INVESTMENT EVALUATION

Professor Tim Thompson

Kellogg School of Management

Investment Evaluation 1
The Finance Function

Financial
Operations Manager Financial
(1a) Raise
(Plant, (2) Investment Funds Markets
Equipment, (Investors)
Projects, (1b) Obligations
etc.) (Stocks, Debt, IOUs)
(4) Reinvest
(3) Cash from
(5) Dividends or
Operations
Interest Payments

The finance function manages the cash flow

Investment Evaluation 2
The Finance Function

Finance focuses on these two decisions

Financial
Operations
Investment Financial Financing Markets
Decision Manager Decision

How much to Where is the $

invest and in going to come
what assets? from?
Capital Budgeting

Investment Evaluation 3
Interaction between Financing &
Investment Decisions

The interplay of the decisions determines the cost of capital

Characteristics
of the
Investment

Investment Financial Financing Financial

Operations Decision
Manager Decision Markets

Cost of Capital

Investment Evaluation 4
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 5
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 6
Forecasting Cash Flows

First, forecast all relevant after-tax expected cash flows

Sample Corporation VALUATION
Actual ProForma
B. Operating Income 1998 1999 2000 2001 2002 2003 2004

1 Sales 1,356.1 1,535.0 1,660.0 1,759.6 1,865.2 1,958.4 2,056.4

2 Operating Costs (1,143.2) (1,304.8) (1,402.7) (1,478.1) (1,566.7) (1,645.1) (1,727.3)

3 Depreciation (67.5) (77.0) (83.0) (80.0) (75.0) (70.0) (65.0)

4 EBIT 145.4 153.3 174.3 201.5 223.4 243.3 264.0

5 Taxes (50.6) (61.3) (69.7) (80.6) (89.4) (97.3) (105.6)

6 EBIAT 94.8 92.0 104.6 120.9 134.1 146.0 158.4

Actual ProForma
C. Cash Flows from Operations 1998 1999 2000 2001 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

9 Changes in WC (87.7) (30.3) (75.0) (19.9) (21.1) (18.7) (19.6)

10 Capital Investment (59.7) (46.2) (48.4) (50.0) (50.0) (50.0) (50.0)

11 Free Cash Flows 14.9 92.4 64.2 131.0 137.9 147.4 153.8

Key is that cash flows must be (a) relevant, costs and income directly
affected by the project, and (b) after-tax, cash into the owners pocket
Investment Evaluation 7
 Forecasting Cash Flows

This is done by estimating operational parameters

Sample Corporation VALUATION

Actual ProForma
A. Operating Parameters 1998 1999 2000 2001 2002 2003 2004 2005 Terminal

S Sales Growth (%) 49.6% 13% 8% 6% 6% 5% 5% 5%

P Operating Profit Margin (%) 15.7% 15.0% 15.5% 16.0% 16.0% 16.0% 16.0% 16.0%
T Tax Rate (%) 39.9% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0% 40.0%
D Depreciation ($) 67.5 77.0 83.0 80.0 75.0 70.0 65.0 65.0
C Capital Expenditure ($) 59.7 46.2 48.4 50.0 50.0 50.0 50.0 50.0
W Working Capital as % of Sales (%) 19.5% 16.9% 60.0% 20.0% 20.0% 20.0% 20.0% 20.0%

Excess Cash -
Market Value of Debt 217.3
# of Outstanding Shares 22.9 This represents a best
Perpetual Growth Rate 5.0% guess about the
These are based on companys future
actual reported performance
performance

Obviously, there is an uncertainty problem but history is used as a guide for

what to expect in the future
Investment Evaluation 8
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 9
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

Include only changes in operating working capital. Short-term debt,
excess cash and marketable securities should not be accounted for.

4) 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 10
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.
c t1
Continuing Value
(r - g)
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 11
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 12
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 13
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 14
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 15
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 16
 Accounting Definition of Working
Capital

Working Capital = Current Assets - Current Liabilities

Accounts receivable Accounts payable

Inventory Accrued taxes
Cash (required for operations) Accrued wages
Excess Cash & marketable securities 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).
Investment Evaluation 17
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 Evaluate as if
entirely equity
= Net Operating Profit After Tax financed
+ Depreciation Ignore
- Capital Expenditures financing/
- Increase in Working Capital no interest line
item
= Cash Flow from Operations
Investment Evaluation 18
 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 19
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 20
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 21
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 Year 2 . . . Year n Year n+1 & on

