WEEK 10-PRINCIPLES OF CAPITAL BUDGETING.ppt

7/27/2019 WEEK 10-PRINCIPLES OF CAPITAL BUDGETING.ppt

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PRINCIPLES OF CAPITAL BUDGETING

I. INVESTMENT APPRAISAL PROCESSA. TECHNICAL ANALYSISB. FINANCIAL ANALYSISC. ECONOMIC ANALYSIS

II. CAPITAL BUDGETING TECHNIQUESA. NONDISCOUNTING METHODS

A.1 PAYBACK PERIOD METHODA.2 AVERAGE RATE OF RETURN METHOD

B. DISCOUNTING METHODSB.1 NET PRESENT VALUE( NPV) METHODB.2 INTERNAL RATE OF RETURN (IRR) METHODB.3 PROFITABILITY INDEX

B.4. COMPARISON OF NPV AND IRR METHODS

III. SPECIAL ISSUES IN CAPITAL BUDGETINGA. CONFLICTING RANKINGS

A.1 REASONS FOR CONFLICTING RANKINGSA.2 ADJUSTMENTS OF IRR METHOD

A.2.1 INCREMENTAL IRRA..2.2 MODIFIED IRR ( MIRR)

B. UNEQUAL LIVESB.1.REPLACEMENT CHAIN METHODB.2 EQUIVALENT ANNUAL ANNUITY APPROACH

C. CAPITAL RATIONING

IV.ALTERNATIVE NPVsA. TRADITIONAL (WACC) APPROACH TO NPVB. EQUITY RESIDUAL METHOD

C. ADJUSTED PRESENT VALUE METHOD

CASE: EVA AND CAPITAL BUDGETING DECISIONS


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I. INVESTMENT APPRAISAL PROCESS

A.TECHNICAL EVALUATION

Technical appraisal of investment projects involves the analysis anddecision making regarding the following issues:

1. Determination of the technical specifications and quality standards ofoutput.

2. The choice of optimum production capacity3. Breakdown of the investment by years4. Determination of the total cost of the fixed investment5. Location selection6. Determining the need for technical assistance, patent, know-how and

their cost

7. Selection of the technical specifications of the machinery andequipment.8. Controlling the adequacy of the available infra-structure9. Evaluation of the availability of raw materials and the flexibility

regarding the number and choice of suppliers


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B. FINANCIAL EVALUATION

In the financial appraisal of investment projects , cash flowsexpected over the life of the project are estimated and the riskiness

of cash flows is determined . The discount rate appropriate for theprojects risk level is used to discount the cash flows and estimatethe profitability of the investment alternatives.

Financial evaluation involves:

1.Estimation of working capital and initial investment needs2.Breakdown of the investment by years3. Estimation of production costs, operating costs,and other operating

cash outflows4. Estimation of operating cash inflows5.Determining the financing need and sources6.Estimating the appropriate discount rate7.Formation of projected income statements over the life of the project8.Evaluating the profitability of the investment proposals.


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C. ECONOMIC EVALUATION

Economic evaluation of the projects involves the following steps:

1. Evaluation of the consistency of the investment with thedevelopment policy. ( five-year targets, objectives ofdevelopment, annual targets)

2.Effects on national income:

2.1. Determining the value added of the investment2.2 Determining Capital/ Output ratio2.3. Effects on Capital /Employment ratio2.4. Social profitability estimation

3. Effects on the Balance of Payments:3.1. Foreign exchange earnings of the project3.2. Marginal productivity of foreign exchange3.3. Foreign exchange output- capital relations


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II. CAPITAL BUDGETING TECHNIQUES

Capital Budgeting involves a current investment in which the benefits

areexpected to be received beyond one year.Thus, any asset with a life

ofmore than one year involves capital budgeting.

