MBAMFM 253 Measuring Return on Investment

MBA/MFM 253 Measuring Return on Investment The Big Picture MBA / MFM 253 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 MBA / MFM 253 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 MBA / MFM 253 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 MBA / MFM 253 Operating Stage Sales Revenue, Operating Expenses, Taxes etc Disposition Stage Sales of fixed assets, Tax consequences What is a Project? MBA / MFM 253 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 MBA / MFM 253 Prerequisite Complementary Independent Mutually Exclusive Project Risk MBA / MFM 253 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 MBA / MFM 253 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% MBA / MFM 253 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? Return Acceptance Region MBA / MFM 253 12.0 10.5 10.0 9.5 A B Rejection Region 8.0 RiskL RiskA RiskH Risk Determining the Project Cost of Equity 1. MBA / MFM 253 2. 3. Single Business – Project risk is similar across all businesses – use the overall cost of equity and cost of debt Multiple Businesses with different risk profiles – estimate cost of equity using project beta – bottom up beta, accounting beta, or regression on cash flows 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 MBA / MFM 253 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 Small and CF similar to firm Cost of Debt Firm’s Cost of Debt MBA / MFM 253 Debt Ratio Firm’s Cost of Equity Project is large CF different from firm Stand Alone Project Cost of debt of Average debt comparable firms ratio of comparable firms Cost of debt for Debt Ratio for project Project Project cost of capital MBA / MFM 253 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 MBA / MFM 253 Accounting earnings are based on accrual accounting Cash flow measures the actual cash generated in a given time period. Operating vs. Capital Expenditures MBA / MFM 253 Operating Expenditures – Occur only in the current period (labor costs etc). These are subtracted from revenue in the period they occur Capital expenditures – Are drawn out over time and deducted from revenue in the form of depreciation and other non cash charges Accrual Based MBA / MFM 253 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? MBA / MFM 253 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 MBA / MFM 253 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 produce benefits over multiple periods Capital Expenditures Non - Cash Charges (depreciation etc) Reduce accounting income, but cash exists Free Cash Flows FCFE (Cash Flow to Equity) = MBA / MFM 253 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 MBA / MFM 253 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 Steps in estimating Cash Flow MBA / MFM 253 Estimate the Income Statement Estimate the Balance Sheet Combine the income statement and balance sheet into a cash flow statement Make a decision Estimation of Income Statement MBA / MFM 253 Most business use an accrual basis - Expenses and Income are recorded whether or not the actual payment is made. Book value of assets decrease via depreciation When goods are purchased or produced it is considered an increase in inventory Estimation of the Balance Sheet MBA / MFM 253 Accounts Receivable and Accounts Payable are active in the early stages of the business. Most assets begin on the balance sheet and flow onto the cash flow statement. Combine Income Statement and Balance Sheet Accounts Receivable MBA / MFM 253 An increase in Accounts receivable represents a sale recorded as income but no cash was received (negative entry on the CF statement) Accounts Payable An increase in accounts payable represents the purchase of items on credit recorded as an expense, but no cash flow occurred (positive entry on CF statement) Combine Income Statement and Balance Sheet Inventory MBA / MFM 253 Two forms items produced and spare parts Holing Losses (theft, obsolescence) are deductible in income statement Increases in inventory are a negative entry on CF statement. Insurance Premiums for example will be recognized as a prepaid expense on Balance Sheet but cash flow occurred in 1st year. Prepaid expenses Combine Income Statement and Balance Sheet Cash Balances MBA / MFM 253 Initial Cash Balance is considered a year 0 cash flow, it represents cash that could have been used elsewhere In disposition stage cash is recovered Negative CF (if purchased for the