Download presentation

Presentation is loading. Please wait.

1
**INVESTMENT EVALUATION**

Professor Tim Thompson Kellogg School of Management Investment Evaluation

2
**The Finance Function Financial Manager Operations Financial Markets**

(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

3
**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

4
**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

5
**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

6
**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

7
**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

8
**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

9
**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

10
**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

11
**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

12
**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 Investment Evaluation

13
**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 Investment Evaluation

14
**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 Investment Evaluation

15
**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 Investment Evaluation

16
**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

17
**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 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). Investment Evaluation

18
**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 Investment Evaluation

19
**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

20
**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

21
**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

22
**Forecasting Cash Flows**

Perpetual growth: Assumes that after time n cash flows are expected to grow at a constant rate perpetually. Year 1 CF1 Year 2 CF2 Year n CFn . . . Terminal Value Year n+1 & on CFn+1/(r-g) Investment Evaluation

23
**8) Be consistent in the treatment of inflation**

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

24
**Forecasting Cash Flows**

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

25
**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 Investment Evaluation

26
**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 3 CF3 Year 4 CF4 Year 5 CF5 . . . Terminal CFn+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 Investment Evaluation

27
**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

28
**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

29
**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

30
**Investment Evaluation**

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

31
**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

32
**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

33
**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

34
**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

35
**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

36
**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

37
**Use of Capital Budgeting Rules in Practice.**

Investment Evaluation

Similar presentations

© 2017 SlidePlayer.com Inc.

All rights reserved.

Ads by Google

Ppt on tata motors history Ppt on preparation of alkanes Ppt on amplitude modulation and demodulation Ppt on rime of the ancient mariner part 1 and 2 Free ppt on motivational skills Ppt on sedimentation decantation and filtration Ppt on non agricultural activities in australia Ppt on conservation of plants and animals for class 8 Do ppt online Ppt on earth and space book