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MBAMFM 253 Measuring Return on Investment

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Title: MBAMFM 253 Measuring Return on Investment


1
MBA/MFM 253 Measuring Return on Investment
2
The Big Picture
  • The last 2 chapters discussed measuring the cost
    of capital the average cost of financing for
    the entire firm
  • This chapter discusses adjusting the cost of
    capital for an individual project.
  • The weighted average represents an average across
    all sources of financing some projects are more
    risky some are less risky
  • Each project should be evaluated at their
    individual cost of capital

3
The Big Picture part II
  • A general valuation model for any asset
  • The value of an asset (either real or financial)
    can be found by based upon the PV of the future
    cash flows generated from owning the asset.
  • The main questions to be addressed are then
  • What future cash flows are generated by the asset
  • What is the appropriate discount rate (interest
    rate) based on the riskiness of the cash flows.

4
Simple 2 project example
  • Firm value consists of the sum of the individual
    parts of the firm.
  • Assume the firm has two assets, A and B, each
    generates a stream of future cash flows that have
    the same riskiness and there are no shared costs.
  • The PV of the firm is simply the PV of the cash
    flows from each set of assets or
  • Firm Value PV (A) PV (B)
  • sum of separate asset values

5
Three Stages of a Project
  • Acquisition Stage
  • Initial outlay of cash
  • Operating Stage
  • Sales Revenue, Operating Expenses, Taxes etc
  • Disposition Stage
  • Sales of fixed assets, Tax consequences

6
What is a Project?
  • Major Strategic Decisions
  • Acquisitions of Other firms
  • New Ventures within existing markets
  • Changes in the way current businesses or ventures
    are approached
  • Spending money on components necessary for
    business (investment in information systems for
    example)

7
The Project Continuum
Mutually Exclusive
Prerequisite
Complementary
Independent
8
Project Risk
  • Should the WACC be used for all projects in the
    firm?
  • No - it is a composite of all projects (an
    average). That means some projects are more
    risky than the average and some less risky.
  • Each project should also be looked at on an
    individual basis.

9
Divisional WACC
  • The WACC represents the composite cost of
    capital across all projects.
  • Before we developed a market-wide relationship
    between risk and return with the security market
    line. You can use a similar concept idea to
    relate risk to a projects cost of capital.
  • This is done with a graph of risk vs. return
    where return is measured by the cost of capital.

10
Divisional Cost of Capital
  • Firm H is High Risk with a WACC 12
  • Firm L is low Risk with a WACC 8
  • Both Firms are considering two projects with
    equal risk equal to the average risk of Firm H
    and Firm L.
  • Project A has an expected return of 10.5,
  • Project B has an expected return of 9.5
  • Which project(s) should each firm accept?

11
Acceptance Region
Return
12.0
A
10.5
Rejection Region
10.0
9.5
B
8.0
Risk
RiskL
RiskA
RiskH
12
Determining the Project Cost of Equity
  • Single Business Project risk is similar across
    all businesses use the overall cost of equity
    and cost of debt
  • Multiple Businesses with different risk profiles
    estimate cost of equity using project beta
    bottom up beta, accounting beta, or regression on
    cash flows
  • Projects with different risk profiles ideally
    estimate cost of equity for each or use
    divisional costs of equity if they are fairly
    close

13
Project Cost of Debt
  • Generally the cost of debt reflects default risk
    however the possibility of default on a given
    project is difficult to estimate.
  • Therefore debt financing is generally thought of
    as a firm value instead of a project value.
  • Whether or not to attempt to measure the cost of
    debt individually depends upon the size of the
    project and it impact on the overall default risk
    of the firm.

14
Cost of Debt - Summary
15
Project cost of capital
  • The combination of different cost of financing
    into a cost of capital requires a weighting for
    each of the types of financing.
  • When the project is large, the financing mix may
    differ from that of the overall firm.
  • In extreme cases the project may be large enough
    to issue its own debt in that case your weights
    for the financing options will vary from the firm
    weights.

16
Measuring Returns
  • Accounting Earnings vs. Cash Flows
  • Accounting earnings are based on accrual
    accounting
  • Cash flow measures the actual cash generated in a
    given time period.

