The Investment Principle

1
The Investment Principle

• 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
What is a investment or a project?

• Any decision that requires the use of resources
  (financial or otherwise) is a project.
• Broad strategic decisions
• Entering new areas of business
• Entering new markets
• Acquiring other companies
• Tactical decisions
• Management decisions
• The product mix to carry
• The level of inventory and credit terms
• Decisions on delivering a needed service
• Lease or buy a distribution system
• Creating and delivering a management information
  system

4
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

5
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.
• Consider all side-costs and side-benefits when
  analyzing project.

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I. Estimating Discount Rates
7
The Essence of Discount Rates The notion of a
benchmark

• Since financial resources are finite, there is a
  hurdle that projects have to cross before being
  deemed acceptable.
• This hurdle will be higher for riskier projects
  than for safer projects.
• A simple representation of the hurdle rate is as
  follows
• Hurdle rate Riskless Rate Risk Premium
• The two basic questions that every risk and
  return model in finance tries to answer are
• How do you measure risk?
• How do you translate this risk measure into a
  risk premium?

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1. The Nominal versus Real Choice A Currency
for your analysis

• A project can be analyzed in nominal terms (in
  which case inflation is incorporated into both
  your cashflows and your discount rate) or in real
  terms. When inflation is high and volatile,
  analysts may find it easier to do everything in
  real terms.
• If an analysis is nominal, you have to pick the
  currency to do the analysis is. Any project can
  be analyzed in any currency. In choosing a
  currency to do the analysis, you should consider
• Where the project will be located and what
  currency its costs and revenues will be in. (The
  costs may be in one currency and the revenues may
  be in another or more than one currency)
• How easy it will be to obtain fundamental
  information on risk free rates and risk premiums
  in that currency.

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2. Risk Free Rate

• For an investment to be risk free, it has to
  fulfill two conditions
• There can have no default risk
• There can be no reinvestment risk
• Using this principle strictly, there can be no
  one risk free rate for any investment that
  delivers cash flows at different points in time.
  The right risk free rate for each cash flow will
  be the interest rate on a zero-coupon default
  free government bond maturity on the same date as
  the cash flow.

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Some common sense rules on risk free rates

• Currency with default free entity If you are
  working with a currency where a default free
  entity exists ( or Euro), use the interest rate
  on a government bond with roughly the same
  duration as the project as the riskfree rate for
  all cashflows.
• Currency with no default free entity There are
  two solutions when there is no default free
  entity
• Approach 1 Subtract default spread from local
  government bond rate
• Government bond rate in local currency terms -
  Default spread for Government in local currency
• Approach 2 Use forward rates and the riskless
  rate in an index currency (say Euros or dollars)
  to estimate the riskless rate in the local
  currency.
• Real Risk free rate To obtain a real riskfree
  rate, you can try the following
• from an inflation-indexed government bond, if one
  exists
• set equal, approximately, to the long term real
  growth rate of the economy in which the valuation
  is being done.

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3. Determine a debt ratio and a cost of debt for
the project

• Most projects do not carry debt on their own.
  Instead, the parent company borrows money, using
  its general assets as collateral, and uses this
  money to fund the projects.
• Some projects are large enough and have assets
  that are separable from the firm. These projects
  sometimes borrow on their own assets, with no
  recourse against the parent company.

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What debt ratio should you use for a project?

• Case 1 Single business company with several,
  small and similar projects
• Companys cost of debt and debt ratio
• Case 2 Diverse company with large projects with
  different risk exposures
• Average debt ratio for the industry in which the
  project is and the cost of debt for the company
• Case 3 Large project which carries its own debt
  (with no or limited recourse to parent company
  assets)
• Estimated debt ratio for the project and cost of
  debt for the project

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What is debt?

• General Rule Debt generally has the following
  characteristics
• Commitment to make fixed payments in the future
• The fixed payments are tax deductible
• Failure to make the payments can lead to either
  default or loss of control of the firm to the
  party to whom payments are due.
• As a consequence, debt should include
• Any interest-bearing liability, whether short
  term or long term.
• Any lease obligation, whether operating or
  capital.

