Black Thursday - Capital Spending Risks Mba540

UOP MBA540 - Increasing Shareholder Wealth

Black Thursday - Capital Spending Risks

October is a month of ghouls, goblins, and financial risks. Many of the worst stock market crashes were sustained during this month, with October 24, 1929 being designated Black Thursday. In 1929, most Americans kept savings in banks rather then speculating on the stock market. Businesses looking to increase capital and already wealthy patrons were the main investors of the era. "If you had $1000 on 9/30/1929, it would have gone down to a whopping $108.14 by July 8th, 1932 or an 89.2% loss. To recover from a loss like that, you would have to watch your portfolio go up 825%!" (Woodard, 2006). While the stock market is only one of several contributing factors to the depression, another often overlooked commodity was the machinery in factories. In many cases, the condition of the equipment was old and deteriorating. Perhaps if businesses were more familiar with present day practices of capital budgeting analysis, they would have realized that maximizing wealth depended upon several factors. Fortunately, today's investors and firms have more financial tools with which to contrast and compare capital expenditures and projects in order to gain returns on their investments. Using standard economic corporate analytics, based upon sound research and figures, a firm can easily determine the present and future value of money thereby minimizing risks while maximizing shareholder wealth.

While they are mainly two ways to raise capital, issues stocks and borrow money, shareholders are always interested in increasing their potential investments. When a corporation is producing all the currently possible widgets that the market will purchase, other financial opportunities for retained earnings are considered. Capital spending takes on many forms and the ideal situation will yield a high rate of return on the investment whether based on technology upgrades or machinery to produce more widgets, or in other monetary investments. "The rate of return rule says that organizations should invest in projects that offer a rate of return that is higher than the opportunity cost of capital, or the return the investors are currently getting from their investment in the company, without the new investment" (University of Phoenix, 2005). Using the net present value (NPV) of money, a firm can mathematically calculate rates of return over time and opportunity costs. Additional rules of financing also assist in analyzing capital spending (Ross, Westerfield, and Jaffe, 2005).

Each of these rules plays an important factor in determining actual costs of the investments or projects for a business. Ross (et al, 2005) suggests four rules: "the payback rule, the accounting-rate-of-return rule, the internal rate of return (IRR), and the profitability index" (p. 59). Although these financial calculations all have merit, there are drawbacks to using the rules in some situations. When making decisions about small investments the payback method is easiest to calculate, such as extending the life of a machine by adding routine maintenance or small parts replacement. In large corporations, these simple financial decisions for capital spending using the payback method are easily determined for managerial control. However, there are some drawbacks using this method since cash flows are not a factor in the decision process, especially when attempting to use the discounted payback period. Some decisions concerning larger investments use the accounting rate of return. This method involves rates of return by calculating additional factors such as depreciation, taxes, and average book values. Dividing the average net income by the average amount invested produces a percentage used for the average rate of return (Ross). Shortcomings of this method include raw materials, timing and arbitrary accounting judgments on dates and targeted returns. The ease of calculating this method allows for marketing of short term profitability rather than overall justification figures.

The internal rate of return produces a unique factor in the discount rate for making informed capital spending decisions. Figuring the percentage of return when the NPV on the project is equal to zero, helps determine when to reject or accept a project. When determining the actual value of this method, other factors must be taken into consideration such as the independent or mutually exclusive investments. Cash flows are not always steady and additional outflows may be greater upfront, tapering off toward the end of the project allowing for revenues in the future. Other types of projects might be tied together. "Because the firm initially pays out money with project A but initially receives money with project B, we refer to project A as an investing-type project and project B as a financing-type project" (Ross, 2005, p. 156). The modified IRR helps to calculate multiple rates of return by discounting and then combining cash flows. The IRR method has specific criteria, which makes it effective, but all these methods should be weighed against the NPV as to merit. The profitability index (PI) is another alternative for evaluating projects.

Ross (2005) shows the formula for figuring the PI as equal to the PV of cash flows subsequent to initial investment divided by the initial investment. Since the PI is a ratio, some factors of exclusivity