Capital budgeting involves generation of investment proposals; thevaluation of cash flows for the proposals,; evaluation of cash flows,selection of projects based on an acceptance criterion; and thecontinuous reevaluation of projects after theiracceptance.Investment projects can be grouped into fivecategories:

1. Projects related to new products and expansion of existing

products2. Projects related to replacement of equipment and buildings3.Research and Development projects4.Exploration investments5.Others ( e.g. Acquisition of a polution control device, or

expenditures to comply with health standards)


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Investment analysis is the process of measuring these expected benefits andrelating them to initial outlay needed to acquire them in such a way so as topermit objective comparison with alternative opportunities.

Basic inputs to financial analysis:

1.Cash flow Schedulea.The amount of initial outlay to acquire projectb.The amount of cash that will be released when the investment is liquidated

at the end of its economic life.(Terminal value)c.The stream of cash flows that will generate over the life of the investment

2.The times at which the cash inflows and outflows are expected to occur3.The expected productive life of the investment4.The rate of return ( hurdle rate which reflects the projects riskiness) at which

this investment be evaluated.

MUTUAL EXCLUSION AND DEPENDENCY

A proposal is said to be mutually exclusive if its acceptance precludes theacceptance of one or more proposals.

A contingent or dependent proposal is the one whose acceptance dependsupon the acceptance of one or more other proposals.


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A. NONDISCOUNTING METHODS

A.1. PAYBACK PERIOD METHOD

Payback period is the time projects have to run before their original investment isreturned. The decision rule is to accept any project having equal or shorter paybackthan the target period.

EXAMPLE 1:W X Y Z

A. OUTLAYS -1000 -1000 -1000 -1000

B.RECEIPTSYears

1 500 250 100 5002 500 250 300 5003 300 250 400 ---

4 100 250 600 ---Payback period 2 years 4 years 3 1/ 3 2 years

NPV ( 10% ) $ 161 .44 -207.52 49.15 -132.25

Target payback= 2 years Select W,Z if independentTarget payback = 4 years Select all , if independent


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Advantages:

1. Payback method makes use of incremental cash flows.It is a popularmethod because :

- It has applications to industries subject to rapid changes- When used with a low payback ( high standard) ,it is referred to

as a dynamic policy where the firm restricts itself to highstandards.

2. Payback period helps to assess the risks of a time nature. However,

even if two projects have the same payback, they may have differentcash flows and payback does not consider the flow of benefits withinthe payback.

Shortcomings of the method:

1.Payback method ignores profitability.A project can have a highpayback but low discounted yield.(e.g. project Z in example 1)

2.Payback method ignores the time value of money.3.Payback method does not consider cash flows beyond the payback

period.

Di t d b k


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Discounted payback:

Second shortcoming can be eliminated by the use of discounted payback.EXAMPLE 2:

Project AYear

0 -20,0001-6 $ 6,500

Payback period = 20,000/ 6500 = 3.07 years

PV= 6500 ( PVIF 10%,1) + 6500 (PVIFA 10%,2)+..+ 6500 (PVIF10%,6)= 5909 + 5372+ 4883+ 4440+ 4036+ 3669

Discounted payback= 3 3836/4440= 3.86 years

In projects with constant cash flows and constant lives, there is a relationship betweenpayback period and profitability.Payback reciprocal is the indicator of profitability.

PV = A( PVIFA i,n)= A ( 1- (1+i) -n / i)= A/ i A/ i x 1/ (1+i)n

i PV = A A x 1/ (1+i)n

if n or i is large, second term gets smaller and profit will be approximated by payback

reciprocal.i = A / PV


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EXAMPLE 3:

Year Cash Flows

0 $22,0001-10 years 5,000

Payback reciprocal = 5000/ 22000= 22.73%22000 = (PVIFA

i,10)

PVIFA i,10 = 4.4i= 19%

Payback reciprocal overestimates profitability.

The use of payback may be such that payback periodmay represent a horizon of confident judgement forbusinessmen.


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A.2. AVERAGE ( ACCOUNTING ) RATE OF RETURN

The average rate of return is an accounting method and represents theratio of the average annual profits after taxes to the initial nvestment.

