Loading...

PPT – Measuring Investment Returns PowerPoint presentation | free to download - id: 422fd3-ZDA0N

The Adobe Flash plugin is needed to view this content

Measuring Investment Returns

- Aswath Damodaran

Stern School of Business

First Principles

- Invest in projects that yield a return greater

than the minimum acceptable hurdle rate. - The hurdle rate should be higher for riskier

projects and reflect the financing mix used -

owners funds (equity) or borrowed money (debt) - Returns on projects should be measured based on

cash flows generated and the timing of these cash

flows they should also consider both positive

and negative side effects of these projects. - Choose a financing mix that minimizes the hurdle

rate and matches the assets being financed. - If there are not enough investments that earn the

hurdle rate, return the cash to stockholders. - The form of returns - dividends and stock

buybacks - will depend upon the stockholders

characteristics.

Measuring Returns Right The Basic Principles

- Use cash flows rather than earnings. You cannot

spend earnings. - Use incremental cash flows relating to the

investment decision, i.e., cashflows that occur

as a consequence of the decision, rather than

total cash flows. - Use time weighted returns, i.e., value cash

flows that occur earlier more than cash flows

that occur later. - The Return Mantra Time-weighted, Incremental

Cash Flow Return

Steps in Investment Analysis

- Estimate a hurdle rate for the project, based

upon the riskiness of the investment - Estimate revenues and accounting earnings on the

investment. - Measure the accounting return to see if the

investment measures up to the hurdle rate. - Convert accounting earnings into cash flows
- Use the cash flows to evaluate whether the

investment is a good investment. - Time weight the cash flows
- Use the time-weighted cash flows to evaluate

whether the investment is a good investment.

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

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

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.

The Home Depots New Store Experience and History

- The Home Depot has 700 stores in existence, at

difference stages in their life cycles, yielding

valuable information on how much revenue can be

expected at each store and expected margins. - At the end of 1999, for instance, each existing

store had revenues of 44 million, with revenues

starting at about 40 million in the first year

of a stores life, climbing until year 5 and then

declining until year 10.

The Margins at Existing Store

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)

Scenario Analysis Boeing Super Jumbo

- We consider two factors
- Actions of Airbus (the competition) Produces new

large capacity plane to match Boeings new jet,

Improves its existing large capacity plane

(A-300) or abandons this market entirely. - Much of the growth from this market will come

from whether Asia. We look at a high growth,

average growth and low growth scenario. - In each scenario,
- We estimate the number of planes that Boeing will

sell under each scenario. - We estimate the probability of each scenario.

Scenario Analysis

- The following table lists the number of planes

that Boeing will sell under each scenario, with

the probabilities listed below each number. - Airbus New Airbus A-300 Airbus abandons

large plane large airplane - High Growth in Asia 120 150 200
- (0.125) (0.125) (0.00)
- Average Growth in Asia 100 135 160
- (0.15) (0.25) (0.10)
- Low Growth in Asia 75 110 120
- (0.05) (0.10) (0.10)
- Expected Value 1200.125150.1252000100.15

135.25 - 160.10 75.05110.1012010 125 planes

III. Measures of return Accounting Earnings

- Principles Governing Accounting Earnings

Measurement - Accrual Accounting Show revenues when products

and services are sold or provided, not when they

are paid for. Show expenses associated with these

revenues rather than cash expenses. - Operating versus Capital Expenditures Only

expenses associated with creating revenues in the

current period should be treated as operating

expenses. Expenses that create benefits over

several periods are written off over multiple

periods (as depreciation or amortization)

From Forecasts to Accounting Earnings

- Separate projected expenses into operating and

capital expenses Operating expenses, in

accounting, are expenses designed to generate

benefits only in the current period, while

capital expenses generate benefits over multiple

periods. - Depreciate or amortize the capital expenses over

time Once expenses have been categorized as

capital expenses, they have to be depreciated or

amortized over time. - Allocate fixed expenses that cannot be traced to

specific projects Expenses that are not directly

traceable to a project get allocated to projects,

based upon a measure such as revenues generated

by the project projects that are expected to

make more revenues will have proportionately more

of the expense allocated to them. - Consider the tax effect Consider the tax

liability that would be created by the operating

income we have estimated

Boeing Super Jumbo Jet Investment Assumptions

- Boeing has already spent 2.5 billion in

research expenditures, developing the Super

Jumbo. (These expenses have been capitalized) - If Boeing decides to proceed with the commercial

introduction of the new plane, the firm will have

to spend an additional 5.5 billion building a

new plant and equipping it for production. - Year Investment Needed
- Now 500 million
- 1 1,000 million
- 2 1,500 million
- 3 1,500 million
- 4 1,000 million
- After year 4, there will be a capital maintenance

expenditure required of 250 million each year

from years 5 through 15.

