Measuring Investment Returns

1
Measuring Investment Returns

• Aswath Damodaran

Stern School of Business
2
First Principles

• Invest in projects that yield a return greater
  than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier
  projects and reflect the financing mix used -
  owners funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on
  cash flows generated and the timing of these cash
  flows they should also consider both positive
  and negative side effects of these projects.
• Choose a financing mix that minimizes the hurdle
  rate and matches the assets being financed.
• If there are not enough investments that earn the
  hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock
  buybacks - will depend upon the stockholders
  characteristics.

3
Measuring Returns Right The Basic Principles

• Use cash flows rather than earnings. You cannot
  spend earnings.
• Use incremental cash flows relating to the
  investment decision, i.e., cashflows that occur
  as a consequence of the decision, rather than
  total cash flows.
• Use time weighted returns, i.e., value cash
  flows that occur earlier more than cash flows
  that occur later.
• The Return Mantra Time-weighted, Incremental
  Cash Flow Return

4
Steps in Investment Analysis

• Estimate a hurdle rate for the project, based
  upon the riskiness of the investment
• Estimate revenues and accounting earnings on the
  investment.
• Measure the accounting return to see if the
  investment measures up to the hurdle rate.
• Convert accounting earnings into cash flows
• Use the cash flows to evaluate whether the
  investment is a good investment.
• Time weight the cash flows
• Use the time-weighted cash flows to evaluate
  whether the investment is a good investment.

5
I. Estimating the Hurdle Rate for an Investment

• If a firm is in only one business, and all of its
  investments are homogeneous
• Use the companys costs of equity and capital to
  evaluate its investments.
• If the firm is in more than one business, but
  investments within each of business are similar
• Use the divisional costs of equity and capital to
  evaluate investments made by that division
• If a firm is planning on entering a new business
• Estimate a cost of equity for the investment,
  based upon the riskiness of the investment
• Estimate a cost of debt and debt ratio for the
  investment based upon the costs of debt and debt
  ratios of other firms in the business

6
Analyzing Project Risk Three Examples

• The Home Depot A New Store
• The Home Depot is a firm in a single business,
  with homogeneous investments (another store).
• We will use The Home Depots cost of equity
  (9.78) and capital (9.51) to analyze this
  investment.
• Boeing A Super Jumbo Jet (capable of carrying
  400 people)
• We will use the cost of capital of 9.32 that we
  estimated for the aerospace division of Boeing.
• InfoSoft An Online Software Store
• We will estimate the cost of equity based upon
  the beta for online retailers (1.725) and
  InfoSofts debt ratio. We will use a much higher
  cost of debt for the project (7) than InfoSofts
  existing debt (6)
• Cost of capital 14.49 (.9338) 7
  (1-.42)(.0662) 13.80

7
II. The Estimation Process

• Experience and History If a firm has invested in
  similar projects in the past, it can use this
  experience to estimate revenues and earnings on
  the project being analyzed.
• Market Testing If the investment is in a new
  market or business, you can use market testing to
  get a sense of the size of the market and
  potential profitability.
• Scenario Analysis If the investment can be
  affected be a few external factors, the revenues
  and earnings can be analyzed across a series of
  scenarios and the expected values used in the
  analysis.

8
The Home Depots New Store Experience and History

• The Home Depot has 700 stores in existence, at
  difference stages in their life cycles, yielding
  valuable information on how much revenue can be
  expected at each store and expected margins.
• At the end of 1999, for instance, each existing
  store had revenues of 44 million, with revenues
  starting at about 40 million in the first year
  of a stores life, climbing until year 5 and then
  declining until year 10.

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

• For revenues, we will assume
• that the new store being considered by the Home
  Depot will have expected revenues of 40 million
  in year 1 (which is the approximately the average
  revenue per store at existing stores after one
  year in operation)
• that these revenues to grow 5 a year
• that our analysis will cover 10 years (since
  revenues start dropping at existing stores after
  the 10th year).
• For operating margins, we will assume
• The operating expenses of the new store will be
  90 of the revenues (based upon the median for
  existing stores)

11
Scenario Analysis Boeing Super Jumbo

• We consider two factors
• Actions of Airbus (the competition) Produces new
  large capacity plane to match Boeings new jet,
  Improves its existing large capacity plane
  (A-300) or abandons this market entirely.
• Much of the growth from this market will come
  from whether Asia. We look at a high growth,
  average growth and low growth scenario.
• In each scenario,
• We estimate the number of planes that Boeing will
  sell under each scenario.
• We estimate the probability of each scenario.

