Reading 24

The four types of capital investments include going concern projects, regulatory/compliance projects, expansion projects, and other projects.

• Going concern projects may be needed to maintain the business or reduce costs. Projects that maintain the business do not require detailed analysis. The only issues are whether the existing operations should continue and, if so, whether existing procedures or processes should be maintained. Projects to improve efficiency may involve determining if equipment that is obsolete, but still usable, should be replaced. To reduce financing risk, companies often use a match funding approach, financing projects with capital sources that are consistent with the project life. Analysts often use a company's annual depreciation expense as an estimate of the capital investment it needs for going concern projects.
• Regulatory/compliance projects may be required by a government agency or insurance company and often involve safety-related or environmental concerns. These projects typically generate little to no revenue and require the company to evaluate alternative ways of carrying out the projects.
• Expansion projects grow the business and require a complex decision-making process that includes forecasting future demand. Expansion projects can involve entering new markets or introducing new products within the same market. A detailed analysis including forecasting revenues and expenses is required.
• Other projects, such as new investments outside a company's existing lines of business, also entail a complex decision-making process with detailed analysis due to the uncertainty involved. Other projects are often similar to startups that explore a new technology or business idea. These projects can also involve buying out an existing company in a new industry, which involve risks that include overpaying.

The capital allocation process is identifying and evaluating capital projects (i.e., projects where the cash flows to the firm will be received over a period longer than a year). Any corporate decisions with an impact on future earnings can be examined using this framework. Decisions about buying a new machine, expanding business into another geographic area, moving the corporate headquarters, or replacing a delivery truck, to name a few, can be examined using a capital allocation analysis.

For a number of good reasons, capital allocation may be the most important responsibility that a financial manager has. First, because a capital allocation decision often involves the purchase of costly long-term assets with lives of many years, the decisions made may determine the future success of the firm. Second, the principles underlying the capital allocation process also apply to other corporate decisions, such as working capital management and making strategic mergers and acquisitions. Finally, making good capital allocation decisions is consistent with management's primary goal of maximizing shareholder value.

The capital allocation process has four administrative steps:

• Step 1: Idea generation. The most important step in the capital allocation process is generating good project ideas. Ideas can come from a number of sources, including senior management, functional divisions, employees, or sources outside the company.
• Step 2: Analyzing project proposals. Because the decision to accept or reject a capital project is based on the project's expected future cash flows, a cash flow forecast must be made for each project to determine its expected profitability.
• Step 3: Create the firm-wide capital budget. Firms must prioritize profitable projects according to the timing of the project's cash flows, available company resources, and the company's overall strategic plan. Many projects that are attractive individually may not make sense strategically.
• Step 4: Monitoring decisions and conducting a post-audit. It is important to follow up on all capital allocation decisions. An analyst should compare the actual results to the projected results, and project managers should explain why projections did or did not match actual performance. Because the capital allocation process is only as good as the estimates of the inputs into the model used to forecast cash flows, a post-audit should be used to identify systematic errors in the forecasting process and improve company operations.

Net Present Value (NPV)

Net present value (NPV) is the sum of the present values of all the expected incremental cash flows if a project is undertaken. The discount rate used is the firm's cost of capital, adjusted for the risk level of the project. For a normal project, with an initial cash outflow followed by a series of expected after-tax cash inflows, the NPV is the present value of the expected inflows minus the initial cost of the project.

\[NPV = CF_0 + \frac{CF_1}{(1+k)^1} + \frac{CF_2}{(1+k)^2} + \dots + \frac{CF_n}{(1+k)^n} = \sum_{t=0}^{n} \frac{CF_t}{(1+k)^t}\]

where:

• \(CF_0\) = initial investment outlay (a negative cash flow)
• \(CF_t\) = after-tax cash flow at time t (can be positive or negative)
• \(k\) = required rate of return for project

A positive NPV project is expected to increase shareholder wealth, a negative NPV project is expected to decrease shareholder wealth, and a zero NPV project has no expected effect on shareholder wealth.

