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Alan Kring Productions in association with Emergent Light Studio presents the Illinois

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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.

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And once I'm finished with that, you have a quiz to take and then that's the end of

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it for the week for us.

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Happy as that time will be.

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And the topic today is actually mostly just Excel and it's not even the kind of thing

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you would do on a template.

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I'll finish it up on Monday.

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I'll extend the deadline for the homework for Chapter 11.

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Just so you, if you haven't gotten it done, you'll get it.

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And this is a repeat of things that I've covered before in the class.

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This is just the formal version of it.

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But before we go to that, we have a look at the numbers such as they are.

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One of those uninspiring days.

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Markets are just basically having no information positive or negative right now.

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As you can see, the NASDAQ was up a lousy eight hundredths of a percent.

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The S&P 500 was up an even lousier ten hundredths, one tenth of a percent.

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And then the Dow was down a little bit.

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If you look at the volume on the S&P 500, it was a little more than half of the normal

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volume.

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It's just that the money is staying off the grid right now as far as investments and securities

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go.

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And if you look on the bright side, crude is just taking a dive.

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It's so far down.

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And that will inevitably, within a week or so, bring gasoline prices down, which are

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unusually high for this level on the crude oil prices.

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The crude oil is just flowing.

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It's on the tankers.

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It's in the refineries.

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It's just a lot of it.

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And gold, of course, is collapsing because there's just no reason to believe that the

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economy is in some severe crisis.

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It's actually in very good shape, as you'll see over here.

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The ten-year bond, the yields are dropping precipitously.

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And that, of course, is good because as the yields on the benchmark go down, so will go

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down other interest rates.

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We'll see mortgage rates going down.

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We'll see car loans going down, interest rates on big ticket items of other kinds going down.

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So that will make the economy stronger.

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And especially going into the Christmas season, that's a good idea to have a robust economy,

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lower interest rates.

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Most likely, those interest rates are easing back because the expected inflation is finally

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beginning to drain out of the economy and specifically out of the risk-free rate, which

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is the base of all interest rates, as I showed you earlier.

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This isn't hard to see.

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It's just that the tight monetary policy takes a while to bring down the expectation of inflation.

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But it is happening now, thank heaven.

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Now the currencies are just sort of bouncing around in their own little world here, not

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euro and the pound are not doing much.

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The yen is depreciating against the dollar.

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So I'm not sure what that is.

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But anyway, going over here to the other side of the other parts of the world, Tokyo just

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didn't have much to do.

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It had another one of those spikes at the opening.

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It was up.

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And then it just sort of piddled its way down until it finished a third of a percent down

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for the day.

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That's nothing spectacular, but it's still, there's just sort of a sourness in Tokyo.

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And of course, you've got the London doing its thing, not as severely as it has been,

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but it just goes up and down and it kind of ends up almost where it started, which is

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sort of what happened over here with these indices.

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So there's sort of a global sort of directionlessness, if there's such a word, for what's happening

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right now in the world economy and in the economies of the developed nations of the

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world.

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Now quickly, just looking at a couple of stocks just to keep you fresh on this.

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Let me start out with, let's try Verizon.

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Verizon is a low beta stock, and it's, as you can see,.37 beta, very safe investment

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in a well diversified portfolio, and it has a, the PE ratio is indicating that it is noticeably

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undervalued.

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So, and it pays out, that's a whopping dividend.

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So if we looked at the one year holding period return, just to make sure that you don't forget

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about that, if you bought it today, then the projection is that in one year, the stock

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price will be.3726, divided by your investment one year earlier today of.3577.

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Then you always subtract one, and then you multiply the result by 100.

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So you've got, that's the capital gain.

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In other words, what's your percentage you'll make off the stock going up in price.

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And it's a lousy 4.17%.

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Well that's a low beta stock, so that's nothing, that's not surprising.

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But you add in that dividend yield of 7.46%, and this turns into something of a gem.

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I mean you've got a total holding period return, stock price going up, and the dividend check

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of 11.63%.

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That's not shabby at all.

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That's a decent price increase, rather, a decent return.

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Especially for a very low beta stock like Verizon.

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So one more, we'll look at Procter & Gamble, another low beta stock.

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Now Procter & Gamble, its beta is a little bit higher than Verizon's, but it's still

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a very safe stock at.46 on the beta.

