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Title: Measuring Investment Returns


1
Measuring Investment Returns
  • Aswath Damodaran

Stern School of Business
2
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.

3
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

4
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.

5
I. Estimating the Hurdle Rate for an Investment
  • 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

6
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 beta for online retailers (1.725) and
    InfoSofts debt ratio. We will use a much higher
    cost of debt for the project (7) than InfoSofts
    existing debt (6)
  • Cost of capital 14.49 (.9338) 7
    (1-.42)(.0662) 13.80

7
II. The 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.
  • 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
    analysis.

8
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.

9
The Margins at Existing Store
10
Projections for The Home Depots New Store
  • 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)

11
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.

12
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

13
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)

14
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

15
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.

16
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 each
    year.
  • 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.)

17
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.

18
Revenues By Year
19
Operating Expenses S,G A By Year
20
Depreciation and Amortization By Year
21
Earnings on Project
22
And the Accounting View of Return
23
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.

24
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

25
6 Application Test Assessing Investment Quality
  • For the most recent period for which you have
    data, compute the after-tax return on capital
    earned by your firm, where after-tax return on
    capital is computed to be
  • After-tax ROC EBIT (1-tax rate)/ (BV of debt
    BV of Equity)previous year
  • For the most recent period for which you have
    data, compute the return spread earned by your
    firm
  • Return Spread After-tax ROC - Cost of Capital
  • For the most recent period, compute the EVA
    earned by your firm
  • EVA Return Spread (BV of Debt BV of Equity)

26
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.

27
Estimating Cash Flows The Boeing Super Jumbo
28
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.

29
Depreciation Methods
  • Broadly categorizing, depreciation methods can be
    classified as straight line or accelerated
    methods. In straight line depreciation, the
    capital expense is spread evenly over time, In
    accelerated depreciation, the capital expense is
    depreciated more in earlier years and less in
    later years. Assume that you made a large
    investment this year, and that you are choosing
    between straight line and accelerated
    depreciation methods. Which will result in higher
    net income this year?
  • Straight Line Depreciation
  • Accelerated Depreciation
  • Which will result in higher cash flows this year?
  • Straight Line Depreciation
  • Accelerated Depreciation

30
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.

31
To cap ex or not to cap ex
  • Assume that you run your own software business,
    and that you have an expense this year of 100
    million from producing and distribution
    promotional CDs in software magazines. Your
    accountant tells you that you can expense this
    item or capitalize and depreciate. Which will
    have a more positive effect on income?
  • Expense it
  • Capitalize and Depreciate it
  • Which will have a more positive effect on cash
    flows?
  • Expense it
  • Capitalize and Depreciate it

32
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.
  • 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.

33
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.

34
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?

35
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?

36
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.

37
The Incremental Cash Flows Boeing Super Jumbo
38
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.

39
Present Value Mechanics
  • Cash Flow Type Discounting Formula Compounding
    Formula
  • 1. Simple CF CFn / (1r)n CF0 (1r)n
  • 2. Annuity
  • 3. Growing Annuity
  • 4. Perpetuity A/r
  • 5. Growing Perpetuity A(1g)/(r-g)

40
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

41
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..

42
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

43
Considering all of the Cashflows The NPV
44
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.

45
The IRR of this project
Internal Rate of Return
46
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.

47
Case 1 IRR versus NPV
  • Consider a project with the following cash flows
  • Year Cash Flow
  • 0 -1000
  • 1 800
  • 2 1000
  • 3 1300
  • 4 -2200

48
Projects NPV Profile
49
What do we do now?
  • This project has two internal rates of return.
    The first is 6.60, whereas the second is 36.55.
  • Why are there two internal rates of return on
    this project?
  • If your cost of capital is 12.32, would you
    accept or reject this project?
  • I would reject the project
  • I would accept this project
  • Explain.

50
Case 2 NPV versus IRR
Project A
350,000
450,000
600,000
Cash Flow
750,000
Investment
1,000,000
NPV 467,937
IRR 33.66
Project B
5,500,000
Cash Flow
4,500,000
3,000,000
3,500,000
Investment
10,000,000
NPV 1,358,664
IRR20.88
51
Which one would you pick?
  • Assume that you can pick only one of these two
    projects. Your choice will clearly vary depending
    upon whether you look at NPV or IRR. You have
    enough money currently on hand to take either.
    Which one would you pick?
  • Project A. It gives me the bigger bang for the
    buck and more margin for error.
  • Project B. It creates more dollar value in my
    business.
  • If you pick A, what would your biggest concern
    be?
  • If you pick B, what would your biggest concern
    be?

