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The Investment Principle


Aswath Damodaran Stern School of Business First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. – PowerPoint PPT presentation

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Title: The Investment Principle

The Investment Principle
  • Aswath Damodaran

Stern School of Business
First Principles
  • Invest in projects that yield a return greater
    than the minimum acceptable hurdle rate.
  • The hurdle rate should be higher for riskier
    projects and reflect the financing mix used -
    owners funds (equity) or borrowed money (debt)
  • Returns on projects should be measured based on
    cash flows generated and the timing of these cash
    flows they should also consider both positive
    and negative side effects of these projects.
  • Choose a financing mix that minimizes the hurdle
    rate and matches the assets being financed.
  • If there are not enough investments that earn the
    hurdle rate, return the cash to stockholders.
  • The form of returns - dividends and stock
    buybacks - will depend upon the stockholders

What is a investment or a project?
  • Any decision that requires the use of resources
    (financial or otherwise) is a project.
  • Broad strategic decisions
  • Entering new areas of business
  • Entering new markets
  • Acquiring other companies
  • Tactical decisions
  • Management decisions
  • The product mix to carry
  • The level of inventory and credit terms
  • Decisions on delivering a needed service
  • Lease or buy a distribution system
  • Creating and delivering a management information

Measuring Returns Right The Basic Principles
  • Use cash flows rather than earnings. You cannot
    spend earnings.
  • Use incremental cash flows relating to the
    investment decision, i.e., cashflows that occur
    as a consequence of the decision, rather than
    total cash flows.
  • Use time weighted returns, i.e., value cash
    flows that occur earlier more than cash flows
    that occur later.
  • The Return Mantra Time-weighted, Incremental
    Cash Flow Return

Steps in Investment Analysis
  • Estimate a hurdle rate for the project, based
    upon the riskiness of the investment
  • Estimate revenues and accounting earnings on the
  • Measure the accounting return to see if the
    investment measures up to the hurdle rate.
  • Convert accounting earnings into cash flows
  • Use the cash flows to evaluate whether the
    investment is a good investment.
  • Time weight the cash flows
  • Use the time-weighted cash flows to evaluate
    whether the investment is a good investment.
  • Consider all side-costs and side-benefits when
    analyzing project.

I. Estimating Discount Rates
The Essence of Discount Rates The notion of a
  • Since financial resources are finite, there is a
    hurdle that projects have to cross before being
    deemed acceptable.
  • This hurdle will be higher for riskier projects
    than for safer projects.
  • A simple representation of the hurdle rate is as
  • Hurdle rate Riskless Rate Risk Premium
  • The two basic questions that every risk and
    return model in finance tries to answer are
  • How do you measure risk?
  • How do you translate this risk measure into a
    risk premium?

1. The Nominal versus Real Choice A Currency
for your analysis
  • A project can be analyzed in nominal terms (in
    which case inflation is incorporated into both
    your cashflows and your discount rate) or in real
    terms. When inflation is high and volatile,
    analysts may find it easier to do everything in
    real terms.
  • If an analysis is nominal, you have to pick the
    currency to do the analysis is. Any project can
    be analyzed in any currency. In choosing a
    currency to do the analysis, you should consider
  • Where the project will be located and what
    currency its costs and revenues will be in. (The
    costs may be in one currency and the revenues may
    be in another or more than one currency)
  • How easy it will be to obtain fundamental
    information on risk free rates and risk premiums
    in that currency.

2. Risk Free Rate
  • For an investment to be risk free, it has to
    fulfill two conditions
  • There can have no default risk
  • There can be no reinvestment risk
  • Using this principle strictly, there can be no
    one risk free rate for any investment that
    delivers cash flows at different points in time.
    The right risk free rate for each cash flow will
    be the interest rate on a zero-coupon default
    free government bond maturity on the same date as
    the cash flow.

Some common sense rules on risk free rates
  • Currency with default free entity If you are
    working with a currency where a default free
    entity exists ( or Euro), use the interest rate
    on a government bond with roughly the same
    duration as the project as the riskfree rate for
    all cashflows.
  • Currency with no default free entity There are
    two solutions when there is no default free
  • Approach 1 Subtract default spread from local
    government bond rate
  • Government bond rate in local currency terms -
    Default spread for Government in local currency
  • Approach 2 Use forward rates and the riskless
    rate in an index currency (say Euros or dollars)
    to estimate the riskless rate in the local
  • Real Risk free rate To obtain a real riskfree
    rate, you can try the following
  • from an inflation-indexed government bond, if one
  • set equal, approximately, to the long term real
    growth rate of the economy in which the valuation
    is being done.

3. Determine a debt ratio and a cost of debt for
the project
  • Most projects do not carry debt on their own.
    Instead, the parent company borrows money, using
    its general assets as collateral, and uses this
    money to fund the projects.
  • Some projects are large enough and have assets
    that are separable from the firm. These projects
    sometimes borrow on their own assets, with no
    recourse against the parent company.

What debt ratio should you use for a project?
  • Case 1 Single business company with several,
    small and similar projects
  • Companys cost of debt and debt ratio
  • Case 2 Diverse company with large projects with
    different risk exposures
  • Average debt ratio for the industry in which the
    project is and the cost of debt for the company
  • Case 3 Large project which carries its own debt
    (with no or limited recourse to parent company
  • Estimated debt ratio for the project and cost of
    debt for the project

What is debt?
  • General Rule Debt generally has the following
  • Commitment to make fixed payments in the future
  • The fixed payments are tax deductible
  • Failure to make the payments can lead to either
    default or loss of control of the firm to the
    party to whom payments are due.
  • As a consequence, debt should include
  • Any interest-bearing liability, whether short
    term or long term.
  • Any lease obligation, whether operating or

Estimating the Cost of Debt
  • If the firm has bonds outstanding, and the bonds
    are traded, the yield to maturity on a long-term,
    straight (no special features) bond can be used
    as the interest rate.
  • If the firm is rated, use the rating and a
    typical default spread on bonds with that rating
    to estimate the cost of debt.
  • If the firm is not rated,
  • and it has recently borrowed long term from a
    bank, use the interest rate on the borrowing or
  • estimate a synthetic rating for the company, and
    use the synthetic rating to arrive at a default
    spread and a cost of debt
  • If you are estimating the cost of debt for a
    project, you usually have to use a synthetic
  • The cost of debt has to be estimated in the same
    currency as the cost of equity and the cash flows
    in the valuation.