Average rate of return (ARR) = Average Net Profit / Initial investment

EXAMPLE 4:

Project A Project B Project CNet Profit Cash Flows Net Profit Cash Flows Net Profit Cash Flows

1 $3000 6000 2000 5000 1000 40002 2000 5000 2000 5000 2000 50003 1000 4000 2000 5000 3000 6000

Each project has an initial investment of $ 9000 and a life of three years.

ARRA = ARRB = ARRC = 2000/ 9000= 22.2%


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The firm determines a minimum required rate of returnon the investments that will be selected. If theprofitability of the project exceeds this rate, it isacceptable.

Advantages:

The method is simple to use.It rests on accounting data,

rather than cash flows , which is easier to obtain.

Disadvantages:

It disregards the pattern of cash flows and their timing.

Most firms prefer project A since it provides a largerportion of cash benefits in the first year.Although ARRmethod treats these projects equally acceptable, thedifferent pattern of cash flows may be influential in

preference of one relative to others.

B DISCOUNTING METHODS


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B.DISCOUNTING METHODS

The discounted cash flow methods explicitly weigh the time value ofmoney and focus on cash inflows and outflows rather than net income as computed in the accrualaccounting sense.Assumptions of the discounted cash flows:

a.Required rate of return on the project is constantb.Cash flows are certainc.Cash flows are independentd.Initial amount that can be borrowed or loaned at the specified discount rate.

B.1. NET PRESENT VALUE METHOD

With net present value method , all cash flows are discounted to present, using the required rate ofreturn.

nNPV= At / (1+k)

tt=1

If NPV is equal to or greater than zero, the proposal is acceptable.If not, it is rejected. When NPV ispositive, the firm is taking on a project with a return greater than that necessary to leave the marketprice of the stock unchanged.

EXAMPLE 5:

An investment with an initial outlay of $ 18,000 and cash flows of $ 5600 for five years and therequired rate of return of 10% has a NPV of $ 3228.

NPV= 5600 ( PVIFA 10%, 5) 18,000= $ 3228

Since NPV>0, the project is acceptable.The value of the firm will rise by$3228 if it undertakes the project.

B 2 INTERNAL RATE OF RETURN (IRR) METHOD


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B.2.INTERNAL RATE OF RETURN (IRR) METHOD

Internal rate of return is the discount rate that equates the present value of the expected cashoutflows with the present value of the expected cash inflows.

n At / (1+r)

t =0t=0

where At is the cash flow for period t whether it be a net cash outflow or inflow and n is the lastperiod in which a cash flow is expected.If cash flows are even, then initial outlay is divided by cashflows and the corresponding interest rate is found.

EXAMPLE 6:In Example 5, the initial investment may be divided by the annual cash flows:

PVIFA i, 5 = 18000/ 5600= 3.214

i (IRR) = 16% > k= 10% so the project can be accepted. In/ (1+r)

n= Dn / (1+r)n (1)

n =0 n=0

Left hand side of equation (1) represents the discounted value of the investment outlays for theproject made at any time from the beginning of year one until infinity. Similarly, the right hand sidestands for the discounted value of the projects net inflows over the same period.The rate of returnthat equates both sides is the internal rate of return.

IRR is compared with the required rate of return (k) and the project will be accepted if IRR is equal toor greater than k . Accepting a project with IRR> k should result in an increase in the market price ofthe stock.

B 3 PROFITABILITY INDEX( Benefit Cost Ratio)


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B.3. PROFITABILITY INDEX( Benefit-Cost Ratio)

Profitability index of a project is the present value of future net cash flows over the initial outlay.n

PI = At / (1+k)t/ A0

t=1

As long as profitability index (PI) is equal to greater than one, the investment is acceptable.

