Any reduction in present value represents economic depreciation; any increase in present value represents negative economic depreciation. Therefore
Economic depreciation reduction in present value
and
Economic income cash flow economic depreciation
The concept works for any asset. Rate of return equals cash flow plus change in value divided by starting value:
Rate of return C1 1PV1 PV0 2
PV0
where PV0 and PV1 indicate the present values of the business at the ends of years 0 and 1.
The only hard part in measuring economic income and return is calculating present value. You can observe market value if shares in the asset are actively traded, but few plants, divisions, or capital projects have shares traded in the stock market. You can observe the present market value of all the firm’s assets but not of any one of them taken separately.
Accountants rarely even attempt to measure present value. Instead they give us net book value (BV), which is original cost less depreciation computed according to some arbitrary schedule. Companies use the book value to calculate the book return on investment:
Book income cash flow book depreciationC1 1BV1 BV0 2
Therefore
Book ROI C1 1BV1 BV0 2
BV0
If book depreciation and economic depreciation are different (they are rarely the same), then the book profitability measures will be wrong; that is, they will not measure true profitability. (In fact, it is not clear that accountants should even try to measure true profitability. They could not do so without heavy reliance on subjective estimates of value. Perhaps they should stick to supplying objective information and leave the estimation of value to managers and investors.)
It is not hard to forecast economic income and rate of return. Table 12.8 shows the calculations. From the cash-flow forecasts we can forecast present value at the start of periods 1 to 6. Cash flow plus change in present value equals economic income. Rate of return equals economic income divided by start-of-period value.
Of course, these are forecasts. Actual future cash flows and values will be higher or lower. Table 12.8 shows that investors expect to earn 10 percent in each year of the store’s six-year life. In other words, investors expect to earn the opportunity cost of capital each year from holding this asset.24
Notice that EVA calculated using present value and economic income is zero in each year of the Nodhead project’s life. For year 2, for example,
EVA 100 1.10 1002 0
24This is a general result. Forecasted profitability always equals the discount rate used to calculate the estimated future present values.
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Year
1
2
3
4
5
6
Cash flow
100
200
250
298
298
298
PV, at start
of year,
10 percent
discount rate
1,000
1,000
901
741
517
271
PV at end
of year,
10 percent
discount rate
1,000
900
741
517
271
0
Change in value
during year
0
100
160
224
246
271
Economic income
100
100
90
74
52
27
Rate of return
.10
.10
.10
.10
.10
.10
Economic depreciation
0
100
160
224
246
271
T A B L E 1 2 . 8
Forecasted economic income and rate of return for the proposed Nodhead store. Economic income equals cash flow plus change in present value. Rate of return equals economic income divided by value at start of year.
Note: There are minor rounding errors in some annual figures.
EVA should be zero, because the project’s true rate of return is only equal to the cost of capital. EVA will always give the right signal if income equals economic income and asset values are measured accurately.
Do the Biases Wash Out in the Long Run?
Some people downplay the problem we have just described. Is a temporary dip in book profits a major problem? Don’t the errors wash out in the long run, when the region settles down to a steady state with an even mix of old and new stores?
It turns out that the errors diminish but do not exactly offset. The simplest steady-state condition occurs when the firm does not grow, but reinvests just enough each year to maintain earnings and asset values. Table 12.9 shows steadystate book ROIs for a regional division which opens one store a year. For simplicity we assume that the division starts from scratch and that each store’s cash flows are carbon copies of the Nodhead store. The true rate of return on each store is, therefore, 10 percent. But as Table 12.9 demonstrates, steady-state book ROI, at 12.6 percent, overstates the true rate of return. Therefore, you cannot assume that the errors in book ROI will wash out in the long run.
