposed to these quadratic equations, and you might have some bad memories about that, but, if you remember, there's two solutions, two roots to that quadratic equation. So when we have a flip in the signs of the cash flows, there are two solutions. And in this case, it is 25 percent and 400 percent for the IRR. If we calculate the NPV, it is a negative 1934 dollars. Clearly, this is a bad deal. We don't want to move ahead with this project, given its negative NPV. So, here's the problem, if you have that switch you really have to go with the I, excuse me, the NPV. The IRR is going to fail because it has this multiple solution problem. So, when you're, again, always calculate NPV, IRR and what's going to help here is the NPV is giving you an answer where the IRR is being nonsensical, or maybe you're getting an error on your spreadsheet, or however you're solving this. What you want to do is go with the NPV and one of the things you want to look for is a switch in the direction or the sign of those cash flows. Transcript: Payback Period The payback period, the simplest of all the capital budgeting decision rules. Basically all it is, is how long does it take for me or my company to earn back that initial investment, that's it, how long. And where it's used is in a variety of settings where time is of the essence. I need the money back quickly to turn it around. A very valuable piece of information, but at the same time it has some drawbacks, important drawbacks that we'll learn about. One rule though that actually tweaks some of those drawbacks is the discounted payback period. Steve, perhaps you can talk a little bit about that. >> Sure, in a discounted payback period model, all we really do to amend the original payback period model is to add to it, the fact that we're using discounted cash flows instead of the raw cash flows, in terms of looking at our payback. Whether or not we use discounted paybacks or 14

15 payback period, we have to keep in mind one really important fact. The really important fact is that the motivation of a company is not simply to get paid back. It's actually to add value. >> It's always a plus when you get paid back though. >> It is an important thing to get paid back, but it's not enough. It's really not enough. So, this is as you said, Scott, one of the simplest, most direct things that we can calculate as a decision rule in capital budgeting. But it really has limitations. Sure so, a plus to know how fast you get paid back but, again it's limiting, again, used very well with other capital budget decision rules. >> Correct and the really great thing about both payback period and discounted payback period but especially payback period is as they say you literally can calculate it on the back of a napkin in a few minutes regardless of how big the project is. > Right. Transcript: Using PBP The payback period. So, if you ever read some finance textbooks, they beat up on it pretty badly. Kind of throw it out. But, in practice it's often a very useful tool. Think of a situation where maybe you're a startup. And you're limited with cash, you really need to get the cash back from the projects to put it back into other opportunities. Let's suppose your other capital budgeting rules are, are basically coming up saying it's okay, maybe you have to choose between a couple. Both are pretty much in the same ballpark, but the payback is much quicker on one versus the other. You're a startup. Would you rather have your money back more quickly relative to the other? I think the answer is obvious. The answer is yes absolutely you do. So very useful in that situation. >> One of the reasons why that's really important is that as you go further out to the future the estimation of cash flows becomes more and more difficult. You can't just assume that the estimation of a cash flow that you make in year one is as accurate as one that you're gone make ten years from now. So, quicker payback period is really important because it relies less on further out cash flows that by their nature are much more difficult to calculate. >> Right and that's again where the art comes in. So, it's another piece that you could use to make these decisions. >> Right. Another thing that we see happening, by the way is in these entrepreneurial environments where, because they're cash strapped, because they're they're unable to have ten projects happening simultaneously, so, it's really especially important for us to recognize that in some environments capital constraints really force us into this payback period domain. 15

16 >> Right. HAME508: Making Capital Investment Decisions Transcript: Profitability Index and Equivalent Annual Cost Let's talk a little bit about profitability index. The profitability index gives us a bang for the buck calculation. Essentially, we start out with what the net present value is and then divide that by the initial cost of the investment. And that gives us a sense of how much we're going to earn on the investment. How much value we're going earn on the investment per dollar of initial cost. This is really important because many companies face capital constraints. And in a constrained environment, whether or not it's a physical constraint, a capital constraint, profitability index is really the way to go. >> Right, and another really valuable capital budgeting tool we're going to learn about is the equivalent annual cost or EAC. Now this particular decision rule or tool is very valuable when you have some job that needs to be done and you need to figure out the most cost- effective way to do it. Now take, for example, maybe your heating and cooling system has gone out and you need to replace it. What is the best way to move ahead? Well it's the most cost- effective way, and what the equivalent annual cost allows you to do is compare a variety of different solutions, which heating and cooling system is the best. >> Some might last longer, some might be shorter. >> And some might cost more. >> Higher cost. >> More efficient. Entering all those decisions, and in fact, maybe you have an old heating unit, and, what you can do then, is make a decision, do I want to replace it now with something more efficient? Or delay it. >> An option to delay it. >> Or you can wait and so on. So, very useful tool. So, within the company all kinds of possibilities to use this. I'm sure heat and cool your plant or your office. You have copy machines, vehicles and so on. So, you want to look at each piece of equipment and apply this tool and you can figure out the best way to do things most efficiently. >> Another area that we'll use the EAC is going to be when we look at regulatory environments. It's particularly important for pollution control. 16

