Alan Kring Productions in association with Emergent Light Studio presents
the Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today, capital budgeting and then once that's done I'll whine and moan until about 2.35 and then you have your happy quiz to take.
And then you're done once you finish your quiz for the day.
And then next week we pick up and clean up chapter 11, what I don't get done today, and then do some more work in chapter 12.
I've sort of blended the two chapters together a little bit just to set the stage for the capital budgeting problems.
And they're not bad at all with Excel. But I'll get to that in just a little bit.
First, I'll look at the numbers and the numbers are just nothing at all.
We have the, nothing is really happening. The NASDAQ is down just a tiny bit, six one hundredths of a percent.
The S&P is down no more, it's down five one hundredths of a percent.
The only one that's down even a slightly noticeable amount is the Dow, down a little more than a quarter of a percent.
So it's just one of those days, it's just a little on the grouchy side, but there's no significant movement to get excited about.
And just as a quick look over here, looking at the volume on the S&P 500, I'll bet it's very light volume.
Oh yeah, it's, I mean it's almost, it's less than a half and we're going into the last hour of trading.
So it's just the investors are not doing much today for one reason or another.
And a lot of it's just sort of a wait and see. We don't have any information bad, new information bad, new information good.
So the market's just kind of piddled along here looking kind of stupid.
But of course at the same time you have the crude oil market is just taking a nosedive now.
We're clear down to 75.52 a barrel and at that price there's no way that the gasoline prices will stay where they are.
They will let up here eventually, possibly by the end of the week because of just this low price for crude oil.
The high seas, the reserves and in the towers right now there is a lot of oil.
So it's good news because that will make fuel energy prices cheaper going into the Christmas season which may stimulate some more buying for the holidays.
Just and going over here, bond yields are finally getting serious about sliding.
Interest rates beginning to drain downward. A lot of that is the expected inflation premium beginning to drain out of the risk free rate and therefore out of all rates.
So that is good news because as the interest rates go down as we'll see in this lecture today,
that means more projects, new projects, replacement projects, expansion projects are going to be accepted.
More jobs and all that good stuff, more salaries to buy stuff.
So this is good news that we see these bond prices beginning to slide down.
How long it will be before we start to see that in home mortgage loans and in car loans and big ticket item loans?
That's hard to say. It could be another month or so before that happens.
But it should begin to take hold in time for people to do more borrowing for the Christmas season and all that good stuff.
Both the euro and the pound are just bouncing around almost near zero so there's no movement in the international currencies.
The yen is depreciating against the dollar so there's that but it's kind of hard to say what that means.
The Nikkei after a rather nasty day, a nasty couple of days, it popped at the opening and then it just slowly, quietly slid down until it ended about a third of a percent down.
Nothing big about that and London showed its usual, it was kind of quiet most of the day but then it started getting volatile.
It spiked in the last trading hour and then it dropped down below but at the end it was down only 0.11%.
So it looks like the whole world is kind of like sitting what's coming next.
Anything exciting, you know, a war or something like that, a meteor strike.
But for right now it's just a quiet market which is actually good for your typical types of investors.
You don't want lots and lots of volatility in the market anyway.
That's not the point. You want your volatility, you want your risk to be based upon your decision on the beta of your portfolio, not these random events in the world.
Now just having a look at a couple of more stocks just to keep that in your minds and how to do that.
We'll look at a couple, start out with VZ, Verizon.
See how it did today. Oh, it took a little bit of a toilet break.
It had a spike a few days ago and then it just has been sliding a little bit ever since then.
Very low risk. Notice that beta is 0.37, undervalued at 7.18 and profitable, just ridiculously profitable, almost $5 a share.
So, and it pays a really fat dividend.
So just quickly having a look just to remind you because I will do that on the final.
I'll ask you to do one of those. Where the heck is my calculator? There it is.
Okay, quickly looking at the projected one year holding period return gain.
We would see 30, if we bought today, the stock would be worth $37.26 per share in a year divided by what you pay for today at $35.69.
And then you subtract one and that gives you times 100 to give you a percent.
So on the stock price appreciation, you'd make kind of a lousy 4.40%.
Adding in that nice fat, look at that dividend, a 7.46% dividend yield for 6.
It comes out that with that dividend included, you got a decent return for such a low beta stock, 11.86% for the one year holding period return.
Most of that coming from just that nice big fat dividend it pays per share.
So, I mean, it doesn't suck at all. Verizon is not a high growth rate company by any means.
It's just so large and it's not going to grow much more.
The competition is just kind of there and there's nothing new going to happen.
