Never base your budget requests on realistic assumptions, as this could lead to a decrease in your funding. — Scott Adams, Dilbert

The Boeing 757 and 767 aeroplanes were developed simultaneously by the aircraft manufacturer in the 1980s. Boeing, an American aircraft manufacturer (they also build satellites, space crafts and other stuff) with headquarters in Chicago, is said to have “bet the shop” on this investment of US$3 billion (yousigma.com/….html)!

In order not to have gone broke they would have had to carefully assess the capital outlay, and also meticulously estimate the expected returns on this investment, before plunging into such a project. That is, Boeing would need to have prepared a very detailed estimate of expected sales for each of the subsequent years of the expected life of the planes.

Since the inflows (consisting of aircraft sales and leases) would be expected to span multiple years, they would have had to consider the risks involved. Possible risks to consider when estimating sales would be the probability of an oil crisis or the probability of an economic downturn (like what happened in 2008). These factors could affect people’s decisions to travel, and ultimately affect aircraft sales.

Boeing would also have to review the expected rates of return on their investment to help them decide whether the project was feasible or not.

As a result of their careful planning, the 757 and 767 aircrafts were major successes, with Boeing having sold over 1,000 of each!

My curious readers may want to know the price of these aircrafts. Well, Donald Trump bought a second-hand 757 for himself for US$100 million! You can see it at financesonline.com/8-most-expensive-planes-in-the-world-how-much-does-it-cost-to-fly-like-the-elite/ with his name (of course) splashed across the side! The price for a brand new 767 is about US$200 million. (If you are interested I can arrange a discount for you if you want three!)

OK, so what does all that have to do with finance?!

Capital budgeting

Typically, management for organisations has multiple investment opportunities from which to choose — since capital (money!) is not infinite. According to Berk and DeMarzo in their text book on corporate finance, “The process of allocating the firm’s capital for investment is known as capital budgeting.”

We will briefly review three of the more popular tools (there are others) used by organisations like Boeing to determine which projects to invest in and the feasibility of such investments. They are the Net Present Value (NPV), the Internal Rate of Return (IRR) and the Payback.

Payback

The payback is the simplest of them all. All it measures is the number of years that it will take to recoup your investment. So, if I invested $9 million building chicken coops and purchasing young chickens with the expectation of getting $3 million in profits for the next three years, then the payback period is — you got it — three years.

Of course, you will realise the potential pitfalls with this method as inflation, cost of capital and other key items are not being considered here. So it is usually recommended that payback is used in conjunction with another more sophisticated tool. Boeing would possibly have had a very good idea if they would achieve payback of their US$3 billion investment after year five, six or 10, etc.

NPV

The Net Present Value is simply the sum of all the cash flows, with cash flowing out being negative and cash flowing in being positive. We already looked at present value in our finance series. The NPV is just a small extension on that. Let us use a basic example.

Say you invested $10 million on a project — that is a negative cash flow.

If you expect to receive cash inflows from that project of $2.6 million per year for five years when possible interest rate is at 10.5 per cent — is that a feasible project?

Well $2.6 million times five equals $13 million, and we only invested $10 million, so this should mean that we would be ahead by $3 million?… But whoah, wait just a minute!

Remember the time value of money! So you would need to find the present value of each of those five $2.6 million you expect to receive in the future. The calculated NPV from these moneys flowing out and in, is a negative number, and when you use NPV you must get a positive number as the starting point to consider proceeding with the project. Negative is a no go! So in a nutshell, this project is not feasible.

There are some nice fancy formulae to calculate NPV — but you can use Excel. To quickly become an expert at using the NPV function in Excel do the following: i) Open Excel ii) Click the Formulae Tab on the Ribbon iii) Click the Insert Function iv) In the “Search for a Function” box type NPV and press enter v) At the bottom of the dialogue box click “Help on this function” vi) Read the Help feature and try the example in Excel. It is …well… very helpful!

Next week we will review and complete with the IRR.

Dr Kenroy Wedderburn is an MBA part-time lecturer. Send your e-mails to drkwedderburn@gmail.com.