Estimating Synthetic Ratings
  • The rating for a firm can be estimated using the
    financial characteristics of the firm. In its
    simplest form, the rating can be estimated from
    the interest coverage ratio
  • Interest Coverage Ratio EBIT / Interest
  • Consider InfoSoft, a private firm with EBIT of
    2000 million and interest expenses of 315
  • Interest Coverage Ratio 2,000/315 6.15
  • Based upon the relationship between interest
    coverage ratios and ratings, we would estimate a
    rating of A for the firm.
  • You can estimate synthetic ratings for individual
    projects that will be carrying their own debt.

Interest Coverage Ratios, Ratings and Default
  • Interest Coverage Ratio Rating Default Spread
  • gt 12.5 AAA 0.20
  • 9.50 - 12.50 AA 0.50
  • 7.50 9.50 A 0.80
  • 6.00 7.50 A 1.00
  • 4.50 6.00 A- 1.25
  • 3.50 4.50 BBB 1.50
  • 3.00 3.50 BB 2.00
  • 2.50 3.00 B 2.50
  • 2.00 - 2.50 B 3.25
  • 1.50 2.00 B- 4.25
  • 1.25 1.50 CCC 5.00
  • 0.80 1.25 CC 6.00
  • 0.50 0.80 C 7.50
  • lt 0.65 D 10.00

Costs of Debt for Boeing, the Home Depot and
  • Boeing Home Depot InfoSoft
  • Bond Rating AA A A
  • Rating is Actual Actual Synthetic
  • Default Spread over treasury 0.50 0.80 1.00
  • Market Interest Rate 5.50 5.80 6.00
  • Marginal tax rate 35 35 42
  • Cost of Debt 3.58 3.77 3.48
  • The treasury bond rate is 5.

4. Cost of Equity
Risk Premium
Everyone uses historical premiums, but..
  • The historical premium is the premium that stocks
    have historically earned over riskless
  • Practitioners never seem to agree on the premium
    it is sensitive to
  • How far back you go in history
  • Whether you use T.bill rates or T.Bond rates
  • Whether you use geometric or arithmetic averages.
  • For instance, looking at the US
  • Arithmetic average Geometric Average
  • Stocks - Stocks - Stocks - Stocks -
  • Historical Period T.Bills T.Bonds T.Bills T.Bonds
  • 1928-2002 7.67 6.25 5.73 4.53
  • 1962-2002 5.17 3.66 3.90 2.76
  • 1992-2002 6.32 2.15 4.69 0.95

Two Ways of Estimating Country Risk Premiums
  • Default spread on Country Bond In this approach,
    the country risk premium is based upon the
    default spread of the bond issued by the country
    (but only if it is denominated in a currency
    where a default free entity exists.
  • Brazil was rated B2 by Moodys and the default
    spread on the Brazilian dollar denominated C.Bond
    at the end of September 2003 was 6.01.
  • Relative Equity Market approach The country risk
    premium is based upon the volatility of the
    market in question relative to U.S market.
  • Country risk premium Risk PremiumUS ?Country
    Equity / ?US Equity
  • Using a 4.53 premium for the US, this approach
    would yield
  • Total risk premium for Brazil 4.53
    (33.37/18.59) 8.13
  • Country risk premium for Brazil 8.13 - 4.53
  • (The standard deviation in weekly returns from
    2001 to 2003 for the Bovespa was 33.37 whereas
    the standard deviation in the SP 500 was 18.59)

And a third approach
  • Country ratings measure default risk. While
    default risk premiums and equity risk premiums
    are highly correlated, one would expect equity
    spreads to be higher than debt spreads.
  • Another is to multiply the bond default spread by
    the relative volatility of stock and bond prices
    in that market. In this approach
  • Country risk premium Default spread on country
    bond ?Country Equity / ?Country Bond
  • Standard Deviation in Bovespa (Equity) 33.37
  • Standard Deviation in Brazil C-Bond 26.15
  • Default spread on C-Bond 6.01
  • Country Risk Premium for Brazil 6.01
    (33.37/26.15) 7.67

Implied Equity Risk Premiums
  • An implied equity risk premium is a forward
    looking estimate, based upon how stocks are
    priced today and expected cashflows in the
  • On January 1, 2003, the SP was trading at
  • Treasury bond rate 3.81
  • Expected Growth rate in earnings (next 5 years)
    8 (Consensus estimate for SP 500 earnings)
  • Expected growth rate after year 5 3.81
  • Dividends stock buybacks 3.29 of index (in
    latest year)
  • Year 1 Year 2 Year 3 Year 4 Year 5
  • Expected Dividends 31.25 33.75 36.45 39.37
  • Stock Buybacks
  • Expected dividends buybacks in year 6 42.52
    (1.0381) 44.14
  • 879.82 31.25/(1r) 33.75/(1r)2
    36.45/(1r)3 39.37/(1r)4 (42.52(44.14/(r-.03
  • Solving for r, r 7.91. (Only way to do this is
    trial and error)
  • Implied risk premium 7.91 - 3.81 4.10

4. Measuring Project Risk Risk and Return Models
Estimating Beta
Decomposing Boeings Beta
  • Segment Revenues Estimated Value bunlevered Weight
    Weighted b Levered Beta
  • Commercial Aircraft 26,929 30,160
    0.91 70.39 0.6405 1.06
  • ISDS 18,125 12,688 0.80 29.61 0.2369 0.93
  • Firm 42,848 100.00 0.88 1.01
  • The values were estimated based upon the revenues
    in each business and the typical multiple of
    revenues that other firms in that business trade
  • The unlevered betas for each business were
    estimated by looking at other publicly traded
    firms in each business, averaging across the
    betas estimated for these firms, and then
    unlevering the beta using the average debt to
    equity ratio for firms in that business.
  • Unlevered Beta Average Beta / (1 (1-tax rate)
    (Average D/E))
  • Using Boeings current market debt to equity
    ratio of 25
  • Boeings Beta 0.88 (1(1-.35)(.25)) 1.014