Thus we still have a problem even in the long run. The extent of the error depends on how fast the business grows. We have just considered one steady state with a zero growth rate. Think of another firm with a 5 percent steady-state growth rate. Such a firm would invest $1,000 the first year, $1,050 the second, $1,102.50 the third, and so on. Clearly the faster growth means more new projects relative to old ones. The greater weight given to young projects, which have low book ROIs, the lower the business’ apparent profitability. Figure 12.1 shows how this works out for a business composed of projects like the Nodhead store. Book ROI will either overestimate or underestimate the true rate of return unless the amount that the firm invests each year grows at the same rate as the true rate of return.25
25This also is a general result. Biases in steady-state book ROIs disappear when the growth rate equals the true rate of return. This was discovered by E. Solomon and J. Laya, “Measurement of Company Profitability: Some Systematic Errors in Accounting Rate of Return,” in A. A. Robichek (ed.), Financial Research and Management Decisions, John Wiley & Sons, Inc., New York, 1967, pp. 152–183.
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PART III Practical Problems in Capital Budgeting
T A B L E 1 2 . 9
Book ROI for a group of stores like the Nodhead store. The steady-state book ROI overstates the 10 percent economic rate of return.
*Book income cash flow change in book value during year.
†Steady-state book ROI.
Year
1
2
3
4
5
6
Book income
for store*
1
67
33
83
131
131
131
2
67
33
83
131
131
3
67
33
83
131
4
67
33
83
5
67
33
6
67
Total book income
67
34
49
180
311
442
Book value
for store
1
1,000
833
667
500
333
167
2
1,000
833
667
500
333
3
1,000
833
667
500
4
1,000
833
667
5
1,000
833
6
1,000
Total book value
1,000
1,833
2,500
3,000
3,333
3,500
Book ROI for
all stores
total book income
.067
.019
.02
.06
.093
.126†
total book value
F I G U R E 1 2 . 1
The faster a firm grows, the lower its book rate of return is, providing true profitability is constant and cash flows are constant or increasing over project life. This graph is drawn for a firm composed of identical projects, all like the Nodhead store (Table 12.7), but growing at a constant compound rate.
Rate of return, percent
12
11
10
Economic rate of return
9
8
Book rate of return
7
Rate of growth,
5
10
15
20
25
percent
CHAPTER 12 Making Sure Managers Maximize NPV
333
What Can We Do about Biases in Accounting Profitability Measures?
The dangers in judging profitability by accounting measures are clear from this chapter’s discussion and examples. To be forewarned is to be forearmed. But we can say something beyond just “be careful.”
It is natural for firms to set a standard of profitability for plants or divisions. Ideally that standard should be the opportunity cost of capital for investment in the plant or division. That’s the whole point of EVA: to compare actual profits with the cost of capital. But if performance is measured by return on investment or EVA, then these measures need to recognize accounting biases. Ideally, the financial manager should identify and eliminate accounting biases before judging or rewarding performance.
This is easier said than done. Accounting biases are notoriously hard to get rid of. Thus, many firms end up asking not “Did the widget division earn more than its cost of capital last year?” but “Was the widget division’s book ROI typical of a successful firm in the widget industry?” The underlying assumptions are that
(1)similar accounting procedures are used by other widget manufacturers and
(2)successful widget companies earn their cost of capital.
There are some simple accounting changes that could reduce biases in performance measures. Remember that the biases all stem from not using economic depreciation. Therefore why not switch to economic depreciation? The main reason is that each asset’s present value would have to be reestimated every year. Imagine the confusion if this were attempted. You can understand why accountants set up a depreciation schedule when an investment is made and then stick to it apart from exceptional circumstances. But why restrict the choice of depreciation schedules to the old standbys, such as straight-line? Why not specify a depreciation pattern that at least matches expected economic depreciation? For example, the Nodhead store could be depreciated according to the expected economic depreciation schedule shown in Table 12.8. This would avoid any systematic biases.26 It would break no law or accounting standard. This step seems so simple and effective that we are at a loss to explain why firms have not adopted it.27
One final comment: Suppose that you do conclude that a project has earned less than its cost of capital. This indicates that you made a mistake in taking on the project and, if you could have your time over again, you would not accept it. But does that mean you should bail out now? Not necessarily. That depends on how much the assets would be worth if you sold them or put them to an alternative use. A plant that produces low profits may still be worth operating if it has few alternative uses. Conversely, on some occasions it may pay to sell or redeploy a highly profitable plant.
Do Managers Worry Too Much about Book Profitability?
