INVESTMENT EVALUATION
Professor Tim Thompson
Kellogg School of Management
Investment Evaluation
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The Finance Function
Operations
(Plant,
Equipment,
Projects,
etc.)
Financial
Manager
(2) Investment
(1a) Raise
Funds
Financial
Markets
(Investors)
(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
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The Finance Function
Finance focuses on these two decisions
Operations Investment Financial Financing
Decision Manager Decision
How much to
invest and in
what assets?
Capital Budgeting
Financial
Markets
Where is the $
going to come
from?
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Interaction between Financing &
Investment Decisions
The interplay of the decisions determines the cost of capital
Characteristics
of the
Investment
Operations
Investment Financial
Decision
Manager
Financing
Decision
Financial
Markets
Cost of Capital
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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.)
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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
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Forecasting Cash Flows
First, forecast all relevant after-tax expected cash flows
Sample Corporation VALUATION
Actual
1998
1999
2000
2001
ProForma
2002
2003
2004
1,356.1
1,535.0
1,660.0
1,759.6
1,865.2
1,958.4
2,056.4
(1,143.2)
(67.5)
(1,304.8)
(77.0)
(1,402.7)
(83.0)
(1,478.1)
(80.0)
(1,566.7)
(75.0)
(1,645.1)
(70.0)
(1,727.3)
(65.0)
4 EBIT
5 Taxes
145.4
(50.6)
153.3
(61.3)
174.3
(69.7)
201.5
(80.6)
223.4
(89.4)
243.3
(97.3)
264.0
(105.6)
6 EBIAT
94.8
92.0
104.6
120.9
134.1
146.0
158.4
B. Operating Income
1 Sales
2 Operating Costs
3 Depreciation
C. Cash Flows from Operations
Actual
1998
1999
2000
2001
ProForma
2002
2003
2004
7 EBIAT
94.8
92.0
104.6
120.9
134.1
146.0
158.4
8 Depreciation
67.5
77.0
83.0
80.0
75.0
70.0
65.0
(87.7)
(30.3)
(75.0)
(19.9)
(21.1)
(18.7)
(19.6)
(59.7)
(46.2)
(48.4)
(50.0)
(50.0)
(50.0)
(50.0)
14.9
92.4
64.2
131.0
137.9
147.4
153.8
9 Changes in WC
10 Capital Investment
11 Free 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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Forecasting Cash Flows
This is done by estimating operational parameters
Sample Corporation VALUATION
A. Operating Parameters
S
P
T
D
C
W
Sales Growth (%)
Operating Profit Margin (%)
Tax Rate (%)
Depreciation ($)
Capital Expenditure ($)
Working Capital as % of Sales (%)
Excess Cash
Market Value of Debt
# of Outstanding Shares
Perpetual Growth Rate
Actual
1998
49.6%
15.7%
39.9%
67.5
59.7
19.5%
1999
13%
15.0%
40.0%
77.0
46.2
16.9%
2000
8%
15.5%
40.0%
83.0
48.4
60.0%
2001
6%
16.0%
40.0%
80.0
50.0
20.0%
217.3
22.9
5.0%
These are based on
actual reported
performance
ProForma
2002
2003
6%
16.0%
40.0%
75.0
50.0
20.0%
5%
16.0%
40.0%
70.0
50.0
20.0%
2004
5%
16.0%
40.0%
65.0
50.0
20.0%
2005
Terminal
5%
16.0%
40.0%
65.0
50.0
20.0%
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 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
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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)
3)
Do not ignore investment in net working capital
4)
Separate investment and financing decisions: Evaluate as if entirely
equity financed
5)
Estimate flows on a incremental basis
•
•
•
6)
Include only changes in operating working capital. Short-term debt,
excess cash and marketable securities should not be accounted for.
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
Opportunity costs cannot be ignored
Investment Evaluation
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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)
c t1
Continuing Value 
(r - g)
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.
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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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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
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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
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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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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.
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Accounting Definition of Working
Capital
Working Capital = Current Assets - Current Liabilities
Accounts receivable
Inventory
Cash (required for operations)
Excess Cash & marketable securities
Accounts payable
Accrued taxes
Accrued wages
short-term debt
• 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).
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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
Evaluate as if
entirely equity
financed
Ignore
financing/
no interest line
item
= Cash Flow from Operations
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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.)
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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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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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Forecasting Cash Flows
•Perpetual growth: Assumes that after time n cash
flows are expected to grow at a constant rate
perpetually.
Terminal Value
Year 1
CF1
Year 2 . . . Year n
CF2
Year n+1 & on
CFn
Investment Evaluation
CFn+1/(r-g)
22
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
7%
{
4% Inflation
Nominal
3% Real
Nominal Rate Real Rate + Inflation
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Forecasting Cash Flows
Nominal vs. Real Cash Flows
Nominal
Real
1
2.00
2.00
2
2.08
2.00
3
2.16
2.00
Inflation @ 4%
Note: Depreciation is based on historical costs and therefore is not
adjusted for inflation
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Forecasting Cash Flows
9) Overhead costs
-
Do not forget
overheads and
other indirect
costs that
increase due
to the project
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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Forecasting Cash Flows
10) Include excess cash, excess real estate, unfunded (overfunded) pension funds, large stock option obligations
Year 1 Year 2 Year 3 Year 4 Year 5 . . . Terminal
CF1
CFn+1/(r-g)
CF2
CF4
CF5
CF3
+
+
+
-
PV(Operating Cash Flows)
Excess cash balance
Excess marketable securities
Excess real estate
Under-funded pension
Assets/Liabilities
not required to
support operations
=Value of the FIRM
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Value of Equity
Value of the Firm
-Value of Debt
=Value of Equity
To calculate share price-divide by the
number of shares outstanding
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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
28
Evaluation Methods: NPV
Net Present Value (NPV) is the sum of all cash flows adjusted
by the discount rate
Example:
Time Period
0
1
2
Buy Hot Dog Cart
Sell Hot Dogs
Sell Hot Dogs
Cash Flows
-187
110
121
Discount Rate
10%
NPV  187 
110
121

