P H l L l P P W.
BINZEL
W I L L I A M D . McEACHRON
DESCRIPTIVE ECONOMICS AND VENTURE ANALYSIS Choose a plant investment giuing the greatest long term projt The past decade has witnessed the development and adoption of many valuable comepts and tools of scientific managemmf. Highly signifiant, .in terms of importance to the over-all future of American business, are the tools of investment selection employing the comepts of cash j o w and time value of money. Investment evaluation methods based on these concepts assist management in one of its primmy rcspom'bilities: selecting the projects in which a f . m invests the capital made available to it. For, in a broad sense, these investment decisions involve the commitment of total cmporate resources-both of capital and labm-toprescribed long-term courses of action. evaluating investments we are concerned with Ineconomic effects which occur over a span of years. I n this situation conventional accounting, as epitomized by a company's annual report, is not appropriate. Figure 1 illustrates the difficulty involved. The vertical dimension represents the total investment that goes to make up a firm, broken down by individual projects or investment decisions. The horizontal dimension represents a portion of the time spectrum which in real life extends indefinitely into the future as well as going back to the inception of the company. The total area on this extended time basis, and including successive life cycles of individual projects, represents the total firm throughout its life. The conventional approach to accounting measures the current health of the enterprise, illustrated by the vertical bar. I n contrast to this, an investment evaluation must measure quite a different cross section. This is illustrated by the shaded horizontal bar. Here we are concerned with a single investment venture throughout its life, and because of the span of years involved, the problem of adequately time-weighting events becomes of crucial importance. When a company invests money in physical facilities, it anticipates that the funds will be recovered with interest. The need for recognizing &ne value of money (3, 10)reflects the need to rewver the capital invested as well as a return on this capital. 34
INDUST'RIAL AND ENGINEERING CHEMl S T R Y
In corporate profit and loss accounting, capital investment is handled via a depreciation charge. The cost of an asset is treated as a prepaid operating expense and is apportioned among the years of its life by use of a systematic annual depreciation charge. In contrast, for investment evaluation, the full investment cost is "charged" at the time it is actually incurred, and depreciation is not a direct component of cash flow. In investment evaluation work, we measure only the flow of actual cash dollars. Basic to any comprehensive investment evaluation method, then, is the development of a complete cashjow schedule. This is true whether the method is discounted cash flow, present value, venture worth, or others. This cash flow schedule circumscribes and expresses in monetary terms the complete pattern of value associated with a given investment decision. It covers all of the economic differences that are expected to occur as the result of making a positive investment decision as compared to a negative one, and provides the raw material for the specific evaluation method used to indicate the attractiveness of a proposed venture. Since the latter must cover the complete l i e span of an investment, often CORPOI
PROJE
ANNING
I I! I
_-
Figure 1. Total arm in thc diagram represents thc totalJim throughits lif. The vertical bar measures present health as indicated by conventional accounting methods ouf
ranging 20 or 25 years into the future, it is easy to overlook some of the important elements. Even the most sophisticated evaluation method cannot compensate for errors or omissions in the basic cash flow estimate. The Investment Decision Process and How Developing a Cash Flow Schedule Fits into It
-Identify
and isolate the investment problem
-Consider
all the economic factors associated with the problem
-Make
each economic factor quantitative in terms of cashflow
-Process the cash flow schedule by the spec& technique to provide the index of attractiveness
evaluation
--Determine how variations affect attractiveness and assist in achieving optimal condztions --Compare
results to project standards you have set up
-Temper
the analysis witfi judgment (the most dficult step)
--Make
the derision
Problem Definition and Isolation
I
Problem definition is properly concerned with the identification and isolation of the pertinent economic factors, including integrated company interactions, and the statement of their relative significance. I n essence, it means spelling out, conceptually, what is to be given up, and what is to be gained. I n most situations this substantially circumscribes the problem. Nevertheless, in some situations pertinent factors can be overlooked because of their subtlety, unless a careful analysis of the situation precedes reduction to actual figures. Here is what might appear: Suppose a petroleum refinery is going to lose its principal residual fuel oil customer because a gas pipeline into the area will be completed soon, and the customer plans to switch to natural gas. Looking ahead, the refinery management foresees a residuum disposal problem and knows that a coker will be a solution. Several coking processes are carefully evaluated and two are found to be attractive relative to curtailing refinery throughput. Economic analysis of the two cases reveals that the one with the higher investment provides a return in excess of the minimum acceptable standard on the differential investment required. A contract is let to construct the coker and erection is well under way when it becomes apparent that asphalt demand is increasing under the impetus of the road building program. The present and probable future price structure for asphalt is such that investment in an asphalt still would have been preferable to building a coker. I n this example the analysis failed to consider what would be lost by building a coker-Le., the profit on another disposition of residuum. More specifically, the problem was defined as one of selecting the most profitable coking process rather than one of determining the optimum disposition of residuum. Every investment decision is a choice between two alternatives; albeit one of them may be to do nothing
