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 once I'm finished with that, you have a quiz to take and then that's the end of
it for the week for us.
Happy as that time will be.
And the topic today is actually mostly just Excel and it's not even the kind of thing
you would do on a template.
I'll finish it up on Monday.
I'll extend the deadline for the homework for Chapter 11.
Just so you, if you haven't gotten it done, you'll get it.
And this is a repeat of things that I've covered before in the class.
This is just the formal version of it.
But before we go to that, we have a look at the numbers such as they are.
One of those uninspiring days.
Markets are just basically having no information positive or negative right now.
As you can see, the NASDAQ was up a lousy eight hundredths of a percent.
The S&P 500 was up an even lousier ten hundredths, one tenth of a percent.
And then the Dow was down a little bit.
If you look at the volume on the S&P 500, it was a little more than half of the normal
volume.
It's just that the money is staying off the grid right now as far as investments and securities
go.
And if you look on the bright side, crude is just taking a dive.
It's so far down.
And that will inevitably, within a week or so, bring gasoline prices down, which are
unusually high for this level on the crude oil prices.
The crude oil is just flowing.
It's on the tankers.
It's in the refineries.
It's just a lot of it.
And gold, of course, is collapsing because there's just no reason to believe that the
economy is in some severe crisis.
It's actually in very good shape, as you'll see over here.
The ten-year bond, the yields are dropping precipitously.
And that, of course, is good because as the yields on the benchmark go down, so will go
down other interest rates.
We'll see mortgage rates going down.
We'll see car loans going down, interest rates on big ticket items of other kinds going down.
So that will make the economy stronger.
And especially going into the Christmas season, that's a good idea to have a robust economy,
lower interest rates.
Most likely, those interest rates are easing back because the expected inflation is finally
beginning to drain out of the economy and specifically out of the risk-free rate, which
is the base of all interest rates, as I showed you earlier.
This isn't hard to see.
It's just that the tight monetary policy takes a while to bring down the expectation of inflation.
But it is happening now, thank heaven.
Now the currencies are just sort of bouncing around in their own little world here, not
euro and the pound are not doing much.
The yen is depreciating against the dollar.
So I'm not sure what that is.
But anyway, going over here to the other side of the other parts of the world, Tokyo just
didn't have much to do.
It had another one of those spikes at the opening.
It was up.
And then it just sort of piddled its way down until it finished a third of a percent down
for the day.
That's nothing spectacular, but it's still, there's just sort of a sourness in Tokyo.
And of course, you've got the London doing its thing, not as severely as it has been,
but it just goes up and down and it kind of ends up almost where it started, which is
sort of what happened over here with these indices.
So there's sort of a global sort of directionlessness, if there's such a word, for what's happening
right now in the world economy and in the economies of the developed nations of the
world.
Now quickly, just looking at a couple of stocks just to keep you fresh on this.
Let me start out with, let's try Verizon.
Verizon is a low beta stock, and it's, as you can see,.37 beta, very safe investment
in a well diversified portfolio, and it has a, the PE ratio is indicating that it is noticeably
undervalued.
So, and it pays out, that's a whopping dividend.
So if we looked at the one year holding period return, just to make sure that you don't forget
about that, if you bought it today, then the projection is that in one year, the stock
price will be.3726, divided by your investment one year earlier today of.3577.
Then you always subtract one, and then you multiply the result by 100.
So you've got, that's the capital gain.
In other words, what's your percentage you'll make off the stock going up in price.
And it's a lousy 4.17%.
Well that's a low beta stock, so that's nothing, that's not surprising.
But you add in that dividend yield of 7.46%, and this turns into something of a gem.
I mean you've got a total holding period return, stock price going up, and the dividend check
of 11.63%.
That's not shabby at all.
That's a decent price increase, rather, a decent return.
Especially for a very low beta stock like Verizon.
So one more, we'll look at Procter & Gamble, another low beta stock.
Now Procter & Gamble, its beta is a little bit higher than Verizon's, but it's still
a very safe stock at.46 on the beta.
Not as undervalued, it's still a little undervalued with a PE ratio of 24.43, but it's quite profitable,
$6.14 a share, but that dividend is actually not very impressive compared to Verizon's.
It's actually a more normal dividend yield.
So we do the numbers again and look at this one.
In a year, the projected price of a share of Procter & Gamble is 155.36 divided by an
initial investment right now of about 150.01 minus 1 equals, now we times that by 100.
So the capital gain is a lousy 3.57%.
Now we add in the dividend yield, which is 2.49%.
And you've got kind of a miserable 6.06% total holding period return, annual for one year
hold.