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Estimating the Cost of Debt

• If the firm has bonds outstanding, and the bonds
  are traded, the yield to maturity on a long-term,
  straight (no special features) bond can be used
  as the interest rate.
• If the firm is rated, use the rating and a
  typical default spread on bonds with that rating
  to estimate the cost of debt.
• If the firm is not rated,
• and it has recently borrowed long term from a
  bank, use the interest rate on the borrowing or
• estimate a synthetic rating for the company, and
  use the synthetic rating to arrive at a default
  spread and a cost of debt
• If you are estimating the cost of debt for a
  project, you usually have to use a synthetic
  rating.
• The cost of debt has to be estimated in the same
  currency as the cost of equity and the cash flows
  in the valuation.

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Estimating Synthetic Ratings

• The rating for a firm can be estimated using the
  financial characteristics of the firm. In its
  simplest form, the rating can be estimated from
  the interest coverage ratio
• Interest Coverage Ratio EBIT / Interest
  Expenses
• Consider InfoSoft, a private firm with EBIT of
  2000 million and interest expenses of 315
  million
• Interest Coverage Ratio 2,000/315 6.15
• Based upon the relationship between interest
  coverage ratios and ratings, we would estimate a
  rating of A for the firm.
• You can estimate synthetic ratings for individual
  projects that will be carrying their own debt.

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Interest Coverage Ratios, Ratings and Default
Spreads

• Interest Coverage Ratio Rating Default Spread
• gt 12.5 AAA 0.20
• 9.50 - 12.50 AA 0.50
• 7.50 9.50 A 0.80
• 6.00 7.50 A 1.00
• 4.50 6.00 A- 1.25
• 3.50 4.50 BBB 1.50
• 3.00 3.50 BB 2.00
• 2.50 3.00 B 2.50
• 2.00 - 2.50 B 3.25
• 1.50 2.00 B- 4.25
• 1.25 1.50 CCC 5.00
• 0.80 1.25 CC 6.00
• 0.50 0.80 C 7.50
• lt 0.65 D 10.00

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Costs of Debt for Boeing, the Home Depot and
InfoSoft

• Boeing Home Depot InfoSoft
• Bond Rating AA A A
• Rating is Actual Actual Synthetic
• Default Spread over treasury 0.50 0.80 1.00
• Market Interest Rate 5.50 5.80 6.00
• Marginal tax rate 35 35 42
• Cost of Debt 3.58 3.77 3.48
• The treasury bond rate is 5.

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4. Cost of Equity
19
Risk Premium
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Everyone uses historical premiums, but..

• The historical premium is the premium that stocks
  have historically earned over riskless
  securities.
• Practitioners never seem to agree on the premium
  it is sensitive to
• How far back you go in history
• Whether you use T.bill rates or T.Bond rates
• Whether you use geometric or arithmetic averages.
• For instance, looking at the US
• Arithmetic average Geometric Average
• Stocks - Stocks - Stocks - Stocks -
• Historical Period T.Bills T.Bonds T.Bills T.Bonds
• 1928-2002 7.67 6.25 5.73 4.53
• 1962-2002 5.17 3.66 3.90 2.76
• 1992-2002 6.32 2.15 4.69 0.95

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Two Ways of Estimating Country Risk Premiums

• Default spread on Country Bond In this approach,
  the country risk premium is based upon the
  default spread of the bond issued by the country
  (but only if it is denominated in a currency
  where a default free entity exists.
• Brazil was rated B2 by Moodys and the default
  spread on the Brazilian dollar denominated C.Bond
  at the end of September 2003 was 6.01.
  (10.18-4.17)
• Relative Equity Market approach The country risk
  premium is based upon the volatility of the
  market in question relative to U.S market.
• Country risk premium Risk PremiumUS ?Country
  Equity / ?US Equity
• Using a 4.53 premium for the US, this approach
  would yield
• Total risk premium for Brazil 4.53
  (33.37/18.59) 8.13
• Country risk premium for Brazil 8.13 - 4.53
  3.60
• (The standard deviation in weekly returns from
  2001 to 2003 for the Bovespa was 33.37 whereas
  the standard deviation in the SP 500 was 18.59)

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And a third approach

• Country ratings measure default risk. While
  default risk premiums and equity risk premiums
  are highly correlated, one would expect equity
  spreads to be higher than debt spreads.
• Another is to multiply the bond default spread by
  the relative volatility of stock and bond prices
  in that market. In this approach
• Country risk premium Default spread on country
  bond ?Country Equity / ?Country Bond
• Standard Deviation in Bovespa (Equity) 33.37
• Standard Deviation in Brazil C-Bond 26.15
• Default spread on C-Bond 6.01
• Country Risk Premium for Brazil 6.01
  (33.37/26.15) 7.67