Book measures of profitability can be wrong or misleading because
1.Errors occur at different stages of project life. When true depreciation is decelerated, book measures are likely to understate true profitability for new projects and overstate it for old ones.
26Using expected economic depreciation will not generate book ROIs that are exactly right unless realized cash flows exactly match forecasted flows. But we expect forecasts to be right, on average.
27This procedure has been suggested by several authors, for example by Zvi Bodie in “Compound Interest Depreciation in Capital Investment,” Harvard Business Review 60 (May–June 1982), pp. 58–60.
334PART III Practical Problems in Capital Budgeting
2.Errors also occur when firms or divisions have a balanced mix of old and new projects. Our steady-state analysis of Nodhead shows this.
3.Errors occur because of inflation, basically because inflation shows up in revenue faster than it shows up in costs. For example, a firm owning a plant built in 1980 will, under standard accounting procedures, calculate depreciation in terms of the plant’s original cost in 1980 dollars. The plant’s output is sold for current dollars. This is why the U.S. National Income and Product Accounts report corporate profits calculated under replacement cost accounting. This procedure bases depreciation not on the original cost of firms’ assets, but on what it would cost to replace the assets at current prices.
4.Book measures are often confused by creative accounting. Some firms pick and choose among available accounting procedures, or even invent new ones, in order to make their income statements and balance sheets look good. This was done with particular imagination in the “go-go years” of the mid-1960s and the late 1990s.
Investors and financial managers have learned not to take accounting profitability at face value. Yet many people do not realize the depth of the problem. They think that if firms eschewed creative accounting, everything would be all right except perhaps for temporary problems with very old or very young projects. In other words, they worry about reason 4, and a little about reasons 1 and 3, but not at all about 2. We think reason 2 deserves more attention.
SUMMARY We began this chapter by describing how capital budgeting is organized and ended by exposing serious biases in accounting measures of financial perfor-
mance. Inevitably such discussions stress the mechanics of organization, control, accounting, and performance measurement. It is harder to talk about the informal procedures that reinforce the formal ones. But remember that it takes informal communication and personal initiative to make capital budgeting work. Also, the accounting biases are partly or wholly alleviated because managers and stock-
holders are smart enough to look behind book earnings. Formal capital budgeting systems usually have four stages:
1.A capital budget for the firm is prepared. This is a plan for capital expenditure by plant, division, or other business unit.
2.Project authorizations are approved to give authority to go ahead with specific projects.
3.Procedures for control of projects under construction are established to warn if projects are behind schedule or are costing more than planned.
4.Postaudits are conducted to check on the progress of recent investments.
Capital budgeting is not entirely a bottom-up process. Strategic planners practice capital budgeting on a grand scale by attempting to identify those businesses in which the firm has a special advantage. Project proposals that support the firm’s accepted overall strategy are much more likely to have clear sailing as they come up through the organization.
But don’t assume that all important capital outlays appear as projects in the capital budgeting process. Many important investment decisions may never receive
CHAPTER 12 Making Sure Managers Maximize NPV
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formal financial analysis. First, plant or division managers decide which projects to propose. Top management and financial staff may never see the alternatives. Second, investments in intangible assets, for example, marketing and R&D outlays, may bypass the capital budget. Third, there are countless routine investment decisions that must be made by middle management. These outlays are small if looked at one by one, but they add up.
Capital investment decisions must be decentralized to a large extent. Consequently agency problems are inevitable. Managers are tempted to slack off, to avoid risk, and to propose empire-building or entrenching investments. Empire building is a particular threat when plant and divisional managers’ bonuses depend just on earnings or on growth in earnings.
Top management mitigates these agency problems by a combination of monitoring and incentives. Many large companies have implemented sophisticated incentive schemes based on residual income or economic value added (EVA). In these schemes, managers’ bonuses depend on earnings minus a charge for capital employed. There is a strong incentive to dispose of unneeded assets and to acquire new ones only if additional earnings exceed the cost of capital. Of course EVA depends on accurate measures of earnings and capital employed.
