MBA/MFM 253 Measuring Return on Investment

The Big Picture The last 2 chapters discussed measuring the cost of capital – the average cost of financing for the entire firm This chapter discusses adjusting the cost of capital for an individual project. The weighted average represents an average across all sources of financing – some projects are more risky some are less risky Each project should be evaluated at their individual cost of capital

The Big Picture – part II A general valuation model for any asset: The value of an asset (either real or financial) can be found by based upon the PV of the future cash flows generated from owning the asset. The main questions to be addressed are then: What future cash flows are generated by the asset What is the appropriate discount rate (interest rate) based on the riskiness of the cash flows.

Simple 2 project example Firm value consists of the sum of the individual parts of the firm. Assume the firm has two assets, A and B, each generates a stream of future cash flows that have the same riskiness and there are no shared costs. The PV of the firm is simply the PV of the cash flows from each set of assets or Firm Value = PV (A) + PV (B) = sum of separate asset values

Three Stages of a Project Acquisition Stage Initial outlay of cash Operating Stage Sales Revenue, Operating Expenses, Taxes etc Disposition Stage Sales of fixed assets, Tax consequences

What is a Project? Major Strategic Decisions Acquisitions of Other firms New Ventures within existing markets Changes in the way current businesses or ventures are approached Spending money on components necessary for business (investment in information systems for example)

The Project Continuum Prerequisite Complementary Independent Mutually Exclusive

Project Risk Should the WACC be used for all projects in the firm? No - it is a composite of all projects (an average). That means some projects are more risky than the average and some less risky. Each project should also be looked at on an individual basis.

Divisional WACC The WACC represents the composite cost of capital across all projects. Before we developed a market-wide relationship between risk and return with the security market line. You can use a similar concept idea to relate risk to a projects cost of capital. This is done with a graph of risk vs. return where return is measured by the cost of capital.

Divisional Cost of Capital Firm H is High Risk with a WACC = 12% Firm L is low Risk with a WACC = 8% Both Firms are considering two projects with equal risk equal to the average risk of Firm H and Firm L. Project A has an expected return of 10.5%, Project B has an expected return of 9.5% Which project(s) should each firm accept?

Risk L Risk A Risk H B A Acceptance Region Rejection Region Risk Return

Determining the Project Cost of Equity 1. Single Business – Project risk is similar across all businesses – use the overall cost of equity and cost of debt 2. Multiple Businesses with different risk profiles – estimate cost of equity using project beta – bottom up beta, accounting beta, or regression on cash flows 3. Projects with different risk profiles – ideally estimate cost of equity for each or use divisional costs of equity if they are fairly close

Project Cost of Debt Generally the cost of debt reflects default risk – however the possibility of default on a given project is difficult to estimate. Therefore debt financing is generally thought of as a firm value instead of a project value. Whether or not to attempt to measure the cost of debt individually depends upon the size of the project and it impact on the overall default risk of the firm.

Cost of Debt - Summary Project Characteristics Cost of DebtDebt Ratio Small and CF similar to firm Firm’s Cost of Debt Firm’s Cost of Equity Project is large CF different from firm Cost of debt of comparable firms Average debt ratio of comparable firms Stand Alone Project Cost of debt for project Debt Ratio for Project

Project cost of capital The combination of different cost of financing into a cost of capital requires a weighting for each of the types of financing. When the project is large, the financing mix may differ from that of the overall firm. In extreme cases the project may be large enough to issue its own debt in that case your weights for the financing options will vary from the firm weights.

Measuring Returns Accounting Earnings vs. Cash Flows Accounting earnings are based on accrual accounting Cash flow measures the actual cash generated in a given time period.

Accrual Based Revenues are realized when the sale is made, and expenses when the purchase or expense occurs, not necessarily when the payment is made. This results in income (earnings) that does not represent cash flow.

Why Cash Flows? Cash represents the ability of the firm to operate (you can’t spend earnings). Accounting earnings are often manipulated to impress shareholders.