For independent projects, the NPV decision rule is simply to accept any project with a positive NPV and to reject any project with a negative NPV.

Internal Rate of Return (IRR)

For a normal project, the internal rate of return (IRR) is the discount rate that makes the present value of the expected incremental after-tax cash inflows just equal to the initial cost of the project. More generally, the IRR is the discount rate that makes the present value of a project's estimated cash inflows equal to the present value of the project's estimated cash outflows. That is, IRR is the discount rate that makes the following relationship hold:

\[PV(\text{inflows}) = PV(\text{outflows})\]

The IRR is also the discount rate for which the NPV of a project is equal to zero:

\[NPV = 0 = CF_0 + \frac{CF_1}{(1+IRR)^1} + \frac{CF_2}{(1+IRR)^2} + \dots + \frac{CF_n}{(1+IRR)^n}\]

IRR decision rule: If IRR is greater than the required rate of return, accept the project. If IRR is less than the required rate of return, reject the project.

The required rate of return for a given project is usually the firm's cost of capital. However, a project analyst may adjust the required rate of return above or below the firm's cost of capital to account for differences between the project's risk and the average risk of all of the firm's projects. For this reason, the minimum IRR above which a project will be accepted is often referred to as the hurdle rate.

A project has a conventional cash flow pattern if the sign on the cash flows changes only once, with one or more cash outflows followed by one or more cash inflows. An unconventional cash flow pattern has more than one sign change, which may produce multiple IRRs that are difficult to interpret. Spreadsheet software is most suitable for calculating NPV and IRR with unconventional cash flows.

Relative Advantages and Disadvantages of the NPV and IRR Methods

A key advantage of NPV is that it is a direct measure of the expected increase in the value of the firm. In theory, a positive NPV project should cause a proportionate increase in a company's stock price.

A key advantage of IRR is that it measures profitability as a percentage, showing the return on each dollar invested. The IRR provides information on the margin of safety that the NPV does not.

The disadvantages of the IRR method are:

• It assumes that project's cash flows are reinvested at the IRR while NPV assumes that those cash flows are reinvested at the project's required rate of return. It is more realistic to assume the latter.
• For multiple sign changes, a project may have multiple IRRs that are difficult to interpret.

Return on Invested Capital (ROIC)

One way to examine whether a company is creating value for its shareholders is to compare the return on the company's investment in assets to its cost of capital. A company's return on invested capital (ROIC), or simply return on capital, is defined as its net operating profit after tax (NOPAT) divided by the average book value of its total capital over the period:

\[\text{ROIC} = \frac{\text{net operating profit after tax (NOPAT)}}{\text{average book value of invested capital}}\]

After-tax operating profit is net income plus after-tax interest expense. We use this because we want to measure the return to all sources of capital (both debt and equity). Invested capital includes long-term debt and equity, but excludes working capital.

We can rewrite the ROIC equation as:

\[\text{ROIC} = \left( \frac{\text{NOPAT}}{\text{Sales}} \right) \times \left( \frac{\text{Sales}}{\text{Average Invested Capital}} \right)\]

We refer to the ratio of after-tax operating profit to sales as operating margin after tax, and we refer to the ratio of sales to invested capital as capital turnover or asset turnover. A company can increase its ROIC by improving its operating margin or by increasing its capital turnover.

Analysts compare ROIC to investors' required rate of return (a blended rate for both debt and equity). If ROIC is greater than the required rate, the firm is adding value over time.

One attraction of ROIC is that it is based on accounting data, which are available to outside investors. While NPV and IRR are project-specific, ROIC is for the firm as a whole.

There are three concerns with using ROIC:

1. Because accounting treatments differ, ROIC may not be comparable across companies.
2. ROIC is backward-looking and can be volatile from year to year.
3. Because ROIC is for the whole company, it may let profitable projects and good decisions mask unprofitable projects and poor decisions.

