Strategic Strategic Financial Financial Management Management MEASURING RETURN ON INVESTMENTS Khuram Raza ACMA, Ms Finance First Principle and Big Picture What is a project? Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year Project analyzed in capital budgeting has three criteria:  a large up-front cost,  cash flows for a specific time period, and  a salvage value at the end, which captures the value of the assets of the project when the project ends What is a project? ect Defined broadly then, any of the following decisions would qualify as projects: Proj dent  Major strategic decisions to enter new areas of business  Acquisitions of new equipment , building or other firms  Decisions on new ventures within existing businesses or markets  Decisions that may change the way existing ventures and projects are run  Decisions on how best to deliver a service that is necessary for the business to run smoothly pen Inde ects Proj e usiv Excl y uall Mut s nue reve e erat gen to ect proj s cost ce redu to ect proj Hurdle rates for projects Project Characteristics  Project is small and has characteristics similar to the firm   Cost of Equity: Project Risk similar within business, Firm’s beta   Cost of Equity: Proxy business Beta, Bottom up Beta   Cost of Equity: Assess the project risk independently, Bottom up Beta Cost of Debit: Firm’s cost of debt  Project is large and has characteristics different from the firm Cost of Debt: cost of debt of the comparable firms  Stand-alone Project Cost of Debt: cost of debt of the Project Measuring Returns: The Choices A Accounting Earnings versus Cash Flows  Why are accounting earnings different from cash flows?    Operating versus Capital Expenditure    Add back all non-cash charges, such as depreciation and amortization, to the operating earnings Non-Cash Charges Accrual versus Cash Revenues and Expenses  From Accounting Earnings to Cash flows Subtract out all cash outflows that represent capital expenditures Net out the effect of changes in non-cash working capital, i.e changes in accounts receivable, inventory and accounts payable Measuring Returns: The Choices B Total versus Incremental Cash Flows Sunk Costs Allocations of fixed expenses, such as general and administrative costs C Time-Weighted versus Nominal Cash Flows Prefer present consumption to future consumption Inflation Uncertainty (risk) Measuring Returns: The Choices Basic characteristics of relevant project flows  Cash (not accounting income) flows  Operating (not financing) flows  After-tax flows  Incremental flows Principles that must be adhered to in the estimation Ignore sunk costs Include opportunity costs Include project-driven changes in working capital net of spontaneous changes in current liabilities Include effects of inflation     Investment Decision Rules Accounting Income Based Decision Rules Earnings before interest and taxes (1- tax rate) Return on Capital = Average Book Value of Total Investment in Project Net Income Return on Equity= Average Book Value of Equity Investment in Project Cash Flow Based Decision Rules Payback The payback on a project is a measure of how quickly the cash flows generated by the project cover the initial investment –40 K 10 K 12 K 15 K 10 K 7K Julie Miller is evaluating a new project for her firm, Basket Wonders (BW) She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years through The initial cash outlay will be $40,000 Payback Payback Solution Solution (#2) (#2) –40 K –30 K –40 K 10 K 12 K 15 K 10 K 7K –18 K PBP Cumulative Cash Flows –3 K 7K = + ( 3K ) / 10K 14 K = 3.3 Years Note: Take absolute value of last negative cumulative cash flow value PBP PBP Acceptance Acceptance Criterion Criterion The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3.5 years [3.3 Years < 3.5 Year Max.] Limitations  By restricting itself to answering the question “When will this project make its initial investment?” it ignores what happens after the initial investment is recouped  The payback rule is designed to cover the conventional project that involves a large up-front investment followed by positive operating cash flows  The payback rule uses nominal cash flows and counts cash flows in the early years the same as cash flows in the later years Internal Internal Rate Rate of of Return Return (IRR) (IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow ICO = CF1 + (1 + IRR) CF2 (1 + IRR) CFn + + (1 + IRR) n IRR IRR Solution Solution $40,000 = $10,000 (1+IRR) $15,000 + (1+IRR) $12,000 + (1+IRR) $10,000 (1+IRR) + $7,000 + (1+IRR) Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000 IRR IRR Solution Solution (Try (Try 10%) 10%) $40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $10,000(PVIF10%,4) + $40,000 = $15,000(PVIF10%,3) + $ 7,000(PVIF10%,5) $10,000(0.909) + $12,000(0.826) + $15,000(0.751) + $10,000(0.683) + $ 7,000(0.621) $40,000 = $9,090 + $9,912 + $11,265 + = $41,444 [Rate is too low!!] $6,830 + $4,347 IRR IRR Solution Solution (Try (Try 15%) 15%) $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $10,000(PVIF15%,4) + $40,000 = $15,000(PVIF15%,3) + $ 7,000(PVIF15%,5) $10,000(0.870) + $12,000(0.756) + $15,000(0.658) + $10,000(0.572) + $ 7,000(0.497) $40,000 = $8,700 + $9,072 + $9,870 + = $36,841 [Rate is too high!!] $5,720 + $3,479 IRR IRR Solution Solution (Interpolate) (Interpolate) 5% 10% 15% $40,000 $41,444 $1,444 -$ 3,159 $36,841 $ 4,603 16% +- 3,159 10% 1,444 x 5% 4,603 11.57% IRR IRR Acceptance Acceptance Criterion Criterion The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type Should this project be accepted? No! The firm will receive 11.57% for each dollar invested in this project at a cost of 13% [ IRR < Hurdle Rate ] IRR IRR Strengths Strengths and and Weaknesses Weaknesses Strengths: • Accounts for • Considers all TVM cash flows Weaknesses: • Assumes all cash at flows reinvested the IRR • Difficulties with Multiple IRRs project rankings and Net Net Present Present Value Value (NPV) (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow NPV = CF1 + (1+k) CF2 (1+k) CFn + + n (1+k) - ICO NPV NPV Solution Solution Basket Wonders has determined that the appropriate discount rate (k) for this project is 13% NPV = $10,000 + (1.13) $10,000 (1.13) $12,000 $15,000 + (1.13) (1.13) $7,000 + (1.13) - $40,000 + NPV NPV Solution Solution NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $10,000(PVIF13%,4) + NPV = $15,000(PVIF13%,3) + $ 7,000(PVIF13%,5) – $40,000 $10,000(0.885) + $12,000(0.783) + $15,000(0.693) + $10,000(0.613) + $ 7,000(0.543) – $40,000 NPV = = $8,850 + $9,396 + $10,395 + - $1,428 $6,130 + $3,801 – $40,000 NPV NPV Acceptance Acceptance Criterion Criterion The management of Basket Wonders has determined that the required rate is 13% for projects of this type Should this project be accepted? No! The NPV is negative This means that the project is reducing shareholder wealth [Reject as NPV < ] Limitations  The net present value is stated in absolute rather than relative terms and does not, therefore, factor in the scale of the projects  The net present value rule does not control for the life of the project Consequently, when comparing mutually exclusive projects with different lifetimes, the NPV rule is biased towards accepting longer term projects ... Defined broadly then, any of the following decisions would qualify as projects: Proj dent  Major strategic decisions to enter new areas of business  Acquisitions of new equipment , building or... last negative cumulative cash flow value PBP PBP Acceptance Acceptance Criterion Criterion The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type Should... 16% +- 3,159 10% 1,444 x 5% 4,603 11.57% IRR IRR Acceptance Acceptance Criterion Criterion The management of Basket Wonders has determined that the hurdle rate is 13% for projects of this type