Capital Budgeting And WACC In Practice

The Association of Financial Professionals recently released its 2013 AFP Estimating and Applying Cost of Capital Survey. The report is rather lengthy, but we would like to discuss some of the findings.

Eighty-five percent of the companies surveyed used discounted cash flow analysis for capital budgeting projects. For those of you who are worried about projecting cash flows far into the future, 51 percent of the companies used an explicit 5-year cash flow projection and 26 percent used an explicit 10-year cash flow projection. After that estimation period, a terminal valuation is used to account for cash flows beyond that period. Additionally, 72 percent of companies used scenario analysis when evaluating a new project.

When estimating the cost of equity, 85 percent of companies use the CAPM. The choice of the risk-free rate is varied, with 39 percent using the 10-year Treasury, which is not consistent with our choice. There is also a disparity in practice whether to apply the current, historical, or forward risk-free rate. The choice of beta is also widely varied, with companies choosing different sources, estimation periods, return frequency, adjustment of the estimated beta toward one, and delevering and relevering beta.

As we discussed in the textbook, many argue that the market risk premium since 1926 is unsustainable going forward. The survey results show the variation in the market risk premium used. Seventeen percent of companies use a market risk premium of 3 percent or less, while 19 percent use a market risk premium of 6 percent or more. One thing we should mention about the market risk premium relates back to the choice of the Treasury used to proxy the risk-free rate. The choice of a longer term Treasury over a shorter term Treasury would result in a lower market risk premium, assuming an upward sloping yield curve. Because the choice of which Treasury maturity should proxy the risk-free rate is directly related to the market risk premium, interpreting the results of this question in isolation is problematic.  

Finally, for those students who feel that they are struggling with finance, rest assured that you are not alone. We would fail the 36 percent of the companies in this survey who use the current book value debt/equity ratio. As we mentioned numerous times, book values are not useful in most instances, but rather market values should be used. However, the 17 percent of companies that use the current book debt/current market equity ratio for the capital structure weights would pass our classes since the book value and market value of debt are generally close.

Britain Issues Sukuk

The British government will become the first non-Muslim country to issue sukuk, a form of debt that complies with Islamic law, which prohibits the payment of interest. Instead, sukuk pays a share of the returns from an underlying asset such as property. The size of the issue, which is expected in 2014, will be about £200 million ($322 million). There are currently 49 sukuk listings on the London Stock exchange, valued at $34 billion. Overall, investments compliant with Islamic law are expected to grow to about £1.3 trillion ($2.08 trillion) in 2014. By way of contrast, the U.S Treasury bond market is about $11.3 trillion and U.S. corporate debt is about $9.2 trillion.

Read Carefully, Think Critically

The Economist recently published an article debunking the already well-debunked myth that U.S. Treasury bonds are risk-free (see Problem 24 in Chapter 10). While we expect that many people are not aware that Treasury bonds have inflation, or purchasing power risk, we hope that by now you do. It is well-known that there is no true risk-free asset, but Treasuries are used as a proxy for the risk-free rate. What is really disappointing is the time value of money skills displayed by the author. The article notes that the real return in Treasury bonds was a loss of about 2 percent per year, for a cumulative purchasing power loss of 91 percent for the period 1946-1981. And of course, this got us fact checking. Based on the returns reported by Ibbotson, an investor in long-term Treasury bonds would have earned a nominal return of 2.35 percent over this 35-year period, while inflation averaged 4.90 percent per year. This gives a real return of -2.43 percent per year, which results in a cumulative real loss of 57.76 percent. Pretty bad, but not even close to the 91 percent reported.

We would also like to point out dangers in any article that chooses a specific period from a longer dataset. If the investor has stayed in the market for the period 1982-1991, the average real return on Treasuries was 12 percent per year for this period. So, over the entire 45-year period, the real return for Treasury bond investors was .78 percent per year.

Investing In Athletes

Fantex recently announced its first pro athlete IPO. The company will issue 1 million shares of tracking stock at $10 each, with the proceeds to be paid to Houston Texans running back Arian Foster. In return, Foster, or the "brand" as he is called in the prospectus, will give Fantex 20 percent of his future earnings. Right now, you likely believe that the stock price will depend on Foster's future earnings, and it will to a degree. But further reading unlocks a host of other risks. For example, the company may never pay dividends to stockholders, but instead reallocate the cash for company expenses. Or, the company can convert the Foster stock into shares of Fantex stock at the discretion of company management. If Fantex fails, investors in Foster stock are left with one percent (or less) of the bankrupt company. All in all, Arian Foster stock appears to be a very risky investment, which brings us to our main point: Many believe that SEC approval of a prospectus means that the SEC feels the security is a good investment. In reality, the SEC merely reads the propesctus to ensure that all required information and risks are disclosed in the prospectus. The SEC does not certify that the security is a good investment. It is up to the individual to determine if the investment is appropriate for their risk tolerance.

The JOBS Act Explained

The Jumpstart Our Business Startups (JOBS) Act has received press recently since Twitter filed its registration documents with the SEC under this Act. An important part of the JOBS Act, which will allow crowdfunding, is not in place yet, although the SEC is meeting today to propose crowdfunding rules. Since the JOBS Act is only a year and a half old, many are unclear of what the Act actually covers. CFO posted a JOBS Act tutorial that answers many questions about the Act.

Reasons For Holding Cash

John Maynard Keynes identified three theories as to why firms hold cash: the speculative motive, the precautionary motive, and the transaction motive. In 1980, firms had about 12 percent of total assets in cash. By 2011, this number had jumped to 22 percent. There are several factors that have lead to this increase. For example, low inflation has lowered the opportunity cost of cash. Additionally, much of the cash horde is held overseas. Bringing the cash back to the U.S. would result in large tax liabilities. However, recent evidence suggests that the previous experience of managers may be the key factor. CEOs who have experienced financial difficulties are likely to hold more cash than CEOs who have not experienced financial difficulties, a nod to the Keynes' precautionary motive.

Finance And Retirement Planning

We have had a number of students claim that they will never use anything they have learned in this class in the future. We hope you are not one of those students. If you are, we could tell you countless stories like a former student who is Director of Marketing at his company, but also responsible for capital budgeting decisions, but we won't do that. One thing we are sure you will use the knowledge you have gained is for retirement planning. A recent poll indicates that 82 percent of workers 50 and over say that it is at least somewhat likely that they will have to work in retirement. And while the recent market downturn affected some of these potential retirees, we would guess that most simply did not prepare early and often enough for retirement.

To help you prepare for your retirement (and it is never as far away as you would like to think), we would like to direct you to Professor Joshua Rauh's free MOOC at Stanford University. The course is the Finance of Retirement and Pensions, and although you do not get a grade, it may help better prepare you for your own retirement planning. Notice, you will get the most out of the course if you understand the value of diversified portfolios, interest rates, inflation, perpetuities, and annuities, which we hope you  already have learned.