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Alan Kring Productions in association with Emergent Light Studio presents

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the Illinois State Collegiate Compendium, Academic Lecture in Business and Economics.

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This is Business Finance, FIL 240 for autumn semester 2023.

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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.

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And then you're done once you finish your quiz for the day.

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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.

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I've sort of blended the two chapters together a little bit just to set the stage for the capital budgeting problems.

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And they're not bad at all with Excel. But I'll get to that in just a little bit.

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First, I'll look at the numbers and the numbers are just nothing at all.

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We have the, nothing is really happening. The NASDAQ is down just a tiny bit, six one hundredths of a percent.

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The S&P is down no more, it's down five one hundredths of a percent.

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The only one that's down even a slightly noticeable amount is the Dow, down a little more than a quarter of a percent.

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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.

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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.

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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.

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So it's just the investors are not doing much today for one reason or another.

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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.

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So the market's just kind of piddled along here looking kind of stupid.

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But of course at the same time you have the crude oil market is just taking a nosedive now.

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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.

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They will let up here eventually, possibly by the end of the week because of just this low price for crude oil.

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The high seas, the reserves and in the towers right now there is a lot of oil.

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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.

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Just and going over here, bond yields are finally getting serious about sliding.

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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.

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So that is good news because as the interest rates go down as we'll see in this lecture today,

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that means more projects, new projects, replacement projects, expansion projects are going to be accepted.

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More jobs and all that good stuff, more salaries to buy stuff.

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So this is good news that we see these bond prices beginning to slide down.

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How long it will be before we start to see that in home mortgage loans and in car loans and big ticket item loans?

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That's hard to say. It could be another month or so before that happens.

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But it should begin to take hold in time for people to do more borrowing for the Christmas season and all that good stuff.

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Both the euro and the pound are just bouncing around almost near zero so there's no movement in the international currencies.

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The yen is depreciating against the dollar so there's that but it's kind of hard to say what that means.

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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.

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Nothing big about that and London showed its usual, it was kind of quiet most of the day but then it started getting volatile.

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It spiked in the last trading hour and then it dropped down below but at the end it was down only 0.11%.

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So it looks like the whole world is kind of like sitting what's coming next.

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Anything exciting, you know, a war or something like that, a meteor strike.

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But for right now it's just a quiet market which is actually good for your typical types of investors.

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You don't want lots and lots of volatility in the market anyway.

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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.

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Now just having a look at a couple of more stocks just to keep that in your minds and how to do that.

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We'll look at a couple, start out with VZ, Verizon.

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See how it did today. Oh, it took a little bit of a toilet break.

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It had a spike a few days ago and then it just has been sliding a little bit ever since then.

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Very low risk. Notice that beta is 0.37, undervalued at 7.18 and profitable, just ridiculously profitable, almost $5 a share.

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So, and it pays a really fat dividend.

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So just quickly having a look just to remind you because I will do that on the final.

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I'll ask you to do one of those. Where the heck is my calculator? There it is.

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Okay, quickly looking at the projected one year holding period return gain.

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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.

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And then you subtract one and that gives you times 100 to give you a percent.

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So on the stock price appreciation, you'd make kind of a lousy 4.40%.

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Adding in that nice fat, look at that dividend, a 7.46% dividend yield for 6.

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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.

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Most of that coming from just that nice big fat dividend it pays per share.

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So, I mean, it doesn't suck at all. Verizon is not a high growth rate company by any means.

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It's just so large and it's not going to grow much more.

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The competition is just kind of there and there's nothing new going to happen.

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Moving over to another industry, just look at Procter & Gamble.

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Again, low beta, necessities of life, essentials, stuff like that.

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All those nice things that you buy in the store, Procter & Gamble kind of stuff, 0.46 beta.

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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.

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It's quite profitable. So, look at that price though. Ouch! That's a big price for that stuff.

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Okay, looking at the one year capital gain returns, just to do this one more time.