Operating Assumptions

- The sale and delivery of the planes is expected

to begin in the fifth year, when 50 planes will

be sold. For the next 15 years (from year 6-20),

Boeing expects to sell 125 planes a year. In the

last five years of the project (from year 21-25),

the sales are expected to decline to 100 planes a

year. While the planes delivered in year 5 will

be priced at 200 million each, this price is

expected to grow at the same rate as inflation

(which is assumed to be 3) each year after that. - Based upon past experience, Boeing anticipates

that its cost of production, not including

depreciation or General, Sales and Administrative

(GSA) expenses, will be 90 of the revenue 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.)

Other Assumptions

- The project is expected to have a useful life of

25 years. - The corporate tax rate is 35.
- Boeing uses a variant of double-declining balance

depreciation to estimate the depreciation each

year. Based upon a typical depreciable life of 20

years, the depreciation is computed to be 10 of

the book value of the assets (other than working

capital) at the end of the previous year. We

begin depreciating the capital investment

immediately, rather than waiting for the revenues

to commence in year 5.

Revenues By Year

Operating Expenses S,G A By Year

Depreciation and Amortization By Year

Earnings on Project

And the Accounting View of Return

Would lead use to conclude that...

- Invest in the Super Jumbo Jet The return on

capital of 12.75 is greater than the cost of

capital for aerospace of 9.32 This would

suggest that the project should not be taken.

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

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)

IV. From Earnings to Cash Flows

- To get from accounting earnings to cash flows
- you have to add back non-cash expenses (like

depreciation and amortization) - you have to subtract out cash outflows which are

not expensed (such as capital expenditures) - you have to make accrual revenues and expenses

into cash revenues and expenses (by considering

changes in working capital). - For the Boeing Super Jumbo, we will assume that
- The depreciation used for operating expense

purposes is also the tax depreciation. - Working capital will be 10 of revenues, and the

investment has to be made at the beginning of

each year.

Estimating Cash Flows The Boeing Super Jumbo

The Depreciation Tax Benefit

- While depreciation reduces taxable income and

taxes, it does not reduce the cash flows. - The benefit of depreciation is therefore the tax

benefit. In general, the tax benefit from

depreciation can be written as - Tax Benefit Depreciation Tax Rate
- For example, in year 2, the tax benefit from

depreciation to Boeing from this project can be

written as - Tax Benefit in year 2 217 million (.35)

76 million - Proposition 1 The tax benefit from depreciation

and other non-cash charges is greater, the higher

your tax rate. - Proposition 2 Non-cash charges that are not tax

deductible (such as amortization of goodwill) and

thus provide no tax benefits have no effect on

cash flows.

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

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.

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

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.

V. From Cash Flows to Incremental Cash Flows

- The incremental cash flows of a project are the

difference between the cash flows that the firm

would have had, if it accepts the investment, and

the cash flows that the firm would have had, if

it does not accept the investment. - The Key Questions to determine whether a cash

flow is incremental - What will happen to this cash flow item if I

accept the investment? - What will happen to this cash flow item if I do

not accept the investment? - If the cash flow will occur whether you take this

investment or reject it, it is not an incremental

cash flow.

Sunk Costs

- Any expenditure that has already been incurred,

and cannot be recovered (even if a project is

rejected) is called a sunk cost - When analyzing a project, sunk costs should not

be considered since they are incremental - By this definition, market testing expenses and

RD expenses are both likely to be sunk costs

before the projects that are based upon them are

analyzed. If sunk costs are not considered in

project analysis, how can a firm ensure that

these costs are covered?

Allocated Costs

- Firms allocate costs to individual projects from

a centralized pool (such as general and

administrative expenses) based upon some

characteristic of the project (sales is a common

choice) - For large firms, these allocated costs can result

in the rejection of projects - To the degree that these costs are not

incremental (and would exist anyway), this makes

the firm worse off. - Thus, it is only the incremental component of

allocated costs that should show up in project

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

how much of the costs are fixed and how much are

variable?

Boeing Super Jumbo Jet

- The 2.5 billion already expended on the jet is a

sunk cost, as is the amortization related that

expense. (Boeing has spent the first, and it is

entitled to the latter even if the investment is

rejected) - Two-thirds of the S,GA expenses are fixed

expenses and would exist even if this project is

not accepted.

The Incremental Cash Flows Boeing Super Jumbo

VI. To Time-Weighted Cash Flows

- Incremental cash flows in the earlier years are

worth more than incremental cash flows in later

years. - In fact, cash flows across time cannot be added

up. They have to be brought to the same point in

time before aggregation. - This process of moving cash flows through time is
- discounting, when future cash flows are brought

to the present - compounding, when present cash flows are taken to

the future - The discount rate is the mechanism that

determines how cash flows across time will be

weighted.

