Question2: Assume you are the head of the financial management team of a clothing and textile firm. The firm is looking to expand and invest into new fashion and products. There is a choice of four (different) options of investment but the firm can only pick one. You, as the head of the financial management team have to make a recommendation. How do you and your team decide which option to recommend? Discuss in detail. Description of the four options is not necessary.
The financial manager in a textile and fashion company has a number of goals that ought to be attained.
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Common principles in capital budgeting
The following are important principles that management should consider meticulously in the capital budgeting process (S. Ross et al. 2007):
1- In capital budgeting, the decision should be based on incremental cash flows arising from the capital project.
Sunk cost: comprise the cost that has been occurred and cannot be reversed. For example, consulting and advertising fees that have been paid for the project at the beginning cannot be reversed if the project is canceled. Since this cost does not affect the decision on the investment in the project, it should not be included (Economist.com n.d.).
Externalities cost: if the firm launches its new project or product, there might be an effect on the firm’s other projects or products already operating in the firm. The effect can be negative (cannibalization) or positive. For instance, if a beverages firm launches a new lemon flavor drink, it may negatively decrease the sales of another cherry flavor drink, since present customers switch to this new product. In such a stance, the loss of the cherry drink sale should be subtracted from the sale of the new lemon product.
2- Opportunity cost is a cost that should be included with the incremental cash flows. The opportunity cost is the cost of the foregone alternative that the organization could undertake if the project does not take place. For example, if the firm owns a land and it will be used for the project, the cost of the land should be included in the cost of the project since it might be sold.
3- The time value of money is an important factor that should be considered in capital budgeting. This comprises that the cash flows that are being earned at the early stage of the project will worth more than the later cash flows. That is, $1 today is more valuable than $1 next year (University of Florida 2006).
4-The cash flows that are being used in capital budgeting should be after-tax cash flows since the value of the firm will be based on the cash flows that they keep not the cash flows that are being sent to the government (Swlearning.com n.d.).
5- The WACC already includes the financing cost of the project. Therefore, the manager should not include the financing cost in his calculation to avoid duplication.
For convenience, the following figures are presumed:
Cost CF1 CF2 CF3 CF4 WACC N -3 1 1.2 1.8 2 15% 4
Cost CF1 CF2 CF3 CF4 WACC N -4 1.5 1.5 1.5 1.5 15% 4
Cost CF1 CF2 CF3 CF4 CF5 WACC N -5.2 1.9 1.6 2.2 2 1 15% 5
Cost CF1 CF2 CF3 CF4 CF5 CF6 WACC N -7 1 1.3 1.7 2.1 2.5 2.9 15% 6
1) Payback period:
The payback period method is widely used in capital budgeting because of its simplicity. It gives us the duration of the project to recover the initial investment. However, it because of such simplicity, it has two disadvantages, which are the following (Investopedia 2009 b):
1- It does not take into account the time value of money; and
2- It ignores any cash flow that might be collected after the payback period.
We will calculate the payback period for project A and B as follows:
Year1= 3,000,000 – 1,000,000 = 2,000,000
Year2= 2,000,000 – 1,200,000= 800,000
Year3= 800,000-1,800,000 = can not be calculated
Therefore, the payback period for project A will be 2+800,000/1,800,000 = 2.44 years
Year1= 4,000,000 – 1,500,000=2,500,000
Year3=500,000-1,500,000= can not be calculated
Therefore, the payback period for project B will be 2+ 500,000/1,500,000= 2.33 years
We do the same for the other projects and then accept the one with the lowest period.
2) Discounted Payback period:
In contrast to payback period, this method takes into account the time value of money. Therefore the expected cash flows are discounted in line with such premise. However, this method still ignores the cash flows that should be collected after the payback period.
Cost= 3,000,000 DCF1=869,565 DCF2=907,372 DCF3=1,183,529 DCF4=1,143,506
Therefore, the discounted payback period= 3+ 39,534/1,143,506= 3.0346 years
Cost=4,000,000 DCF1=1,304,347 DCF2=1,134,215 DCF3,=986,274 DCF4=857,629
Therefore, the discounted payback period will be 3+575163/857,629= 3.67 years
We do the same for the other projects and then accept the one with the lowest period.
3) Accounting rate of Return (ARR):
The accounting rate of return is one of the methods that do not abide with the time value of money. The accounting rate of return (also know as the return on investment and return on capital employed) is calculated by dividing the average annual profit from one a project into the average investment cost" (Drury 2007, p307). The main difference between ARR and other methods is that the ARR examines the project by looking at profitability, while the other methods take a cash flow perspective. Profits does not equate cash flows because financial accounting profit measurement is based on the accruals concept" (Drury 2007,p 307).
The ARR is applied for project A and project B as follows:
Cost CF1 CF2 CF3 CF4 WACC N -3 1 1.2 1.8 2 15% 4
It is assumed that the projects have no scrap value and that straight-line depreciation is used.
