Measuring Investments

Measuring Investment – (Returns Measurement)

First Principles

Ø  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

Ø  The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

Ø  Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Ø  Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

Ø  If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

Ø  The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

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Measures of return: earnings versus cash flows

Ø  Principles Governing Accounting Earnings Measurement

1.      Accrual Accounting: Show revenues when products and services are sold or provided, not when they are paid for. Show expenses associated with these revenues rather than cash expenses.

2.      Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization)

Ø  To get from accounting earnings to cash flows:

1.      you have to add back non-cash expenses (like depreciation)

2.      you have to subtract out cash outflows which are not expensed (such as capital expenditures)

3.      You have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital).

Measuring Returns Right: The Basic Principles

Ø  Use cash flows rather than earnings. You cannot spend earnings.

Ø  Use “incremental” cash flows relating to the investment decision, i.e., cashflows that occur as a consequence of the decision, rather than total cash flows.

Ø  Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

Application Test: Assessing Investment Quality

Ø  For the most recent period for which you have data, compute the aftertax return on capital earned by your firm, where after-tax return on capital is computed to be

After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of Equity) previous year

Ø  For the most recent period for which you have data, compute the return spread earned by your firm:

Return Spread = After-tax ROC - Cost of Capital

Ø  For the most recent period, compute the EVA earned by your firm

EVA = Return Spread * ((BV of debt + BV of Equity) previous year

The Depreciation Tax Benefit

Ø  While depreciation reduces taxable income and taxes, it does not reduce the cash flows.

Ø  The benefit of depreciation is therefore the tax benefit. In general, the tax benefit from depreciation can be written as:

Tax Benefit = Depreciation * Tax Rate

Ø  Proposition 1: The tax benefit from depreciation and other non-cash charges is greater, the higher your tax rate.

Ø  Proposition 2: Non-cash charges that are not tax deductible (such as amortization of goodwill) and thus provide no tax benefits have no effect on cash flows.

Depreciation Methods

Broadly categorizing, depreciation methods can be classified as straight line or accelerated methods. In straight line depreciation, the capital expense is spread evenly over time, in accelerated depreciation; the capital expense is depreciated more in earlier years and less in later years.

The Capital Expenditures Effect

Ø  Capital expenditures are not treated as accounting expenses but they do cause cash outflows. Capital expenditures can generally be categorized into two groups

1.      New (or Growth) capital expenditures are capital expenditures designed to create new assets and future growth

2.      Maintenance capital expenditures refer to capital expenditures designed to keep existing assets.

Ø  Both initial and maintenance capital expenditures reduce cash flows. The need for maintenance capital expenditures will increase with the life of the project. In other words, a 25-year project will require more maintenance capital expenditures than a 2-year asset

 ...... To be Continued Tomorrow