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)

Discounted cash flow measures of return

- Net Present Value (NPV) The net present value is

the sum of the present values of all cash flows

from the project (including initial investment). - NPV Sum of the present values of all cash flows

on the project, including the initial investment,

with the cash flows being discounted at the

appropriate hurdle rate (cost of capital, if cash

flow is cash flow to the firm, and cost of

equity, if cash flow is to equity investors) - Decision Rule Accept if NPV gt 0
- Internal Rate of Return (IRR) The internal rate

of return is the discount rate that sets the net

present value equal to zero. It is the percentage

rate of return, based upon incremental

time-weighted cash flows. - Decision Rule Accept if IRR gt hurdle rate

Closure on Cash Flows

- In a project with a finite and short life, you

would need to compute a salvage value, which is

the expected proceeds from selling all of the

investment in the project at the end of the

project life. It is usually set equal to book

value of fixed assets and working capital - In a project with an infinite or very long life,

we compute cash flows for a reasonable period,

and then compute a terminal value for this

project, which is the present value of all cash

flows that occur after the estimation period

ends..

Salvage Value on Boeing Super Jumbo

- We will assume that the salvage value for this

investment at the end of year 25 will be the book

value of the investment. - Book value of capital investments at end of year

25 1,104 million - Book value of working capital investments yr 25

3,612 million - Salvage Value at end of year 25 4,716 million

Considering all of the Cashflows The NPV

Which makes the argument that..

- The project should be accepted. The positive net

present value suggests that the project will add

value to the firm, and earn a return in excess of

the cost of capital. - By taking the project, Boeing will increase its

value as a firm by 4,019 million.

The IRR of this project

Internal Rate of Return

The IRR suggests..

- The project is a good one. Using time-weighted,

incremental cash flows, this project provides a

return of 14.88. This is greater than the cost

of capital of 9.32. - The IRR and the NPV will yield similar results

most of the time, though there are differences

between the two approaches that may cause project

rankings to vary depending upon the approach used.

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

Projects NPV Profile

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.

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

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?

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.

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.

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

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.

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.

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

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.

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

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

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

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

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

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

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

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.

Equity Analysis The Parallels

- The investment analysis can be done entirely in

equity terms, as well. The returns, cashflows and

hurdle rates will all be defined from the

perspective of equity investors. - If using accounting returns,
- Return will be Return on Equity (ROE) Net

Income/BV of Equity - ROE has to be greater than cost of equity
- If using discounted cashflow models,
- Cashflows will be cashflows after debt payments

to equity investors - Hurdle rate will be cost of equity

A New Store for the Home Depot

- It will require an initial investment of 20

million in land, building and fixtures. - The Home Depot plans to borrow 5 million, at an

interest rate of 5.80, using a 10-year term

loan. - The store will have a life of 10 years. During

that period, the store investment will be

depreciated using straight line depreciation. At

the end of the tenth year, the investments are

expected to have a salvage value of 7.5

million. - The store is expected to generate revenues of 40

million in year 1, and these revenues are

expected to grow 5 a year for the remaining 9

years of the stores life. - The pre-tax operating margin, at the store prior

to depreciation, is expected to be 10 for the

entire period.

Interest and Principal Payments

Net Income on The Home Depot Store

The Hurdle Rate

- The analysis is done in equity terms. Thus, the

hurdle rate has to be a cost of equity - The cost of equity for the Home Depot is 9.78.

Since the Home Depots investments are assumed to

be homogeneous, the cost of equity for this

project is also assumed to be 9.78.

ROE on this Project

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

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.

An Incremental CF Analysis

NPV of the Store

Internal Rate of Return The Home Depot Store

The Role of Sensitivity Analysis

- Our conclusions on a project are clearly

conditioned on a large number of assumptions

about revenues, costs and other variables over

very long time periods. - To the degree that these assumptions are wrong,

our conclusions can also be wrong. - One way to gain confidence in the conclusions is

to check to see how sensitive the decision

measure (NPV, IRR..) is to changes in key

assumptions.

Viability of New Store Sensitivity to Operating

Margin

What does sensitivity analysis tell us?

- Assume that the manager at The Home Depot who has

to decide on whether to take this plant is very

conservative. She looks at the sensitivity

analysis and decides not to take the project

because the NPV would turn negative if the

operating margin drops below 8. Is this the

right thing to do? - Yes
- No
- Explain.

The Consistency Rule for Cash Flows

- The cash flows on a project and the discount rate

used should be defined in the same terms. - If cash flows are in one currency, the discount

rate has to be a dollar (baht) discount rate - If the cash flows are nominal (real), the

discount rate has to be nominal (real). - If consistency is maintained, the project

conclusions should be identical, no matter what

cash flows are used.

