Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

1D. Making Capital Investment Decisions

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Samuel Weaver on Capital Budgeting at Hershey Foods Corporation

The capital program at Hershey Foods Corporation and most Fortune 500 or Fortune 1,000 companies involves a three-phase approach: planning or budgeting, evaluation, and postcompletion reviews.

The first phase involves identification of likely projects at strategic planning time. These are selected to support the strategic objectives of the corporation. This identification is generally broad in scope with minimal financial evaluation attached. As the planning process focuses more closely on the short-term plans, major capital expenditures are scrutinized more rigorously. Project costs are more closely honed, and specific projects may be reconsidered.

Each project is then individually reviewed and authorized. Planning, developing, and refining cash flows underlie capital analysis at Hershey Foods. Once the cash flows have been determined, the application of capital evaluation techniques such as those using net present value, internal rate of return, and payback period is routine. Presentation of the results is enhanced using sensitivity analysis, which plays a major role for management in assessing the critical assumptions and resulting impact.

The final phase relates to postcompletion reviews in which the original forecasts of the project's performance are compared to actual results and/or revised expectations.

Capital expenditure analysis is only as good as the assumptions that underlie the project. The old cliché of GIGO (garbage in, garbage out) applies in this case. Incremental cash flows primarily result from incremental sales or margin improvements (cost savings). For the most part, a range of incremental cash flows can be identified from marketing research or engineering studies. However, for a number of projects, correctly discerning the implications and the relevant cash flows is analytically challenging. For example, when a new product is introduced and is expected to generate millions of dollars' worth of sales, the appropriate analysis focuses on the incremental sales after

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accounting for cannibalization of existing products.

One of the problems that we face at Hershey Foods deals with the application of net present value, NPV, versus internal rate of return, IRR. NPV offers us the correct investment indication when dealing with mutually exclusive alternatives. However, decision makers at all levels sometimes find it difficult to comprehend the result. Specifically, an NPV of, say, $535,000 needs to be interpreted. It is not enough to know that the NPV is positive or even that it is more positive than an alternative. Decision makers seek to determine a level of "comfort" regarding how profitable the investment is by relating it to other standards.

Although the IRR may provide a misleading indication of which project to select, the result is provided in a way that can be interpreted by all parties. The resulting IRR can be mentally compared to expected inflation, current borrowing rates, the cost of capital, an equity portfolio's return, and so on. An IRR of, say, 18 percent is readily interpretable by management. Perhaps this ease of understanding is why surveys indicate that most Fortune 500 or Fortune 1,000 companies use the IRR method as a primary evaluation technique.

In addition to the NPV versus IRR problem, there are a limited number of projects for which traditional capital expenditure analysis is difficult to apply because the cash flows can't be determined. When new computer equipment is purchased, an office building is renovated, or a parking lot is repaved, it is essentially impossible to identify the cash flows, so the use of traditional evaluation techniques is limited. These types of "capital expenditure" decisions are made using other techniques that hinge on management's judgment.

Samuel Weaver, Ph.D., is the former director, financial planning and analysis, for Hershey Chocolate North America. He is a certified management accountant. His position combined the theoretical with the pragmatic and involved the analysis of many different facets of finance in addition to capital expenditure analysis.

Now, we know that this $215 total cash flow has to be "dollars in" less "dollars out" for the year. We could therefore ask a different question: What were cash revenues for the year? Also, what were cash costs?

To determine cash revenues, we need to look more closely at net working capital. During the year, we had sales of $500. However, accounts receivable rose by $30 over the same time period. What does this mean? The $30 increase tells us that sales ex-

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

IV. Capital Budgeting

10. Making Capital Investment Decisions

© The McGraw-Hill Companies, 2002

CHAPTER 10 Making Capital Investment Decisions ceeded collections by $30. In other words, we haven't yet received the cash from $30 of the $500 in sales. As a result, our cash inflow is $500 - 30 = $470. In general, cash income is sales minus the increase in accounts receivable.

Cash outflows can be similarly determined. We show costs of $310 on the income statement, but accounts payable increased by $55 during the year. This means that we have not yet paid $55 of the $310, so cash costs for the period are just $310 - 55 = $255. In other words, in this case, cash costs equal costs less the increase in accounts payable.9

Putting this information together, we calculate that cash inflows less cash outflows is $470 - 255 = $215, just as we had before. Notice that:

Cash flow = Cash inflow - Cash outflow = ($500 - 30) - (310 - 55) = ($500 - 310) - (30 - 55) = Operating cash flow - Change in NWC = $190 - (- 25) = $215

More generally, this example illustrates that including net working capital changes in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments.

Cash Collections and Costs

For the year just completed, the Combat Wombat Telestat Co. (CWT) reports sales of $998 and costs of $734. You have collected the following beginning and ending balance sheet information:

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