12
Scenario Analysis

• The following table lists the number of planes
  that Boeing will sell under each scenario, with
  the probabilities listed below each number.
• Airbus New Airbus A-300 Airbus abandons
  large plane large airplane
• High Growth in Asia 120 150 200
• (0.125) (0.125) (0.00)
• Average Growth in Asia 100 135 160
• (0.15) (0.25) (0.10)
• Low Growth in Asia 75 110 120
• (0.05) (0.10) (0.10)
• Expected Value 1200.125150.1252000100.15
  135.25
• 160.10 75.05110.1012010 125 planes

13
III. Measures of return Accounting Earnings

• Principles Governing Accounting Earnings
  Measurement
• Accrual Accounting Show revenues when products
  and services are sold or provided, not when they
  are paid for. Show expenses associated with these
  revenues rather than cash expenses.
• Operating versus Capital Expenditures Only
  expenses associated with creating revenues in the
  current period should be treated as operating
  expenses. Expenses that create benefits over
  several periods are written off over multiple
  periods (as depreciation or amortization)

14
From Forecasts to Accounting Earnings

• Separate projected expenses into operating and
  capital expenses Operating expenses, in
  accounting, are expenses designed to generate
  benefits only in the current period, while
  capital expenses generate benefits over multiple
  periods.
• Depreciate or amortize the capital expenses over
  time Once expenses have been categorized as
  capital expenses, they have to be depreciated or
  amortized over time.
• Allocate fixed expenses that cannot be traced to
  specific projects Expenses that are not directly
  traceable to a project get allocated to projects,
  based upon a measure such as revenues generated
  by the project projects that are expected to
  make more revenues will have proportionately more
  of the expense allocated to them.
• Consider the tax effect Consider the tax
  liability that would be created by the operating
  income we have estimated

15
Boeing Super Jumbo Jet Investment Assumptions

• Boeing has already spent 2.5 billion in
  research expenditures, developing the Super
  Jumbo. (These expenses have been capitalized)
• If Boeing decides to proceed with the commercial
  introduction of the new plane, the firm will have
  to spend an additional 5.5 billion building a
  new plant and equipping it for production.
• Year Investment Needed
• Now 500 million
• 1 1,000 million
• 2 1,500 million
• 3 1,500 million
• 4 1,000 million
• After year 4, there will be a capital maintenance
  expenditure required of 250 million each year
  from years 5 through 15.

16
Operating Assumptions

• The sale and delivery of the planes is expected
  to begin in the fifth year, when 50 planes will
  be sold. For the next 15 years (from year 6-20),
  Boeing expects to sell 125 planes a year. In the
  last five years of the project (from year 21-25),
  the sales are expected to decline to 100 planes a
  year. While the planes delivered in year 5 will
  be priced at 200 million each, this price is
  expected to grow at the same rate as inflation
  (which is assumed to be 3) each year after that.
• Based upon past experience, Boeing anticipates
  that its cost of production, not including
  depreciation or General, Sales and Administrative
  (GSA) expenses, will be 90 of the revenue each
  year.
• Boeing allocates general, selling and
  administrative expenses (G,S A) to projects
  based upon projected revenues, and this project
  will be assessed a charge equal to 4 of
  revenues. (One-third of these expenses will be a
  direct result of this project and can be treated
  as variable. The remaining two-thirds are fixed
  expenses that would be generated even if this
  project were not accepted.)

17
Other Assumptions

• The project is expected to have a useful life of
  25 years.
• The corporate tax rate is 35.
• Boeing uses a variant of double-declining balance
  depreciation to estimate the depreciation each
  year. Based upon a typical depreciable life of 20
  years, the depreciation is computed to be 10 of
  the book value of the assets (other than working
  capital) at the end of the previous year. We
  begin depreciating the capital investment
  immediately, rather than waiting for the revenues
  to commence in year 5.

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

• Invest in the Super Jumbo Jet The return on
  capital of 12.75 is greater than the cost of
  capital for aerospace of 9.32 This would
  suggest that the project should not be taken.