or to continue operations as at present. As such, we are necessarily dealing with a difference evaluation, and it is very important that the philosophy on the two sides be carefully matched. There is considerable hazard in such an incremental approach in not making the comparison on an optimum or comparable basis. For example, we may be comparing a new investment against a case where we are currently losing money (clearly nonoptimum) , In situations such as this, the value of quitting (8) may be erroneously assigned to the new investment. When the problem is not properly defined, as was the case with the coker example, it is quite easy lo omit some of the not-so-obvious alternatives and be led to make costly investment decisions. A second area which often distresses the analyst concerns reinvestment of the cash income produced by a project (5). Except in rather rare circumstances when some of the funds generated are later needed by the project, this situation should present no conceptual problem. I n a typical industrial project involving depreciable facilities, the investment is gradually recovered over the project’s economic life. What is done with the capital recovered has no bearing on the attractiveness of the particular project under study. The income from investing it in some olher project is the evaluation concern of the other project-not of this one. Considering all of the economic effects associated with a project implies assigning money figures. What will happen if we make the investment? What will happen if we do not? T o reach a sound decision it is essential that every part of the decision be put into dollars and cents. This involves starting with a valueless situation insofar as the proposal is concerned, and ending up with a valueless situation. The economic factors which must be monetized refer collectively to the investment, income, and cost elements thought to be operable in the investment proposal under consideration. As mentioned earlier, we are concerned only with the proposed investment under consideration and its consequences. However, it should be realized that the framework in which the proposal is measured is dynamic. I n a growing concern it will not be the first investment to be made, or the last. Insofar as it supplies or utilizes parts of an idle system, provisions must be made in the cash flow schedule to recognize this capacity effect when new facilities are required (15). A reoccurring example in this area is the use of incremental steam- and power-generating facilities. If idle utilities capacity will be used up by the proposed venture, the economic description must provide the investment necessary to replace this capacity at some future date. Almost every investment uses some part of an idle system, and even if this system would otherwise forever remain idle, its commitment to a specific project may require future replacement when it is worn out. AUTHORS
P. W . Binzel is the Supervisor of Current Planning
for the Standard Oil Co. (Indiana) and W. D.McEachron is
Manager of Long-range Planning. VOL. 5 4
NO. 2
FEBRUARY 1962
35
Dimensions of Cash Flow
Economic Factors to Be Considered
Once the problem has been defined and the economic factors analyzed, a cash flow schedule can be estimated. Since a dollar received today is more valuable than one to be received in the future, the critical elements involved in setting up a cash Row schedule are the amount of money, its direction of flow, and timing. If we can define all of the elements of cash flow in terms of amount, direction, and timing, we can theoretically define any project and provide a sound basis for deciding whether or not it should be undertaken. For most investment situations encountered, this is all we need to know.
Items of cash flow closely associated with the project, and therefore rarely overlooked, are broadly : --Investment -Expense --Income
taxes
-Salvage
value ( 7 )
Some less obvious economic elements relating to the project may be suggested : --$’hat
These Projects Exhibit a Typical Cash Flow Pattern
Investment Cash return
Total cash return
Time
A
0 0-1 1-2 2-3
- 1000
Project, $ B -1000 400 400 400
- 1000
+1200
+1500
+ 4- 600 + 500 + + 600 f 500 + + 300 - - + 500 f1500
will be the incremental effect of this project on the corporation’s overhead?
--Are C
operating pro& or savings
-Gross
any future obligations involved?
--Have all the requirements f o r supporting inaestment and working capital been considered? -What investment will be needed ocer the liJe oj the project to sustain earning power ugainst inroads of changing technology and competition?
--,4 re there any special risks that require special consideration? --Have
Two useful conventions are used in this schedule. The sign preceding the dollar amount of money denotes the direction in which cash is flowing. Money going into the project carries a negative sign, while money generated by the project is positive. Thus, the investment of $1000 under this convention is shown as negative. The cash return items listed represent money generated by the project and, thus, a positive sign is used. With regard to timing, a single number such as the zero shown after the investment denotes instantaneous flow. Other lines such as 0-1, 1-2, and 2-3, denote flow of cash over a period of time: for example, the first full year following investment. Looking at the appropriate cash flow schedule, which is the better investment, A or B? Just by inspection we can see that A is better. Why? Because each year’s cash return for A is greater than for B. What about A and C? Although total cash return is the same, it is apparent that C is somewhat better than A . Why? Because it returns the bulk of its income at an earlier date. Although real life situations are never as clear-cut and simple as this, it illustrates the manner in which the factors, amount of cash flow and its timing, operate to determine the relative economic quality of a project. Generally speaking, alternative projects will involve different investments and benefits. The alternative which involves a higher investment normally leads to greater future advantages such as lower annual costs, higher revenues, longer life, or higher salvage value. The investment decision involves the question of whether future advantages are sufficient to justify higher investment. Thus, it becomes necessary to process the cash flow schedule into a manageable index of attractiveness (step four in the investment decision process) before an intelligent decision can be made. 36
INDUSTRIAL A N D ENGINEERING CHEMISTRY
the alternatives been comprehensively considered?
