Net present value method in capital budgeting decisions

NPV

The net present value calculation is the best way to make a capital budgeting decision. NPV takes the incremental cash flows from a project and then discounts them to present-day dollars. This technique allows managers to not only identify the incremental cash flows associated with a project, but also allows them to discount future cash flows to present day, so as to account for the effects of inflation.

In this case, we have the following schedule of cash flows:

Cash Flow

If T-Mobile is considering a project with these flows, and the company has a discount rate of 4%, then the NPV of the project would be as follows:

Cash Flow

PV

NPV

Thus, this project has a net present value of $ -170.68. A project should only be accepted if it has a positive net present value. The reason for this is that the discount rate effectively represents the opportunity cost of capital (Brealy & Myers, 1996). This means that the 4% rate we are using for T-Mobile represents what T-Mobile earns on its ongoing business. If the project has a positive NPV, the project earns more than the existing T-Mobile business; if it has a negative NPV, the project earns less than the ongoing T-Mobile business. Thus, a project with a negative NPV should be rejected because it would reduce shareholder wealth. A positive NPV represents a project that will enhance shareholder wealth. By agency theory, managers act as agents for the shareholders, and therefore should undertake actions in the best interests of the shareholders. It is assumed that shareholders would want to pursue actions that enhance the value of their investments. Therefore, managers should approve projects with positive net present values because those projects improve shareholder wealth. Thus, because this project has a negative NPV, it should be rejected because that represents a diminishment of shareholder wealth.

Another issue facing T-Mobile at present is a possible merger with Sprint Nextel. This issue has come into the public sphere by way of comments from the Sprint CEO (ABMN, 2010). Ultimately, for a merger to take place, the shareholders of both firms must benefit. There are a number of considerations that need to be analyzed here. The first is the impact on T-Mobile shareholders. T-Mobile is a subsidiary of Deutsche Telekom, so strategically DT would only accept the merger under two conditions. The first is if it wanted to exit the U.S. market, and the second is if it did not want to exit and was allowed to maintain a stake in the combined entity. But those are structural issues that can be worked out at a later point in time.

The more important consideration is the acquisition premium. It is assumed that T-Mobile is currently valued at its intrinsic value. That is, if T-Mobile was publicly traded, the company's value would correspond with the present value of its expected future cash flows. For shareholders of T-Mobile, any offer for takeover would have to exceed this amount in order for them to be enticed to sell out today. The amount by which the offer exceeds the intrinsic value of the firm is known as the acquisition premium. The acquisition premium varies depending on the deal. The average acquisition premium in 2006 was 21%, but it was 34% in 2009, so there is considerable leeway in setting an acquisition premium (Milano, 2011). For T-Mobile shareholders, the acquisition premium is an immediate benefit that they must receive in order for the deal to be accepted.

For Sprint shareholders, as owners of the acquiring firm, the deal must be worth paying the acquisition premium. Since the company is paying more than fair (intrinsic) value for T-Mobile, this implies that the combined company will need to be able to extract greater value than the acquisition premium. This is typically the result of "synergy," which can mean a lot of different things. In this case, the two companies are in the same business, so synergy most likely refers to lowering the fixed cost as a percentage of revenue, by way of improved economies of scale (McClure, 2012).

There are a number of opportunities for synergies here, if the two firms can combine their operations (management, customer service, etc.). More importantly, the two firms would be able to combine their infrastructure investment. The telecommunications industry has high fixed costs associated with continual upgrades to technology -- the move to 4G is a major one the industry is addressing right now. Two companies would need two 4G networks, one company would need one 4G network. Obviously, the latter is cheaper, so there is an obvious synergy right there. For shareholders of Sprint Nextel, the benefits of those synergies will need to exceed the acquisition premium that they paid for T-Mobile in order to make this deal worthwhile.

The financial condition of the combined corporation should also be taken into consideration. Sprint is a consistent money loser, in part because of high infrastructure costs, so spreading those costs out over more customers is an obvious win for Sprint. T-Mobile does not publish full financial figures for its U.S. subsidiary, but it is believed that the unit is profitable on an operating basis. The fixed costs are not known. The combined operation might still not be viable, but if Sprint wants to pursue this deal it must be assumed that their management has seen T-Mobile's numbers and believes that the combined entity will be stronger than Sprint is today. The theoretical project above is irrelevant to this decision, as the project will not be undertaken, and $3 million is nothing compared with the billions these companies spent on infrastructure.

There are of course pitfalls to success. The primary downfall of such a merger is that the synergies fail to materialize. Often this is a bigger risk with companies in different industries. However, it could happen here as well. There may be some synergies, but they are always an unknown in a merger, and the dollar value of synergies might be lower than expected, or lower than the acquisition premium. As well, there could be cultural issues that undermine the integration of the operations of the two firms. In this case, if Deutsche Telekom wanted to remain involved in the combined entity, that would increase the risk of cultural problems with Sprint, and control problems as well. Ideally, Sprint would have full control over the combined company, so that DT management was no longer in the picture. This is not a slight on DT, just a reflection that two companies vying for de facto control of the combined entity are likely to clash. If only one set of managers is working on the integration of the two companies, that is definitely going to improve the likelihood of success for this deal.