24
From Project to Firm Return on Capital

• Just as a comparison of project return on capital
  to the cost of capital yields a measure of
  whether the project is acceptable, a comparison
  can be made at the firm level, to judge whether
  the existing projects of the firm are adding or
  destroying value.
• Boeing Home Depot InfoSoft
• Return on Capital 5.82 16.37 23.67
• Cost of Capital 9.17 9.51 12.55
• ROC - Cost of Capital -3.35 6.87 11.13

25
6 Application Test Assessing Investment Quality

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

26
IV. From Earnings to Cash Flows

• To get from accounting earnings to cash flows
• you have to add back non-cash expenses (like
  depreciation and amortization)
• you have to subtract out cash outflows which are
  not expensed (such as capital expenditures)
• you have to make accrual revenues and expenses
  into cash revenues and expenses (by considering
  changes in working capital).
• For the Boeing Super Jumbo, we will assume that
• The depreciation used for operating expense
  purposes is also the tax depreciation.
• Working capital will be 10 of revenues, and the
  investment has to be made at the beginning of
  each year.

27
Estimating Cash Flows The Boeing Super Jumbo
28
The Depreciation Tax Benefit

• While depreciation reduces taxable income and
  taxes, it does not reduce the cash flows.
• The benefit of depreciation is therefore the tax
  benefit. In general, the tax benefit from
  depreciation can be written as
• Tax Benefit Depreciation Tax Rate
• For example, in year 2, the tax benefit from
  depreciation to Boeing from this project can be
  written as
• Tax Benefit in year 2 217 million (.35)
  76 million
• Proposition 1 The tax benefit from depreciation
  and other non-cash charges is greater, the higher
  your tax rate.
• Proposition 2 Non-cash charges that are not tax
  deductible (such as amortization of goodwill) and
  thus provide no tax benefits have no effect on
  cash flows.

29
Depreciation Methods

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

30
The Capital Expenditures Effect

• Capital expenditures are not treated as
  accounting expenses but they do cause cash
  outflows.
• Capital expenditures can generally be categorized
  into two groups
• New (or Growth) capital expenditures are capital
  expenditures designed to create new assets and
  future growth
• Maintenance capital expenditures refer to capital
  expenditures designed to keep existing assets.
• Both initial and maintenance capital expenditures
  reduce cash flows
• The need for maintenance capital expenditures
  will increase with the life of the project. In
  other words, a 25-year project will require more
  maintenance capital expenditures than a 2-year
  asset.

31
To cap ex or not to cap ex

• Assume that you run your own software business,
  and that you have an expense this year of 100
  million from producing and distribution
  promotional CDs in software magazines. Your
  accountant tells you that you can expense this
  item or capitalize and depreciate. Which will
  have a more positive effect on income?
• Expense it
• Capitalize and Depreciate it
• Which will have a more positive effect on cash
  flows?
• Expense it
• Capitalize and Depreciate it

32
The Working Capital Effect

• Intuitively, money invested in inventory or in
  accounts receivable cannot be used elsewhere. It,
  thus, represents a drain on cash flows
• To the degree that some of these investments can
  be financed using suppliers credit (accounts
  payable) the cash flow drain is reduced.
• Investments in working capital are thus cash
  outflows
• Any increase in working capital reduces cash
  flows in that year
• Any decrease in working capital increases cash
  flows in that year
• To provide closure, working capital investments
  need to be salvaged at the end of the project
  life.

33
V. From Cash Flows to Incremental Cash Flows

• The incremental cash flows of a project are the
  difference between the cash flows that the firm
  would have had, if it accepts the investment, and
  the cash flows that the firm would have had, if
  it does not accept the investment.
• The Key Questions to determine whether a cash
  flow is incremental
• What will happen to this cash flow item if I
  accept the investment?
• What will happen to this cash flow item if I do
  not accept the investment?
• If the cash flow will occur whether you take this
  investment or reject it, it is not an incremental
  cash flow.

34
Sunk Costs

• Any expenditure that has already been incurred,
  and cannot be recovered (even if a project is
  rejected) is called a sunk cost
• When analyzing a project, sunk costs should not
  be considered since they are incremental
• By this definition, market testing expenses and
  RD expenses are both likely to be sunk costs
  before the projects that are based upon them are
  analyzed. If sunk costs are not considered in
  project analysis, how can a firm ensure that
  these costs are covered?

