MBAMFM 253 Measuring Return on Investment

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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

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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.

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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

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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

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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)

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The Project Continuum
Mutually Exclusive
Prerequisite
Complementary
Independent
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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.

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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.

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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?

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Acceptance Region
Return
12.0
A
10.5
Rejection Region
10.0
9.5
B
8.0
Risk
RiskL
RiskA
RiskH
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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

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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.

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Cost of Debt - Summary
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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.

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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.

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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

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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.

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Why Cash Flows?

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

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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

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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

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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

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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

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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

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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.

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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)

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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.

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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

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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)

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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

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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

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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.

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Special Problems

• Sunk Costs
• Externalities
• Opportunity Costs
• Shipping and Installation costs

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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?

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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.

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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

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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

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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.

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Shipping and Installation Cost

• Included as part of the original cost of the
  project

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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

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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.

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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).

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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.

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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.

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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

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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.

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Financial Planning

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

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Goals of the Plan

• Examining Interactions
• Exploring Options
• Avoiding Surprises
• Evaluating Feasibility

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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

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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)

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Main Issues

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

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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

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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.

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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)

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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

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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

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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

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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

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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

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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
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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.

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Forecasts

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

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Information Problems

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

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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.

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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.

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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.

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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

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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

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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.

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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.

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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.

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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.

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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

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Capital Budgeting Decision RulesAccounting
Returns

• Return on Equity on the project
• If ROE gt Cost of Equity Accept the project

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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)

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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.

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Economic Value Added

• A measure of the surplus value created by a
  firms projects.

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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

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Payback Period

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

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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

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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

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Payback Period Benefits

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

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Payback Period Weaknesses

• Ignores Time Value of Money
• Ignores all cash flows after the payback

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Discounted Payback Period

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

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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

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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

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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

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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