investment evaluation abridged

8/2/2019 Investment Evaluation Abridged

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Investment Evaluation 1

INVESTMENT EVALUATION

Professor Tim Thompson

Kellogg School of Management


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The Finance Function

FinancialMarkets

(Investors)

Operations(Plant,

Equipment,Projects,

etc.)

FinancialManager

(1a) RaiseFunds

(1b) Obligations(Stocks, Debt, IOUs)

(2) Investment

(3) Cash fromOperations

(5) Dividends orInterest Payments

The finance function manages the cash flow

(4) Reinvest


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FinancialMarkets

Operations FinancialManager

InvestmentDecision

FinancingDecision

How much toinvest and inwhat assets?

Where is the $going to come

from?Capital Budgeting

Finance focuses on these two decisions


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Interaction between Financing &

Investment Decisions

FinancialMarkets

Operations FinancialManager

InvestmentDecision

FinancingDecision

The interplay of the decisions determines the cost of capital

Cost of Capital

Characteristicsof the

Investment


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The objective of the financial managerand the corporation is to MAXIMIZE

THE CURRENT VALUE OFSHAREHOLDERS' WEALTH.

(Taken literally, this means that a firm should pursue policies thatmaximize its today's quotation in the Wall Street Journal.)

By making investing and financing decisions, the financialmanager is attempting to achieve the following objective:


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Investment Evaluation in 3 Basic Steps

1) Forecast all relevant after tax expected cash flows generatedby the project2) Estimate the opportunity cost of capital--r(reflects the timevalue of money and the risk)3) Evaluation

DCF (discounted cash flows)NPV (net present value)

Accept project if NPV is positiveReject project if NPV is negative

IRR (internal rate of returnAccept project if IRR > r

Payback, Profitability IndexROA, ROFE, ROI, ROCEROEEVA


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Forecasting Cash Flows

First, forecast all relevant after-tax expected cash flows

Actual

B. Operating Income 1998 1999 2000 2001 2002 2003 2004

1 Sales 1,356.1 1,535.0 1,660.0 1,759.6 1,865.2 1,958.4 2,056.4

2 Operating Costs (1,143.2) (1,304.8) (1,402.7) (1,478.1) (1,566.7) (1,645.1) (1,727.3)

3 Depreciation (67.5) (77.0) (83.0) (80.0) (75.0) (70.0) (65.0)

4 EBIT 145.4 153.3 174.3 201.5 223.4 243.3 264.0

5 Taxes (50.6) (61.3) (69.7) (80.6) (89.4) (97.3) (105.6)

6 EBIAT 94.8 92.0 104.6 120.9 134.1 146.0 158.4

Actual

C. Cash Flows from Operations 1998 1999 2000 2001 2002 2003 2004

7 EBIAT 94.8 92.0 104.6 120.9 134.1 146.0 158.4

8 Depreciation 67.5 77.0 83.0 80.0 75.0 70.0 65.0

9 Changes in WC (87.7) (30.3) (75.0) (19.9) (21.1) (18.7) (19.6)

10 Capital Investment (59.7) (46.2) (48.4) (50.0) (50.0) (50.0) (50.0)

11 Free Cash Flows 14.9 92.4 64.2 131.0 137.9 147.4 153.8

ProForma

ProForma

Sample Corporation VALUATION

Key is that cash flows must be (a) relevant, costs and income directlyaffected by the project, and (b) after-tax, cash into the owners pocket


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This is done by estimating operational parameters

Actual

A. Operating Parameters 1998 1999 2000 2001 2002 2003 2004 2005 Terminal

S Sales Growth (%) 49.6% 13% 8% 6% 6% 5% 5% 5%

P Operating Profit Margin (%) 15.7% 15.0% 15.5% 16.0% 16.0% 16.0% 16.0% 16.0%

T Tax Rate (%) 39.9% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%

D Depreciation ($) 67.5 77.0 83.0 80.0 75.0 70.0 65.0 65.0

C Capital Expenditure ($) 59.7 46.2 48.4 50.0 50.0 50.0 50.0 50.0

W Working Capital as % of Sales (%) 19.5% 16.9% 60.0% 20.0% 20.0% 20.0% 20.0% 20.0%

Excess Cash -

Market Value of Debt 217.3

# of Outstanding Shares 22.9

Perpetual Growth Rate 5.0%

Sample Corporation VALUATION

ProForma

These are based onactual reportedperformance

This represents a bestguess about thecompanys futureperformance

Obviously, there is an uncertainty problem but history is used as a guide forwhat to expect in the future


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Investment Evaluation

Evaluating investments involves the following:

1) Forecast all relevant after tax expected cash flows generatedby the project2) Estimate the opportunity cost of capital--r(reflects the timevalue of money and the risk)3) Evaluation



IRR (internal rate of returnAccept project if IRR > rPayback , Profitability IndexROA, ROFE, ROI, ROCEROEEVA


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1) Depreciation is not a cash flow, but it affects taxation

2) Do not ignore investment in fixed assets (Capital Expenditures)

3) Do not ignore investment in net working capital Include only changes in operating working capital. Short-term debt,

excess cash and marketable securities should not be accounted for.

