Capital Budgeting- Investment Decisions

At times corporations need to make investment decisions. These decisions are important as they help firms build up their assets and future cash flows, at the same time would need considerable investments.

An important aspect of these investments is the time value of money, i.e. cash received earlier has more value than cash received at a later time.

Stages in Capital Budgeting

• Stage 1: Investment screening and selection
• Stage 2: Capital budget proposal
• Stage 3: Budgeting approval and authorization
• Stage 4: Project tracking
• Stage 5: Post-completion audit

Financial Appraisal tools for Capital Budgeting

Payback Method: The payback period is the number of years it takes to recover the project cost. The payback method helps understand projects’ risk and liquidity and is easy to understand. On the downside, it does not consider the time value of money (TVM) and does not consider cash flows after the payback period.

An alternate to payback method is discounted payback, where instead of exact Cash Flow (CF), a discounted CF is considered to take care of TVM.

NPV: An important tool to evaluate projects is NPV or Net Present Value. In simple terms, NPV is is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. If NPV>0, the project can be considered for acceptance.

Any project with NPV>0 is profitable. The higher the NPV, the more profitable is the project. So in the case of mutually exclusive projects (the only one that can be chosen), the one with higher NPV is preferred.

IRR or Internal Rate of Return: “The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.” – investopedia.com. A Higher IRR rate makes the project more desirable.

To calculate IRR, set NPV=0 in the NPV formula mentioned above.

If IRR>WACC (Weighted Average Cost of Capital), the project is profitable.

Sunk Cost: Sunk cost is a cost that has already been incurred and as such, exists irrespective of whether the project is undertaken or not. For example the salary of the employees. This cost should not be considered as part of project cash flows.

Opportunity Cost: For example, if the company has land which is to be used to set up a factory for the current project. This cost will be added to the project.

Profitability Index: When comparing multiple projects of different sizes, directly comparing NPV might not make sense as one project might be worth 10000 and another might be 1000000. Profitability index or PI is calculated as NPV/ Initial investment and helps us calculate profit generated per dollar invested. A PI> 1 means the project is profitable.

Corporate Finance: Value Maximization

Value Pentagon

Company as-is value is the value of the company without any restructuring or change.

The company’s optimum value is the value that can be achieved after the restructuring is done.

Internal restructuring: Find out redenancies, wastages, remove bottlenecks.

External Restructuring: Merger, demerger, acquisition, etc.

Financial restructuring: Writing down useless assets, debt restructuring etc.

Shareholder vs Stakeholder value

When we talk about the value of the company, they normally have two approaches, increase shareholder value or stakeholder value. Both approaches have their pros and cons. The shareholder value approach is easy to track, as you can look at the numbers and figure out if the shareholder value has increased. But at the same time, this approach can be myopic and focus on short-term goals.

The stakeholder value approach has a broader view, where it talks about customers, employees, society, shareholders, and other stakeholders. The problem here it is hard to track as there is no direct way to track it. For example, giving better discounts and better salaries might help me keep my customers and employees happy, but might add to losses.

Measuring shareholder wealth creation

Market Value Addition or MVA is an important aspect to understand shareholder value. For example, there are two companies, A and B, both with a market cap of say 1000 crore. But the network of company A is 500 crore and company B is 250 crore. We can see MVA for company A is 500 crore whereas company B is 250 crores. In other words, the market view potential for growth in company B.

Corporate Restructuring

Corporate restructuring includes acquisitions, demergers, joint ventures, etc. For example, buying Corus helped Tata steel to jump from 55th ranked in steel revenue worldwide to 5th rank.

Corprate restructuring can be done by

Expansion: Absorption, Tender Offer, Asset acquisition, Joint venture, etc.

Contraction: Demerger – Spin off, split off, split up, Equity carve out etc.

Corporates can unlock value by demergers. Studies report that the observed value of the diversified firm is, on average, 15 percent less than the sum of the implied market value of its divisions, as compared to stand-alone market values of single-segment firms in those industries.

Factors behind diversification discount

Information hypothesis: the inability of markets to correctly evaluate conglomerate structures with unrelated businesses, leading to possible undervaluation.

Inefficient Management hypothesis: the inability of the managers to efficiently manage unrelated businesses.

Inefficient investment hypothesis: distortion of investment due to competition among units for resources.

Modes of asset disposition

Slump sale:  Slump sale means the transfer of one or more undertakings as a result of the sale for a lump sum consideration. For example, Ruchi Soya buying biscuit business from Patanjali Natural Biscuits Pvt Ltd (PNBPL) for 60 crores.

Spin-Off: A spinoff is the creation of an independent company through the sale or distribution of new shares of an existing business or division of a parent company. When a new company B is carved out of company A, mostly shareholders of company A will get some proportional shares of company B.

Spin-Off helps in

• Unlocking hidden value: establish a public market valuation for undervalued assets.
• Undiversification: divest non-core business and sharpen strategic focus
• Institutional sponsorship: Promote equity research coverage
• Public currency: the public currency for acquisition and stock-based compensation programs
• Motivating Management
• Eliminating dis-synergies
• Corporate Defence: Divest “crown jewel” asset to make the takeover of parent company less attractive.

Challenges in spin-off: There are certain aspects that need to be managed, for example, if the parent company has debt, how this debt will be divided between parent and spin-off company. The lenders need to agree on the arrangement.

Split-Off: In a split-off, the parent company offers its shareholders the opportunity to exchange their parent-co shares. For example, a big shareholder can give up shares in the parent company to gain controlling stakes in the new company.

Split-up: Division of a company into two or more publically traded companies. The difference here is that instead of the parent company and spun-off company, we have completely new companies into existence.

Equity Carve-out: Also known as IPO carve-out, the parent company sells a portion or all of its interests in a subsidiary to the public in an initial public offering.

Financial Restructuring

Cleaning up a balance sheet: writing off losses, writing down useless assets, can be done through asset restructuring and recapitalization.

Debt Restructuring

• Strategy-Driven: Restructure debt by lowering the interest rates.
• Crisis-Driven: When a company defaults, the company is forced to restructure debt.

Equity Restructuring

• Special dividend: One-time dividend
• Share buyback: reduces the shareholder base. As a regulatory requirement, the debt-equity ratio should be 2:1, after the buyback. Buyback can happen through the open markets, tender offers, and buyback from employees.
• Stock Splits: helps with liquidity
• Bonus Shares: When the company is growing fast but does not want to distribute cash in form of a dividend, a bonus share will help reward the shareholders.