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The cost of capital for projects: conceptual and practical issues Anderson, Ronald C; Byers, Steven S; Groth, John C . Anderson, Ronald C; Byers, Steven S; Groth, John C.

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ABSTRACT Managers often evaluate capital projects, cost saving proposals, divestitures, acquisitions or leases. The evaluation process entails: Identifying the economic or cash flow consequences of an alternative; gauging the cash flows against the standard of a hurdle rate. The correct hurdle rate is incisive in the analysis. Unfortunately, choosing the appropriate cost of capital or hurdle rate is non-trivial and yet, an inescapable task. On some occasions, the firm's cost of capital or weighted cost of capital is appropriate in evaluation. Other instances require an alternative rate. This paper provides a conceptual understanding of the hurdle rate required to enhance economic value. Second, it offers practical guidelines on the selection of the hurdle rate for analysis. In the process, the paper bridges the gap between theory and practical application. Readers will find the specific guideline on selecting hurdle rates helpful. FULL TEXT Ronald C. Anderson: American University, Washington, DC, USA Steven S. Byers: Idaho State University, Pocatello, Idaho, USA John C. Groth: Texas A&M University, College Station, Texas, USA ACKNOWLEDGMENT: Revised 3 April 2000. The authors thank anonymous reviewers, A. Roberts, and the Editor for their assistance; and claim any residual errors. Introduction Success in creating value hinges on two critical events. First, one must deliver need fulfillment to customers in exchange for gross economic returns. Second, the residual net economic (cash flow) returns must please the providers of capital. Additions to value require that net economic earnings exceed the required rate of return (RROR), hurdle rate, or cost of capital. If the market judges that economic returns are less than the cost of capital, share price falls. Making capital investments that add value to the company, shareholders, and society rest on four important tasks[1]. 1 Identifying potentially attractive projects. 2 Determining the after-tax economic events that will transpire from pursuit of the project. 3 Gauging the attractiveness of these economic events against the hurdle rate.

4 Accepting and effectively managing attractive projects. These four critical events are sequential and the choice of a hurdle rate important. Managers often evaluate capital projects, cost saving proposals, divestitures, acquisitions, or leases. The evaluation process entails: identifying the economic or cash flow consequences of an alternative; gauging the cash flows against the standard of a hurdle rate. The correct hurdle rate is incisive in the analysis. Unfortunately, choosing the appropriate cost of capital or hurdle rate is non-trivial and yet, an inescapable task. On some occasions, the firm's cost of capital or weighted cost of capital is appropriate in evaluation. Other instances require an alternative rate. This paper provides a conceptual understanding of the hurdle rate required to enhance economic value. Second, it offers practical guidance on the selection of the hurdle rate for analysis. In the process, the paper bridges the gap between theory and practical application. Readers will find the specific guidance on selecting hurdle rates helpful. First, we review important issues related to the firm's cost of capital. Next, attention centers on estimating and calculating the weighted cost of capital (WCOC). The discussion then illuminates the pool of capital concept. An examination of important issues related to the hurdle rate for individual projects follows. The paper then offers practical guidance on determining rates for evaluating projects, examines special circumstances, and provides guidelines for the analyst and manager. The paper closes with a summary. Hurdle rate: overall firm The hurdle rate The required rate of return or hurdle rate is critical in management's pursuit to create value. The germane perspective recognizes that valuation occurs in the marketplace. Consequently, the appropriate hurdle rate is the minimum rate market participants view as compensatory for exposure of their capital at a given level of risk. The opportunity cost on capital (OCC) reflects the notion that people can use capital elsewhere in some expected risk-return opportunity. The OCC is the minimum expected rate or return available elsewhere at the same risk. Actions of a firm and the resultant effect on value stem from investors distilling the consequences of those actions and comparing the perceived outcome to other alternatives at similar risk. A scenario:"A company discloses a project to the market. Investor perceptions that the project will earn a return greater than the correct hurdle rate result in an immediate increase in firm and in stock value. The revaluation captures investor perceptions of the present value of the project taking account of the host of factors that investors view as relevant." Changes in circumstances with the passage of time will cause revisions in expected returns, risk, and other variables that influence value. Accordingly, these revisions distill alterations in share price. Project completion yielding observable ex post returns that equal or exceed the market's expectations results in permanent increases in firm value[2]. In contra fashion, initial acceptance of a project offering inadequate expected returns causes an immediate decline in share price. Estimating the appropriate hurdle rate for each circumstance is illusive. In practice, this estimation process calls for a sensitivity to the business and investor environment, compels one to examine theory, borders on being artistic rather than scientific, and entails a good measure of judgment. We begin with background and perspective to support the ultimate judgment of the correct cost of capital. The approach begins with a review of the minimum acceptable

