Major capital investment are a significant operational, organizational and financial stress in any company. But apart from that, these investments are also a managerial stress, since a poorly chosen investment can become a cash hog and cause losses in the end. Because of these reasons, and having in mind that the target of all managers is to increase profits and shareholder value, a controlled process of investment evaluation is needed before every investment. This paper will investigate the process of capital budgeting through the case study of XYZ Company projects. In the first part, we will investigate the literature to identify the methods used in capital budgeting, which will then be applied to the project proposals of XYZ Company in order to select the better project proposal In the second part, we will investigate the options of XYZ Company for Sources of Capital, Capital Rationing and Capital Structure. In the third part, we will explore the effect that the proposed projects in XYZ Company will have on the shareholder value in the longer term (the expected lifetime of the investment) Capital Budgeting Capital budgeting as a process is tasked with planning and evaluation of capital investments. The end result of capital budgeting process is an answer whether and which investments will bring value to the company (Brealey and Myers, 2003; Sheffrin and O’Sullivan, 2007). While there are multiple ways of generating value for the stakeholders of the company, proper investment in capital assets is one of the most prominent ones.
This is simply because capital investments are long-lived, an error in the capital budgeting will be felt for a long time. In order to provide maximum return and value to the shareholders, each manager should engage in a process of analysis of possible investment decisions, using well-known and tested methodologies and approaches. The end result of the analysis should be a ranking of all projects by their expected rates of return. In order to maximize value, managers should focus on implementing projects with high expected rates of return. The process of capital budgeting investigates possible future outcomes, and includes multiple analysis methods. Most of these methods observe the incremental cash flows of the possible capital investment and their timing, and do not concern themselves with profit. In order to properly investigate the future outcomes and perform an analysis, the process of capital budgeting uses discounted cash flows, which are applied as Present Value (PV) of future cash flows (International Federation of Accountants, 2008). The two most common methods of discounted cash flows analysis in Capital Budgeting are the Net Present Value (NPV) and Internal Rate of Return (IRR) (Brijlal and Quesada, 2009). The results of these methods are frequently disputed by the literature, but they are still the preferred A¿A½weapon of choiceA¿A½ when performing a financial analysis of a project. In order to minimize the risk of poor project selection, most managers will use multiple methods to confirm their decision. The calculation of NPV represents the current value of the future payoff, and the basic rule is that a project should go ahead only of the NPV is greater than the investment (Brealey and Myers, 2003). The second most frequent method of calculation is the Internal Rate of Return (IRR) (Corelia, 2012), which returns the discount rate at which the NPV is equal to zero (Brealey and Myers, 2003; International Federation of Accountants, 2008; Corelia, 2012). Both these methods are dependent upon the external economic environment, and in order to provide a proper estimate, the analyst must observe the cost of capital, the zero-risk returns as well as the returns of other investments for the same capital (International Federation of Accountants, 2008). The NPV as the most commonly used method gives the difference amount between the present value of the investment to the present value of all future inflows/outflows of money related to the investment. The difficulty of NPV is the proper assessment of the discount rate which includes both risk-free return and market return which is difficult to properly assess. A method that uses the same inputs as NPV is Profitability Index (PI). Instead of subtracting the present value of investment from the present value of future cash flows, it divides the two values, thus resulting in a ratio which presents the amount of value generated. Again, the discount rate of future cash flows must be calculated prior to the calculation of NPV, so both methods have the same weak point. The IRR method takes another approach A¿A½ it returns the discount value at which the difference between the present value of the investment and the future inflows of money are equal, i.e. the discount rate at which NPV = 0. This gives the analyst a reference point (worst case scenario) of discount which he/she can compare to the factors included in the calculation of the NPV discount rate. If the calculated discount rate is less then IRR, the project returns value into the company. A A¿A½quick and dirtyA¿A½ method of selecting a project is through the calculation of a payback period (PP). The PP calculation simply estimates the time needed for the investment A¿A½to pay for itselfA¿A½ A¿A½ earn the invested amount of money.
