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Investment Evaluation1 INVESTMENT EVALUATION Professor Tim Thompson Kellogg School of Management

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Investment Evaluation2 The Finance Function Financial Markets (Investors) Financial Markets (Investors) Operations (Plant, Equipment, Projects, etc.) Operations (Plant, Equipment, Projects, etc.) Financial Manager (1a) Raise Funds (1b) Obligations (Stocks, Debt, IOUs) (2) Investment (3) Cash from Operations (5) Dividends or Interest Payments The finance function manages the cash flow (4) Reinvest

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Investment Evaluation3 The Finance Function Financial Markets Operations Financial Manager Financial Manager Investment Decision Financing Decision How much to invest and in what assets? Where is the $ going to come from? Capital Budgeting Finance focuses on these two decisions

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Investment Evaluation4 Interaction between Financing & Investment Decisions Financial Markets Operations Financial Manager Financial Manager Investment Decision Financing Decision The interplay of the decisions determines the cost of capital Cost of Capital Characteristics of the Investment

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Investment Evaluation5 The Finance Function 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.) 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.) By making investing and financing decisions, the financial manager is attempting to achieve the following objective:

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Investment Evaluation6 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

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Investment Evaluation7 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

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Investment Evaluation8 Forecasting Cash Flows This is done by estimating operational parameters These are based on actual reported performance This represents a “best guess” about the company’s future performance Obviously, there is an uncertainty problem but history is used as a guide for what to expect in the future

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Investment Evaluation9 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

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Investment Evaluation10 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 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 The Ten Commandments Forecasting Cash Flows: The Ten Commandments

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Investment Evaluation11 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. The Ten Commandments Forecasting Cash Flows: The Ten Commandments

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Investment Evaluation12 Forecasting Cash Flows 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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Investment Evaluation13 Forecasting Cash Flows 1) Depreciation is not a cash flow, but it affects taxation 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

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Investment Evaluation14 Forecasting Cash Flows 2) Do not ignore investment in fixed assets. 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

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Investment Evaluation15 Forecasting Cash Flows 3) Do not ignore investment in net working capital. 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

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Investment Evaluation16 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. n The distinction is a direct result of the 4th commandment above: We need the operating working capital, not the operating and financial working capital.

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Investment Evaluation17 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 receivable Inventory Cash (required for operations) Excess Cash & marketable securities Accounts payable Accrued taxes Accrued wages short-term debt Working Capital =Current Assets - Current Liabilities

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Investment Evaluation18 Forecasting Cash Flows 4) Separate investment and financing decisions 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 Evaluate as if entirely equity financed Ignore financing/ no interest line item Evaluate as if entirely equity financed Ignore financing/ no interest line item

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Investment Evaluation19 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.) 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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Investment Evaluation20 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.

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Investment Evaluation21 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.

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Investment Evaluation22 Forecasting Cash Flows Perpetual growth: Assumes that after time n cash flows are expected to grow at a constant rate perpetually. Year 1 CF 1 Year 2 CF 2 Year n CF n... Terminal Value Year n+1 & on CF n+1 /(r-g)

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Investment Evaluation23 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) discount rate used to discount real cash flows Bias towards short-term investment Nominal vs. Real Interest Rate 7% 4% 3% Nominal Inflation Real { Forecasting Cash Flows

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Investment Evaluation24 Nominal vs. Real Cash Flows Note: Depreciation is based on historical costs and therefore is not adjusted for inflation Forecasting Cash Flows

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Investment Evaluation25 Forecasting Cash Flows 9) Overhead costs 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 Do not forget overheads and other indirect costs that increase due to the project

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Investment Evaluation26 Forecasting Cash Flows 10) Include excess cash, excess real estate, unfunded (over- funded) pension funds, large stock option obligations Year 1 CF 1 Year 2 CF 2 Year 3 CF 3 Year 4 CF 4 Year 5 CF 5 Terminal CF n+1 /( r -g)... 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

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Investment Evaluation27 Value of the Firm -Value of Debt =Value of Equity To calculate share price-divide by the number of shares outstanding Value of Equity

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Investment Evaluation28 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

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Investment Evaluation29 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

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Investment Evaluation30 Evaluation Methods: NPV Net Present Value (NPV) is the sum of all cash flows adjusted by the discount rate Example:

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Investment Evaluation31 Evaluation Methods: IRR As the discount rate increases, the PV of future cash flows is lower and the NPV is reduced Example: Internal rate of return (IRR) is the discount rate that sets the NPV to zero IRR: Discount rate at which the project has a NPV of zero

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Investment Evaluation32 Calculation of IRR The IRR is the r that solves Decision Rule: Accept the project if IRR > Opportunity Cost of Capital

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Investment Evaluation33 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

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Investment Evaluation34 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 (NPV a, NPV b, NPV c ) Highest (IRR a, IRR b, IRR c ) Obviously, the return in absolute dollars must be considered Preference for CF early! But, it depends.

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Investment Evaluation35 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 Evaluation Methods: NPV vs. IRR

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Investment Evaluation36 Other Evaluation Methods Payback: How long does it take for the project to payback? Problems: No discounting the first 3 years Infinite discounting of later years è 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 Profitability Index: PV/I. Problem: Biases against large-scale projects.

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Investment Evaluation37 Use of Capital Budgeting Rules in Practice.

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