The Home Depots Comparable Firms
Estimating The Home Depots Bottom-up Beta
  • Average Beta of comparable firms 0.93
  • D/E ratio of comparable firms
    (2002076)/16,232 14.01
  • Unlevered Beta for comparable firms
  • 0.86

Beta for InfoSoft, a Private Software Firm
  • The following table summarizes the unlevered
    betas for publicly traded software firms.
  • Grouping Number of Beta D/E Ratio Unlevered
    Firms Beta
  • All Software 264 1.45 3.70 1.42
  • Small-cap Software 125 1.54 10.12 1.45
  • Entertainment Software 31 1.50 7.09 1.43
  • We will use the beta of entertainment software
    firms as the unlevered beta for InfoSoft.
  • We will also assume that InfoSofts D/E ratio
    will be similar to that of these publicly traded
    firms (D/E 7.09)
  • Beta for InfoSoft 1.43 (1 (1-.42) (.0709))
  • (We used a tax rate of 42 for the private firm)

Total Risk versus Market Risk
  • Adjust the beta to reflect total risk rather than
    market risk. This adjustment is a relatively
    simple one, since the R squared of the regression
    measures the proportion of the risk that is
    market risk.
  • Total Beta Market Beta / vR squared
  • In the InfoSoft example, where the market beta
    is 1.10 and the average R-squared of the
    comparable publicly traded firms is 16,
  • Total Beta 1.49/v0.16 3.725
  • Total Cost of Equity 5 3.725 (5.5) 25.49
  • This cost of equity is much higher than the cost
    of equity based upon the market beta because the
    owners of the firm are not diversified.

Estimating a beta for a project
  • Case 1 Single business company with several,
    small and similar projects
  • Companys levered beta
  • Case 2 Diverse company with large projects with
    different risk exposures
  • Levered beta for the industry in which the
    project operates. (Alternatively, you can use an
    unlevered beta for the industry in which the
    project operates and use the companys debt to
    equity ratio to lever up)
  • Case 3 Large project which carries its own debt
    (with no or limited recourse to parent company
  • Levered beta estimated using unlevered beta for
    publicly traded firms comparable to the project
    and the debt to equity ratio for project.

5. Cost of Capital
Estimating Cost of Capital Boeing
  • Equity
  • Cost of Equity 5 1.01 (5.5) 10.58
  • Market Value of Equity 32.60 Billion
  • Equity/(DebtEquity ) 82
  • Debt
  • After-tax Cost of debt 5.50 (1-.35) 3.58
  • Market Value of Debt 8.2 Billion
  • Debt/(Debt Equity) 18
  • Cost of Capital 10.58(.80)3.58(.20) 9.17

Boeings Divisional Costs of Capital
  • Boeing Aerospace Defense
  • Cost of Equity 10.58 10.77 10.07
  • Equity/(Debt Equity) 79.91 79.91 79.91
  • Cost of Debt 3.58 3.58 3.58
  • Debt/(Debt Equity) 20.09 20.09 20.09
  • Cost of Capital 9.17 9.32 8.76

Cost of Capital InfoSoft and The Home Depot
  • The Home Depot InfoSoft
  • Cost of Equity 9.78 25.49
  • Equity/(Debt Equity) 95.45 93.38
  • Cost of Debt 3.77 3.48
  • Debt/(Debt Equity) 4.55 6.62
  • Cost of Capital 9.51 24.03

In summary Estimating cost of capital for a
  • If a firm is in only one business, and all of its
    investments are homogeneous
  • Use the companys costs of equity and capital to
    evaluate its investments.
  • If the firm is in more than one business, but
    investments within each of business are similar
  • Use the divisional costs of equity and capital to
    evaluate investments made by that division
  • If a firm is planning on entering a new business
  • Estimate a cost of equity for the investment,
    based upon the riskiness of the investment
  • Estimate a cost of debt and debt ratio for the
    investment based upon the costs of debt and debt
    ratios of other firms in the business

Analyzing Project Risk Three Examples
  • The Home Depot A New Store
  • The Home Depot is a firm in a single business,
    with homogeneous investments (another store).
  • We will use The Home Depots cost of equity
    (9.78) and capital (9.51) to analyze this
  • Boeing A Super Jumbo Jet (capable of carrying
    400 people)
  • We will use the cost of capital of 9.32 that we
    estimated for the aerospace division of Boeing.
  • InfoSoft An Online Software Store
  • We will estimate the cost of equity based upon
    the total beta for online retailers (5.25). We
    will also assume that the online software company
    will not borrow any money (reflecting industry
  • Cost of capital Cost of equity 33.875

Current Practices in the US Costs of Capital
Choosing a Hurdle Rate
  • Either the cost of equity or the cost of capital
    can be used as a hurdle rate, depending upon
    whether the returns measured are to equity
    investors or to all claimholders on the firm
  • If returns are measured to equity investors, the
    appropriate hurdle rate is the cost of equity.
  • If returns are measured to capital (or the firm),
    the appropriate hurdle rate is the cost of

II. The Estimation Process Sources of
Information/ Estimation
  • Experience and History If a firm has invested in
    similar projects in the past, it can use this
    experience to estimate revenues and earnings on
    the project being analyzed.
  • Market Testing If the investment is in a new
    market or business, you can use market testing to
    get a sense of the size of the market and
    potential profitability.
  • Macro economic/ Sector forecasters There are
    services that provide forecasts of varying
    accuracy/ reliability on what they think will
    happen to the economy or a particular sector.
  • Market Data There are some cases where market
    prices provide information that can be used in
    forecasts. This is especially the case when you
    are forecasting interest rates, exchange rates
    and commodity prices.