project) at acquisition Positive Cash flow at disposition Land is separated from buildings since it is not depreciable Land Combine Income Statement and Balance Sheet Buildings MBA / MFM 253 Negative CF entry at year 0 and depreciated (nonresidential) Equipment Recognized as purchase price, setup expenses, shipping and instillation. Can be depreciated Changes in Net working capital (inventory cannot be depreciated) Combine Income Statement and Balance Sheet Depreciation MBA / MFM 253 Represents a non cash expense and is a positive entry on the cash flow statement Net Working Capital Current Assets minus Current liabilities Incremental changes throughout the life of the project Combine Income Statement and Balance Sheet Taxes During Acquisition Stage MBA / MFM 253 Investment Tax Credits, lowers tax liability Training and Advertising are a one time deduction at the beginning of the project Combine Income Statement and Balance Sheet Taxes during Operating Stage MBA / MFM 253 Depreciation Loss back and Carry forward Negative income can be used to offset current tax liability and carried to other periods. Special Problems Sunk Costs Externalities Opportunity Costs Shipping and Installation costs MBA / MFM 253 Sunk Costs MBA / MFM 253 Occur prior to the decision concerning the new project and should not be counted Example Nestle spent $1 Million to develop new coffee flavor If they produce the project NPV = $600,000 if the sunk cost is ignored Counting the sunk cost the loss is -$400,000 Should the project be undertaken? Externalities MBA / MFM 253 Indirect Costs (shared costs and overhead costs). New plant requiring additional computer support Pure Joint Costs Cannot be separated Airline pilot salary who carries freight and passengers. Externalities continued Pure Joint Costs MBA / MFM 253 Estimate the NPV of the project with an estimate of the impact of the joint cost If they have positive NPV consider groups of projects including all joint costs Cannibalization IBM and Main Frames Externalities continued Indirect benefits (Synergies) MBA / MFM 253 Assume a bank offers a new checking account -- some customers will also sign up for credit card. New suburban location of a bank Existing customers start using new branch New customers using original location Opportunity Costs MBA / MFM 253 The best foregone opportunity Dole Inc. Prime real estate in Hawaii could be used to grow pineapple or as resort land. Early 1980’s converted the land after looking at the lost income GM forgoes $1Million it could earn by renting a plant site and decides to build a new plant on the land. Shipping and Installation Cost MBA / MFM 253 Included as part of the original cost of the project Combine Income Statement and Balance Sheet Taxes at Disposition Stage MBA / MFM 253 Capital Gains and Losses Gain or loss on assets that were not intended to be used in the regular course of business. 1245 Gain and Loss All assets except real estate gain or loss from comparing Sale Price to Original basis 1250 Gain or Loss Real Assets that are depreciated (buildings) Gain or loss from comparing sale price to remaining basis Make a Decision MBA / MFM 253 Once the Balance sheet and income statement are combined and cash flow is estimated use NPV, and other decision tools to make a decision on the project. Project Interactions MBA / MFM 253 Once individual projects are investigated you need to look at possible interactions between projects and timing options for the projects. Given that all the future cash flows can be estimated. This is relatively easy. You would want to investigate projects so that the NPV is maximized (keeping other constraints constant). The Capital Investment Process MBA / MFM 253 Capital Budget – An annual assessment of investment projects The budget is a product of negotiation between divisional managers and plant managers. The budget should also reflect the strategic plan of the firm, the two process should compliment each other. Capital Budget vs. Approval MBA / MFM 253 The capital budget is a general plan that does not always imply final approval of a project. Final approval is often contingent upon a more detailed cash flow analysis in the appropriation request. Capital Budgets and Spending MBA / MFM 253 Not all large investments are part of the capital budget Information Technology Research and Development Marketing Training and Development Operating Decisions Monitoring MBA / MFM 253 Due to the ability of costs to exceed forecasts and changes in the economy it is important for the firm to perform audits of the project as it progresses. Financial Planning MBA / MFM 253 Establish an outline of the process by which the firms goals are to be realized Goals of the Plan Examining Interactions MBA / MFM 253 Exploring Options Avoiding Surprises Evaluating Feasibility Elements of a Financial Plan 1. MBA / MFM 253 2. 