Capital Budgeting Techniques: Mitigating Risks - Example

Capital Budgeting Techniques: Mitigating Risks Introduction Managers constantly face the problem of deciding which assets to invest in, but in orderto be able to make that type of decision accurately and repeatedly, the manager must be guided by techniques or models that consistently estimate with reasonable accuracy the value of the potential investments. Guided by the results of the valuation exercise, the financial manager then evaluates the alternative investment opportunities to decide which ones the firm may invest in, given its capital budget constraints, to realize the highest value added to the firm (Peterson and Fabozzi, 1). A firm’s capital is comprised of all its assets, and capital investment refers to the firm’s investment in its assets. A capital investment decision is typically a choice of one or more among several possible value-generating alternatives, each referred to as a project (Peterson and Fabozzi 5). The manner in which the manager arrives at this decision is guided by the capital budgeting process, described in the next section below. Stages in the Capital Budgeting Process The capital budgeting process may be described in five steps. The first step involves the screening and selection of investments. In this step, project proposals are generated which are consistent with the strategy of the corporation. The expected cash flows from each of the projects are likewise identified, and analyzed. The projects are thereafter evaluated according to how they impact on the firm’s future cash flows, to see how much added value they contribute to the firm. The second step is to propose a capital budget for those projects which have passed the selection process in the first step. The budget specifies the projects and their corresponding cost of investment as well as their expected revenues. The third step is to secure the authorization and approval of the projects chosen, as well as the allocation for expenditures. The fourth step involves project tracking, meaning the interim reports resulting from the supervision and oversight of the project. Project tracking will enable management, in communication with operations, to identify potential cost overruns and the need for additional research. Finally, the fifth step includes the post-completion audit which takes place immediately after project completion and for some time thereafter, most likely for the next two to three years (Peterson and Fabozzi 7). Basic Capital Budgeting Techniques There are a number of capital budgeting techniques, each of which may be classified as one of two types: the nondiscounted capital budgeting techniques, and the discounted capital budgeting techniques. Under the nondiscounted techniques are the payback method and the unadjusted rate of return method, while the discounted capital budgeting techniques include the net present value method and the internal rate of return method. These are the most commonly used capital budgeting techniques, and have varying decision criteria. Nondiscounted techniques are the first methods most often relied upon in the course of evaluating alternative projects, because of their ease and simplicity in calculation. They have a serious drawback, however, in the fact that they do not take into account the time value of money. The Payback Period The payback period is calculated by the formula: The strength of this method is that it immediately determines the length of time the project takes to recover the investment cost. The company may immediately determine whether or not the length of investment recovery is acceptable to them. The weakness of this method, aside from not taking the time value of money into account, is that it measures the duration of the recovery, but not the profitability, of the investment (Albrecht, et al 1181). As far as risk is concerned, the payback period provides a direct indication of risk in terms of whether or not the investment will be recovered sooner than the life of the project. Take the following example: Project Investment cost Annual net cash inflows Payback Period Life of project Decision A $120,000 $10,000 12 30 YES B $120,000 $20,000 6 5 NO The example shown in the table above highlights the risk-mitigating feature of the payback period. Under this method, the project with the shorter payback period should be the investment of choice. However, if the life of the project is shorter than the payback period, then the investment cost will be unrecoverable, and the project should be rejected on this basis. The risk is therefore greater for Project B than for Project A, which has a life of 30 years, leaving the cash flow of 18 years as profit after the investment has been recovered in the 12th year. Unadjusted Rate of Return Method This method is also known as the simple rate of return or the accounting rate of return method, the formula for this model is: The increase in future average net income is the difference between the increase in net revenues and the increase in annual depreciation expense, as a result of the adoption of the project. The unadjusted rate of return method is an improvement over the payback period in that it attempts to measure the profitability of the new investment; the criterion for making the decision to adopt the investment is whether or not the unadjusted rate of return will meet the expected rate of return of shareholders or the established standard rate, known as the hurdle rate. Also the unadjusted rate of return uses GAAP-based income, unlike the payback period which uses cash flows (Albrecht, et al. 1183). Risk mitigation through the unadjusted rate of return method lies in the estimation of risk in terms of percentage, which may be added on to the hurdle rate against which the unadjusted rate of return should be compared. Unlike the payback period, the result of calculation using this method is in percentage terms, thereby facilitating comparison against the hurdle rate and any margin for risk. The following two methods to be discussed are discounted capital budgeting techniques, which both take into account the time value of money. The net cash inflows or cash savings projected to materialize in the future are the result of investments made at the present time, and should therefore be reckoned in terms of today’s currency. By discounting future cash flows to obtain the present value, the comparison may be made against the investment cost which takes place in the present. The Net Present Value (NPV) Method The NPV method involves obtaining the value of future cash flows at the present to coincide with the investment cost, by discounting these cash flows against the standard discount rate or hurdle rate (Albrecht, et al. 1184). The NPV is calculated by the following equation: where CFt is the expected net cash flow for period t, k is the discount rate, n is the expected life of the project, and I0 is the initial investment which is incurred in the present when t = 0. The criterion to determine the project of choice is the project with the highest positive NPV (in the case of non-mutually exclusive projects, all projects ranked from highest positive NPV to lowest). Projects with negative NPVs should be rejected. Risk may be taken into account in the use of the NPV by adjusting the discount rate to include the expected rate of risk, thereby creating the risk-adjusted discount rate (RADR). The RADR shall be the discount rate to be used to calculate the present values of the cash flows, from which the initial investment shall be deducted to obtain the NPVRADR (Baker and Powell 310). The Internal Rate of Return (IRR) Method The IRR method is also known as the time-adjusted rate of return