52
Capital Rationing, Uncertainty and Choosing a Rule
  • If a business has limited access to capital, has
    a stream of surplus value projects and faces more
    uncertainty in its project cash flows, 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, limited surplus value
    projects, and more certainty on its project cash
    flows, 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.

53
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 initial investment. This is
    called the profitability index.
  • Profitability Index (PI) NPV/Initial Investment
  • In the example described, the PI of the two
    projects would have been
  • PI of Project A 467,937/1,000,000 46.79
  • PI of Project B 1,358,664/10,000,000 13.59
  • Project A would have scored higher.

54
Case 3 NPV versus IRR
Project A
5,000,000
4,000,000
3,200,000
Cash Flow
3,000,000
Investment
10,000,000
NPV 1,191,712
IRR21.41
Project B
5,500,000
Cash Flow
4,500,000
3,000,000
3,500,000
Investment
10,000,000
NPV 1,358,664
IRR20.88
55
Why the difference?
  • These projects are of the same scale. Both the
    NPV and IRR use time-weighted cash flows. Yet,
    the rankings are different. Why?
  • Which one would you pick?
  • Project A. It gives me the bigger bang for the
    buck and more margin for error.
  • Project B. It creates more dollar value in my
    business.

56
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.
    Implicit is the assumption that the firm has an
    infinite stream of projects yielding similar
    IRRs.
  • 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.

57
Solution to Reinvestment Rate Problem
400
500
600
Cash Flow
300
Investment
lt 1000gt
600
500(1.15)
575
2
400(1.15)
529
3
300(1.15)
456
Terminal Value
2160
Internal Rate of Return 24.89
Modified Internal Rate of Return 21.23
58
Why NPV and IRR may differ..
  • A project can have only one NPV, whereas it can
    have more than one IRR.
  • The NPV is a dollar surplus value, whereas the
    IRR is a percentage measure of return. The NPV is
    therefore likely to be larger for large scale
    projects, while the IRR is higher for
    small-scale projects.
  • The NPV assumes that intermediate cash flows get
    reinvested at the hurdle rate, which is based
    upon what you can make on investments of
    comparable risk, while the IRR assumes that
    intermediate cash flows get reinvested at the
    IRR.

59
Case NPV and Project Life
Project A
400
400
400
400
400
-1000
NPV of Project A 442
Project B
350
350
350
350
350
350
350
350
350
350
-1500
NPV of Project B 478
Hurdle Rate for Both Projects 12
60
Choosing Between Mutually Exclusive Projects
  • The net present values of mutually exclusive
    projects with different lives cannot be compared,
    since there is a bias towards longer-life
    projects.
  • To do the comparison, we have to
  • replicate the projects till they have the same
    life (or)
  • convert the net present values into annuities

61
Solution 1 Project Replication
Project A Replicated
400
400
400
400
400
400
400
400
400
400
-1000
-1000 (Replication)
NPV of Project A replicated 693
Project B
350
350
350
350
350
350
350
350
350
350
-1500
NPV of Project B 478
62
Solution 2 Equivalent Annuities
  • Equivalent Annuity for 5-year project
  • 442 PV(A,12,5 years)
  • 122.62
  • Equivalent Annuity for 10-year project
  • 478 PV(A,12,10 years)
  • 84.60

63
What would you choose as your investment tool?
  • Given the advantages/disadvantages outlined for
    each of the different decision rules, which one
    would you choose to adopt?
  • Return on Investment (ROE, ROC)
  • Payback or Discounted Payback
  • Net Present Value
  • Internal Rate of Return
  • Profitability Index

64
What firms actually use ..
  • Decision Rule of Firms using as primary
    decision rule in
  • 1976 1986
  • IRR 53.6 49.0
  • Accounting Return 25.0 8.0
  • NPV 9.8 21.0
  • Payback Period 8.9 19.0
  • Profitability Index 2.7 3.0