17 >> Absolutely. HAME508: Making Capital Investment Decisions >> Especially in the world of global warming that we have. >> Yeah sure, environmental issues so sometimes if you have to do it, what's the most cost effective way to do it? >> Or if you want to do it and there's no cash flow involved. Critical thing with the EAC is there's no cash flow, right. >> Correct, exactly, at least in inflow. >> Right. Transcript: An EAC Decision A very common capital investment decision involves a situation where you must replace an existing piece of equipment and now must choose between two or more alternative pieces of equipment that will have different initial costs, useful lives, and annual operating costs. Examples of this kind fo decision include equipment like a delivery truck, a heating, ventilation, and air conditioning system, an x- ray or CAT scan in a hospital, or an assembly machine in a manufacturing plant. The differentiating factor with this kind of decision, as opposed to all those we have looked at before, is that these equipment replacements are considered necessary. So we are not deciding whether or not to make the investment, instead what we are trying to determine here is which of the alternatives provides the lowest cost solution. To the required replacement of the equipment. Take for example Big Red Trucking, who now must replace one of their delivery trucks. They must decide between two trucks that each fulfill the company's need for size and accessibility. Truck A costs $45,000 dollars, will last for three years, and has an operating cost which includes gas, maintenance, and insurance of $12,000 per year. Truck B only costs $30,000 dollars, however it will last for two years and has an operating cost of $18,000 dollars per year. Assuming that Big Red plans to be in business indefinitely, which truck should they buy? First, let's take a look at the cash flows and present value cost of each truck. The cash flows for each truck are shown here. Truck A has an initial cost of $45,000. Once we take the 45,000 cost to day along with the 12,000 cost over three years, we arrive at a present value cost of 74,842. Now for truck B. Once we consider the $30,000 outflow today along with the $18,000 cost over two years, we arrive at a present value cost of $61,240. This analysis implies that Truck B is the least expensive alternative as the present value of its total cost is $61, , which is less 17

18 than the present value cost of Truck A at 74,842. While it looks neat and clean, there is a problem with the analysis presented here. Truck A lasts three years while Truck B only lasts two years. So we decide to go with truck B as the analysis suggests we should. What do we do during year three? For that matter, what happens after year three? The assumption is that Big Red Trucking plans to be in business indefinitely. So regardless of which truck we select, there will need to be a second, third and more rounds of reinvestments going in to the future. So how can we adjust our analysis so that it accurately reflects the repeating reinvestments in equipment over time? As it turns out, there are two methods we can use to address this issue. In the first approach we can match up the cycles so that the timing of both alternatives line up. In this particular case, that would mean reinvesting twice in truck A, and three times in truck B. The total horizon for the two investments would now line up. Two times three years for truck A, and three times two years for truck B. Both equalling 6 years of investments. The cash flows for these two repeating investments are seen here. The present value at ten percent of this cost stream, equals 131,070. Now for truck B. The present value of all these costs, at ten percent would be 153,670. Look at what has happened when we used the same horizon to evaluate both trucks. Truck A now has a lower cost over the six year horizon than truck B. So now the best alternative is in truck A. There are two issues that we should take note of here. While lining up a two year project and a three year project was fairly easy, where six years is the common denominator and it only took two to thee cycles to complete the process, it could have been much worse. Imagine if we had 5 and 7 year alternatives. Then we would have had to replicate this process out to 35 years in order to line up the two projects. In addition to this, we are still making the assumption that we are going to reinvest in the same piece of equipment over and over again. Changes in technology make this assumption questionable. What happens if truck manufacturers come out with an efficient hydrogen cell truck in five years? The analysis here locks us into the technology that we have originally chosen the entire length of the analysis. Six years in the example here. Luckily there is a much easier and direct way to solve this problem, without making all of the assumptions. It is called equivalent annual cost, or EAC. To find the EAC, we go back to the original calculation where we compared a two year and three year investment. Now we take the present value of each truck and determine what would be the equivalent cost over the time horizon for each truck, three years for truck A, And two years for Truck B. We do this by calculating the annuity amount that would give you the same present value amount calculated in our example. Take for example Truck A. Truck A's present value cost is $74,842 So we need to find the three year annuity that would give you the same present dollar amount as the 74,842. Truck B's present value is 61,240 So we need to find the two year annuity that would give you the same present dollar amount as the 61,240. So truck A costs less to operate over its life and we should choose truck A. Note that this is the same answer we found in the second approach. We arrived there without as much computation, did not have to bother with repeating the 18

