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INVESTMENT EVALUATION Professor Tim Thompson Kellogg School of Management. The Finance Function. Financial Manager. Operations (Plant, Equipment, Projects, etc.). Financial Markets (Investors). (1a) Raise Funds. (2) Investment. (1b) Obligations (Stocks, Debt, IOUs). (4) Reinvest.

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INVESTMENT EVALUATION

Professor Tim Thompson

Kellogg School of Management

Investment Evaluation


The finance function
The Finance Function

Financial

Manager

Operations

(Plant, Equipment, Projects, etc.)

Financial Markets

(Investors)

(1a) Raise

Funds

(2) Investment

(1b) Obligations

(Stocks, Debt, IOUs)

(4) Reinvest

(3) Cash from

Operations

(5) Dividends or

Interest Payments

The finance function manages the cash flow

Investment Evaluation


The finance function1
The Finance Function

Finance focuses on these two decisions

Operations

Financial Markets

Investment

Decision

Financing

Decision

Financial

Manager

How much to invest and in what assets?

Where is the $ going to come from?

Capital Budgeting

Investment Evaluation


Interaction between financing investment decisions
Interaction between Financing & Investment Decisions

The interplay of the decisions determines the cost of capital

Characteristics

of the

Investment

Investment

Decision

Financing

Decision

Operations

Financial Markets

Financial

Manager

Cost of Capital

Investment Evaluation


The finance function2
The Finance Function

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

The objective of the financial manager and the corporation is to MAXIMIZE THE CURRENT VALUE OF SHAREHOLDERS' WEALTH.

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

Investment Evaluation


Investment Evaluation in 3 Basic Steps

  • 1) Forecast all relevant after tax expected cash flows generated by the project

  • 2) Estimate the opportunity cost of capital--r (reflects the time value of money and the risk)

  • 3) Evaluation

    • DCF (discounted cash flows)

      • NPV (net present value)

        • Accept project if NPV is positive

        • Reject project if NPV is negative

      • IRR (internal rate of return

        • Accept project if IRR > r

    • Payback, Profitability Index

    • ROA, ROFE, ROI, ROCE

    • ROE

    • EVA

Investment Evaluation


Forecasting Cash Flows

First, forecast all relevant after-tax expected cash flows

Key is that cash flows must be (a) relevant, costs and income directly affected by the project, and (b) after-tax, cash into the owner’s pocket

Investment Evaluation


Forecasting Cash Flows

This is done by estimating operational parameters

This represents a “best guess” about the company’s future performance

These are based on actual reported performance

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

Investment Evaluation


Investment Evaluation

Evaluating investments involves the following:

  • 1) Forecast all relevant after tax expected cash flows generated by the project

  • 2) Estimate the opportunity cost of capital--r (reflects the time value of money and the risk)

  • 3) Evaluation

    • DCF (discounted cash flows)

      • NPV (net present value)

        • Accept project if NPV is positive

        • Reject project if NPV is negative

      • IRR (internal rate of return

        • Accept project if IRR > r

    • Payback , Profitability Index

    • ROA, ROFE, ROI, ROCE

    • ROE

    • EVA

Investment Evaluation


Forecasting Cash Flows: The Ten Commandments

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

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

  • 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.

  • Separate investment and financing decisions: Evaluate as if entirely equity 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

  • Investment Evaluation


    Forecasting Cash Flows: The Ten Commandments

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

      • Liquidation value: Estimate the proceeds from the sale of assets after the explicit forecast period. (Recover investment in working capital, tax-shield or fixed assets but missing the intangibles and value of on-going business)

      • Perpetual growth: Assume cash flows are expected to grow at a constant rate perpetually.

  • 8) Be consistent in your treatment of inflation

    • Nominal cash flows (including inflation) -- use a nominal cost of capital R

    • Real 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 off balance sheet items.

  • Investment Evaluation


    Forecasting cash flows

    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

    Forecasting Cash Flows

    Cash Flows from Operations

    Investment Evaluation


    Forecasting cash flows1

    Revenue

    - Cost of Goods Sold

    - Depreciation

    - 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

    Forecasting Cash Flows

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

    Investment Evaluation


    Forecasting cash flows2

    Revenue

    - Cost of Goods Sold

    - Depreciation

    - 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

    Forecasting Cash Flows

    2) Do not ignore investment in fixed assets.

    Investment Evaluation


    Forecasting cash flows3

    Revenue

    - Cost of Goods Sold

    - Depreciation

    - 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

    Forecasting Cash Flows

    3) Do not ignore investment in net working capital.

    Investment Evaluation


    Forecasting cash flows4
    Forecasting Cash Flows

    • There is an important distinction between the accounting definition of working capital and the economic/finance definition relevant to cash flows forecast.

      • The distinction is a direct result of the 4th commandment above: We need the operating working capital, not the operating and financial working capital.

    Investment Evaluation


    Accounting definition of working capital

    Working Capital=

    Current Assets -

    Current Liabilities

    Accounts receivable

    Inventory

    Cash (required for operations)

    Excess Cash & marketable securities

    Accounts payable

    Accrued taxes

    Accrued wages

    short-term debt

    Accounting Definition of Working Capital

    • 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-operatingshort-term debt (below the dotted line).

