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Linear programming models seem tailor-made for solving capital budgeting problems when resources are limited. Why then are they not universally accepted either in theory or in practice? One reason is that these models can turn out to be very complex. Second, as with any sophisticated long-range planning tool, there is the general problem of getting good data. It is just not worth applying costly, sophisticated methods to poor data. Furthermore, these models are based on the assumption that all future investment opportunities are known. In reality, the discovery of investment ideas is an unfolding process.
Our most serious misgivings center on the basic assumption that capital is limited. When we come to discuss company financing, we shall see that most large corporations do not face capital rationing and can raise large sums of money on fair terms. Why then do many company presidents tell their subordinates that capital is limited? If they are right, the capital market is seriously imperfect. What then are they doing maximizing NPV?13 We might be tempted to suppose that if capital is not rationed, they do not need to use linear programming and, if it is rationed, then surely they ought not to use it. But that would be too quick a judgment. Let us look at this problem more deliberately.
Soft Rationing Many firms' capital constraints are "soft." They reflect no imperfections in capital markets. Instead they are provisional limits adopted by management as an aid to financial control.
Some ambitious divisional managers habitually overstate their investment opportunities. Rather than trying to distinguish which projects really are worthwhile, headquarters may find it simpler to impose an upper limit on divisional expenditures and thereby force the divisions to set their own priorities. In such instances budget limits are a rough but effective way of dealing with biased cash-flow forecasts. In other cases management may believe that very rapid corporate growth could impose intolerable strains on management and the organization. Since it is difficult to quantify such constraints explicitly, the budget limit may be used as a proxy.
Because such budget limits have nothing to do with any inefficiency in the capital market, there is no contradiction in using an LP model in the division to maximize net present value subject to the budget constraint. On the other hand, there
13Don't forget that in Chapter 2 we had to assume perfect capital markets to derive the NPV rule.
5. Why Net Prsnt Value Leads to Better Investments Decisions than Other Criteria
CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
is not much point in elaborate selection procedures if the cash-flow forecasts of the division are seriously biased.
Even if capital is not rationed, other resources may be. The availability of management time, skilled labor, or even other capital equipment often constitutes an important constraint on a company's growth.
Hard Rationing Soft rationing should never cost the firm anything. If capital constraints become tight enough to hurt—in the sense that projects with significant positive NPVs are passed up—then the firm raises more money and loosens the constraint. But what if it can't raise more money—what if it faces hard rationing?
Hard rationing implies market imperfections, but that does not necessarily mean we have to throw away net present value as a criterion for capital budgeting. It depends on the nature of the imperfection.
Arizona Aquaculture, Inc. (AAI), borrows as much as the banks will lend it, yet it still has good investment opportunities. This is not hard rationing so long as AAI can issue stock. But perhaps it can't. Perhaps the founder and majority shareholder vetoes the idea from fear of losing control of the firm. Perhaps a stock issue would bring costly red tape or legal complications.14
This does not invalidate the NPV rule. AAI's shareholders can borrow or lend, sell their shares, or buy more. They have free access to security markets. The type of portfolio they hold is independent of AAI's financing or investment decisions. The only way AAI can help its shareholders is to make them richer. Thus AAI should invest its available cash in the package of projects having the largest aggregate net present value.
A barrier between the firm and capital markets does not undermine net present value so long as the barrier is the only market imperfection. The important thing is that the firm's shareholders have free access to well-functioning capital markets.
The net present value rule is undermined when imperfections restrict shareholders' portfolio choice. Suppose that Nevada Aquaculture, Inc. (NAI), is solely owned by its founder, Alexander Turbot. Mr. Turbot has no cash or credit remaining, but he is convinced that expansion of his operation is a high-NPV investment. He has tried to sell stock but has found that prospective investors, skeptical of prospects for fish farming in the desert, offer him much less than he thinks his firm is worth. For Mr. Turbot capital markets hardly exist. It makes little sense for him to discount prospective cash flows at a market opportunity cost of capital.