35
Allocated Costs

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

36
Boeing Super Jumbo Jet

• The 2.5 billion already expended on the jet is a
  sunk cost, as is the amortization related that
  expense. (Boeing has spent the first, and it is
  entitled to the latter even if the investment is
  rejected)
• Two-thirds of the S,GA expenses are fixed
  expenses and would exist even if this project is
  not accepted.

37
The Incremental Cash Flows Boeing Super Jumbo
38
VI. To Time-Weighted Cash Flows

• Incremental cash flows in the earlier years are
  worth more than incremental cash flows in later
  years.
• In fact, cash flows across time cannot be added
  up. They have to be brought to the same point in
  time before aggregation.
• This process of moving cash flows through time is
• discounting, when future cash flows are brought
  to the present
• compounding, when present cash flows are taken to
  the future
• The discount rate is the mechanism that
  determines how cash flows across time will be
  weighted.

39
Present Value Mechanics

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

40
Discounted cash flow measures of return

• Net Present Value (NPV) The net present value is
  the sum of the present values of all cash flows
  from the project (including initial investment).
• NPV Sum of the present values of all cash flows
  on the project, including the initial investment,
  with the cash flows being discounted at the
  appropriate hurdle rate (cost of capital, if cash
  flow is cash flow to the firm, and cost of
  equity, if cash flow is to equity investors)
• Decision Rule Accept if NPV gt 0
• Internal Rate of Return (IRR) The internal rate
  of return is the discount rate that sets the net
  present value equal to zero. It is the percentage
  rate of return, based upon incremental
  time-weighted cash flows.
• Decision Rule Accept if IRR gt hurdle rate

41
Closure on Cash Flows

• In a project with a finite and short life, you
  would need to compute a salvage value, which is
  the expected proceeds from selling all of the
  investment in the project at the end of the
  project life. It is usually set equal to book
  value of fixed assets and working capital
• In a project with an infinite or very long life,
  we compute cash flows for a reasonable period,
  and then compute a terminal value for this
  project, which is the present value of all cash
  flows that occur after the estimation period
  ends..

42
Salvage Value on Boeing Super Jumbo

• We will assume that the salvage value for this
  investment at the end of year 25 will be the book
  value of the investment.
• Book value of capital investments at end of year
  25 1,104 million
• Book value of working capital investments yr 25
  3,612 million
• Salvage Value at end of year 25 4,716 million

43
Considering all of the Cashflows The NPV
44
Which makes the argument that..

• The project should be accepted. The positive net
  present value suggests that the project will add
  value to the firm, and earn a return in excess of
  the cost of capital.
• By taking the project, Boeing will increase its
  value as a firm by 4,019 million.

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

• The project is a good one. Using time-weighted,
  incremental cash flows, this project provides a
  return of 14.88. This is greater than the cost
  of capital of 9.32.
• The IRR and the NPV will yield similar results
  most of the time, though there are differences
  between the two approaches that may cause project
  rankings to vary depending upon the approach used.

47
Case 1 IRR versus NPV

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

48
Projects NPV Profile
49
What do we do now?

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

50
Case 2 NPV versus IRR
Project A
350,000
450,000
600,000
Cash Flow
750,000
Investment
1,000,000
NPV 467,937
IRR 33.66
Project B
5,500,000
Cash Flow
4,500,000
3,000,000
3,500,000
Investment
10,000,000
NPV 1,358,664
IRR20.88
51
Which one would you pick?

• Assume that you can pick only one of these two
  projects. Your choice will clearly vary depending
  upon whether you look at NPV or IRR. You have
  enough money currently on hand to take either.
  Which one would you pick?
• Project A. It gives me the bigger bang for the
  buck and more margin for error.
• Project B. It creates more dollar value in my
  business.
• If you pick A, what would your biggest concern
  be?
• If you pick B, what would your biggest concern
  be?

52
Capital Rationing, Uncertainty and Choosing a Rule

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

53
An Alternative to IRR with Capital Rationing

• The problem with the NPV rule, when there is
  capital rationing, is that it is a dollar value.
  It measures success in absolute terms.
• The NPV can be converted into a relative measure
  by dividing by the initial investment. This is
  called the profitability index.
• Profitability Index (PI) NPV/Initial Investment
• In the example described, the PI of the two
  projects would have been
• PI of Project A 467,937/1,000,000 46.79
• PI of Project B 1,358,664/10,000,000 13.59
• Project A would have scored higher.