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Not as undervalued, it's still a little undervalued with a PE ratio of 24.43, but it's quite profitable,

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$6.14 a share, but that dividend is actually not very impressive compared to Verizon's.

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It's actually a more normal dividend yield.

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So we do the numbers again and look at this one.

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In a year, the projected price of a share of Procter & Gamble is 155.36 divided by an

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initial investment right now of about 150.01 minus 1 equals, now we times that by 100.

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So the capital gain is a lousy 3.57%.

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Now we add in the dividend yield, which is 2.49%.

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And you've got kind of a miserable 6.06% total holding period return, annual for one year

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hold.

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And as you can see, that indicates that Verizon, another low beta stock dominates as far as

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an investment choice.

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If you had to choose between these, Verizon would be, obviously, it's almost twice as

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it'll have a total holding period return for a one year hold of almost twice what Procter

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& Gamble will.

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And as I've pointed out before, these aren't complicated, technical, graphical, and all

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that kind of analyses.

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They're just basic numbers and some arithmetic to make some investment decisions, not having

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to work through complex mathematics and what these day traders do all the time.

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You can see with just the basic numbers which investments are more prospective than others.

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Doesn't mean that these are the numbers that will actually happen in a year, but this is

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our best estimate right now of what will happen.

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And everything in our business is about what is expected, not history at all.

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Okay, let's clear out this and I'm going to take you on the little journey here.

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Now I kind of mixed together a little bit chapters 11 and 12 because in chapter 11 we

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talk about free cash flow and then chapter 12 we sort of lay out how free cash flow works.

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So if you remember from Monday, free cash flow would be your revenues minus your costs,

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and I should put up here operating costs, operating costs minus your depreciation and

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amortization.

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And then you take that on an after tax basis by taking that final amount times 1 minus

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the tax rate.

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This is this mess right here, revenue minus operating costs minus depreciation and amortization,

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all times 1 minus the tax rate.

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We call that no-pact.

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So free cash flow is no-pact and then you take away the actual capital expenditures.

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And then you take away the change in net operating working capital.

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And that's what buys you your final numbers, your free cash flow.

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Here's the thing though.

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Now I won't go through any numbers on that because this is taking what you get and using

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it in what we call capital budgeting.

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This is deciding what projects you're going to fund and which ones you're not going to

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fund, accepting some, rejecting others.

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The capital budgeting is the core of the decision making at the long term level for any corporation.

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This is how the company grows.

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Now it can be either these projects can be expansion projects or they can be the replacement

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projects, as I explained in the last lecture.

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But one way or the other we have to decide yes or no.

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And it's actually at the end of the day, once you've got the free cash flow projections,

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the rest of it is not that hard.

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It's an, well it's certainly not hard anymore with Excel.

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Back in the day it was a couple of hours of cranking on a hand calculator or something

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like that.

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And before that having your math wizards do the actual formulas.

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But in order to do this, there are three different ways that we can decide yes or no.

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And well let me just write them down.

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The oldest way, the oldest way is quite literally ancient.

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It I mean we have indications that this was how the decision making was made even into

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ancient times.

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The payback period method.

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And it was still about the only quantitative way that it was done even into the 1950s,

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60s, 70s.

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This was the way it was done.

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Even today the payback period method is used in some corporations.

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A survey, recent survey indicated a payback period which is actually not a valid method.

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We've got two more modern methods that are valid.

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It's still used by about, maybe about a quarter of all corporations.

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And that survey, which was an academic, a study that was done by a partnership of industries

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and academics, found about a quarter of corporations do this.

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However, what they didn't do, which I can tell you is still the case, this is actually

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still used for a lot of quick decision making.

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Even though it's not valid, it's still used in more than just 25% of corporations or whatever

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the number is.

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There are two more modern methods.

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One is called the net present value method.

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And one, the other is called the internal rate of return method.

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Now as a side note, as a side note, the more valid method is the net present value, NPV

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method.

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It is what we call, well I won't get into that, but okay.

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The internal rate of return method has a couple of flaws in it, but it's still miles better

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than the payback period method.

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The reason net present value is not as popular is that you have to do a little more calculating

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in the net present value method.

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You have to do a calculation before you do the net present value to use the net present

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value method.

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But I'll get into that in a little bit.

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The best way to do this is to just show you an example.

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Let's take just a project.

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And I'm going to write a table and the year on the left side and the free cash flow on

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the right side.