method, or the discounted rate of return method (Albrecht, et al. 1189). Some managers are reluctant to use the IRR because of its difficulty of calculation, while others prefer it because investment alternatives are directly comparable when their yields are expressed in terms of rates of return. The IRR is a true discount rate that reflects investment yields. This means that if the present value of future net cash flows were made equal to the investment cost, then the resulting discount rate would be the IRR. Simply stated, the net present value of a project is zero when the IRR is used as the discount rate. The straightforward method of calculating the IRR using the present value tables is carried out by: (1) calculating the present value factor by dividing the investment cost by the annual net cash inflows; (2) finding the present value factor in the table that is closest to the number calculated in the preceding step; (3) finding the exact internal rate of return represented by the present value factor in the first step, resorting to interpolation if called for (Albrecht, et al 1189). There are a number of methods by which the risk of future cash flows may be calculated. These include the calculation of the range or swing of the cash flows, the standard deviation and coefficient of variation, sensitivity analysis, and the calculation of risk-adjusted risk using the Capital Asset Pricing Model or CAPM. These are topics for another discussion; suffice it to say that risk may be numerically represented for use in the preceding capital budgeting techniques, through any of the risk calculation methods mentioned here. Empirical evidence on risk mitigation in the use of capital budgeting models There have been field studies on the use of capital budgeting techniques among businesses in different industries and economies. These studies have found that the theory concerning the use of risk mitigation techniques in capital budgeting does not entirely conform to the practice in the experience of managers. Cotter, Marcum and Martin contend that the standard capital budgeting techniques are outdated (71-80), and managers instinctively look for alternative methods ranging from their subjective assessments, to the use of the sophisticated economic value added modeling technique. Lazaridis polled managers, mostly those in charge of finances, in small and medium scale companies in Cyprus, on the capital budgeting techniques they made use of. The study found that two-thirds of these firms did not make use of risk analysis in their investment decisions because: (1) the use of such methods have little bearing on the firm’s profits; (2) there are no available information services at their level of business volume; (3) the managers are unfamiliar with risk analysis; and (4) they lack time, staff, and sufficient experience to conduct this type of analysis. More than half of the sample does not use different types of techniques for capital budgeting when they encounter different types of risk. As to the type of risk assessment used, a little over one-third of the companies compare their cash flows to those of other companies; slightly less than one-third estimate the probability of losses; and about one-fourth determine risk according to subjective criteria (430 – 431). The study by Hogaboam and Shook investigated the capital investment practices of a number of publicly owned U.S. forest products firms. Majority of the firms indicated a preference for the discount cash flow techniques. There has been an increase in recent years in the use of the NPV, while there is widespread use of IRR. The larger companies that can afford the cost of information gathering used more sophisticated evaluation techniques such as economic value added (EVA). When asked about the risk considerations their companies regard with respect to capital budgeting techniques, the theoretical answer which should have been the “variation in returns” was only ranked fourth among the possible answers. More than 75 per cent answered that the probability of not achieving a target return is the principal risk consideration in their companies; the second was uncertain market potential, and the third was ‘entering an inexperienced area (148-151). The study confirmed the Lazaridis that majority of managers still employ subjective assessment in evaluating the degree of risk in their businesses. Sagner (42) found that there is too much in companies’ balance sheets, and too few attractive capital investments. About 8 out of 10 companies put their money in short-term investments rather than invest long-term using capital budgeting techniques, and this trend may continue into the future. Two factors are behind the reticence to commit more funds to longer term investments. One of these is that chief financial officers (CFOs) do not trust the results produced by DCF analysis. The study determined that there are a large number of companies resorting to payback, though still not as many as those who use NPV and IRR, and many in tandem with them. Payback period technique is used to support decisions from NPV and IRR; the majority of financial managers are uncomfortable relying on one method in making capital budgeting decisions, and would prefer to conduct multiples studies before making decisions. Experience has led many managers to believe that even IRR and NPV cannot be completely trusted (42 – 43). Apparently, this trend has been in place for some time. Smith determined as early as 2001 that managers have expressed greater trust in relying on their subjective assessments of risk, primarily because the NPV and IRR methods have a track record of being wrong. About 85% of respondents stated that they use subjective judgments while only 65% used quantitative techniques. The most popular method of risk adjustment methods preferred by a good number of respondents was to increase the required rate of return or cost of capital in order to compensate for risk considerations. Glen and Hatzopoulos conducted a study on the use of quantitative methods of risk assessment and value-based performance measures. The study found that there is a greater preference for the use of the traditional, non-DCF methods. Many of the firms linked their capital budgeting and risk assessment techniques to the specific strategy of the firm: for instance, one firm responded that they preferred ‘More emphasis on payback due to tighter cash control’ while another espoused ‘More interest in discounted payback coupled with IRR and NPV’(610). In a similar study among Australian businesses, the more popular methods of capital budgeting are the Payback, the NPV and the IRR, usually in combination with each other. The project cash flows are discounted at the weighted average cost of capital, or WACC, which represents the cost of capital of equity and debt in proportional weights (Truong, Partington and Peat 116 – 118). Conclusion The development of capital budget theory has sought to combine simplicity of approach and an increasingly accurate representation of returns and risk. The theoretical models make assumptions, however, which diminish somewhat the model’s faithfulness to the empirical results, and therefore depart from reality. Several of the studies surveyed report managers preferring to rely on subjective risk assessments rather than resort to quantitative methods, for various reasons such as the high cost of gathering more detailed information required by the model, or difficulty of calculation, but mostly because the results arrived at are often inaccurate. Those who do rely on quantitative methods do so by resorting to several of them, in order to corroborate the findings. 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