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Implied Equity Risk Premiums

• An implied equity risk premium is a forward
  looking estimate, based upon how stocks are
  priced today and expected cashflows in the
  future.
• On January 1, 2003, the SP was trading at
  879.82.
• Treasury bond rate 3.81
• Expected Growth rate in earnings (next 5 years)
  8 (Consensus estimate for SP 500 earnings)
• Expected growth rate after year 5 3.81
• Dividends stock buybacks 3.29 of index (in
  latest year)
• Year 1 Year 2 Year 3 Year 4 Year 5
• Expected Dividends 31.25 33.75 36.45 39.37
  42.52
• Stock Buybacks
• Expected dividends buybacks in year 6 42.52
  (1.0381) 44.14
• 879.82 31.25/(1r) 33.75/(1r)2
  36.45/(1r)3 39.37/(1r)4 (42.52(44.14/(r-.03
  81))/(1r)5
• Solving for r, r 7.91. (Only way to do this is
  trial and error)
• Implied risk premium 7.91 - 3.81 4.10

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4. Measuring Project Risk Risk and Return Models
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Estimating Beta
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Decomposing Boeings Beta

• Segment Revenues Estimated Value bunlevered Weight
  Weighted b Levered Beta
• Commercial Aircraft 26,929 30,160
  0.91 70.39 0.6405 1.06
• ISDS 18,125 12,688 0.80 29.61 0.2369 0.93
  
• Firm 42,848 100.00 0.88 1.01
• The values were estimated based upon the revenues
  in each business and the typical multiple of
  revenues that other firms in that business trade
  for.
• The unlevered betas for each business were
  estimated by looking at other publicly traded
  firms in each business, averaging across the
  betas estimated for these firms, and then
  unlevering the beta using the average debt to
  equity ratio for firms in that business.
• Unlevered Beta Average Beta / (1 (1-tax rate)
  (Average D/E))
• Using Boeings current market debt to equity
  ratio of 25
• Boeings Beta 0.88 (1(1-.35)(.25)) 1.014

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The Home Depots Comparable Firms
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Estimating The Home Depots Bottom-up Beta

• Average Beta of comparable firms 0.93
• D/E ratio of comparable firms
  (2002076)/16,232 14.01
• Unlevered Beta for comparable firms
  0.93/(1(1-.35)(.1401))
• 0.86

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Beta for InfoSoft, a Private Software Firm

• The following table summarizes the unlevered
  betas for publicly traded software firms.
• Grouping Number of Beta D/E Ratio Unlevered
  Firms Beta
• All Software 264 1.45 3.70 1.42
• Small-cap Software 125 1.54 10.12 1.45
• Entertainment Software 31 1.50 7.09 1.43
• We will use the beta of entertainment software
  firms as the unlevered beta for InfoSoft.
• We will also assume that InfoSofts D/E ratio
  will be similar to that of these publicly traded
  firms (D/E 7.09)
• Beta for InfoSoft 1.43 (1 (1-.42) (.0709))
  1.49
• (We used a tax rate of 42 for the private firm)

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Total Risk versus Market Risk

• Adjust the beta to reflect total risk rather than
  market risk. This adjustment is a relatively
  simple one, since the R squared of the regression
  measures the proportion of the risk that is
  market risk.
• Total Beta Market Beta / vR squared
• In the InfoSoft example, where the market beta
  is 1.10 and the average R-squared of the
  comparable publicly traded firms is 16,
• Total Beta 1.49/v0.16 3.725
• Total Cost of Equity 5 3.725 (5.5) 25.49
• This cost of equity is much higher than the cost
  of equity based upon the market beta because the
  owners of the firm are not diversified.

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Estimating a beta for a project

• Case 1 Single business company with several,
  small and similar projects
• Companys levered beta
• Case 2 Diverse company with large projects with
  different risk exposures
• Levered beta for the industry in which the
  project operates. (Alternatively, you can use an
  unlevered beta for the industry in which the
  project operates and use the companys debt to
  equity ratio to lever up)
• Case 3 Large project which carries its own debt
  (with no or limited recourse to parent company
  assets)
• Levered beta estimated using unlevered beta for
  publicly traded firms comparable to the project
  and the debt to equity ratio for project.

