Capital Budgeting Part 3: The Payback Period Rule

PERSONAL FINANCE 101

In Part 2, I discussed the net present value (NPV) rule for capital budgeting. While this method is the most fundamentally sound and most widely used capital budgeting decision criteria available, there's another rule that smaller businesses favor more because it's simpler to use and understand: the payback period rule.

The concept is probably not new to you, although like some people I know you might have mistakenly referred to it as "return on investment," which is a different thing altogether. The payback period rule asks a simple question: how soon will you be able to recover your investment? If the answer is "soon enough," then invest in the project or buy the asset in question; if not, then don't.

For example, if you estimate that a particular project, which costs 4 million pesos, will generate after-tax cash flows of 1 million per year in the next five years, then its payback period--the number of years it will take to recover your initial investment--is four years. That in itself does not lead to a decision; you would have to ask yourself whether, for whatever reason, that payback period is acceptable to you.

It's easy to see why small businesses and many individuals prefer using this method over the NPV rule. First, it's easier to use since there is no need to estimate the cost of capital (the discount rate used to get the present value of cash flows) and it involves infinitely less complicated computations. And second, it just seems to make sense that the shorter the payback period, the more "liquid"--and thus more attractive--the project is.

Unfortunately, like my favorite toy line there's more than meets the eye to the payback period rule--there is a reason why bigger and more sophisticated financial managers use NPV instead. First, unlike NPV, the payback period rule does not consider the riskiness of cash flows and the time value of money. Second, the payback period rule ignores cash flows beyond the payback period (such as the last million in year five of the example). These limitations are crucial because they could lead to the acceptance of negative-NPV or value-losing projects, and vice versa.

Therefore, despite its simplicity, the payback period rule should not be used as a stand-alone capital budgeting criteria. At most, use this method only to roughly gauge the attractiveness of investment prospects, before the cost of capital can be estimated and used for NPV analysis.

PSE Targets 2013 for REITs in the Philippines

IN THE NEWS

A real estate investment trust or REIT is a modern innovation in finance which allows small investors to participate in future and existing real estate development projects. While the issuance of REITs in the Philippines has already been covered by the REIT Act of 2009, property developers have found requirements too steep to actually push through with an issue. Concerns center on a 40% public-ownership requirement, which needs to be raised to 67% in three years, and the imposition of value-added tax on the transfer of property assets into the REIT. The PSE now proposes changes to these regulations to ease the burden on potential issuers and lead to the first REIT offerings in 2013.

REITs have generated considerable interest from both property developers and investors; the eventual issuance of REITs is seen to further the development of local financial markets. As such, the SEC and the Department of Finance have expressed openness to review the proposals of the PSE.

via Business Mirror

Dilbert on Market Timing

via Dilbert

Liu Hai and the Golden Toad

Have you ever seen a figure of a fat frog (it's actually a toad), sometimes sitting on top of a pile of coins, with a single gold coin in its mouth?

It's easy to see how the toad would have something to do with luck and making money, but have you ever wondered what's the story behind the toad and why, upon closer inspection, does it have only three legs.

The toad comes from the ancient Chinese story, "Liu Hai Teasing the Golden Toad." Liu Hai one of a handful Chinese deities of money and wealth. He is often portrayed adorned with a string of gold coins and accompanied by a three-legged toad. In one version of the story, Liu Hai and the toad are friends; whenever the toad gets trapped in a well, Liu Hai uses a line baited with gold to fish it out. In another version, the toad is an evil monster who lived in a deep pool and terrorized villagers with its noxious fumes; Liu Hai exploits the toad's greed by using a line of gold coins to catch and destroy it. Regardless of the version, Liu Hai and his toad have become popular symbols of prosperity and wealth in Chinese folklore and history (nowadays the latter more than the former).

If you happen to find yourself in Hong Kong, be sure to check out the exhibition "Cruising the Universe: Fantastic Animals in the Arts of China" at the Hong Kong Museum of Art. The collection features some interesting works depicting Liu Hai and the three-legged toad, among other things. Here are some of the pieces you'll see in the exhibition (they look much, much better in person, of course).

Mailbag Cleanup: Business Registration, Bond Yields, and Risk and Return

DEAR INVESTOR JUAN

I've been very busy these past few weeks preparing for a conference (which I'll hopefully have time to talk about in the near future) that I've barely had time to meet my monthly post quota and no opportunity to respond to emails from readers. I'll try to make up for this temporary dereliction of duty by answering some of these neglected emails in this post.

***

Dear Investor Juan,

I enjoy your blog; it's very interesting and helpful for someone like me who wants to have a financial knowledge.

I would like to ask, do I need to register (I know somehow I need to) a business that operates on the Internet? I'm located abroad, my server is here but the domain I'm using is for Philippines because that is my target market. I talked to someone about it, he said I need to, because its a business. But I don't know where to register it: here or Philippines?