Depreciation= 3,000,000/4= 750,000
Profit for year 1= 1,000,000-750,000= 250,000
Profit for year 2= 1,200,000-750,000= 450,000
Profit for year 3= 1,800,000-750,000= 1,050,000
Profit for year 4= 2,000,000-750,000= 1,250,000
Average annual profit= 250,000+450,000+1,050,000+1,250,000= 3,000,000/4=750,000
ARR= average annual profit/initial investment = 750,000/3,000,000 = 25%
Cost CF1 CF2 CF3 CF4 WACC N -4 1.5 1.5 1.5 1.5 15% 4 Depreciation = 4,000,000/4= 1,000,000
Profit for year 1= 1,500,000-1,000,000= 500,000
Profit for year 2= 500,000
Profit for year 3 = 500,000
Profit for year 4= 500,000
Average profit = 500,000
ARR= 500,000/4,000,000= 12.5%
4) Net Present Value (NPV):
NPV is another tool used in capital budgeting process. It measure the overall financial wealth of the capital project. The NPV deducts the initial cost (outflow) from the incoming return (inflows) discounted at appropriate interest rate and determines whether investing in the particular project can enhance the financial wealth of the organization. The below formula illustrates how the NPV is calculated:
The project with positive NPV should be chosen while the project with negative NPV should be rejected. In addition, if the projects are mutually exclusive and all the NPVs are positive, the manager should select the one with the highest positive value since it will provide the highest increase in shareholders’ wealth. From the given examples, we will show how NPV is calculated for the first project:
As it was already mentioned above, the project with the highest positive NPV should be chosen which is Project A, because the projects are mutually exclusive.
The Cost of Capital:
For simplicity, we assumed the weighted average cost of capital WACC to be 15%. However, in real life projects, the financial manager should calculate the components of WACC taking into consideration that the WACC for the projects differs from the WACC for the firm because of the additional risk element pertinent to the project. The WACC includes cost of debt + cost of equity + cost of Retained Earnings+ Cost of Preferred Stocks (Investopedia.com).
A- Cost of Retained Earnings:
The cost of retained earrings can be calculated n one of the following methods:
1- Capital Assets Pricing Model (CAPM)
In CAPM, there are two types of risk, one is firm-specific risk and the other is the market risk. The firm specific risk can be eliminated by portfolio diversification, while the market risk cannot be eliminated and the investor is compensated accordingly for it. The measure for market risk is as follows:
The model equation is
Where =cost of retained earnings
= Risk free rate asset
= Market risk
= Market risk premium
= Project risk
2- Bond Yield + Premium Method
Here we add the bond yield (long-term) to long-term bond yield to a risk premium
3- Discounted Cash flows Method
Where D is dividends per share for the next year
P is the current stock price
G is the growth rate of dividends
B- Cost of newly issued Equity:
F is the flotation cost in percentage
C- Cost of Debt:
The cost of borrowing money equals the interest rate of newly issued loan multiplied by (1-tax rate) since the interest is tax deductible.
After tax cost of debt= = kd (1-t)
D- Cost of Preferred Stocks:
Provides a specific fixed dividend that is paid before any dividends are paid to common stock holders, and which takes precedence over common stock in the event of a liquidation. Like common stock, preferred stocks represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights, like the common stockholders.(Investorwords.com n. d. a). It is calculated as follows:
kps = Dps/Pnet
Where D comprises fixed dividends and Pnet is the stock price
Special cases in capital budgeting techniques:
1- Different Lives:
When there is a difference in the number of years for mutually exclusive projects the Equivalent Annual Annuity (EAA) is utilized. This technique calculates the net present value of the projects on annual basis (Academicengage.com 2008, pp 2-4). For example, project X has duration of 6 years, while project Y has duration of 3 years with the following cash flows:
X: Cost=19999$, CF1=3999$ CF2=6999$ CF3=64999$ CF4=5999$ CF5=5499$ CF6=4999$ WACC=12%
Y: Cost=9999$ CF1=34999$ CF2=64999$ CF3=5999$ WACC=12%
By calculating NPV, We will get NPV for X=3245.47$ and NPV for Y=2577.44$
Using a financial calculator or excel, we plug in NPV as Present Value, and calculate Annual Payment which will be PMT X=$789 and PMT Y=$1,073
Therefore, we choose project Y because it has the highest annual payment.
2- Different Cash flows.
There is a problem in comparing between two projects due to the differing cash outflows and inflows. For example, if we have projects with the following numbers:
X: Cost=20 CF1=60 CF2=10 WACC=10%
Y: Cost=10 CF1=10 CF2=40 WACC=10%
NPV X=$43 and NPV Y=$32
Since the cash flows are not identical, a technique called Profitability index (PI) should be adopted. The profitability index divides the present value of cash inflows by initial cost. If the NPV for the project is positive, the profitability index will be more than 1 and vice versa (Attenhauser 2008, pp 3-5). For example, choosing between Project X and Y, choosing Project X is a wrong decision despite its NPV is higher than that of project Y NPV. This is because the PI, favors Project Y as follows:
3- International or Local Project
In evaluating the projects, the company should consider whether the project is in the same country or abroad since there will be different cost of capital in each country due to the exchange rate risk. There are two methods used:
1- The home currency approach (centralized):
In this method, the manager should convert all the expected cash flows to the local currency using future rates and then he does his calculations for NPV.