Top management also create agency costs (e.g., empire building). In this case they are the agents and shareholders are the principals. Shareholders’ interests are represented by the board of directors and are also protected by delegated monitors (e.g., the accountants who audit the company’s books).
In most public corporations, top management’s compensation is tied to the performance of the company’s stock. This aligns their interests with shareholders’. But compensation tied to stock returns is not a complete solution. Stock returns respond to events outside management’s control, and today’s stock prices already reflect investors’ expectations of managers’ future performance.
Thus most firms also measure performance by accounting or book profitability. Unfortunately book income and return on investment (ROI) are often seriously biased measures of true profitability. For example, book ROIs are generally too low for new assets and too high for old ones. Businesses with important intangible assets generally have upward-biased ROIs because the intangibles don’t appear on the balance sheet.
In principle, true or economic income is easy to calculate: You just subtract economic depreciation from the asset’s cash flow. Economic depreciation is simply the decrease in the asset’s present value during the period.
Unfortunately we can’t ask accountants to recalculate each asset’s present value every time income is calculated. But it does seem fair to ask why they don’t try at least to match book depreciation schedules to typical patterns of economic depreciation.
The most extensive study of the capital budgeting process is:
J.L. Bower: Managing the Resource Allocation Process, Division of Research, Graduate School of Business Administration, Harvard University, Boston, 1970.
The article by Pohlman, Santiago, and Markel is a more up-to-date survey of current practice:
R. A. Pohlman, E. S. Santiago, and F. L. Markel: “Cash Flow Estimation Practices of Large Firms,” Financial Management, 17:71–79 (Summer 1988).
FURTHER READING
336
PART III Practical Problems in Capital Budgeting
For an easy-to-read description of EVA, with lots of success stories, see
A. Ehrbar: EVA: The Real Key to Creating Wealth, John Wiley & Sons, Inc., New York, 1998.
Biases in book ROI and procedures for reducing the biases are discussed by:
E.Solomon and J. Laya: “Measurement of Company Profitability: Some Systematic Errors in the Accounting Rate of Return,” in A. A. Robichek (ed.), Financial Research and Management Decisions, John Wiley & Sons, Inc., New York, 1967, pp. 152–183.
F.M. Fisher and J. I. McGowan: “On the Misuse of Accounting Rates of Return to Infer Monopoly Profits,” American Economic Review, 73:82–97 (March 1983).
J.A. Kay: “Accountants, Too, Could Be Happy in a Golden Age: The Accountant’s Rate of Profit and the Internal Rate of Return,” Oxford Economic Papers, 28:447–460 (1976).
Z. Bodie: “Compound Interest Depreciation in Capital Investment,” Harvard Business Review, 60:58–60 (May–June 1982).
QUIZ
1. True or false?
a.The approval of a capital budget allows managers to go ahead with any project included in the budget.
b.Capital budgets and project authorizations are mostly developed “bottom up.” Strategic planning is a “top-down” process.
c.Project sponsors are likely to be overoptimistic.
d.Investments in marketing (for new products) and R&D are not capital outlays.
e.Many capital investments are not included in the company’s capital budget. (If true, give some examples.)
f.Postaudits are typically undertaken about five years after project completion.
2.Explain how each of the following actions or problems can distort or disrupt the capital budgeting process.
a.Overoptimism by project sponsors.
b.Inconsistent forecasts of industry and macroeconomic variables.
c.Capital budgeting organized solely as a bottom-up process.
d.A demand for quick results from operating managers, e.g., requiring new capital expenditures to meet a payback constraint.
3.What is the practical implication of Brealey and Myers’s Second Law? The law reads, “The proportion of proposed projects having a positive NPV at the corporate hurdle rate is independent of the hurdle rate.”
4.Define the following: (a) Agency costs in capital investment, (b) private benefits, (c) empire building, (d) free-rider problem, (e) entrenching investment, (f) delegated monitoring.
5.Monitoring alone can never completely eliminate agency costs in capital investment. Briefly explain why.
6.Here are several questions about economic value added or EVA.
a.Is EVA expressed as a percentage or a dollar amount?
b.Write down the formula for calculating EVA.
c.What is the difference, if any, between EVA and residual income?
d.What is the point of EVA? Why do firms use it?
e.Does the effectiveness of EVA depend on accurate measures of accounting income and assets?
