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What long-term investments should the firm undertake (capital budgeting) and how will investment and finance decisions affect the firm's value (valuation)?
How can cash be raised for the required investments? This is known as the financing decision' (cost of capital, capital structure and leasing).
How will the firm manage its day-to-day cash and financial affairs (short-term financing and net working capital)?
The Capital Budgeting Mini Case presents a financial decision of acquiring another corporation. Two choices are available; Corporation A and Corporation B, the cost of each choice is $250,000, and acquiring both corporations is not an option. The primary goal of any company is to create value for its shareholders and as such, the most important job of the financial manager is to create value from the company's capital budgeting,
Financial managers must be particularly aware of the timing of cash flows (the time value of money') and associated risks. This financial decision-maker will use projected cash flows to determine whether acquiring Corporation A or Corporation B (i.e. NPV and IRR) is the best choice. If acquisition does not generate positive cash flow, the company is effectively providing finance for the acquired corporation.
Capital Budgeting Decisions
Many business opportunities involve sacrificing current earnings for future profits (opportunity cost). For the acquisition to be worth pursuing, it must generate a higher rate of return than what could be earned in the capital markets (Jaffe et al., 2002:200). When assessing capital budgeting projects, financial decision makers typically use discounted cash flow methods such as Net Present Value (NPV) or Internal Rate of Return (IRR).
Net Present Value (NPV)
The most commonly used technique for financial decision making is Net Present Value (NPV) analysis. NPV is the present value of future cash returns, discounted at the appropriate market interest rate, minus the present value of the cost of investment. NPV includes the current cost of the investment in determining its value and not simply what it will return. The NPV rule that should be used by decision-makers is that an investment is worth making if it has a positive NPV and should be rejected if it has a negative NPV. An investment with a positive NPV is worth undertaking because doing so is essentially the same as receiving cash payments equal to the NPV (Jaffe et al., 2002:59,926).
Using the discount rate as the required rate of return, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows.
A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)
NPV = PVB - PVC
To calculate the NPV (Net Present Value), I discounted the cash flow at discount rate of 10% for Corporation A and a discount rate of 11% for Corporation B. By using the discount rate I conducted a test to see if the project is expected to earn our minimum desired rate of return. Here are my decision rules:
If the NPV is: Benefits vs. Costs Should we expect to earn at least
our minimum rate of return? Accept the
Positive Benefits > Costs Yes, more than Accept
Zero Benefits = Costs Exactly equal to Indifferent
Negative Benefits < Costs No, less than Reject
In the Capital Budgeting Mini Case, Corporation A's NPV is equal to 20,979 and Corporation B's NPV is equal to 40,252. Corporation B is the better selection because:
(1) The benefits are greater than the costs
(2) Expect to earn at least the minimum rate of return and more
Whilst, Jaffe et al. (2002:140,157) argue that "the NPV approach is the best one for evaluating capital budgeting projects" alternative methods exist, of which the Internal Rate of Return (IRR) method has "redeemable qualities". IRR is the rate at which the NPV of the project is equal to zero and investment decision becomes "accept the project if IRR is greater than the discount rate, [and] reject the project if IRR is less than the discount rate" (Jaffe et al., 2002:147). Jaffe et al. (2002:146) argues that IRR is the "most important alternative to the NPV approach", because it is independent of the prevailing capital market interest rate in its attempt to resolve an internal (or intrinsic) rate that is dependent only on the cash flows from the project.
Internal Rate of Return (IRR)
Importantly, IRR is a method for determining value that does not depend on the determination of a discount rate. This method requires the calculation of a discount rate such that the discounted value of future cost-benefit flows exactly equals the initial investment. Dean (1951 in Smith, 1986:8) recommends that the company make investment decisions by "looking to the capital markets for the firm's cost of capital, accepting each project with an internal rate of return and exceeds this market-determined cost of capital". As such, to apply the IRR reference must be made to the discount rate in order to arrive at a decision.
Theoretically, the NPV and IRR techniques arrive at the same investment decision and an investor can be indifferent as to which method is used. NPV is positive for discount rates below the IRR and negative for projects above the IRR. As such, the IRR rule coincides with the NPV rule and if a company accepts projects when the discount rate is less then the IRR, the company will simultaneously be accepting positive NPV projects and vice versa (Jaffe et al., 2002:149).
Under normal circumstances (where the initial outflows of an independent project are followed by a series of inflows), IRR always reaches the same conclusion as NPV. However, several problems occur with the IRR approach in more complicated, real world situations. Although rare, some projects have large initial cash inflows followed by a series of outflows (i.e. advanced bookings for a future service) and are functionally equivalent to borrowing. Under these circumstances the IRR decision rule becomes inverted and the project should be accepted only when the IRR is below the discount rate.