17
Operating vs. Capital Expenditures
  • Operating Expenditures Occur only in the
    current period (labor costs etc). These are
    subtracted from revenue in the period they occur
  • Capital expenditures Are drawn out over time
    and deducted from revenue in the form of
    depreciation and other non cash charges

18
Accrual Based
  • Revenues are realized when the sale is made, and
    expenses when the purchase or expense occurs, not
    necessarily when the payment is made.
  • This results in income (earnings) that does not
    represent cash flow.

19
Why Cash Flows?
  • Cash represents the ability of the firm to
    operate (you cant spend earnings).
  • Accounting earnings are often manipulated to
    impress shareholders.

20
Cash Flow vs. Accounting Earnings
  • GAAP is based on accrual accounting
  • Revenues are realized at the time of the sale,
    not when cash is received (Expenses are realized
    at the time acquired, not when paid for
  • Operating Expenditures
  • Produce benefits only in the current period
  • Capital Expenditures
  • produce benefits over multiple periods
  • Non - Cash Charges (depreciation etc)
  • Reduce accounting income, but cash exists

21
Free Cash Flows
  • FCFE (Cash Flow to Equity)
  • Net Income Depreciation Amortization
  • -Changes in Non-Cash Net Working Capital
  • - Capital Expenditures - Principal Repayments
  • New Debt Issues
  • FCFF (Cash Flow to Firm)
  • EBIT(1-t) Depreciation Amortization
  • - Changes in Non-Cash Net Working Capital
  • - Capital Expenditures

22
Incremental Cash Flow
  • Cash flow changes that result from a particular
    project
  • Relevant Cash Outflows
  • Increase Cash outflow
  • Elimination of cash inflow
  • Investment in Assets
  • Relevant Cash Inflow
  • Increase in cash inflow
  • Elimination of cash outflow
  • Liquidation of assets

23
Steps in estimating Cash Flow
  • Estimate the Income Statement
  • Estimate the Balance Sheet
  • Combine the income statement and balance sheet
    into a cash flow statement
  • Make a decision

24
Estimation of Income Statement
  • Most business use an accrual basis - Expenses and
    Income are recorded whether or not the actual
    payment is made.
  • Book value of assets decrease via depreciation
  • When goods are purchased or produced it is
    considered an increase in inventory

25
Estimation of the Balance Sheet
  • Accounts Receivable and Accounts Payable are
    active in the early stages of the business.
  • Most assets begin on the balance sheet and flow
    onto the cash flow statement.

26
Combine Income Statement and Balance Sheet
  • Accounts Receivable
  • An increase in Accounts receivable represents a
    sale recorded as income but no cash was received
    (negative entry on the CF statement)
  • Accounts Payable
  • An increase in accounts payable represents the
    purchase of items on credit recorded as an
    expense, but no cash flow occurred (positive
    entry on CF statement)

27
Combine Income Statement and Balance Sheet
  • Inventory
  • Two forms items produced and spare parts
  • Holing Losses (theft, obsolescence) are
    deductible in income statement
  • Increases in inventory are a negative entry on CF
    statement.
  • Prepaid expenses
  • Insurance Premiums for example will be recognized
    as a prepaid expense on Balance Sheet but cash
    flow occurred in 1st year.

28
Combine Income Statement and Balance Sheet
  • Cash Balances
  • Initial Cash Balance is considered a year 0 cash
    flow, it represents cash that could have been
    used elsewhere
  • In disposition stage cash is recovered
  • Land
  • Negative CF (if purchased for the project) at
    acquisition
  • Positive Cash flow at disposition
  • Land is separated from buildings since it is not
    depreciable

29
Combine Income Statement and Balance Sheet
  • Buildings
  • Negative CF entry at year 0 and depreciated
    (nonresidential)
  • Equipment
  • Recognized as purchase price, setup expenses,
    shipping and instillation. Can be depreciated
  • Changes in Net working capital (inventory cannot
    be depreciated)

30
Combine Income Statement and Balance Sheet
  • Depreciation
  • Represents a non cash expense and is a positive
    entry on the cash flow statement
  • Net Working Capital
  • Current Assets minus Current liabilities
  • Incremental changes throughout the life of the
    project

31
Combine Income Statement and Balance Sheet
  • Taxes During Acquisition Stage
  • Investment Tax Credits, lowers tax liability
  • Training and Advertising are a one time deduction
    at the beginning of the project

32
Combine Income Statement and Balance Sheet
  • Taxes during Operating Stage
  • Depreciation
  • Loss back and Carry forward
  • Negative income can be used to offset current tax
    liability and carried to other periods.