And as you can see, that indicates that Verizon, another low beta stock dominates as far as
an investment choice.
If you had to choose between these, Verizon would be, obviously, it's almost twice as
it'll have a total holding period return for a one year hold of almost twice what Procter
& Gamble will.
And as I've pointed out before, these aren't complicated, technical, graphical, and all
that kind of analyses.
They're just basic numbers and some arithmetic to make some investment decisions, not having
to work through complex mathematics and what these day traders do all the time.
You can see with just the basic numbers which investments are more prospective than others.
Doesn't mean that these are the numbers that will actually happen in a year, but this is
our best estimate right now of what will happen.
And everything in our business is about what is expected, not history at all.
Okay, let's clear out this and I'm going to take you on the little journey here.
Now I kind of mixed together a little bit chapters 11 and 12 because in chapter 11 we
talk about free cash flow and then chapter 12 we sort of lay out how free cash flow works.
So if you remember from Monday, free cash flow would be your revenues minus your costs,
and I should put up here operating costs, operating costs minus your depreciation and
amortization.
And then you take that on an after tax basis by taking that final amount times 1 minus
the tax rate.
This is this mess right here, revenue minus operating costs minus depreciation and amortization,
all times 1 minus the tax rate.
We call that no-pact.
So free cash flow is no-pact and then you take away the actual capital expenditures.
And then you take away the change in net operating working capital.
And that's what buys you your final numbers, your free cash flow.
Here's the thing though.
Now I won't go through any numbers on that because this is taking what you get and using
it in what we call capital budgeting.
This is deciding what projects you're going to fund and which ones you're not going to
fund, accepting some, rejecting others.
The capital budgeting is the core of the decision making at the long term level for any corporation.
This is how the company grows.
Now it can be either these projects can be expansion projects or they can be the replacement
projects, as I explained in the last lecture.
But one way or the other we have to decide yes or no.
And it's actually at the end of the day, once you've got the free cash flow projections,
the rest of it is not that hard.
It's an, well it's certainly not hard anymore with Excel.
Back in the day it was a couple of hours of cranking on a hand calculator or something
like that.
And before that having your math wizards do the actual formulas.
But in order to do this, there are three different ways that we can decide yes or no.
And well let me just write them down.
The oldest way, the oldest way is quite literally ancient.
It I mean we have indications that this was how the decision making was made even into
ancient times.
The payback period method.
And it was still about the only quantitative way that it was done even into the 1950s,
60s, 70s.
This was the way it was done.
Even today the payback period method is used in some corporations.
A survey, recent survey indicated a payback period which is actually not a valid method.
We've got two more modern methods that are valid.
It's still used by about, maybe about a quarter of all corporations.
And that survey, which was an academic, a study that was done by a partnership of industries
and academics, found about a quarter of corporations do this.
However, what they didn't do, which I can tell you is still the case, this is actually
still used for a lot of quick decision making.
Even though it's not valid, it's still used in more than just 25% of corporations or whatever
the number is.
There are two more modern methods.
One is called the net present value method.
And one, the other is called the internal rate of return method.
Now as a side note, as a side note, the more valid method is the net present value, NPV
method.
It is what we call, well I won't get into that, but okay.
The internal rate of return method has a couple of flaws in it, but it's still miles better
than the payback period method.
The reason net present value is not as popular is that you have to do a little more calculating
in the net present value method.
You have to do a calculation before you do the net present value to use the net present
value method.
But I'll get into that in a little bit.
The best way to do this is to just show you an example.
Let's take just a project.
And I'm going to write a table and the year on the left side and the free cash flow on
the right side.
And we'll do a five year project down the left column, zero, one, two, three, four,
and five.
Now the start of the project, going back to what we talked about in the last lecture,
let's say it's negative $250,000.
That's your initial investment.
That includes all of the buying the facilities, the computers, the desks, the work tables
and whatever.
Everything is right there on the front end.
And you go out, you get the bids, you lay out everything you're going to need that's
capital, in other words, long term expenditures.
You get the bids from the different suppliers, you get the low ball bid and you add them
up, there is the capital expenditure.
But there's also going to be other parts too because as I had mentioned before, you're
also going to have in that year before you light up the sign, you're going to have to
build up the inventory.
So there's going to be an increase in net operating working capital which would be another
cost because you have to buy the inventory before you can even start the operation.
There's a story that comes right out of here, out of the area where, not right here, but
it was not too far from here I believe, that there was a group of entrepreneurial types.
They decided they were going to open a restaurant, kind of a higher end restaurant.
Well, they got the capital expenditures and built the restaurant, the frying surfaces,
the refrigerators, the freezers, everything, but they opened the store, they'd forgotten
to add, to buy inventory.