Investment Considerations
The economic elements relating to a project can be broken down into investment-related items and incomerelated items. Look first at the investment portion. Here it should be recognized that in the technology of an economic evaluation, the term investment sometimes differs from that of a strict accounting definition. I t can be thought of as the outlay of funds made in anticipation of subsequent earnings during the life of the project. N o distinction need be made between monies capitalized and monies expended for bookkeeping purposes as long as the associated tax effects are properly considered. Since the investment decision is based on the earnings efficiency on the outstanding investment, the importance of considering all of the investment requirements is clear. The total investment relating- to a particular project can generally be classified, as shown in Figure 2. in the probable sequence of occurrence. This figure shows that associated with any given project there are three broad classes of investment. In point of time the first of these is exploratory, followed by self-supporting investment, and finally protective investment. Preliminary investment constitutes the exploratory class, and covers those costs expended in an effort to develop the principal investment, the earnings upon which it depends for support. Since preliminary investment represents money spent before the evidence is available on which to make a decision, there is no satisfactory way of evaluating it, except perhaps in a stepwise fashion. Thus, the test-tube reaction must look quite promising before bench-scale expenditures are undertaken. Results of the latter determine whether
TIMING OF INVESTMENT
I I I I I I I I I I I I I A
EXPLORATORY -_
SELF-SUPPORTING
I
I I’ I I
I
PROTECTIVE
I I I I I
I I I I I I
I
PRIMARY FACILITIES I I I I
-
R
I I I I I I
I I I
4 b -
TIME SCALE
the project should be carried through the pilot plant step. By the time the opportunity uncovered by research is sufficiently well defined to permit the plant scale project, economic analysis properly excludes preliminary investment. It has been expended already and is not germane to the evaluation. However, for long-term administrative control, there may be some merit in a secondary evaluation of the new venture, including the preliminary investment from which it was spawned. Of the three elements composing the self-supporting class, primary facilities are generally the easiest to isolate because they are the main target of the investment evaluation. Disbursements for primary facilities are generally made over the construction period, and this timing should he reflected in the cash flow schedule. Supporting facilities are of a contemporary nature and include items such as mechanical shops, utilities, wash and locker facilities, and distribution facilities, which are generally needed immediately and should thus be included in the evaluation. In cases where the project involves the use of surplus supporting-facilities capacity, the replacement of which is subsequently charged to the project, the timing of the supporting investment must reflect its probable future incidence. For example, suppose that a major process unit is proposed for completion in 1962. This unit will require auxiliary steam- and power-generating facilities. Without the project, adequate spare capaciiy is available to meet expected growth in demand until 1966. If the inveslment in a project is made, additional generating facilities will be required in 1965. Thus, even though the project is using existing idle capacity, it should be charged with the cost of advancing the next utilities investment horn 1966 to 1965. In addition to the net investment in properties, the earning power of a project must support what is defined as “project working capital.” This includes the addifionol requirements for cash, net accounts receivable, and inventories (16). The effeq of an individual project can be either to increase or decrease working capital. Because project working capital can change the attractiveness of an investment proposal, its proper inclusion in the cash flow
D
D-
schedule is imperative. In general terms, the need for project working capital will increase as sales increase, and thus is fairly closely related to income. I n the protective class is sustaining investment which is required to protect or maintain the earning power of the original project. Examples: replacement of premature equipment failures, pollution control subsequently required by law or social pressure, or product quality improvement needed to maintain the level of sales. Although sustaining investment occurs subsequent to the project decision, the ultimate need for such investment can and should be included as one of the considerations on which the decision is predicted. This point is mentioned because there may be a tendency to omit sustaining investment due to its remoteness in time and the uncertainty with which it applies to any single individual project. Cost and Income Considerations
Let us now look at the cash income or earnings from a project, because this is the element which must provide for the return of the capital invested, as well as an adequate return of capital invested. The use of the adjective “cash” before the word “income” is important, because economic evaluation works with cash effects and nor the accountant’s definition of income or earnings. Thus, cash income is measured prior to any depreciation charges and independent of any disbursements to investors. The reason it must be independent of disbursements to investors is fundamental to the decision process-Le., we are trying to measure the opmational ejiciewy of the facilities independent of how they may be financed. This operational efficiency is in turn balanced against the standard or minimum acceptable level at the decision point. Inasmuch as the minimum acceptable efficiency has in it all of the elements of capital cost (4)to the company-e.g., earnings expected by the equity holders, interest paid to bondholders, and lease payments (6) paid to lessors-blended together in their proper proportion, it is imperative that the cash flow description be free of any of these cost-of-capital elements. VOL. 5 4
NO.