33
Special Problems
  • Sunk Costs
  • Externalities
  • Opportunity Costs
  • Shipping and Installation costs

34
Sunk Costs
  • Occur prior to the decision concerning the new
    project and should not be counted
  • Example Nestle spent 1 Million to develop new
    coffee flavor
  • If they produce the project NPV 600,000 if the
    sunk cost is ignored
  • Counting the sunk cost the loss is -400,000
  • Should the project be undertaken?

35
Externalities
  • Indirect Costs (shared costs and overhead costs).
  • New plant requiring additional computer support
  • Pure Joint Costs
  • Cannot be separated
  • Airline pilot salary who carries freight and
    passengers.

36
Externalities continued
  • Pure Joint Costs
  • Estimate the NPV of the project with an estimate
    of the impact of the joint cost
  • If they have positive NPV consider groups of
    projects including all joint costs
  • Cannibalization
  • IBM and Main Frames

37
Externalities continued
  • Indirect benefits (Synergies)
  • Assume a bank offers a new checking account --
    some customers will also sign up for credit card.
  • New suburban location of a bank
  • Existing customers start using new branch
  • New customers using original location

38
Opportunity Costs
  • The best foregone opportunity
  • Dole Inc. Prime real estate in Hawaii could be
    used to grow pineapple or as resort land. Early
    1980s converted the land after looking at the
    lost income
  • GM forgoes 1Million it could earn by renting a
    plant site and decides to build a new plant on
    the land.

39
Shipping and Installation Cost
  • Included as part of the original cost of the
    project

40
Combine Income Statement and Balance Sheet
  • Taxes at Disposition Stage
  • Capital Gains and Losses Gain or loss on assets
    that were not intended to be used in the regular
    course of business.
  • 1245 Gain and Loss All assets except real estate
    gain or loss from comparing Sale Price to
    Original basis
  • 1250 Gain or Loss Real Assets that are
    depreciated (buildings) Gain or loss from
    comparing sale price to remaining basis

41
Make a Decision
  • Once the Balance sheet and income statement are
    combined and cash flow is estimated use NPV, and
    other decision tools to make a decision on the
    project.

42
Project Interactions
  • Once individual projects are investigated you
    need to look at possible interactions between
    projects and timing options for the projects.
  • Given that all the future cash flows can be
    estimated. This is relatively easy. You would
    want to investigate projects so that the NPV is
    maximized (keeping other constraints constant).

43
The Capital Investment Process
  • Capital Budget An annual assessment of
    investment projects
  • The budget is a product of negotiation between
    divisional managers and plant managers.
  • The budget should also reflect the strategic plan
    of the firm, the two process should compliment
    each other.

44
Capital Budget vs. Approval
  • The capital budget is a general plan that does
    not always imply final approval of a project.
  • Final approval is often contingent upon a more
    detailed cash flow analysis in the appropriation
    request.

45
Capital Budgets and Spending
  • Not all large investments are part of the capital
    budget
  • Information Technology
  • Research and Development
  • Marketing
  • Training and Development
  • Operating Decisions

46
Monitoring
  • Due to the ability of costs to exceed forecasts
    and changes in the economy it is important for
    the firm to perform audits of the project as it
    progresses.