Three approaches to estimation
  • Expected value approach In this approach, we
    estimate the expected revenues and earnings of a
    project. While these are point estimates, they
    presumably incorporate all the information you
    have on other scenarios.
  • Simulation In this approach, we estimate a
    statistical distribution (and the parameters of
    the distribution) for each variable. We then run
    simulations drawing from the distribution and
    compute the return on each simulation. The output
    is a distribution of the decision variable (NPV,
    IRR, ROC etc.)
  • Scenario Analysis In this approach, we define
    scenarios for key variables and probabilities of
    each occurring. We then compute the revenues and
    earnings under scenario. The output is the
    decision variable under each scenario.

The Home Depots New Store Experience and History
  • The Home Depot has 700 stores in existence, at
    difference stages in their life cycles, yielding
    valuable information on how much revenue can be
    expected at each store and expected margins.
  • At the end of 1999, for instance, each existing
    store had revenues of 44 million, with revenues
    starting at about 40 million in the first year
    of a stores life, climbing until year 5 and then
    declining until year 10.

The Margins at Existing Stores
Projections for The Home Depots New Store
-Expected Value Analysis
  • For revenues, we will assume
  • that the new store being considered by the Home
    Depot will have expected revenues of 40 million
    in year 1 (which is the approximately the average
    revenue per store at existing stores after one
    year in operation)
  • that these revenues to grow 5 a year
  • that our analysis will cover 10 years (since
    revenues start dropping at existing stores after
    the 10th year).
  • For operating margins, we will assume
  • The operating expenses of the new store will be
    90 of the revenues (based upon the median for
    existing stores)

The Simulation Alternative
  • Instead of using the expected values for each
    variable and arriving at a set of expected
    cashflows for the analysis, we could have
    enriched the analysis by assuming a distribution
    for each of the key variables - revenues, margins
    and growth, for instance.
  • Steps in a simulation
  • Step 1 Determine the variables that you will be
    estimating distributions/parameters for.
  • Step 2 Choose the statistical distribution for
    each of the variables and esitmate the parameters
    of the distribution.
  • Step 3 Run your first simulation, drawing one
    outcome from each distribution.
  • Step 4 Repeat process. The number of simulations
    run will depend upon how many variables are being
    simulated and the range of outcomes.
  • Step 5 Compute your decision variable (NPV, IRR,
    ROIC) for each simulation and report the findings
    in a distribution.

What simulations do and what they do not
  • Simulations do
  • Provide richer information about a projects
    outcomes to decision makers.
  • Provide information about potentially dangerous
    outcomes (for the firm), in terms of worst case
    scenarios. (Violation of lending covenants,
    Failure to make interest payments etc.)
  • A measure of outcome variability that can be
    compared across mutually exclusive investments
  • Simulations do not
  • Adjust cash flows for risk (They generate
    expected cashflows)
  • Provide better estimates of the expected value or
    NPV of an investment.

When simulations make sense and when they do not..
  • Simulations make sense
  • When there is sufficient information to estimate
    the correct statistical distributions for each
    variables and the parameters of those
    distributions. This is most likely to be the case
    for firms that
  • Take the same kind of investment over and over
    again (like the Home Depot)
  • Have done extensive market testing of a product
    or service and generated output from the testing
    which can be used in the distribution
  • When there is a lower bound constraint, which if
    violated, can lead to the project ending. (An
    example would be capital ratio constraints at
  • Simulations dont make sense
  • When the distributions chosen and the parameters
    used are arbitrary. It is garbage in, garbage

Scenario Analysis Boeing Super Jumbo
  • We consider two factors
  • Actions of Airbus (the competition) Produces new
    large capacity plane to match Boeings new jet,
    Improves its existing large capacity plane
    (A-300) or abandons this market entirely.
  • Much of the growth from this market will come
    from whether Asia. We look at a high growth,
    average growth and low growth scenario.
  • In each scenario,
  • We estimate the number of planes that Boeing will
    sell under each scenario.
  • We estimate the probability of each scenario.

Scenario Analysis
  • The following table lists the number of planes
    that Boeing will sell under each scenario, with
    the probabilities listed below each number.
  • Airbus New Airbus A-300 Airbus abandons
    large plane large airplane
  • High Growth in Asia 120 150 200
  • (0.125) (0.125) (0.00)
  • Average Growth in Asia 100 135 160
  • (0.15) (0.25) (0.10)
  • Low Growth in Asia 75 110 120
  • (0.05) (0.10) (0.10)
  • Expected Value 1200.125150.1252000100.15
  • 160.10 75.05110.1012010 125 planes

III. Measures of return Accounting Earnings
  • Principles Governing Accounting Earnings
  • Accrual Accounting Show revenues when products
    and services are sold or provided, not when they
    are paid for. Show expenses associated with these
    revenues rather than cash expenses.
  • Operating versus Capital Expenditures Only
    expenses associated with creating revenues in the
    current period should be treated as operating
    expenses. Expenses that create benefits over
    several periods are written off over multiple
    periods (as depreciation or amortization)

From Forecasts to Accounting Earnings
  • Separate projected expenses into operating and
    capital expenses Operating expenses, in
    accounting, are expenses designed to generate
    benefits only in the current period, while
    capital expenses generate benefits over multiple
  • Depreciate or amortize the capital expenses over
    time Once expenses have been categorized as
    capital expenses, they have to be depreciated or
    amortized over time.
  • Allocate fixed expenses that cannot be traced to
    specific projects Expenses that are not directly
    traceable to a project get allocated to projects,
    based upon a measure such as revenues generated
    by the project projects that are expected to
    make more revenues will have proportionately more
    of the expense allocated to them.
  • Consider the tax effect Consider the tax
    liability that would be created by the operating
    income we have estimated

Boeing Super Jumbo Jet Investment Assumptions
  • Boeing has already spent 2.5 billion in
    research expenditures, developing the Super
    Jumbo. (These expenses have been capitalized)
  • If Boeing decides to proceed with the commercial
    introduction of the new plane, the firm will have
    to spend an additional 5.5 billion building a
    new plant and equipping it for production.
  • Year Investment Needed
  • Now 500 million
  • 1 1,000 million
  • 2 1,500 million
  • 3 1,500 million
  • 4 1,000 million
  • After year 4, there will be a capital maintenance
    expenditure required of 250 million each year
    from years 5 through 15.