hurdle rate for a company, commonly referred to as the weighted cost of capital (WCOC). The WCOC serves as a benchmark. One makes adjustments to this benchmark to take account of the minimum rate of return required for scenarios that differ in risk from the risk complexion of the firm. Weighted cost of capital The simplest capital structure results in firms obtaining funding or capital from equity or from a combination of debt and equity. A weighted combining (1) of the cost of funding from these sources yields the firm's weighted average cost of capital (WCOC).(see equation 1)In (1), w[sub]d and w[sub]e represent the target portions of debt and equity in the firm's capital structure. The capital structure and other factors determine k[sub]d and k[sub]e, the respective after-tax cost of debt and equity. Factors influencing the determination of a firm's capital structure (the weighting of debt and equity) are important but not integral to this discussion on the required rates of return for projects that vary in risk. The realization that investors value what they expect to realize - the after-tax effects of ownership - dictates analysis of after-tax benefits of ownership employing an after-tax cost of capital or hurdle rate. WCOC is the minimum return that investors will accept in order to provide capital to the firm. As a consequence, the WCOC is the minimum acceptable hurdle rate used to evaluate projects having the same risk as the risk complexion of the company. The importance of the WCOC prompts a summary of several points concerning WCOC. - 1 WCOC is forward-looking. It represents the expected costs of additional or incremental capital. It does not reflect embedded or historical capital costs[3]. - 2 WCOC captures investors' expectations about inflation, risk, taxes and any other factors that influence investors' perceptions. - 3 WCOC reflects investors' perceptions about a company's operating environment, including: - Past and future operating performance. - Expected financing decisions and dividend policy. - Alternative investment opportunities available to investors. - Uncertainties in investors' minds about the above. - The price of bearing risk. A characterization of the WCOC in equation (1) in terms of returns provides an intuitive exposition.(see equation 2)The risk-free rate available to investors serves as a base for decision making. Investors seek expected higher returns with attendant higher risk if circumstances and the price of bearing risk seem attractive. Characteristically, most define US government securities as the best proxy for a risk free investment. We recognize that even with absent default on principle and interest payments, US government securities carry interest rate risk. Generally, people employ a long- term (10-, 20-, 30-year) rate as the risk-free rate. The supporting logic for using the long-term rate stems from the notion that capital investments often are long term in nature. The last term in equation (2), [Sigma](Risk premium), represents the summation of any risk premiums that equity and debt investors require for providing capital to the firm.

Risk Despite the great role risk plays in the cost of capital, considerable debate exists on how to measure risk, which types of risk are relevant, and how risk maps through to required rates of return. For example, some argue one should view the risk of a project only in a portfolio context; others disagree. For our purposes, engaging in arguments about the definition of relevant risk adds little in determining a practical method to find the discount rate. We need not define risk in a particular way. Instead, we suggest what most would accept as a reasonable measure of risk; namely, the market's determination. Investor willingness to provide capital for a company and its projects determines the hurdle rates for those projects. Investors form expectations about risk-return opportunities and then incorporate a risk premium added to the risk- free rate. Efficient markets do not compensate investors for unnecessarily bearing risk - whatever the relevant risk. We term unnecessary risk as any elements of risk one could avoid without adversely affecting returns. If project risk exists that could be avoided without adversely affecting project returns, no clever person would pay for bearing this unnecessary risk. We assume effective managers have eliminated unnecessary risk and that the firm's WCOC reflects risk level R. Bias in our guidance Portfolio theory argues that firms can reduce their overall risk by investing in a set of projects having returns not perfectly correlated with existing project returns. For instance, a firm investing in a computer subsidiary and a transportation subsidiary would have earnings streams from two segments of the economy. As a result, its overall risk is less than a firm that only invests in the computer industry. If markets fulfill the prescription of portfolio theory, the methods we use will overstate discount rates because we do not account for possible risk reduction through diversification. This practical approach recognizes the possible overstatement of hurdle rates and the possibility of rejecting some marginal projects. We prefer to slightly overstate (rather than possibly understate) hurdle rates and to avoid marginal projects rather than risk accepting projects that destroy economic value. Estimating the firm's cost of capital Equation (1) describes the method of calculating the firm's weighted cost of capital. While considerable debate exists on the appropriate inputs to equation (1), we provide some simple techniques that yield reasonable estimates for WCOC. We start with the appropriate weightings for debt and equity, w[sub]d and w[sub]e. The equity weighting is:(see equation 3)Price per share is the market price of the firm's stock. We observe the market value of the long-term debt. Absent public trading of debt, we examine the yield of similar debt publicly traded and calculate the value of the debt. Debt weighting is W[sub]d = 1 - W[sub]e. Ibbotson Associates publish the Cost of Capital Quarterly, a rich resource for estimates of the cost of equity, k[sub]e. This source provides estimates based on different theoretical models detailed by standard industry classification codes (SICs)[4]. Alternatively, though not supported by theoretical models, some firms use the yield on long-term government securities and add a premium to adjust for the additional risk to equity holders.

