In this course, participants will learn about the key financial decisions modern corporations face, as well as the alternative methods that can be employed to optimize the value of the firm’s assets. This is part of a Specialization in corporate finance created in partnership between the University of Melbourne and Bank of New York Mellon (BNY Mellon).
1.4 Alternatives to DCF Techniques
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Do curso por The University of Melbourne
Corporate Financial Decision-Making for Value Creation
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The University of Melbourne
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Curso 3 de 5 em Specialization Essentials of Corporate Finance
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Alternative Approaches to Making the Optimal Investment Decision
This week we will define and explain the key approaches to investment evaluation utilized by corporations around the world. We will also consider the way in which sensitivity analysis might be employed so as to provide information to management beyond the simple “invest-don’t-invest” decision.
Conheça os instrutores
Paul KofmanDean, Faculty of Business and Economics
Sidney Myer Chair of Commerce
Sean PinderAssociate Professor
Faculty of Business and Economics
So the two techniques we've covered so
far have been based upon discounted cash flow analysis.
Let's have a look at some alternatives to that approach.
Looking back at the survey evidence,
what we find is that the pay back period and the accounting rate of return
technique are both approaches to project evaluation that also are very popular.
Let's consider the payback period first.
A project's payback period is the amount of time it takes to recoup the initial
cost of the project from the project's after tax net cash flows.
So the payback period is focusing on the liquidity created from the project.
Because ultimately it doesn't matter how profitable, how much wealth your projects
will create in the future, you need to be able to pay your electricity bill today.
So, it's giving you a feel for cash flow, and
how long it takes to get that cash flow back from a project.
So let's consider an earlier example, costing 2 million dollars initially and
generating, or
expecting to generate, 800,000 dollars in each of the next four years.
Assuming that the cash flows occur at year end, the payback period for
this project is three years.
If the cash flows were evenly spaced throughout the year
then the payback period, well after two years we have $1.6 million.
We need to generate another $400,000 to recoup
the $2 million initially investment.
So halfway through that third year, we've recouped the $2 million dollars.
So the payback period is two and a half years.
So there are three very simple steps to the payback period approach.
Once again we forecast the expected cash flows, both the timing and
the amount of those cash flows.
Secondly, we calculate how long it will take to recoup the initial investment from
those net cash flows.
Thirdly, we apply the appropriate decision rule.
For independent projects,
we accept projects with a payback period less than the maximum allowable period.
That'll be some external benchmark.
For mutually exclusive projects, there's a two-tiered decision rule.
Just as with MPV an internal rate of return,
we prefer the project with the shortest payback period.
Provided that payback period is less than the maximum allowable period.
So let's demonstrate how to use the payback period
to evaluate mutually exclusive projects.
So, we have project seven and eight, and
we'll assume the maximum allowable payback period of five years.
So just pause for a sec, if both of these projects have a payback period
in excess of five years, we would reject them both.
So project seven,which reflects the project we had earlier,
has a payback period of three years or two and
a half years if the cash flows occur continuously over the year.
Project eight has a payback period of four years.
You'll see that it has much more of it's cashflow concentrated towards the end of
it's life, or 3.346 years, if we assume the cashflow occur continuously.
So, because those payback periods are less than the maximum allow period,
then they're both acceptable if they're independent projects.
But, if they're mutually exclusive,
we clearly prefer Project 7 of the project day.
Now, let's consider some of the problems, potential problems or warnings, that we
should be aware of when dealing with the payback period in project evaluation.
Once again, let's deal with Project 7 on that.
As we saw in the previous slide,
Project 7 dominated Project 8 on the basis of payback period.
But when we employ the NPV technique,
Project 8 generates much more wealth than Project 7.
So how do we get that conflict in rankings?
Well the reason is very simple, the payback period ignores the fact
that cash flows are occurring after we've recouped the initial investment.
So this leads to a natural bias against projects with a longer
developmental lives.
The other point to make is that the payback period fails to explicitly account
for the time value of money.
So we have Project 9 and Project 10 here,
two projects with very different cash flow streams, very different cash flows.
Most of the cash flows from project 10 are occurring towards the end of its life.
Project 9, the cash flows are much more evenly spread.
However, the payback period for these two projects is identical.
We wouldn't be able to
differentiate between these two projects by solely upon payback period.
So the warning here is very simple.
Use the payback period, it gives your measure of liquidity, if gives you
feedback about the cashflow problems that the firm may face in the future.
It gives you a feel for when projects will start delivering
cash that you can use to pay the electricity bill.
But always back it up with an MPV calculation to make sure
you're making the optimal decision.
Our next technique is the accounting rate of return.
And a project's accounting rate of return is simply the net income or
the net rate of earnings generated by the project over it's
life divided by the capital invested in the project.
With the capital invested could be measured as historical cost or
the average book value of the asset over its life.
So three simple steps in the Accounting Rate of Return approach.
We forecast expected earnings.
Earnings this time, not cash flows, and that's an important point.
We calculate the average earnings over the life of the project.
We express that as a percentage of the cost of the asset, or
the average book value of the asset.
We then apply the appropriate decision rule, and
the decision rule is very straight forward.
You'll accept all projects with an accounting rate of return
in excess of a minimum benchmark rate.
Or for mutually exclusive projects, once again it's a two tier decision rule.
Prefer the project with the highest rate of return
provided that meets the minimum benchmark.
So let's have a look at an example.
We have a project here that requires a million dollars initially investment,
has a life of four years, and
a book value at the end of that four years of only $200,000.
Let's assume straight line depreciation,
recalling that depreciation in an accounting sense is the allocation
of the cost of an asset over it's useful life.
So we start with a book value of $1,000,000, ending at $200,000.
So the average book value of the asset is $600,000.
The average earnings from this asset?
150, 140, 120 and 90 thousand dollars.
We add those up, divide by 4, we end with average earnings of $125,000.
The accounting rate of return based on the initial investment is 12.5%.
The accounting rate of return based upon the average book value,
125,000 divided by 600,000 gives us 20.83%.
So we would simply compare those accounting rates of return with our
benchmark or hurdle rate to determine the project's acceptability.
But once again, there is some potential problems or
warnings that go along with the use of the accounting rate of return method.
The first point to make,
is that the accounting rate of return is based upon earnings, not cash flows.
And earnings numbers, as we're aware, can be highly subjective.
If we employed one particular inventory valuation or
depreciation method over another we'll end up with a different final earnings figure
so there's some subjectivity associated with it.
The other point to make is that earnings reflect your accrual decisions as well.
So you can't buy a can of soda with a million dollars of earnings,
you need a dollar of cash.
The second point to make is that the accounting rate of return method ignores
the time value of money.
So let's consider these two projects.
These two projects have exactly the same accounting rate of return,
assuming the same investment.
It fails to account for the fact that the first project
generates it's earnings at an earlier point in time than the second project.
So in summary, the payback period measures the time it takes to recoup
the initial investment in a project.
It gives management a lot of very useful information about the future
liquidity concerns, or opportunities of the company.
It's problematic because it doesn't account explicitly for
the time value of money, and ignores the cash flows after investment is payback.
One point to make though, is that the Payback Period is very, very popular.
But wouldn't be used on a.
It tends to be used in tandem with MPV and the Internal Rate of Return technique.
The Accounting Rate of Return measures the profitability of a project using
Net Income and the Book Value of Asset figures.
It's very popular because of the ready availability of accounting data.
But it's problematic because it relies upon subjective earnings numbers and
doesn't account explicitly for the time value of money.
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