LEASE VERSUS BUY DECISION ANALYSIS: CORRECT ONE

Terlampir adalah kertas kerja untuk menganalisa keputusan capital budgeting terkait apakah sewa guna usaha (jangka panjang) vs membeli (long-term lease vs buy decision analysis).

 

Enclosed is the working sheet to analyse the capital budgeting decision on Long-Term Lease vs Purchase.

 

Workbook Lease vs Buy Sukarnen

 

Jakarta, 29 March 2018

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.

CAPITAL BUDGETING ANALYSIS : PROJECT DURATION

 

Many Capital Budgeting books, looks like there is no mention about to determine the project duration from the perspective of cash flows. It is so common for people that just because the project has, let’s say 10-year contract, then, the project life is 10 years and people just look at 10-year bond to check the interest.
Fortunately we could grab the idea of Bond duration to measure the duration of corporate project.
By knowing the project duration then we could match it with the bonds duration that we are going to issue. At the end of the day, it is so important to have an asset-liability duration matching, something is so crucial in banking sector. Equity financing is expensive (much expensive that the loan), and it is so easy to think that equity financing is free as it has no obligation to pay the interest, no due date and no incurrence/maintenance covenants. So I always suggest to see the equity financing as the last option to go to get the money for the project financing.
By picking up the bond duration matched with the project duration, we could learn something about the the sensitivity of the project value by looking at the relationship between bond duration and its interest and bond value.
 [to be continued]

USE AVERAGE INTERNAL RATE OF RETURN (AIRR) AND NOT INTERNAL RATE OF RETURN (IRR) PART 3

Dear Karnen,

Please find enclosed my latest paper on AIRR, recently published in the Journal of Mathematical Economics.   Section 8, specifically devoted to practitioners, shows three different examples, including HomeNet’s example from Berk and DeMarzo’s textbook.

I welcome your comments and thank you very much for your attention

Best regards

Carlo Alberto Magni, Associate Professor
Department of Economics, University of Modena and Reggio Emilia
 
The Engineering Economist – Area Editor

I forward Prof. C.A. Magni’s above paper to Prof. Peter DeMarzo to seek his comments.

Personally, I see Magni’s paper on AIRR is quite comprehensive and convincing.

Hi Prof. Peter DeMarzo,I sent herewith one article written by Prof. C.A. Magni, in which he
shows AIRR implementation by using the HomeNet’s example taken from your book (see page 70 and 71).Though of course, we could just jump to NPV, yet, by putting something into “rate of return” (in %) it is much easier to get the point across to the other side of the table in many project analysis discussions.

It works for somebody without or with short finance course in the backdrop. Though I see a lot of Corporate Finance traditional textbooks explaining away on how to get the IRR, but it is not really touching the bone of this IRR. One article back in 1976 by C.B. Akerson, I guess, appropriately quite well in giving us a better idea about what this IRR is. From this paper, IRR seems this concept is built around the savings bank account analysis, in which the intermediate value is pretty clear to forecast.Akerson, C.B., The Internal Rate Of Return in Real Estate Investments,

A Research Monograph, Prepared for the American Society of Real Estate Counselors, 1976. Looking forward to hearing your opinion on this.

Thanks

Karnen

Prof. Peter DeMarzo:

 

Hi Karnen,

I have looked briefly at this but still remain unconvinced that it is very practical.  Like IRR, it does not improve upon NPV.  And worse, it tempts users to rank projects by their returns – don’t you agree?

Ignacio Velez-Pareja (IVP)

Listen, I don’t like rates of returns, in general. Imagine this: you surely calculate THE internal rate of return of  one project. However, if you do correctly the valuation, as you know, you have DIFFERENT discount rates for each period. N discount rates. What do you do with ONE IRR and N discount rates? Which discount rate is the one you choose to compare IRR with it?
Karnen:

On the last line from Ignacio Velez-Pareja:

What do you do with ONE IRR and N discount rates? Which discount rate is the one you choose to compare IRR with it?

I guess, the question is not quite apple-to-apple. IRR is, as we know, an “internal” rate of return, calculating by only need to know two things : the cash flows and the period (underlying assumption : the interval of the cash flow from one period to another period is the same), which means, under normal condition, we should have one or single rate. Since this is a single rate, then we need to compare it with another ‘single’ rate, which we could use CAGR, or many methods to come up with one single rate.

IVP:

Dear Karnen

Remember that when correctly done, your cashflow valuation depends on two variables, among others: inflation rate and leverage. Also remember the circularity when using some methods of valuation. Hence, if discount rates change with time, (inflation and leverage) you will end up with N different discount rates. Which one will you choose for comparing the IRR with? The highest? The lowest? The simple average? Some kind of weighted average? Weighted on which basis?

Remind me what is CAGR, please.

Karnen:

CAGR = Compounded Annual Growth Rate. Let’s say we were earning a total three-year holding rate of  certain %, then CAGR is the annualized rate of return over that 3-year investment period.