2- The foreign currency approach (Decentralized):
In this method, the manager calculates the NPV in the foreign country and after that, he converts the NPV at the spot rate to local currency.
The inflation is defined as a continuous increase in given products for a period of time. The inflation can reduce the purchasing power of money and reduce the value of money being collected from the project. Financial managers should be careful in matching the cash flows with its appropriate cost of capital. For example, the manager should discount cash flows with nominal yield and discount real cash flows (inflation is excluded) with real yields which is approximated as
Real Yields = Nominal Yields – Inflation
5) Internal Rate of Return (IRR):
Internal rate of return is the rate where the cash inflow of the projects equates the cash outflow of it. It can be seen as the break-even point of the project. In other words, it is the discount rate when NPV equals zero.
The IRR is determined through trail and error and the formula for IRR is as follows:
The decision rules for the IRR are the following:
1-Accept the project that has IRR greater than its required rate of return because it means the project’s NPV is positive.
2- Reject the project that has IRR less than the required rate of return because it means that the NPV is negative.
For our examples, if we want to calculate the IRR for the projects:
By comparing each IRR with the required rate of return which is in this case the WACC =15%, we conclude that we should accept projects A, B, C and reject project D. However, since these projects are mutually exclusive, we will choose the project with the highest IRR which is in this case project A.
In addition, IRR has some problems in dealing with nonconventional cash flows. For example, if there are projects with cash flows as follows: -70$, +150$, -90$, many IRRs will be determined. Therefore, we use a technique called Multiple Internal Rate of Return (MIRR).
NOTE: There is a problem in selecting between mutually exclusive projects when we calculate NPV and IRR. This problem arises because of the different initial cost and different timing of the cash flows between the projects. Thus, if we calculate the NPV and IRR for the projects, we may get conflicting ranking for the projects. For example, if we have two projects with the following:
X) Initial cost 4999$, cash inflow in year one 7900$ and the WACC is 10%.
Y) Initial cost 29999$, cash inflow in year one 39999$ and the WACC is 10%
For project X, we will come up with IRR=60% and NPV=2272.72$
And for project Y, we will come up with IRR=33% and NPV=6363.64$
Based on the above example, we should choose project X since it provides higher IRR. However, project Y provides higher NPV. As a result, when the manager faces this conflicting problem, he should always choose the one with higher NPV since it positive NPV has direct impact on the wealth of the shareholders. (Schweser 2007).
It is the relationship between NPV and different rates of cost of capital. It is illustrated by the following graph (Investopedia 2009 a):
This graph shows us that if the cost of capital is less than 7.2% we should choose project 1. On the other hand, if the cost of capital is above 7.2% we should choose project 2. In addition, this graph shows us that IRR for project 1 is 11.8% when NPV=0 and the same thing for project 2 where its IRR=14.5%
Project risk management:
In capital budgeting, there are a lot of techniques that can be implemented in order to better manage risk, these techniques comprise the following (Ross et al. 2007):
1- Sensitivity analysis
In sensitivity analysis, we change one input of the variables of the income statement for example to see its effect on the output (holding other inputs constant). For instance, we might change the selling and administrative expense in the income statement to see its effect in the NPV or IR
2- Scenario analysis
Scenario analysis we change more than one input to see its effect on the output by using probability distribution. In addition, we see the effect of these changes by setting worst, base and best-case scenario.
3- Simulation analysis:
The simulation analysis consists of many steps in order to get a probability distribution for the outcome such as NPV or IRR.
Common mistakes in capital budgeting
Qualitative factors like the following should also be considered. Otherwise a wrong decision may still be taken.
1-The manager does not take into account economic responses. For example, if the project that will be handled has low barriers to entry, a competitor may accomplish similar project and therefore lower profitability.
2- Managers whose compensation is related to the EPS and ROE will sacrifice projects with positive NPV and focus on projects that increase the EPS and ROE in the short-run.
3- In mutually exclusive projects, the manager might based his decision on IRR and omit NPV which is wrong decision since NPV has direct impact on shareholder wealth maximization.
4- The estimated cash flows might not be accurate due to uncertainty.
5- Sometimes the manager does not consider the impact of inflation on his decision.
6- The cost that are related to the project sometimes might be difficult to estimates
7- Using company’s WACC instead of project’s WACC may lead to false decisions since the risk in the projects differs than the risk in the company
8- Problems with sunk cost and opportunity cost. For example, the manager should not consider sunk cost and consider only opportunity cost.
Based on the above discussion, we have illustrated different methods that are widely used in the capital budgeting topic. We have also mentioned special cases for these techniques relating to different cash flows, different lives, inflation, and international projects. Furthermore, we have mentioned some common mistakes the manager should be aware of. In conclusion, we think that the best method to be used in capital budgeting is NPV because it accounts for time value of money and it does not give as conflicting result, like the IRR. However, attention should also be devoted to qualitative variables and the capital budgeting evaluation should not concentrate solely on the NPV technique.
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