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INVESTMENT EVALUATION Professor Tim Thompson Kellogg School of ManagementPowerPoint Presentation

INVESTMENT EVALUATION Professor Tim Thompson Kellogg School of Management

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Separate investment and financing decisions: Evaluate as if entirely equity financed 5) Estimate flows on a incremental basis 6) Opportunity costs cannot be ignored

8) Be consistent in your treatment of inflation 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.

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 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

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 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

- NPV (net present value)
- Payback, Profitability Index
- ROA, ROFE, ROI, ROCE
- ROE
- EVA

- DCF (discounted cash flows)

Investment Evaluation

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

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

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

- NPV (net present value)
- Payback , Profitability Index
- ROA, ROFE, ROI, ROCE
- ROE
- EVA

- DCF (discounted cash flows)

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.

- 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

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.

- Nominal cash flows (including inflation) -- use a nominal cost of capital R
- Real cash flows (without inflation) -- use a real cost of capital r

Investment Evaluation

- 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 FlowsCash Flows from Operations

Investment Evaluation

- 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 Flows1) Depreciation is not a cash flow, but it affects taxation

Investment Evaluation

- 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 Flows2) Do not ignore investment in fixed assets.

Investment Evaluation

- 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 Flows3) Do not ignore investment in net working capital.

Investment Evaluation

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

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

- 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 Flows4) Separate investment and financing decisions

Evaluate as if entirely equity financed

Ignore financing/

no interest line item

Investment Evaluation

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

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

Investment Evaluation

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 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

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

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 Flows

Nominal vs. Real Cash Flows

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

Investment Evaluation

- 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 Flows9) Overhead costs

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

Investment Evaluation

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 the Firm

-Value of Debt

=Value of Equity

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

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

- NPV (net present value)
- Payback , Profitability Index
- ROA, ROFE, ROI, ROCE
- ROE
- EVA

- DCF (discounted cash flows)

Investment Evaluation

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

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

Example:

Investment Evaluation

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

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

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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