CF1 CF2 CFn CFn+1/(r-g)

Investment Evaluation 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

4% Inflation
7%
Nominal
{3% Real
Nominal Rate Real Rate + Inflation
Investment Evaluation 23
Forecasting Cash Flows

Nominal vs. Real Cash Flows

1 2 3
Nominal 2.00 2.08 2.16
Real 2.00 2.00 2.00
Inflation @ 4%

Note: Depreciation is based on historical costs and therefore is not

adjusted for inflation

Investment Evaluation 24
 Forecasting Cash Flows
9) Overhead costs
Revenue
- Cost of Goods Sold
- Depreciation
- Selling, General & Admin.
Do not forget
= Operating Profit
overheads and - Cash Taxes on Operating Profit
other indirect
costs that = Net Operating Profit After Tax
increase due + Depreciation
- Capital Expenditures
to the project
- Increase in Working Capital

= Cash Flow from Operations

Investment Evaluation 25
Forecasting Cash Flows
10) Include excess cash, excess real estate, unfunded (over-
funded) pension funds, large stock option obligations
Year 1 Year 2 Year 3 Year 4 Year 5 . . . Terminal
CF1 CF2 CF3 CF4 CF5 CFn+1/(r-g)

PV(Operating Cash Flows)

+ Excess cash balance
+ Excess marketable securities Assets/Liabilities
+ Excess real estate not required to
- Under-funded pension support operations

=Value of the FIRM

Investment Evaluation 26
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 27
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

Activity Buy Hot Dog Cart Sell Hot Dogs Sell Hot Dogs

Cash Flows -187 110 121

Discount Rate 10%

110 121
NPV 187
(1 0.10) (1 0.10) 2

NPV 187 100 100 13

Future cash flows are discounted penalized for time and risk
Investment Evaluation 29
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

Activity Buy Hot Dog Cart Sell Hot Dogs Sell Hot Dogs

Cash Flows -200 110 121

Discount Rate 10%

110 121
NPV 200
(1 0.10) (1 0.10) 2

NPV 200 100 100 0

Investment Evaluation 30
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
30 IRR: Discount rate at
20
which the project has a
NPV ($)

NPV of zero
10
0
-10
0%

2%

4%

6%

8%

%
10

12

14

16

18

20

22

24
-20
-30
Discount Rate (%)

Internal rate of return (IRR) is the discount rate that sets the
NPV to zero
Investment Evaluation 31
Calculation of IRR

The IRR is the r that solves

C1 C2 Cn
0 C0 ....
1 r (1 r ) 2
(1 r ) n

Decision Rule: Accept the project if

IRR > Opportunity Cost of Capital

Investment Evaluation 32
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 33
Evaluation Methods:
NPV vs. IRR

2) Mutually Exclusive Projects (Ranking)

Problems with IRR: Highest (NPVa, NPVb, NPVc)

A) Scale Highest (IRRa, IRRb, IRRc)

Time Period: 0 1 IRR

Project A -1 5 400% Obviously, the return in absolute
Project B -100 120 20% dollars must be considered

B) Timing of Cash Flows: Bias against long-term

investments
Time Period: 0 1 2 IRR NPV@0% NPV@10% NPV@20%
Preference for CF early!
Project A -100 20 120 20% 40 17.3 0.0
But, it depends.
Project B -100 100 31.25 25% 31.25 16.7 5.0

Investment Evaluation 34
Evaluation Methods:
NPV vs. IRR

The ranking of the projects depends on the discount rate

Time Period: 0 1 2 IRR NPV@0% NPV@10%
Project A -100 20 120 20% 40 17.3
Project B -100 100 31.25 25% 31.25 16.7

A is a LT project and when discount rate PV

B is a ST project and when discount rate PVdrops less
Investment Evaluation 35
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: 0 1 2 3 4 5 Problems:
Project A -100 20 30 50 Pass No discounting the first
3 years
Project B -10 2 2 2 10 5B Fail
Infinite discounting of
Corporate Rule: Project must payback in at most 3 years! later years
Biases against long-

}
ROA (return on assets) term projects.

ROI (return on investment) Earnings

= Investment
ROFE (return on funds employed)
ROCE (return on capital employed) Problems:
Investment not valued at market
Net Income Earnings vs. cash flows
ROE =
Shareholders Equity
Book Value

Investment Evaluation 36