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If you held it for a year, you bought it today, in a year you'd have, you could sell it for $155.36

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divided by what you paid for it one year before, that is today, 149.74 and then minus one, always minus one,

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and then times it by 100. So, your capital gain, the stock price going up, is only 3.75%.

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That's a big whoop-de-doo, but again, it's a low beta stock. But, you add in the forward dividend yield,

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which is 2.49%, that's kind of lousy compared to Verizon.

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So, you get an overall return that is not spectacular at all, 6.24%. Of course, it's a low beta stock.

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But, if I had a choice between Procter & Gamble and Verizon, I'd go with Verizon.

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It's got a much stronger one year holding period return and most of that's because it's got such a strong dividend.

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Procter & Gamble has a more normal dividend, which is not nearly as good.

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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.

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You just look at the numbers and figure out, well, what's the beta, is that my kind of beta?

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Now, for a lot of people, that might be a beta that's a little on the low side. So, was Verizon's beta?

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You would kind of like a little bit higher, take a little bit more risk.

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But, I mean, with Verizon, for such low risk to get a decent return, it certainly dominates Procter & Gamble,

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at least as far as this quick analysis goes.

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Of course, you'd want to look at some of the fundamentals of both companies, but they're both big companies.

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They're not going to be spectacular, do anything insanely great.

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They're just in a, essentially in economics, you might have learned about oligopolies.

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Oligopolies have a, they're not competitive in the way that monopolistic competitors are.

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Monopolistic competitors are always fiercely fighting against each other, taking market share, new stuff out there to gain an advantage.

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Oligopolies don't work that way. They're on this long, long chessboard that they just kind of watch each other.

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They come out with, they almost mirror each other. You've got Verizon comes out with its new phones.

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Samsung comes out with its, well, they're not the same, but AT&T comes out with its new product packages and all that.

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So they don't really have any way that they can fight their way up to the top.

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They just kind of exist against each other over a period of decades, maybe even centuries.

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So there's that.

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Let me take you on a little bit of a journey here.

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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,

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but it doesn't need much more than a single lecture, and I've gone through some of this before,

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and I'm just reiterating it for the Chapter 11 homework.

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This has to do with what's called capital budgeting, deciding what capital projects you are going to fund

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versus the capital projects that are not worth the company's time to fund.

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That's all capital budgeting means.

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And it boils down to some fairly simple routines.

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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.

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The problem is you just set them up, do a custom job on each one, and I think I do have a template,

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but I mean, you don't really have to do that with these.

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It's just net present value, internal rate of return, and then that beast called modified internal rate of return

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that I showed you much earlier in the semester.

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But it all boils down to the question of whether a project that we are proposing is a go or a no-go.

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That's why I spent yesterday, or yesterday, Monday, yes, talking about free cash flow,

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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.

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We need these free cash flows.

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So in the background, and that's not the subject really here today, revenue minus free cash flow,

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revenue minus cost, minus depreciation and amortization, and then you take that times 1 minus the tax rate.

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And that is what we call the net operating profit after taxes, no pat.

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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.

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I'm not going to do any calculations of free cash flows right now.

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So free cash flow, you then say minus the capital expenditures, minus the change in net operating work and capital.

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So that's what I mean by free cash flow.

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Now let's pretend that that's all by the wayside here, and now we get down to the business.

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Year and the free cash flow.

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Now year zero is the bleed year.

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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.

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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.

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Let's figure out what we have to spend to get it going.

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You have a group that gets together, a committee that goes through, gets the bids for the different parts of the project,

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well gets the set up of the project, gets the cost of the different parts, the machinery, maybe a new factory, whatever.

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So in that first year you have your initial investment.

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Let's say that that initial investment is, well let me, is better seen with a marker that works.

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I've got four here, one of them has to work well.

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Okay, negative $250,000.

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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.

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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.

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Which I'll tell you a little story about this, it's kind of a famous thing, forgetting about inventory.

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Okay, but let's say you're one, the project gets off the ground.

