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The IRR rule is appealing in that it usually gives the same guidance as the NPV rule when the threshold equals the company‟s cost of capital. If a project‟s IRR exceeds the firm‟s cost of capital, the project must be creating wealth for the firm. The project would produce returns greater than the firm‟s financing costs, and the spread would be added wealth for the investors. Unfortunately, the IRR rule frequently breaks down and gives misleading advice. The IRR rule suffers from two flaws. First, it ignores the relative sizes of alternative projects. For example, suppose a firm had to choose between two projects, each of which lasts one year. The first project costs $10,000 to set up but then pays back $16,000 one year later. The second project costs $100,000 to set up but pays back $120,000 one year later. Clearly, the IRR of the first project is 60%, and the IRR of the second project is 20%. On the basis of IRR, the first project seems to be superior. However, if the firm‟s cost of capital is 10%, the first project has an NPV of $4,454, whereas the second project has an NPV of $9,091. Clearly the second project creates more wealth. The first project has a higher rate of return but on a smaller investment. The second project‟s lower return on a larger scale is a better use of the firm‟s scarce managerial resources. The second flaw in the IRR rule stems from the fact that a given project may have multiple IRRs. The IRR is not always a single, unique value. Consider a two-year project. Initially the project costs $1,000 to set up. In the first year it returns $3,000. In the second year there is a cleanup costing $2,000. It is easy to verify that 0% is one correct value for the firm‟s IRR: Discounting at 0% and adding up all the discounted cash flows gives an NPV of zero. Notice, however, that 100% is another correct value for the IRR: Discounting all cash flows at 100% per year also gives an NPV of zero. If the firm‟s cost of capital is 10%, should this project be accepted or rejected? Ten percent is greater than 0%, but less than 100%. Only by computing the NPV at the discount rate of 10% do we find out that this project has a positive NPV of $74 and so should be accepted. When a project has two or more IRRs, the analyst would have no way of knowing which was the correct one to use if he or she did not also compute the NPV and apply the NPV rule. If the analyst computed only the IRR of 100%, she or he would reject this valuable project. It turns out that a project will have one IRR for every change in sign in its cash flows. If a project has an initial outlay and then subsequently all cash flows are positive inflows, there will be one unique IRR. If a project has an initial outlay, a string of positive inflows, and then a cleanup cost at the end, there will be two IRRs since the direction of cash flow changed twice. If there is an initial outlay, a positive inflow, another net outflow during a retooling year, followed by a positive inflow, the three sign changes would produce three different IRRs. The IRR rule would provide little guidance in such a scenario and could possibly lead to an incorrect judgment of the project‟s worth. In situations where its two fatal flaws are not at issue, the IRR rule gives the same result as the NPV rule. If the project‟s cash flows change sign only once, there is no problem of multiple IRRs. If all competing projects are of the same magnitude or if there is only one project under consideration, the size issue will not be a problem, either. In such a situation, the firm would be justified in selecting the project on the basis of IRR. One circumstance in which alternative projects are of equal size and cash flows change direction only once is in the analysis of alternative mortgage plans. These days, a person financing a home may choose from a multitude of mortgage plans. A variety of payment schedules are available, and some plans charge points in exchange for lower monthly payments. Since all mortgages considered by the
home buyer finance the same house, the size issue is not a concern. Also, the typical home mortgage involves a cash inflow at the beginning and then only cash outflows over the period when the borrower must pay back the loan. Thus, there is only one sign change among the cash flows. Borrowers can thus compare mortgages on the basis of their IRRs. They should calculate the cash flows over the horizon during which they expect to pay back the mortgage, and should then choose the lowest-IRR mortgage from among those whose monthly payments are affordable. The annual percentage rate (APR) quoted by mortgage companies is the IRR of the mortgage calculated after factoring in points and origination fees and assuming the mortgage will not be prepaid. Innovations in Capital Budgeting While a general consensus has been reached that wealth maximization is the objective of optimal capital budgeting, the tools for measuring wealth creation and the indicators that business policy is succeeding at that goal continue to evolve. The fact that new paradigms are still being invented tells us that NPV is not the last word in capital budgeting. Analysts and investors are constantly looking for better tools for making long-range capital decisions. An approach known as Economic Value Added (EVA®) was introduced by the consulting firm Stern Stewart & Company, which owns the term as a registered trademark. Another advanced paradigm known as “real options” is complex but gaining traction. Economic Value Added Economic Value Added (EVA®) is an accounting metric that aims to capture how much wealth a company creates in a given year. EVA is the amount of invested capital multiplied by the spread between the company‟s return on invested capital and its cost of capital. EVA aims to measure wealth creation in a given year rather than over the life of a project. EVA‟s advocates advise managers to adopt projects that maximize EVA and manage projects so as to maximize EVA each year. Managers should monitor projects and make modifications, award incentives, and impose penalties to continuously boost EVA. Real Options The real options paradigm seeks to measure not only the value of a project‟s forecast cash flows but also the value of strategic flexibility that a project creates for a company. For example, suppose a company is contemplating an initiative to market its wares on the Internet. The forecast cash flows may be weak, but establishing a presence on the Internet may be valuable in that it wards off potential competition and creates opportunities that can later be exploited. The option to expand or the flexibility to later pursue a wide range of initiatives is captured using the real option paradigm, whereas the value of these options is usually missed completely in the standard NPV approach. The real options paradigm entails identifying the strategic options inherent in a proposed project and then valuing them using modern mathematical option-pricing formulas. If the value of a proposed project