14A majority owner who is "locked in" and has much personal wealth tied up in AAI may be effectively cut off from capital markets. The NPV rule may not make sense to such an owner, though it will to the other shareholders.
If you are going to persuade your company to use the net present value rule, you ^SUMMARY must be prepared to explain why other rules may not lead to correct decisions. That is why we have examined three alternative investment criteria in this chapter.
Some firms look at the book rate of return on the project. In this case the company decides which cash payments are capital expenditures and picks the appropriate rate to depreciate these expenditures. It then calculates the ratio of book income to the book value of the investment. Few companies nowadays base their investment decision simply on the book rate of return, but shareholders pay attention to book
PART I Value measures of firm profitability and some managers therefore look with a jaundiced eye on projects that would damage the company's book rate of return.
Some companies use the payback method to make investment decisions. In other words, they accept only those projects that recover their initial investment within some specified period. Payback is an ad hoc rule. It ignores the order in which cash flows come within the payback period, and it ignores subsequent cash flows entirely. It therefore takes no account of the opportunity cost of capital.
The simplicity of payback makes it an easy device for describing investment projects. Managers talk casually about quick-payback projects in the same way that investors talk about high-P/E common stocks. The fact that managers talk about the payback periods of projects does not mean that the payback rule governs their decisions. Some managers do use payback in judging capital investments. Why they rely on such a grossly oversimplified concept is a puzzle.
The internal rate of return (IRR) is defined as the rate of discount at which a project would have zero NPV. It is a handy measure and widely used in finance; you should therefore know how to calculate it. The IRR rule states that companies should accept any investment offering an IRR in excess of the opportunity cost of capital. The IRR rule is, like net present value, a technique based on discounted cash flows. It will, therefore, give the correct answer if properly used. The problem is that it is easily misapplied. There are four things to look out for:
1. Lending or borrowing? If a project offers positive cash flows followed by negative flows, NPV can rise as the discount rate is increased. You should accept such projects if their IRR is less than the opportunity cost of capital.
2. Multiple rates of return. If there is more than one change in the sign of the cash flows, the project may have several IRRs or no IRR at all.
3. Mutually exclusive projects. The IRR rule may give the wrong ranking of mutually exclusive projects that differ in economic life or in scale of required investment. If you insist on using IRR to rank mutually exclusive projects, you must examine the IRR on each incremental investment.
4. Short-term interest rates may be different from long-term rates. The IRR rule requires you to compare the project's IRR with the opportunity cost of capital. But sometimes there is an opportunity cost of capital for one-year cash flows, a different cost of capital for two-year cash flows, and so on. In these cases there is no simple yardstick for evaluating the IRR of a project.
If you are going to the expense of collecting cash-flow forecasts, you might as well use them properly. Ad hoc criteria should therefore have no role in the firm's decisions, and the net present value rule should be employed in preference to other techniques. Having said that, we must be careful not to exaggerate the payoff of proper technique. Technique is important, but it is by no means the only determinant of the success of a capital expenditure program. If the forecasts of cash flows are biased, even the most careful application of the net present value rule may fail.
In developing the NPV rule, we assumed that the company can maximize shareholder wealth by accepting every project that is worth more than it costs. But, if capital is strictly limited, then it may not be possible to take every project with a positive NPV. If capital is rationed in only one period, then the firm should follow a simple rule: Calculate each project's profitability index, which is the project's net present value per dollar of investment. Then pick the projects with the highest profitability indexes until you run out of capital. Unfortunately, this procedure fails when capital
CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
is rationed in more than one period or when there are other constraints on project choice. The only general solution is linear or integer programming.
Hard capital rationing always reflects a market imperfection—a barrier between the firm and capital markets. If that barrier also implies that the firm's shareholders lack free access to a well-functioning capital market, the very foundations of net present value crumble. Fortunately, hard rationing is rare for corporations in the United States. Many firms do use soft capital rationing, however. That is, they set up self-imposed limits as a means of financial planning and control.