3. 4. Forecasting: What future assets will be needed and how will they be obtained Capital Structure Policy: How will the assets be financed Dividend Policy: What portion of earnings will be returned to shareholders Working Capital: The amount of liquidity needed for the firm to conduct daily operations Main issues addressed MBA / MFM 253 Corporate Purpose: Overview of long run mission of firm Corporate Scope: Geographic location and main business line Corporate Objectives: Specific Goals for the firm ( targets) Main Issues MBA / MFM 253 Corporate Strategy: A plan to obtain the firms objectives Operating Plans: Five year horizon each year less specific Steps in the planning process 1. 2. 3. 4. 5. 6. MBA / MFM 253 Pro Forma Financial Statements and NPV Determine the funds needed to support the plan Forecast the funds available Establish controls Plan for other contingencies Establish a performance based compensation plan Applying the NPV Rule Discount only Incremental Cash Flows MBA / MFM 253 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. A simple forecasting model MBA / MFM 253 Assume that all variables are directly tied to sales – If sales increases so do the other entries on the balance sheet and income statement (by the same %) As sales increase so do assets – why? (Assume total capacity utilization) Simple Income Statement MBA / MFM 253 Assume that sales increase by 25% over the next year. Sale 1,000 Costs 800 Net income 200 Sale 1,250 Costs 1,000 Net income 250 Simple Balance Sheet MBA / MFM 253 The balance sheet would be impacted the same way Assets 500 Debt 250 Equity 250 500 500 Assets 625 Debt 312.5 Equity 312.5 625 625 Percentage of Sales Approach MBA / MFM 253 Two categories those that vary directly with sales and those that do not. Income Statement: Costs – remain a set % of sales Dividend Payout – Assume it remains constant Balance Sheet Find % of sales for LHS (assets) On RHS find % of sales for Accounts Payable, But not for financing choices: L-T Debt or retained earnings or equity Retained Earnings – use dividend payout Income Statement Sales 1,000 Costs 800 Taxable income 200 Taxes 68 Net Income 132 Dividends 44 Addition to Ret E 88 RetRate=88/132=66.67% MBA / MFM 253 Sales 1,250 Costs 1,000 Taxable income 250 Taxes 85 Net Income 165 Addition to Ret Earn .6667(165) = 110 Balance Sheet Assets Current Assets 160 16% Accts Rec 440 44% Inventory 600 60% Total 1200 120% Fixed Assets 1800 180% Total Assets 3000 300% MBA / MFM 253 Liabilities Current Liab 300 30% Notes Pay 500 na Total 800 na L-T debt 800 na Ret Earn 1000 na Total Liab 3000 300% Proforma Balance Sheet Sales increase by 25% Assets Current Assets 200 16% Accts Rec 550 44% Inventory 750 60% Total 1500 120% Fixed Assets 2250 180% Total Assets 3750 300% MBA / MFM 253 Liabilities Current Liab 375 30% Accts Pay 500 na Total 875 na LT Debt 800 na Ret Earn 1110 na Total Liab 2785 300% They do not balance! The difference is the EFN EFN = 3750 –2785 = 965 External Financing Needed MBA / MFM 253 Should be equal to Change in Assets – Change in Liabilities Represents the amount of cash that needs to be raised to finance the assets. Forecasts MBA / MFM 253 The forecasts for expected revenue and costs are based upon Experience and History Market testing Scenario Analysis Information Problems MBA / MFM 253 For good investment decisions to take place management needs to have correct and reliable information. Consistent Economic Forecasts MBA / MFM 253 Consistent assumptions across divisions If different managers make different assumptions about future economic activity it is difficult to compare their forecasts – the assumptions may make one project appear better as opposed to the actual project Therefore the capital budgeting process often starts with forecasts about macroeconomic variables that should be used by all managers. Forecast Bias MBA / MFM 253 Managers have incentive to be overly optimistic. Management needs to avoid setting incentives in a way that promotes bias. For