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