Thank you and more power to your blog.

Anonymous


Dear Anonymous,

Thanks for liking the blog, and sorry for the late reply.

Are you already operating? And do you actually need/use an office for operations, where you are and/or in the Philippines? If you don't, I don't think there's any need to register at this point, especially if you have been able to manage without it. The primary benefit of being a registered entity is that it improves your credibility (by being able to issue receipts, for example) and let's you enter above-board transactions (like getting a business loan). While you may be able to run your business without being registered at this point, you definitely have to do it eventually as your business becomes bigger--both where you are and in the Philippines.

***

Dear Investor Juan,

Would like to thank you for your consistent updating and dedication to your blog. I've only started reading your blog for the past month, and I've already learned a lot from it. I have a follow-up question regarding your post on bonds.

Does it imply that as long as we get the bond with the highest yield in the market, would that mean we're getting the best value? Since my understanding of yield is, if you hold this bond until maturity, then you would earn this percentage per year.

Thanks!

Regards,
Bash


Dear Bash,


Sorry for the late reply.

You're right, you would earn the coupon every period as long as you own the bond. The problem is if interest rates go up and make coupons on newly-issued bonds higher than what you receive; missing out on the opportunity to earn higher coupons when interest rates go up is what makes your bond "lose" value. So if you buy a high-yield bond--that is, when interest rates are very high--the price of your bond will only go down if interest rates go even higher; if you have reason to believe that this is unlikely, then yes, buying bonds when yields are high (or bond prices are low) would be a good strategy.

***

Dear Investor Juan,

I currently have an extra 100k and I want to use it for investment but I don't know where to start. I'm looking at investing it with BPI and ask them which fund is currently producing higher returns. Do you have any suggestions?

Thanks.

Jon


Dear Jon,

Sorry for the late reply.

Historically, equity funds (i.e., UITFs and mutual funds) generate higher returns than bond or money market funds, but also involve a higher likelihood of losing principal. So in choosing an investment, you might also want to consider the risk of losing money apart from the potential of earning high returns.

Putting the Philippines' Recent Economic Gains Into Perspective

IN THE NEWS

Bloomberg released a very interesting graphic today: how does the Philippines stack up against its ASEAN neighbors in terms of poverty alleviation, especially given the significant economic gains that the country and region has recently been experiencing? The answer, it seems, is "not to well"?

The above graph shows the GDP growth and poverty reduction rates of three ASEAN nations--the Philippines, Malaysia, and Thailand--since 1988. We see that while the Philippines has been able to keep up with the general pace of economic growth in the region, it has been a consistent laggard when it comes to poverty reduction (where lower or more negative means less poverty, so is better). 

On the surface, these statistics make us think: if the country as a whole is getting richer and the poor remain poor, where is the money going to? What the graphic makes clear is that the income inequality issue does not only apply to the US or China, where discussions have been most lively and publicized, but also to emerging markets like the Philippines. The problem is that a lot of us, Filipinos--or at least those who have Internet access--seem to have been deluded into complacency by the outperforming stock market and recent pats-on-the-back from ratings agencies and investment analysts. Income inequality in the Philippines has been a persistent problem--perhaps now more than ever--that we need to continue (or start?) talking about to at least have a chance to solve. Unfortunately, we are all too pleased with how well we've been doing to even care.

By the way, Bloomberg, if you're reading this--what's up with that x-axis?

Solving Prisoner's Dilemma

Many of us probably first encountered game theory from the 2001 film A Beautiful Mind where the Nobel-economist John Nash, played by Russel Crowe, showed us that "every man for himself" may not be the best strategy in picking up girls in a bar.

Game theory has a couple of advantages over other approaches in studying decision making. First, it recognizes that the consequences (e.g., payoffs) of the decision of one player are affected by the decisions of other players. And second, it acknowledges that in the real world, players often have to make decisions simultaneously and that waiting for other players to make their move and just react is not possible (or practical).

In this post we will take another look at the "prisoner's dilemma" game that I introduced in the previous post and try to come up with a methodological solution that you may or may not agree with.

Two men are arrested, but the police do not possess enough information for a conviction. Following the separation of the two men, the police offer both a similar deal—if one testifies against his partner (defects/betrays), and the other remains silent (cooperates/assists), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each 'rats out' the other, each receives a three-month sentence. Each prisoner must choose either to betray or remain silent; the decision of each is kept quiet. What should they do?