example, if divisions “bid” for limited resources. There is an agency cost, the divisional manager wants to secure the resources and has incentive to make their project look better. Setting the Cost of Capital MBA / MFM 253 Assume that top management sets the cost of capital for a particular division. This can help the divisional managers make good decisions, but it also tells managers how optimistic they will need to be in their forecasts to make the project look acceptable. Aligning Management Incentives with the Value of the Firm MBA / MFM 253 There are many Principal-Agent problems that can exist in the capital budgeting process. Problems with Salary only Compensation Reduced Effort Perks Empire Building Entrenching Investment Avoiding Risk Avoiding Agency Costs MBA / MFM 253 Monitoring can eliminate some of the problems associated with salary only compensation for example perks and empire building. However, it is more difficult to address the other problems such as entrenchment. Monitoring is performed by many groups Senior management Shareholders Auditors Creditors Avoiding Agency Costs Compensation MBA / MFM 253 Often compensation is tied to performance in the form of bonuses and options. However this forces management to be tied in part to things out of their control such as macroeconomic conditions. This can also increase some agency costs. The final combination of compensation reflects a compromise between managers accepting some macro risks and shareholders accepting additional agency costs. Compensation and Market Risks The best case would be if management’s compensation was tied to their decisions, but independent of macroeconomic fluctuations. Should management compensation be tied to performance above a market average? MBA / MFM 253 Yes and No – Price reflects expectations, new outstanding manager results in increased stock price followed by average returns. Compensation would fail to reward the managers performance. Other Issues Don’t ignore market values MBA / MFM 253 Market values should represent a “fair price” There is no reason to assume that your firm has an inside ability to calculate a different price of a commodity Example: future value of real estate. Capital Budgeting Decision Rules MBA / MFM 253 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 MBA / MFM 253 Return on Capital – the return earned by the firm on its total investment EBIT ROC  (Average Book Value of Capital Invested) 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 MBA / MFM 253 Net Income Project ROE  Average Book Value of Equity Investmentin Project If ROE > Cost of Equity Accept the project Problems with Accounting Returns MBA / MFM 253 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 MBA / MFM 253 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 MBA / MFM 253 A measure of the surplus value created by a firm’s projects. EVA and ROE EVA  NOPAT - Capital Charge MBA / MFM 253 Total   After  tax      EBIT(1 T) -  investor - supplied  percentage   operatingcaptial  cost of capital     Net Income  (equity capital) (cost of equity captial)  Net Income   (equity capital)  cost of equity capital  Equity Capital   (equity capital)(ROE - cost of equity capital) Capital Budgeting Decision Rules MBA / MFM 253 Payback Period and Discounted Payback Net Present Value Internal Rate of Return & Modified IRR Profitability Index and Modified Profitability index Payback Period MBA / MFM 253 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…. MBA / MFM 253 You need to look at the cumulative cash flow and compare to the initial cost. Calculating Payback Period  MBA / MFM 253     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 Yearly Cumulative Cash Flow Cash Flow 40,000 40,000 30,000 70,000 25,000 95,000 20,000 115,000 MBA / MFM 253 YR 1 2 3 4 Remaining Cash Flow 60,000 30,000 5,000 -15,000 Payback = 3 + 5,000/20,000 = 3.25 Payback Period: Benefits Easy to Understand and Interpret MBA / MFM 253 Reject / Accept based on a Minimum payback Provides measure of risk Payback Period Weaknesses Ignores Time Value of Money MBA / MFM 253 Ignores all cash flows after the payback Discounted Payback Period MBA / MFM 253 Attempts to account for time value of money by evaluating the yearly cash flows in their present value. Calculating Discounted Payback Period  MBA / MFM 253      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% MBA / MFM 253 YR 1 2 3 4 5 Yearly PV Cumul Remaining CF