INVESTMENT EVALUATION

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• INVESTMENT EVALUATION
• Professor Tim Thompson
• Kellogg School of Management

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The Finance Function
Financial Manager
Operations (Plant, Equipment, Projects, etc.)
Financial Markets (Investors)
(1a) Raise Funds
(2) Investment
(1b) Obligations (Stocks, Debt, IOUs)
(4) Reinvest
(3) Cash from Operations
(5) Dividends or Interest Payments
The finance function manages the cash flow
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The Finance Function
Finance focuses on these two decisions
Financial Markets
Operations
Investment Decision
Financing Decision
Financial Manager
How much to invest and in what assets?
Where is the going to come from?
Capital Budgeting
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Interaction between Financing Investment
Decisions
The interplay of the decisions determines the
cost of capital
Characteristics of the Investment
Investment Decision
Financing Decision
Financial Markets
Operations
Financial Manager
Cost of Capital
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The Finance Function
By making investing and financing decisions, the
financial manager is attempting to achieve the
following objective

• The objective of the financial manager and the
  corporation is to MAXIMIZE THE CURRENT VALUE OF
  SHAREHOLDERS' WEALTH.
• (Taken literally, this means that a firm should
  pursue policies that maximize its today's
  quotation in the Wall Street Journal.)

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Investment Evaluation in 3 Basic Steps
1) Forecast all relevant after tax expected cash
flows generated by the project 2) Estimate the
opportunity cost of capital--r (reflects the time
value of money and the risk) 3) Evaluation DCF
(discounted cash flows) NPV (net present
value) Accept project if NPV is positive Reject
project if NPV is negative IRR (internal rate of
return Accept project if IRR gt r Payback,
Profitability Index ROA, ROFE, ROI, ROCE ROE EVA
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Forecasting Cash Flows
First, forecast all relevant after-tax expected
cash flows
Key is that cash flows must be (a) relevant,
costs and income directly affected by the
project, and (b) after-tax, cash into the owners
pocket
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Forecasting Cash Flows
This is done by estimating operational parameters
This represents a best guess about the
companys future performance
These are based on actual reported performance
Obviously, there is an uncertainty problem but
history is used as a guide for what to expect in
the future
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Investment Evaluation
Evaluating investments involves the following
1) Forecast all relevant after tax expected cash
flows generated by the project 2) Estimate the
opportunity cost of capital--r (reflects the time
value of money and the risk) 3) Evaluation DCF
(discounted cash flows) NPV (net present
value) Accept project if NPV is positive Reject
project if NPV is negative IRR (internal rate of
return Accept project if IRR gt r Payback ,
Profitability Index ROA, ROFE, ROI, ROCE ROE EVA
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Forecasting Cash Flows The Ten Commandments

• 1) Depreciation is not a cash flow, but it
  affects taxation
• 2) Do not ignore investment in fixed assets
  (Capital Expenditures)
• Do not ignore investment in net working capital
• Include only changes in operating working
  capital. Short-term debt, excess cash and
  marketable securities should not be accounted
  for.
• Separate investment and financing decisions
  Evaluate as if entirely equity financed
• 5) Estimate flows on a incremental basis
• Forget sunk costs cost incurred in the past and
  irreversible
• Include all externalities - the effects of the
  project on the rest of the firm - e.g.,
  cannibalization or erosion, enhancement
• 6) Opportunity costs cannot be ignored

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Forecasting Cash Flows The Ten Commandments

• 7) Do not forget continuing value (residual or
  terminal value)
• Liquidation value Estimate the proceeds from the
  sale of assets after the explicit forecast
  period. (Recover investment in working capital,
  tax-shield or fixed assets but missing the
  intangibles and value of on-going business)
• Perpetual growth Assume cash flows are expected
  to grow at a constant rate perpetually.
• 8) Be consistent in your treatment of inflation
• Nominal cash flows (including inflation) -- use a
  nominal cost of capital R
• Real cash flows (without inflation) -- use a real
  cost of capital r
• 9) Overhead costs
• 10) Include excess cash, excess real estate,
  unfunded (over-funded) pension fund, large stock
  option obligations, and other relevant off
  balance sheet items.

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Forecasting Cash Flows
Cash Flows from Operations
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Forecasting Cash Flows
1) Depreciation is not a cash flow, but it
affects taxation
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Forecasting Cash Flows
2) Do not ignore investment in fixed assets.
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Forecasting Cash Flows
3) Do not ignore investment in net working
capital.
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Forecasting Cash Flows

• There is an important distinction between the
  accounting definition of working capital and the
  economic/finance definition relevant to cash
  flows forecast.
• The distinction is a direct result of the 4th
  commandment above We need the operating working
  capital, not the operating and financial working
  capital.

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Accounting Definition of Working Capital

• Current assets include operating assets (above
  dotted line). However, excess cash and marketable
  securities not required for operations (below
  dotted line) are not operating working capital
  and accounted separately for value (see 10th
  commandment).
• Current liabilities include both operating
  liabilities (above the dotted line) and
  non-operating short-term debt (below the dotted
  line).

