Investment Decisions

1
Investment Decisions

• 04/22/08
• Ch. 5

2
Pick Industries and Companies

• Each Group Picks Industry
• First and Second Choice
• Industries unique to a group
• Groups then pick companies
• Must trade on major exchange
• Should be US company
• Exception to US company, ADRs
• Substitutes after initial selection
• One week

3
Investment Decision

• We will examine three items in this chapter
• Incremental Cash Flow
• Decision Models
• Where good projects come from
• Incremental Cash Flow...the basis of the project
• Decision Models Discounted Cash Flow
• Picking good projects luck or talent?

4
Incremental Cash Flow

• It is only the net new dollars of a project that
  are important
• Sunk Costs do count in decision
• Not in the cash flow
• Could provide valuable information on cash flow
• Example, market study before product launch
• Erosion Costs
• Story of pudding pops
• When are erosion costs not erosion costs?
• Allocated Costs
• Only the additional costs should be considered
• Use accounting income format with adjustments for
  the Incremental Cash Flow

5
Incremental Cash Flow

• Three main parts
• 1. Invested Capital
• 2. Operating Cash Flow
• we think of these as the income stream from the
  project over the life of the project
• 3. Working capital
• we think of these costs as the support of the
  project, for example, inventory

6
What is the appropriate decision rule?

• Objective vs. Subjective
• Like to quantify all the important issues and
  data
• Like to use experience
• Solution is consistent with firm value
  maximization
• Works in a variety of settings

7
Some Choices that fail

• Accounting based decisions, Return on Capital
• Earnings are not cash
• Possible to manipulate the earnings
• Economic Value Added
• Again relies on accounting information to find
  the Return on Equity
• Is consistent with increasing firm value

8
Net Present Value

• The preferred discount model as it includes all
  future cash flow discounted back to present at
  the appropriate risk-related rate
• NPV profile provides the NPV at various discount
  rates
• Is sensitive to the incremental cash flow
  estimates
• NPV formula

9
Internal Rate of Return, IRR

• Alternative to NPV
• Finds the discount rate at the point where the
  NPV is zero then compares to hurdle rate
• Has some potential problems
• Multiple IRRs
• Assumes all intermediate cash flow is reinvested
  at the IRR rate
• Can lead to some wrong choices when comparing
  projects

10
Modified Internal Rate of Return

• Changes the reinvestment assumption of IRR from
  the IRR rate to the hurdle rate
• Takes all positive cash flow to the end of
  project at the hurdle rate
• Finds the future value of the positive cash flow
  at end of project
• Finds the discount rate that equates the FV of
  the benefits with the PV of the costs
• Is this better than IRR?

11
Where do good projects come from?

• First and foremostgood ideas
• Good ideas
• Smart People
• Innovative People
• Risk Takers
• Luck
• Others?
• Do all good projects work out?

12
How to exploit good projects

• Economies of Scale (large volume)
• Cost Advantages (overseas labor access)
• Capital Requirements (Off shore oil platforms)
• Product Differentiation (reputation or recognized
  products, Coca-Cola)
• Access to Distribution Channels (Microbrews)
• Legal and Government Barriers (patents and
  licensing requirements)

13
Problems from Chapter 5

• 9 (Estimate NPV and IRR)
• 10 (Estimate MIRR)
• 11 (Mutually Exclusive) Also draw the NPV
  profile of the two projects. What does this tell
  you?
• 12 (IRR puzzle)
• 16 (NPV and IRR)
• 17 (Changing discount rates)
• 19 (NPV and IRR)