We can summarize the payoffs for two prisoners A and B as follows:

One approach in arriving at a solution to this game is to identify dominant and dominated strategies. A dominant strategy is one which dominates all other strategies: that is, it is the best move for a particular player regardless of what the other player does. For example, in the prisoner's dilemma game, if Prisoner B keeps silent, the best move for A is to betray Prisoner B; if Prisoner B betrays A, then it would be best if Prisoner A betrays B. These arguments show us that "betray" is a dominant strategy for A, and following the same reasoning, also for B. By eliminating the dominated strategies (keeping silent for each prisoner), we are left with one solution: for the two prisoners to betray each other and be sentenced to three months each.

Do you agree with this solution? I'm sure that a lot of you don't. The problem with the dominant strategy approach is that it (implicitly) excludes the option to cooperate or collude. But as John Nash (in the movie) and that player from Golden Balls showed us, if players work together, each will be able to receive the best payoffs for himself and the group: everyone will get laid!

Let's Play Golden Balls

Imagine the following situation:

Two men are arrested, but the police do not possess enough information for a conviction. Following the separation of the two men, the police offer both a similar deal—if one testifies against his partner (defects/betrays), and the other remains silent (cooperates/assists), the betrayer goes free and the cooperator receives the full one-year sentence. If both remain silent, both are sentenced to only one month in jail for a minor charge. If each 'rats out' the other, each receives a three-month sentence. Each prisoner must choose either to betray or remain silent; the decision of each is kept quiet. What should they do?

If you were one of the arrested men, would you betray your partner or remain silent? If you were just an observer, what do you think should the two arrested individuals do?

Golden Balls is a game show in the UK that places two contestants (after a couple of "elimination" rounds) in a similar situation. Given a jackpot amount that was determined in earlier rounds, contestants given two golden balls, one with the word SPLIT printed inside and the other with the word STEAL printed inside. They are then asked to secretly choose a ball. Each contestant's winnings are determined by the following rules:

• If both contestants choose a SPLIT ball, the jackpot is split equally between them.
• If one contestant chooses a SPLIT ball and the other chooses a STEAL ball, the "stealer" gets all the money and the "splitter" gets nothing.
• If both contestants choose STEAL balls, they both get nothing.

The players have a chance to speak with each other face to face before making their choices.

If you were one of the contestants, how would you play the game? If you want to see one of the better ways to do it, watch this video.

The two situations above represent a problem called prisoner's dilemma, a classic example of game theory--which is a method of studying how people, businesses, and other entities make decisions. In a follow-up post, I will discuss a proposed solution to the prisoner's dilemma problem and we'll see how this solution agrees to or differs from how you and I will play the game.

Rethinking Investment Risk

In a post two years ago, I discussed investment risk--how it is usually defined as the chance of losing money in an investment, its trade off with investment returns, and how diversification may be used to manage it. Whenever I discussed the topic in my finance classes, I described the risk of typical investment vehicles this way

Or, in general,

government debt < corporate debt < common equity (i.e., stocks)

Debt, in general, is considered less risky than common stock because interest and principal payments are explicitly defined in debt contracts, although guaranteed only to the extent that these contracts can be enforced. Since dividends are at the discretion of the board of directors and capital gains are the result of uncontrollable market forces, earnings of common stockholders are much more uncertain. Furthermore, equity investors are in a riskier position than creditors because the latter get paid first, both in the course of the firm's operations when interest and dividends are paid and during bankruptcy proceedings when the firm's assets are used to satisfy financial obligations.

Why is government debt less risky than corporate debt? In financial theory, government debt instruments like treasury bills and bonds are considered "risk-free", even though they are strictly only default risk-free; this means that government securities are still exposed to risks such as inflation risk, interest rate risk, and reinvestment risk that affect other types of debt . And the only reason why government debt holders would be immune to default risk is that the borrower--in this case, the government--can theoretically always just print more money to pay back its debt. This is why the downgrade of US debt from a AAA rating in August last year baffled a lot of people: credit ratings are basically just a reflection of default risk, so as long as the US Treasury can print more US dollars, there is no way the US will default on its debt.

Developments in the world economy in the past few months force us to reevaluate these traditional views of investment risk. Sovereign defaults are not new, but what happened in Greece in March, where creditors lost around 74% of the value of their investments, makes us wonder what "risk-free" really means. Recent reports that the US treasury is planning to sell negative-yield bonds, a move which does not make sense to ordinary investors like you and I, further add to the confusion.

In his most recent letter to Berkshire Hathaway shareholders, Warren Buffet underlines the idea that investments that are traditionally considered "safe"--government securities and corporate bonds--are really far from being risk-free, particularly if we define risk as "the probability--the reasoned probability--of that investment causing its owner a loss of purchasing power over his contemplated holding period."

And if government securities and bonds aren't really safe, then what other reasons do ordinary investors have for holding them? Not for the returns, definitely, since we all know that these offer lower expected returns than most other investments. Maybe we really are better off buying productive assets like businesses and real estate, as Buffet suggests. Businesses and real estate, businesses and real estate. Maybe we can never go wrong with businesses and real estate.