Projects with shorter payback periods are preferred, but the method ignores two potentially very important elements: the time value of money, and there is no interest in the future cash flows after the payback period (Brealey and Myers, 2002). Capital Budgeting Evaluation of XYZ Project Proposals This chapter will perform Capital Budgeting analysis of the options available to the Management of Company XYZ in the form of project proposals for purchase of new press machine. The following table presents the summary of all methodologies of capital budgeting analysis applied to the proposed projects. The full set of tables of the analysis is included in Appendix A through E. We will discuss the results of each methodology. Press A Press B Net Present Value (CAPM) $98,485.65 $88,242.35 IRR 18.86% 21.15% Profitability Index 115.21% 121.14% Payback Period (years) 3.69 3.25 Net Present Value (BYPRP) at 4% risk premium $20,297.69 $37,569.58 All NPV calculations rely on the NPV discount rate which is the indicator of the expected risk premium.
The most commonly used risk premium calculation method is the Capital asset pricing model (CAPM). R_i=R_f+A¿A½(R_m-R_f) Where R_i is the expected return on the capital asset, R_f is the risk-free return, R_mis the expected return of the capital market and A¿A½ is the sensitivity. This is the most common and basic NPV calculation, and using this calculation we arrive at a higher NPV for Press A then Press B, thus indicating Press A as the better choice. As a second methodology, an Internal Rate of Return (IRR) is calculated, which returns the risk premium level at which the project will yield an NPV of 0. The IRR for Press A is 18.86% while the IRR for Press B is 21.15%. The IRR calculation puts Press B at an advantage, since Press B will bring value if the risk premium is higher then Press A, up to 21.15% Although NPV is considered superior to IRR (Wong, 2000), Since the two most common methodologies for capital budgeting did not yield the same result, additional capital budgeting methods need to be applied to properly choose the optimal investment. Another method of evaluating the project value, which supplements IRR is the Profitability Index (PI). PI is an indicator of the quantity of value that is created per dollar/unit of investment. The PI takes into account the time value of money by calculating the present value of future cash flows. In the case of XYZ Company, the PI index is more favorable to Project B, which returns more then 1.2 dollars per dollar invested, while Project A returns only 1.15 dollars per dollar invested. The payback period (PP) is also calculated for both projects, as a quick test of recouping the investment, without taking into account the time value of money. The PP value for project A is 3.69 years, while project B will pay for itself in 3.25 years, thus again putting Project B at an advantage over Project A. CAPM methodology was applied for calculation of discount rate used in NPV and PI. This methodology is met with discussion (Magni, 2009), which may indicate a use of another methodology for discount rate calculation. This approach is also supported by (Brigham and Ehrhardt, 2011), which identify the Bond Yield Plus Risk Premium (BYPRP) method of calculating the discount rate as the approach when wishing to adjust the discount rate and include the companyA¿A½s judgmental risk on the cost of equity. (Brigham and Ehrhardt, 2011) conclude that the judgmental risk premium is applied by adding between 3% and 5% to the CAPM discount rate, depending on historical trends and future estimates. Applying the higher risk discount rate should be primarily applied to the Press A investment due to itA¿A½s higher cost and therefore greater exposure to debt, but we have applied it to both Presses, just to simulate worst case scenario on both presses. To apply the judgmental risk into the calculation we will recalculate the NPV using Bond Yield Plus Risk Premium model for calculating the NPV discount rate. We will take a more risk-averse position and apply a risk premium of 4% After applying the BYPRP discount rate to NPV, the NPV results in a higher value for Press B, thus confirming the results given by IRR, PI and PP. In order to view the movement of NPV in relation to risk, we created a simulation on multiple levels of risk premium.