For the Capital Budgeting Mini case, I started by conducting a test using the discount rate. This told me whether the project is expected to earn us more than or less than the discount rate.
Results Interpretation of Results Next percentage
to be tested?
PVB > PVC The project is expected to earn more than the percentage rate used for the test A higher rate
PVB < PVC The project is expected to earn less than the percentage rate used for the test A lower rate
In the Capital Budgeting Mini Case, Corporation A's IRR is equal to 13.05% and Corporation B's NPV is equal to 16.94%. Corporation B is the better selection because the return that a company would earn if they expanded or invested in themselves, rather than investing that money abroad Is greater than Corporation A..
Modified Internal Rate of Return (MIRR)
Jaffe et al. (2002:140,157) argues that IRR has "redeeming qualities" because by providing a single rate of return, it fills a need that NPV does not. The Modified Internal Rate of Return (MIRR) better reflects the profitability of a project. IRR assumes the cash flows from the project are reinvested at the IRR, whereas the Modified IRR assumes that all cash flows are reinvested at the firm's cost of capital. In practice, the MIRR always lies between the investors required rate of return and the IRR.
In summary, NPV is expressed explicitly as the effect of an investment on the firm's wealth position and is considered the theoretically preferred method. IRR by comparison, is only implicitly associated with wealth and in cases where it is necessary to evaluate the additive wealth effect, IRR is not applicable (Agnes-Cheng, in Cooper and Argyris, 1998:65). Moreover, IRR cannot handle periodical variations of rate of return and is problematic when cash flows have alternative signs. One advantage of IRR, especially as a medium of communication, is that it does not require cost of capital in the initial calculation stage.
While NPV and IRR can reach the same conclusion regarding the profitability of a single project with cash inflows after initial investment they tend to be inconsistent when evaluating multiple projects, with different lives. This is because of the reinvestment rate assumptions that are used by NPV and IRR. When project lives differ in length, NPV assumes that "the reinvestment rate for a future project equals the cost of capital while the IRR assumes it equals the IRR" (Agnes-Cheng, in Cooper and Argyris, 1998:65).
The Payback Period is the weakest of the capital budgeting method used in Capital Budgeting Mini Case. By definition, the payback period is the length of time that it takes to recover the investment of $250,000. The length of time required to recover the cost of the $250,000 investment is 4 years for both Corporation A and Corporation B.
Profitability Index Method is an extension of the Net Present Value Method. The Profitability Index is calculated by dividing by dividing the sum of the present values of all cash flows by the initial investment.
Profitability Index = Total PV / Initial Investment
A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate the corporation's NPV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed acquisition, therefore, Corporation B is the better choice.
Discounted Payback Period
The Discount Payback Period is an Investment decision rule in which Cash flows are discounted at an Interest rate and one determines how long it takes for the sum of the discounted cash flows to equal the initial investment. For Corporation A and Corporation B this period is the 5 years.
For the acquisition to be worth pursuing, it must generate a higher rate of return than what could be earned in the capital markets (Jaffe et al., 2002:200). This is only true if the NPV is positive and as such, we must conclude that Corporation B should be acquired.
The MIRR and IRR may be interpreted as the annual compound rates at which the initial investment would need to be invested elsewhere, in order to obtain as much money by the end of project life. The MIRR (14.36%) always lies between the required rate of return (10%) and the IRR (16.94%).
The payback method is the simplest measure to calculate and the least consistent with other decision making criteria. Interpretation of the project payback is subjective and dependent on the firm's objectives (i.e. a 10 year payback may be appropriate for a mining project).
In Capital Budgeting Mini Case, if Corporation A had a 5-year projection and Corporation B had a 7-year projection, the cash flows for both the Corporations would be calculated. All other calculations would then be carried out with the respective cash flows and the analysis of the capital budgeting requests would be performed in the same manner as the projects had equal projected years.
Cooper, C. & Argyris, C., eds. (1998) Encyclopedia of Management. Blackwell business: Oxford.
Jaffe, Jeffrey; Ross, Stephen A.; and Westerfield, Randolph (2001). Corporate Finance: Fifth edition, Custom Electronic Text for the University of Phoenix, McGraw- Hill. Unknown (2002).
Smith, C. (1986). The theory of corporate finance: A historical overview. In, The modern theory corporate finance, eds Jensen & Smith. McGraw Hill: Sydney.