    Investment Evaluation


    Forecasting cash flows5

    Revenue

    - Cost of Goods Sold

    - Depreciation

    - 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

    Forecasting Cash Flows

    4) Separate investment and financing decisions

    Evaluate as if entirely equity financed

    Ignore financing/

    no interest line item

    Investment Evaluation


    Forecasting cash flows6
    Forecasting Cash Flows

    5) Estimate flows on an incremental basis

    Incremental = total firm cash flow - total firm cash flow

    Cash Flow WITH the project WITHOUT the 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.)

  • Investment Evaluation


    Forecasting cash flows7
    Forecasting Cash Flows

    6) Opportunity costs cannot be ignored

    What other

    uses could

    resources be

    put to?

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

    Investment Evaluation


    Forecasting cash flows8
    Forecasting Cash Flows

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

    • Two approaches are available:

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

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

    Investment Evaluation


    Forecasting cash flows9

    Terminal Value

    Year n+1 & on

    CFn+1/(r-g)

    . . .

    Year 1

    CF1

    Year 2

    CF2

    Year n

    CFn

    Forecasting Cash Flows

    • Perpetual growth: Assumes that after time n cash flows are expected to grow at a constant rate perpetually.

    Investment Evaluation


    Forecasting Cash Flows

    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

    Common Mistake: Nominal (inflation adjusted) discount rate used to discount real cash flows

    Bias towards short-term investment

    Nominal vs. Real Interest Rate

    {

    4%

    Inflation

    7%

    Nominal

    3%

    Real

    Nominal Rate » Real Rate + Inflation

    Investment Evaluation


    Forecasting cash flows10
    Forecasting Cash Flows

    Nominal vs. Real Cash Flows

    Note: Depreciation is based on historical costs and therefore is not adjusted for inflation

    Investment Evaluation


    Forecasting cash flows11

    Revenue

    - Cost of Goods Sold

    - Depreciation

    - 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

    Forecasting Cash Flows

    9) Overhead costs

    Do not forget overheads and other indirect costs that increase due to the project

    Investment Evaluation


    Forecasting cash flows12
    Forecasting Cash Flows

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

    . . .

    Year 1

    CF1

    Year 2

    CF2

    Year 4

    CF4

    Year 5

    CF5

    Terminal

    CFn+1/(r-g)

    Year 3

    CF3

    PV(Operating Cash Flows)

    + Excess cash balance

    + Excess marketable securities

    + Excess real estate

    - Under-funded pension

    =Value of the FIRM

    Assets/Liabilities not required to support operations

    Investment Evaluation


    Value of equity
    Value of Equity

    Value of the Firm

    -Value of Debt

    =Value of Equity

    To calculate share price-divide by the number of shares outstanding

    Investment Evaluation


    Investment Evaluation

    Evaluating investments involves the following:

    • 1) Forecast all relevant after tax expected cash flows generated by the project

    • 2) Estimate the opportunity cost of capital--r (reflects the time value of money and the risk)

    • 3) Evaluation

      • DCF (discounted cash flows)

        • NPV (net present value)

          • Accept project if NPV is positive

          • Reject project if NPV is negative

        • IRR (internal rate of return

          • Accept project if IRR > r

      • Payback , Profitability Index

      • ROA, ROFE, ROI, ROCE

      • ROE

      • EVA

    Investment Evaluation


    Evaluation Methods: NPV

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

    Example:

    Future cash flows are discounted “penalized” for time and risk

    Investment Evaluation


    Evaluation Methods: NPV

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

    Example:

    Investment Evaluation


    Evaluation Methods: IRR

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

    Example:

    IRR: Discount rate at which the project has a NPV of zero

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

    Investment Evaluation


    Calculation of irr
    Calculation of IRR

    The IRR is the r that solves

    Decision Rule: Accept the project if

    IRR > Opportunity Cost of Capital

    Investment Evaluation


    Evaluation Methods: NPV vs. IRR

    NPV is a measure of absolute performance, whereas IRR measures relative performance:

    1) Independent Projects

    Accept if NPV > 0

    Accept if IRR > Opportunity Cost of Capital

    Investment Evaluation


    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

    Highest (NPVa, NPVb, NPVc)

    Highest (IRRa, IRRb, IRRc)

    Obviously, the return in absolute

    dollars must be considered

    Preference for CF early!

    But, it depends.

    Investment Evaluation


    Evaluation Methods: NPV vs. IRR

    The ranking of the projects depends on the discount rate

    A is a LT project and when discount rate ­PV ¯

    B is a ST project and when discount rate ­PV ¯ drops less

    Investment Evaluation


    Other Evaluation Methods

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

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

    • Problems:

    • No discounting the first 3 years

    • Infinite discounting of later 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 =

    Earnings

    Investment

    =

    • Problems:

    • Investment not valued at market

    • Earnings vs. cash flows

    Net Income

    Shareholders’ Equity

    Book Value

    Investment Evaluation


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