(1  0.10) (1  0.10) 2
Activity
NPV  187  100  100  13
Future cash flows are discounted “penalized” for time and risk
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Evaluation Methods: NPV
Net Present Value (NPV) is the sum of all cash flows adjusted
by the discount rate
Example:
Time Period
0
1
2
Buy Hot Dog Cart
Sell Hot Dogs
Sell Hot Dogs
Cash Flows
-200
110
121
Discount Rate
10%
NPV  200 
110
121

(1  0.10) (1  0.10) 2
Activity
NPV  200  100  100  0
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Evaluation Methods: IRR
As the discount rate increases, the PV of future cash flows is
lower and the NPV is reduced
Example:
Hot Dog Cart Valuation
50
40
IRR: Discount rate at
which the project has a
NPV of zero
20
10
24
%
22
%
20
%
18
%
16
%
14
%
12
%
10
%
8%
6%
0%
-10
4%
0
2%
NPV ($)
30
-20
-30
Discount Rate (%)
Internal rate of return (IRR) is the discount rate that sets the
NPV to zero
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Calculation of IRR
The IRR is the r that solves
Cn
C1
C2
0  C0 

 .... 
2
1  r (1  r )
(1  r ) n
Decision Rule: Accept the project if
IRR > Opportunity Cost of Capital
Investment Evaluation
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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
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Evaluation Methods:
NPV vs. IRR
2) Mutually Exclusive Projects (Ranking)
Problems with IRR:
A) Scale
Time Period:
Project A
Project B
0
-1
-100
Highest (NPVa, NPVb, NPVc)
Highest (IRRa, IRRb, IRRc)
1
5
120
IRR
400%
20%
Obviously, the return in absolute
dollars must be considered
B) Timing of Cash Flows: Bias against long-term
investments
Time Period:
Project A
Project B
0
-100
-100
1
20
100
2
120
31.25
IRR
20%
25%
NPV@0% NPV@10% NPV@20%
Preference for CF early!
40
17.3
0.0
But, it depends.
31.25
16.7
5.0
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Evaluation Methods:
NPV vs. IRR
The ranking of the projects depends on the discount rate
Time Period:
Project A
Project B
0
-100
-100
1
20
100
2
120
31.25
IRR
20%
25%
NPV@0%
40
31.25
NPV@10%
17.3
16.7
A is a LT project and when discount rate PV 
B is a ST project and when discount rate PV drops less
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Other Evaluation Methods
Profitability Index: PV/I. Problem: Biases against large-scale projects.
Payback: How long does it take for the project to payback?
Time Period:
Project A
Project B
0
-100
-10
1
2
20
2
3
30
2
4
50
2
5
10
Corporate Rule: Project must payback in at most 3 years!
ROA (return on assets)
ROI (return on investment)
ROFE (return on funds employed)
ROCE (return on capital employed)
ROE =
}
Net Income
Shareholders’ Equity
Pass
5B Fail
Problems:
•No discounting the first
3 years
•Infinite discounting of
later years
 Biases against longterm projects.
Earnings
= Investment
Problems:
•Investment not valued at market
•Earnings vs. cash flows
Book Value
Investment Evaluation
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