Measuring return on
investments
04/28/08
Ch. 5
Investment decision revisited
 Acceptable projects are those that yield a return
greater than the minimum acceptable hurdle rate with
adjustments for project riskiness.
 We know now how to calculate the acceptable hurdle
rate (cost of capital)
 Here we will understand how to evaluate projects.
The focus will be on extending what you have
learned in previous courses.
2
Project definition
 Project – any proposal that will result in the use
of a firm’s resources

extension of business, acquisitions, new lines, etc.
 The risks (to equity holders and debt holders) for
projects should be determined by project-specific
characteristics
 Project cash flows are defined by:
 Length of project,
 Initial and subsequent investments required, and
 Cash inflows generated by the project
3
Why not use firm’s cost of equity or
capital to evaluate all projects?

Ex., Ford has a cost of capital of 10% and is
considering entering the software
development industry. The rate of return it
expects to earn on projects it undertakes is
13%. Should these projects be accepted?
4
Estimating project cost of equity
 Single line business, homogenous projects
 Firm operates just one line of business and
the projects adopted by the firm have the
same level of risk

Use firm’s beta (from a regression or bottomup approach) to determine cost of equity

The advantage of this approach is that it does
not require risk estimation prior to each project
evaluation
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Estimating project cost of equity
 Multiple line business, homogeneous projects
within each line OR new line

In this case, the risk profile of the business is
different across its business lines (new line)
but adopted projects within a particular line
have similar risk

We must determine a separate cost of equity
for the business line in which the project is

Use bottom-up approach (pure-play approach) to
estimating beta
6
Estimating project cost of debt
 Assessing default risk (and thus the cost of debt) for
individual projects is usually very difficult as projects
seldom borrow on their own.
 The method used to determine the appropriate cost
of debt and the financing mix to be used to evaluate
the project is based on:



Size of project relative to the firm
Cash flow characteristics of the project
Whether the project is a stand-alone project
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Project cost of debt / financing mix
Project
characteristics
Cost of Debt
Debt Ratio
Small/CFs are
similar to firm’s CFs
Firm’s cost of debt
Firm’s debt ratio
Large/ CFs are
different from firm’s
CFs
Comparable firm
cost of debt
Average debt ratio of
comparable firms
OR firm’s debt ratio
Stand-alone
projects*
Cost of debt for
project (can be
based on synthetic
ratings)
Debt ratio for project
*Projects that raise their own funds
8
Project cost of capital
 Estimate an appropriate cost of equity
 Estimate an appropriate cost of debt
 Calculate the weighted average cost of
capital based on your estimates and an
appropriate debt and equity mix
9
Accounting for project risk
 Adjust the cost of capital
 Adjust cash flows – in practice this is primarily done subjectively
 Problems with the latter approach



Adjustment can vary depending on who is doing the analysis
Risks that are diversifiable may be adjusted for
There may be double adjustment of risks if the cost of capital
is also adjusted.
 Risk adjustment techniques used:



Subjective adjustment - 48%
Cost of capital adjustment – 29%
No adjustment – 14%
10
Project cash flows estimation
 Estimating project cash flows requires:



Estimating project revenues
Allocating appropriate expenses
Converting these projections into incremental cash
flows
 We need to understand the differences between:


Accounting earnings and cash flows, and
cash flows and incremental cash flows.
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Accounting earnings vs. cash flows
 Accrual accounting requires the recognition of
expenses during the period in which the related
revenue is recognized. Cash flows may not coincide.
 Capital expenditures are treated as if generated over
multiple periods and expensed (depreciation or
amortization) rather than subtracted from revenues
when the occur.
 Because of accrual accounting and capital
expenditure accounting, accounting earnings can
differ significantly from cash flows.
12
Accounting earnings vs. cash flows
 To go from accounting earnings (EBIT) to
cash flows, we must adjust for:



Non-cash expenses, such as depreciation and
amortization,
Capital expenditures, and
working capital investment
13
Working capital investment
 Intuitively, money invested in inventory or in accounts receivable
cannot be used elsewhere. It, thus, represents a drain on cash
flows
 To the degree that some of these investments can be financed
using suppliers credit (accounts payable) the cash flow drain is
reduced.
 Investments in working capital are thus cash outflows