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Forecasting Cash Flows
4) Separate investment and financing decisions
Evaluate as if entirely equity financed Ignore
financing/ no interest line item
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Forecasting Cash Flows
5) Estimate flows on an incremental
basis Incremental total firm cash flow -
total firm cash flow Cash Flow WITH
the project WITHOUT the project

• Forget Sunk Costs
• costs incurred in the past and irreversible
• Include all effects of the project on the rest of
  the firm (e.g., cannibalization, erosion,
  enhancement, etc.)

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Forecasting Cash Flows
6) Opportunity costs cannot be ignored
What other uses could resources be put to?
The cost of any resource is the foregone
opportunity of employing this resources in the
next best alternative use.
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Forecasting Cash Flows

• 7) Do not forget continuing value (residual or
  terminal)
• Two approaches are available
• Liquidation value Estimate the proceeds from
  the sale of assets after the explicit forecast
  period. (Include the recovery of investment in
  working capital, tax-shield on the undepreciated
  fixed assets and any revenue from assets sale).
• This approach results in under-valuation since it
  misses the value of on-going business. It
  ignores the value of intangibles.

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Forecasting Cash Flows

• Perpetual growth Assumes that after time n cash
  flows are expected to grow at a constant rate
  perpetually.

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Forecasting Cash Flows
8) Be consistent in the treatment of inflation
Discount nominal cash flows with nominal cost of
capital Discount real cash flows with real cost
of capital
Common Mistake Nominal (inflation adjusted)
discount rate used to discount real cash flows
Bias towards short-term investment
Nominal vs. Real Interest Rate
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Inflation
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Nominal
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Real
Nominal Rate Real Rate Inflation
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Forecasting Cash Flows
Nominal vs. Real Cash Flows
Note Depreciation is based on historical costs
and therefore is not adjusted for inflation
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Forecasting Cash Flows
9) Overhead costs
Do not forget overheads and other indirect costs
that increase due to the project
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Forecasting Cash Flows
10) Include excess cash, excess real estate,
unfunded (over-funded) pension funds, large stock
option obligations
. . .
Year 1 CF1
Year 2 CF2
Year 3 CF3
Year 4 CF4
Year 5 CF5
Terminal CFn1/(r-g)
PV(Operating Cash Flows) Excess cash balance
Excess marketable securities Excess real
estate - Under-funded pension Value of the FIRM
Assets/Liabilities not required to support
operations
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Value of Equity

• Value of the Firm
• -Value of Debt
• Value of Equity
• To calculate share price-divide by the number of
  shares outstanding

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Investment Evaluation
Evaluating investments involves the following
1) Forecast all relevant after tax expected cash
flows generated by the project 2) Estimate the
opportunity cost of capital--r (reflects the time
value of money and the risk) 3) Evaluation DCF
(discounted cash flows) NPV (net present
value) Accept project if NPV is positive Reject
project if NPV is negative IRR (internal rate of
return Accept project if IRR gt r Payback ,
Profitability Index ROA, ROFE, ROI, ROCE ROE EVA
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Evaluation Methods NPV
Net Present Value (NPV) is the sum of all cash
flows adjusted by the discount rate
Example
Future cash flows are discounted penalized for
time and risk
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Evaluation Methods NPV
Net Present Value (NPV) is the sum of all cash
flows adjusted by the discount rate
Example
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Evaluation Methods IRR
As the discount rate increases, the PV of future
cash flows is lower and the NPV is reduced
Example
IRR Discount rate at which the project has a NPV
of zero
Internal rate of return (IRR) is the discount
rate that sets the NPV to zero
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Calculation of IRR

• The IRR is the r that solves
• Decision Rule Accept the project if
• IRR gt Opportunity Cost of Capital

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Evaluation Methods NPV vs. IRR
NPV is a measure of absolute performance, whereas
IRR measures relative performance 1) Independent
Projects Accept if NPV gt 0 Accept if
IRR gt Opportunity Cost of Capital
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Evaluation Methods NPV vs. IRR
2) Mutually Exclusive Projects (Ranking) Problem
s with IRR A) Scale B) Timing of Cash
Flows Bias against long-term investments
Highest (NPVa, NPVb, NPVc) Highest (IRRa, IRRb,
IRRc)
Obviously, the return in absolute dollars must be
considered
Preference for CF early! But, it depends.
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Evaluation Methods NPV vs. IRR
The ranking of the projects depends on the
discount rate

A is a LT project and when discount rate PV B
is a ST project and when discount rate PV
drops less
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Other Evaluation Methods
Profitability Index PV/I. Problem Biases
against large-scale projects.
Payback How long does it take for the project to
payback?

• Problems
• No discounting the first 3 years
• Infinite discounting of later years
• Biases against long-term projects.

ROA (return on assets) ROI (return on
investment) ROFE (return on funds employed) ROCE
(return on capital employed) ROE
Earnings Investment

• Problems
• Investment not valued at market
• Earnings vs. cash flows

Net Income Shareholders Equity
Book Value
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Use of Capital Budgeting Rules in Practice.