4) Separate investment and financing decisions: Evaluate as if entirelyequity financed

5) Estimate flows on a incremental basis Forget sunk costs: cost incurred in the past and irreversible Include all externalities - the effects of the project on the rest of the firm -

e.g., cannibalization or erosion, enhancement

6) Opportunity costs cannot be ignored

Forecasting Cash Flows: The Ten Commandments


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7) Do not forget continuing value (residual or terminal value)Liquidation value: Estimate the proceeds from the sale of assets after theexplicit forecast period. (Recover investment in working capital, tax-shield orfixed assets but missing the intangibles and value of on-going business)Perpetual growth: Assume cash flows are expected to grow at a constant rateperpetually.

8) Be consistent in your treatment of inflationNominal cash flows (including inflation) -- use a nominal cost of capital RReal cash flows (without inflation) -- use a real cost of capital r

9) Overhead costs

10) Include excess cash, excess real estate, unfunded (over-funded)pension fund, large stock option obligations, and other relevant offbalance sheet items.

Forecasting Cash Flows: The Ten Commandments

g)-(rcValueContinuing 1t


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Cash Flows from Operations

Revenue- Cost of Goods Sold- Depreciation (may be in CGS)

- Selling, General & Admin.

= Operating Profit- Cash Taxes on Operating Profit

= Net Operating Profit After Tax+ Depreciation- Capital Expenditures- Increase in Working Capital

= Cash Flow from Operations


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1) Depreciation is not a cash flow, but it affects taxation

Revenue- Cost of Goods Sold- Depreciation






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2) Do not ignore investment in fixed assets.







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3) Do not ignore investment in net working capital.







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There is an important distinction betweenthe accounting definition of working

capital and the economic/financedefinition relevant to cash flows forecast.

The distinction is a direct result of the 4thcommandment above: We need the operatingworking capital, not the operating andfinancial working capital.


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Current assets include operating assets (above dotted line). However,

excess cash and marketable securities not required for operations (below

dotted line) are not operating working capital and accounted separately for

value (see 10th commandment).

Current liabilities include both operating liabilities (above the dotted line)

and non-operating short-term debt (below the dotted line).

Accounting Definition of Working

Capital

Accounts receivableInventory

Cash (required for operations)

Excess Cash & marketable securities

Accounts payableAccrued taxes

Accrued wages

short-term debt

Working Capital= Current Assets - Current Liabilities


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4) Separate investment and financing decisions






Evaluate as ifentirely equity

financed

Ignorefinancing/

no interest lineitem


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5) Estimate flows on an incremental basis

Incremental = total firm cash flow - total firm cash flowCash Flow WITHthe project WITHOUTthe project

Forget Sunk Costs

costs incurred in the past and irreversible

Include all effects of the project on the rest of the firm(e.g., cannibalization, erosion, enhancement, etc.)


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6) Opportunity costs cannot be ignored

What other

uses couldresources beput to?

The cost of any resource is the foregone opportunity ofemploying this resources in the next best alternative use.


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7) Do not forget continuing value (residual or terminal)

Two approaches are available:

Liquidation value: Estimate the proceeds from the sale ofassets after the explicit forecast period. (Include the recoveryof investment in working capital, tax-shield on theundepreciated fixed assets and any revenue from assets sale).

This approach results in under-valuation since it misses thevalue of on-going business. It ignores the value ofintangibles.


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Perpetual growth: Assumes that after time n cashflows are expected to grow at a constant rateperpetually.

Year 1

CF1

Year 2

CF2

Year n

CFn

. . .

Terminal Value

Year n+1 & on

CFn+1

/(r-g)


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8) Be consistent in the treatment of inflation

Discount nominal cash flows with nominal cost of capital

Discount real cash flows with real cost of capital

Nominal Rate

Real Rate + Inflation

Common Mistake: Nominal (inflation adjusted) discountrate used to discount real cash flowsBias towards short-term investment

7%

4%

3%Nominal

Inflation

Real{



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1 2 3

Nominal 2.00 2.08 2.16Real 2.00 2.00 2.00

Inflation @ 4%

Nominal vs. Real Cash Flows

Note: Depreciation is based on historical costs and therefore is notadjusted for inflation



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9) Overhead costs






Do not forgetoverheads andother indirect

costs thatincrease dueto the project


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10) Include excess cash, excess real estate, unfunded (over-funded) pension funds, large stock option obligations

Year 1CF1

Year 2CF2

Year 3CF3

Year 4CF4

Year 5CF5

TerminalCFn+1/(r-g)

. . .

