Slide strategic financial management l07

The process of identifying, analyzing, and selecting investment projects whose returns cash flows are expected to extend beyond one year.. Hurdle rates for projectsProject Characteristic

Strategic Financial 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.

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What is a project?

Defined broadly then, any of the following decisions would qualify as projects:

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.

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 Debit: Firm’s cost of debt

Project is large and has characteristics different from the firm

 Cost of Equity: Proxy business Beta, Bottom up Beta

 Cost of Debt: cost of debt of the comparable firms

Stand-alone Project

 Cost of Equity: Assess the project risk independently, Bottom up Beta

 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

 Non-Cash Charges

 Accrual versus Cash Revenues and Expenses

From Accounting Earnings to Cash flows

 Add back all non-cash charges, such as depreciation and amortization, to the operating earnings

 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

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

 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)

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

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 1

through 5 The initial cash outlay will be $40,000.

0 1 2 3 4 5

–40 K 10 K 12 K 15 K 10 K 7 K

Payback Solution (#2)

PBP = 3 + ( 3K ) / 10K = 3.3 YearsNote: Take absolute value of last negative cumulative cash flow value.

PBP Acceptance Criterion

PBP Acceptance Criterion

Yes! The firm will receive back the initial cash outlay in less than 3.5 years [3.3

Years < 3.5 Year Max.]

Yes! The firm will receive back the initial cash outlay in less than 3.5 years [3.3

Years < 3.5 Year Max.]

The management of Basket Wonders has set a maximum PBP of 3.5 years for projects of this type

Should this project be accepted?

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 Rate of Return (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

CF1 CF2 CFn

(1 + IRR )1 (1 + IRR )2 (1 + IRR )n

+ + +

ICO =

$15,000 $10,000 $7,000

IRR Solution

$10,000 $12,000 (1+ IRR ) 1 (1+ IRR ) 2

Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000

+ +

$40,000 =

(1+ IRR ) 3 (1+ IRR ) 4 (1+ IRR ) 5

IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) +

IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) +

IRR Solution (Interpolate)

10% 15%

$41,444 $40,000 $36,841 $1,444 -$ 3,159

IRR Acceptance Criterion

No! The firm will receive 11.57% for each dollar invested in this project at a

cost of 13% [ IRR < Hurdle Rate ]

No! The firm will receive 11.57% for each dollar invested in this project at a

cost of 13% [ IRR < Hurdle Rate ]

The management of Basket Wonders has determined that the hurdle rate is

13% for projects of this type

Should this project be accepted?

IRR Strengths and Weaknesses

IRR Strengths and Weaknesses

Net Present Value (NPV)

NPV is the present value of an investment project’s net cash flows

minus the project’s initial cash outflow.

Basket Wonders has determined that the appropriate discount rate (k) for this

The management of Basket Wonders has determined that the required rate

is 13% for projects of this type

Should this project be accepted?

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