Corporate Underinvestment

A recent article indicates that financial managers may not be following good capital budgeting techniques. The median hurdle rate used to value new projects is 12.0 percent, with an average rate of 13.6 percent. Meanwhile, the same survey notes that the median WACC is 9.8 percent, with a mean of 10.6 percent. While that article infers that these numbers should be the same, we differ on this assumption. If new projects are riskier than the company, which would likely be the case, then the cost of capital for new projects would necessarily be greater than the WACC since the required return on a project depends on the use of funds, not the source of funds.

Underinvestment still does occur, as 67 percent of respondents answers “No” when asked if their company undertook all projects that create value. Common reasons given for not pursuing value creating projects were:

Shortage of management time and expertise (51%)

The project is not consistent with the company’s core strategy (41%)

The risk of the project is too high (39%)

Shortage of funds (38%)

Shortage of employees (32%)

Cash Flow Rises

According to a recent study, free cash flow for 20 industries increased to 4.97 percent last year, meaning that for every dollar of sales, companies generated 4.97 cents in cash flow. An increase in operating efficiency generated .89 percent, a decrease in working capital contributed .69 percent, and lower capex contributed .17 percent. The lower capex spending may be worrisome as it is an indication of lower investment in fixed assets.

Dividends Dry Up

Even though motorists are happy with lower gas prices, investors in oil and natural gas companies are feeling pinched away from the pump as $7.4 billion in dividends have dried up. For example, Anadarko Petroleum reduced its dividend by 81 percent and Kinder Morgan and Devon Energy both reduced dividends by 75 percent. Kinder Morgan was the largest dividend cut in terms of dollars ($3.44 billion), followed by ConocoPhillips ($2.42 billion). Chevron has chosen another alternative as it is reduced its capital spending and is considering increasing its debt to maintain the company's dividend. The steep decline in energy prices has also hit capital budgeting as oil and gas companies have resulted in the cancellation of more than $100 billion in new projects.

Spirit Grows To Grow

In its recent quarterly report, Spirit Airlines reported poor results. In a sharp criticism of company management, an analyst notes “growth for growth’s sake will not be rewarded in this environment.” Evidently, Spirit has yet to figure out that growth is only good if the new projects are positive NPV projects. In Spirit's case, the industry is experiencing weakening prices, yet Spirit continues to expand, with an announced capacity growth of more than 20 percent in 2016.

Exxon Slows Capital Spending

As we mention in the textbook, capital spending is often cyclical. For example, although the recent drop in oil price is welcome news at the gas pump, it is bad news for Exxon's capital budgeting. Exxon said that it may delay some investments if oil prices stay low. Even though Exxon's projects are long-term, a short-term decrease in the price of oil can still affect the profitability of a new project. In a filing last week, Exxon announced that its capital spending in the next several years would only be $34 billion, down from a previously announced capital budget of $37 billion.

Capital Budgeting For A College Degree

The decision to attend college is at least in part a capital budgeting decision. A recent report by economists at the Federal Reserve Bank of New York completed that analysis for us. The NPV of a college degree today is about $273,000, down from a high of $338,000 in 2001, but three times the 1980s NPV of $80,000. Additionally, the payback period today is about 10 years, much quicker than the 15 to 25 years during the 1970s. What about the IRR? The IRR overall for a college degree is about 15 percent. Engineers have the highest IRR at 21 percent, while education majors have the lowest IRR at about 9 percent.

U.S. Oil And Natural Gas Capital Spending

The American Petroleum Institute recently released projected capital spending on oil and natural gas projects in the U.S. through 2020 and the numbers are staggering. During 2014, an estimated $87.4 billion will be spent in the U.S., with spending declining to $75.0 billion in 2020. During the next seven years, a projected $568.4 billion will be spent on U.S. oil and natural gas projects. With the dollar amount being invested, we hope a careful capital budgeting analysis is being performed on these projects.

