1. Reason in terms of cash flows

We have already seen that the return on an investment is assessed in terms of the resulting cash flows. One must therefore analyse the negative and positive cash flows, and not the accounting income and expenses. These accounting measures are irrelevant because they do not take into account working capital generated by the investment and include depreciation, which is a non-cash item.

We stress the fact that in finance, negative cash flows will only imply a cost from the time they are paid and positive cash flows will only provide benefits from the time they are actually cashed in, and this regardless of the accounting treatment.

2. Reason in terms of incremental flows

When considering an investment, one must take into account the flows it generates, all these flows, and nothing else but these flows. It is crucial to assess all the consequences of an investment upon a company’s cash position. Some of these are self-evident and easy to measure, and others are less so.

A movie theatre group plans to launch a new complex, and substantial costs have already been incurred in its design. Should these be included in the investment programme’s cash flows? The answer is no, since the costs have already been incurred regardless of whether or not the complex is actually built. These are sunk costs. Therefore, they should not be considered part of the investment expenditure.

It would be absurd to carry out an investment simply because the preparations were costly and one hopes to recoup funds that, in any case, have already been spent. The only valid reason for pursuing an investment is that it is likely to create value.

Now, if the personnel department has to administer an additional 20 employees hired for the new complex (e.g. 5% of its total workforce), should 5% of the department’s costs be allocated to the new project? Again, the answer is no. With or without the new complex, the personnel department is part of overhead costs. Its operating expenses would only be affected if the planned investment generates additional costs – for example, recruitment expenses.

However, design and overheads will be priced into the ticket charged for entry to the new complex.

A perfume company is about to launch a new product line that may cut sales of its older perfumes by half. Should this decline be factored into the calculation of the investment’s return? Yes, because the new product line will prompt a shift in consumer behaviour: the decline in cash flow from the older perfume stems directly from the introduction of this new product.

Nevertheless, we can mention that in certain very specific sectors with very low marginal costs, this reasoning may lead to overinvestment, creating overcapacity and therefore price wars.

3. Reason in terms of opportunity

For financial managers, an asset’s value is its market value, which is the price at which it can be bought (investment decision) or sold (divestment decision). From this standpoint, its book or historic value is of no interest whatsoever, except for tax purposes (taxes payable on book capital gains, tax credit on capital losses, etc.).

For example, if a project is carried out on company land that was previously unused, the land’s after-tax resale value must be considered when valuing the investment. After all, in principle, the company can choose between selling the land and booking the after-tax sales price, or using the land for the new project. Note that the book value of the land does not enter into this line of reasoning.

The opportunity principle boils down to some very simple rules:

• if a company decides to hold on to a business, this implies that it should be prepared to buy that business (if it did not already own it) in identical operating circumstances; and
• if a company decides to hold on to a financial security that is trading at a given price, this security is identical to one that it should be prepared to buy (if it did not already own it) at the same price.

Financial managers are, in effect, “asset dealers”. They must introduce this approach within their company, even if it means standing up to other managers who view their respective business operations as essential and viable. Only by systematically confronting these two viewpoints can a company balance its decision-making and management processes.

Theoretically, a financial manager does not view any activity as essential, regardless of whether it is one of the company’s core businesses or a potential new venture. The CFO must constantly be prepared to question each activity and reason in terms of:

• buying and selling assets; and
• entering or withdrawing from an economic sector of activity.

The concept of necessity should be interpreted as regards the strategy of the firm, the investment is then a tool for achieving this strategy; a necessary tool, hence highly profitable.

4. Disregard the type of financing

When comparing an investment’s return with its cost of financing (what we will call weighted average cost of capital in Chapter 29), the two items must be considered separately.

In practice, since the discount rate is the cost of financing the investment (weighted average cost of capital), interest expense, repayments or dividends should not be included in the flows. Only operating and investment flows are taken into account, but never financing flows. This is the same distinction that was made in Chapter 2. Failure to do so would skew the project’s net present value. This would also overstate its IRR, since the impact of financing would be included twice:

• first, within the weighted average cost of capital for this investment, which is its cost of financing; and
• second, at the cash flow level.

Consider, for example, an investment with the following flows:

The NPV of this investment is 7.2 (if cash flows are discounted at 12%) and its IRR is 15%. Now, assume that 20% of the investment was financed by debt at an annual after-tax cost of 6%. Then it is possible to deduct the debt flows from the investment flows and calculate its NPV and IRR:

With a rate of 12%, the NPV is 10.1 and the IRR is 17.2%. Now, if 50% of the investment were financed by debt, the NPV would rise to 14.4 and the IRR to 24%. At 80% debt financing, NPV works out to 18.7 and the IRR to 51%.