Any increase in working capital reduces cash flows in that
year
Any decrease in working capital increases cash flows in that
year
 To provide closure, working capital investments need to be
salvaged at the end of the project life.
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Cash flows vs. incremental cash
flows
 The appropriate cash flows to consider in evaluating
whether a project makes a firm more valuable is the
incremental cash flows generated by the project.
 This can differ from total cash flows for three reasons:
 Sunk costs
 Opportunity costs
 Allocated costs that the firm would incur even if the
project was not accepted.
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Sunk costs
 Any expenditure that has already been incurred, and cannot be
recovered (even if a project is rejected) is called a sunk cost
 When analyzing a project, sunk costs should not be considered
since they are not incremental
 By this definition, market testing expenses and R&D expenses
are both likely to be sunk costs before the projects that are
based upon them are analyzed.
16
Opportunity costs
 Opportunity costs are cash flows that could be realized from the
best alternative use of the asset.
 When analyzing a project, opportunity costs should be
considered since they represent cash flows that the firm would
have generated if the project is not accepted, but are lost if the
project is accepted.
17
Allocated costs
 Firms allocate costs to individual projects from a centralized
pool (such as general and administrative expenses) based upon
some characteristic of the project (sales is a common choice)
 For large firms, these allocated costs can result in the rejection
of projects
 To the degree that these costs are not incremental (and would
exist anyway), this makes the firm worse off.
 Thus, it is only the incremental component of allocated costs
that should show up in project analysis.
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Project revenue estimation process
 Experience and History: If a firm has invested in similar
projects in the past, it can use this experience to estimate
revenues and earnings on the project being analyzed.
 Market Testing: If the investment is in a new market or
business, you can use market testing to get a sense of the size
of the market and potential profitability.
 Ex., Home Depot Expo Stores
 Scenario Analysis: If the investment can be affected be a few
external factors, the revenues and earnings can be analyzed
across a series of scenarios and the expected values used in
the analysis.
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Scenario analysis
 Scenario analysis is made up of four components:

Factors that determine the success of the project


Number of scenarios to be considered



Analysis should focus on two or three of the most critical factors
Three scenarios for each factor (best, average and worst-case)
tend to most useful
Estimation of project revenues and/or expenses under each
scenario
Assigning probabilities to each scenario
n
E (value)   P( scenario j ) * E (value j )
j 1
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From forecasts to operating income
(EBIT)
 Calculate/estimate the appropriate expenses associated
with the estimated revenues
 Separate projected expenses into operating and capital
expenses.
 Operating expenses are designed to generate benefits
in the current period, while capital expenses generate
benefits over multiple periods
 Depreciate or amortize the capital expenses over time.
 Allocate fixed expenses that cannot be traced to specific
projects.
21
From forecasts to operating income
(EBIT)
 Operating income (EBIT) measures the
income earned on all the capital invested in
a project and is calculated as
EBIT=Rev – Cost of Goods Sold – SG&A Expenses
– Other allocated expenses - Depr.&Amort.
22
From accounting income to cash flows
 To get from EBIT to cash flows

add back non-cash expenses (like depreciation
and amortization)

subtract out cash outflows which are not expensed
(such as capital expenditures)

Include investment in working capital.
Cash flow to firm = EBIT(1-t) + Depr.&Amort. – Chg in WC – Cap Exp.
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Investment decision revisited
 Acceptable projects are those that yield a return
greater than the minimum acceptable hurdle rate with
adjustments for project riskiness.
 We know now how to calculate the acceptable hurdle
rate (cost of capital), and relevant project cash flows.
 The final step in the process is to evaluate the
project. This entails understanding and applying the
appropriate investment decision tools. We must also
understand their benefits and drawbacks.
24
Accounting income-based investment
decision rules
 These include Return on Capital and Return on Equity
 Problems with these measures:

Changing depreciation methods may result in different decisions

Ignores the time value of money

Accounting earnings are easier to manipulate
Note: You can assess the collective quality of a firm’s investments
by measuring firm ROC as:
ROC = EBIT(1-t) / (BV of equity + BV of debt)
25
Discounted cash flow measures of
return
 Discounted cash flow measures of return address
the problems with accounting returns.
 The most widely used measures are Net Present
Value (NPV) and Internal Rate of Return (IRR).
26
Discounted cash flow measures of
return
 Net Present Value (NPV): Sum of the present values of all cash flows
on the project, including the initial investment, with the cash flows
being discounted at the appropriate hurdle rate (cost of capital, if cash
flow is cash flow to the firm, and cost of equity, if cash flow is to equity
investors)
n
CFt
NPV  
t


1

hurdlerate
t 0

Decision Rule: Accept if NPV > 0
27
Discounted cash flow measures of
return
 Attractive properties of NPV