Exxon's Performance

While we don't often discuss an analyst's report, a recent report on Exxon caught our eye. One way to create a positive NPV project is to have economic moats. An economic moat can be a competitive advantage over others in the same industry, or barriers to entry. The article discusses several concepts that we think should interest you after what you have learned in this class so you can see how key concepts are applied in other areas of finance. For example, the article discusses Exxon's low cost of capital (Why would Exxon have a lower cost of capital than its competitors?), as well as economic rents. You can think of economic rents as a positive NPV. The article also discusses Exxon's lower F&D (finding and development) costs in relation to its peers, as well as a lower cost structure, which is the application of ratio analysis.

Economic Profit

McKinsey Quarterly recently published an article on the results of its study of economic profit for 3,000 large companies. If you prefer, a narrated slideshow discussing the results is also available. As a quick review, economic profit is also known as Economic Value Added (EVA) and is similar to an NPV calculation for the company as a whole. The results of the study show the disparities between the top and bottom performers from middle-of-the-pack companies. Surprisingly, bottom performers tend to have higher revenues than middling performers, have the highest tangible-capital ratio, but the lowest asset turnover. They are likely to be in a capital intensive industry such as airlines, electric utilities, and railroads. Top performers tend to have high margins and a low tangible-capital ratio.

Interestingly, top performers were likely to remain as such, in part due to more fresh capital. In other words, they stay on top because they get bigger and seem to invest in profitable projects. Of course, a company can improve its performance, but much of the improvement lies in the industry. In fact, companies that do improve (or experience a decline) in economic profit tend to be driven by industry performance. The results of the study indicate that as much as 54 percent of a company's economic profit is due to its industry. Interestingly though, top quintile companies rely the least on industry effects.

Copper Mine NPV

Tintina Resources announced that its Preliminary Economic Assessment (capital budgeting analysis) of the company's Black Butte Copper Project in central Montana resulted in an IRR of 30.5 percent, an NPV of $218 million at a cost of capital of 8 percent, and a 3.6 year payback. The company announced a post-tax NPV of $110 million, but infortunately appears to have used the same 8 percent cost of capital. A pre-tax valuation should use a pre-tax interest rate, while a post-tax valuation should use a post-tax interest rate. 

An Olympic Capital Budget

While it may come as a surprise, even the Olympics can be viewed as a capital budgeting project. And the London Olympics could have had better financial planning. The 2012 Summer Olympics cost London nearly $15 billion, or about five times the original estimate. London gets repaid with broadcast dollars, and the broadcasters get repaid with sponsors' advertisements. Whether the sponsors actually receive a return on investment is more difficult to calculate.

Why Is There No Corporate Investment?

During the recent financial crisis, blame has been placed on corporations for a lack of new investments. While corporate cash balances have been climbing, new investments have stalled. One reason may be an increasing equity risk premium, or market risk premium (MRP), as we call it in the text. An increase in the MRP premium increases the cost of capital for any project, making the NPV less favorable. A recent article in CFO argues that an increase in the MRP is a factor behind the slowdown in capital investments. This may be part of the problem, but we would like you to consider a couple of things.

While the MRP may have increased, the cost of debt has decreased, so the overall cost of capital could have remained the same, or even decreased.  As the article points out, calculating the MRP is not an exact science. An increase in the MRP may be a factor, but the impact is unknown at this time.

While we hope your education is teaching you to critically examine arguments you hear or read, we would also like to point out a glaring error in the logic of the argument presented in this article. The article states that "stock investors are questioning the very integrity of the markets, and the perceived risk of holding an equity portfolio has increased." One reason given for this is the Facebook IPO debacle. And while the Facebook IPO problems may have affected investors' beliefs about risk and market integrity, the Facebook IPO occurred about six weeks ago, much too recently to have had any effect on the MRP during most of the period in question.  http://www3.cfo.com/blogs/banking-cap-markets/banking--capital-markets/2012/06/the-real-reason-companies-aren’t-investing