The Home Depot A New Store in Chile

- It will require an initial investment of 4700

million pesos for land, building and fixtures.

The Home Depot plans to borrow 1880 million

pesos, at an interest rate of 12.02, using a

10-year term loan. - The store will have a life of 10 years. During

that period, the store will be depreciated using

straight line depreciation. At the end of the

tenth year, the investments are expected to have

a salvage value of 2,350 million pesos. - The store is expected to generate revenues of

7,050 million pesos in year 1, and these revenues

are expected to grow 12 a year for the remaining

9 years. - The pre-tax operating margin at the store, prior

to depreciation, is expected to be 6 for the

entire period. - The working capital requirements are estimated to

be 10 of total revenues, and investments will be

made at the beginning of each year.

The Home Depot Chile Store Cashflows in Pesos

The Home Depot Chile Store Cost of Equity in

Pesos

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

1.1 - Relative Volatility of Chilean Equity to Bond

Market 2.2 - Country risk premium for Chile 1.1 2.2

2.42 - Cost of Equity for a Chilean Store (in U.S. )
- 5 0.87 (5.5 2.42) 11.88
- Assume that the expected inflation rate in Chile

is 8 and the expected inflation rate in the U.S.

is 2. - Cost of Equity for a Chilean Store (in Pesos)
- (1 Cost of Equity in ) (1

inflationChile)/ (1 inflationUS) - 1 - 1.1188 (1.08/1.02) -1 18.46

NPV in Pesos

Converting Pesos to U.S. dollars

- This entire analysis can be done in dollars, if

we convert the peso cash flows into U.S. dollars. - If you want the analysis to yield consistent

conclusions, expected exchange rates have to be

estimated based upon expected inflation rates - Current Exchange Rate 470 pesos
- Expected Ratet Exchange Rate (1

inflationChile)/ (1 inflationUS) - Expected Exchange Rate in year 1 470 pesos

(1.08/1.02) 497.65

Analyzing the Project U.S. Dollars

NPV in U.S. Dollars

Dealing with Inflation

- In our analysis, we used nominal dollars and

pesos. Would the NPV have been different if we

had used real cash flows instead of nominal cash

flows? - It would be much lower, since real cash flows are

lower than nominal cash flows - It would be much higher
- It should be unaffected

From Nominal to Real The Home Depot

- To do a real analysis, you need a real cost of

equity or capital - Nominal cost of equity for The Home Depot 9.78
- Expected Inflation rate 2
- Real Cost of Equity (1.0978/1.02)-1 7.59
- To estimate cash flows in real terms
- Real Cash flowt Nominal Cash flowt / (1

Expected Inflation rate)t

Nominal versus Real

Side Costs and Benefits

- Most projects considered by any business create

side costs and benefits for that business. - The side costs include the costs created by the

use of resources that the business already owns

(opportunity costs) and lost revenues for other

projects that the firm may have. - The benefits that may not be captured in the

traditional capital budgeting analysis include

project synergies (where cash flow benefits may

accrue to other projects) and options embedded in

projects (including the options to delay, expand

or abandon a project). - The returns on a project should incorporate these

costs and benefits.

Opportunity Cost

- An opportunity cost arises when a project uses a

resource that may already have been paid for by

the firm. - When a resource that is already owned by a firm

is being considered for use in a project, this

resource has to be priced on its next best

alternative use, which may be - a sale of the asset, in which case the

opportunity cost is the expected proceeds from

the sale, net of any capital gains taxes - renting or leasing the asset out, in which case

the opportunity cost is the expected present

value of the after-tax rental or lease revenues. - use elsewhere in the business, in which case the

opportunity cost is the cost of replacing it.

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

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

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

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

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.

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

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.

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.

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.

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

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.

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.

Present Value Effect of Working Capital

NPV of Boeing Super Jumbo and Working Capital as

of Revenues

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.

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.

Firm Value Schedule as a function of Working

Capital

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)

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.

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.

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

Inventory in an EOQ Model

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

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.

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.

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.

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.

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

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

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

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.

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.

Project Options

- One of the limitations of traditional investment

analysis is that it is static and does not do a

good job of capturing the options embedded in

investment. - The first of these options is the option to delay

taking a project, when a firm has exclusive

rights to it, until a later date. - The second of these options is taking one project

may allow us to take advantage of other

opportunities (projects) in the future - The last option that is embedded in projects is

the option to abandon a project, if the cash

flows do not measure up. - These options all add value to projects and may

make a bad project (from traditional analysis)

into a good one.

The Option to Delay

- When a firm has exclusive rights to a project or

product for a specific period, it can delay

taking this project or product until a later

date. - A traditional investment analysis just answers

the question of whether the project is a good

one if t