Principles of Capital Allocation

The capital allocation process involves the following key principles:

• Decisions are based on after-tax cash flows, not accounting income. Accounting income is based on accruals and does not consider the timing of cash flows. The impact of taxes must be considered when analyzing all capital allocation projects. Firm value is based on cash flows firms get to keep, not those they send to the government. Any tax savings from non-cash tax deductions, such as depreciation and amortization, should also be included in the analysis.
• Incremental cash flows only. Incremental cash flows are those that change if the project is undertaken. Sunk costs are costs that cannot be avoided even if the project is not undertaken. Because these costs are not affected by the accept/reject decision, they should not be included in the analysis. An example of a sunk cost is a consulting fee paid to a marketing research firm to estimate demand for a new product before making a decision on the project. Project analysis should consider the cash flow impact on other parts of the business. A negative effect, called cannibalization, occurs when a new project replaces sales from an existing product. A positive externality exists when doing the project would have a positive effect on sales of a firm's other product lines.
• The timing of cash flows is important. Capital allocation decisions account for the time value of money, which means that cash flows received earlier are worth more than cash flows to be received later.

Cognitive Errors

Common cognitive mistakes managers make when evaluating capital projects include:

• Poor forecasting. Examples include incorrectly allocating overhead costs or neglecting to anticipate how competitors will respond to a project.
• Not considering the cost of internal funds. Often, the cost of internally generated funds is not accounted for (it should be same as cost of equity because those funds would have been paid as dividends if not for the project). Companies that have an aversion to paying dividends are potentially using the retained earnings to fund poor projects.
• Incorrectly accounting for inflation. Firms can analyze projects either in nominal or real terms. An analysis based on real cash flows must also use a real discount rate.

Behavioral Biases

• Pet projects of senior management. Projects that have the personal backing of influential members of senior management may contain overly optimistic projections that make the project appear more profitable than it really is. In addition, the project might not be subjected to the same level of scrutiny as other projects.
• Inertia in setting the entire capital budget. Capital budgets for many companies are similar from one year to the next. This indicates anchoring of capital budgets to the prior year rather than appropriately considering what opportunities exist every year. Analysts should watch for companies with static or rising capital budgets coupled with declining returns as a sign of this bias.
• Basing investment decisions on EPS or ROE. Managers whose incentive compensation is tied to increasing EPS or ROE may avoid positive long-term NPV investments that are expected to reduce EPS or ROE in the short run.
• Failure to generate alternative investment ideas. Generating investment ideas is a crucial step in the capital allocation process. However, once a manager comes up with a "good" idea, he or she may go with it rather than searching for an idea that is "better."

Real options are future actions that a firm can take, given that they invest in a project today. Real options are similar to financial options (put and call options) in that they give the option holder the right, but not the obligation, to take a future action. The value of real options could enhance a project's NPV. Options never have negative values because if, in the future, the specified action will have a negative value, the option holder will not take the action (i.e., not exercise the option).

Types of real options include the following:

• Timing options allow a company to delay making an investment because it expects to have better information in the future.
• Abandonment options allow management to abandon a project if the present value of the incremental cash flows from exiting a project exceeds the present value of the incremental cash flows from continuing the project.
• Expansion options or growth options allow a company to make additional investments in future projects if the company decides they will create value.
• Flexibility options give managers choices regarding the operational aspects of a project. The two main forms are:
  • Price-setting options: allow the company to change the price of a product. For example, the company may raise prices if demand for a product is high.
  • Production-flexibility options: may include paying workers overtime, using different materials as inputs, or producing a different variety of product.
• Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. The operator has the option to close the mine when prices are low and open it when prices are high.

One way companies can include real options in their project analysis is to estimate their value and add it to the NPV (while subtracting any extra cost to acquire the real option). This can incorporate available techniques such as option pricing models or decision trees. Another approach is to simply consider the NPV without real options to be the project's minimum value.