Operating Assumptions
  • The sale and delivery of the planes is expected
    to begin in the fifth year, when 50 planes will
    be sold. For the next 15 years (from year 6-20),
    Boeing expects to sell 125 planes a year. In the
    last five years of the project (from year 21-25),
    the sales are expected to decline to 100 planes a
    year. While the planes delivered in year 5 will
    be priced at 200 million each, this price is
    expected to grow at the same rate as inflation
    (which is assumed to be 3) each year after that.
  • Based upon past experience, Boeing anticipates
    that its cost of production, not including
    depreciation or General, Sales and Administrative
    (GSA) expenses, will be 90 of the revenue
  • Boeing allocates general, selling and
    administrative expenses (G,S A) to projects
    based upon projected revenues, and this project
    will be assessed a charge equal to 4 of
    revenues. (One-third of these expenses will be a
    direct result of this project and can be treated
    as variable. The remaining two-thirds are fixed
    expenses that would be generated even if this
    project were not accepted.)

Other Assumptions
  • The project is expected to have a useful life of
    25 years.
  • The corporate tax rate is 35.
  • Boeing uses a variant of double-declining balance
    depreciation to estimate the depreciation each
    year. Based upon a typical depreciable life of 20
    years, the depreciation is computed to be 10 of
    the book value of the assets (other than working
    capital) at the end of the previous year. We
    begin depreciating the capital investment
    immediately, rather than waiting for the revenues
    to commence in year 5.

Revenues By Year
Operating Expenses S,G A By Year
Depreciation and Amortization By Year
Earnings on Project
And the Accounting View of Return
Would lead use to conclude that...
  • Invest in the Super Jumbo Jet The return on
    capital of 12.75 is greater than the cost of
    capital for aerospace of 9.32 This would
    suggest that the project should not be taken.

An extension to existing projects Return Spreads
and EVA
  • How good are the collective investments that a
    firm has already made? One way, albeit a limited
    one, is to compute the collective return on
    capital for the entire company and compare it to
    the cost of capital for the entire company. This
    is a return spread.
  • Extending this approach, you can convert the
    return spread (which is a percentage value) into
    an absolute value by multiplying the return
    spread by the capital invested in the firm (which
    generates an economic value added)
  • EVA (Return on capital - Cost of capital)
    (Capital invested)
  • Where
  • Return on capital EBIT (1-t)/ Invested Capital
  • Cost of capital Hurdle rate for investments of
    equivalend risk at the start of the period of
  • Capital invested Book value Book Value Cash -

EVAs and project quality
  • The EVA for a project is good measure of project
    quality when
  • Project earnings closely resemble cashflows.
  • Project earnings are measured consistently and
    the annual cashflows are fairly uniform over
  • The firm using its is a mature firm with most of
    its assets already in place with little or no
    investment needed for long term grosth.
  • The EVA for a project is a poor measures of
    project quality when
  • Project earnings are being manipulated by
    questionable accounting practices.
  • Project are volatile and change over time.
  • The firm is a growth firm with most of its value
    from growth assets.

From Project to Firm Return on Capital
  • Just as a comparison of project return on capital
    to the cost of capital yields a measure of
    whether the project is acceptable, a comparison
    can be made at the firm level, to judge whether
    the existing projects of the firm are adding or
    destroying value.
  • Boeing Home Depot InfoSoft
  • Return on Capital 5.82 16.37 23.67
  • Cost of Capital 9.17 9.51 12.55
  • ROC - Cost of Capital -3.35 6.87 11.13

IV. From Earnings to Cash Flows
  • To get from accounting earnings to cash flows
  • you have to add back non-cash expenses (like
    depreciation and amortization)
  • you have to subtract out cash outflows which are
    not expensed (such as capital expenditures)
  • you have to make accrual revenues and expenses
    into cash revenues and expenses (by considering
    changes in working capital).
  • For the Boeing Super Jumbo, we will assume that
  • The depreciation used for operating expense
    purposes is also the tax depreciation.
  • Working capital will be 10 of revenues, and the
    investment has to be made at the beginning of
    each year.

Estimating Cash Flows The Boeing Super Jumbo
The Depreciation Tax Benefit
  • While depreciation reduces taxable income and
    taxes, it does not reduce the cash flows.
  • The benefit of depreciation is therefore the tax
    benefit. In general, the tax benefit from
    depreciation can be written as
  • Tax Benefit Depreciation Tax Rate
  • For example, in year 2, the tax benefit from
    depreciation to Boeing from this project can be
    written as
  • Tax Benefit in year 2 217 million (.35)
    76 million
  • Proposition 1 The tax benefit from depreciation
    and other non-cash charges is greater, the higher
    your tax rate.
  • Proposition 2 Non-cash charges that are not tax
    deductible (such as amortization of goodwill) and
    thus provide no tax benefits have no effect on
    cash flows.

