Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter 8 Investment Analysis

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter Overview Investment AnalysisInvestment Analysis –Application of TVM and Market Value WACCWACC Discount RateDiscount Rate Capitalization Method of ValuationCapitalization Method of Valuation

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter Overview Investment Analysis ToolsInvestment Analysis Tools –Payback period –NPV –IRR –MIRR Factors Impacting Investment AnalysisFactors Impacting Investment Analysis

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Components of Investment Analysis WACCWACC Discount RateDiscount Rate Capitalization Method of ValuationCapitalization Method of Valuation

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved WACC Used to calculate present value of an investmentUsed to calculate present value of an investment Rate used to discount future cash flowsRate used to discount future cash flows Mix of debt and equity depends on how much the company can borrow and pay debt serviceMix of debt and equity depends on how much the company can borrow and pay debt service

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved WACC Review Amount of interest expense and cash flow allotted to equity investors divided by the amount of capitalAmount of interest expense and cash flow allotted to equity investors divided by the amount of capital Takes into consideration:Takes into consideration: –Capital mix –Tax effect Interest portion of debt service treated as an expense for tax purposes in the US

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved WACC Calculation WACC = w d k d (1-T) + w e k e Weight of debt = w d Cost of debt = k d (1-T) Tax rate of business = T Tax effect = (1-T) Weighted cost of debt = w d k d (1-T) Weight of equity = w e Cost of equity = k e Weighted cost of equity = w e k e

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Discount Rate Includes the cost of debt and investor’s required ROIIncludes the cost of debt and investor’s required ROI Used to calculate present value of an asset by discounting each year’s cash flowUsed to calculate present value of an asset by discounting each year’s cash flow

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Capitalization Method of Valuation Values the asset’s prior twelve months’ cash flowValues the asset’s prior twelve months’ cash flow Provides the asset’s approximate market valueProvides the asset’s approximate market value Cap Rate Method Equation CR (X) = CF or X = CF/CR X = estimated current market value CR = cap rate (WAAC) CF = prior or trailing 12 months of cash flow

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Investment Analysis Tools Payback PeriodPayback Period –Amount of time a project requires to pay back the initial equity investment Advantage –Easy to calculate Disadvantages –Does not include the time value of money –Ignores cash flow after the required payback period

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Payback Period Calculation Payback Period = cost / incremental cash flow An asset costs $25,000 and will provide incremental cash flows of $10,000 per year. = $25,000 / $10,000 = $25,000 / $10,000 = 2.5 years = 2.5 years

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Investment Analysis Tools Net Present Value (NPV)Net Present Value (NPV) –Calculates the difference between an asset’s present value and purchase price Advantages –Takes into account all cash flows –Takes into consideration the TVM Disadvantage –Difficult to compare multiple investment opportunities with different costs

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved NPV Calculation | | | | | | Years Years at 10% interest at 10% interest Utilize [CF] button and enter: CF0 = -800 CF1 = 50 CF2 = 100 CF3 = 300 CF4 = 305 CF5 = 320 Now enter [CPT][NPV] I/Y = 10 CPT NPV = -$39.49 Do not invest!

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Investment Analysis Tools Internal Rate of Return (IRR)Internal Rate of Return (IRR) –Discount rate that makes the NPV of an investment equal to zero Advantage –Compare multiple deals with varying sales prices and costs Disadvantages –Assumes cash flows generated by the project are reinvested at the IRR calculated –Multiple IRRs when cash flows go from negative to positive

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved IRR Calculation | | | | | | Years Years Utilize [CF] button and enter: CF0 = -800 CF1 = 50 CF2 = 100 CF3 = 300 CF4 = 305 CF5 = 320 CPT IRR = 8.5%

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Investment Analysis Tools Modified Internal Rate of Return (MIRR)Modified Internal Rate of Return (MIRR) –Rate of return which assumes all cash flows are reinvested at the firm’s WACC –MIRR is more conservative than IRR

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Factors Impacting Investment Analysis Cost of capital (WACC)Cost of capital (WACC) Cap rate used to calculate the assumed sale price at the end of the analysis periodCap rate used to calculate the assumed sale price at the end of the analysis period Amount and timing of annual cash flows projectedAmount and timing of annual cash flows projected Acquisition price or development cost of the assetAcquisition price or development cost of the asset

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Factors Impacting Investment Analysis Cost of CapitalCost of Capital –The more financial leverage used, the lower the cost of capital –The lower the cost of capital, the lower the discount rate –The lower the discount rate, the higher the present value and NPV

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Factors Impacting Investment Analysis Cap RateCap Rate –The lower the cap rate, the higher the sales price and PV, NPV, and IRR –The higher the cap rate, the lower the PV, NPV, and IRR

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Factors Impacting Investment Analysis Amount and Timing of Projected Cash FlowsAmount and Timing of Projected Cash Flows –The more cash flow projected in the early years, the higher the PV, NPV, and IRR

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Factors Impacting Investment Analysis Acquisition PriceAcquisition Price –The lower the price of the asset or total project cost, the higher the NPV and IRR