Cash Flow vs. Accounting Earnings GAAP is based on accrual accounting Revenues are realized at the time of the sale, not when cash is received (Expenses are realized at the time acquired, not when paid for Operating Expenditures Produce benefits only in the current period Capital Expenditures produce benefits over multiple periods Non - Cash Charges (depreciation etc) Reduce accounting income, but cash exists

Free Cash Flows FCFE (Cash Flow to Equity) =  Net Income + Depreciation& Amortization  -Changes in Non-Cash Net Working Capital  - Capital Expenditures - Principal Repayments  + New Debt Issues FCFF (Cash Flow to Firm) =  EBIT(1-t) + Depreciation& Amortization  - Changes in Non-Cash Net Working Capital  - Capital Expenditures

Incremental Cash Flow Cash flow changes that result from a particular project Relevant Cash Outflows Increase Cash outflow Elimination of cash inflow Investment in Assets Relevant Cash Inflow Increase in cash inflow Elimination of cash outflow Liquidation of assets

Applying the NPV Rule Discount only Incremental Cash Flows Incremental cash flows represent changes that are a result of the project under consideration Be careful about Inflation Do not double count inflation. If you price estimates and future cash flows include inflation, then the correct discount rate should be a REAL rate not the nominal rate.

Steps in estimating Cash Flow Estimate the Income Statement Estimate the Balance Sheet Combine the income statement and balance sheet into a cash flow statement Make a decision

Steps in the planning process 1. Pro Forma Financial Statements and NPV 2. Determine the funds needed to support the plan 3. Forecast the funds available 4. Establish controls 5. Plan for other contingencies 6. Establish a performance based compensation plan

Capital Budgeting Decision Rules Balance between subjective assessment and consistency across projects Reinforces the main goal of corporate finance – Maximize the value of the firm Be applicable to a wide range of possible investments.

Capital Budgeting Decision Rules Accounting Returns Return on Capital – the return earned by the firm on its total investment Accept the project if ROC > Cost of Capital More difficult for multiyear projects

Capital Budgeting Decision Rules Accounting Returns Return on Equity on the project If ROE > Cost of Equity Accept the project

Problems with Accounting Returns Accounting choices cause the balance between subjective judgment and consistency to be called into question. Based on Earnings (Net Income) – so acceptance of a project may or may not add value to the firm (PV of expected future cash flows) Works best for projects with large upfront costs (large capital invested)

Accounting returns for entire firm Both ROE and ROC can provide good intuition about the overall quality of projects accepted by the firm. Both can be calculated for the aggregate firm using book value of equity and book value of capital.

Economic Value Added A measure of the surplus value created by a firm’s projects.

EVA and ROE

Capital Budgeting Decision Rules Payback Period and Discounted Payback Net Present Value Internal Rate of Return & Modified IRR Profitability Index and Modified Profitability index

Payback Period Intuition: Measures length of time it takes for the firm to payback the original investment. Simple example: Cost = 100,000 Cash Flow = 20,000 a year Payback = Cost / Cash Flows = 100,000 / 20,000 = 5 years

Payback Period Most problems do not work out even…. You need to look at the cumulative cash flow and compare to the initial cost.

Calculating Payback Period  Calculate the cumulative cash flow (total cash flow received)  Calculate the Remaining Cost (Total Cost - Cumulative Cash Flow)  Repeat 1 and 2 until remaining cost is less than zero  In last positive year divide remaining cash flow by yearly cash flow in next year  Calculate total payback

Example: Initial Cost = 100,000 YearlyCumulativeRemaining YRCash Flow Cash FlowCash Flow 140,000 40,000 60, ,000 70,000 30, ,000 95,000 5, , , ,000 Payback = 3 + 5,000/20,000 = 3.25

Payback Period: Benefits Easy to Understand and Interpret Reject / Accept based on a Minimum payback Provides measure of risk

Payback Period Weaknesses Ignores Time Value of Money Ignores all cash flows after the payback

Discounted Payback Period Attempts to account for time value of money by evaluating the yearly cash flows in their present value.

Calculating Discounted Payback Period  Calculate the PV of each cash flow  Calculate the cumulative present value of the cash flows (total cash flow received)  Calculate the Remaining Cost (Total Cost - Cumulative PV Cash Flow)  Repeat 1 & 2 until remaining cost is less than 0  In last positive year divide remaining cash flow by yearly cash flow in next year  Calculate total payback

Initial Cost=100,000 r = 10% Yearly PV Cumul Remaining YRCF CF CF CF 1 40,000 36,364 36,364 63, ,000 24,793 61,157 38, ,000 18,783 79,940 20, ,000 13,660 93,600 6, ,000 9, ,914 -2,914 Payback = /9314 = 4.687

Discounted Payback Weakness: Still ignores cash flows after payback Strengths: Accounts for time value of money, easy to understand and calculate, risk measure Accept / Reject -- Set Minimum payback and compare

Net Present Value The sum of the PV of the positive cash flows minus the PV of negative cash flows or

Incremental Cash Flows The cash flows used should represent any changes to Free Cash Flow that result from undertaking the project.

