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Measuring return on investments


Acceptable projects are those that yield a return greater than the minimum ... working capital investments need to be salvaged at the end of the project life. ... – PowerPoint PPT presentation

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Title: Measuring return on investments

Measuring return on investments
  • 04/28/08
  • Ch. 5

Investment decision revisited
  • Acceptable projects are those that yield a return
    greater than the minimum acceptable hurdle rate
    with adjustments for project riskiness.
  • We know now how to calculate the acceptable
    hurdle rate (cost of capital)
  • Here we will understand how to evaluate projects.
    The focus will be on extending what you have
    learned in previous courses.

Project definition
  • Project any proposal that will result in the
    use of a firms resources
  • extension of business, acquisitions, new lines,
  • The risks (to equity holders and debt holders)
    for projects should be determined by
    project-specific characteristics
  • Project cash flows are defined by
  • Length of project,
  • Initial and subsequent investments required, and
  • Cash inflows generated by the project

Why not use firms cost of equity or capital to
evaluate all projects?
  • Ex., Ford has a cost of capital of 10 and is
    considering entering the software development
    industry. The rate of return it expects to earn
    on projects it undertakes is 13. Should these
    projects be accepted?

Estimating project cost of equity
  • Single line business, homogenous projects
  • Firm operates just one line of business and the
    projects adopted by the firm have the same level
    of risk
  • Use firms beta (from a regression or bottom-up
    approach) to determine cost of equity
  • The advantage of this approach is that it does
    not require risk estimation prior to each project

Estimating project cost of equity
  • Multiple line business, homogeneous projects
    within each line OR new line
  • In this case, the risk profile of the business is
    different across its business lines (new line)
    but adopted projects within a particular line
    have similar risk
  • We must determine a separate cost of equity for
    the business line in which the project is
  • Use bottom-up approach (pure-play approach) to
    estimating beta

Estimating project cost of debt
  • Assessing default risk (and thus the cost of
    debt) for individual projects is usually very
    difficult as projects seldom borrow on their own.
  • The method used to determine the appropriate cost
    of debt and the financing mix to be used to
    evaluate the project is based on
  • Size of project relative to the firm
  • Cash flow characteristics of the project
  • Whether the project is a stand-alone project

Project cost of debt / financing mix
Project characteristics Cost of Debt Debt Ratio
Small/CFs are similar to firms CFs Firms cost of debt Firms debt ratio
Large/ CFs are different from firms CFs Comparable firm cost of debt Average debt ratio of comparable firms OR firms debt ratio
Stand-alone projects Cost of debt for project (can be based on synthetic ratings) Debt ratio for project
Projects that raise their own funds
Project cost of capital
  • Estimate an appropriate cost of equity
  • Estimate an appropriate cost of debt
  • Calculate the weighted average cost of capital
    based on your estimates and an appropriate debt
    and equity mix

Accounting for project risk
  • Adjust the cost of capital
  • Adjust cash flows in practice this is primarily
    done subjectively
  • Problems with the latter approach
  • Adjustment can vary depending on who is doing the
  • Risks that are diversifiable may be adjusted for
  • There may be double adjustment of risks if the
    cost of capital is also adjusted.
  • Risk adjustment techniques used
  • Subjective adjustment - 48
  • Cost of capital adjustment 29
  • No adjustment 14

Project cash flows estimation
  • Estimating project cash flows requires
  • Estimating project revenues
  • Allocating appropriate expenses
  • Converting these projections into incremental
    cash flows
  • We need to understand the differences between
  • Accounting earnings and cash flows, and
  • cash flows and incremental cash flows.

Accounting earnings vs. cash flows
  • Accrual accounting requires the recognition of
    expenses during the period in which the related
    revenue is recognized. Cash flows may not
  • Capital expenditures are treated as if generated
    over multiple periods and expensed (depreciation
    or amortization) rather than subtracted from
    revenues when the occur.
  • Because of accrual accounting and capital
    expenditure accounting, accounting earnings can
    differ significantly from cash flows.

Accounting earnings vs. cash flows
  • To go from accounting earnings (EBIT) to cash
    flows, we must adjust for
  • Non-cash expenses, such as depreciation and
  • Capital expenditures, and
  • working capital investment

Working capital investment
  • 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.
  • Investments in working capital are thus cash
  • Any increase in working capital reduces cash
    flows in that year
  • Any decrease in working capital increases cash
    flows in that year
  • To provide closure, working capital investments
    need to be salvaged at the end of the project

Cash flows vs. incremental cash flows
  • The appropriate cash flows to consider in
    evaluating whether a project makes a firm more
    valuable is the incremental cash flows generated
    by the project.
  • This can differ from total cash flows for three
  • Sunk costs
  • Opportunity costs
  • Allocated costs that the firm would incur even if
    the project was not accepted.

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 not 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

Opportunity costs
  • Opportunity costs are cash flows that could be
    realized from the best alternative use of the
  • When analyzing a project, opportunity costs
    should be considered since they represent cash
    flows that the firm would have generated if the
    project is not accepted, but are lost if the
    project is accepted.

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

Project revenue estimation process
  • 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.
  • Ex., Home Depot Expo Stores
  • Scenario Analysis If the investment can be
    affected be a few external factors, the revenues
    and earnings can be analyzed across a series of
    scenarios and the expected values used in the

Scenario analysis
  • Scenario analysis is made up of four components
  • Factors that determine the success of the project
  • Analysis should focus on two or three of the most
    critical factors
  • Number of scenarios to be considered
  • Three scenarios for each factor (best, average
    and worst-case) tend to most useful
  • Estimation of project revenues and/or expenses
    under each scenario
  • Assigning probabilities to each scenario

From forecasts to operating income (EBIT)
  • Calculate/estimate the appropriate expenses
    associated with the estimated revenues
  • Separate projected expenses into operating and
    capital expenses.
  • Operating expenses are designed to generate
    benefits in the current period, while capital
    expenses generate benefits over multiple periods
  • Depreciate or amortize the capital expenses over
  • Allocate fixed expenses that cannot be traced to
    specific projects.