Classic articles on the internal rate of return rule include:
J. H. Lorie and L. J. Savage: "Three Problems in Rationing Capital," Journal of Business, 28:229-239 (October 1955).
E. Solomon: "The Arithmetic of Capital Budgeting Decisions," Journal of Business, 29:124-129 (April 1956).
A. A. Alchian: "The Rate of Interest, Fisher's Rate of Return over Cost and Keynes' Internal Rate of Return," American Economic Review, 45:938-942 (December 1955).
The classic treatment of linear programming applied to capital budgeting is: H. M. Weingartner: Mathematical Programming and the Analysis of Capital Budgeting Problems, Prentice-Hall, Inc., Englewood Cliffs, N.J., 1963.
There is a long scholarly controversy on whether capital constraints invalidate the NPV rule. Wein-gartner has reviewed this literature:
H. M. Weingartner: "Capital Rationing: n Authors in Search of a Plot," Journal of Finance, 32:1403-1432 (December 1977).
FURTHER READING
1. What is the opportunity cost of capital supposed to represent? Give a concise definition. QUIZ
2. a. What is the payback period on each of the following projects?
Project |
Cash Flows ($) | ||||
C> |
Ci |
C2 |
C3 |
C4 | |
A |
-5,000 |
+ 1,000 |
+ 1,000 |
+3,000 |
0 |
B |
-1,000 |
0 |
+ 1,000 |
+2,000 |
+ 3,000 |
C |
-5,000 |
+ 1,000 |
+ 1,000 |
+3,000 |
+ 5,000 |
b. Given that you wish to use the payback rule with a cutoff period of two years, which projects would you accept?
c. If you use a cutoff period of three years, which projects would you accept?
d. If the opportunity cost of capital is 10 percent, which projects have positive NPVs?
e. "Payback gives too much weight to cash flows that occur after the cutoff date." True or false?
f. "If a firm uses a single cutoff period for all projects, it is likely to accept too many short-lived projects." True or false?
g. If the firm uses the discounted-payback rule, will it accept any negative-NPV projects? Will it turn down positive-NPV projects? Explain.
3. What is the book rate of return? Why is it not an accurate measure of the value of a capital investment project?
PART I Value
4. Write down the equation defining a project's internal rate of return (IRR). In practice how is IRR calculated?
5. a. Calculate the net present value of the following project for discount rates of 0, 50, and
100 percent:
Cq Ci C2
b. What is the IRR of the project?
6. You have the chance to participate in a project that produces the following cash flows:
The internal rate of return is 13 percent. If the opportunity cost of capital is 10 percent, would you accept the offer?
7. Consider a project with the following cash flows:
Co |
Ci |
C2 |
-100 |
+ 200 |
-75 |
a. How many internal rates of return does this project have?
b. The opportunity cost of capital is 20 percent. Is this an attractive project? Briefly explain.
Consider projects Alpha and Beta:
Cash Flows ($) | ||||
Project |
Co |
Ci |
C2 |
IRR (%) |
Alpha |
-400,000 |
+ 241,000 |
+ 293,000 |
21 |
Beta |
-200,000 |
+ 131,000 |
+ 172,000 |
31 |
The opportunity cost of capital is 8 percent.
Suppose you can undertake Alpha or Beta, but not both. Use the IRR rule to make the choice. Hint: What's the incremental investment in Alpha?
9. Suppose you have the following investment opportunities, but only $90,000 available for investment. Which projects should you take?
Project |
NPV |
Investment |
1 |
5,000 |
10,000 |
2 |
5,000 |
5,000 |
3 |
10,000 |
90,000 |
4 |
15,000 |
60,000 |
5 |
15,000 |
75,000 |
6 |
3,000 |
15,000 |
Brealey-Meyers: Principles of Corporate Finance, Seventh Edition
I. Value
5. Why Net Prsnt Value Leads to Better Investments Decisions
© The McGraw-H Companies, 2003
CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
10. What is the difference between hard and soft capital rationing? Does soft rationing mean the manager should stop trying to maximize NPV? How about hard rationing?