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You're in the introductory phase of the project in that graph that I showed you on Monday.

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So in year one you've got, let's say, a lousy $30,000 in free cash flow from that.

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You're going to project based upon your analysis, and this is actually marketing.

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This is the marketing people's job.

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And then in year two, you get into your growth phase, you get, let's say, $80,000.

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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.

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And then in year four, you're starting to slide back, and you'll get another $40,000, let's say $40,000.

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And then in the last year, this will be a composite.

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You're closing the project down, last year of sales, and you're also going to drain down your inventory,

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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.

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We're just going to write a number down.

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And then in year three, the total value of free cash flow in the last year is $25,000.

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Okay, what do we do with these numbers?

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There are three different ways that you can say go, no go.

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There is an old way. It's almost an ancient way.

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It's been used actually for thousands of years, and it was still very much the way it was done into the 20th century,

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and a surprising number of companies still do it this way now, an appalling number, because it's not a good method.

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It's not best practices, but it's still used.

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It's called the payback period.

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It's really simple, and that's why it's still embraced to this day,

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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.

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Let's say in this example that the payback period is, example, three years.

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Okay, there's the first problem right there.

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This is arbitrary.

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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.

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And it's a policy, and a lot of times, well, I have even asked, well, where did this payback period come from?

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Well, I don't know, we just always use this period.

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This is the right one. Right by whom?

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It's so capricious, so arbitrary.

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But they're just saying a project has to pay back what we put into it within three years.

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So in this example, if I look at this example, down 25, 250,000.

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So after one year, you're still down $220,000.

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After the $30,000, you're still in the hole that much.

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And then after two years, you're still in the hole $140,000, after you get $80,000 more in.

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And after three years, you're still down $20,000.

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And you don't even come up for air until the fourth year, at which time you are up $20,000.

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And at the end, you're up $45,000.

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So this project would be rejected because it didn't cover the initial cost within three years.

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And that's all there is to it. That's the payback period method.

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There are two problems with it. First of all is the arbitrary nature of the three years.

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The other is that these cash flows, they're comparing a cash flow in year zero directly to a cash flow in year one,

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another one in year two. And those, though you can't compare them directly, you'd have to take the present value of those.

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To compare negative $250,000, for example, to $120,000, well, you'd have to discount that $120,000 back to the year zero.

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In other words, the present value three years out of $120,000.

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So you're not comparing numbers that are of the same value as they appear.

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You don't have that time value of money included in.

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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.

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There, that fixes it. Well, not really.

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Because there are other problems. But you're still coming back to the question of the three years. Where is it coming from?

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How serious is this? Well, different surveys have been done. And there are actually three methods.

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This is one of the methods that corporate America, corporate world uses.

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And then there are two much more modern methods. One is called the net present value method.

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And there's another way that is called the internal rate of return method.

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Now, slowly out over the past 50 years, these two more modern methods have begun to dominate the payback period method.

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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.

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But there's something else. The surveys don't show something that I've seen in my work, my discussions with corporate people,

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is that they secretly use the payback period method, even though they would say, well, we use the internal rate of return method.

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They do quick back of the envelope decisions on a payback period.

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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.

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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.

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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.

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In other words, there was an automatic decision that didn't have anything to do with best practices.

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It was just a quick return to the payback period method for decisions on lower end capital expenditures.

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So it's out there, one way or the other. But that's how it works.

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This project actually, in this case, it would pay for itself in exactly three and a half years.

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You look at the break, the pair of break years, and you say, well, the lower one plus the higher one,

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and you divide them by two, and that would mean the zero point would be right there between them.

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But one way or the other, you reject the project because it didn't blow past payback in three years.

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It's off the table.

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Now, let me take you to these two. A couple of quick notes about this.

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These, both of these are modern. And if you're almost anywhere in corporate, marketing, production, obviously finance is where we do this.

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But they will use one of these two methods to decide whether a project is a go or a no-go.