This demonstrates that by taking on various degrees of debt, it is possible to manipulate the NPV and IRR. This is the same as using the financial leverage that was discussed in Chapter 12. However, this is a slippery slope. It can lead unwary companies to invest in projects whose low industrial profitability is offset by high debt, which in fact increases the risk considerably.

When debt increases, so does the required return on equity as the risk increases for shareholders, as we have seen in Chapter 12. It is not correct to continue valuing NPV at a constant discount rate of 12%. The discount rate has to be raised in conjunction with the level of debt. This corrects our reasoning and NPV remains constant. The IRR is now higher, but the minimum required return has risen as well to reflect the greater degree of risk of an investment financed by borrowings.

It would be absurd to believe that one can undertake an investment because it generates an IRR of 10% whereas the corresponding debt can be financed at a rate of 7%. In fact, the debt is only available because the company has equity that acts as collateral for creditors. Equity has to be remunerated, and this is not reflected in the 7% interest on the debt. No company can be fully financed by debt, and it is therefore impossible to establish a direct comparison between the cost of debt and the project’s return.

5. Consider taxation

Clearly, taxation is an issue because corporate executives endeavour to maximise their after-tax flows. Consider that:

• additional depreciation generates tax savings that must be factored into the equation;
• the cash flows generated by the investment give rise to taxes, which must be included as well; and
• certain tax shields offer tax credits, rebates, subsidies, allowances and other advantages for carrying out investment projects.

In practice, it is better to value a project using after-tax cash flows and an after-tax discount rate in order to factor in the various tax benefits from an investment. Therefore, the return required by investors and creditors is calculated after tax.

In cases where cash flows are discounted before tax, it is important to ascertain that all flows and components of weighted average cost of capital are considered before taxes as well.

6. Be consistent!

Finally, the best advice is to always be consistent. If the basis of valuation is constant euro values – that is, excluding inflation – be sure that the discount rate excludes inflation as well. We recommend using current euro values, because the discount rate already includes the market’s inflation expectations.

If it is a pre-tax valuation, make sure the discount rate reflects the pre-tax required rate of return. We recommend using after-tax valuations because a world without taxes only exists in textbooks!

And if flows are denominated in a given currency, the discount rate must correspond to the interest rate in that currency as well.

1. Operating flows

The investment’s contribution to total earnings before interest, taxes, depreciation and amortisation (EBITDA) must be calculated. It represents the difference between the additional income and expenses arising from the investment, excluding depreciation and amortisation.

Then, from EBITDA, the theoretical tax on the additional operating profit must be deducted. The actual tax is then calculated by multiplying the tax rate borne by the project with the differential on the operating profit, taking into account any tax-loss carryforwards.

In other words:¹

where T _c is the corporate tax rate.

2. Investment flows

The definition of investment is quite inclusive, ranging from investments in working capital to investments in fixed assets.

It is essential to deduct changes in working capital from EBITDA. Unfortunately, many people tend to forget this. In most cases, working capital is just a matter of a time lag. It builds up gradually, grows with the company and is retrieved when the business is discontinued. A euro capitalised today in working capital can be retrieved in 10 years’ time, but it will not be worth the same. Money invested in working capital is not lost. It is simply capitalised until the investment is discontinued. However, this capitalisation carries a cost, which is reflected in the discounted amount.

Investment in fixed assets comprises investment in production capacity and growth, whether in the form of tangible assets (machinery, land, buildings, etc.) or intangible assets (research and development, patents and licences, business capital, etc.) or financial assets (shares in subsidiaries) for external growth.

The calculation must be made for each period, as the investment is not necessarily restricted to just one year, nor spread evenly over the period. Once again, remember that our approach is based on cash and not accounting data. The investment flows must be recognised when they are paid, not when the decisions to make them were incurred. And finally, do not forget to reason in terms of net investment; that is, after any disposals, investment subsidies and other tax credits.

3. Extraordinary flows

It may seem surprising to mention extraordinary items when projecting estimated cash flows. However, financial managers frequently know in advance that certain expenses that have not been booked under EBITDA (litigation, tax audits, etc.) will be disbursed in the near future. These expenses must all be included on an after-tax basis in the calculation of estimated free cash flow.

Extraordinary flows can usually be anticipated at the beginning of the period since they reflect known items. Beyond a two-year horizon, it is generally assumed that they will be zero.

This gives us the following cash flow table:

1. The payback period

The payback period is the time necessary to recover the initial outlay on an investment. Where annual cash flows are identical, the payback period is equal to:

For the following investment:

the payback period is 2.1/0.8 = 2.6 years.

Where the annual flows are not identical, the cumulative cash flows are compared with the amount invested, as below:

The cumulative flow is 0.7 for period 2 and 1.1 for period 3. The payback period is thus two to three years. A linear interpolation gives us a payback period of 2.75 years.