So customers were coming in and they didn't have any food when they did their grand opening
day.
So there you go.
It's one thing for your capital expenditures, but you also got to remember that you're going
to spend money by increasing your net operating working capital.
They did put it in the inventory and so the restaurant closed the first day and it didn't
open back up.
Seems that a lot of the fancy people who would have went in there were a little miffed that
there wasn't any food to sell them.
And then you're into the life of the company.
Let's say the first year, your introductory, $30,000 you pull in.
Well you're cruising along now, you got your introductory and then you go into your growth
phase, $80,000 and you top out at $120,000.
You're still cooking, now you've gotten maturity and you're into your decline, $4,000, $40,000.
And then you have your last sales in year five, you also sell off the last of your inventory
which you don't replace so that depletes net operating working capital which is the cash
inflow and then you have your salvage value and let's just say after tax salvage value
is $25,000 and your revenues and your decrease in inventory, that pulls in $25,000 on the
back end year.
Now there we go, there's your numbers.
Now they're easy here but that's the, in reality you would be doing projections.
Usually you project revenues, your base revenue and then you start projecting percent increase
in revenue.
And then all of the other numbers, kind of a lazy way to do it but this is really how
you do it, how it's done.
You take those percentages of revenue, okay our operating cost will be 40% of revenues
every year and then our depreciation and amortization, we can do that off those depreciation and
amortization tables or Excel does it.
And then down the line you can get everything generating to get your projected free cash
flows.
Once you get the hang of it and if you've got a model in Excel to do it, it's not bad
at all to do it.
It used to be a real pain in the butt.
But anyway there they are.
You got a five year project and this is its profile.
Now let me take you through the first of the methods.
Payback period.
The payback period starts with an assumption which is the deepest of all the flaws in it.
A corporate policy will be in place.
For example, let's say that the payback period according to corporate policy is three years.
Now what that means is that in this corporation any project would have to pay back the initial
investment in three years or less.
So if you look at this one, at the beginning you're down $250,000.
After the first year with $30,000 coming in, you're now down $220,000.
After the second year of operation, you're down, that brings in $80,000 more, you're
down $140,000.
And then in the third year with $120,000 more in, you're down $20,000.
Then in the fifth year with $40,000 more in, you're up $20,000.
And then by the end with the final punch of $25,000, you're up $45,000.
Now by the payback period method we would reject this project because it didn't clear
by the end of the third year.
In fact, in this case, it was exactly halfway through that it cleared the fourth year.
So in other words, the payback period was 3.5 years, which was greater than the policy
and so we reject the project.
It is simple and it seems to make sense.
The first major flaw, well, there's one flaw that is more of a financial matter.
Those numbers, $30,000, $80,000, $120,000, $40,000, $25,000, those, you can't compare
those to each other or to the initial investment because you would have to take all of them
back to the present value.
As it stands, $30,000 in in the first year.
You can't compare that to the negative $250,000 unless you've taken the present value of $30,000
back one year.
Similarly, in the second year, $80,000, that's not comparable to the negative $250,000 because
you would have to take the present value of $80,000 two years back in order to make it
in the same time units as the initial investment.
So it ignores the time value of money.
Now there is a variation on payback period method called discounted payback period method
where they do that.
They correct each of those free cash flows years one through five.
They discount them back the appropriate number of years.
And then they say, well, that takes care of that problem.
So it's a great method.
No, it's not.
The simple reason is the three years.
Where did that come from?
In my consulting time, every time I ask that, well, that just sounds like it's right.
Or that's what we've always used, so we're going to use it for everything we do.
It's consistency.
Well, if you're consistently using turds to make your sandwiches, that doesn't make the
sandwiches any healthier.
That's the problem is it has that completely arbitrary number there that drives the entire
decision that you make, yes or no, except to reject the project.
So that's where it falls down completely, even though it is used.
And as I had said before, and I'll make a mention of this, it was almost two years ago,
I was at a dinner with some executives of a company out of Peoria.
And the treasury, the second in command in their treasury, the finance department, was
talking about having to lecture this one of her subordinates who had a project.
It was a low cost, quick project.
It was going to cost about 25 grand, and this executive would say, well, you just think
about it.
It was going to make $10,000 the first year, and then $10,000 the second year, and $10,000
the third year.
That's three years before it pays off.
And I thought, that executive turned it down using a mental payback period method.
Didn't calculate net present value, anything like that, just did a mental calculation of
a payback period and rejected the project, even though the company itself uses internal
rate of return for capital budgeting.