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Table of Contents Title Page Copyri
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Chapter 6 - Planning Capital Expend
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For Further Reading Part IV - Manag
Page 7 and 8:
Successful Postmerger Implementatio
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This book is printed on acid-free p
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Syllabus How Chapter Topics in This
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Some of these experts are full-time
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About the Contributors Richard T. B
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Advances in Quantitative Analysis o
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enterprise development. Dr. Zachara
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The left side shows Nutrimin‟s in
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Gail, let‟s go over this balance
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Gail, do you have any questions abo
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11. Not all expenses are cash outfl
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Financial Statements: Who Uses Them
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profitability to keep investing for
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Financial Accounting Standards It i
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Downloadable Resources for this cha
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Next, we explain each of these thre
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liquidity. Or, more simply, achievi
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If these ratios are seriously defic
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The debt-to-equity ratio is evaluat
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year 1 to year 3. The net effect wa
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to rate of return on the equity. Th
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Other types of comparisons of finan
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income/sales), asset turnover (sale
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successful businesspeople should ha
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More than a decade ago, a special c
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companies is used for illustration.
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The identification of nonrecurring
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The Dow Chemical single-step income
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is a pretax measure, but income fro
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Sources: Companies‟ annual report
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Exhibit 3.11 Examples of discontinu
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amortization purposes, the Company
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Examples of nonrecurring items disc
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During Fiscal 2006, inventory quant
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The nonrecurring items of Boston Sc
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The disclosure presented earlier in
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gains or losses that appear as part
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ecurring as for Kimberly-Clark, the
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Summarizing Nonrecurring Items and
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This example of using the SEB works
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Exhibit 3.27 Other income (expense)
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Source: Pfizer, Inc., annual report
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Exhibit 3.30 Acquisitions note: Pfi
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Source: Pfizer, Inc., annual report
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Exhibit 3.33 Cost-reduction initiat
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Exhibit 3.36 Share-based payment no
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The Pfizer Worksheet Analysis: Down
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Some Further Points on the Pfizer W
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• It is common to treat items as
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FedEx Corporation (2007) First Sola
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1 The American Institute of Certifi
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28 These alternative translation me
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If you need some instruction in Exc
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To solve using Excel, open your Exc
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As you can see from the previous ex
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C6 = 5 • Now enter the “=” si
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Ordinary Annuity An ordinary annuit
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To confirm that the number of payme
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The FV of this first payment into t
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Exhibit 4.15 Finding the future val
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Exhibit 4.18 Finding the present va
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From Exhibit 4.20, we see that as t
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Exhibit 4.22 Amortization schedule
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Exhibit 4.25 Regular cash flows wit
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Internet Links For Further Reading