65
Boeing 747 What about exchange rate risk?
  • A substantial portion of Boeings cash flows on
    the Super Jumbo will come from sales to foreign
    airlines. Assuming that the price is set in U.S.
    dollars, this exposes Boeing to exchange rate
    risk. Should there be a premium added on to the
    discount rate for exchange rate risk? (Should we
    use a cost of capital higher than 9.32?)
  • Yes
  • No

66
Should there be a risk premium for projects with
substantial foreign exposure?
  • The exchange rate risk may be diversifiable risk
    (and hence should not command a premium) if
  • the company has projects is a large number of
    countries (or)
  • the investors in the company are globally
    diversified.
  • For Boeing, it can be argued that this risk is
    diversifiable.
  • The same diversification argument can also be
    applied against political risk, which would mean
    that it too should not affect the discount rate.
    It may, however, affect the cash flows, by
    reducing the expected life or cash flows on the
    project.
  • For Boeing, this risk too is assumed to not
    affect the cost of capital. Any expenses
    associated with protecting against political risk
    (say, insurance costs) can be built into the cash
    flows.

67
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

68
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.

69
Interest and Principal Payments
70
Net Income on The Home Depot Store
71
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.

72
ROE on this Project
73
From Project ROE to Firm ROE
  • As with the earlier analysis, where we used
    return on capital and cost of capital to measure
    the overall quality of projects, we can compute
    return on equity and cost of equity to pass
    judgment on whether a firm is creating value to
    its equity investors.
  • Boeing Home Depot InfoSoft
  • Return on Equity 7.58 22.37 33.47
  • Cost of Equity 10.58 9.78 13.19
  • ROE - Cost of Equity -2.99 12.59 20.28

74
Additional Assumptions
  • Working capital is assumed to be 8 of revenues
    and the investment in working capital is at the
    beginning of each year. At the end of the project
    life, the working capital is fully salvaged.
  • At the end of the project life, the book value of
    the store is assumed to be equal to the salvage
    value.

75
An Incremental CF Analysis
76
NPV of the Store
77
Internal Rate of Return The Home Depot Store
78
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.

79
Viability of New Store Sensitivity to Operating
Margin
80
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.

81
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.

82
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.

83
The Home Depot Chile Store Cashflows in Pesos
84
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

85
NPV in Pesos
86
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

87
Analyzing the Project U.S. Dollars
88
NPV in U.S. Dollars
89
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

90
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

91
Nominal versus Real
92
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.

93
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.

94
Case 1 Opportunity Costs
  • Assume that Boeing owns the land that will be
    used to build the plant for the Super Jumbo Jet
    already. This land is undeveloped and was
    acquired several years ago for 40 million. The
    land currently can be sold for 100 million,
    though that would create a capital gain (which
    will be taxed at 20). In assessing the Boeing
    Super Jumbo, which of the following would you do
  • Ignore the cost of the land, since Boeing owns
    its already
  • Use the book value of the land, which is 40
    million
  • Use the market value of the land, which is 100
    million
  • Other

95
Case 2 Excess Capacity
  • In the Boeing example, assume that the firm will
    use its existing storage facilities, which have
    excess capacity, to hold inventory associated
    with the Super Jumbo. The project analyst argues
    that there is no cost associated with using these
    facilities, since they have been paid for already
    and cannot be sold or leased to a competitor (and
    thus has no competing current use). Do you agree?
  • Yes
  • No

96
Estimating the Cost of Excess Capacity
  • Existing Capacity 100,000 units
  • Current Usage 50,000 (50 of Capacity) 50
    Excess Capacity
  • New Product will use 30 of Capacity Sales
    growth at 5 a year CM per unit 5/unit
  • Book Value 1,000,000 Cost of a building new
    capacity 1,500,000 Cost of Capital 12
  • Current product sales growing at 10 a year. CM
    per unit 4/unit
  • Basic Framework
  • If I do not take this product, when will I run
    out of capacity?
  • If I take thisproject, when will I run out of
    capacity
  • When I run out of capacity, what will I do?
  • cut back on production cost is PV of after-tax
    cash flows from lost sales
  • buy new capacity cost is difference in PVbetween
    earlier later investment

