Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

return on investment (ROI) – which was introduced in Chapter 2 – for measuring a company’s overall

effectiveness in generating returns with its available assets. Companies will usually establish some

minimum accounting rate of return, the hurdle rate, which projects must earn before they can be funded.

When more than one project exceeds the minimum standard, companies prioritise projects based on

their accounting rates of return and invest in projects with higher returns first.

example

Suppose that the practice at Global Untethered is

to calculate a project’s accounting rate of return

by taking the project’s average contribution to net

income and dividing by its average book value.

Global Untethered ranks projects based on this

measure, and accepts those that offer an accounting

rate of return of at least 25%. So far, we have been

given the cash flows from each of the two projects

that Global Untethered is evaluating. Chapter 10

discusses in greater depth the differences between

cash flow and net income; but for now, the net

income figures for each project appear below. We will

assume that the company depreciates fixed assets on

a straight-line basis over five years.

Therefore, the Western Europe project will have

an annual depreciation charge of $50 million (one-

fifth of $250 million), and the South-eastern Australia

project will have an annual depreciation charge of

$10 million (one-fifth of $50 million). The Western

Europe project begins with a book value of $250

million. After five years of depreciation it has a book

value of $0. Therefore, the average book value of

that project is $125 million ([$250 – $0] ÷ 2). The

project’s average net income equals $66 million

([–$15 + $30 + $80 + $110 + $125] ÷ 5), so its

average accounting rate of return is an impressive

52.8% ($66 ÷ $125). The same steps applied to the

South-eastern Australia project yield an average

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finance in practice

CFO SURVEY EVIDENCE (II)

In a survey of CFOs, Graham, Harvey and Rajgopal

asked CFOs to identify the most important

financial measures that they reported to outside

investors. The pie chart to the right shows that the

overwhelming response was earnings. The study

also reported that CFOs believed that reporting

earnings in the current quarter that are higher

than earnings in the same quarter in the prior

year was the most important earnings benchmark

for companies to achieve – even more important

than beating equity analysts’ earnings forecasts.

This focus on earnings stands in contrast to our

recommendation that managers focus on cash

flows.

Source: John R. Graham, Campbell R. Harvey and Shiva Rajgopal, ‘The

Economic Implications of Corporate Financial Reporting,’ Journal of

Accounting and Economics, 40, 2005, pp.3–73.

Earnings

51%

Revenues

12%

Cash flows from

operations

12%

Free cash flows

10%

Pro forma

earnings

12%

Other

3%

Net income ($ in millions)

Year Western Europe

project

South-eastern

Australia project

1 –15 8

2 30 12

3 80 15

4 110 20

5 125 22