B.4. COMPARISON OF THE METHODS

NPV method only produces optimal solutions under conditions of certainty and perfectknowledge. The valuation based on NPV assumes that all net cash flows from a project are

paid out as dividends and that cash flows are known with certainty.By accepting all projectswhich have a positive NPV, we ensure that V0 is maximized since we assume the value of thefirm is the total present value of cash dividends from its projects. Thus ignoring uncertainty,value of the firm depends on the size of its dividend stream and discount rate. Underuncertainty, the use of NPV may not be optimal. So, NPV models should be adjusted foruncertainty .

NPV and IRR have different reinvestment assumptions. These methods have different

assumptions with respect to the marginal reinvestment rate on funds released from theprojects.The IRR implies that the funds are reinvested at the internal rate of return over theremaining life of the proposal. NPV assumes a reinvestment rate equal to the required rate ofreturn.

NPV always provides correct rankings of mutually exclusive projects whereas IRR sometimesdoes not.IRR asumes a high reinvestment rate for projects with high IRR and vice versa.Withthe NPV method, the reinvestment rate is the same for each proposal.

II SPECIAL ISSUES IN CAPITAL BUDGETING


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II. SPECIAL ISSUES IN CAPITAL BUDGETING

A. CONFLICTING RANKINGS

A.1.Reasons For Conflicting Solutions

When choosing one of several mutually exclusive projects, one might obtainconflicting results. Conflicting rankings can ocur between NPV versus IRR and PI.The methods give contradictory rankings when:

1.The initial outlays are different.2.The pattern of cash flows are different3.The lives of the projects are different.

EXAMPLE 7:

Year Project A Project B0 -23,616 -23,616

1 10,000 02 10,000 5,0003 10,000 10,0004 10,000 32,675

NPV (10%) $ 8083 $ 10,346

IRR 25% 22%

EXAMPLE 8:


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EXAMPLE 8:

Year Machine A Machine B0 $-5,000 -10,0001-5 $ 1672 3200

NPV (14%) $ 740 986IRR 20% 18%

MIRR 17.2% 16.2%

In the above two examples, the NPV and IRR methods give conflicting results. In this case ,usually theproject that has the highest NPV is selected. NPV always provides correct rankings whereas IRRsometimes does not.There are several reasons:

1.Because the IRR method is expressed as a percentage, the scale of investment is ignored. IRRfavors small projects whereas NPV method takes scale into consideration and has a bias in favor of

large projects affording a greater NPV.

2. Multiple IRR or no IRR: If there are cash outflows in more than one period and these are separatedby one or more periods of net cash inflows, there may be more than one IRR that equates outflows tothe present value of inflows.

EXAMPLE 9:Year Cash Flows

0 -80,9071 180,0002 -100,000

IRR1= 7 %IRR2 = 15 %

Accept the investment if the required rate of return is between 7 % and 15%. NPV is positivebetween these rates and negative at all other rates.

Since 7 1/2%


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EXAMPLE 10:Year Cash Flows

0 +1.01 -2.02 +1.5

This cash flow stream has no IRR.

3. Changing discount rates

NPV method can easily be used when the required rate of return changes over the life of theinvestment. However, it is difficult to determine which k to use to compare with IRR. Usually, anaverage k is calculated and compared with IRR.

4.NPV has additive property.

NPV(A+B)= NPVA + NPVBThis property enables the firm to select projects in a way to maximize total NPV.

A.2. Adjustments of the IRR method

A.2.1.Incremental internal rate of returnProjects A and B in example 8, can be evaluated usingincremental IRR approach.

a.Compute the difference in cash flows between thelarger and the smaller projects.

b.Compute the IRR on the difference.c.If the firm earns more than the IRR on the difference ,

it should choose the smaller mutually exclusiveproject and choose the larger project if the firm

earns less.

EXAMPLE 11:


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EXAMPLE 11:Year Investment B Investment A

0 -50001-5 1528

NPV( 14%) = $ 246IRR= 16% >k. Investment B is regarded as two investments- one offering 20% (A)and the other

offering 16%.If the firm can earn more than $ 1528 on the difference on a new projectC ,the firm would prefer A and the new investment C.