97
Opportunity Cost of Excess Capacity
  • Year Old New Old New
    Lost ATCF PV(ATCF)
  • 1 50.00 30.00 80.00 0
  • 2 55.00 31.50 86.50 0
  • 3 60.50 33.08 93.58 0
  • 4 66.55 34.73 101.28 5,115 3,251
  • 5 73.21 36.47 109.67 38,681 21,949
  • 6 80.53 38.29 118.81 75,256 38,127
  • 7 88.58 40.20 128.78 115,124
    52,076
  • 8 97.44 42.21 139.65 158,595
    64,054
  • 9 107.18 44.32 151.50 206,000
    74,286
  • 10 117.90 46.54 164.44 257,760
    82,992
  • PV(LOST SALES) 336,734
  • PV (Building Capacity In Year 3 Instead Of Year
    8) 1,500,000/1.123 -1,500,000/1.128 461,846
  • Opportunity Cost of Excess Capacity 336,734

98
Product and Project Cannibalization
  • When a firm makes a new investment, some of the
    revenues may come from existing investments of
    the firm. This is referred to as cannibalization.
    Examples would be
  • A New Starbucks that is opening four blocks away
    from an existing Starbucks
  • A personal computer manufacturer like Apple or
    Dell introducing a new and more powerful PC
  • The key question to ask in this case is
  • What will happen if we do not make this new
    investment?
  • If the sales on existing products would have been
    lost anyway (to competitors), there is no
    incremental effect and the lost sales should not
    be considered.
  • If the sales on existing products would remain
    intact, the cannibalization is a real cost.

99
Product and Project Cannibalization A Real Cost?
  • Assume that in the Home Depot Store analysis, 20
    of the revenues at the store are expected to come
    from people who would have gone to a existing
    store nearby. In doing the analysis of the store,
    would you
  • Look at only incremental revenues (i.e. 80 of
    the total revenue)
  • Look at total revenues at the park
  • Choose an intermediate number
  • Would your answer be different if you were
    analyzing whether introducing the Boeing Super
    Jumbo would cost you sales on the Boeing 747?
  • Yes
  • No

100
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.

101
Other Investments
  • Firms often make investments in
  • Short term assets, such as inventory and accounts
    receivable.
  • Marketable securities, such as
  • Government securities (Treasury Bills, bonds)
  • Corporate bonds
  • Equities of other companies
  • The investment principle continues to apply to
    these investments. If they make a return that
    exceeds the hurdle rate (given their riskiness),
    they will create value. If not, they will destroy
    value.

102
I. Investments in Non-Cash Working Capital
  • The difference between current assets and current
    liabilities is often titled working capital by
    accountants.
  • We modify that definition to make it the
    difference between non-cash current assets and
    non-debt current liabilities and call it non-cash
    working capital.
  • We eliminate cash from current assets because
    large cash balances today earn a fair market
    return. Thus, they cannot be viewed as a wasting
    asset.
  • We eliminate debt from current liabilities
    because we consider debt to be part of our
    financing and include it in our cost of capital
    calculations.

103
Distinguishing between Working Capital and
Non-cash Working Capital
  • Boeing The Home Depot
  • Current Assets 16,375 4,933
  • Current Liabilities 13,422 2,857
  • Working Capital 2,953 2,076
  • Non-cash Current Assets
  • Inventory 8,349 4,293
  • Accounts Receivable 5,564 469
  • Non-cash Current Liabilities
  • Accounts Payables 10,733 1,586
  • Other Current Liabilities 1,820 1,257
  • Non-cash Working Capital 1,360 1,919

104
Why investments in non-cash working capital
matter..
  • Any investment in non-cash working capital can be
    viewed as cash that does not earn a return. Thus,
    any increases in non-cash working capital can be
    viewed as a cash outflow, while any decreases can
    be viewed as a cash inflow.
  • This affects
  • The analysis of investments, because the
    incremental cash flows on a project are after
    non-cash working capital cash flows.
  • Firm value, because the cash flows to a firm are
    also after non-cash working capital cash flows.

105
The Effect of Non-cash working capital on a
Project Boeing Super Jumbo
  • Boeing is assumed to invest 10 of its revenues
    in non-cash working capital at the beginning of
    each year on the Super Jumbo project.
  • At the end of the 25th year, we assume that the
    entire working capital investment is salvaged.
  • The cost of capital for the project is 9.32.

106
Present Value Effect of Working Capital
107
NPV of Boeing Super Jumbo and Working Capital as
of Revenues
108
Firm Value and Working Capital Investments
  • Investments in working capital drain cash flows,
    and other things remaining equal, reduce the
    value of the firm.
  • When firms reduce their investments in non-cash
    working capital (hold less inventory, grant less
    credit or use more supplier credit), they
  • Increase their cash flows, but
  • Potentially decrease revenues, cash flows and
    expected growth, because of lost sales they
    might also make themselves riskier firms.