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Investors who are risk averse will
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considering the risk of a single as
Page 152 and 153: Portfolio Risk Stand-alone risk is
Page 154 and 155: In spite of unique or diversifiable
Page 156 and 157: If a particular stock is highly sus
Page 158 and 159: The formula tells us that, to begin
Page 160 and 161: for the entire market of stocks sin
Page 162 and 163: The dividend per share for preferre
Page 164 and 165: If you are able to determine the cu
Page 166 and 167: Debt finance is the lower-cost meth
Page 168 and 169: We don‟t observe many firms whose
Page 170 and 171: Capital Structure in Practice Finan
Page 172 and 173: are able to observe regularities in
Page 174 and 175: dividends and capital gains. We wil
Page 176 and 177: where EBIT is earnings before inter
Page 178 and 179: Since long-term debt holders have a
Page 180 and 181: accept more investment projects. Re
Page 184 and 185: A beer company is considering build
Page 186 and 187: accounts receivable, and tabulates
Page 188 and 189: profit by the tax rate determines t
Page 190 and 191: Accounting profit often mixes varia
Page 192 and 193: The concept that future cash flows
Page 194 and 195: Like project A, project C also cost
Page 196 and 197: The after-tax interest rate is the
Page 198 and 199: equal mix of debt and equity, its d
Page 200 and 201: The payback period rule stipulates
Page 204 and 205: complete with its real options is g
Page 208 and 209: What does it matter that one invest
Page 210 and 211: Exhibit 7.3 Time line in dollars an
Page 212 and 213: There are a number of countries in
Page 214 and 215: eturn of 10% on its investments in
Page 216 and 217: Exhibit 7.12 Summary of exchange ra
Page 218 and 219: and so will the value of the liabil
Page 220 and 221: Source: CIA, World Factbook, availa
Page 222 and 223: Exhibit 7.18 Net present value of c
Page 224 and 225: equired interest payments to be pai
Page 226 and 227: So if the assistant treasurer was r
Page 228 and 229: This theory is far from perfect, as
Page 230 and 231: The Consulting Firm Jennifer, Jean,
Page 232 and 233: part by a statute, the Uniform Limi
Page 234 and 235: formation in Delaware (or any state
Page 236 and 237: purpose of requiring qualification.
Page 238 and 239: Phil‟s death may terminate the bu
Page 240 and 241: the transfer. This means that if Br
Page 242 and 243: These rules extend to tort liabilit
Page 244 and 245: In the absence of a meeting, stockh
Page 246 and 247: A more detailed discussion on the b
Page 248 and 249: Partnerships If possible, the resul
Page 250 and 251: associated with this arrangement ar
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Partnerships are also not separate
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For most start-up businesses, howev
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form, even at the risk of some unli
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likely that our consultants will be
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Thus, the corporation and LLC, with
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It is not possible to fully describ
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usiness corporation for all purpose
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a cash-basis taxpayer to be taxed a
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The Tax Reform Act of 1986 substant
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limit is the product of the value o
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he would have spent anyway. In fact
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protect Brad from the scenario of h
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paying for the privilege. If the st
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The second tax scenario attaches to
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include that nullity in his taxable
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then the capital gain to be taxed h
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Most relevant to Morris is Section
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To begin with, the ESOP will have t
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general partner of a limited partne
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small businesses) is also subject t
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oth Lisa and Brad would be free to
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Assume that a limited liability com
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corporations, and had been audited
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There is plenty of blame from the c
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• An important study about top ma
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• The federal government made at
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$79.7 million for other services, a
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Budgets offer a variety of benefits
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determine the impact of specific pr
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Exhibit 11.2 Budget variance report
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udget, we just add more to it next
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income statement. The financial bud
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For a manufacturing company, cost o
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C&G‟s Gift Shop has a policy to m
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Meeting cash obligations as they co
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was unusually low, say, due to the
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A fixed budget, sometimes called a
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A large part of the budget selling
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• Centralized resource allocation
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Merewitz, Leonard, and Stephen H. S
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This chapter starts with a discussi
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Interestingly the numbers for quart
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Exhibit 12.4 Scenarion analysis.