EXAMPLE 12:Year Project C

0 -5,0001-5 $ 1,562

IRR = 17%NPV ( 14%) = $ 362

Investment NPV (k=14%)A 740B 986

C 362

Since Project C provides higher cash flows than the incremental project, projects A+C should beselected.In this case NPV would be maximized.

NPV A+C= 740+ 362= 1102

NPVA+C> NPV B,

A 2 2 Modified IRR (MIRR)


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A.2.2. Modified IRR (MIRR)

When the IRR criterion is used with a project that has non conventional cash flows ,multiple rates of return arises. Modified internal rate of return can be used to eliminatesome of the problems. MIRR assumes that cash flows from all projects are reinvested atsome explicit rate, generally the cost of capital, while the regular IRR assumes that thecash flows are reinvested at the projects IRR. MIRR solves the multiple IRR problem.

EXAMPLE 13:Year Project S Project L

0 -1000 -10001 500 1002 400 3003 300 4004 100 600

NPV (10%) $ 78.80 $ 49.15IRR 14.5% 11.8%MIRR 12.1% a 11.3%b

a.TVs= 500(FVIF 10%,3)+ 400(FVIF 10%,2)+ 300( FVIF 10%,1)+ 100 =1579.51000= 1579.5( PVIFi,4)

i= 12.1%

b.TVL = 15361000= 1536( PVIF i,4)PVIFi,4= 0.65104

i=11.3%


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MIRR is superior to regular IRR as an indicator ofthe projects true rate of return but NPV is stillbetter in choosing among competing projects that

differ in size.

*If two projects are of equal size but differ inlives, the MIRR will always lead to the same accept

/reject signal as NPV

**If projects differ in size, then conflicts stilloccur.The NPV of the larger project is greater butMIRR of the smaller project is higher as can beseen in Example 8. So, IRR and MIRR conflict withNPV when scales of the mutually exclusiveprojects differ.

B UNEQUAL LIVES


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B. UNEQUAL LIVES

When two mutually exclusive projects have unequal lives, the comparison of the two can not berealized.There are two approaches for resolving the problem:

B.1 Replacement Chain Approach

It is common to compute the cash flows assuming one or morereplacements until a common horizon is reached.

EXAMPLE 14:Year Model A Year Model B

0 -38,750 0 -85,0001-5 20,000 1-10 23,000

NPV (k= 12%) $33,346 $44,955

It is assumed that model A is replaced with a similar machine 5years from today at an estimated cost of $ 45,000 and will continueto produce cash flows of 20,000 each year.

Year Cash Flows0 -38,7501-4 20,0005 -25,000 ( 20,000-45,000)

6-10 20,000

NPV (k=12%) $48,720

Over a ten year period NPV of Model A ( $48,720) is higher than that promised by Model B ($ 44,955)over the same period.

B 2 Equivalent Annual Annuity Approach ( EAA)


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B.2. Equivalent Annual Annuity Approach ( EAA)

Another method used to deal with unequal lives is NPV normalization or EAA method. Cash flowsare assumed to be the same each time the model is replaced.This assumption allows thecomputation of NPV for an infinite horizon.

EXAMPLE 15:

Year A B0 -15,000 -15,0001 -5,000 -5,5002 -6,000 - 6,5003 -8,000 -9,0004 ------ -11,000

NPV(k=10%) $ -30,514 $- 39,647Project A :A (PVIFA 10%,3)= -30,514

A= -30,514/ 2.4869A= $-12,270NPV= -12,270/ .10= $-122,700

Firm will be indifferent betwen the above cash flows and $ -12,270 forever.

Project B:A (PVIFA 10%,4) = -39,647

A= -39,647/ 3.1699= $ -12,507

NPV= 12507/ .10= $-125,070

This is equivalent to a firm spending $ 12,507 forever.The annuities for Project A is lower.Sincethese are outflows, we select the Project with lower outflows; Project A.

