Futronics is a communications firm founded in 1937. This $2 billion company has been selling consumer communications products, as well as communications systems for governments, for more than half a century. However, it is currently experiencing problems due to competition, overall economic conditions, and poor sales, so it is planning a program to reduce its corporate overhead. The company proposes to outsource its central office stores to other vendors, an investment which will cost the company $1,000,000. For this project, incremental cash flows are predicted at $450,000 for year 1, $350,000 for year 2, $300,000 in year 3, and $250,000 in the fourth year. The cost of capital for Futronics is 8%. Based on these figures, the company seeks to determine the net present value, internal rate of return, and simple payback period for this project. These values are the three most common that are computed for capital budgeting, i.e., deciding whether a project would be profitable.
In this formula, Ct is the net cash flow during a given time period, C0 is the initial investment for the project, r is the discount rate (in this case, the cost of capital), and t is the total number of time periods (Frino et al., 2012). NPV for this project is computed to be $138, 642.39. This method gives an accurate picture of the profitability of the project. In this case, the positive value suggests that the project is worthwhile, based on the rule for interpreting NPV. As a caveat, the measure used for the discount rate should be carefully considered; since it is suggested that using WACC is the most accurate measure, using any other quantity must be reviewed for potential bias and unsupported assumptions (Hasan, 2013).
The second quantity which can provide guidance on capital budgeting is the internal rate of return (IRR), defined as the discount rate which will produce an NPV of 0. It is computed using a process of trial and error — a certain rate is chosen and the NPV is calculated (Frino et al., 2012). If it is nonzero, the rate is raised or lowered and NPV is recalculated. This procedure is repeated until NPV is very close to zero. If the internal rate of return is higher than the cost of capital, the project is a good investment; if IRR is lower than cost of capital, the project should not be continued. For Futronics, the outsourcing project has an IRR of 15%, considerably higher than the cost of capital (8%). This suggests it is a wise investment.
Finally, the computation of simple payback determines how long, based on the projected cash flows, it will take for the project to pay for itself. If the cash flows are the same for each time period, simple payback can be found by dividing the initial investment by the cash flow per period (Chittenden & Derregia, 2013). If, as in this case, cash flows are not the same in all time periods, cumulative cash flow must be calculated. This project has a payback period of 2.67 years (about 2 years and 8 months), which is a relatively short time. Thus, all three quantities are in favor of the outsourcing project. Futronics should proceed with its plans.
The project to outsource central office functions will benefit the company in several ways. First, after the initial investment, there is no further cost to the company — cash flows will be positive (into the company) rather than negative ( out of the company). Thus, it fulfills the need to reduce overhead. Second, if outsourcing proceeds as predicted, Futronics can concentrate its funds on improving or expanding its products (i.e., on R&D) or on increased marketing and building a larger customer base. It can maintain product quality while potentially freeing up money for other purposes.
Although the capital budgeting methods discussed here are common and well-accepted, there are more advanced methods that could decrease uncertainty in decision making. One of these is “real options,” a process in which the choices available are evaluated in the same way that stock options are evaluated (Bennouna et al., 2010). That is, a chance to invest is similar to a call option, while a chance to sell is like a put option. This leads to the three basic choices a company can make when confronted with an investment: the option to expand, the option to abandon, and the option to wait. This approach has two underlying assumptions: one, that humans (individuals or groups) have the capability of learning from experience, and two, that humans can and will apply what they have learned when making future decisions. The consequences of one choice, therefore, will affect the next decision (Grullon et al., 2012). The real options method, as opposed to DCF methods such as NPV, adjusts for the value of learning, and gives a more accurate idea of a project’s true value. Also, the method requires the examination of the underlying assumptions of the choice, thereby preventing thinking errors that could result in a wrong decision. If Futronics chose to use real options valuation in its capital budgeting, it could get better results.
On the other hand, IRR — although it is, in many respects, the complement of NPV — has pitfalls that can produce incorrect decisions regarding investments. First, IRR will not produce a correct decision when the cash flows are not normal. For instance, if cash flows are not positive in each time period after the initial investment, IRR may give inaccurate results. Second, when IRR is used to compared projects that are mutually exclusive, assumptions regarding the reinvestment rate may lead to inaccurate measures and subsequent poor decisions (Bennouna et al., 2010). Simple payback also has drawbacks and should only be used in conjunction with other methods such as NPV. In this case, it functions as a check on the NPV, so if the two do not give the same guidance, there must be an inaccurate assumption or quantity.
- Bennouna, K., Meredith, G. G., & Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada.’Management decision,48(2), 225-247.
- Chittenden, F., & Derregia, M. (2013). Uncertainty, irreversibility and the use of ‘rules of thumb’ in capital budgeting.’The British Accounting Review. doi:10.1016/j.bar.2013.12.003
- Frino, A., Hill, A., & Chen, Z. (2012).’Introduction to corporate finance. Pearson Higher Education AU.
- Grullon, G., Lyandres, E., & Zhdanov, A. (2012). Real options, volatility, and stock returns.’The Journal of Finance,’67(4), 1499-1537.
- Hasan, M. (2013). Capital Budgeting Techniques Used by Small Manufacturing Companies.’Journal of Service Science and Management,’6, 38.