PV(Operating Cash Flows)+ Excess cash balance

+ Excess marketable securities+ Excess real estate- Under-funded pension

=Value of the FIRM

Assets/Liabilitiesnot required tosupport operations


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Value of the Firm

-Value ofDebt

=Value ofEquity

To calculate share price-divide by thenumber of shares outstanding

Value of Equity


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Investment Evaluation

Evaluating investments involves the following:

1) Forecast all relevant after tax expected cash flows generated bythe project2) Estimate the opportunity cost of capital--r(reflects the time

value of money and the risk)3) Evaluation



IRR (internal rate of returnAccept project if IRR > r

Payback , Profitability IndexROA, ROFE, ROI, ROCEROEEVA


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Evaluation Methods: NPV

Net Present Value (NPV) is the sum of all cash flows adjustedby the discount rate

Example:Time Period 0 1 2

Activity Buy Hot Dog Cart Sell Hot Dogs Sell Hot Dogs

Cash Flows -187 110 121

Discount Rate 10%

13100100187

)10.01(121

)10.01(110187

2

NPV

NPV

Future cash flows are discounted penalized for time and risk


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Evaluation Methods: NPV

Net Present Value (NPV) is the sum of all cash flows adjustedby the discount rate

Example:Time Period 0 1 2

Activity Buy Hot Dog Cart Sell Hot Dogs Sell Hot Dogs

Cash Flows -200 110 121

Discount Rate 10%

0100100200

)10.01(121

)10.01(110200

2

NPV

NPV


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Evaluation Methods: IRR

As the discount rate increases, the PV of future cash flows islower and the NPV is reduced

Example: Hot Dog Cart Valuation

-30

-20

-10

0

10

20

30

40

50

0% 2% 4% 6% 8% 10%

12%

14%

16%

18%

20%

22%

24%

Discount Rate (%)

NPV(

$)

Internal rate of return (IRR) is the discount rate that sets the

NPV to zero

IRR: Discount rate atwhich the project has aNPV of zero


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Calculation of IRR

The IRR is the r that solves

Decision Rule: Accept the project if

IRR > Opportunity Cost of Capital

n

n

r

C

r

C

r

CC

)1(....)1(10 221

0


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Evaluation Methods:

NPV vs. IRR

NPV is a measure of absolute performance, whereas IRRmeasures relative performance:

1) Independent Projects

Accept if NPV > 0

Accept if IRR > Opportunity Cost of Capital


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Evaluation Methods:

NPV vs. IRR

2) Mutually Exclusive Projects (Ranking)

Problems with IRR:

A) Scale

B) Timing of Cash Flows: Bias against long-term

investments

Time Period: 0 1 IRR

Project A -1 5 400%

Project B -100 120 20%

Highest (NPVa, NPVb, NPVc)Highest (IRRa, IRRb, IRRc)

Obviously, the return in absolutedollars must be considered

Preference for CF early!But, it depends.

Time Period: 0 1 2

Project A -100 20 120

Project B -100 100 31.25

Time Period: 0 1 2 IRR NPV@0% NPV@10% NPV@20%

Project A -100 20 120 20% 40 17.3 0.0

Project B -100 100 31.25 25% 31.25 16.7 5.0

E l i M h d


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The ranking of the projects depends on the discount rateTime Period: 0 1 2 IRR NPV@0% NPV@10%

Project A -100 20 120 20% 40 17.3

Project B -100 100 31.25 25% 31.25 16.7

A is a LT project and when discount rate PV

B is a ST project and when discount rate PVdrops less

Evaluation Methods:

NPV vs. IRR


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Other Evaluation Methods

Payback: How long does it take for the project to payback?

Time Period: 0 1 2 3 4 5

Project A -100 20 30 50 Pass

Project B -10 2 2 2 105B Fail

Corporate Rule: Project must payback in at most 3 years!

Problems:No discounting the first3 years

Infinite discounting oflater years Biases against long-term projects.ROA (return on assets)

ROI (return on investment)ROFE (return on funds employed)

ROCE (return on capital employed)

ROE =

} EarningsInvestment=Problems:Investment not valued at marketEarnings vs. cash flowsNet Income

Shareholders Equity

Book Value

Profitability Index: PV/I. Problem: Biases against large-scale projects.

investment evaluation abridged

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