54
Case 3 NPV versus IRR
Project A
5,000,000
4,000,000
3,200,000
Cash Flow
3,000,000
Investment
10,000,000
NPV 1,191,712
IRR21.41
Project B
5,500,000
Cash Flow
4,500,000
3,000,000
3,500,000
Investment
10,000,000
NPV 1,358,664
IRR20.88
55
Why the difference?

• These projects are of the same scale. Both the
  NPV and IRR use time-weighted cash flows. Yet,
  the rankings are different. Why?
• Which one would you pick?
• Project A. It gives me the bigger bang for the
  buck and more margin for error.
• Project B. It creates more dollar value in my
  business.

56
NPV, IRR and the Reinvestment Rate Assumption

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

57
Solution to Reinvestment Rate Problem
400
500
600
Cash Flow
300
Investment
lt 1000gt
600
500(1.15)
575
2
400(1.15)
529
3
300(1.15)
456
Terminal Value
2160
Internal Rate of Return 24.89
Modified Internal Rate of Return 21.23
58
Why NPV and IRR may differ..

• A project can have only one NPV, whereas it can
  have more than one IRR.
• The NPV is a dollar surplus value, whereas the
  IRR is a percentage measure of return. The NPV is
  therefore likely to be larger for large scale
  projects, while the IRR is higher for
  small-scale projects.
• The NPV assumes that intermediate cash flows get
  reinvested at the hurdle rate, which is based
  upon what you can make on investments of
  comparable risk, while the IRR assumes that
  intermediate cash flows get reinvested at the
  IRR.

59
Case NPV and Project Life
Project A
400
400
400
400
400
-1000
NPV of Project A 442
Project B
350
350
350
350
350
350
350
350
350
350
-1500
NPV of Project B 478
Hurdle Rate for Both Projects 12
60
Choosing Between Mutually Exclusive Projects

• The net present values of mutually exclusive
  projects with different lives cannot be compared,
  since there is a bias towards longer-life
  projects.
• To do the comparison, we have to
• replicate the projects till they have the same
  life (or)
• convert the net present values into annuities

61
Solution 1 Project Replication
Project A Replicated
400
400
400
400
400
400
400
400
400
400
-1000
-1000 (Replication)
NPV of Project A replicated 693
Project B
350
350
350
350
350
350
350
350
350
350
-1500
NPV of Project B 478
62
Solution 2 Equivalent Annuities

• Equivalent Annuity for 5-year project
• 442 PV(A,12,5 years)
• 122.62
• Equivalent Annuity for 10-year project
• 478 PV(A,12,10 years)
• 84.60

63
What would you choose as your investment tool?

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

64
What firms actually use ..

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

65
Boeing 747 What about exchange rate risk?

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

66
Should there be a risk premium for projects with
substantial foreign exposure?

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

67
Equity Analysis The Parallels

• The investment analysis can be done entirely in
  equity terms, as well. The returns, cashflows and
  hurdle rates will all be defined from the
  perspective of equity investors.
• If using accounting returns,
• Return will be Return on Equity (ROE) Net
  Income/BV of Equity
• ROE has to be greater than cost of equity
• If using discounted cashflow models,
• Cashflows will be cashflows after debt payments
  to equity investors
• Hurdle rate will be cost of equity

68
A New Store for the Home Depot

• It will require an initial investment of 20
  million in land, building and fixtures.
• The Home Depot plans to borrow 5 million, at an
  interest rate of 5.80, using a 10-year term
  loan.
• The store will have a life of 10 years. During
  that period, the store investment will be
  depreciated using straight line depreciation. At
  the end of the tenth year, the investments are
  expected to have a salvage value of 7.5
  million.
• The store is expected to generate revenues of 40
  million in year 1, and these revenues are
  expected to grow 5 a year for the remaining 9
  years of the stores life.
• The pre-tax operating margin, at the store prior
  to depreciation, is expected to be 10 for the
  entire period.

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

• The analysis is done in equity terms. Thus, the
  hurdle rate has to be a cost of equity
• The cost of equity for the Home Depot is 9.78.
  Since the Home Depots investments are assumed to
  be homogeneous, the cost of equity for this
  project is also assumed to be 9.78.