Moving over to another industry, just look at Procter & Gamble.
Again, low beta, necessities of life, essentials, stuff like that.
All those nice things that you buy in the store, Procter & Gamble kind of stuff, 0.46 beta.
Little bit undervalued at 24 a share and it's profitable. It's really, well, of course, it's just such a big, big company.
It's quite profitable. So, look at that price though. Ouch! That's a big price for that stuff.
Okay, looking at the one year capital gain returns, just to do this one more time.
If you held it for a year, you bought it today, in a year you'd have, you could sell it for $155.36
divided by what you paid for it one year before, that is today, 149.74 and then minus one, always minus one,
and then times it by 100. So, your capital gain, the stock price going up, is only 3.75%.
That's a big whoop-de-doo, but again, it's a low beta stock. But, you add in the forward dividend yield,
which is 2.49%, that's kind of lousy compared to Verizon.
So, you get an overall return that is not spectacular at all, 6.24%. Of course, it's a low beta stock.
But, if I had a choice between Procter & Gamble and Verizon, I'd go with Verizon.
It's got a much stronger one year holding period return and most of that's because it's got such a strong dividend.
Procter & Gamble has a more normal dividend, which is not nearly as good.
So, this is the way you shape your analysis, you look at these stocks and you don't have to use fancy or complicated math to do this.
You just look at the numbers and figure out, well, what's the beta, is that my kind of beta?
Now, for a lot of people, that might be a beta that's a little on the low side. So, was Verizon's beta?
You would kind of like a little bit higher, take a little bit more risk.
But, I mean, with Verizon, for such low risk to get a decent return, it certainly dominates Procter & Gamble,
at least as far as this quick analysis goes.
Of course, you'd want to look at some of the fundamentals of both companies, but they're both big companies.
They're not going to be spectacular, do anything insanely great.
They're just in a, essentially in economics, you might have learned about oligopolies.
Oligopolies have a, they're not competitive in the way that monopolistic competitors are.
Monopolistic competitors are always fiercely fighting against each other, taking market share, new stuff out there to gain an advantage.
Oligopolies don't work that way. They're on this long, long chessboard that they just kind of watch each other.
They come out with, they almost mirror each other. You've got Verizon comes out with its new phones.
Samsung comes out with its, well, they're not the same, but AT&T comes out with its new product packages and all that.
So they don't really have any way that they can fight their way up to the top.
They just kind of exist against each other over a period of decades, maybe even centuries.
So there's that.
Let me take you on a little bit of a journey here.
Now one thing about what I'm going to do in this lecture, and it's a relatively short lecture, and I'll do a little cleanup,
but it doesn't need much more than a single lecture, and I've gone through some of this before,
and I'm just reiterating it for the Chapter 11 homework.
This has to do with what's called capital budgeting, deciding what capital projects you are going to fund
versus the capital projects that are not worth the company's time to fund.
That's all capital budgeting means.
And it boils down to some fairly simple routines.
The one thing that I will tell you, though, is that in Excel, it's almost like there's not even a template that I could set up for you.
The problem is you just set them up, do a custom job on each one, and I think I do have a template,
but I mean, you don't really have to do that with these.
It's just net present value, internal rate of return, and then that beast called modified internal rate of return
that I showed you much earlier in the semester.
But it all boils down to the question of whether a project that we are proposing is a go or a no-go.
That's why I spent yesterday, or yesterday, Monday, yes, talking about free cash flow,
because we are going to need to project free cash flows for a new project, whether it's an expansion project or a replacement project.
We need these free cash flows.
So in the background, and that's not the subject really here today, revenue minus free cash flow,
revenue minus cost, minus depreciation and amortization, and then you take that times 1 minus the tax rate.
And that is what we call the net operating profit after taxes, no pat.
Now this is what I did on Monday, but I'm going to repeat it here quickly, and then I'm just going to say free cash flow.
I'm not going to do any calculations of free cash flows right now.
So free cash flow, you then say minus the capital expenditures, minus the change in net operating work and capital.
So that's what I mean by free cash flow.
Now let's pretend that that's all by the wayside here, and now we get down to the business.
Year and the free cash flow.
Now year zero is the bleed year.
This is when the money all goes out, or at least the significant capital expenditures go out to get a project set up so that you can go forward with it.
Now we're looking at the future, so at this point you would end up in real life, this would be, okay, we've got this project.
Let's figure out what we have to spend to get it going.
You have a group that gets together, a committee that goes through, gets the bids for the different parts of the project,
well gets the set up of the project, gets the cost of the different parts, the machinery, maybe a new factory, whatever.