The appropriate rate for the cost of debt, k[sub]d, is the after-tax yield the market currently demands on the firm's outstanding debt. This current rate captures the market's perceptions about the risk and valuation of cash flows associated with the company's debt. We observe the pre-tax rate and adjust to after-tax. If the debt does not trade in the market, we observe the yield on debt of similar risk and characteristics. Pool of capital Firms have funds available to invest, obtained consistent with the capital structure decision and the strategy for raising funds. Funds in this pool have a cost equal to the WCOC. We assume firms finance projects using funds from its "pool of capital." The cash flows related to the project will commingle with the company's other cash flows. Similarly, the company retains the liability of the project. If the project does not generate the anticipated cash flows and instead generates liabilities, the company faces the liability of covering required shortfalls. With the pool of capital concept, we should not tie a particular project to a particular current source of capital, e.g. sometimes a temptation if the company currently is or just borrowed funds. The WCOC assumes the company will obtain funds in the proportions according to its capital structure. The hurdle rate for a project is not sensitive to the offer in which the company raises the funds and puts them into the pool of capital. "Company project" and cost of capital Let us distinguish between the firm's weighted cost of capital (WCOC) and the cost of capital for a project (PCOC). As we shall see, the WCOC is appropriate as a discount rate for only some projects. Managers select, undertake, and operate projects to generate economic returns that result in increased share price. This perspective compels one to employ the market's perceptions of the appropriate discount rate in evaluating projects. In rare instances, one might support the use of a hurdle rate different from the market's perception of the appropriate discount rate. For example, management possesses information that is currently unknown to the market, but when revealed, the market will incorporate the information by appropriately adjusting the hurdle rate. It is risky to assume management has "better information" that warrants using a below-market rate. Management may be wrong. Alternatively, management may be right, but the market fails to adopt management's view. Last, assuming the market eventually does accept management's view, the stock price may suffer in the short run. In summary, ignoring market guidance on the appropriate cost of capital may: - adversely affect stock price, at least until the information is released and the market accepts the alternative rate as appropriate; - lead to loss of credibility with investors with attendant decline in share price; - lead to greater perceived uncertainty by investors and higher required rates of return; - result in legal liabilities. Investors who held and then sold the stock prior to the release of the "superior information" may argue they suffered loss resulting from concealment of the information; and - have behavioral consequences with adverse results. A management "in love with a project" may rationalize a lower