47
Financial Planning
  • Establish an outline of the process by which the
    firms goals are to be realized

48
Goals of the Plan
  • Examining Interactions
  • Exploring Options
  • Avoiding Surprises
  • Evaluating Feasibility

49
Elements of a Financial Plan
  • Forecasting What future assets will be needed
    and how will they be obtained
  • Capital Structure Policy How will the assets be
    financed
  • Dividend Policy What portion of earnings will
    be returned to shareholders
  • Working Capital The amount of liquidity needed
    for the firm to conduct daily operations

50
Main issues addressed
  • Corporate Purpose Overview of long run mission
    of firm
  • Corporate Scope Geographic location and main
    business line
  • Corporate Objectives Specific Goals for the
    firm ( targets)

51
Main Issues
  • Corporate Strategy A plan to obtain the firms
    objectives
  • Operating Plans Five year horizon each year
    less specific

52
Steps in the planning process
  • Pro Forma Financial Statements and NPV
  • Determine the funds needed to support the plan
  • Forecast the funds available
  • Establish controls
  • Plan for other contingencies
  • Establish a performance based compensation plan

53
Applying the NPV Rule
  • Discount only Incremental Cash Flows
  • Incremental cash flows represent changes that are
    a result of the project under consideration
  • Be careful about Inflation
  • Do not double count inflation. If you price
    estimates and future cash flows include
    inflation, then the correct discount rate should
    be a REAL rate not the nominal rate.

54
A simple forecasting model
  • Assume that all variables are directly tied to
    sales If sales increases so do the other
    entries on the balance sheet and income statement
    (by the same )
  • As sales increase so do assets why?
  • (Assume total capacity utilization)

55
Simple Income Statement
Assume that sales increase by 25 over the next
year.
  • Sale 1,250
  • Costs 1,000
  • Net income 250
  • Sale 1,000
  • Costs 800
  • Net income 200

56
Simple Balance Sheet
The balance sheet would be impacted the same way
  • Assets 500 Debt 250
  • Equity 250
  • 500 500
  • Assets 625 Debt 312.5
  • Equity 312.5
  • 625 625

57
Percentage of Sales Approach
  • Two categories those that vary directly with
    sales and those that do not.
  • Income Statement
  • Costs remain a set of sales
  • Dividend Payout Assume it remains constant
  • Balance Sheet
  • Find of sales for LHS (assets)
  • On RHS find of sales for Accounts Payable, But
    not for financing choices L-T Debt or retained
    earnings or equity
  • Retained Earnings use dividend payout

58
Income Statement
  • Sales 1,250
  • Costs 1,000
  • Taxable income 250
  • Taxes 85
  • Net Income 165
  • Addition to Ret Earn
  • .6667(165) 110
  • Sales 1,000
  • Costs 800
  • Taxable income 200
  • Taxes 68
  • Net Income 132
  • Dividends 44
  • Addition to Ret E 88
  • RetRate88/13266.67

59
Balance Sheet
  • Assets
  • Current Assets 160 16
  • Accts Rec 440 44
  • Inventory 600 60
  • Total 1200 120
  • Fixed Assets 1800 180
  • Total Assets 3000 300
  • Liabilities
  • Current Liab 300 30
  • Notes Pay 500 na
  • Total 800 na
  • L-T debt 800 na
  • Ret Earn 1000 na
  • Total Liab 3000 300

60
Proforma Balance SheetSales increase by 25
  • Assets
  • Current Assets 200 16
  • Accts Rec 550 44
  • Inventory 750 60
  • Total 1500 120
  • Fixed Assets 2250 180
  • Total Assets 3750 300
  • Liabilities
  • Current Liab 375 30
  • Accts Pay 500 na
  • Total 875 na
  • LT Debt 800 na
  • Ret Earn 1110 na
  • Total Liab 2785 300

They do not balance! The difference is the
EFN EFN 3750 2785 965
61
External Financing Needed
  • Should be equal to Change in Assets Change in
    Liabilities
  • Represents the amount of cash that needs to be
    raised to finance the assets.

62
Forecasts
  • The forecasts for expected revenue and costs are
    based upon
  • Experience and History
  • Market testing
  • Scenario Analysis

63
Information Problems
  • For good investment decisions to take place
    management needs to have correct and reliable
    information.

64
Consistent Economic Forecasts
  • Consistent assumptions across divisions
  • If different managers make different assumptions
    about future economic activity it is difficult to
    compare their forecasts the assumptions may
    make one project appear better as opposed to the
    actual project
  • Therefore the capital budgeting process often
    starts with forecasts about macroeconomic
    variables that should be used by all managers.

65
Forecast Bias
  • Managers have incentive to be overly optimistic.
  • Management needs to avoid setting incentives in a
    way that promotes bias. For example, if
    divisions bid for limited resources. There is
    an agency cost, the divisional manager wants to
    secure the resources and has incentive to make
    their project look better.

