CAPITAL BUDGETING TECHNIQUES DOESN’T ANSWER : WILL I GET MY MONEY BACK?

This is what I am thinking of about all those capital budgeting techniques that I have learnt so far.

Many corporate finance and investment textbooks (and the training on capital budgeting) will spend a lot of time discussing about the methods being used in evaluating the feasibility of the [real] project investment. This will include the long discussions and plus-minus of using Net Present Value (NPV), IRR (Internal Rate of Return), Payback period, [Accounting] Rate of Return. Though NPV is theoretically superior (and highly recommended by many finance scholars) compared to IRR, yet IRR still a very interesting topic being asked by the participants/readers. Probably, this is because IRR is so close to “interest rate” that are so commonly mentioned in the newspapers, including by Central Bank. In a sense, IRR is a ‘yield’, and most often, the feasibility of the investment is described by its yield alone. I guess, this is because, IRR is easy to explain away. No need to touch on the assumptions, base scenario, downside and upside case. The participants seems to understand quickly.

 

However, IRR/yield doesn’t answer at all about the most basic question, I were to put my money, in a project: WILL I GET MY MONEY (PRINCIPAL) BACK? (and how long? Payback partially address the latter question).

 

In fact, yield is just the third goal in terms of importance order in analyzing an investment feasibility:

 

First, the project legal is clean & clear (in other words, doesn’t expose the investor to risk of legal suit/dispute

 

Second, the investor gets his/her [principal] amount of money back (this is usually called return OF capital]

 

Third, the last one (read: least important), the investor will be compensated with fair rate of return, that is how much money the project will earn from the project (if all assumptions and cash flow forecasts prove to be realized.]

 

So it means, hiring or having a good legal consultant is the first step to do even prior to analyzing the financial feasibility of a project.

 

Addressing second goal above, IRR/yield definitely is not the answer, and NPV as well according to me. Though a positive NPV means that the investor will get his money back plus fair rate of interest rate (if possible), but still it doesn’t straightforward say this. Getting the money back will involve many things other than just having a positive NPV from a project. Other factors of the project’s characteristics will be playing even more important, such as, whether the investor have a control over the project, other participants being participating and have a financial interest in the project, the capability of the investor to use its power over the project to affect the returns of the project, project’s financing structure, and  other contractual arrangement.

 

So walking out of the finance class (and capital budgeting training class) by knowing how to analyze from a finance aspect of the project, doesn’t really equip us quite well to answer the most basic of investor’s question: WILL I GET MY MONEY BACK?

 

Then, if the capital budgeting techniques doesn’t give us the answer whether my money will be back, what should we do?

My suggestion, even before we open our Excel to start doing our project analysis, it is far more important and so critical to put our feet on the ground.

Many efforts that we could do, for example, in the case there is a proposal to open a retail store in the mall, I am suggesting the following to “put our feet on the ground”

  • Visiting the mall, check whether it is a destination mall, neighborhood mall, weekdays mall, weekend mall, young family mall, hang-out mall, lunch/dinner mall, in business district?
  • Visiting the parking area of that mall? How many car/motor cycles are there? How many cars/motor cycles coming to that mall every week? Are visitors coming using the public transportation or using their own vehicle?
  • How is the surroundings of the mall? near office tower, near apartments (how many towers?, is it all occupied), in the midst of residential complex?
  • Who is the big box store or anchor tenant, supermarket/department store, there near or inside the mall? Are they really a traffic pooler to that mall?
  • How is the gross income per capita in that area? Density? Population aging profile? How is the spending power profile for the visitors coming that mall? Are they buying 1-2 items per basket? Or more?
  • Customer profile for that mall visitors (age, male/female composition, family, singly coming);
  • Meeting or talk with your suppliers/visitors/customers to see their views on that mall traffic.
  • Where is the location of the proposed store (lower ground, first floor, second floor, etc.)? Is it near the escalator, lift (for easy access)? Is there any traffic passing the store front, for example, near ATM machines, good restaurants, saloon, gym location? What is the plan from the landlord for that mall strategy to attract more traffic coming to that mall? Many thematic event being held every month?
  • What brand stores that have been there? Where are their location? Lower ground, first floor, etc.? How long have they been there? Is there any plan/news that we heard they are going to move out from that mall for whatever reason?
  • Is there any competitor brand that have opened stores? Where are their location? Are they within your shouting distance? We could even observe their traffic/footfall, see how many people passing the store front, and how many people flowing into that store, and then go converted to customer (to cashier area for check-out). How is the product range in that store? Customer profile going into that store.
  • How is the rental rate? Calculated from the Revenue in certain % fixed, or fixed rate per sqm, with 30-40% paid in advance, and the remaining to be installed less than 4 years, which will push the rental outflow happen in the first years of rental period, putting heavy pressure on the cashflow while the store traffic ramp up is building up.

By doing above, I believe, this will equip us with having a thorough independent understanding of the business idea than to trust on so-called fancy capital budgeting techniques, or experts building  the financial projection.