discount rate. Setting the PCOC higher than the market's required discount rate is appropriate if management has reason to suspect that risk is greater than that perceived by the market. To avoid information uncertainty, management should communicate the practice of adjusting hurdle rates upward because of differences in expectations. An appropriate disclosure follows:"Although considerable evidence suggests markets are efficient, we feel markets currently underestimate inflation. To insure our projects earn an economic return attractive net of inflation, we have added a two percent inflation premium to hurdle rates for new projects." A suitable message to shareholders would be:"The higher hurdle rates we use in our decisions will cause us to find fewer acceptable projects. However, we want to insure we only accept projects that add value. The higher hurdle rates may cause us to reject some projects. We would rather miss a marginal project than accept a bad one. In addition, I am pleased to say we have more attractive projects than we can currently undertake." The appropriate rate for specific projects First, general guidelines: - If the company invests in a project and the net result is a mere expansion of scale without changing the company's risk level R, the PCOC for the project is the company's WCOC. Often a project does not fit this restrictive condition. - If the risk of the project differs from R, one must employ a discount rate other than the WCOC. Since valuation is market determined and we seek to take actions that add value, the rate used must stem from the market's perception about the required return. - We must assess the risk of the project perceived by the market and the minimum acceptable expected return if we choose to undertake the project. Counter to some arguments, markets likely do perceive that the risk and stream of expected benefits of a given project are a function of the firm undertaking the project. For example, the perceived risk associated with the development and sale of a new software product and the attendant generation of cash flows will vary depending on which company sells the product. Similarly, the risk associated with Lockheed Martin developing a new super spy aircraft will vary considerably from the perceived risk associated for the same effort by another firm. As a consequence, the major steps in determining the appropriate PCOC for a given product are: - Estimate how the market will evaluate the risk of the project if your firm chooses to undertake the project. Assume that estimate is PR. - Next, estimate the minimum expected returns or cost of capital demanded by the market for risk level PR, PCOC|PR. PCOC|PR is the "appropriate" hurdle rate or the project cost of capital given the project risk. The problem, as you undoubtedly and quickly concluded, is finding PCOC|PR. Thus, guidelines offered should take possible errors into consideration. Practical guidance Several points assist us in understanding and later applying specific guidance on the selection of the "appropriate" cost of capital.

- Discounting across time. Often we evaluate the net cash flow benefits of a project for each period of its life using the same discount rate. The use of the same rate across periods implicitly discounts cash flows in successive periods increasingly more because the discount factor is non-linear across time. - Discounting within a period. To the extent subsets of the expected cash flows exhibit significantly different risk, one should evaluate subsets of cash flows with separate discount rates and then aggregate the results. - Discounting inflows and outflows. The more risky an inflow, the higher the discount rate. The more risky an outflow, the lower the rate employed. We will review this notion shortly. - Uncertainty will exist in the estimates of the appropriate cost of capital. At the final point of determination, err in the direction of the conservative. Consequently, one should, if anything, overestimate the appropriate cost of capital used to evaluate risky benefits. This implies setting a higher rate as a hurdle in the decision making process. - If one errs and sets hurdle rates above the true rates, clearly one will reject some "good" projects. A modest overestimate of the rate may result in rejecting what generally, though not always, are marginal projects. On the other hand, setting the PCOC|PRs too low naturally may result in acceptance of unattractive projects. - It is better to err and avoid some marginal projects than to accept unattractive projects. Some theorists will offer persuasive counter arguments. They will dwell on trying to refine the estimates of a PCOC|PR. We suggest a practical as well as important perspective. If inadvertently setting the PCOC|PRs a little high depletes the firm of enough "good" projects to undertake, the company has a much bigger problem than estimating the cost of capital. If marginal projects compose a significant subset of its total project set, its managers are not doing a very good job of unearthing attractive opportunities in the environment. Time would be better spent finding very attractive opportunities rather than refining an estimate of the cost of capital[5]. - The PCOC|PR we select must take account of the time value of money as well as the uncertainty that the expected cash flows will occur in the amount and at the expected time. Furthermore, the rate used should reflect the risk of "realization" of those cash flows by those who are investing in and bearing the risk of the project. For example, a project may generate all anticipated cash flows but foreign governments may not allow the firm to repatriate the cash. - In selecting the PCOC|PR, one must consider the risk of whether the project will generate the expected cash inflows and outflows. Next, one must address factors affecting the realization of these flows on an after-tax basis. Uncertainty about the taxes on the flows can be considerable. - In certain international investments risks of appropriation, foreign exchange risk, and the inability to bring the cash flows "home" are important. Although these risks are not "project resident risks," they are relevant risks since they affect the realization of the expected benefits. Identical projects with the same project conditions (cash inflows, outflows, time line ...) undertaken by the same company in different countries most likely will require different PCOC|PRs. To the extent one cannot or chooses not to hedge away such risks "extant" to the project itself, one must consider these risks in the PCOC|PRs. - The internal rate of return (IROR) or, as many in business call it, the discounted cash flow rate of return (DCFROR), is the solution to a mathematical equation. The IROR is calculated from the cash flows of the projects themselves. The IROR is then compared to the PCOC|PR. It is not the required rate of return (RROR) or hurdle rate, except by accident.