So in that first year you have your initial investment.
Let's say that that initial investment is, well let me, is better seen with a marker that works.
I've got four here, one of them has to work well.
Okay, negative $250,000.
That includes everything, that would be also that one as I mentioned last time, okay, we're going to buy all the capital stuff, the equipment, building, and all that.
And also we'd have to boost our inventory in that first year, so that would be a cash outflow, buying that inventory for the start of the project.
Which I'll tell you a little story about this, it's kind of a famous thing, forgetting about inventory.
Okay, but let's say you're one, the project gets off the ground.
You're in the introductory phase of the project in that graph that I showed you on Monday.
So in year one you've got, let's say, a lousy $30,000 in free cash flow from that.
You're going to project based upon your analysis, and this is actually marketing.
This is the marketing people's job.
And then in year two, you get into your growth phase, you get, let's say, $80,000.
And then you're still gathering steam, so in the third year you're up to $140,000, well no, let's say $120,000.
And then in year four, you're starting to slide back, and you'll get another $40,000, let's say $40,000.
And then in the last year, this will be a composite.
You're closing the project down, last year of sales, and you're also going to drain down your inventory,
and you're going to sell off the equipment that you've got and calculate taxes on it, which we're not going to do here.
We're just going to write a number down.
And then in year three, the total value of free cash flow in the last year is $25,000.
Okay, what do we do with these numbers?
There are three different ways that you can say go, no go.
There is an old way. It's almost an ancient way.
It's been used actually for thousands of years, and it was still very much the way it was done into the 20th century,
and a surprising number of companies still do it this way now, an appalling number, because it's not a good method.
It's not best practices, but it's still used.
It's called the payback period.
It's really simple, and that's why it's still embraced to this day,
is the company decides a number of years a project will be allowed to keep going before it has to pay off the initial investment.
Let's say in this example that the payback period is, example, three years.
Okay, there's the first problem right there.
This is arbitrary.
I have actually consulted for companies, and I know quite a few more, that just three years, five years, seven, it's just all over the board.
And it's a policy, and a lot of times, well, I have even asked, well, where did this payback period come from?
Well, I don't know, we just always use this period.
This is the right one. Right by whom?
It's so capricious, so arbitrary.
But they're just saying a project has to pay back what we put into it within three years.
So in this example, if I look at this example, down 25, 250,000.
So after one year, you're still down $220,000.
After the $30,000, you're still in the hole that much.
And then after two years, you're still in the hole $140,000, after you get $80,000 more in.
And after three years, you're still down $20,000.
And you don't even come up for air until the fourth year, at which time you are up $20,000.
And at the end, you're up $45,000.
So this project would be rejected because it didn't cover the initial cost within three years.
And that's all there is to it. That's the payback period method.
There are two problems with it. First of all is the arbitrary nature of the three years.
The other is that these cash flows, they're comparing a cash flow in year zero directly to a cash flow in year one,
another one in year two. And those, though you can't compare them directly, you'd have to take the present value of those.
To compare negative $250,000, for example, to $120,000, well, you'd have to discount that $120,000 back to the year zero.
In other words, the present value three years out of $120,000.
So you're not comparing numbers that are of the same value as they appear.
You don't have that time value of money included in.
Well, there's a modification. Okay, fine. You want that? We'll do the present values of $30,000, $80,000, $120,000, $40,000, $25,000.
There, that fixes it. Well, not really.
Because there are other problems. But you're still coming back to the question of the three years. Where is it coming from?
How serious is this? Well, different surveys have been done. And there are actually three methods.
This is one of the methods that corporate America, corporate world uses.
And then there are two much more modern methods. One is called the net present value method.
And there's another way that is called the internal rate of return method.
Now, slowly out over the past 50 years, these two more modern methods have begun to dominate the payback period method.
But there are still a number of companies out there that use it. Maybe about a fourth to a third of companies still use payback period method.
But there's something else. The surveys don't show something that I've seen in my work, my discussions with corporate people,
is that they secretly use the payback period method, even though they would say, well, we use the internal rate of return method.
They do quick back of the envelope decisions on a payback period.
I had one, I was at a dinner a couple, well, yeah, it was a couple of years ago, just less than two years ago.
And there was a corporate treasury official, a finance department executive, and he said, well, we're not going to do that because it's going to cost $80,000.
And if you look at the cash flows from it, well, it's not going to cover that $80,000 for five years. We just don't want to do that.
In other words, there was an automatic decision that didn't have anything to do with best practices.
