Accounting Flows versus Cash Flows
In most capital budgeting decisions the emphasis is on cash flow, rather than reported income. Let us consider the logic of using cash flow in the capital budgeting process. Because depreciation does not represent an actual expenditure of funds in arriving at profit, it is added back to profit to determine the amount of cash flow generated.1 Assume the Alston Corporation has $50,000 of new equipment to be depreciated at $5,000 per year. The firm has $20,000 in earnings before depreciation and taxes and pays 35 percent in taxes. The information is presented in Table 12-1 to illustrate the key points involved.
Figure 12-1 Capital budgeting procedures
The firm shows $9,750 in earnings after taxes, but it adds back the noncash deduction of $5,000 in depreciation to arrive at a cash flow figure of $14,750. The logic of adding back depreciation becomes even greater if we consider the impact of $20,000 in depreciation for the Alston Corp. (Table 12-2). Net earnings before and after taxes are zero, but the company has $20,000 cash in the bank.
Table 12-1 Cash flow for Alston Corporation
|Earnings before depreciation and taxes (cash inflow)||$20,000|
|Depreciation (noncash expense)||5,000|
|Earnings before taxes||$15,000|
|Taxes (cash outflow)||5,250|
|Earnings after taxes||$ 9,750|
Table 12-2 Revised cash flow for Alston Corporation
|Earnings before depreciation and taxes||$20,000|
|Earnings before taxes||$ 0|
|Earnings after taxes||$ 0|
To the capital budgeting specialist, the use of cash flow figures is well accepted. However, top management does not always take a similar viewpoint. Assume you are the president of a firm listed on the New York Stock Exchange and must select between two alternatives. Proposal A will provide zero in aftertax earnings and $100,000 in cash flow, while Proposal B, calling for no depreciation, will provide $50,000 in aftertax earnings and cash flow. As president of a publicly traded firm, you have security analysts constantly penciling in their projections of your earnings for the next quarter, and you fear your stock may drop dramatically if earnings are too low by even a small amount. Although Proposal A is superior, you may be more sensitive to aftertax earnings than to cash flow and you may therefore select Proposal B. Perhaps you are overly concerned about the short-term impact of a decision rather than the long-term economic benefits that might accrue.
You must be sensitive to executives’ concessions to short-term pressures. Nevertheless in the material that follows, the emphasis is on the use of proper evaluation techniques to make the best economic choices and assure long-term wealth maximization.
Methods of Ranking Investment Proposalsn
I order to choose among competing capital projects, we must understand the methods commonly used to rank investment proposals. Let us consider two projects whose cash flows are presented as follows:
Three widely used methods for evaluating capital expenditures will be considered, along with the shortcomings and advantages of each:
1. Payback method.
2. Internal rate of return.
3. Net present value.
The first method, while not conceptually sound, is often used. Approaches 2 and 3 are more acceptable, and one or the other should be applied to most situations.
Under the payback method, we compute the time required to recoup the initial investment. Assume we are called on to select between Investments A and B in Table 12-3. Notice that the values in this table match the preceding timeline.
Table 12-3 Investment alternatives
|Cash Inflows (of $10,000 investment)|
|Year||Investment A||Investment B|
The payback period for Investment A is 2 years, while Investment B requires 3.8 years. In the latter case, we recover $6,000 in the first three years, leaving us with the need for another $4,000 to recoup the full $10,000 investment. Since the fourth year has a total inflow of $5,000, $4,000 represents 0.8 of that value. Thus the payback period for Investment B is 3.8 years.
In using the payback method to select Investment A, we ignore two important considerations. First there is no consideration of inflows after the cutoff period. The $2,000 in year 3 for Investment A in Table 12-3 is ignored, as is the $5,000 in year 5 for Investment B. Even if the $5,000 were $50,000, it would have no impact on the decision under the payback method.
Second, the method fails to consider the concept of the time value of money. If we had two $10,000 investments with the following inflow patterns, the payback method would rank them equally.
|Year||Early Returns||Late Returns|
Capital Budgeting Practices Utilized by Smaller, Privately Held Businesses Finance in ACTION Managerial
While the techniques described in this chapter are intended to be used by the modern, sophisticated business manager, not everyone uses them. It is, however, true that survey studies of large business firms over the past decade have shown an increasing acceptance of such concepts as discounted cash flow (as represented by the internal rate of return or net present value methods) and weighted average cost of capital.
But what about people who do capital budgeting analyses for smaller, privately held business firms? Extensive studies show that only a relatively small percentage of these firms (generally less than 20 percent) use discounted cash flow methods. For example, Runyon* found only 14.4 percent of his questionnaire respondents in small business firms used the internal rate of return or net present value approach. The rest used the payback method or some other unsophisticated approach.
Why do large business firms use theoretically correct approaches, while small business firms do not? There are two primary reasons. The first is that the small business manager is likely to be less sophisticated and educated in financial matters than the CFO of a larger corporation. The small businessperson’s skills are more likely to be in designing products, meeting customer demands, and hiring and satisfying employees.
But rather than be too critical, we should also realize the second reason why small business owners might be using the payback method or similar less sophisticated techniques. Small business owners must deal primarily with bankers or finance companies rather than stockholders or bondholders. When small business owners approach a banker for a loan to finance a capital investment, they should be prepared to demonstrate their capacity to repay the loan within a set period of time rather than quote their internal rate of return or net present value. That is the reason the payback method is often used, and the payback period required often is “the maturity the bank will allow on the loan.”
*L. R. Runyon, “Capital Budgeting Decision Making in Small Firms,” Journal of Business Research 11, pp. 389–97.
Although both investments have a payback period of two years, the first alternative is clearly superior because the $9,000 comes in the first year rather than the second.
The payback method does have some features that help to explain its use by U.S. corporations. It is easy to understand, and it emphasizes liquidity. An investment must recoup the initial investment quickly or it will not qualify (most corporations use a maximum time horizon of three to five years). A rapid payback may be particularly important to firms in industries characterized by rapid technological developments.
Nevertheless the payback method, concentrating as it does on only the initial years of investment, fails to discern the optimum or most economic solution to a capital budgeting problem. The analyst is therefore required to consider more theoretically correct methods.
Net Present Value
Net present value (NPV) is often the preferred investment selection method for two important reasons. First, it is a theoretically valid method. Second, it is well understood and used by real-world finance professionals. In other words, not only is NPV a theoretically correct method, it is also often the preferred method in practice. The net present value is the sum of the present values of all outflows and inflows related to a project. The present value of each inflow and outflow is usually discounted using the weighted average cost of capital, Ka, for the firm. Thus inflows that arrive in later years must provide a return that at least equals the cost of the invested capital. In Table 12-4, we calculate the NPVs for Investments A and B using an assumed cost of capital, or discount rate, of 10 percent.