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5. Cost of Capital
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Estimating Cost of Capital Boeing

• Equity
• Cost of Equity 5 1.01 (5.5) 10.58
• Market Value of Equity 32.60 Billion
• Equity/(DebtEquity ) 82
• Debt
• After-tax Cost of debt 5.50 (1-.35) 3.58
• Market Value of Debt 8.2 Billion
• Debt/(Debt Equity) 18
• Cost of Capital 10.58(.80)3.58(.20) 9.17

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Boeings Divisional Costs of Capital

• Boeing Aerospace Defense
• Cost of Equity 10.58 10.77 10.07
• Equity/(Debt Equity) 79.91 79.91 79.91
• Cost of Debt 3.58 3.58 3.58
• Debt/(Debt Equity) 20.09 20.09 20.09
• Cost of Capital 9.17 9.32 8.76

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Cost of Capital InfoSoft and The Home Depot

• The Home Depot InfoSoft
• Cost of Equity 9.78 25.49
• Equity/(Debt Equity) 95.45 93.38
• Cost of Debt 3.77 3.48
• Debt/(Debt Equity) 4.55 6.62
• Cost of Capital 9.51 24.03

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In summary Estimating cost of capital for a
project

• 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

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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 total beta for online retailers (5.25). We
  will also assume that the online software company
  will not borrow any money (reflecting industry
  practices)
• Cost of capital Cost of equity 33.875

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Current Practices in the US Costs of Capital
39
Choosing a Hurdle Rate

• Either the cost of equity or the cost of capital
  can be used as a hurdle rate, depending upon
  whether the returns measured are to equity
  investors or to all claimholders on the firm
  (capital)
• If returns are measured to equity investors, the
  appropriate hurdle rate is the cost of equity.
• If returns are measured to capital (or the firm),
  the appropriate hurdle rate is the cost of
  capital.

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II. The Estimation Process Sources of
Information/ Estimation

• 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.
• Macro economic/ Sector forecasters There are
  services that provide forecasts of varying
  accuracy/ reliability on what they think will
  happen to the economy or a particular sector.
• Market Data There are some cases where market
  prices provide information that can be used in
  forecasts. This is especially the case when you
  are forecasting interest rates, exchange rates
  and commodity prices.

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Three approaches to estimation

• Expected value approach In this approach, we
  estimate the expected revenues and earnings of a
  project. While these are point estimates, they
  presumably incorporate all the information you
  have on other scenarios.
• Simulation In this approach, we estimate a
  statistical distribution (and the parameters of
  the distribution) for each variable. We then run
  simulations drawing from the distribution and
  compute the return on each simulation. The output
  is a distribution of the decision variable (NPV,
  IRR, ROC etc.)
• Scenario Analysis In this approach, we define
  scenarios for key variables and probabilities of
  each occurring. We then compute the revenues and
  earnings under scenario. The output is the
  decision variable under each scenario.

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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.

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The Margins at Existing Stores
44
Projections for The Home Depots New Store
-Expected Value Analysis

• 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)

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The Simulation Alternative

• Instead of using the expected values for each
  variable and arriving at a set of expected
  cashflows for the analysis, we could have
  enriched the analysis by assuming a distribution
  for each of the key variables - revenues, margins
  and growth, for instance.
• Steps in a simulation
• Step 1 Determine the variables that you will be
  estimating distributions/parameters for.
• Step 2 Choose the statistical distribution for
  each of the variables and esitmate the parameters
  of the distribution.
• Step 3 Run your first simulation, drawing one
  outcome from each distribution.
• Step 4 Repeat process. The number of simulations
  run will depend upon how many variables are being
  simulated and the range of outcomes.
• Step 5 Compute your decision variable (NPV, IRR,
  ROIC) for each simulation and report the findings
  in a distribution.

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What simulations do and what they do not

• Simulations do
• Provide richer information about a projects
  outcomes to decision makers.
• Provide information about potentially dangerous
  outcomes (for the firm), in terms of worst case
  scenarios. (Violation of lending covenants,
  Failure to make interest payments etc.)
• A measure of outcome variability that can be
  compared across mutually exclusive investments
• Simulations do not
• Adjust cash flows for risk (They generate
  expected cashflows)
• Provide better estimates of the expected value or
  NPV of an investment.