In fact, if the IROR matches the project's PCOC|PR, we are indifferent to the project. A project's expected IROR is compared to the market-determined hurdle rate. If the IROR is greater than the hurdle, then the project is a good project. - Changing the hurdle rate or discount rate naturally does not change the project's IROR. To change the IROR, one must change the magnitudes and/or pattern of the project's cash flows. Different rates for the same project Certain relationships are important in understanding why and when one should use different hurdle rates in evaluating a single project. We should add whether one uses IROR or net present value (NPV) analysis to evaluate a project, the IROR and NPV: - Ultimately require the same estimate of PCOC|PR. - Utilize the same estimates of project cash flows. - Employ discounting, directly in the case of NPV or indirectly in determining IROR. Before discussing when one should use different discount rates for different cash flows of a project, we should address certain implications of using a single hurdle for a project. An implicit relationship exists if one uses a single hurdle or discount rate across time. The use of the same discount rate in different future periods implicitly assumes an increased risk of cash flows in successive periods. This follows since discounting is non-linear. The higher the rate and/or the longer the time, the greater the non-linearity. Most find comfort in using a single discount rate despite the non-linear relationship for the following reason. The further into the future one is making estimates, usually the more difficult it is to make those estimates. Thus, using the same discount rate in successive periods makes an adjustment for this increased uncertainty about the estimate. In general, we agree the use of a single rate is reasonable and practical. However, some circumstances warrant the use of more than one discount rate in project analysis. Some instances call for the: - use of different rates for inflows and outflows for the same project; - use of different rates in different periods; and - use of different rates for different cash flows within the same period. If logic says different rates should be used for different cash flows, we favor the use of net present value analysis. There currently is no practical and conceptually sound way to utilize IROR in analysis and decision and use different discount rates for different periods or cash flows[6]. Here are guidelines for employing NPV. General rules of thumb The rules for expected cash inflows differ slightly but importantly from expected cash outflows.

Inflows vs. outflows For expected cash inflows: - The more uncertain an inflow, the higher the rate at which it must be discounted, or the greater the minimum acceptable rate of return. For expected cash outflows: - The more uncertain an outflow, the lower the appropriate discount rate. At first this seems counter-intuitive. It is a point often overlooked. The logic is as follows. The more uncertain you are about the magnitude and/or timing of cash outflows, the more difficult it is to justify a project. One should reflect uncertainty about the actual dollars required to undertake a project in the analysis. For example, you may have greater confidence in estimating how much money or the precise timing of cash outflows required to accomplish a project similar to several other projects you previously have managed. In contrast, estimates of outlays required for a venture in which you have no experience are riskier. The more risky the outflows, the greater you want to weight them negatively in the net present value. One must carefully assess and manage outlays. If the project is accepted as a good project, project management must insure expected cash outlays remain under control with respect to magnitude and timing of cash flows. Failure to accomplish this properly has resulted in good projects becoming forever bad. The economic disasters in the nuclear power industry in the USA unfortunately serve as ideal examples of what can go wrong in terms of timing and magnitude of cash outflows. Different rates, time periods and cash flows If cash flows are of a different risk within a period or across periods, use different discount rates for the different cash flows. These examples illustrate the concept. - You will receive a lease payment on property you lease to another party. The contract specifies the timing and size of expected cash flows. The risk associated with these cash flows is similar to the risk the market assigns to the bonds of the firm making lease payments to you. Use as a discount rate the yield to maturity based on the market price of that firm's bonds. - It may be difficult to predict incremental units sold and/or the sales price for units sold to different segments of the market. Discount incremental cash revenues at a higher rate for those sales more difficult to estimate compared to those sales about which you have reasonable confidence. In this case, treat the total possible sales in each period as two segments: the portion about which you are quite certain; those cash flows from less certain sales. Then discount the reasonably certain portion of cash sales at one rate and the higher risk sales at a premium rate. - You can sign an agreement to lease a warehouse, maintenance included. Alternatively, you could build your own warehouse. However, with building, you face uncertainty about construction costs and maintenance and upkeep. Since these will be outflows under both alternatives, use a lower discount rate for the higher risk building alternative. Scenarios and discount rates