NPVs are additive


value of the firm is the NPV of all projects adopted by the firm
The additional value to the firm of divestitures and acquisitions
can be calculated as Price – expected NPV
Intermediate CFs are reinvested at the
hurdle rate
 NPV calculations allow for changes in
interest rates and hurdle rates

28
Discounted cash flow measures of
return
 Why is NPV not used exclusively?

Managers are more comfortable talking about
percentage returns than absolute returns

Capital rationing, the inability of firms to
invest in all positive NPV projects,
necessitates managers choosing the projects
that add most value to the firm
29
Discounted cash flow measures of
return
 Internal Rate of Return (IRR): The internal rate of return is the
discount rate that sets the net present value equal to zero. It is the
percentage rate of return, based upon incremental time-weighted
cash flows.
n
CFt
NPV  0  
t
t 0 1  IRR 

Decision Rule: Accept if IRR > hurdle rate
Where the hurdle rate is the cost of capital if cash flow is
cash flow to the firm, and cost of equity if cash flow is to
equity investors
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Discounted cash flow measures of
return
 The multiple IRR problem


The number of IRRs equals the number of
sign changes in cash flows
Therefore, if the sign of cash flows changes
more than once during the life of the project,
multiple IRRs will result
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Discounted cash flow measures of
return
 NPV and IRR generally result in the same
decision about projects.
 However, when the projects are mutually
exclusive, differences can arise

Differences in scale


Capital rationing may be a factor
Difference in reinvestment rate assumption
32
Capital rationing and choosing a
rule
 If a business has limited access to capital and has a stream of
surplus value projects, it is much more likely to use IRR as its
decision rule.
Small, high-growth companies and private businesses are much
more likely to use IRR.
 If a business has substantial funds on hand, access to capital
and limited surplus value projects, it is much more likely to use
NPV as its decision rule.
As firms go public and grow, they are much more likely to gain from
using NPV.
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The sources of capital rationing…
Cause
Debt limit imposed by outside agreement
Debt limit placed b y management externa l
to fi rm
Limit placed on borrowing by interna l
management
Restrictive policy imposed on retaine d
earnings
Maintenance of target EPS or PE ratio
Number of firms
10
3
Percent of total
10.7
3.2
65
69.1
2
2.1
14
14.9
34
An alternative to IRR with capital
rationing
 The problem with the NPV rule, when there is capital
rationing, is that it is a dollar value. It measures
success in absolute terms.
 The NPV can be converted into a relative measure by
dividing by the investment required in the project.
This is called the profitability index (PI).
PV of cash inflows
PI  PV
of cash outflows
 Decision rule: If PI > 1, the project is acceptable.
35
NPV, IRR and the reinvestment
rate assumption
 The NPV rule assumes that intermediate cash flows on the
project get reinvested at the hurdle rate (which is based upon
what projects of comparable risk should earn).
 The IRR rule assumes that intermediate cash flows on the
project get reinvested at the IRR.
Conclusion: When the IRR is high (the project is creating significant
surplus value) and the project life is long, the IRR will overstate
the true return on the project.
36
Solution to the reinvestment rate
problem: Modified IRR
 The modified IRR (MIRR) calculates a project’s rate of return assuming
that intermediate cash flows get reinvested at the hurdle rate.
 The MIRR is calculated as follows:
 Calculate the terminal value, which is the future value of cash flows
after initial investment compounded at the hurdle rate
n
TermValue   CFt * 1  hurdlerate 
n t
t 1

Calculate the MIRR assuming the terminal value equals the future
value and initial investment equals the present value
1/ n
 TermValue 
MIRR  

 InitialInv estment 

1
Decision Rule: Accept if MIRR > hurdle rate
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What firms actually use ..
Decision Rule
IRR
Accounting Return
NPV
PI
Payback Period
% of Firms using as primary decision
rule in
1976
1986
2000
53.6%
25.0%
9.8%
2.7%
8.9%
49.0%
8.0%
21.0%
3.0%
19.0%
47.0%
8.1%
23.3%
6.0%
15.0%
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How to exploit good projects
 We now know how to measure whether a
project is worthwhile – it is if it generates
excess returns.
 However, in a competitive market we would
expect these excess returns would dissipate
over time unless there are barriers to new or
existing competitors to generate the same
project.
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How to exploit good projects
 Maintaining barriers..





Invest in projects that exploit economies of
scale
Establish cost advantages
Product differentiation
Access to distribution channels
Develop legal barriers (such as patents)
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