19 investments two or three times, and did not have to worry about an assumption that we were locked into the chosen technology. Transcript: Empire Building The profitability index, remember, an important caveat is you only want to use it when you have some kind of constraint. Now, typically that's a constraint on capital, or how much money you have to invest. Now, you might think of a large company. They have access to the capital markets. They could issue debt, issue more stock. They have plenty of cash rolling in. But often, even in a company such as that, what you're going to have is uses for the profitability index. Typically when capital budgeting is pushed down into the organization's division level, or maybe even down further in the organization, you're given capital constraints. And now, the idea there is if you are running this division or this subgroup within the division, chances are you're going to want to grow your division or your subgroup into a larger organization. It's human nature, we call it empire building. And what happens is, you're going to tend to overinvest and maybe make your projects look a little bit better than they would when you float them up in your organization. So what companies sometimes, sometimes do to combat this is they will give you a capital budget. You're only allowed to invest, oh, up to so much. So, even though the company might not have a capital constraint within the division, or subgroup, you will have a capital constraint. That capital budget. Here the profitability index is very useful. How do I best use that capital budget to get the most bang for my company's buck? And that's exactly what the profitability index will do. You might have lots of great projects. It will help you choose those projects that take your business the furthest as far as creating wealth. >> Also if there's a, just a limiting factor within within the company and they do have a capital constraint, on the margin as they get to the last five or six projects. >> Oh absolutely. >> A large company might do. >> Actually, actually, actually so, you might actually have a company with a real constraint, and again very valuable. >> Sure. >> So, in terms of the EAC, or the equivalent annual cost, it's important for us to realize that again, there are no cash inflows associated with these projects. They're just projects that are going to cost us, that's the idea between the equivalent annual cost. And what we do in this analysis is to make these projects equivalent. Some may last ten years. Some may last five years for the same type of solution. So we'd have to replicate it, two five- year solutions for a ten- year solution, for example. This is really, really germane right now when you're seeing all these 19

20 companies try to figure out power options. You know, do you go solar? Do you go natural gas? Given all the natural gas that they're finding, for instance, here in the United States. Even more so internationally. Cause internationally, the price of power, the price of energy varies so greatly. So in that kind of environment especially, using an equivalent annual cost analysis provides a company with a really wide range of options. > > Absolutely. Transcript: All the Tools We've just been talking about capital budgeting decision rules. Let's see if I can remember them all, Steve. We have the NPV, IRR, payback period, discounted payback period, we have the profitability index, equivalent annual cost, and the return on investments or ROI. Did I get them all? >> I think so. >> Think so, all right perfect so really, I always advise my corporate consulting customers and my students, calculate all of them. They all bring something to the table. And when it's really revealing is when the various rules give you a different answer. Right, that richness, that tapestry is going to give you something to talk about. Some will have a higher NPV, or some will be favored, maybe better said, under the NPV rule. Others will be better, more favored, under the payback period, or the IRR rule. Right, this, it's particularly true when we have multiple projects, and we only can take maybe one of them. Maybe it's a single piece of property. We have different ways we can develop it. >> Right. >> And each of the rules might have a different answer. And this is when you really have to understand the pros and the cons and work through. It helps if you ask the right kinds of questions. >> And this is particularly the area where a non- financial manager will be able to add an incredible amount to the discussion. They'll be able to say why it is, from a marketing perspective, or from an HR perspective, something in this area is better than that area. Just because it has a better payback, or an IRR, if there's disagreement in the company, non- financial managers have a real opportunity to add. >> And exactly and that's really the whole point of what we're trying to do here is to explain to the non- financial manager enough about the finance and I think we've successfully done that 20