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Investment Evaluation Abridged PDF
Investment Evaluation Abridged PDF
Investment Evaluation
Operations
(Plant,
Equipment,
Projects,
etc.)
Financial
Manager
(2) Investment
(1a) Raise
Funds
Financial
Markets
(Investors)
(1b) Obligations
(Stocks, Debt, IOUs)
(4) Reinvest
(3) Cash from
Operations
(5) Dividends or
Interest Payments
Operations
Financial
Markets
Where is the $
going to come
from?
Investment Evaluation
Investment Financial
Decision
Manager
Financing
Decision
Financial
Markets
Cost of Capital
Investment Evaluation
Investment Evaluation
Investment Evaluation
1999
2000
2001
ProForma
2002
2003
2004
1,356.1
1,535.0
1,660.0
1,759.6
1,865.2
1,958.4
2,056.4
(1,143.2)
(67.5)
(1,304.8)
(77.0)
(1,402.7)
(83.0)
(1,478.1)
(80.0)
(1,566.7)
(75.0)
(1,645.1)
(70.0)
(1,727.3)
(65.0)
4 EBIT
5 Taxes
145.4
(50.6)
153.3
(61.3)
174.3
(69.7)
201.5
(80.6)
223.4
(89.4)
243.3
(97.3)
264.0
(105.6)
6 EBIAT
94.8
92.0
104.6
120.9
134.1
146.0
158.4
B. Operating Income
1 Sales
2 Operating Costs
3 Depreciation
Actual
1998
1999
2000
2001
ProForma
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
(87.7)
(30.3)
(75.0)
(19.9)
(21.1)
(18.7)
(19.6)
(59.7)
(46.2)
(48.4)
(50.0)
(50.0)
(50.0)
(50.0)
14.9
92.4
64.2
131.0
137.9
147.4
153.8
9 Changes in WC
10 Capital Investment
11 Free Cash Flows
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
A. Operating Parameters
S
P
T
D
C
W
Actual
1998
49.6%
15.7%
39.9%
67.5
59.7
19.5%
1999
13%
15.0%
40.0%
77.0
46.2
16.9%
2000
8%
15.5%
40.0%
83.0
48.4
60.0%
2001
6%
16.0%
40.0%
80.0
50.0
20.0%
217.3
22.9
5.0%
ProForma
2002
2003
6%
16.0%
40.0%
75.0
50.0
20.0%
5%
16.0%
40.0%
70.0
50.0
20.0%
2004
5%
16.0%
40.0%
65.0
50.0
20.0%
2005
Terminal
5%
16.0%
40.0%
65.0
50.0
20.0%
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
1)
2)
3)
4)
5)
6)
10
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.
8)
c t1
Continuing Value
(r - g)
9)
Overhead costs
10)
11
Revenue
Cost of Goods Sold
Depreciation (may be in CGS)
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
12
Revenue
Cost of Goods Sold
Depreciation
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
13
Revenue
Cost of Goods Sold
Depreciation
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
14
Revenue
Cost of Goods Sold
Depreciation
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
15
16
Accounts receivable
Inventory
Cash (required for operations)
Excess Cash & marketable securities
Accounts payable
Accrued taxes
Accrued wages
short-term debt
17
Revenue
Cost of Goods Sold
Depreciation
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
Evaluate as if
entirely equity
financed
Ignore
financing/
no interest line
item
18
19
Investment Evaluation
20
21
Year 2 . . . Year n
CF2
CFn
Investment Evaluation
CFn+1/(r-g)
22
7%
4% Inflation
Nominal
3% Real
Nominal Rate Real Rate + Inflation
Investment Evaluation
23
Nominal
Real
1
2.00
2.00
2
2.08
2.00
3
2.16
2.00
Inflation @ 4%
Investment Evaluation
24
Do not forget
overheads and
other indirect
costs that
increase due
to the project
Revenue
Cost of Goods Sold
Depreciation
Selling, General & Admin.
= Operating Profit
- Cash Taxes on Operating Profit
=
+
-
25
+
+
+
-
Assets/Liabilities
not required to
support operations
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
Time Period
Cash Flows
-187
110
121
Discount Rate
10%
NPV 187
110
121
(1 0.10) (1 0.10) 2
Activity
Future cash flows are discounted penalized for time and risk
Investment Evaluation
29
Time Period
Cash Flows
-200
110
121
Discount Rate
10%
NPV 200
110
121
(1 0.10) (1 0.10) 2
Activity
Investment Evaluation
30
20
10
24
%
22
%
20
%
18
%
16
%
14
%
12
%
10
%
8%
6%
0%
-10
4%
2%
NPV ($)
30
-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
Cn
C1
C2
0 C0
....
2
1 r (1 r )
(1 r ) n
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:
A) Scale
Time Period:
Project A
Project B
0
-1
-100
IRR
400%
20%
0
-100
-100
1
20
100
2
120
31.25
IRR
20%
25%
Investment Evaluation
34
Evaluation Methods:
NPV vs. IRR
The ranking of the projects depends on the discount rate
Time Period:
Project A
Project B
0
-100
-100
1
20
100
2
120
31.25
IRR
20%
25%
NPV@0%
40
31.25
NPV@10%
17.3
16.7
35
0
-100
-10
2
20
2
3
30
2
4
50
2
5
10
Net Income
Shareholders Equity
Pass
5B Fail
Problems:
No discounting the first
3 years
Infinite discounting of
later years
Biases against longterm projects.
Earnings
= Investment
Problems:
Investment not valued at market
Earnings vs. cash flows
Book Value
Investment Evaluation
36