INVESTMENT

RETURNS II: FROM

EARNINGS TO TIME-WEIGHTED CASH
FLOWS
Time is money.

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

Revisi?ng accoun?ng earnings on Rio Disney

Direct expenses: 60% of revenues for theme parks, 75% of revenues for resort properties

Allocated G&A: Company G&A allocated to project, based on projected revenues. Two
thirds of expense is fixed, rest is variable.

Taxes: Based on marginal tax rate of 36.1%

The cash ow view of this project..

After-tax Operating Income

+ Depreciation & Amortization

- Capital Expenditures

I.

10

-$32

-$96 -$54 $68 $202 $249 $299 $352 $410 $421

$0

$50

$425 $469 $444 $372 $367 $364 $364 $366 $368

$0

$63
$25
$38
$31
$16
$17
$19
$21
$5

($2,500)
($982)
($921)
($361)
$198
$285
$314
$332
$367
$407
$434

added back all non-cash charges such as depreciation.

Depreciation

Tax Bendfits from Depreciation

II.
subtracted
III.

$2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350

- Change in non-cash Work Capital

Cashflow to firm

1
2
3
4
5
6
7
8
9
10
$50 $425 $469 $444 $372 $367 $364 $364 $366 $368
$18 $153 $169 $160 $134 $132 $132 $132 $132 $133

out the capital expenditures

subtracted out the change in non-cash working capital

The incremental cash ows on the project

$ 500 million has

already been spent & $
50 million in
depreciation will exist
anyway

2/3rd of allocated G&A is fixed.

Add back this amount (1-t)

Tax rate = 36.1%

To Time-Weighted Cash Flows

Incremental cash ows in the earlier years are worth
more than incremental cash ows in later years.
In fact, cash ows across ?me cannot be added up.
They have to be brought to the same point in ?me
before aggrega?on.
This process of moving cash ows through ?me is

discoun?ng, when future cash ows are brought to the

present
compounding, when present cash ows are taken to the
future
6

Present Value Mechanics

Cash Flow Type

Formula
1. Simple CF
2. Annuity

Discoun?ng Formula

Compounding

CFn / (1+r)n
"
1

$1 -

CF0 (1+r)n

A$
$
#

3. Growing Annuity

4. Perpetuity
5. Growing Perpetuity

%
(1 + r) n '
'
r
'
&

"
(1 + g) n
$1 (1 + r) n
A(1 + g) $
r-g
$
$#

" (1 + r) n - 1 %
A$
'
r
#
&

%
'
'
'
'&

A/r
Expected Cashow next year/(r-g)

Discounted cash ow measures of return

Net Present Value (NPV): The net present value is the

sum of the present values of all cash ows from the
project (including ini?al investment).

NPV = Sum of the present values of all cash ows on the project,
including the ini?al investment, with the cash ows being
discounted at the appropriate hurdle rate (cost of capital, if cash
ow is cash ow to the rm, and cost of equity, if cash ow is to
equity investors)
Decision Rule: Accept if NPV > 0

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 ?me-weighted cash ows.

Decision Rule: Accept if IRR > hurdle rate

Closure on Cash Flows

In a project with a nite 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 xed assets and working capital
In a project with an innite or very long life, we compute cash
ows for a reasonable period, and then compute a terminal value
for this project, which is the present value of all cash ows that
occur ager the es?ma?on period ends..
Assuming the project lasts forever, and that cash ows ager year
10 grow 2% (the ina?on rate) forever, the present value at the
end of year 10 of cash ows ager that can be wriien as:

Terminal Value in year 10= CF in year 11/(Cost of Capital - Growth Rate)

=715 (1.02) /(.0846-.02) = $ 11,275 million

Which yields a NPV of..

Discounted at Rio Disney cost

of capital of 8.46%

10

Which makes the argument that..

The project should be accepted. The posi?ve net
present value suggests that the project will add
value to the rm, and earn a return in excess of the
cost of capital.
By taking the project, Disney will increase its value
as a rm by $3,296 million.

11

The IRR of this project

$5,000.00

$4,000.00

$3,000.00

$2,000.00

NPV

Internal Rate of Return=12.60%

$1,000.00

$0.00

8%
9%
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
21%
22%
23%
24%
25%
26%
27%
28%
29%
30%

-$1,000.00

-$2,000.00

-$3,000.00

Discount Rate

12

The IRR suggests..

The project is a good one. Using ?me-weighted, incremental cash ows, this
project provides a return of 12.60%. This is greater than the cost of capital of
8.46%.
The IRR and the NPV will yield similar results most of the ?me, though there are
dierences between the two approaches that may cause project rankings to vary
depending upon the approach used. They can yield dierent results, especially
why comparing across projects because

A project can have only one NPV, whereas it can have more than one IRR.
The NPV is a dollar surplus value, whereas the IRR is a percentage measure of return. The NPV
is therefore likely to be larger for large scale projects, while the IRR is higher for small-
scale projects.
The NPV assumes that intermediate cash ows get reinvested at the hurdle rate, which is
based upon what you can make on investments of comparable risk, while the IRR assumes
that intermediate cash ows get reinvested at the IRR.

13

Task
Describe a
typical
investment
for your
company

14

Read
Chapter 5