47
When simulations make sense and when they do not..

• Simulations make sense
• When there is sufficient information to estimate
  the correct statistical distributions for each
  variables and the parameters of those
  distributions. This is most likely to be the case
  for firms that
• Take the same kind of investment over and over
  again (like the Home Depot)
• Have done extensive market testing of a product
  or service and generated output from the testing
  which can be used in the distribution
• When there is a lower bound constraint, which if
  violated, can lead to the project ending. (An
  example would be capital ratio constraints at
  banks)
• Simulations dont make sense
• When the distributions chosen and the parameters
  used are arbitrary. It is garbage in, garbage
  out.

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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.

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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

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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)

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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

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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.

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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
• 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.)

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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.

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Revenues By Year
56
Operating Expenses S,G A By Year
57
Depreciation and Amortization By Year
58
Earnings on Project
59
And the Accounting View of Return
60
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.

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An extension to existing projects Return Spreads
and EVA

• How good are the collective investments that a
  firm has already made? One way, albeit a limited
  one, is to compute the collective return on
  capital for the entire company and compare it to
  the cost of capital for the entire company. This
  is a return spread.
• Extending this approach, you can convert the
  return spread (which is a percentage value) into
  an absolute value by multiplying the return
  spread by the capital invested in the firm (which
  generates an economic value added)
• EVA (Return on capital - Cost of capital)
  (Capital invested)
• Where
• Return on capital EBIT (1-t)/ Invested Capital
• Cost of capital Hurdle rate for investments of
  equivalend risk at the start of the period of
  analysis
• Capital invested Book value Book Value Cash -
  Debt

62
EVAs and project quality

• The EVA for a project is good measure of project
  quality when
• Project earnings closely resemble cashflows.
• Project earnings are measured consistently and
  the annual cashflows are fairly uniform over
  time.
• The firm using its is a mature firm with most of
  its assets already in place with little or no
  investment needed for long term grosth.
• The EVA for a project is a poor measures of
  project quality when
• Project earnings are being manipulated by
  questionable accounting practices.
• Project are volatile and change over time.
• The firm is a growth firm with most of its value
  from growth assets.

63
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

64
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.

65
Estimating Cash Flows The Boeing Super Jumbo
66
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.

67
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.

68
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.
• Assets that earn a fair market return should not
  be counted as part of working capital for cash
  flow purposes. Since cash is usually invested to
  earn a fair market return in marketable
  securities, it should generally not be considered
  as part of working capital.
• 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.

69
NPV of Boeing Super Jumbo and Working Capital as
of Revenues
70
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.

71
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?

72
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?

73
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.

74
The Incremental Cash Flows Boeing Super Jumbo
75
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.

76
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

77
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..

78
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

79
Considering all of the Cashflows The NPV
80
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.

81
The IRR of this project
Internal Rate of Return
82
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.

83
An IRR-based Approach to analyzing existing
investments - CFROI

• The CFROI is the internal rate of return that you
  generate by looking collectively at the
  investment in all of your assets and the
  cashflows you expect to generate from them.
  CFROI is usually done in real terms and should
  generally be compared to a real cost of capital.
• In terms of inputs, CFROI is usually computed
  using the following
• Gross investment in plant and equipment, which is
  obtained by adding back accumulated depreciation
  to net plant and equipment, is used as the
  equivalent of the initial investment.
• The annual cashflow is computed by adding back
  depreciation to after-tax operating income.
• The life of the asset, at the time of the
  original purchase, is used as the life of the
  assets

84
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

85
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.

86
Interest and Principal Payments
87
Net Income on The Home Depot Store
88
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.

89
An Incremental CF Analysis
90
NPV of the Store
91
Internal Rate of Return The Home Depot Store
92
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.

93
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.

94
The Home Depot Chile Store Cashflows in Pesos
95
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

96
NPV in Pesos
97
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

98
Analyzing the Project U.S. Dollars
99
NPV in U.S. Dollars
100
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.

101
Viability of New Store Sensitivity to Operating
Margin
102
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.

103
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

104
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

105
Nominal versus Real
106
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.

107
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.

108
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.

109
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.

110
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 taken today.
• Thus, the fact that a project does not pass
  muster today (because its NPV is negative, or its
  IRR is less than its hurdle rate) does not mean
  that the rights to this project are not valuable.