109
Working Capital and Value A Simple Example
  • A mail-order retail firm has current revenues of
    1 billion and operating profits after taxes of
    100 million.
  • If the firm maintains no working capital, its
    operating profits after taxes are expected to
    grow 3 a year forever and the firm will have a
    cost of capital of 12.50.
  • As the working capital increases as a percent of
    revenues, the expected growth in operating
    profits will increase, at a decreasing rate, and
    the cost of capital will decrease by .05 for
    every 10 increase in working capital as a
    percent of revenues.

110
Firm Value Schedule as a function of Working
Capital
111
The Trade Off on Elements of Working Capital
  • Effect of Increasing Element
  • Element Positive Aspects Negative Aspects
  • Inventory Fewer lost sales Storage Costs
  • Lower re-ordering costs Cash tied up in
    inventory
  • Accounts More Revenues Bad Debts (Default)
  • Receivable Cash tied up in receivables
  • Accounts Used to finance Increased credit risk
  • Payable inventory accounts Implicit Cost (if
    there is a
  • receivable discount for prompt payment)

112
Managing Inventory
  • Economic Order Quantity Models For firms with a
    homogeneous products and clearly defined ordering
    and storage costs, the optimal level of inventory
    can be estimated simply by trading off the two
    costs.
  • Peer Group Analysis Firms can compare their
    inventory holdings to those of comparable firms
    in the sector to see if they are holding too much
    in inventory.

113
Inventory Trade Off
  • For firms with a single product that knows what
    the demand for its product is with certainty, the
    optimal level of inventory can be estimated by
    trading off the carrying costs against the
    ordering costs. The optimal amount that the firm
    should order can be written as
  • Economic Order Quantity
  • If there is uncertainty about future demand, the
    inventory will have to be augmented by a safety
    inventory that will cover excess demand.

114
A Simple Example
  • A new car dealer reports the following
  • The annual expected sales, in units, is 1200
    cars there is some uncertainty associated with
    this forecast, and monthly sales are normally
    distributed with a mean of 100 cars and a
    standard deviation of 15 cars.
  • The cost per order is 10,000, and it takes 15
    days for new cars to be delivered by the
    manufacturer.
  • The carrying cost per car, on an annualized
    basis, is 1,000.
  • The Economic order quantity for this firm can be
    estimated as follows
  • Economic Order Quantity
    155 cars
  • Safety Inventory Assuming that the firm wants to
    ensure, with 99 probability, that it does not
    run out of inventory, the safety inventory would
    have to be increased by 30 cars (which is twice
    the standard deviation).
  • Delivery Lag .5(Monthly Sales) .5(100) 50
    cars
  • Safety Inventory Delivery Lag Uncertainty
    50 30 80 cars

115
Inventory in an EOQ Model
116
Peer Group Analysis
  • Company Name Inventory/Sales ln(Revenues) s
    Operating Earnings
  • Building Materials 10.74 6.59
    35.82
  • Catalina Lighting 17.46 5.09
    52.76
  • Cont'l Materials Corp 14.58 4.59
    25.15
  • Eagle Hardware 20.88 6.88 45.50
  • Emco Limited 16.50 7.14 39.68
  • Fastenal Co. 19.96 5.99 43.41
  • Home Depot 14.91 10.09 24.15
  • HomeBase Inc. 21.27 7.30 36.93
  • Hughes Supply 18.43 7.54 35.90
  • Lowe's Cos. 16.91 9.22 33.72
  • National Home Centers 12.72 5.02
    70.93
  • Waxman Industries. Inc. 24.76 4.66
    112.57
  • Westburne Inc. 14.79 7.76 25.14
  • Wolohan Lumber 9.24 6.05 24.56
  • Average 16.65 43.30

117
Analyzing The Home Depots Inventory
  • Inventory at the Home Depot is 14.91 of sales,
    while the average for the sector is slightly
    higher at 16.65. However, The Home Depot is
    larger and less risky than the average firm in
    the sector, which would lead us to expect a lower
    inventory holding at the firm.
  • We regressed inventory as a percent of sales
    against firm size (measured as ln(Revenues)) and
    risk (measured using standard deviation in
    operating earnings) for this sector
  • Inventory/Sales 0.056 .0082 ln(Revenues)
    0.1283 (Standard Deviation)
  • (0.87) (1.11) (2.51)
  • Plugging in the values of each of these variables
    for the Home Depot yields a predicted
    inventory/sales ratio
  • Inventory/SalesHome Depot 0.056 .0082 (10.09)
    .1283 (.2415) 0.1697
  • The actual inventory/sales ratio of 14.91 is
    slightly lower than this predicted value.