72
ROE on this Project
73
From Project ROE to Firm ROE

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

74
Additional Assumptions

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

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

• Our conclusions on a project are clearly
  conditioned on a large number of assumptions
  about revenues, costs and other variables over
  very long time periods.
• To the degree that these assumptions are wrong,
  our conclusions can also be wrong.
• One way to gain confidence in the conclusions is
  to check to see how sensitive the decision
  measure (NPV, IRR..) is to changes in key
  assumptions.

79
Viability of New Store Sensitivity to Operating
Margin
80
What does sensitivity analysis tell us?

• Assume that the manager at The Home Depot who has
  to decide on whether to take this plant is very
  conservative. She looks at the sensitivity
  analysis and decides not to take the project
  because the NPV would turn negative if the
  operating margin drops below 8. Is this the
  right thing to do?
• Yes
• No
• Explain.

81
The Consistency Rule for Cash Flows

• The cash flows on a project and the discount rate
  used should be defined in the same terms.
• If cash flows are in one currency, the discount
  rate has to be a dollar (baht) discount rate
• If the cash flows are nominal (real), the
  discount rate has to be nominal (real).
• If consistency is maintained, the project
  conclusions should be identical, no matter what
  cash flows are used.

82
The Home Depot A New Store in Chile

• It will require an initial investment of 4700
  million pesos for land, building and fixtures.
  The Home Depot plans to borrow 1880 million
  pesos, at an interest rate of 12.02, using a
  10-year term loan.
• The store will have a life of 10 years. During
  that period, the store will be depreciated using
  straight line depreciation. At the end of the
  tenth year, the investments are expected to have
  a salvage value of 2,350 million pesos.
• The store is expected to generate revenues of
  7,050 million pesos in year 1, and these revenues
  are expected to grow 12 a year for the remaining
  9 years.
• The pre-tax operating margin at the store, prior
  to depreciation, is expected to be 6 for the
  entire period.
• The working capital requirements are estimated to
  be 10 of total revenues, and investments will be
  made at the beginning of each year.

83
The Home Depot Chile Store Cashflows in Pesos
84
The Home Depot Chile Store Cost of Equity in
Pesos

• Cost of Equity for a U.S. store 9.78
• Estimating the Country Risk Premium for Chile
• Default spread based on Chilean Bond rating
  1.1
• Relative Volatility of Chilean Equity to Bond
  Market 2.2
• Country risk premium for Chile 1.1 2.2
  2.42
• Cost of Equity for a Chilean Store (in U.S. )
• 5 0.87 (5.5 2.42) 11.88
• Assume that the expected inflation rate in Chile
  is 8 and the expected inflation rate in the U.S.
  is 2.
• Cost of Equity for a Chilean Store (in Pesos)
• (1 Cost of Equity in ) (1
  inflationChile)/ (1 inflationUS) - 1
• 1.1188 (1.08/1.02) -1 18.46

85
NPV in Pesos
86
Converting Pesos to U.S. dollars

• This entire analysis can be done in dollars, if
  we convert the peso cash flows into U.S. dollars.
• If you want the analysis to yield consistent
  conclusions, expected exchange rates have to be
  estimated based upon expected inflation rates
• Current Exchange Rate 470 pesos
• Expected Ratet Exchange Rate (1
  inflationChile)/ (1 inflationUS)
• Expected Exchange Rate in year 1 470 pesos
  (1.08/1.02) 497.65

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

• In our analysis, we used nominal dollars and
  pesos. Would the NPV have been different if we
  had used real cash flows instead of nominal cash
  flows?
• It would be much lower, since real cash flows are
  lower than nominal cash flows
• It would be much higher
• It should be unaffected

90
From Nominal to Real The Home Depot

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

91
Nominal versus Real
92
Side Costs and Benefits

• Most projects considered by any business create
  side costs and benefits for that business.
• The side costs include the costs created by the
  use of resources that the business already owns
  (opportunity costs) and lost revenues for other
  projects that the firm may have.
• The benefits that may not be captured in the
  traditional capital budgeting analysis include
  project synergies (where cash flow benefits may
  accrue to other projects) and options embedded in
  projects (including the options to delay, expand
  or abandon a project).
• The returns on a project should incorporate these
  costs and benefits.