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And we'll do a five year project down the left column, zero, one, two, three, four,

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and five.

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Now the start of the project, going back to what we talked about in the last lecture,

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let's say it's negative $250,000.

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That's your initial investment.

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That includes all of the buying the facilities, the computers, the desks, the work tables

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and whatever.

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Everything is right there on the front end.

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And you go out, you get the bids, you lay out everything you're going to need that's

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capital, in other words, long term expenditures.

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You get the bids from the different suppliers, you get the low ball bid and you add them

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up, there is the capital expenditure.

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But there's also going to be other parts too because as I had mentioned before, you're

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also going to have in that year before you light up the sign, you're going to have to

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build up the inventory.

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So there's going to be an increase in net operating working capital which would be another

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cost because you have to buy the inventory before you can even start the operation.

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There's a story that comes right out of here, out of the area where, not right here, but

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it was not too far from here I believe, that there was a group of entrepreneurial types.

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They decided they were going to open a restaurant, kind of a higher end restaurant.

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Well, they got the capital expenditures and built the restaurant, the frying surfaces,

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the refrigerators, the freezers, everything, but they opened the store, they'd forgotten

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to add, to buy inventory.

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So customers were coming in and they didn't have any food when they did their grand opening

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day.

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So there you go.

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It's one thing for your capital expenditures, but you also got to remember that you're going

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to spend money by increasing your net operating working capital.

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They did put it in the inventory and so the restaurant closed the first day and it didn't

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open back up.

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Seems that a lot of the fancy people who would have went in there were a little miffed that

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there wasn't any food to sell them.

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And then you're into the life of the company.

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Let's say the first year, your introductory, $30,000 you pull in.

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Well you're cruising along now, you got your introductory and then you go into your growth

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phase, $80,000 and you top out at $120,000.

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You're still cooking, now you've gotten maturity and you're into your decline, $4,000, $40,000.

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And then you have your last sales in year five, you also sell off the last of your inventory

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which you don't replace so that depletes net operating working capital which is the cash

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inflow and then you have your salvage value and let's just say after tax salvage value

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is $25,000 and your revenues and your decrease in inventory, that pulls in $25,000 on the

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back end year.

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Now there we go, there's your numbers.

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Now they're easy here but that's the, in reality you would be doing projections.

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Usually you project revenues, your base revenue and then you start projecting percent increase

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in revenue.

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And then all of the other numbers, kind of a lazy way to do it but this is really how

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you do it, how it's done.

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You take those percentages of revenue, okay our operating cost will be 40% of revenues

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every year and then our depreciation and amortization, we can do that off those depreciation and

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amortization tables or Excel does it.

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And then down the line you can get everything generating to get your projected free cash

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flows.

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Once you get the hang of it and if you've got a model in Excel to do it, it's not bad

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at all to do it.

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It used to be a real pain in the butt.

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But anyway there they are.

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You got a five year project and this is its profile.

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Now let me take you through the first of the methods.

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Payback period.

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The payback period starts with an assumption which is the deepest of all the flaws in it.

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A corporate policy will be in place.

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For example, let's say that the payback period according to corporate policy is three years.

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Now what that means is that in this corporation any project would have to pay back the initial

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investment in three years or less.

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So if you look at this one, at the beginning you're down $250,000.

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After the first year with $30,000 coming in, you're now down $220,000.

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After the second year of operation, you're down, that brings in $80,000 more, you're

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down $140,000.

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And then in the third year with $120,000 more in, you're down $20,000.

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Then in the fifth year with $40,000 more in, you're up $20,000.

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And then by the end with the final punch of $25,000, you're up $45,000.

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Now by the payback period method we would reject this project because it didn't clear

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by the end of the third year.

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In fact, in this case, it was exactly halfway through that it cleared the fourth year.

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So in other words, the payback period was 3.5 years, which was greater than the policy

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and so we reject the project.

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It is simple and it seems to make sense.

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The first major flaw, well, there's one flaw that is more of a financial matter.

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Those numbers, $30,000, $80,000, $120,000, $40,000, $25,000, those, you can't compare

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those to each other or to the initial investment because you would have to take all of them

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back to the present value.

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As it stands, $30,000 in in the first year.

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You can't compare that to the negative $250,000 unless you've taken the present value of $30,000

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back one year.