From forecasts to operating income (EBIT)
  • Operating income (EBIT) measures the income
    earned on all the capital invested in a project
    and is calculated as
  • EBITRev Cost of Goods Sold SGA Expenses
    Other allocated expenses - Depr.Amort.

From accounting income to cash flows
  • To get from EBIT to cash flows
  • add back non-cash expenses (like depreciation and
  • subtract out cash outflows which are not expensed
    (such as capital expenditures)
  • Include investment in working capital.
  • Cash flow to firm EBIT(1-t) Depr.Amort.
    Chg in WC Cap Exp.

Investment decision revisited
  • Acceptable projects are those that yield a return
    greater than the minimum acceptable hurdle rate
    with adjustments for project riskiness.
  • We know now how to calculate the acceptable
    hurdle rate (cost of capital), and relevant
    project cash flows.
  • The final step in the process is to evaluate the
    project. This entails understanding and applying
    the appropriate investment decision tools. We
    must also understand their benefits and

Accounting income-based investment decision rules
  • These include Return on Capital and Return on
  • Problems with these measures
  • Changing depreciation methods may result in
    different decisions
  • Ignores the time value of money
  • Accounting earnings are easier to manipulate
  • Note You can assess the collective quality of a
    firms investments by measuring firm ROC as
  • ROC EBIT(1-t) / (BV of equity BV of debt)

Discounted cash flow measures of return
  • Discounted cash flow measures of return address
    the problems with accounting returns.
  • The most widely used measures are Net Present
    Value (NPV) and Internal Rate of Return (IRR).

Discounted cash flow measures of return
  • Net Present Value (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

Discounted cash flow measures of return
  • Attractive properties of NPV
  • NPVs are additive
  • value of the firm is the NPV of all projects
    adopted by the firm
  • The additional value to the firm of divestitures
    and acquisitions can be calculated as Price
    expected NPV
  • Intermediate CFs are reinvested at the hurdle
  • NPV calculations allow for changes in interest
    rates and hurdle rates

Discounted cash flow measures of return
  • Why is NPV not used exclusively?
  • Managers are more comfortable talking about
    percentage returns than absolute returns
  • Capital rationing, the inability of firms to
    invest in all positive NPV projects,
    necessitates managers choosing the projects that
    add most value to the firm

Discounted cash flow measures of return
  • 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
  • Where the hurdle rate is the cost of capital if
    cash flow is cash flow to the firm, and cost of
    equity if cash flow is to equity investors

Discounted cash flow measures of return
  • The multiple IRR problem
  • The number of IRRs equals the number of sign
    changes in cash flows
  • Therefore, if the sign of cash flows changes more
    than once during the life of the project,
    multiple IRRs will result

Discounted cash flow measures of return
  • NPV and IRR generally result in the same decision
    about projects.
  • However, when the projects are mutually
    exclusive, differences can arise
  • Differences in scale
  • Capital rationing may be a factor
  • Difference in reinvestment rate assumption

Capital rationing and choosing a rule
  • If a business has limited access to capital and
    has a stream of surplus value projects, it is
    much more likely to use IRR as its decision rule.
  • Small, high-growth companies and private
    businesses are much more likely to use IRR.
  • If a business has substantial funds on hand,
    access to capital and limited surplus value
    projects, it is much more likely to use NPV as
    its decision rule.
  • As firms go public and grow, they are much more
    likely to gain from using NPV.

The sources of capital rationing
An alternative to IRR with capital rationing
  • The problem with the NPV rule, when there is
    capital rationing, is that it is a dollar value.
    It measures success in absolute terms.
  • The NPV can be converted into a relative measure
    by dividing by the investment required in the
    project. This is called the profitability index
  • Decision rule If PI gt 1, the project is

NPV, IRR and the reinvestment rate assumption
  • The NPV rule assumes that intermediate cash flows
    on the project get reinvested at the hurdle rate
    (which is based upon what projects of comparable
    risk should earn).
  • The IRR rule assumes that intermediate cash flows
    on the project get reinvested at the IRR.
  • Conclusion When the IRR is high (the project is
    creating significant surplus value) and the
    project life is long, the IRR will overstate the
    true return on the project.

Solution to the reinvestment rate problem
Modified IRR
  • The modified IRR (MIRR) calculates a projects
    rate of return assuming that intermediate cash
    flows get reinvested at the hurdle rate.
  • The MIRR is calculated as follows
  • Calculate the terminal value, which is the future
    value of cash flows after initial investment
    compounded at the hurdle rate
  • Calculate the MIRR assuming the terminal value
    equals the future value and initial investment
    equals the present value
  • Decision Rule Accept if MIRR gt hurdle rate

What firms actually use ..
  • Decision Rule of Firms using as primary
    decision rule in
  • 1976 1986 2000
  • IRR 53.6 49.0 47.0
  • Accounting Return 25.0 8.0 8.1
  • NPV 9.8 21.0 23.3
  • PI 2.7 3.0 6.0
  • Payback Period 8.9 19.0 15.0

How to exploit good projects
  • We now know how to measure whether a project is
    worthwhile it is if it generates excess
  • However, in a competitive market we would expect
    these excess returns would dissipate over time
    unless there are barriers to new or existing
    competitors to generate the same project.

How to exploit good projects
  • Maintaining barriers..
  • Invest in projects that exploit economies of
  • Establish cost advantages
  • Product differentiation
  • Access to distribution channels
  • Develop legal barriers (such as patents)