INVESTMENT EVALUATION

Professor Artur Raviv

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

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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

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The Finance Function

The objective the financial manager:

Make investing and financing decisions
so as to
MAXIMIZE SHAREHOLDERS'
WEALTH.

Investment Evaluation 5

Other Possible Objectives for

the Manager
What about other stakeholders?
Workers, community, tax collector…
Maximizing Sales or Market Share
Does not account for the cost of doing so.
Maximizing Earnings and Earnings Growth
Accounting earnings are different than cash flows.
Does not account for timing of earnings.
Maximizing Return on Investment or Return on
Equity
Based on accounting (book) values

Investment Evaluation 6

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 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, ROIC, ROI, ROCE
ROE
EVA

Investment Evaluation 7

Forecasting Cash Flows

First, forecast all relevant after-tax expected cash flows

Sample Corporation VALUATION
Actual ProForma
B. Operating Income 2018 2019 2020 2021 2022 2023 2024

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 2018 2019 2020 2021 2022 2023 2024

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

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 Forecasting Cash Flows

This is done by estimating operational parameters

Sample Corporation VALUATION

Actual ProForma
A. Operating Parameters 2018 2019 2020 2021 2022 2023 2024

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

P Operating Profit Margin (%) 15.7% 15.0% 15.5% 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%
D Depreciation ($) 67.5 77.0 83.0 80.0 75.0 70.0 65.0
C Capital Expenditure ($) 59.7 46.2 48.4 50.0 50.0 50.0 50.0
W Working Capital as % of Sales (%) 19.5% 16.9% 60.0% 20.0% 20.0% a “best
This represents 20.0% 20.0%
guess” about the
Excess Cash - These are based on
company’s future
Market Value of Debt 217.3 actual reported
performance
# of Outstanding Shares 22.9 performance
Perpetual Growth Rate 5.0%

Investment Evaluation 9

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, ROIC, ROI, ROCE
ROE
EVA

Investment Evaluation 10

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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 11

Forecasting Cash Flows: The Ten Commandments

7) Overhead costs

8) 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 t1
Continuing Value 
(r - g)
9) 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

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 12

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Forecasting Cash Flows
Cash Flows from Operations
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

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 14

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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 15

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 Operating Working Capital

= Cash Flow from Operations

Investment Evaluation 16

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 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.
We need the operating working capital,
not the operating and financial working
capital.

Investment Evaluation 17

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). Excess cash
and marketable securities not required for operations (below dotted line)
are not operating working capital and are accounted separately for value
(see 10th commandment).
• Current liabilities include operating liabilities (above the dotted line).
Non-operating liabilities e.g., short-term debt (below the dotted line) are
accounted for separately. Investment Evaluation 18

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 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 19

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 20

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 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 21

Forecasting Cash Flows

7) 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 22

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Forecasting Cash Flows

8) 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 23

Forecasting Cash Flows

•Continuation: 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)

The terminal value measures the PV of cash flows from period

n+1 and on as of time n. Need to compute the PV of terminal
value by discounting for n periods.
Investment Evaluation 24

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Forecasting Cash Flows

9) 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
{
To calculate the precise
real interest rates use the
7% following formula:
Nominal (1  Nominal ) /(1  Inflation)  1  Real
3% Real
Nominal Rate Real Rate + Inflation
Investment Evaluation 25

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 26

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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 27

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 28

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 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, ROIC, ROI, ROCE
ROE
EVA

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 -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 30

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Evaluation Methods: NPV

Interpretation of NPV: shareholder value created

Modified
Time Period 0 1 2
Example:
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 31

Evaluation Methods: IRR

$50

$40

$30

$20 IRR: Discount rate at

which the NPV=0
NPV

$10 IRR=15%

$0
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22%
-$10

-$20

-$30

Discount Rate

Investment Evaluation 32

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Evaluation Methods: IRR

As the discount rate increases, the PV of future

cash flows is lower and the NPV is reduced
Internal rate of return (IRR) is the discount rate
that sets NPV=0

110 121
0  187  
1  r (1  r ) 2
IRR=15%. Accept since 15% > 10%

Investment Evaluation 33

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 34

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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 35

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 36

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Evaluation Methods: NPV vs. IRR

The ranking changes:

A is preferred for low discount rates
B is preferred for high discount rates
A is a long term project
NPV is very sensitive to discount rate
B is a short term project
NPV is less sensitive to discount rate

Investment Evaluation 37

Evaluation Methods: NPV vs. IRR

The ranking depends on the discount rate

$50

$40

$30

$20
NPV

$10

$0
0% 3% 6% 9% 12% 15% 18% 21% 24% 27% 30%

($10)

($20)

Discount Rate

Project A Project B

Investment Evaluation 38

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Other Evaluation Methods

Profitability Index: NPV/Inv. 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
ROIC (return on invested capital)
ROCE (return on capital employed) Problems:
•Investment not valued at market
Net Income •Earnings vs. cash flows
ROE =
Shareholders’ Equity
Book Value

Investment Evaluation 39

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