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Similarly, in the second year, $80,000, that's not comparable to the negative $250,000 because

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you would have to take the present value of $80,000 two years back in order to make it

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in the same time units as the initial investment.

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So it ignores the time value of money.

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Now there is a variation on payback period method called discounted payback period method

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where they do that.

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They correct each of those free cash flows years one through five.

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They discount them back the appropriate number of years.

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And then they say, well, that takes care of that problem.

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So it's a great method.

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No, it's not.

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The simple reason is the three years.

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Where did that come from?

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In my consulting time, every time I ask that, well, that just sounds like it's right.

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Or that's what we've always used, so we're going to use it for everything we do.

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It's consistency.

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Well, if you're consistently using turds to make your sandwiches, that doesn't make the

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sandwiches any healthier.

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That's the problem is it has that completely arbitrary number there that drives the entire

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decision that you make, yes or no, except to reject the project.

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So that's where it falls down completely, even though it is used.

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And as I had said before, and I'll make a mention of this, it was almost two years ago,

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I was at a dinner with some executives of a company out of Peoria.

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And the treasury, the second in command in their treasury, the finance department, was

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talking about having to lecture this one of her subordinates who had a project.

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It was a low cost, quick project.

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It was going to cost about 25 grand, and this executive would say, well, you just think

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about it.

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It was going to make $10,000 the first year, and then $10,000 the second year, and $10,000

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the third year.

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That's three years before it pays off.

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And I thought, that executive turned it down using a mental payback period method.

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Didn't calculate net present value, anything like that, just did a mental calculation of

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a payback period and rejected the project, even though the company itself uses internal

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rate of return for capital budgeting.

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So it's more widespread than just what you might see in official surveys, the payback

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period method seems to make sense, but it doesn't, because one, you're not discounting,

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and two, you're picking an arbitrary number of years to cut off as a cutoff.

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So there you are.

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That's that one.

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Along comes the 20th century, the last half of the 20th century, and it was not embraced

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well at all, really until I would say the 1990s, these two more modern methods, net

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present value and internal rate of return.

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I was in the fray at the time when the transition was being made.

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We were teaching it in classes like this, these two new methods, and then they were

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filtering out into corporate, and they were bringing the new ways, the new technology

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of decision making with them, and then it started to creep in.

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So you are the inheritors of that first wave in a generation or so before you.

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But here's how net present value works.

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I'll do internal rate of return on Tuesday, or on Monday of next week.

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But the net present value is just gloriously simple in theory, and also in Excel.

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The only problem with the, and this is one that the internal rate of return method doesn't

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suffer, but unfortunately, the internal rate of return method is weaker because it doesn't

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do this warmup.

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You see the internal rate of return method needs a discount rate.

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You have to discount cash flows.

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So what percentage do you use for the discount rate?

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Most corporations take the lazy approach.

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They just say, well, we'll use the weighted average cost of capital.

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That's a bad idea because weighted average cost of capital is measuring the overall risk

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of all the projects of the corporation as a portfolio.

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But as I had fussed about on Monday, we're supposed to sandbox new projects.

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They are not part of the company yet.

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They have their own risk.

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Now a project might be less risk than the overall risk of the company, in which case

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the whack would be a number two high.

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Or this could be a riskier project than the typical project of the company, the average

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project of the company.

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So the discount rate you use would be higher than the weighted average cost of capital.

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But one way or the other, now a better method to get the right discount rate for a project

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would probably be to use the capital asset pricing model.

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Get the beta of the project and then just throw it into that R sub F plus the beta times

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the expected return to the market portfolio minus the risk free rate.

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And then you'd get a real one.

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But there's a problem.

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What beta?

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Where would you get the beta?

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Now that would be kind of, and I think I mentioned this before, you've got a project.

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You don't know a beta.

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There's not a beta stamped on the project.

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What you would probably do is go out and look at a bunch of companies that were specializing

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in that kind of project.

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That was their thing.

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And then you take an average of their betas.

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And that would be a good shot at the beta of your project that was like theirs.

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In other words, you wouldn't be looking at conglomerate companies.

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You'd be looking at specialty companies that do just this kind of project and see what

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kinds of betas they were generating.

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And then you just throw it into the capital asset pricing model, get the risk free rate,

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the expected return to the market portfolio, and just do that simple equation.

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But one way or the other, one way or the other, we are going to need a discount rate for the,

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00:33:25,360 --> 00:33:31,680
if we're going to do an NPV, then we're going to need a discount rate.