111
Valuing the Option to Delay a Project
PV of Cash Flows
from Project
Initial Investment in
Project
Present Value of Expected
Cash Flows on Product
Project's NPV turns
Project has negative
positive in this section
NPV in this section
112
Insights for Investment Analyses

• Having the exclusive rights to a product or
  project is valuable, even if the product or
  project is not viable today.
• The value of these rights increases with the
  volatility of the underlying business.
• The cost of acquiring these rights (by buying
  them or spending money on development - RD, for
  instance) has to be weighed off against these
  benefits.

113
The Option to Expand/Take Other Projects

• Taking a project today may allow a firm to
  consider and take other valuable projects in the
  future.
• Thus, even though a project may have a negative
  NPV, it may be a project worth taking if the
  option it provides the firm (to take other
  projects in the future) provides a
  more-than-compensating value.
• These are the options that firms often call
  strategic options and use as a rationale for
  taking on negative NPV or even negative
  return projects.

114
The Option to Expand
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Present Value of Expected
Cash Flows on Expansion
Expansion becomes
Firm will not expand in
attractive in this section
this section
115
An Example of an Expansion Option

• Assume that The Home Depot is considering opening
  a small store in France. The store will cost 100
  million French Francs (FF) to build, and the
  present value of the expected cash flows from the
  store is 120 million FF. Thje store has a
  negative NPV of 20 million FF.
• Assume, however, that by opening this store, the
  Home Depot will acquire the option to expand its
  operations any time over the next 5 years. The
  cost of expansion will be 200 million FF, and it
  will be undertaken only if the present value of
  the expected cash flows from expansion exceeds
  200 million FF. At the moment, this present value
  is believed to be only 150 million FF. The Home
  Depot still does not know much about the market
  for home improvement products in France, and
  there is considerable uncertainty about this
  estimate. The variance in the estimate is 0.08.

116
Valuing the Expansion Option

• Value of the Underlying Asset (S) PV of Cash
  Flows from Expansion, if done now 150 million FF
• Strike Price (K) Cost of Expansion 200 million
  FF
• Variance in Underlying Assets Value 0.08
• Time to expiration Period for which expansion
  option applies 5 years
• Call Value 150 (0.6314) -200 (exp(-0.06)(20)
  (0.3833) 37.91 million FF

117
Considering the Project with Expansion Option

• NPV of Store 80 million FF - 100 million FF
  -20 million
• Value of Option to Expand 37.91 million FF
• NPV of store with option to expand -20 million
  37.91 million 17.91 mil FF
• Accept the project

118
The Option to Abandon

• A firm may sometimes have the option to abandon a
  project, if the cash flows do not measure up to
  expectations.
• If abandoning the project allows the firm to save
  itself from further losses, this option can make
  a project more valuable.

PV of Cash Flows
from Project
Cost of Abandonment
Present Value of Expected
Cash Flows on Project
119
Valuing the Option to Abandon

• Assume that the Home Depot is considering a new
  store that requires a net initial investment of
  9.5 million and generates cash flows with a
  present value of 8.563 million. The net present
  value of -937,287 would lead us to reject this
  project.
• To illustrate the effect of the option to
  abandon, assume that the Home Depot has the
  option to close the store any time over the next
  10 years and sell the land back to the original
  owner for 5 million. In addition, assume that
  the standard deviation in the present value of
  the cash flows is 22.

120
Project with Option to Abandon

• Value of the Underlying Asset (S) PV of Cash
  Flows from Project 8,562,713
• Strike Price (K) Salvage Value from Abandonment
  5 million
• Variance in Underlying Assets Value 0.222
  0.0484
• Time to expiration Life of the Project 10
  years
• Dividend Yield 1/Life of the Project 1/10
  0.10 (We are assuming that the projects present
  value will drop by roughly 1/n each year into the
  project)
• The riskless rate is 5.

121
Should The Home Depot take this project?

• Value of Put 5,000,000 exp(-0.05)(10)
  (1-0.4977) - -8,562,713 exp(0.10)(10) (1-0.7548)
  474,831
• The value of this abandonment option has to be
  added to the net present value of the project of
  - 937,287, yielding a total net present value
  that remains negative.
• NPV without abandonment option -937,287
• Value of abandonment option 474,831
• NPV with abandonment option -462,456
• Notwithstanding the abandonment option, this
  store should not be opened.

122
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 fund