The Capital Expenditures Effect
  • Capital expenditures are not treated as
    accounting expenses but they do cause cash
  • Capital expenditures can generally be categorized
    into two groups
  • New (or Growth) capital expenditures are capital
    expenditures designed to create new assets and
    future growth
  • Maintenance capital expenditures refer to capital
    expenditures designed to keep existing assets.
  • Both initial and maintenance capital expenditures
    reduce cash flows
  • The need for maintenance capital expenditures
    will increase with the life of the project. In
    other words, a 25-year project will require more
    maintenance capital expenditures than a 2-year

The Working Capital Effect
  • Intuitively, money invested in inventory or in
    accounts receivable cannot be used elsewhere. It,
    thus, represents a drain on cash flows.
  • To the degree that some of these investments can
    be financed using suppliers credit (accounts
    payable) the cash flow drain is reduced.
  • Assets that earn a fair market return should not
    be counted as part of working capital for cash
    flow purposes. Since cash is usually invested to
    earn a fair market return in marketable
    securities, it should generally not be considered
    as part of working capital.
  • Investments in working capital are thus cash
  • Any increase in working capital reduces cash
    flows in that year
  • Any decrease in working capital increases cash
    flows in that year
  • To provide closure, working capital investments
    need to be salvaged at the end of the project

NPV of Boeing Super Jumbo and Working Capital as
of Revenues
V. From Cash Flows to Incremental Cash Flows
  • The incremental cash flows of a project are the
    difference between the cash flows that the firm
    would have had, if it accepts the investment, and
    the cash flows that the firm would have had, if
    it does not accept the investment.
  • The Key Questions to determine whether a cash
    flow is incremental
  • What will happen to this cash flow item if I
    accept the investment?
  • What will happen to this cash flow item if I do
    not accept the investment?
  • If the cash flow will occur whether you take this
    investment or reject it, it is not an incremental
    cash flow.

Sunk Costs
  • Any expenditure that has already been incurred,
    and cannot be recovered (even if a project is
    rejected) is called a sunk cost
  • When analyzing a project, sunk costs should not
    be considered since they are incremental
  • By this definition, market testing expenses and
    RD expenses are both likely to be sunk costs
    before the projects that are based upon them are
    analyzed. If sunk costs are not considered in
    project analysis, how can a firm ensure that
    these costs are covered?

Allocated Costs
  • Firms allocate costs to individual projects from
    a centralized pool (such as general and
    administrative expenses) based upon some
    characteristic of the project (sales is a common
  • For large firms, these allocated costs can result
    in the rejection of projects
  • To the degree that these costs are not
    incremental (and would exist anyway), this makes
    the firm worse off.
  • Thus, it is only the incremental component of
    allocated costs that should show up in project
  • How, looking at these pooled expenses, do we know
    how much of the costs are fixed and how much are

Boeing Super Jumbo Jet
  • The 2.5 billion already expended on the jet is a
    sunk cost, as is the amortization related that
    expense. (Boeing has spent the first, and it is
    entitled to the latter even if the investment is
  • Two-thirds of the S,GA expenses are fixed
    expenses and would exist even if this project is
    not accepted.

The Incremental Cash Flows Boeing Super Jumbo
VI. To Time-Weighted Cash Flows
  • Incremental cash flows in the earlier years are
    worth more than incremental cash flows in later
  • In fact, cash flows across time cannot be added
    up. They have to be brought to the same point in
    time before aggregation.
  • This process of moving cash flows through time is
  • discounting, when future cash flows are brought
    to the present
  • compounding, when present cash flows are taken to
    the future
  • The discount rate is the mechanism that
    determines how cash flows across time will be

Discounted cash flow measures of return
  • Net Present Value (NPV) The net present value is
    the sum of the present values of all cash flows
    from the project (including initial investment).
  • NPV Sum of the present values of all cash flows
    on the project, including the initial investment,
    with the cash flows being discounted at the
    appropriate hurdle rate (cost of capital, if cash
    flow is cash flow to the firm, and cost of
    equity, if cash flow is to equity investors)
  • Decision Rule Accept if NPV gt 0
  • Internal Rate of Return (IRR) The internal rate
    of return is the discount rate that sets the net
    present value equal to zero. It is the percentage
    rate of return, based upon incremental
    time-weighted cash flows.
  • Decision Rule Accept if IRR gt hurdle rate

Closure on Cash Flows
  • In a project with a finite and short life, you
    would need to compute a salvage value, which is
    the expected proceeds from selling all of the
    investment in the project at the end of the
    project life. It is usually set equal to book
    value of fixed assets and working capital
  • In a project with an infinite or very long life,
    we compute cash flows for a reasonable period,
    and then compute a terminal value for this
    project, which is the present value of all cash
    flows that occur after the estimation period

Salvage Value on Boeing Super Jumbo
  • We will assume that the salvage value for this
    investment at the end of year 25 will be the book
    value of the investment.
  • Book value of capital investments at end of year
    25 1,104 million
  • Book value of working capital investments yr 25
    3,612 million
  • Salvage Value at end of year 25 4,716 million

Considering all of the Cashflows The NPV
Which makes the argument that..
  • The project should be accepted. The positive net
    present value suggests that the project will add
    value to the firm, and earn a return in excess of
    the cost of capital.
  • By taking the project, Boeing will increase its
    value as a firm by 4,019 million.

The IRR of this project
Internal Rate of Return
The IRR suggests..
  • The project is a good one. Using time-weighted,
    incremental cash flows, this project provides a
    return of 14.88. This is greater than the cost
    of capital of 9.32.
  • The IRR and the NPV will yield similar results
    most of the time, though there are differences
    between the two approaches that may cause project
    rankings to vary depending upon the approach used.

An IRR-based Approach to analyzing existing
investments - CFROI
  • The CFROI is the internal rate of return that you
    generate by looking collectively at the
    investment in all of your assets and the
    cashflows you expect to generate from them.
    CFROI is usually done in real terms and should
    generally be compared to a real cost of capital.
  • In terms of inputs, CFROI is usually computed
    using the following
  • Gross investment in plant and equipment, which is
    obtained by adding back accumulated depreciation
    to net plant and equipment, is used as the
    equivalent of the initial investment.
  • The annual cashflow is computed by adding back
    depreciation to after-tax operating income.
  • The life of the asset, at the time of the
    original purchase, is used as the life of the

Equity Analysis The Parallels
  • The investment analysis can be done entirely in
    equity terms, as well. The returns, cashflows and
    hurdle rates will all be defined from the
    perspective of equity investors.
  • If using accounting returns,
  • Return will be Return on Equity (ROE) Net
    Income/BV of Equity
  • ROE has to be greater than cost of equity
  • If using discounted cashflow models,
  • Cashflows will be cashflows after debt payments
    to equity investors
  • Hurdle rate will be cost of equity

A New Store for the Home Depot
  • It will require an initial investment of 20
    million in land, building and fixtures.
  • The Home Depot plans to borrow 5 million, at an
    interest rate of 5.80, using a 10-year term
  • The store will have a life of 10 years. During
    that period, the store investment will be
    depreciated using straight line depreciation. At
    the end of the tenth year, the investments are
    expected to have a salvage value of 7.5
  • The store is expected to generate revenues of 40
    million in year 1, and these revenues are
    expected to grow 5 a year for the remaining 9
    years of the stores life.
  • The pre-tax operating margin, at the store prior
    to depreciation, is expected to be 10 for the
    entire period.