Selecting the correct PCOC|PR or RROR is a crucial as well as a non-trivial task. Rather than provide a multitude of examples, we provide some general guidelines and several illustrative scenarios. Assume the business risk associated with operating a firm's assets and its relationship to the market is level R. For our purposes it is not necessary to define R. Basic guidelines - If the firm commits to a new project of risk R, then the firm's operating risk does not change. This is an expansion of scale. - If the firm accepts a project that has risk greater than R, then the project is increasing the firm's risk. - If the firm accepts a project that has risk less than R, the firm's operating risk is decreased. - Selecting projects having risk different from R changes the firm's business risk. One must select a PCOC|PR for the project to insure returns are adequate to compensate for risk. Suppose the project has risk level 1.5R. - The PCOC|PR used must be that demanded by market participants given the opportunity for them to invest capital elsewhere at a risk level of 1.5R. - Several approaches provide guidance on discount rates to use in an analysis. We describe one, the premium or discount approach, as follows. Use the firm's cost of capital WCOC plus or minus a premium to adjust the WCOC to take account of differences in risk. If the company's overall risk is R with associated WCOC, then: - Risk greater R: WCOC + premium - Risk R: WCOC - Risk less R: WCOC - discount One selects the discount or premium applied after careful analysis of the nature and risk of the project's cash flows compared to the risk of the firm's existing operating cash flows. Several examples illustrate this point. - It is usually easier to estimate cash flows (outflows and inflows) associated with incremental sales of a current product than the cash flows expected from a new product in a new market. Thus the premium for incremental sales usually would be less than the premium for a new product. - It is usually easier to estimate cash flows associated with a cost reduction program in an area in which you have previous experience compared to an area in which you have no experience. Thus, the hurdle rate is lower on the cost reduction project that has greater certainty about savings. One must be careful to assess the difference between effecting versus realizing the benefits of a cost reduction. Example: You are successful in reducing the material and labor cost produced. You only realize the benefits if you sell the projected number of units and hence need to produce and thus realize the savings in cost.

Guidelines Table I depicts several scenarios reflecting projects varying in risk compared to the current risk of the company. Compare a project under consideration to these scenarios. Think in terms of how acceptance of the project will affect the risk of the operating cash flows of the company. If the project does exactly fit one of these, evaluate whether it "falls between" the categories of projects described. Decide on the necessary adjustment to your base WCOC given the perceived risk of the project. Independently, you might have two or three others make the same judgment and then compare your "answers." A variance in the estimated adjustment suggests the need to analyze the project further. The effects of a cost reduction project on operating risk require a separate analysis to determine the adjustment to apply to the base WCOC. The Appendix provides specific guidance to assist you in analyzing the impact of the cost reduction process on operating risk. Summary The paper reviewed important conceptual issues related to the cost of capital or hurdle rate one should employ in the evaluation of a project. It provided practical guidelines useful to the practicing manager in deciding on the cost of capital appropriate for a particular project. Since the characteristics of cost reduction projects often differ from new projects, the paper also provided special guidelines useful in determining the hurdle rate to employ in the analysis of cost reduction projects. Notes 1 Environments that tax the activities of firms share in the value of good projects and subsidize bad projects. In competitive markets, value-adding projects transfer wealth to society. 2 Assuming conditions external to the firm do not change, e.g. assuming the price of bearing risk in the market does not change. 3 In some circumstances in regulated industries, capital costs that reflected elements of embedded or historical capital costs are relevant in some analysis and decisions. We ignore these special circumstances in this paper. 4 Ibbotson Associates, 225 North Michigan Avenue, Suite 700, Chicago, Illinois 60601-7676. The authors have no direct or indirect affiliation or financial interest with Ibbotson Associates. 5 For guidance on searching for opportunities, see 'Groth, J.C. (1991), "The crucial task: finding investment opportunities", Managerial Finance, Vol. 17 No. 2, pp. 89-95. 6 Some may argue the use of "certainty equivalents" allows one to adjust flows "appropriately" and then utilize IROR. First, this is not practical. Second, it requires a host of heroic assumption. Application questions 1 Consider a recent project and calculate the hurdle rate according to this article. How is the figure different from the figure used in the original project? Why?