The following diagram presents a simulation of NPV of both presses for varying levels of additional risk premium, from 1% up to 7% risk premium. Press A is a better choice and will return more value only in very low risk scenarios (0% and 1% additional risk). For anything above 1% risk premium, the NPV of Press A drops much faster than Press B, and it is a worse choice of the two. Additionally, the diagram indicates that Press B will still return value even at very high levels of additional risk premium (7%) while Press A will create a loss at a judgemental risk level just above 5%. Capital Rationing of XYZ Project Proposals The general results of the analysis show that both projects will return value, and in the ideal world of infinite capital both investments can be started. However in a more realistic scenario of very limited financial resources, the choice of the project will be determined not only by itA¿A½s estimated returns but also by the available capital resources. The process used to prevent a company from A¿A½spreading too thinA¿A½ is known as capital rationing. The case of XYZ has two viable projects, and we will observe two possible scenarios with different available resources Scenario A A¿A½ Low resources A¿A½ slightly less or equal to value of Press B A¿A½ this is a very simple scenario, with only one logical project selection A¿A½ Press B. Scenario B A¿A½ High resources A¿A½ slightly less or equal to value of Press A A¿A½ this scenario has two possible projects available A¿A½ either Press A or Press B. The NPV analysis concluded that Press A is a better project, but the IRR and PI analyses are favoring the Press B as a better choice.
Also, if we use the modified NPV (BYPRP) which includes external risk, press B becomes much more promising, especially if the company has a pessimistic outlook of the future. The Scenario B presents a very simplified version of a real process of decision making regarding capital budgeting and rationing. There are cases in which NPV will fail to identify the real superior project (Wong, 2000). Even if NPV is still the most common method (Brigham and Ehrhardt, 2011) for capital budgeting and investments, managers are encouraged to apply multiple methodologies (Ryan and Ryan, 2002; Wong, 2000; Brigham and Ehrhardt, 2011). Since the regular methodologies of capital budgeting can yield different results, and each of them has different shortcomings, a necessity arises for a wide-encompassing approach to the risk and changes during the length of the project. A new method that is being used in this analysis is the Real Options (RO) method (Chen, 2012), which investigates the options that a company has in each projects, in itA¿A½s size, timing and operations. This method is a complex mathematical modeling method and is not unlike the modeling of financial derivatives. Financing options for the XYZ Project Proposals In order to provide financing for a project, a company can use one or more of the three general sources of capital: shareholder equity, debt or retained profit. All of these sources have different good and bad points associated to each of them. Shareholder equity is available to companies who are listed on stock exchange.
The good point of this source of capital is that there is no interest, nor obligation to repay this capital in a given time frame. On the flip side of the coin, shareholders will provide equity for a piece of ownership in the company. This means that ownership structure may shift, and the company may possibly fall prey to shareholder interest disputes. Retained profit is the simplest way to finance an internal project within a company. There is no interest to pay, and is a very good way of maintaining growth in conditions where cost of capital is high. The bad side of this source of capital is that the owners of the company expect the profit as their own money, and the company will require the consent of the owners in order to use retained profit for investments. Debt is usually observed as the principal method of financing projects, which maintains the ownership structure and control, and does not reduce the profits of owners. Also, having debt provides tax benefits for the company.
The issue of debt is itA¿A½s timing and cost A¿A½ there is a responsibility to repay the debt within a given time frame, and to pay interest on the borrowed capital. During periods when interest rates are high and spare capital is hard to find, obtaining debt can be prohibitively expensive, or increase the risk of bankruptcy Capital Structure Decision After observing the possible sources of capital for the projects, it can be observed that all options for financing bring some variation of risk or exposure for the company.
Capital structure is about striking the balance between increasing debt, managing shareholder expectations and profits and the ownership structure of the company. This balance is very hard to achieve, and can be very subjective in nature from one company to another, based on internal policies and requirements and expectations of major shareholders. The theory of capital structure is initiated by (Modigliani and Miller, 1958), but their theory is based on perfect conditions, of borrowing under same conditions for everyone, no taxes and financing decisions independent of investment decisions. By extending the theory to include taxes and debt risk, the theory reaches a conclusion that optimal capital structure consists entirely of debt, with no equity. Starting from the roots of (Modigliani and Miller, 1958), several theories were developed. We will investigate the proposals of two theories A¿A½ Trade-off theory and Pecking Order theory. The trade-off theory is based on the idea that a company will balance itA¿A½s equity and debt based on the costs and benefits (Frank and Goyal, 2007; Kraus and Litzenberger, 1973) The theory concludes that there is an advantage of financing with debt (tax shield), but the benefits of debt (marginal benefits) decrease as debt increases, while the costs of debt will increase. The theory was met with heavy criticism (Myers, 1984). The pecking order theory proposes that companies will choose financing in a A¿A½pecking orderA¿A½ from most preferred to least. The order of preference gives priority to internal financing through retained profits, and only if it is insufficient external financing is chosen.