118
Managing Accounts Receivable
  • Cash Flow Analysis Compare the present value of
    the cash flows (from higher sales) that will be
    generated from easier credit to the present value
    of the costs (higher bad debts, more cash tied up
    in accounts receivable)
  • Peer Group Analysis Compare the accounts
    receivable as a percent of revenues at a firm to
    the same ratio at other firms in the business.

119
Cash Flow Analysis A Simple Example
  • Stereo City, an electronics retailer, has
    historically not extended credit to its customers
    and has accepted only cash payments. In the
    current year, it had revenues of 10 million and
    pre-tax operating income of 2 million. If
    Stereo City offers 30-day credit to its
    customers, it expects these changes to occur
  • Sales are expected to increase by 1 million
    each year, with the pre-tax operating margin
    remaining at 20 on these incremental sales.
  • The store expects to charge an annualized
    interest rate of 12 on these credit sales.
  • The bad debts (including the collection costs and
    net of any repossessions) are expected to be 5
    of the credit sales.
  • The cost of administration associated with credit
    sales is expected to be 25,000 a year, along
    with an initial investment in a computerized
    credit-tracking system of 100,000. The
    computerized system will be depreciated straight
    line over 10 years.
  • The tax rate is 40.
  • The store is expected to be in business for 10
    years at the end of that period, it is expected
    that 95 of the accounts receivable will be
    collected (and salvaged)
  • The store is expected to face a cost of capital
    of 10.

120
The Cash Flows Investment in System
  • The initial investment needed to generate the
    credit consists of two outlays.
  • The first is the cost of the computerized system
    needed for the credit sales, which is 100,000.
  • The second is the investment of 1 million in
    accounts receivable created as a consequence of
    the credit sales.

121
Incremental After-tax Cash Flows
  • Incremental Revenues 1,000,000
  • Incremental Pre-tax Operating Income (20)
    200,000
  • Interest Income from Credit 114,000
  • - Bad Debts 50,000
  • - Annual Administrative Costs 25,000
  • Incremental Pre-tax Operating Profit 239,000
  • - Taxes (at 40) 95,600
  • Incremental After-tax Operating Profit 143,400
  • Tax Benefit from Depreciation 4,000 10,000
    0.4
  • Incremental After-tax Cash Flow 147,400

122
NPV of Credit Decision
  • The salvage value comes from the collection of
    outstanding accounts receivable at the end of the
    stores life, which amounts to 95 of 1 million.
  • We can find the present value of the credit
    decision, using the cost of capital of 10
  • NPV of Credit Decision - 1,100,000 147,400
    (PV of Annuity, 10 years, 10) 950,000/1.1010
    171,975

123
Investments In Marketable Securities
  • Firms often invest in marketable securities.
    These marketable securities can range from
    short-term government securities (with no default
    or price risk) to equity in other firms (which
    can have substantial risk)

Risky
Riskless
Treasuries
Commercial Paper
Equity in Publicly Traded firms
Equity in Private Businesses
Corporate Bonds
124
Investments in Riskless Securities
  • Investments in riskless securities will generally
    earn much lower returns than investments in risky
    projects.
  • These low returns notwithstanding, investments in
    riskless securities are value neutral because the
    required return (hurdle rate) for these projects
    is the riskless rate.

125
Investments in Risky Securities
  • Risky securities can range from securities with
    default risk (corporate bonds) to securities with
    equity risk (equity in other companies)
  • The investment principle continues to apply. If
    the expected return on these investments is equal
    to the required return, these investments are
    value neutral.
  • If securities are fairly priced, investments in
    the marketable securities are value neutral.
  • If securities are under priced, investments in
    marketable securities can create value (have
    positive net present value)
  • If securities are over valued, investments in
    marketable securities are value destroying.

126
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.

127
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 t
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