2 Which method of calculation did you use? Why? Appendix: cost reduction projects General observations - Use a higher discount rate when it is difficult to estimate the benefits (inflows) of the cost reduction or the certainty they will be realized. - Some cost savings projects will alter the risk of the firm. Consider this effect in selecting the appropriate PCOC. Practical guidance Classifying cost savings projects according to the nature of the costs usually is the best initial approach. Non product-market sensitive The savings will be realized independent of demand for product or particular product. Most common example: a project that decreases the firm's fixed overhead over future periods. Other examples: true labor saving devices or changes that will allow you to realize the savings independent of product demand; improvement of energy usage in heat treatment of parts assuming the firm will be treating a certain number of units over the period of time you estimate the savings. Generally these cost saving projects lower the risk of the firm by reducing fixed costs and/or reducing variable costs (e.g., the heat treating example). If this is true, the risk of the firm is reduced, and the RROR or PCOC|PR for such project is lower. In some cases, the PCOC|PR should be lower than the firm's weighted cost of capital. That follows since risk reduction lowers capital costs. An aside, but important point. The benefits of true cost reduction are several fold. - The first, and obvious one, is the increase in profitability. - The second is important and of a special nature. A reduction in risk, given the same benefit, results in an increase in firm value. Note also there exists an asymmetric relationship between risk and value. This phenomena is easiest to visualize if one remembers the following: A change in risk changes the discount rate. An equal size increase or decrease in discount rate has an unequal effect on value. A decrease in discount rate (lower risk) has a greater change in dollar value than an equal sized increase in rate. Thus, eliminating unnecessary risk has an amplifying effect on value. - Third, a reduction in variable costs per unit produced normally results in a disinvestment of capital. With the same number of units in work in process, finished goods, and reflected in the accounts receivables created through the sale of goods, less capital is invested. In addition, if the reduction in costs is material dependent, raw materials inventory might also be kept at a lower level representing another reduction in capital. This reduction in capital will result in an increase in return on assets. - In addition, an opportunity cost on capital employed implies an opportunity for the released capital to earn

incremental returns for the company elsewhere. - Last, with a reduction in costs, the margins are greater, capital generated internally, greater, and an attendant reduction in the use of outside capital with its attendant costs. This may lead to increased returns. Product-market sensitive Cost reduction projects depending on market demand for realization of savings are more risky than those in the category described above since the saving only will be realized to the extent anticipated demand for a product materializes. Hence, they require a greater RROR than required for the more certain cost savings described above. However, one must also consider the effect the cost reduction will have on the risk associated with the product line. We can illustrate these concepts best with some simple scenarios. Scenario The firm produces transmissions for an existing line equipment currently sold. A project calls for design and manufacturing changes that will reduce manufacturing costs and improve quality. Benefits include: savings in variable costs per unit; savings in future warranty claims; possible incremental sales if customers perceive the increased quality and are willing to pay more for the product and/or, more units of the products are purchased because of greater customer acceptance. The savings per unit will only be realized if the units are sold. The uncertainty associated with the savings is at least as great as that of the sales of the transmission. You won't have the savings unless you make and sell the transmissions. As a consequence, these savings most likely should be discounted at the same rate as one discounts the expected cash flows attributable to incremental sales. Returns and cost of capital Economic returns refer to cash flow returns - not accounting returns. Economic and accounting returns generally differ because accepted accounting standards do not fully recognize the cash flows that firms generate over an economic period. The most notable difference arises from depreciation; accounting standards dictate that firms expense a portion of an asset's cost each period, however no cash flow actually occurs. In making value-adding decisions, the appropriate measure is economic or cash flow returns. Illustration Caption: Table I; Illustrative scenarios and premiums or discounts; (see equation 1); (see equation 2); (see equation 3) DETAILS

Subject: Capital costs; Project management; Efficient markets; Project finance; Government securities; Risk premiums; Earnings; Equity; Capital structure; Cash flow; Rates of return; Investments; Capital investments; Investors

Business indexing term: Subject: Capital costs Project management Efficient markets Project finance Government securities Risk premiums Earnings Equity Capital structure Cash flow Rates of return Capital investments

Classification: 9130: Experimental/theoretical; 2600: Management science/operations research; 3100: Capital & debt management

Publication title: Management Decision; London

Volume: 38

Issue: 6

Pages: 384-393

Number of pages: 0

Publication year: 2000

Publication date: 2000

Publisher: Emerald Group Publishing Limited

Place of publication: London

Country of publication: United Kingdom

Publication subject: Business And Economics--Management

ISSN: 00251747

e-ISSN: 17586070

CODEN: MANDA4

Source type: Scholarly Journal

Language of publication: English

Document type: Feature

DOI: https://doi.org/10.1108/00251740010344568

ProQuest document ID: 212092805

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