The Required Return What interest rate should be used to discount the cash flows? The project cost of capital

NPV Accept or Reject (The NPV Rule in Detail) If the NPV is positive the PV of the benefits is greater than the PV of the cost -- You should accept the project (The value of the firm will increase if the project is accepted) If the NPV is negative, The PV of the benefits is less than the PV of the cost -- You should reject the project (The value of the firm would decrease if the project is accepted)

NPV Example Assume a cost of capital of 10% (the WACC) YearCash Flow Present Value 0-1,000-1, , ,000-1, ,000 2, NPV = NPV =

Calculator HP 10B -1,000 1,000 -2,000 3,000 10

NPV Note, as in the case of our bond and stock valuation models there will be an inverse relationship between the required return and the NPV. A lower WACC increases the NPV of the project (And the value of the firm)

Internal Rate of Return (The Rate of Return Rule in detail) The IRR is the required return that makes the NPV of a project equal to zero. If IRR is greater than the hurdle rate (the cost of capital) Accept the project IF IRR is less than the hurdle rate (the cost of capital) Reject the project

IRR and NPV IRR and NPV will always provide the same accept / reject decision WHY???? IRR is the rate that makes NPV zero If the (cost of capital) < IRR accept the project, this also implies a positive NPV If the (cost of capital) > IRR reject the project, this also implies a negative NPV

IRR Benefits Intuitive Measure of risk compared to Cost of Capital Weaknesses Ignores size and amount of wealth created Ignores project life It is possible to have multiple IRR’s

Multiple IRR’s Time Cash Flow IRR = 7.4% and 67.6% Time Cash Flow IRR = 7.4% and 67.6% 2 180

Multiple IRR’s vs. NPV Time Cash Flow % = $ Time Cash Flow % = -$3 2180

Multiple IRR’s An easy check for Multiple IRR’s Mathematically the largest number of IRR’s that is possible equals the number of sign changes in the cash flow stream

Modified IRR The discount rate that makes the PV of the projects costs equal the PV of the terminal value of the project Terminal Value = the FV of the positive Cash flows compounded at the cost of capital

Example Cost of Capital = 10% TimeCash Flow PV FV , , = /(1+MIRR) 4 MIRR = 10.34%

Profitability Index Measures the value created per dollar invested

PI If the PI is greater than 1 accept the project (NPV is positive) If the PI is less than 1 reject the project (NPV is negative) If PI = 1.45 it would imply that the project will produce $1.45 for each $1 invested.

Quick Review MethodAcceptReject PaybackPayback cutoff Disc. PaybackSame as Payback NPV NPV > 0 NPV < 0 IRR IRR > WACC IRR < WACC MIRR MIRR >WACC MIRR < WACC PI PI > 1PI < 1

Mutually Exclusive NPV provides the best ranking when comparing between mutually exclusive investments, The rest can produce inconsistent rankings.

Example ProjectInitial Cost YR1 CF YR2 CF A1,000,000 1,000,000 0 B1,200,000 1,119, ,000 C900, , ,000 D1,100, , ,000 Compare the different methods for both 7% and 12% (in Class)

Comparison of results

IRR vs. NPV revisited Investment Cost YR 1 IRR A 10,000 12,000 20% B 15,000 17,700 18% A B for both

On the Graph 14% Asset A Asset B 20%18%

Summary Use NPV as the first rule The other criteria can provide secondary information Which criteria is most often used by managers?

Identifying Good Projects Creation of Barriers to competitors and their Maintaining the barriers Economies of Scale Cost Advantages Capital Requirements Product Differentiation Access to Distribution Channels Legal and Government Barriers

Putting it all together: The Value of a Share This definition includes value of equity and debt. If you subtract the value of debt (and preferred stock) you would have a measure of the Market Value of Equity or the Market Value of the claims of the shareholders

The Share Price

EVA and Share Price The market value of the firm should represent the book value of the firm plus a claim on all future EVA created or:

Market Value Share Price x Shares Outstanding + Debt Market Value Added Capital Economic Value Added EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA EVAEVA Market Value Added = Present Value of Future EVA™ EVA™ = NOPAT – Capital Charge EVA IS a trademark of Stern Stewart

Market Price Can analysts forecast future EVA and FCF? Information and market problem Agency Problems Short Term vs. Long Term (Bounded Self Control?) Valuing Strategic Options Other Problems

Identifying Good Projects Creation of Barriers to competitors and their Maintaining the barriers Economies of Scale Cost Advantages Capital Requirements Product Differentiation Access to Distribution Channels Legal and Government Barriers