66
Setting the Cost of Capital
  • Assume that top management sets the cost of
    capital for a particular division.
  • This can help the divisional managers make good
    decisions, but it also tells managers how
    optimistic they will need to be in their
    forecasts to make the project look acceptable.

67
Aligning Management Incentives with the Value of
the Firm
  • There are many Principal-Agent problems that can
    exist in the capital budgeting process.
  • Problems with Salary only Compensation
  • Reduced Effort
  • Perks
  • Empire Building
  • Entrenching Investment
  • Avoiding Risk

68
Avoiding Agency Costs
  • Monitoring can eliminate some of the problems
    associated with salary only compensation for
    example perks and empire building. However, it
    is more difficult to address the other problems
    such as entrenchment.
  • Monitoring is performed by many groups
  • Senior management
  • Shareholders
  • Auditors
  • Creditors

69
Avoiding Agency Costs
  • Compensation
  • Often compensation is tied to performance in the
    form of bonuses and options.
  • However this forces management to be tied in part
    to things out of their control such as
    macroeconomic conditions.
  • This can also increase some agency costs.
  • The final combination of compensation reflects a
    compromise between managers accepting some macro
    risks and shareholders accepting additional
    agency costs.

70
Compensation and Market Risks
  • The best case would be if managements
    compensation was tied to their decisions, but
    independent of macroeconomic fluctuations.
  • Should management compensation be tied to
    performance above a market average?
  • Yes and No Price reflects expectations, new
    outstanding manager results in increased stock
    price followed by average returns. Compensation
    would fail to reward the managers performance.

71
Other Issues
  • Dont ignore market values
  • Market values should represent a fair price
  • There is no reason to assume that your firm has
    an inside ability to calculate a different price
    of a commodity
  • Example future value of real estate.

72
Capital Budgeting Decision Rules
  • Balance between subjective assessment and
    consistency across projects
  • Reinforces the main goal of corporate finance
    Maximize the value of the firm
  • Be applicable to a wide range of possible
    investments.

73
Capital Budgeting Decision RulesAccounting
Returns
  • Return on Capital the return earned by the firm
    on its total investment
  • Accept the project if ROC gt Cost of Capital
  • More difficult for multiyear projects

74
Capital Budgeting Decision RulesAccounting
Returns
  • Return on Equity on the project
  • If ROE gt Cost of Equity Accept the project

75
Problems with Accounting Returns
  • Accounting choices cause the balance between
    subjective judgment and consistency to be called
    into question.
  • Based on Earnings (Net Income) so acceptance of
    a project may or may not add value to the firm
    (PV of expected future cash flows)
  • Works best for projects with large upfront costs
    (large capital invested)

76
Accounting returns for entire firm
  • Both ROE and ROC can provide good intuition about
    the overall quality of projects accepted by the
    firm. Both can be calculated for the aggregate
    firm using book value of equity and book value of
    capital.

77
Economic Value Added
  • A measure of the surplus value created by a
    firms projects.

78
EVA and ROE
79
Capital Budgeting Decision Rules
  • Payback Period and Discounted Payback
  • Net Present Value
  • Internal Rate of Return Modified IRR
  • Profitability Index and Modified Profitability
    index

80
Payback Period
  • Intuition Measures length of time it takes for
    the firm to payback the original investment.
  • Simple example
  • Cost 100,000 Cash Flow 20,000 a year
  • Payback Cost / Cash Flows
  • 100,000 / 20,000 5 years

81
Payback Period
  • Most problems do not work out even.
  • You need to look at the cumulative cash flow and
    compare to the initial cost.