Once the payback period has been calculated, it is compared with an arbitrary cut-off date determined by the financial manager. If the payback period is longer than the cut-off period, then the investment should be rejected. Clearly, when the perceived risk on the investment is high, the company will look for a very short payback period in order to get its money back before it is too late!

The payback ratio is used as an indicator of an investment’s risk and profitability. However, it can lead to the wrong decision, as shown in the example below of investments A and B.

The payback rule would prompt us to choose investment B, even though investment A has positive NPV but B does not. The payback rule can be misleading because it does not take all flows into account. It emphasises the liquidity of an investment rather than its value.

Moreover, because it considers that a euro today is worth the same as a euro tomorrow, the payback rule does not factor in the time value of money. To remedy this, one sometimes calculates a discounted payback period representing the time needed for the project to have positive NPV. Returning to the example, with a 20% discount rate, it then becomes:

The discounted payback period is now 4 years compared with 2.6 years before discounting. Discounted or not, the payback period is a risk indicator, since the shorter it is, the lower the risk of the investment. That said, it ignores the most fundamental aspect of risk: the uncertainty of estimating liquidity flows. Therefore, it is just an approximate indicator since it only measures liquidity.

However, the payback ratio is fully suited to productive investments that affect neither the company’s level of activity nor its strategy. Its very simplicity encourages employees to suggest productivity improvements that can be seen to be profitable without having to perform lengthy calculations. It only requires common sense. However, calculating flows in innovative sectors can be something of a shot in the dark. Also, the payback rule tends to favour investments with a high turnover rate. As a result, it has come under quite a bit of criticism because it can only compare investments that are similar.

2. Return on capital employed

The return on capital employed (ROCE) represents the increase in after-tax operating profit generated by the investment over the year divided by the capital employed (sum of fixed assets and the working capital generated by the investment):

This ratio has a strong accounting bias, and is frequently just a comparison between the project’s operating profit and the average book value of fixed assets and working capital. The average accounting return can then be calculated, which is the annual ROCE over the life of the investment. The computation of ROCE takes into account the after-tax operating profit and capital employed (working capital plus the residual investment after depreciation).

Depreciation plays a detrimental role, as shown in the example below of an initial investment of 500 generating annual EBITDA of 433 for five years. With stable working capital of 500 and a 40% tax rate, the free cash flow projection is as follows:

The investment’s IRR works out at 23.75%. What is its return on capital employed?

Assuming the asset is depreciated on a straight-line basis over five years, we have:

If the declining balance method of depreciation is used (40%, 30%, 20%, 5% and 5%), this yields:

So, what is the return on capital employed? In the first case it averages 29.8% and in the second case it is 35%. Do you really believe that just changing an accounting method can influence the intrinsic profitability of a project? Of course not, and this example clearly illustrates the flaw inherent in the criteria.

Although the highest returns are usually obtained on projects with the longest durations, average accounting rates of return do not take into account the dates of the flows. Hence, they generally tend to overstate returns. Another drawback with accounting rates of return is that they maximise rates without considering the corresponding risk.

On the surface, it may seem that there is no connection between return on capital employed and the internal rate of return. The first discounts flows, while the second calculates book wealth. And yet, taken over a year, their outcomes are identical. An amount of 100 that increases to 110 a year later has an IRR of 100 = 110/(1 + r), so r = 10%, and ROCE of 10/100, or 10%.

ROCE and IRR are equal over a given period of time. ROCE is therefore calculated by period, while IRR and NPV are computed for the entire life of the investment.

Although accounting rates of return should not be used as investment or financing criteria, they can be useful financial control tools.

Sooner or later, a discounted return has to be translated into an accounting rate of return. If not, the investment has not generated the anticipated ex-post return and has not achieved its purpose. We strongly advise you to question any differences between IRR and ROCE, i.e. are income flows distributed or retained, do profits arise unevenly over the period (starting out slowly or not at all and then gathering momentum), what is the terminal value, etc.?

3. Capital rationing and the present value index

Sometimes there is a strict capital constraint imposed on the firm, and it is faced with more NPV-positive projects than it can afford. In order to determine which project(s) to pursue, the best formula to use is the present value index (PVI). This is the present value of cash inflows divided by the present value of cash outflow:

By using the PVI, financial managers can rank the different projects and then select the investment with the highest PVI – that is, the project with the highest NPV relative to the present value of outflows. After making this selection, if the total amount of capital available has not been fully exhausted, the managers should then invest in the project with the second-highest PVI, and so on until no more capital remains to invest.

More generally, the objective is to compare all combinations of projects that meet the budget and find the one that maximises the weighted average PVI:

Questions

Exercises

Answers

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