When choosing external financing, debt is preferred to equity. The theories that are investigated give an overview of the theoretical best practices that managers can use, but also of the most common mindset of managers when choosing a source of capital. Current research is focusing on the specifics of companies, and not on general criteria of the theory. For instance (Brigham and Houston, 2009) propose that companies with stable outlook to raise capital from debt, while companies who are at high risk of business failure to rely more on internal or equity funding. Also there is an observation that top management dislikes to issue debt because higher debt will mean more external oversight and less A¿A½elbow roomA¿A½ in their management style and decisions (Berger and Ofek, 1997). The Effect of Investment on Shareholders The expectations of a shareholder in a company are to increase his/her investment value in the form of stock value and direct profits in the form of dividend. To estimate the extra value of a company, multiple metrics have been applied historically, including ROA, ROE, EPS (Dumitru and Dumitru, 2008). In order to estimate the future dividend payout per share, we calculated the dividend value table in appendix F without and with the investment. In the scenario of no investment, the annual growth rate of dividends from the previous years averages out at 11% annual growth rate. Given that average trend, the value of the dividend in 5 years will reach 2.85 $. The investment will change the scenario, and will move the average growth trend to 15% annually, thus yielding a dividend of 3.59 $ within 5 years after the investment. To calculate the stock value, we will utilize the Gordon model, or dividend discount model (Gordon, 1959). Dividend discount model, risk = 4% Without investment With Investment Dividend Value $1.90 Dividend Value $2.05 Discount 13.70% Discount 17.70% Average dividend increase 11% Average dividend increase 15% Stock Value $70.37 Stock Value $75.93 In terms of value of shareholder equity, and given a risk premium of 4%, the value of the common Stock will be increased from 70.37 $ to 75.93 $. The following diagram presents the possible values of the shareholder equity depending on the risk premium. Economic Value Added (EVA) is considered as a stronger tool to estimate the market value of the company (Dumitru and Dumitru, 2008) (Salmi and Virtanen, 2001) (Petrescu, 2009). However, the available input for the case study did not include the necessary elements to calculate the EVA of the company, therefore we will maintain only the Gordon model calculated above. In general, shareholder equity will increase in value for all except the highest risk premium scenarios.
Given these observations, from the point of view of shareholders we can support the proposal for investment at XYZ Company. Conclusion Through the investigation of the academic literature, we identified 4 capital budgeting methods which we used in the proposed project analysis. In order to provide for judgmental risk, we also included a second method for calculating the present value discount rate. With these tools, we performed an analysis of the proposed projects for XYZ company. The theoretically superior NPV methodology disagreed with the IRR, PP and PI results A¿A½ NPV proposed Project A as the more beneficial, while IRR, PI and PP proposed Project B. After adding judgmental risk to the discount rate, the NPV value of the Project B was also superior (even if applying the higher risk discount both to Project A and Project B). Based on the varying results of different methods, it is apparent that different risk aversion and information asymmetry can significantly change an outlook for a project, so management should strive for more information and multiple scenarios and checks. In terms of capital rationing, capital structure and financing options, Project B has the advantage of lower capital requirements, and multiple options of capital structure and financing were proposed based in the environmental and market conditions in which the company will operate. In terms of shareholder value, again multiple scenarios of risk aversion were investigated, but in all scenarios the project investment indicated an increase in value over the non-investment value of stock. This is true even if we added a judgmental risk to the risk profile, thus indicating a very risk-averse investor.
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