Project |
Cash Flows ($) | |||||
Co |
Ci |
C2 |
C3 |
C4 |
C5 | |
A |
-1,000 |
+ 1,000 |
0 |
0 |
0 |
0 |
B |
-2,000 |
+ 1,000 |
+ 1,000 |
+ 4,000 |
+ 1,000 |
+ 1,000 |
C |
-3,000 |
+ 1,000 |
+ 1,000 |
0 |
+ 1,000 |
+ 1,000 |
Co |
Ci |
C2 |
C3 |
-3,000 |
+ 3,500 |
+4,000 |
-4,000 |
For what range of discount rates does the project have positive-NPV? 7. Consider the following two mutually exclusive projects:
Cash Flows ($) | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Project |
Co |
Ci |
C2 |
C3 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
A |
-100 |
+60 |
+ 60 |
0 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
B |
-100 |
0 |
0 |
QUESTIONS a. If the opportunity cost of capital is 10 percent, which projects have a positive NPV? b. Calculate the payback period for each project. c. Which project(s) would a firm using the payback rule accept if the cutoff period were three years? 2. How is the discounted payback period calculated? Does discounted payback solve the deficiencies of the payback rule? Explain. 3. Does the following manifesto make sense? Explain briefly. We're a darn successful company. Our book rate of return has exceeded 20 percent for five years running. We're determined that new capital investments won't drag down that average. 4. Respond to the following comments: a. "I like the IRR rule. I can use it to rank projects without having to specify a discount rate." b. "I like the payback rule. As long as the minimum payback period is short, the rule makes sure that the company takes no borderline projects. That reduces risk." 5. Unfortunately, your chief executive officer refuses to accept any investments in plant expansion that do not return their original investment in four years or less. That is, he insists on a payback rule with a cutoff period of four years. As a result, attractive long-lived projects are being turned down. The CEO is willing to switch to a discounted payback rule with the same four-year cutoff period. Would this be an improvement? Explain. 6. Calculate the IRR (or IRRs) for the following project: Calculate the NPV of each project for discount rates of 0, 10, and 20 percent. Plot these on a graph with NPV on the vertical axis and discount rate on the horizontal axis. What is the approximate IRR for each project? PART I Value c. In what circumstances should the company accept project A? d. Calculate the NPV of the incremental investment (B - A) for discount rates of 0, 10, and 20 percent. Plot these on your graph. Show that the circumstances in which you would accept A are also those in which the IRR on the incremental investment is less than the opportunity cost of capital. 8. Mr. Cyrus Clops, the president of Giant Enterprises, has to make a choice between two possible investments:
The opportunity cost of capital is 9 percent. Mr. Clops is tempted to take B, which has the higher IRR. a. Explain to Mr. Clops why this is not the correct procedure. b. Show him how to adapt the IRR rule to choose the best project. c. Show him that this project also has the higher NPV. 9. The Titanic Shipbuilding Company has a noncancelable contract to build a small cargo vessel. Construction involves a cash outlay of $250,000 at the end of each of the next two years. At the end of the third year the company will receive payment of $650,000. The company can speed up construction by working an extra shift. In this case there will be a cash outlay of $550,000 at the end of the first year followed by a cash payment of $650,000 at the end of the second year. Use the IRR rule to show the (approximate) range of opportunity costs of capital at which the company should work the extra shift. 10. "A company that ranks projects on IRR will encourage managers to propose projects with quick paybacks and low up-front investment." Is that statement correct? Explain. 11. Look again at projects E and F in Section 5.3. Assume that the projects are mutually exclusive and that the opportunity cost of capital is 10 percent. a. Calculate the profitability index for each project. b. Show how the profitability-index rule can be used to select the superior project. 12. In 1983 wealthy investors were offered a scheme that would allow them to postpone taxes. The scheme involved a debt-financed purchase of a fleet of beer delivery trucks, which were then leased to a local distributor. The cash flows were as follows:
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