Interest and Principal Payments
Net Income on The Home Depot Store
The Hurdle Rate
  • The analysis is done in equity terms. Thus, the
    hurdle rate has to be a cost of equity
  • The cost of equity for the Home Depot is 9.78.
    Since the Home Depots investments are assumed to
    be homogeneous, the cost of equity for this
    project is also assumed to be 9.78.

An Incremental CF Analysis
NPV of the Store
Internal Rate of Return The Home Depot Store
The Consistency Rule for Cash Flows
  • The cash flows on a project and the discount rate
    used should be defined in the same terms.
  • If cash flows are in one currency, the discount
    rate has to be a dollar (baht) discount rate
  • If the cash flows are nominal (real), the
    discount rate has to be nominal (real).
  • If consistency is maintained, the project
    conclusions should be identical, no matter what
    cash flows are used.

The Home Depot A New Store in Chile
  • It will require an initial investment of 4700
    million pesos for land, building and fixtures.
    The Home Depot plans to borrow 1880 million
    pesos, at an interest rate of 12.02, using a
    10-year term loan.
  • The store will have a life of 10 years. During
    that period, the store will be depreciated using
    straight line depreciation. At the end of the
    tenth year, the investments are expected to have
    a salvage value of 2,350 million pesos.
  • The store is expected to generate revenues of
    7,050 million pesos in year 1, and these revenues
    are expected to grow 12 a year for the remaining
    9 years.
  • The pre-tax operating margin at the store, prior
    to depreciation, is expected to be 6 for the
    entire period.
  • The working capital requirements are estimated to
    be 10 of total revenues, and investments will be
    made at the beginning of each year.

The Home Depot Chile Store Cashflows in Pesos
The Home Depot Chile Store Cost of Equity in
  • Cost of Equity for a U.S. store 9.78
  • Estimating the Country Risk Premium for Chile
  • Default spread based on Chilean Bond rating
  • Relative Volatility of Chilean Equity to Bond
    Market 2.2
  • Country risk premium for Chile 1.1 2.2
  • Cost of Equity for a Chilean Store (in U.S. )
  • 5 0.87 (5.5 2.42) 11.88
  • Assume that the expected inflation rate in Chile
    is 8 and the expected inflation rate in the U.S.
    is 2.
  • Cost of Equity for a Chilean Store (in Pesos)
  • (1 Cost of Equity in ) (1
    inflationChile)/ (1 inflationUS) - 1
  • 1.1188 (1.08/1.02) -1 18.46

NPV in Pesos
Converting Pesos to U.S. dollars
  • This entire analysis can be done in dollars, if
    we convert the peso cash flows into U.S. dollars.
  • If you want the analysis to yield consistent
    conclusions, expected exchange rates have to be
    estimated based upon expected inflation rates
  • Current Exchange Rate 470 pesos
  • Expected Ratet Exchange Rate (1
    inflationChile)/ (1 inflationUS)
  • Expected Exchange Rate in year 1 470 pesos
    (1.08/1.02) 497.65

Analyzing the Project U.S. Dollars
NPV in U.S. Dollars
The Role of Sensitivity Analysis
  • Our conclusions on a project are clearly
    conditioned on a large number of assumptions
    about revenues, costs and other variables over
    very long time periods.
  • To the degree that these assumptions are wrong,
    our conclusions can also be wrong.
  • One way to gain confidence in the conclusions is
    to check to see how sensitive the decision
    measure (NPV, IRR..) is to changes in key

Viability of New Store Sensitivity to Operating
What does sensitivity analysis tell us?
  • Assume that the manager at The Home Depot who has
    to decide on whether to take this plant is very
    conservative. She looks at the sensitivity
    analysis and decides not to take the project
    because the NPV would turn negative if the
    operating margin drops below 8. Is this the
    right thing to do?
  • Yes
  • No
  • Explain.

Dealing with Inflation
  • In our analysis, we used nominal dollars and
    pesos. Would the NPV have been different if we
    had used real cash flows instead of nominal cash
  • It would be much lower, since real cash flows are
    lower than nominal cash flows
  • It would be much higher
  • It should be unaffected

From Nominal to Real The Home Depot
  • To do a real analysis, you need a real cost of
    equity or capital
  • Nominal cost of equity for The Home Depot 9.78
  • Expected Inflation rate 2
  • Real Cost of Equity (1.0978/1.02)-1 7.59
  • To estimate cash flows in real terms
  • Real Cash flowt Nominal Cash flowt / (1
    Expected Inflation rate)t

Nominal versus Real
Side Costs and Benefits
  • Most projects considered by any business create
    side costs and benefits for that business.
  • The side costs include the costs created by the
    use of resources that the business already owns
    (opportunity costs) and lost revenues for other
    projects that the firm may have.
  • The benefits that may not be captured in the
    traditional capital budgeting analysis include
    project synergies (where cash flow benefits may
    accrue to other projects) and options embedded in
    projects (including the options to delay, expand
    or abandon a project).
  • The returns on a project should incorporate these
    costs and benefits.