It was just a quick return to the payback period method for decisions on lower end capital expenditures.
So it's out there, one way or the other. But that's how it works.
This project actually, in this case, it would pay for itself in exactly three and a half years.
You look at the break, the pair of break years, and you say, well, the lower one plus the higher one,
and you divide them by two, and that would mean the zero point would be right there between them.
But one way or the other, you reject the project because it didn't blow past payback in three years.
It's off the table.
Now, let me take you to these two. A couple of quick notes about this.
These, both of these are modern. And if you're almost anywhere in corporate, marketing, production, obviously finance is where we do this.
But they will use one of these two methods to decide whether a project is a go or a no-go.
It's just how they do it.
The problem is that actually this NPV method is superior to the internal rate of return method.
For two reasons, and I'll talk about that in a little bit here.
But the internal rate of return method is more popular than the NPV method.
Because the internal rate of return method does not require that you calculate a discount rate before you do the problem.
A discount rate actually comes out of the internal rate of return method.
Now, if you'll recall, finding the discount rate, there are a couple of ways you could do it.
You could just guess at a discount rate.
You could use the weighted average cost of capital for your discount rate, which is what most companies will do in an internal rate of return approach.
Or you could use the capital asset pricing model to do it.
You know, the beta of the project, throw it into CAPM with the risk-free rate and the expected return to the market portfolio.
And get a custom discount rate for each project.
But that requires an extra calculation before you can attack the project using NPV.
With internal rate of return, the internal rate of return just comes out with an answer.
Let me show you.
Now, I would have in previous years, this would have been painful because you have to take the present value of all of these positive free cash flows.
And then you add them up and then you subtract the initial investment.
If it's a positive, then you say go.
If it's a negative, you say no.
So in other words, the NPV is simply the sum from I equals, well, let me do it this way.
I'm going to do it the way Excel does it.
And this is bad.
Excel doesn't recognize that the initial investment is part of the NPV,
which we've tried to talk to Microsoft for years about this and they just ignore us.
Okay, the initial free cash flow, which is the negative, plus the sum from I equals one to N, the end of the project,
of the free cash flows of the, I'm sorry, the present value of the free cash flows for each period.
In other words, you take the present value, add up the present values of all of these,
and subtract the initial free cash flow, and there's your Uncle Bob.
That's the NPV.
If that present value is positive, you accept the project.
If the NPV is negative, then you reject the project.
That's all there is to it at the end,
which kind of in itself is annoying to the people who propose projects, production, the production people,
the marketing people, we say yes or no based upon an end number.
That's it.
Now I'll do one in Excel.
I'll just do this one in Excel, just so you can see it.
It is a joy compared to what it used to be.
Whoops, I didn't mean to do that.
I meant to expand it.
Gear, free cash flow, year zero, one, two, three, four, five, free cash flow,
in this case, negative, 200, 250,000, and then you've got 30,000, 80,000,
and then you've got 120,000, and then you've got 40,000,
and then you've got your final year with salvage included and drain of inventory and all that, 25,000.
Now the one thing we need to do here is we're going to need a discount rate.
And doing what is wrong, let's say the weighted average cost of capital of this company is 7.5%.
So we're going to put that somewhere over here, discount rate, 27.5%,
and then your net present value is equal to, now remember,
this has to be put in separately, the initial investment, plus, and they call this NPV.
It's not.
The NPV should include the initial, but they don't do it that way.
These, my ass, oh, I forgot.
I forgot to put in the discount rate.
My bad.
And it's going to get to us as a percent, which we want to turn into a number again.
It's a negative net present value project, so we reject.
Notice what would have happened if I had had a lower discount rate.
Let's say 5.25.
It would have been a positive NPV.
So the NPV analysis is sensitive to what discount rate you choose.
If this project is lower than the typical risk of the project,
7.5% weighted average cost of capital would be too high.
But notice what would happen if I had a higher discount rate.
Let's say 9.75.
Oh, it would have been hashtags.
So in other words, NPV goes down as discount rate goes up.
It's a negative relationship.
So the higher the discount rate you use, the more likely you are to reject a project.
So you kind of see what I mean that it would be difficult to do a template
because you have how many years the project is going to go as a critical part of it.
And the template isn't particularly good for that
because you have to use a custom number of years for each table you make.
But it's not too bad.
Yeah, we're okay.
Okay, I'll do internal rate of return on Monday.
I'll extend the deadline for the Chapter 11 homework a little bit for you.
But right now you need to get ready for a quiz.
And once you're finished with the quiz, that's all I have for you today.
Thank you.