One of the most common financial analysis tasks with which a controller is confronted is evaluating capital investments. In some industries, the amount of money poured into capital improvements is a very substantial proportion of sales, and so is worthy of a great deal of analysis to ensure that a company is investing its cash wisely in internal improvements. This post reviews the concept of the hurdle rate, as well as the payback period. As for the NPV and IRR, I have planned to discuss them in the near future which may conclude with reviews of the capital investment proposal form and the postcompletion project analysis, which brings to a close the complete cycle of evaluating a capital project over the entire course of its acquisition, installation, and operation of a new project [or business].

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Hurdle Rate

When controllers are given capital investment proposal forms to review, they need some basis on which to conduct the evaluation.

What makes a good capital investment? Is it the project with the largest net cash flow, the one that uses the least capital, or some other standard of measure?

 

The standard criterion for investment is the hurdle rate—the discounting rate at which all of a company’s investments must exhibit a positive cash flow. It is called a hurdle rate because the summary of all cash flows must exceed, or hurdle, this rate, or else the underlying investments will not be approved. The use of a discount rate is extremely important, for it reduces the value of cash inflows and outflows scheduled for some time in the future, so that they are comparable to the value of cash flows in the present.

Without the use of a discount rate, we would judge the value of a cash flow 10 years in the future to be the same as one that occurs right now. However, the difference between the two is that the funds received now can also earn interest for the next 10 years, whereas there is no such opportunity to invest the funds that will arrive in 10 years. Consequently, a discount rate is the great equalizer that allows us to make one-to-one comparisons between cash flows in different periods.

The hurdle rate is derived from the cost of capital. This is the average cost of funds that a company uses, and is based on the average cost of its debt, equity, and various other funding sources that are combinations of these two basic forms of funds. For example: if a company has determined its cost of capital to be 16 percent, then the discounted cash flows from all of its new capital investments, using that discount rate, must yield a positive return. If they do not, then the cash flow resulting from its capital investments will not be sufficient for the company to pay for the funds it invested. Thus, the primary basis on which a controller reviews potential capital investments is the hurdle rate.

A company may choose to use several hurdle rates, depending on the nature of the investment. For example: if the company must install equipment to make its production emissions compliant with federal air quality standards, then there is no hurdle rate at all—the company must complete the work or be fined by the government. At the opposite extreme, a company may assign a high hurdle rate to all projects that are considered unusually risky. For example, if capital projects are for the extension of a current production line, there is very little perceived risk, and a hurdle rate that matches the cost of capital is deemed sufficient. If the capital expenditure is for a production line that creates equipment in a new market in which the company is the first entrant, however, and no one knows what kind of sales will result, the hurdle rate may be set a number of percentage points higher than the cost of capital.

Thus, different hurdle rates can apply to different situations. Although the hurdle rate is the fundamental measuring stick against which all capital investments are evaluated, there is one exception to the rule: “the payback period”. Let’s move on to the payback period…

 

Payback Period

The primary criterion for evaluating a capital investment is its ability to return a profit that exceeds a hurdle rate. However, this method misses one important element—it does not fully explain investment risk in a manner that is fully understandable to managers. Investment risk can be defined as the chance that the initial investment will not be earned back, or that the rate of return target will not be met. Discounting can be used to identify or weed out such projects, simply by increasing the hurdle rate. For example, if a project is perceived to be risky, an increase in the hurdle rate will reduce its net present value, which makes the investment less likely to be approved by management. Management may not be comfortable dealing with discounted cash flow methods when looking at a risky investment, however; they just want to know how long it will take until they get their invested funds back.

Though this is a decidedly unscientific way to review cash flows, the I have yet to find a management team that did not insist on seeing a payback calculation alongside other, more sophisticated analysis methods.

There are two ways to calculate the payback period. The first method is the easiest to use but can yield a skewed result. That calculation is to divide the capital investment by the average annual cash flow from operations. For example, table below shows a stream of cash flows over five years that is heavily weighted toward the time periods that are farthest in the future.

Stream of Cash Flows for a Payback Calculation

Year           Cash Flow
1                 $1,000,000
2                   1,250,000
3                   1,500,000
4                   2,000,000
5                   3,000,000

 

The sum of those cash flows is $8,750,000, which is an average of $1,750,000 per year. We will also assume that the initial capital investment was $6 million. Based on this information, the payback period is $6 million divided by $1,750,000, which is 3.4 years.

However, if we review the stream of cash flows in the next table, it is evident that the cash inflow did not cover the investment at the 3.4- year mark.

Stream of Cash Flows for a Manual Payback Calculation

Year    Cash Flow               Net Investment Remaining
0                          0                $6,000,000
1          $1,000,000                  5,000,000
2            1,250,000                  3,750,000
3            1,500,000                  2,250,000
4            2,000,000                     250,000
5            3,000,000                              —

 

In fact, the actual cash inflow did not exceed $6 million until shortly after the end of the fourth year.

What happened?

 

The stream of cash flows in the example was so skewed toward future periods that the annual average cash flow was not representative of the annual actual cash flow. Thus, the averaging method can be used only if the stream of future cash flows is relatively even from year to year.

The most accurate way to calculate the payback period is to do so manually. This means that we deduct the total expected cash inflow from the invested balance, year by year, until we arrive at the correct period. For example: the stream of cash flows from the first tabale have been re-created in the second table, but now with an extra column that shows the net capital investment remaining at the end of each year. This format can be used to reach the end of year four; we know that the cash flows will pay back the investment sometime during year five, but we do not have a month-by-month cash flow that tells us precisely when. Instead, we can assume an average stream of cash flows during that period, which works out to $250,000 per month ($3 million cash inflow for the year, divided by 12 months). Because there was only $250,000 of net investment remaining at the end of the fourth year, and this is the same monthly amount of cash flow in the fifth year, we can assume that the payback period is 4.1 years.

As already stated, the payback period is not a highly scientific method, because it completely ignores the time value of money. Nonetheless, it tells management how much time will pass before it recovers its invested funds, which can be useful information, especially in environments such as high technology, in which investments must attain a nearly immediate payback before they become obsolete. Accordingly, it is customary to include the payback calculation in a capital investment analysis, though it must be strongly supplemented by discounted cash flow analyses, which I plan to post soon.