7.The Modern Language Division earned $1.6 million on net assets of $20 million. The cost of capital is 11.5 percent. Calculate the net percentage return on investment and EVA.
8.True or false? Briefly explain your answers.
a.Accountants require companies to write off outlays for R&D as current expenses. This makes R&D-intensive companies look less profitable than they really are.
CHAPTER 12 Making Sure Managers Maximize NPV
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b.Companies with valuable intangible assets will show upward-biased accounting rates of return.
9.Fill in the blanks:
“A project’s economic income for a given year equals the project’s __________ less its
__________ depreciation. Book income is typically __________ than economic income early in the project’s life and __________ than economic income later in its life.”
10.Consider the following project:
Period
0
1
2
3
Net cash flow
100
0
78.55
78.55
The internal rate of return is 20 percent. The NPV, assuming a 20 percent opportunity cost of capital, is exactly zero. Calculate the expected economic income and economic depreciation in each year.
1. Discuss the value of postaudits. Who should conduct them? When? Should they con- PRACTICE
sider solely financial performance? Should they be confined to the larger projects?
QUESTIONS
2.Draw up an outline or flowchart tracing the capital budgeting process from the initial idea for a new investment project to the completion of the project and the start of operations. Assume the idea for a new obfuscator machine comes from a plant manager in the Deconstruction Division of the Modern Language Corporation.
Here are some questions your outline or flowchart should consider: Who will prepare the original proposal? What information will the proposal contain? Who will evaluate it? What approvals will be needed, and who will give them? What happens if the machine costs 40 percent more to purchase and install than originally forecasted? What will happen when the machine is finally up and running?
3.Compare typical compensation and incentive arrangements for (a) top management, for example, the CEO or CFO, and (b) plant or division managers. What are the chief differences? Can you explain them?
4.Suppose all plant and division managers were paid only a fixed salary—no other incentives or bonuses.
a.Describe the agency problems that would appear in capital investment decisions.
b.How would tying the managers’ compensation to EVA alleviate these problems?
5.Table 12.10 shows a condensed income statement and balance sheet for Androscoggin
Copper’s Rumford smelting plant.
EXCEL
a.Calculate the plant’s EVA. Assume the cost of capital is 9 percent.
b.As Table 12.10 shows, the plant is carried on Androscoggin’s books at $48.32 million. However, it is a modern design, and could be sold to another copper company for $95 million. How should this fact change your calculation of EVA?
6.Here are a few questions about compensation schemes that tie top management’s compensation to the rate of return earned on the company’s common stock.
a.Today’s stock price depends on investors’ expectations of future performance. What problems does this create?
b.Stock returns depend on factors outside the managers’ control, for example, changes in interest rates or prices of raw materials. Could this be a serious problem? If so, can you suggest a partial solution?
c.Compensation schemes that depend on stock returns do not depend on accounting income or ROI. Is that an advantage? Why or why not?
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PART III Practical Problems in Capital Budgeting
T A B L E
1 2 . 1 0
Income Statement for 2001
Assets, December 31, 2001
Condensed financial
Revenue
$56.66
Net working capital
$7.08
statements for the Rumford
Raw materials cost
18.72
smelting plant. See practice
Operating cost
21.09
Investment in plant and equipment
69.33
question 5 (figures in $
Depreciation
4.50
Less accumulated depreciation
21.01
millions).
Pretax income
12.35
Net plant and equipment
48.32
Tax at 35%
4.32
Net income
$8.03
Total assets
$55.40
7.
Herbal Resources is a small but profitable producer of dietary supplements for pets.
This is not a high-tech business, but Herbal’s earnings have averaged around $1.2 mil-
lion after tax, largely on the strength of its patented enzyme for making cats nonaller-
genic. The patent has eight years to run, and Herbal has been offered $4 million for the
patent rights.
Herbal’s assets include $2 million of working capital and $8 million of property,
plant, and equipment. The patent is not shown on Herbal’s books. Suppose Herbal’s
cost of capital is 15 percent. What is its EVA?