Of course, a single rate might be a bit questioning if we are talking for more than 2-3 year investment horizon, yet I guess, the interest in certain countries could be quite stabile over a couple of years.

How about Ku (cost of unlevered equity)? Do you think business risk of the company will stay relatively the same? I guess, again, for certain industries, especially the mature ones, we could have used one Ku or one discount rate to compare to against IRR.

 

IVP:

Dear Karnen

 

I am happy to read that authors start discrediting IRR as a decision tool to rank projects. I keep saying what I have said during many years: Don’t use IRR to rank projects, HOWEVER, use NPV AND calculate IRR to show the “size” of your return; if your project/firm has a strange behaviour and you can define a constant discount rate to compare with. Those cases of constant discount rates don’t exist for 2 simple reasons: first, in presence of varying inflation even Ku will vary and second, when properly done, D/E will vary in real life (I don’t know real cases of keeping constant D/E or D%, which is not very easy to model) and discount rate will vary as well.

 

Again, workout the NPV, the IRR and what I call the discounted payback period that is the moment when the firm/project repays all the investment including interest (discount rate).  As follows:

  Imágenes integradas 1

The formulation assumes or shows constant discount rate i, BUT it can be non-constant. There is no (or better, I have no) compact formula to calculate Discounted Payback Period, with constant or non-constant I).

Yes, the problem is not calculating IRR. Usually you can calculate it, but that is not the problem. The problem arises when you calculate IRR = 12.5%, say and your discount rates are 5%, 10% 9%, 13%, 14.5% 10%, whatever. Which discount rate will you use to compare IRR with? A different thing is to calculate the IRR to estimate your avergae return, just that. Will you average your discount rates? If yes, that finally is massaging data. Remember what a econometrist said: If you torture enough your data, they will confess and tell what you need or something like that (https://www.goodreads.com/quotes/1249307-if-you-torture-the-data-long-enough-it-will-confess).

Carlo Alberto Magni, Associate Professor

Department of Economics, University of Modena and Reggio Emilia viale Berengario 51, 41121 Modena

Dear Karnen,

Prof. DeMarzo‘s answer is in line with what he wrote to you in Dec 2015. He seems to dislike rates of return and prefer NPV.

I agree with him that NPV is the gold standard, but practitioners feel the rate-of-return notion is more intuitive, so it is our duty as scholars to provide an NPV-consistent measure of economic efficiency in relative terms

I sometimes work with practitioners and m always requested to provide an alternative to IRR which can be compatible with the NPV notion. AIRR is one such measure.

As for the idea that AIRR “tempts users to rank projects by their returns” my latest paper indeed shows that practitioners may use AIRR for ranking projects, getting the same result as the NPV ranking. You can download the paper:

Chisini Means and Rational Decision Making: Equivalence of Investment Criteria (by Carlo Alberto Magni, University of Modena and Reggio Emilia – Department of Economics; Piero Veronese, Bocconi University – Department of Decision Sciences; Rebecca Graziani, Bocconi University – Department of Policy Analysis and Public Management) Date written September 14, 2017

 

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3037103

, where I presnet two different-but-equivalent method.

This is not to say that ranking projects with rates of return is recommended in general. It is only to say that (standardized) rates of return may be reliably employed for ranking projects. Evidently, care is needed to handle these cases and, needless to say, ranking with IRR is NPV-inconsistent.

I am currently working on a monograph presenting an integrated approach to proejct appraisal. Its title is “Project appraisal and the logic of valuation. Linking finance, acconting, and engineering economics” and all these issues will be investigated.

 

My paper on reinvestment assumption of IRR and NPV, coauthored by Prof. John Martin,  is now available on SSRN, with the title : “The Reinvestment Rate Assumption Fallacy for IRR and NPV“.

Click here to download it.

Best regards

Carlo Alberto

Note:

I sent to Prof. Peter DeMarzo, the paper co-written by Carlo Alberto Magni under the title: Chisini means and rational decision making: Equivalence of investment criteria.

 

Peter’s’ response :  while the math is fine, I have yet to see a practical example where AIRR provides a useful and differentiated insight.  Do you know of one?

NET PRESENT VALUE AND BORROWING

Dalam training capital budgeting, timbul beberapa pertanyaan terkait Net Present Value, misalnya:

Apakah NPV yang positif selalu berarti perusahaan wajib menjalankannya, bagaimana kalau tidak ada dana untuk menjalankannya?

Net Present Value, dalam penerapannya relatif mudah dihitung, apalagi fungsi Excel NPV dapat digunakan kalau sudah ada cash flow pada t=0, t=1, dan seterusnya, sepanjang merupakan pola arus kas yang konvensional.

Aturan NPV juga sederhana, apabila NPV suatu proyek adalah memberikan arus kas bersih pada t=0, maka proyek tersebut akan memberikan “nilai tambah” bagi nilai kekekayaan pemegang saham (shareholders’ wealth). Secara teori, “nilai tambah” ini akan terwujud dalam kenaikan nilai saham.