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So for lack of any better inspiration, let's use the WAC, notwithstanding what I just said

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about that, which is standing at 7.50%.

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And we crank it.

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00:33:53,640 --> 00:33:58,080
And I'll do this again on Thursday so you can see it one more time.

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00:33:58,080 --> 00:34:00,520
Or Wednesday, I'm sorry.

361
00:34:00,520 --> 00:34:03,560
But you put in the year.

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00:34:03,560 --> 00:34:09,720
Try that again.

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00:34:09,720 --> 00:34:12,440
Year free cash flow, discount rate.

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00:34:12,440 --> 00:34:19,600
Year zero, one, two, three, four, five.

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00:34:19,600 --> 00:34:35,680
Put in the free cash flows, which would be negative 250,000, 30,000 in year one, 80,000

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00:34:35,680 --> 00:34:56,760
in year two, 120,000 in year three, 40,000 in year four, and 25,000 in the terminal year.

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And we put in a weighted average cost of capital here of 7.5%.

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Now here's where Excel really annoys us in finance.

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00:35:13,680 --> 00:35:21,640
Because the net present value, you're going to take the present value back to the time

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00:35:21,640 --> 00:35:31,160
now of all of the positive free cash flows minus the initial investment.

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00:35:31,160 --> 00:35:33,640
It's all the net present value.

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00:35:33,640 --> 00:35:38,600
But Excel doesn't think that's the case.

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Excel expects you to put in the initial investments separately.

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00:35:46,560 --> 00:35:57,280
So I'm going to say equals B2 plus NPV, open the parenthesis, and I'm going to put in the

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00:35:57,280 --> 00:36:03,880
discount rate, comma, the positive free cash flows.

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00:36:03,880 --> 00:36:14,720
What did I do wrong there?

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00:36:14,720 --> 00:36:17,880
We reject the project.

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00:36:17,880 --> 00:36:19,160
It's got a negative NPV.

379
00:36:19,160 --> 00:36:20,160
It's simple.

380
00:36:20,160 --> 00:36:22,680
If NPV is positive, accept.

381
00:36:22,680 --> 00:36:25,560
If NPV is negative, reject.

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00:36:25,560 --> 00:36:27,800
That's all there is to it.

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00:36:27,800 --> 00:36:32,240
And notice how quick it is in Excel.

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00:36:32,240 --> 00:36:35,000
Why don't you notice something?

385
00:36:35,000 --> 00:36:45,280
Notice that I had said, well, actually, the discount rate should have been 6.00%.

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00:36:45,280 --> 00:36:48,480
Oh, look.

387
00:36:48,480 --> 00:36:52,400
The NPV becomes positive.

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00:36:52,400 --> 00:37:00,320
In other words, the NPV is inversely related to the discount rate.

389
00:37:00,320 --> 00:37:02,920
You lower the discount rate.

390
00:37:02,920 --> 00:37:06,800
The NPV goes up.

391
00:37:06,800 --> 00:37:18,800
So if I use 6.00%, I accept the project because it has an NPV of $621.12.

392
00:37:18,800 --> 00:37:22,320
So there you are.

393
00:37:22,320 --> 00:37:23,600
That's the net present value.

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00:37:23,600 --> 00:37:28,720
As you can see, like I said, you can't even really do this on a template because different

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00:37:28,720 --> 00:37:33,640
projects would have different numbers of years, and you have to fill in, you have to create

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00:37:33,640 --> 00:37:36,680
the table based upon the number of years.

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00:37:36,680 --> 00:37:38,960
But it's really straightforward.

398
00:37:38,960 --> 00:37:41,440
That's all there is to it.

399
00:37:41,440 --> 00:37:47,200
And the internal rate of return is even easier because the internal rate of return, you don't

400
00:37:47,200 --> 00:37:49,520
need a discount rate.

401
00:37:49,520 --> 00:37:55,080
It generates a discount rate, which is also its greatest weakness too.

402
00:37:55,080 --> 00:37:59,440
But anyway, that's all I have as far as the lecture goes.

403
00:37:59,440 --> 00:38:02,640
You now have a quiz to take.

404
00:38:02,640 --> 00:38:06,080
And once you're finished with that, that's all I have for you today.

405
00:38:06,080 --> 00:38:26,480
I thank you.