Loading...

PPT – The Investment Principle PowerPoint presentation | free to download - id: 3d1252-NWNhM

The Adobe Flash plugin is needed to view this content

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

characteristics.

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

system

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

investment. - 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

benchmark

- 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

follows - 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

entity - 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

currency. - Real Risk free rate To obtain a real riskfree

rate, you can try the following - from an inflation-indexed government bond, if one

exists - 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

assets) - Estimated debt ratio for the project and cost of

debt for the project

What is debt?

- General Rule Debt generally has the following

characteristics - 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

capital.

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

rating. - 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

Expenses - Consider InfoSoft, a private firm with EBIT of

2000 million and interest expenses of 315

million - 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

Spreads

- 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

InfoSoft

- 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

securities. - 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.

(10.18-4.17) - 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

3.60 - (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

future. - On January 1, 2003, the SP was trading at

879.82. - 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

42.52 - 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

81))/(1r)5 - 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

for. - 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

0.93/(1(1-.35)(.1401)) - 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))

1.49 - (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

assets) - 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

project

- 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

investment. - 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

practices) - 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

(capital) - 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

capital.

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

banks) - Simulations dont make sense
- When the distributions chosen and the parameters

used are arbitrary. It is garbage in, garbage

out.

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

135.25 - 160.10 75.05110.1012010 125 planes

III. Measures of return Accounting Earnings

- Principles Governing Accounting Earnings

Measurement - 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

periods. - 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

analysis - Capital invested Book value Book Value Cash -

Debt

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

time. - 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

outflows. - 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

asset.

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

outflows - 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

life.

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

choice) - 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

analysis. - How, looking at these pooled expenses, do we know

how much of the costs are fixed and how much are

variable?

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

rejected) - 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

years. - 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

weighted.

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

ends..

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

assets

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

loan. - 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

million. - 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

Pesos

- Cost of Equity for a U.S. store 9.78
- Estimating the Country Risk Premium for Chile
- Default spread based on Chilean Bond rating

1.1 - Relative Volatility of Chilean Equity to Bond

Market 2.2 - Country risk premium for Chile 1.1 2.2

2.42 - 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

assumptions.

Viability of New Store Sensitivity to Operating

Margin

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

flows? - 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

investment. - 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

date. - 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

Project

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

benefits.

The Option to Expand/Take Other Projects

- Taking a project today may allow a firm to

consider and take other valuable projects in the

future. - 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

FF - 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

expectations. - 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

project. - 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

0.0484 - Time to expiration Life of the Project 10

years - 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

project) - 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)

474,831 - 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