82
Calculating Payback Period
  • Calculate the cumulative cash flow (total
    cash flow received)
  • Calculate the Remaining Cost
  • (Total Cost - Cumulative Cash Flow)
  • Repeat 1 and 2 until remaining cost is less
    than zero
  • In last positive year divide remaining cash
    flow by yearly cash flow in next year
  • Calculate total payback

83
Example Initial Cost 100,000
  • Yearly Cumulative Remaining
  • YR Cash Flow Cash Flow Cash Flow
  • 1 40,000 40,000 60,000
  • 2 30,000 70,000 30,000
  • 3 25,000 95,000 5,000
  • 4 20,000 115,000 -15,000
  • Payback 3 5,000/20,000 3.25

84
Payback Period Benefits
  • Easy to Understand and Interpret
  • Reject / Accept based on a Minimum payback
  • Provides measure of risk

85
Payback Period Weaknesses
  • Ignores Time Value of Money
  • Ignores all cash flows after the payback

86
Discounted Payback Period
  • Attempts to account for time value of money by
    evaluating the yearly cash flows in their present
    value.

87
Calculating Discounted Payback Period
  • Calculate the PV of each cash flow
  • Calculate the cumulative present value of the
    cash flows (total cash flow received)
  • Calculate the Remaining Cost
  • (Total Cost - Cumulative PV Cash Flow)
  • Repeat 1 2 until remaining cost is less than 0
  • In last positive year divide remaining cash
    flow by yearly cash flow in next year
  • Calculate total payback

88
Initial Cost100,000 r 10
  • Yearly PV Cumul Remaining
  • YR CF CF CF CF
  • 1 40,000 36,364 36,364 63,636
  • 2 30,000 24,793 61,157 38,843
  • 3 25,000 18,783 79,940 20,060
  • 4 20,000 13,660 93,600 6,400
  • 5 15,000 9,314 102,914 -2,914
  • Payback 4 6400/9314 4.687

89
Discounted Payback
  • Weakness Still ignores cash flows after payback
  • Strengths Accounts for time value of money, easy
    to understand and calculate, risk measure
  • Accept / Reject -- Set Minimum payback and compare

90
Net Present Value
  • The sum of the PV of the positive cash flows
    minus the PV of negative cash flows
  • or

91
Incremental Cash Flows
  • The cash flows used should represent any changes
    to Free Cash Flow that result from undertaking
    the project.

92
The Required Return
  • What interest rate should be used to discount the
    cash flows?
  • The project cost of capital

93
NPV Accept or Reject(The NPV Rule in Detail)
  • If the NPV is positive the PV of the benefits is
    greater than the PV of the cost -- You should
    accept the project (The value of the firm will
    increase if the project is accepted)
  • If the NPV is negative, The PV of the benefits is
    less than the PV of the cost -- You should reject
    the project (The value of the firm would decrease
    if the project is accepted)

94
NPV Example
  • Assume a cost of capital of 10 (the WACC)
  • Year Cash Flow Present Value
  • 0 -1,000 -1,000.00
  • 1 1,000 909.90
  • 2 -2,000 -1,652.89
  • 3 3,000 2,253.94
  • NPV 510.14

95
Calculator
  • HP 10B
  • -1,000 ltCFjgt
  • 1,000 ltCFjgt
  • -2,000 ltCFjgt
  • 3,000 ltCFjgt
  • 10 ltI/Ygt
  • ltNPVgt

96
NPV
  • Note, as in the case of our bond and stock
    valuation models there will be an inverse
    relationship between the required return and the
    NPV.
  • A lower WACC increases the NPV of the project
    (And the value of the firm)

97
Internal Rate of Return(The Rate of Return Rule
in detail)
  • The IRR is the required return that makes the NPV
    of a project equal to zero.
  • If IRR is greater than the hurdle rate (the cost
    of capital) Accept the project
  • IF IRR is less than the hurdle rate (the cost of
    capital) Reject the project

98
IRR and NPV
  • IRR and NPV will always provide the same accept /
    reject decision WHY????
  • IRR is the rate that makes NPV zero
  • If the (cost of capital) lt IRR accept the
    project, this also implies a positive NPV
  • If the (cost of capital) gt IRR reject the project
    , this also implies a negative NPV

99
IRR
  • Benefits
  • Intuitive
  • Measure of risk compared to Cost of Capital
  • Weaknesses
  • Ignores size and amount of wealth created
  • Ignores project life
  • It is possible to have multiple IRRs

100
Multiple IRRs
  • Time Cash Flow
  • 0 -100
  • 1 275 IRR 7.4 and 67.6
  • 2 -180
  • Time Cash Flow
  • 0 100
  • 1 -275 IRR 7.4 and 67.6
  • 2 180