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Pitfalls Although this analytic tec
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Exhibit 12.6 Variable cost element
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Variable Cost as a Function of Outp
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If scenario 2 yields a lower profit
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Microsoft certainly does not price
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If it is determined that dumping ha
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Leaving government agencies and not
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transaction processing. Each proces
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Exhibit 13.3 E-commerce transaction
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To summarize the analysis, the busi
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Capacity costs are probably the mos
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which it was, but for the inventory
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They called this strategic cost man
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A closer study, however, revealed s
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the benefits of business planning.
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The last type of plan is called a d
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The Business Plan We will progress
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Hook the Reader That means having t
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Industry The goal of this section i
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upscale suburban client who wants p
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Company and Product Description Com
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Exhibit 14.8 shows the competitive
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Exhibit 14.9a Advertising schedule.
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Scope of Operations What is the pro
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Development Time Line A development
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By law, most organization types req
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As mentioned in the development pla
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that can be depreciated, you should
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1 Special thanks to Matt Feczko, Mi
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For better or worse, the business e
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Leeson bet and lost. Japanese stock
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Between February and April 1994, Da
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LTCM could be picky when it came to
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An investor who wished to invest in
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Similarly, the swaps market has rev
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speculator would suffer losses equa
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American manufacturer will suffer l
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The ease with which futures facilit
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Exhibit 15.1 Call option payoff dia
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Exhibit 15.2 Payoff diagram for a w
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Notice that the put option payoff r
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Bank, owns a large block of NASDAQ
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can be tailored so that the money r
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Finally, the last step is to choose
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3 Fischer Black, who co-invented th
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not include assets that the firm ha
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Thus, a business valuation will usu
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Negative • Acme is highly depende
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Exhibit 16.3 Acme Manufacturing, In
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Profitability ratios reflect the re
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When we talk about the value of a b
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This example illustrates that with
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Income Approach: Discounted Cash Fl
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Exhibit 16.5 Acme Manufacturing, In
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Victoria explains that the second p
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Victoria analyzes Acme‟s audited
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In summary, the discounted cash flo
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Adjustment for Illiquidity As previ
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51% position sells for a higher pri
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examples. The proper application of
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The subject of this chapter is grow
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Finally, an acquisition can be effe
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M&A activity has been the focus of
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companies continue to make the same
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equals was taking on a distinctive
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Anatomy of a Successful Acquirer: T
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employees kept their original jobs
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where ΔCF t is the incremental cas
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where it‟s ultimately buried. Suc
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The following example summarizes th
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make sure that you are at least awa
Page 493 and 494:
acquisition, there is no immediate
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its vascular business, which was so
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While all employees should be part
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makes strategic and financial sense
Page 501 and 502:
Bhagat, Sanjai, Ming Dong, David Hi
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The 2008 financial crisis underscor
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Source: Plunkett’s Outsourcing &
Page 509 and 510:
To summarize: Trends • Large numb
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Companies are becoming increasingly
Page 513 and 514:
What steps should a company follow
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• Results of meetings with vendor