2
FEBRUARY 1962
37
Since income taxes are a cash cost, just as much as labor and materials, the cash flow~chedulemust always be determined after income taxes. “Before tax” is analogous to “before labor”-it just does not exist. Depreciation, being a noncash charge, is not reflected as an item of expense in determining cash income. It does, however, enter into the income tax calculation. As mentioned previously, expenditures made prior to the time of decision are not pertinent thereto, and thus should be treated as sunk costs and excluded from the estimate of cash flow. Cash income is, of course, a residual value obtained after considering all revenue and cost elements. Considerable insight into related company operation is essential in establishing the pertinent items to be incorporated into this estimate. Generally speaking, revenue will increase over the first few years as sales build up and/or as capacity bottlenecks are removed. Realistic estimates of start-up expenses (2) and probable start-up delays are important because of their early timewise occurrence. Credence given the results of a cash flow description is a function of how well the estimates have circumscribed the future dynamic environment in which the project, if accepted, will operate. Income to be derived from a project is more difficult to estimate than is investment because of the inability to foresee far into the future and the usual near-term concentration of most of the investment. Defining the future income stream effectively determines the economic life of the project. And the pattern of future income is of vital concern ( 1 7 ) . Pattern of Future Income
No hard and fast guidelines can be spelled out to aid in estimating income for specific investment proposals, but the reasonableness of some frequently used assumptions can he tested. Since uncertainties about the future defy accurate prediction of either revenue or
CONSTANT EARNINGS PATTERNS FOR TEN YEAR PROJECT
n
expense for more than a few years, there is a tendency on the part of the estimator to project the magnitude of their differences as being constant. For example, Figure 3 shows the net cash flow (income side only) for a 10-year project involving a depreciable investment with no salvage value. A certain income has been estimated to be generated each year for 10 years at which. time the project is terminated. So far so good. But a critical examination of the termination of the project leads to some rather disturbing questions. Why does the cash flow, constant through 10 years of operation, suddenly disappear at the beginning of the llth? Or, if it does not disappear, as suggested by the dotted box in the 11th year, why not continue operating the project for another year? Or, for several more years until its earning power declines? Clearly, it makes no sense to halt a project capable of generating more income just because the estimated life is at an end, or because it is fully depreciated. The only economic justification for terminating the project is that it can no longer earn the minimum required return od the salvage value that could be obtained from its disposal. Since this example involves no salvage value, the project should be operated until the cash income declines to zero. If earning power at termination is at or near zero, it must decline during the project’s life. A sudden drop after 10 years as shown seems unrealistic considering the workings of our economic system. Even the best efforts toward modernization and improvement cannot ordinarily keep a project, once committed, up-to-date as compared to the later investments of competitors. These pressures result in an almost inexorable downward trend in earning power which should be reflected in the cash flow schedule for most projects. It would seem that declining earning power is entirely rational. Some type of income decline is probably the rule rather than the exception (Figures 4 and 5).
DECLINING EARNINGS PATTERN FOR TEN YEAR PROJECT
3 0
-1
U
r
li“U
I
2 V
I
1
I I I I I I III
!1
k
I 1 1 1
Z
I1 I
I I
1 2 k
3 4 5 6 7 8 9 10 11 YEAR OF LIFE
Figure 3. A constant earning rate &ring the Itye of a project is highIy improbable. But such an assumption isfrequently used 38
INDUSTRIAL A N D ENGINEERING CHEMISTRY
t;
z 1 2 3 4 5 6 7 -8 9-10 YEAR OF LIFE Figure 4 Some type of declining income, perhaps similar to there ovnsimpl$ed patterm, is probably the rulc rather than thc exception
&tlaUan:
While it is zenerally considered to be the decision-
:. :..TLill*Li
I n an age when inflation is more a fact of life than an scription. I n addition to providing decision, a sensitivity analysis will to the analyst which of the variables are most t, and, thus, indicate the areas of concern where
If an economic evaluation allows for inflation (72,
74,
lnhngibles
must consider all the effects. Often it is expedient
avoid.risk at any cost. Acceptance of risk is the foundation of bushy$ ,:en&rise,, and 'in our competitive : f excessive caution is high.
,
SUCCESTE .