Opportunity Cost
  • An opportunity cost arises when a project uses a
    resource that may already have been paid for by
    the firm.
  • When a resource that is already owned by a firm
    is being considered for use in a project, this
    resource has to be priced on its next best
    alternative use, which may be
  • a sale of the asset, in which case the
    opportunity cost is the expected proceeds from
    the sale, net of any capital gains taxes
  • renting or leasing the asset out, in which case
    the opportunity cost is the expected present
    value of the after-tax rental or lease revenues.
  • use elsewhere in the business, in which case the
    opportunity cost is the cost of replacing it.

Project Synergies
  • A project may provide benefits for other projects
    within the firm. If this is the case, these
    benefits have to be valued and shown in the
    initial project analysis.
  • For instance, the Home Depot, when it considers
    opening a new restaurant at one of its stores,
    will have to examine the additional revenues that
    may accrue to this store from people who come to
    the restaurant.

Project Options
  • One of the limitations of traditional investment
    analysis is that it is static and does not do a
    good job of capturing the options embedded in
  • The first of these options is the option to delay
    taking a project, when a firm has exclusive
    rights to it, until a later date.
  • The second of these options is taking one project
    may allow us to take advantage of other
    opportunities (projects) in the future
  • The last option that is embedded in projects is
    the option to abandon a project, if the cash
    flows do not measure up.
  • These options all add value to projects and may
    make a bad project (from traditional analysis)
    into a good one.

The Option to Delay
  • When a firm has exclusive rights to a project or
    product for a specific period, it can delay
    taking this project or product until a later
  • A traditional investment analysis just answers
    the question of whether the project is a good
    one if taken today.
  • Thus, the fact that a project does not pass
    muster today (because its NPV is negative, or its
    IRR is less than its hurdle rate) does not mean
    that the rights to this project are not valuable.

Valuing the Option to Delay a Project
PV of Cash Flows
from Project
Initial Investment in
Present Value of Expected
Cash Flows on Product
Project's NPV turns
Project has negative
positive in this section
NPV in this section
Insights for Investment Analyses
  • Having the exclusive rights to a product or
    project is valuable, even if the product or
    project is not viable today.
  • The value of these rights increases with the
    volatility of the underlying business.
  • The cost of acquiring these rights (by buying
    them or spending money on development - RD, for
    instance) has to be weighed off against these

The Option to Expand/Take Other Projects
  • Taking a project today may allow a firm to
    consider and take other valuable projects in the
  • Thus, even though a project may have a negative
    NPV, it may be a project worth taking if the
    option it provides the firm (to take other
    projects in the future) provides a
    more-than-compensating value.
  • These are the options that firms often call
    strategic options and use as a rationale for
    taking on negative NPV or even negative
    return projects.

The Option to Expand
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Present Value of Expected
Cash Flows on Expansion
Expansion becomes
Firm will not expand in
attractive in this section
this section
An Example of an Expansion Option
  • Assume that The Home Depot is considering opening
    a small store in France. The store will cost 100
    million French Francs (FF) to build, and the
    present value of the expected cash flows from the
    store is 120 million FF. Thje store has a
    negative NPV of 20 million FF.
  • Assume, however, that by opening this store, the
    Home Depot will acquire the option to expand its
    operations any time over the next 5 years. The
    cost of expansion will be 200 million FF, and it
    will be undertaken only if the present value of
    the expected cash flows from expansion exceeds
    200 million FF. At the moment, this present value
    is believed to be only 150 million FF. The Home
    Depot still does not know much about the market
    for home improvement products in France, and
    there is considerable uncertainty about this
    estimate. The variance in the estimate is 0.08.

Valuing the Expansion Option
  • Value of the Underlying Asset (S) PV of Cash
    Flows from Expansion, if done now 150 million FF
  • Strike Price (K) Cost of Expansion 200 million
  • Variance in Underlying Assets Value 0.08
  • Time to expiration Period for which expansion
    option applies 5 years
  • Call Value 150 (0.6314) -200 (exp(-0.06)(20)
    (0.3833) 37.91 million FF

Considering the Project with Expansion Option
  • NPV of Store 80 million FF - 100 million FF
    -20 million
  • Value of Option to Expand 37.91 million FF
  • NPV of store with option to expand -20 million
    37.91 million 17.91 mil FF
  • Accept the project

The Option to Abandon
  • A firm may sometimes have the option to abandon a
    project, if the cash flows do not measure up to
  • If abandoning the project allows the firm to save
    itself from further losses, this option can make
    a project more valuable.

PV of Cash Flows
from Project
Cost of Abandonment
Present Value of Expected
Cash Flows on Project
Valuing the Option to Abandon
  • Assume that the Home Depot is considering a new
    store that requires a net initial investment of
    9.5 million and generates cash flows with a
    present value of 8.563 million. The net present
    value of -937,287 would lead us to reject this
  • To illustrate the effect of the option to
    abandon, assume that the Home Depot has the
    option to close the store any time over the next
    10 years and sell the land back to the original
    owner for 5 million. In addition, assume that
    the standard deviation in the present value of
    the cash flows is 22.

Project with Option to Abandon
  • Value of the Underlying Asset (S) PV of Cash
    Flows from Project 8,562,713
  • Strike Price (K) Salvage Value from Abandonment
    5 million
  • Variance in Underlying Assets Value 0.222
  • Time to expiration Life of the Project 10
  • Dividend Yield 1/Life of the Project 1/10
    0.10 (We are assuming that the projects present
    value will drop by roughly 1/n each year into the
  • The riskless rate is 5.

Should The Home Depot take this project?
  • Value of Put 5,000,000 exp(-0.05)(10)
    (1-0.4977) - -8,562,713 exp(0.10)(10) (1-0.7548)
  • The value of this abandonment option has to be
    added to the net present value of the project of
    - 937,287, yielding a total net present value
    that remains negative.
  • NPV without abandonment option -937,287
  • Value of abandonment option 474,831
  • NPV with abandonment option -462,456
  • Notwithstanding the abandonment option, this
    store should not be opened.

First Principles
  • Invest in projects that yield a return greater
    than the minimum acceptable hurdle rate.
  • The hurdle rate should be higher for riskier
    projects and reflect the financing mix used -
    owners fund