101
Multiple IRRs vs. NPV
  • Time Cash Flow
  • 0 -100
  • 1 275 NPV _at_ 15 3
  • 2 -180
  • Time Cash Flow
  • 0 100
  • 1 -275 NPV _at_ 15 -3
  • 2 180

102
Multiple IRRs
  • An easy check for Multiple IRRs
  • Mathematically the largest number of IRRs that
    is possible equals the number of sign changes in
    the cash flow stream

103
Modified IRR
  • The discount rate that makes the PV of the
    projects costs equal the PV of the terminal value
    of the project
  • Terminal Value the FV of the positive Cash
    flows compounded at the cost of capital

104
Example Cost of Capital 10
  • Time Cash Flow PV FV
  • 0 -1000 -1000.00
  • 1 500 665.50
  • 2 400 484.00
  • 3 -150 -112.69
  • 4 500 500.00
  • -1,112.69 1,649.50
  • 1112.69 1649.50/(1MIRR)4
  • MIRR 10.34

105
Profitability Index
  • Measures the value created per dollar invested

106
PI
  • If the PI is greater than 1 accept the project
    (NPV is positive)
  • If the PI is less than 1 reject the project (NPV
    is negative)
  • If PI 1.45 it would imply that the project will
    produce 1.45 for each 1 invested.

107
Quick Review
  • Method Accept Reject
  • Payback Payback lt cutoff Paybackgtcutoff
  • Disc. Payback Same as Payback
  • NPV NPV gt 0 NPV lt 0
  • IRR IRR gt WACC IRR lt WACC
  • MIRR MIRR gtWACC MIRR lt WACC
  • PI PI gt 1 PI lt 1

108
Mutually Exclusive
  • NPV provides the best ranking when comparing
    between mutually exclusive investments, The rest
    can produce inconsistent rankings.

109
Example
  • Project Initial Cost YR1 CF YR2 CF
  • A 1,000,000 1,000,000 0
  • B 1,200,000 1,119,000 312,000
  • C 900,000 195,000 970,000
  • D 1,100,000 980,000 345,000
  • Compare the different methods for both 7 and
    12 (in Class)

110
Comparison of results
111
IRR vs. NPV revisited
  • Investment Cost YR 1 IRR
  • A 10,000 12,000 20
  • B 15,000 17,700 18
  • NPV_at_12 NPV_at_16
  • A 714 344.82
  • B 803.50 258.60
  • NPV_at_14 526.31579 for both

112
On the Graph
Asset B
526.32
Asset A
20
18
14
113
Summary
  • Use NPV as the first rule
  • The other criteria can provide secondary
    information
  • Which criteria is most often used by managers?

114
Identifying Good Projects
  • Creation of Barriers to competitors and their
    Maintaining the barriers
  • Economies of Scale
  • Cost Advantages
  • Capital Requirements
  • Product Differentiation
  • Access to Distribution Channels
  • Legal and Government Barriers

115
Putting it all together The Value of a Share
  • This definition includes value of equity and
    debt. If you subtract the value of debt (and
    preferred stock) you would have a measure of the
    Market Value of Equity or the Market Value of the
    claims of the shareholders

116
The Share Price
117
EVA and Share Price
  • The market value of the firm should represent the
    book value of the firm plus a claim on all future
    EVA created or

118
Economic Value Added
Market Value Added Present Value of Future EVA
Market Value Share Price x Shares Outstanding
Debt
Market Value Added
EVA
EVA
EVA
EVA
EVA
EVA
EVA
EVA
EVA
EVA
Capital
EVA NOPAT Capital Charge
EVA IS a trademark of Stern Stewart
119
Market Price
  • Can analysts forecast future EVA and FCF?
  • Information and market problem
  • Agency Problems
  • Short Term vs. Long Term (Bounded Self Control?)
  • Valuing Strategic Options
  • Other Problems

120
Identifying Good Projects
  • Creation of Barriers to competitors and their
    Maintaining the barriers
  • Economies of Scale
  • Cost Advantages
  • Capital Requirements
  • Product Differentiation
  • Access to Distribution Channels
  • Legal and Government Barriers
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