8.
List and define the agency problems likely to be encountered in a firm’s capital invest-
ment decisions.
9.
Large brokerage and investment companies, such as Merrill Lynch and Morgan Stan-
ley Dean Witter, employ squadrons of security analysts. Each analyst devotes full time
to an industry—aerospace, for example, or insurance—and issues reports and buy,
hold, or sell recommendations for companies in the industry. How do security analysts
help overcome free-rider problems in monitoring management? How do they help
avoid agency problems in capital investment?
10.
What is meant by delegated monitoring? Who are these monitors and what roles do
they play?
11.
True or false? Explain briefly.
a. Book profitability measures are biased measures of true profitability for individual
assets. However, these biases “wash out” when firms hold a balanced mix of old
and new assets.
b. Systematic biases in book profitability would be avoided if companies used
depreciation schedules that matched expected economic depreciation. However,
few, if any, firms have done this.
12.
Calculate the year-by-year book and economic profitability for investment in polyzone
EXCEL
production, as described in Chapter 11. Use the cash flows and competitive spreads
shown in Table 11.2.
What is the steady-state book rate of return (ROI) for a mature company produc-
ing polyzone? Assume no growth and competitive spreads.
13.
Suppose that the cash flows from Nodhead’s new supermarket are as follows:
Year
0
1
2
3
4
5
6
Cash flows ($ thousands) 1,000
298
298
298
138
138
138
a.Recalculate economic depreciation. Is it accelerated or decelerated?
b.Rework Tables 12.7 and 12.8 to show the relationship between the “true” rate of return and book ROI in each year of the project’s life.
CHAPTER 12 Making Sure Managers Maximize NPV
339
14.Use the Market Insight database (www.mhhe.com/edumarketinsight) to estimate the economic value added (EVA) for three firms. What problems did you encounter in doing this?
1.Is there an optimal level of agency costs? How would you define it?
2.Suppose it were possible to measure and track economic income and the true economic value of a firm’s assets. Would there be any remaining need for EVA? Discuss.
3.Reconstruct Table 12.9 assuming a steady-state growth rate of 10 percent per year. Your answer will illustrate a fascinating theorem, namely, that book rate of return equals the economic rate of return when the economic rate of return and the steady-state growth rate are the same.
4.Consider an asset with the following cash flows:
CHALLENGE QUESTIONS
Year
0
1
2
3
Cash flows ($ millions)
12
5.20
4.80
4.40
The firm uses straight-line depreciation. Thus, for this project, it writes off $4 million per year in years 1, 2, and 3. The discount rate is 10 percent.
a.Show that economic depreciation equals book depreciation.
b.Show that the book rate of return is the same in each year.
c.Show that the project’s book profitability is its true profitability.
You’ve just illustrated another interesting theorem. If the book rate of return is the same in each year of a project’s life, the book rate of return equals the IRR.
5.The following are extracts from two newsletters sent to a stockbroker’s clients:
Investment Letter—March 2001
Kipper Parlors was founded earlier this year by its president, Albert Herring. It plans to open a chain of kipper parlors where young people can get together over a kipper and a glass of wine in a pleasant, intimate atmosphere. In addition to the traditional grilled kipper, the parlors serve such delicacies as Kipper Schnitzel, Kipper Grandemere, and (for dessert) Kipper Sorbet.
The economics of the business are simple. Each new parlor requires an initial investment in fixtures and fittings of $200,000 (the property itself is rented). These fixtures and fittings have an estimated life of 5 years and are depreciated straight-line over that period. Each new parlor involves significant start-up costs and is not expected to reach full profitability until its fifth year. Profits per parlor are estimated as follows:
Year after Opening
1
2
3
4
5
Profit
0
40
80
120
170
Depreciation
40
40
40
40
40
Profit after
depreciation
–40
0
40
80
130
Book value at start
of year
200
160
120
80
40
Return on investment (%)
–20
0
33
100
325
Kipper has just opened its first parlor and plans to open one new parlor each year. Despite the likely initial losses (which simply reflect start-up costs), our calculations show a dra-
ended by exposing serious biases in accounting measures of financial perfor-