EXAMPLE 16 :


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EXAMPLE 16 :

Project Life Annual cash Initial outlay IRR NPVflows (10%)

A 5 1000 2864 22% $927B 10 1000 4192 20% 1953

C 15 1000 5092 18% 2514

Project A:A(PVIFA 10%,5) = 927

A= 927/ 3.7908A= $ 245NPV = $ 245/ 0.10 = $ 2450

Project B:A (PVIFA 10%,10) =1953

A = 1953/ 6.1446A= 318

NPV= 318/0.10= $ 3180

Project C :A (PVIFA 10%,15) = 2514

A= 2514 /7.6061A=$ 331

NPV= 331/ 0.10= $ 3310Normalized NPVs reveal that Project C has the highest annuity and NPV of all.

NPVC> NPVB>NPVA

C CAPITAL RATIONING


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C . CAPITAL RATIONING

Capital rationing occurs any time there is a budget ceiling ,or constraints on the amount of funds thatcan be invested during a specific period.

EXAMPLE 17:

Project Profitability Index Initial investment4 1.25 $ 400,0007 1.19 100,0002 1.16 175,0003 1.14 125,0006 1.09 200,0005 1.05 100,0001 0.97 150,000

If budget ceiling is $ 1 million during the present period and the proposals are independent of eachother, we select proposals in descending order of profitability until the budget is exhausted.

In the above example proposal 5 is rejected even though its profitability index is above one since thebudget is exhausted.

*If the firm rations capital and rejects projects that yield more than the required rate of return, theninvestment policy is less than optimal.

*In this analysis , it is assumed that capital is rationed for one period and all the projects areindependent.When these conditions do not apply, ranking by profitability index may not give theoptimal combination.

*Under capital rationing , the combination that gives the highest NPV should be selected.

EXAMPLE 18:


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EXAMPLE 18:

Proposal Initial outlay PI NPV

3 -200,000 1.15 $ 30,000

1 -125,000 1.13 16,250

2 - 175,000 1.11 19,250

4 -150,000 1.08 12,000

If budget constraint was $ 300,000, proposals 2 and 1should be selected rather than proposal 3 which has thehighest profitability index. Total NPV generated byproposals 1 and 2 are $ 35,500.

With multiperiod analysis, the postponement ofinvestments is possible until a subsequent period whenthe budget will permit investment.

ALTERNATIVE NPV CALCULATIONS


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ALTERNATIVE NPV CALCULATIONS

A project has an economic life of two years and an initial investment of $ 100,000. Thecompany plans to finance 50% of this investment using debt and 50% from equity. Thebefore tax cost of debt is 10% and cost of equity is 16%. Corporate tax rate is 40%. Thecost of equity for an all equity financed firm is 13%. The revenues and operatingexpenses related to the project are $150,000 and $ 60,000, respectively.The machine is

depreciated on a straight line basis. Find NPV of the project.

A.WACC APPROACH

Year 1 Year 2Revenues 150,000 150,000

Operating costs (60,000) (60,000)Depreciation expense (50,000) (50,000)Operating Income 40,000 40,000Taxes(40%) (16,000) 16,000)Net operating income 24,000 24,000Depreciation expense 50,000 50,000Net operating cash flows 74,000 74,000

NPV= -100,000+ 74,000 + 74,000(1.11)1 (1.11)2

= $ 26,727 Note the weighted average cost of capital is:

kw= ( 0.50)( 0.10)( 0.60)+ ( 0.50)(0.16)= 11%

B EQUITY RESIDUAL METHOD


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B. EQUITY RESIDUAL METHOD

Year 1 Year 2

Operating profit 40,000 40,000

Interest * (5,000) ( 5,000)Earnings before taxes 35,000 35,000Taxes (14,000) (14,000)Net Income 21,000 21,000Depreciation 50,000 50,000