Namun bagaimana memaknai apakah NPV suatu proyek yang positif apakah memang “benar-benar” layak dijalankan.
Menurut penulis, faktor “bankability” suatu proyek dapat merupakan salah satu pertimbangan dalam melihat secara realistis suatu NPV proyek.

NPV proyek yang positif, dapat saja terjadi karena terjadi “forecasting bias” atau bahkan “forecasting error”, “overconfident”, atau yang menarik untuk ditanyakan dapakah suatu proyek diusulkan karena proyek tersebut memberikan NPV yang positif, atau malah sebaliknya, karena proyek tersebut diusulkan, maka proyek tersebut perlu memberikan NPV yang positif?

Catatan di atas diingatkan oleh Brealey dan Myers (2000) :

Why is an M.B.A student who has learned about DCF like a baby with a hammer? Answer: Because to a baby with a hammer, everything looks like a nail.
Our point is that you should not focus on the arithmetic of DCF and thereby ignore the forecasts that are the basis of every investment decision. Senior managers are continuously bombarded with requests for funds for capital expenditures. All these requests are supported with detailed DCF analyses showing that the projects have positive NPVs. How, then, can managers distinguish the NPVs that are truly positive from those that are merely the result of forecasting errors? We suggest that they should ask some probing questions about the possible sources of economic gain.

(Brealey, Richard A., dan Stewart C. Myers. Principles of Corporate Finance. Edisi 6. USA: The McGraw-Hill Companies, Inc. 2000. Bab 11: Where Positive Net Present Values Come From. Halaman 291.)

Dalam banyak buku-buku teks manajemen keuangan, tidak banyak disinggung kaitan antara NPV suatu proyek yang positif dengan pinjaman (borrowing).

Secara teori, suatu proyek yang memberikan NPV yang positif, mestinya dapat dibiayai dengan pinjaman (borrowing), dan proses ini dapat membantu perusahaan untuk memperoleh bantuan dari pihak ketiga, di luar perusahaan, terutama dari pihak banker, untuk melihat apakah analisa NPV yang positif memang menggambarkan “profitability” dan “kemampuan menghasilkan arus kas”.

Ross, Westerfield dan Jaffe (2005) :

The net present value of an investment is a simple criterion for deciding whether or not to undertake an investment. NPV answers the question of how much cash an investor would need to have today as a substitute for making the investment. If the net present value is positive, the investment is worth taking on because doing so is essentially the same as receiving a cash payment equal to the net present value. If the net present value is negative, taking on the investment today is equivalent to giving up some cash today, and the investment should be rejected.

(Ross, Stephen A., Randolph W. Westerfield, dan Jeffrey Jaffe. Corporate Finance. Edisi ketujuh. New York (USA): McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc. Bab 4: Net Present Value.  Appendix 4A : Net Present Value : First Principles of Finance. Halaman 103.)

NPV positif berarti perusahaan memiliki kas (dalam kondisi kepastian/certainty) pada hari ini, dan kas tersebut berarti perusahaan cukup percaya diri untuk menjual kas tersebut untuk didanai oleh pihak bank.

Bagaimana caranya?

Sebagai ilustrasi sederhana, katakan ada suatu proyek dengan data-data sebagai berikut:
• Investasi awal CU (Currency Unit) 12
• Arus kas t=1 : CU 10; t=2 : CU 5
• Tingkat diskonto = 5% (konstan selama 2 tahun)

 

Dari analisa spreadsheet, proyek ini akan memberikan NPV positif sebesar CU 2.06, dan karena NPV proyek tersebut positif, maka proyek tersebut layak untuk dijalankan.

 

NPV CU 2.06 berarti ini sama dengan memiliki kas hari ini sebesar CU 2.06.

Mengetahui bahwa akan ada arus kas sebesar CU 10 pada t=1, dan CU 5 pada t=2, kita bisa tawarkan ke Bank untuk mendanai sebesar CU 14.06, yaitu nilai diskonto dari CU 10 dan CU 5 pada tingkat diskonto 5%. Katakan kita bisa meminjam dengan tingkat suku bunga pinjaman sebesar 5% per tahun, maka kita akan mendapatkan dana sebesar CU 14.06 dari bank. Karena investasi proyek hanya memerlukan CU 12, maka selisih antara pinjaman CU 14.06 – CU 12 = CU 2.06, praktis dapat “kantongin” oleh perusahaan tersebut. Dengan kata lain, NPV positif berarti memiliki “kas” sebesar CU 2.06 pada hari ini.

Analisa spreadsheet sebagai berikut:

Dari analisa di atas, tampak bahwa kita dapat mempertimbangkan pembiayaan oleh pihak Bank untuk membantu analis mengurangi bias atas analisa NPV suatu proyek.

Sukarnen
22 Januari 2017