93
Opportunity Cost

• An opportunity cost arises when a project uses a
  resource that may already have been paid for by
  the firm.
• When a resource that is already owned by a firm
  is being considered for use in a project, this
  resource has to be priced on its next best
  alternative use, which may be
• a sale of the asset, in which case the
  opportunity cost is the expected proceeds from
  the sale, net of any capital gains taxes
• renting or leasing the asset out, in which case
  the opportunity cost is the expected present
  value of the after-tax rental or lease revenues.
• use elsewhere in the business, in which case the
  opportunity cost is the cost of replacing it.

94
Case 1 Opportunity Costs

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

95
Case 2 Excess Capacity

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

96
Estimating the Cost of Excess Capacity

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

97
Opportunity Cost of Excess Capacity

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

98
Product and Project Cannibalization

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

99
Product and Project Cannibalization A Real Cost?

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

100
Project Synergies

• A project may provide benefits for other projects
  within the firm. If this is the case, these
  benefits have to be valued and shown in the
  initial project analysis.
• For instance, the Home Depot, when it considers
  opening a new restaurant at one of its stores,
  will have to examine the additional revenues that
  may accrue to this store from people who come to
  the restaurant.

101
Other Investments

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

102
I. Investments in Non-Cash Working Capital

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

103
Distinguishing between Working Capital and
Non-cash Working Capital

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

104
Why investments in non-cash working capital
matter..

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

105
The Effect of Non-cash working capital on a
Project Boeing Super Jumbo

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

106
Present Value Effect of Working Capital
107
NPV of Boeing Super Jumbo and Working Capital as
of Revenues
108
Firm Value and Working Capital Investments

• Investments in working capital drain cash flows,
  and other things remaining equal, reduce the
  value of the firm.
• When firms reduce their investments in non-cash
  working capital (hold less inventory, grant less
  credit or use more supplier credit), they
• Increase their cash flows, but
• Potentially decrease revenues, cash flows and
  expected growth, because of lost sales they
  might also make themselves riskier firms.

109
Working Capital and Value A Simple Example

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

110
Firm Value Schedule as a function of Working
Capital
111
The Trade Off on Elements of Working Capital

• Effect of Increasing Element
• Element Positive Aspects Negative Aspects
• Inventory Fewer lost sales Storage Costs
• Lower re-ordering costs Cash tied up in
  inventory
• Accounts More Revenues Bad Debts (Default)
• Receivable Cash tied up in receivables
• Accounts Used to finance Increased credit risk
• Payable inventory accounts Implicit Cost (if
  there is a
• receivable discount for prompt payment)

112
Managing Inventory

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

113
Inventory Trade Off

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

114
A Simple Example

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

115
Inventory in an EOQ Model
116
Peer Group Analysis

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

117
Analyzing The Home Depots Inventory

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

118
Managing Accounts Receivable

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

119
Cash Flow Analysis A Simple Example

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

120
The Cash Flows Investment in System

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

121
Incremental After-tax Cash Flows

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

122
NPV of Credit Decision

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

123
Investments In Marketable Securities

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

Risky
Riskless
Treasuries
Commercial Paper
Equity in Publicly Traded firms
Equity in Private Businesses
Corporate Bonds
124
Investments in Riskless Securities

• Investments in riskless securities will generally
  earn much lower returns than investments in risky
  projects.
• These low returns notwithstanding, investments in
  riskless securities are value neutral because the
  required return (hurdle rate) for these projects
  is the riskless rate.

125
Investments in Risky Securities

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

126
Project Options

• One of the limitations of traditional investment
  analysis is that it is static and does not do a
  good job of capturing the options embedded in
  investment.
• The first of these options is the option to delay
  taking a project, when a firm has exclusive
  rights to it, until a later date.
• The second of these options is taking one project
  may allow us to take advantage of other
  opportunities (projects) in the future
• The last option that is embedded in projects is
  the option to abandon a project, if the cash
  flows do not measure up.
• These options all add value to projects and may
  make a bad project (from traditional analysis)
  into a good one.

127
The Option to Delay

• When a firm has exclusive rights to a project or
  product for a specific period, it can delay
  taking this project or product until a later
  date.
• A traditional investment analysis just answers
  the question of whether the project is a good
  one if t