So it's more widespread than just what you might see in official surveys, the payback
period method seems to make sense, but it doesn't, because one, you're not discounting,
and two, you're picking an arbitrary number of years to cut off as a cutoff.
So there you are.
That's that one.
Along comes the 20th century, the last half of the 20th century, and it was not embraced
well at all, really until I would say the 1990s, these two more modern methods, net
present value and internal rate of return.
I was in the fray at the time when the transition was being made.
We were teaching it in classes like this, these two new methods, and then they were
filtering out into corporate, and they were bringing the new ways, the new technology
of decision making with them, and then it started to creep in.
So you are the inheritors of that first wave in a generation or so before you.
But here's how net present value works.
I'll do internal rate of return on Tuesday, or on Monday of next week.
But the net present value is just gloriously simple in theory, and also in Excel.
The only problem with the, and this is one that the internal rate of return method doesn't
suffer, but unfortunately, the internal rate of return method is weaker because it doesn't
do this warmup.
You see the internal rate of return method needs a discount rate.
You have to discount cash flows.
So what percentage do you use for the discount rate?
Most corporations take the lazy approach.
They just say, well, we'll use the weighted average cost of capital.
That's a bad idea because weighted average cost of capital is measuring the overall risk
of all the projects of the corporation as a portfolio.
But as I had fussed about on Monday, we're supposed to sandbox new projects.
They are not part of the company yet.
They have their own risk.
Now a project might be less risk than the overall risk of the company, in which case
the whack would be a number two high.
Or this could be a riskier project than the typical project of the company, the average
project of the company.
So the discount rate you use would be higher than the weighted average cost of capital.
But one way or the other, now a better method to get the right discount rate for a project
would probably be to use the capital asset pricing model.
Get the beta of the project and then just throw it into that R sub F plus the beta times
the expected return to the market portfolio minus the risk free rate.
And then you'd get a real one.
But there's a problem.
What beta?
Where would you get the beta?
Now that would be kind of, and I think I mentioned this before, you've got a project.
You don't know a beta.
There's not a beta stamped on the project.
What you would probably do is go out and look at a bunch of companies that were specializing
in that kind of project.
That was their thing.
And then you take an average of their betas.
And that would be a good shot at the beta of your project that was like theirs.
In other words, you wouldn't be looking at conglomerate companies.
You'd be looking at specialty companies that do just this kind of project and see what
kinds of betas they were generating.
And then you just throw it into the capital asset pricing model, get the risk free rate,
the expected return to the market portfolio, and just do that simple equation.
But one way or the other, one way or the other, we are going to need a discount rate for the,
if we're going to do an NPV, then we're going to need a discount rate.
So for lack of any better inspiration, let's use the WAC, notwithstanding what I just said
about that, which is standing at 7.50%.
And we crank it.
And I'll do this again on Thursday so you can see it one more time.
Or Wednesday, I'm sorry.
But you put in the year.
Try that again.
Year free cash flow, discount rate.
Year zero, one, two, three, four, five.
Put in the free cash flows, which would be negative 250,000, 30,000 in year one, 80,000
in year two, 120,000 in year three, 40,000 in year four, and 25,000 in the terminal year.
And we put in a weighted average cost of capital here of 7.5%.
Now here's where Excel really annoys us in finance.
Because the net present value, you're going to take the present value back to the time
now of all of the positive free cash flows minus the initial investment.
It's all the net present value.
But Excel doesn't think that's the case.
Excel expects you to put in the initial investments separately.
So I'm going to say equals B2 plus NPV, open the parenthesis, and I'm going to put in the
discount rate, comma, the positive free cash flows.
What did I do wrong there?
We reject the project.
It's got a negative NPV.
It's simple.
If NPV is positive, accept.
If NPV is negative, reject.
That's all there is to it.
And notice how quick it is in Excel.
Why don't you notice something?
Notice that I had said, well, actually, the discount rate should have been 6.00%.
Oh, look.
The NPV becomes positive.
In other words, the NPV is inversely related to the discount rate.
You lower the discount rate.
The NPV goes up.
So if I use 6.00%, I accept the project because it has an NPV of $621.12.
So there you are.
That's the net present value.
As you can see, like I said, you can't even really do this on a template because different
projects would have different numbers of years, and you have to fill in, you have to create
the table based upon the number of years.
But it's really straightforward.
That's all there is to it.
And the internal rate of return is even easier because the internal rate of return, you don't
need a discount rate.
It generates a discount rate, which is also its greatest weakness too.
But anyway, that's all I have as far as the lecture goes.
You now have a quiz to take.
And once you're finished with that, that's all I have for you today.
I thank you.