CF CF CF 40,000 36,364 36,364 63,636 30,000 24,793 61,157 38,843 25,000 18,783 79,940 20,060 20,000 13,660 93,600 6,400 15,000 9,314 102,914 -2,914 Payback = 4 + 6400/9314 = 4.687 Discounted Payback MBA / MFM 253 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 MBA / MFM 253 The sum of the PV of the positive cash flows minus the PV of negative cash flows or  CFt   (1  WACC) t  t 1 n    Initial Cost   Incremental Cash Flows MBA / MFM 253 The cash flows used should represent any changes to Free Cash Flow that result from undertaking the project. The Required Return MBA / MFM 253 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) MBA / MFM 253 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 MBA / MFM 253 Assume a cost of capital of 10% (the WACC) Year Cash Flow Present Value 0 -1,000 -1,000.00 1 1,000 909.90 2 -2,000 -1,652.89 3 3,000 2,253.94 NPV = 510.14 Calculator HP 10B -1,000 1,000 -2,000 3,000 10 MBA / MFM 253 NPV MBA / MFM 253 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) MBA / MFM 253 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 MBA / MFM 253 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 MBA / MFM 253 Weaknesses Ignores size and amount of wealth created Ignores project life It is possible to have multiple IRR’s Multiple IRR’s Time 0 1 2 Time 0 1 2 MBA / MFM 253 Cash Flow -100 275 IRR = 7.4% and 67.6% -180 Cash Flow 100 -275 IRR = 7.4% and 67.6% 180 Multiple IRR’s vs. NPV Time 0 1 2 Time 0 1 2 Cash Flow -100 275 NPV @ 15% = $3 -180 MBA / MFM 253 Cash Flow 100 -275 NPV @ 15% = -$3 180 Multiple IRR’s An easy check for Multiple IRR’s MBA / MFM 253 Mathematically the largest number of IRR’s that is possible equals the number of sign changes in the cash flow stream Modified IRR MBA / MFM 253 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% Time 0 1 2 3 4 Cash Flow -1000 500 400 -150 500 PV -1000.00 -112.69 MBA / MFM 253 FV 665.50 484.00 500.00 -1,112.69 1,649.50 1112.69 = 1649.50/(1+MIRR)4 MIRR = 10.34% Profitability Index Measures the value created per dollar invested MBA / MFM 253  CFt   t   t 1 (1  r)   1  NPV PI I0 I0 n PI MBA / MFM 253 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 MBA / MFM 253 Method Accept Reject Payback Payback < cutoff Payback>cutoff Disc. Payback Same as Payback NPV NPV > 0 NPV < 0 IRR IRR > WACC IRR < WACC MIRR MIRR >WACC MIRR < WACC PI PI > 1 PI < 1 Mutually Exclusive NPV provides the best ranking when comparing between mutually exclusive investments, The rest can produce inconsistent rankings. MBA / MFM 253 Example MBA / MFM 253 Project Initial Cost YR1 CF YR2 CF A 1,000,000 1,000,000 0 B 1,200,000 1,119,000 312,000 C 900,000 195,000 970,000 D 1,100,000 980,000 345,000 Compare the different methods for both 7% and 12% (in Class) Comparison of results Discounted Paback 0.07 1.5512 1.8472 1.6110 0.12 A (107,142.86) B 51,831.63 C 47,385.20 D 50,031.89 0.8929 1.0433 1.0527 1.0455 1.7916 1.9387 1.8181 1.0000 1.2468 1.7268 1.3478 MBA / MFM 253 NPV A B C D (65,420.56) 122,307.28 129,478.56 117,224.21 PI 0.9346 1.1023 1.1439 1.1066 Pay 1.0000 1.2468 1.7268 1.3478 IRR 0.0000 0.1604 0.1521 0.1610 0.0000 0.1604 0.1521 0.1610 IRR vs. NPV revisited Investment A B Cost 10,000 15,000 YR 1 12,000 17,700 MBA / MFM 253 IRR 20% 18% NPV@12% NPV@16% A 714 344.82 B 803.50 258.60 NPV@14% 526.31579 for both On the Graph MBA / MFM 253 Asset B 526.32 Asset A 18% 20% 14% Summary MBA / MFM 253 Use NPV as the first rule The other criteria can provide secondary information Which criteria is most often used by managers? Identifying Good Projects MBA / MFM 253 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 MBA / MFM 253 Market Value of the Firm  PV of Free Cash Flows 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 MBA / MFM 253 Value of one  share Market Value of Equity # of common Shares Outstanding EVA and Share Price MBA / MFM 253 EVA  equtiy captial (ROE - Cost of equity capital) 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 of the Firm  BookValue  PV of future EVAs Economic Value Added MBA / MFM 253 Market Value Added = Present Value of Future EVA™ Market Value Added Market Value E V A E V A E V A E V A E V A E V A E V A E V A E V A E V A Share Price x Shares Outstanding + Debt Capital EVA™ = NOPAT – Capital Charge EVA IS a trademark of Stern Stewart Market Price MBA / MFM 253 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 MBA / MFM 253 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