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It's just how they do it.

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The problem is that actually this NPV method is superior to the internal rate of return method.

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For two reasons, and I'll talk about that in a little bit here.

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But the internal rate of return method is more popular than the NPV method.

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Because the internal rate of return method does not require that you calculate a discount rate before you do the problem.

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A discount rate actually comes out of the internal rate of return method.

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Now, if you'll recall, finding the discount rate, there are a couple of ways you could do it.

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You could just guess at a discount rate.

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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.

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Or you could use the capital asset pricing model to do it.

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You know, the beta of the project, throw it into CAPM with the risk-free rate and the expected return to the market portfolio.

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And get a custom discount rate for each project.

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But that requires an extra calculation before you can attack the project using NPV.

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With internal rate of return, the internal rate of return just comes out with an answer.

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Let me show you.

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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.

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And then you add them up and then you subtract the initial investment.

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If it's a positive, then you say go.

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If it's a negative, you say no.

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So in other words, the NPV is simply the sum from I equals, well, let me do it this way.

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I'm going to do it the way Excel does it.

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And this is bad.

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Excel doesn't recognize that the initial investment is part of the NPV,

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which we've tried to talk to Microsoft for years about this and they just ignore us.

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Okay, the initial free cash flow, which is the negative, plus the sum from I equals one to N, the end of the project,

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of the free cash flows of the, I'm sorry, the present value of the free cash flows for each period.

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In other words, you take the present value, add up the present values of all of these,

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and subtract the initial free cash flow, and there's your Uncle Bob.

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That's the NPV.

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If that present value is positive, you accept the project.

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If the NPV is negative, then you reject the project.

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That's all there is to it at the end,

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which kind of in itself is annoying to the people who propose projects, production, the production people,

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the marketing people, we say yes or no based upon an end number.

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That's it.

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Now I'll do one in Excel.

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I'll just do this one in Excel, just so you can see it.

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It is a joy compared to what it used to be.

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Whoops, I didn't mean to do that.

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I meant to expand it.

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Gear, free cash flow, year zero, one, two, three, four, five, free cash flow,

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in this case, negative, 200, 250,000, and then you've got 30,000, 80,000,

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and then you've got 120,000, and then you've got 40,000,

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and then you've got your final year with salvage included and drain of inventory and all that, 25,000.

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Now the one thing we need to do here is we're going to need a discount rate.

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And doing what is wrong, let's say the weighted average cost of capital of this company is 7.5%.

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So we're going to put that somewhere over here, discount rate, 27.5%,

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and then your net present value is equal to, now remember,

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this has to be put in separately, the initial investment, plus, and they call this NPV.

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It's not.

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The NPV should include the initial, but they don't do it that way.

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These, my ass, oh, I forgot.

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I forgot to put in the discount rate.

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My bad.

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And it's going to get to us as a percent, which we want to turn into a number again.

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It's a negative net present value project, so we reject.

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Notice what would have happened if I had had a lower discount rate.

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Let's say 5.25.

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It would have been a positive NPV.

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So the NPV analysis is sensitive to what discount rate you choose.

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If this project is lower than the typical risk of the project,

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7.5% weighted average cost of capital would be too high.

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But notice what would happen if I had a higher discount rate.

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Let's say 9.75.

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Oh, it would have been hashtags.

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So in other words, NPV goes down as discount rate goes up.

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It's a negative relationship.

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So the higher the discount rate you use, the more likely you are to reject a project.

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So you kind of see what I mean that it would be difficult to do a template

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because you have how many years the project is going to go as a critical part of it.

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And the template isn't particularly good for that

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because you have to use a custom number of years for each table you make.

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But it's not too bad.

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Yeah, we're okay.

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Okay, I'll do internal rate of return on Monday.

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I'll extend the deadline for the Chapter 11 homework a little bit for you.

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But right now you need to get ready for a quiz.

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And once you're finished with the quiz, that's all I have for you today.

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Thank you.