Net cash flow 71,000 71,000Principal repayments - (50,000)Net cash to equityholders 71,000 21,000

* 50,000x0.10= 5000

Net present Value:

NPV= -50,000 + 71,000 + 21,000( 1.16)1 (1.16)2

= $26,813

C ADJUSTED PRESENT VALUE METHOD


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C. ADJUSTED PRESENT VALUE METHOD

NPV= PV of cash flows+ PV of tax savings

PV of cash flows= -100,000+ 74,000 + 74,000

(1.13)1 (1.13)2

Tax savings= 5,000 (0.40)= 2,000

PV of tax savings= 2000+ 2000

(1.10)1 (1.10)2

= 3,471

APV= 23,440+ 3471= $26,911

In general terms:

APV= NPV at opportunity +PV of financing side effectscost of capital

( Base case NPV)

These methods give different figures for NPV. The ERM and WACC


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These methods give different figures for NPV. The ERM and WACCmethods are comparable if the value of debt outstanding is a constantporportion of the remaining cash flows, which implies a constant debtratio.APV is comparable to the other two only if the project life can bedescribed as either one period or as infinite with constant perpetualflows in all periods.

The WACC formula picks up only one financing side effect: the valueof interest tax shieldson debt supported by the project.If there areother side effects,subsidized financing tied to a project ,you shoulduse APV. Financing side effects may be:

1.Issue costs: If accepting the project forces the firm to issuesecurities,then the PV of issue costs should be subtracted from thebase case NPV.

2.Interest tax shields:Debt interest is a tax deductable expense.Thus aproject that prompts the firm to borrow more generates additional

value.The projects APV is increased by the PV of interest tax shieldson debt the project supports.

3.Special financing: Sometimes special financing opportunities are tiedto project acceptance.The government may offer subsidized financingfor socially desirable projects.You calculate the PV of the financing

opportunity and add it to the base case NPV.


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CASE: EVA AND CAPITAL

BUDGETING DECISIONS

EVA and CAPITAL BUDGETING DECISIONS


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Henry Bodenheimer started Bodies Blimps, one of the largest high speed blimp manufacturers.Hisprojects grew rapidly,in some cases becoming whole divisions.He needs to evaluate the performanceof these divisions to reward the managers.

Henry first measured the performance of his various divisions using ROA, paying a bonus to each ofthe division managers based on ROA of his division.While ROA was generally effective motivatingthe managers , there were a number of situations where ROA was counterproductive.

Henry always believed that Sharon Smith, the head of the supersonic division was his bestmanager.The ROA of Smiths division was generally in the high double digits but the cost of capitalwas 20%.Furthermore , the division had been growing rapidly.However, as soon as Henry paidbonuses based on ROA, the division stopped growing.At that time, Smiths division had a ROA of100%( $ 2 mil/ $ 2 mil).

Henry found out why the growth had stopped when he suggested a project to Smith that would earn $1 million per year on an investment of $ 2 million.This would be an attractive project with a ROA of50%( $ 1 mil/ $ 2 mil).He thought that Smith would jump to place this project in her division becauseROA was much higher than the cost of capital of 20%.But Smith did everything to kill theproject.Smith realized that if the project was accepted, the divisions ROA would be 75%.

2 mil+ 1 mil /2 mil+ 2mil = 75%Henry was later exposed to the EVA approach which seems to obviate this poblem. If EVA is used:

EVA ( without project)= (100%- 20%) x 2,000,000= $ 1,600,000EVA( with the new project)= ( 75%- 20%)x 4,000,000= $ 2,200,000

Questions:1.Why did ROA decrease while EVA increased?2.Which is a better performance indicator for a compensation system?3.What is the difference between performance measurement and capital budgeting ?

4 Discuss the advantages and disadvantages of ROA and EVA when used in capital budgeting

WEEK 10-PRINCIPLES OF CAPITAL BUDGETING.ppt

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