 

Dr. Tal Mofkadi *) sharing his thoughts on my statements above (via email on 3rd April 2018)

Many corporate finance and investment textbooks (and the training on capital budgeting) will spend a lot of time discussing about the methods being used in evaluating the feasibility of the [real] project investment. This will include the long discussions and plus-minus of using Net Present Value (NPV), IRR (Internal Rate of Return), Payback period, [Accounting] Rate of Return. Though NPV is theoretically superior (and highly recommended by many finance scholars) compared to IRR, yet IRR still a very interesting topic being asked by the participants/readers. Probably, this is because IRR is so close to “interest rate” that are so commonly mentioned in the newspapers, including by Central Bank. In a sense, IRR is a ‘yield’, and most often, the feasibility of the investment is described by its yield alone. I guess, this is because, IRR is easy to explain away. No need to touch on the assumptions, base scenario, downside and upside case. The participants seems to understand quickly. [Dr. Tal Mofkadi: I am not sure this statement is fully correct, for the IRR we need the same cash-flows as for the NPV]

However, IRR/yield doesn’t answer at all about the most basic question, I were to put my money, in a project: WILL I GET MY MONEY (PRINCIPAL) BACK? (and how long? Payback partially address the latter question). [Dr. Tal Mofkadi : When the IRR is >0 it means that the principal is paid back, isn’t it?]

 

In fact, yield is just the third goal in terms of importance order in analyzing an investment feasibility:

 

First, the project legal is clean & clear (in other words, doesn’t expose the investor to risk of legal suit/dispute [Dr. Tal Mofkadi: nice point. You can argue that this is quantified in the expected cash-flows]

 

Second, the investor gets his/her [principal] amount of money back (this is usually called return OF capital]

 

Third, the last one (read: least important), the investor will be compensated with fair rate of return, that is how much money the project will earn from the project (if all assumptions and cash flow forecasts prove to be realized.]

 

So it means, hiring or having a good legal consultant is the first step to do even prior to analyzing the financial feasibility of a project.

 

Addressing second goal above, IRR/yield definitely is not the answer, and NPV as well according to me. Though a positive NPV means that the investor will get his money back plus fair rate of interest rate (if possible), but still it doesn’t straightforward say this. Getting the money back will involve many things other than just having a positive NPV from a project. Other factors of the project’s characteristics will be playing even more important, such as, whether the investor have a control over the project, other participants being participating and have a financial interest in the project, the capability of the investor to use its power over the project to affect the returns of the project, project’s financing structure, and  other contractual arrangement.

 

So walking out of the finance class (and capital budgeting training class) by knowing how to analyze from a finance aspect of the project, doesn’t really equip us quite well to answer the most basic of investor’s question: WILL I GET MY MONEY BACK? [Dr. Tal Mofkadi: I disagree with this statement. Since standard financial analysis covers this question.]

Dr. Tal Mofkadi: I see the angle here and I actually like it, however to my humble opinion I think that the text is not 100% accurate.

 

*) Dr. Tal Mofkadi holds a Ph.D. in financial economics from Tel-Aviv University. He was a visiting assistant professor in Kellogg School of Management at Northwestern University and is teaching financial courses in Tel-Aviv University, University of Amsterdam, Tallinn University of Technology, Copenhagen Business School and more. He is the co-authored of two books:Principle of Finance with Excel 3rd edition, (co-authored with Benninga). Oxford University Press, New-York 2017.The Handbook of Corporate Valuation (Hebrew), (co-authored with Ben-Horin and Yosef). Probook, Tel-Aviv 2013.Tal is the managing partner of a leading financial and economic consultancy firm in Israel (www.numerics.co.il) and has a vast practical experience in valuations, portfolio theory, financial analysis and providing expert opinion in legal processes. (taken from https://mba.nucba.ac.jp/research/faculty/entry.html?u_bid=157&u_eid=14942 dated 8th April 2018)

Karnen’s responses to Dr. Tal Mofkadi via email on 8th April 2018:

To be honest, what I see from many textbook on corporate finance related to introducing the capital budgeting techniques to the students, it is inclined to the students to think more about the return ON capital, though if they are working for a corporation, they need to think more on the first and second question, instead of the third question.
IRR (even if more than 0) or positive NPV could send the impression that the project is feasible financially, and the money that the corporation has invested, could be recouped. I believe, in real life, it is so hard…to find a project (projects) with IRR > 0 (or positive NPV), and in many cases, by pushing the analysts to answer the second question (that is return OF capital), this will make the analysts to see what is there (particularly, whether the company has a very competitive advantage over its competitors) that could make the project proposal delivering a positive NPV or IRR >0. I am quite concerned when analysts within days/weeks could give me a project/projects with positive NPV (or IRR >0). IRR or NPV techniques could be a hammer to a baby, who will see everything is like a nail.
Comments from Ignacio Velez-Pareja(via email dated 8 April 2018):

Let me put my position on the issue:

  1. To know if the project/investment is good or not, the NPV is the most “correct” tool. It measures the value added by all the physical assets and the intangibles assets. In fact, NPV is a measure of the total intangle value generated by the firm. The problem of intangibles arise when you try to split all that NPV into patents, brands, etc.
  2. To kow the return, use the IRR
  3. To know when you get your money back forget the traditional payback period. I propose what I call the discounted payback period (DPB). This is the time when the NPV of the investment reaches zero. See this graph for the following CFs and DR

DR = 12%

t CF
0 -1.000
1 400
2 400
3 400
4 400

 

 

This means that the investor will receive not only her investment (book value) but added with the opportunity cost of having the funds devoted to the project.

Posted in CAPITAL BUDGETING.

Leave a Reply