Measuring Investments (Part-2)

The Working Capital Effect

Ø  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

1.      Any increase in working capital reduces cash flows in that year

2.      Any decrease in working capital increases cash flows in that year

3.      To provide closure, working capital investments need to be salvaged at the end of the project life

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Proposition 1: The failure to consider working capital in a capital budgeting project will overstate cash flows on that project and make it look more attractive than it really is.

Proposition 2: Other things held equal, a reduction in working capital requirements will increase the cash flows on all projects for a firm.

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 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. If sunk costs are not considered in project analysis, how can a firm ensure that these costs are covered?

Allocated Costs

Ø  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)

Ø  For large firms, these allocated costs can result in the rejection of projects

Ø  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.

Ø  How, looking at these pooled expenses, do we know how much of the costs are fixed and how much are variable?

To Time-Weighted Cash Flows

Ø  Incremental cash flows in the earlier years are worth more than incremental cash flows in later years.

Ø  In fact, cash flows across time cannot be added up. They have to be brought to the same point in time before aggregation.

Ø  This process of moving cash flows through time is

1.      discounting, when future cash flows are brought to the present

2.      compounding, when present cash flows are taken to the future

Ø  The discounting and compounding is done at a discount rate that will reflect

1.      Expected inflation: Higher Inflation -> Higher Discount Rates

2.      Expected real rate: Higher real rate -> Higher Discount rate

3.      Expected uncertainty: Higher uncertainty -> Higher Discount Rate

Present Value Mechanics

Discounted cash flow measures of return

Ø  Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment).

            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)

                        Decision Rule: Accept if NPV > 0

Ø  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.

                        Decision Rule: Accept if IRR > hurdle rate

Closure on Cash Flows

Ø  In a project with a finite and short life, you would need to compute a salvage value, which is the expected proceeds from selling all of the investment in the project at the end of the project life. It is usually set equal to book value of fixed assets and working capital

Ø  In a project with an infinite or very long life, we compute cash flows for a reasonable period, and then compute a terminal value for this project, which is the present value of all cash flows that occur after the estimation period ends.

Ø  Assuming the project lasts forever, and that cash flows after year 9 grow 3% (the inflation rate) forever, the present value at the end of year 9 of cash flows after that can be written as:

                        Terminal Value in year 9 = CF in year 10/(Cost of Capital - Growth Rate)

                        = 822/(.1232-.03) = $ 8,821 million

Note that this is the terminal value in year 9; So cash flow in year 10 is used.

Which makes the argument that...?

Ø  The project should be accepted. The positive net present value suggests that the project will add value to the firm, and earn a return in excess of the cost of capital.

What would you choose as your investment tool?

Ø  Given the advantages/disadvantages outlined for each of the different decision rules, which one would you choose to adopt?

1.      Return on Investment (ROE, ROC)

2.      Payback or Discounted Payback

3.      Net Present Value

4.      Internal Rate of Return

5.      Profitability Index

Should there be a risk premium for foreign Projects?

Ø  The exchange rate risk may be diversifiable risk (and hence should not command a premium) if

1. the company has projects is a large number of countries (or)
2. The investors in the company are globally diversified.

Ø  The same diversification argument can also be applied against political risk, which would mean that it too should not affect the discount rate.

It may, however, affect the cash flows, by reducing the expected life or cash flows on the project.

Dealing with Inflation

Ø  In our analysis, we used nominal dollars and Bt. Would the NPV have been different if we had used real cash flows instead of nominal cash flows?

1.      It would be much lower, since real cash flows are lower than nominal cash flows

2.      It would be much higher

3.      It should be unaffected

Equity Analysis: The Parallels

Ø  The investment analysis can be done entirely in equity terms, as well. The returns, cashflows and hurdle rates will all be defined from the perspective of equity investors.

Ø  If using accounting returns,

1.      Return will be Return on Equity (ROE) = Net Income/BV of Equity

2.      ROE has to be greater than cost of equity

Ø  If using discounted cashflow models,

1.      Cashflows will be cashflows after debt payments to equity investors

2.      Hurdle rate will be cost of equity

The Role of Sensitivity Analysis

Ø  Our conclusions on a project are clearly conditioned on a large number of assumptions about revenues, costs and other variables over very long time periods.

Ø  To the degree that these assumptions are wrong, our conclusions can also be wrong.

Ø  One way to gain confidence in the conclusions is to check to see how sensitive the decision measure (NPV, IRR...) is to changes in key assumptions.

Side Costs and Benefits

Ø  Most projects considered by any business create side costs and benefits for that business.

1.      The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have.

2.      The benefits that may not be captured in the traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay, expand or abandon a project).

Ø  The returns on a project should incorporate these costs and benefits.

Opportunity Cost

Ø  An opportunity cost arises when a project uses a resource that may already have been paid for by the firm. When a resource that is already owned by a firm is being considered for use in a project, this resource has to be priced on its next best alternative use, which may be

1.      a sale of the asset, in which case the opportunity cost is the expected proceeds from the sale, net of any capital gains taxes

2.      Renting or leasing the asset out, in which case the opportunity cost is the expected present value of the after-tax rental or lease revenues.

3.      Use elsewhere in the business, in which case the opportunity cost is the cost of replacing it.

Project Synergies

Ø  A project may provide benefits for other projects within the firm. If this is the case, these benefits have to be valued and shown in the initial project analysis.

Project Options

Ø  One of the limitations of traditional investment analysis is that it is static and does not do a good job of capturing the options embedded in investment.

1.      The first of these options is the option to delay taking a project, when a firm has    exclusive rights to it, until a later date.

2.      The second of these options is taking one project may allow us to take advantage of          other opportunities (projects) in the future

3.      The last option that is embedded in projects is the option to abandon a project, if the         cash flows do not measure up.

Ø  These options all add value to projects and may make a “bad” project

The Option to Delay

Ø  When a firm has exclusive rights to a project or product for a specific period, it can delay taking this project or product until a later date.

Ø  A traditional investment analysis just answers the question of whether the project is a “good” one if taken today.

Ø  Thus, the fact that a project does not pass muster today (because its NPV is negative, or its IRR is less than its hurdle rate) does not mean that the rights to this project are not valuable.

Valuing the Option to Delay a Project

Ø  Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today.

Ø  The value of these rights increases with the volatility of the underlying business.

Ø  The cost of acquiring these rights (by buying them or spending money on development - R&D, for instance) has to be weighed off against these benefits.

The Option to Expand/Take Other Projects

Ø  Taking a project today may allow a firm to consider and take other valuable projects in the future. . Thus, even though a project may have a negative NPV, it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value.

Ø  These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects.

The Option to Abandon

Ø  A firm may sometimes have the option to abandon a project, if the cash flows do not measure up to expectations.

Ø  If abandoning the project allows the firm to save it from further losses, this option can make a project more valuable.