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• Breach of contract and remedies
Page 519 and 520:
Assuming the project or service rev
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The answer is: profits. The company
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19 Information Technology and You D
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People‟s lives have been turned u
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its self-contained rechargeable bat
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Random-Access Memory (RAM) Random-a
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On laptop computers and PDAs, the s
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Operating System An operating syste
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the spreadsheet software together w
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Exhibit 19.5 Pro forma sales and in
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Database Software A database is a c
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Internet e-mail addresses often con
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Personal Finance Software There are
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There are several different approac
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One of the major attractions of the
Page 551 and 552:
While not a new version of the Web
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industrial revolution, and has occu
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Dummies Inc. has a series of books
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organization. This chapter is desig
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As technology has evolved, the term
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While the software mentioned earlie
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Most of the focus of the investor c
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Data Access and OLAP Before the lat
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Exhibit 20.5 illustrates a differen
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Productivity Tools Workers expect t
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Client-server technology is based o
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Today, most programmers write in C+
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Exhibit 20.6 is a model of a typica
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No treatment of relational database
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Online analytical processing (OLAP)
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server) and the rest on the users
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the other operational departments w
Page 587:
The world of business has changed d
Page 591:
Chaffey, Dave, E-Commerce and E-Com
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According to the results of the sur
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understand the financial situation
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MBA graduates who are hoping to ent
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Summary Financial services opportun
Page 603 and 604:
Let‟s begin with the “I left it
Page 605 and 606:
MBA student: “Well, I go to [Grea
Page 607 and 608:
Aiming for Your Goals For career ch
Page 609 and 610:
Networking is generally regarded as
Page 611 and 612:
Let‟s begin with some key assumpt
Page 613 and 614:
like, or moving ahead in the compan
Page 618 and 619:
Accrual accounting: An accounting m
Page 620 and 621:
Cash flow: Cash that is spent or re
Page 622 and 623:
Distribution channel: A chain of in
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Goodwill: As it relates to valuatio
Page 626 and 627:
Management’s discussion and analy
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Ordinary annuity: An annuity that p
Page 630 and 631:
Securities and Exchange Commission
Page 632 and 633:
Vertical merger: A merger in which
Page 634 and 635:
about activity-based costing progre
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Application systems ARPAnet Arthur
Page 638 and 639:
Bell Labs Benefit measurement Beta
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goal orientation legal and contract
Page 642 and 643:
segment information note share-base
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process of purpose of real world us
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uy/build decision capital budget in
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written resume Careers in corporate
Page 650 and 651:
Cell Center for Research in Securit
Page 652 and 653:
Compensation and ownership Competit
Page 654 and 655:
Corporate culture Corporate debt in
Page 656 and 657:
profit planning from an internal pe
Page 658 and 659:
Data Data access and OLAP Database
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Askin Capital Management Barings Ba
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market approach publicly traded gui
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Electronic data interchange (EDI) E
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Extensible markup language (XML) Ex
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short term liquidity users and uses
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Fourth generation programming (4GL)
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Going private Going private transac
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Hypertext links Hypertext markup la
Page 676 and 677:
Information technology and the firm
Page 678 and 679:
International Accounting Standards
Page 680 and 681:
Last-in-first out (LIFO) vs. curren
Page 682 and 683:
Long call option payoff Longer-term
Page 684 and 685:
Market risks Market size and struct
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Motivation to outsource Multiple IR
Page 688 and 689:
Nonrecurring items defined disclosu
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Operational complexity Operational
Page 692 and 693:
Outsourcing metrics Overhead Over-t
Page 694 and 695:
Personal end game Personal expense
Page 696 and 697:
Price competition Price decreases P
Page 698 and 699:
Projected cash flow statements Proj
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Relevant range Relevant range assum
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Risk sharing Risk transfer Risk vs.
Page 704 and 705:
Short call option payoff Short part
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Spot price Spreadsheet software Spr
Page 708 and 709:
Summarizing nonrecurring items and
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acquisition the business dividends
Page 712 and 713:
Timmon‟s Model of Opportunity Rec
Page 714 and 715:
U.S. immigration quotas U.S. Intern
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discounting with discount rate form
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