Investment Analysis

Guillermo Davila
 First Principles

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash
rate fund your operations to owners of your business

The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities

2
 Post Class Test
• Which of the following assets is best suited for
intrinsic valuation?
a. A finite life asset with no cash flows associated
with it
b. An infinite life asset with no cash flows
associated with it
c. An asset with uncertain cash flows over any life
period..
d. An asset with cash flows contingent on an event
happening
e. None of the above
 Post Class Test
• c. An asset with uncertain cash flows over any time
period. You cannot do intrinsic valuation on non-‐cash
flow generating assets (collectibles, paintings, gold).
An asset with contingent cash flows is best valued as
an option
 Post Class Test
• What type of investor will get the biggest payoff from using
intrinsic valuation?
a. An investor with a short time horizon that believes that
markets are always wrong.
b. An investor with a long time horizon that believes that
markets are always wrong.
c. An investor with a short time horizon that believes that
markets make mistakes on pricing but that they correct
them over time.
d. An investor with a long time horizon that believes that
markets make mistakes on pricing but that they correct
them over time..
e. An investor that believes that markets are always right.
 Post Class Test
• d. An investor with a long time horizon that thinks that markets
are wrong at points in time but that they correct themselves
over time. If markets are always wrong, you will not make any
money on your intrinsic valuation and you need a long time
horizon to improve your odds of markets correcting themselves.
 Post Class Test
• Which of the following assets is best suited for relative
valuation?
a. An untraded, unique asset with nothing comparable or
similar to it.
b. An traded, unique asset with nothing comparable or
similar to it.
c. An asset that is similar to other assets, none of which
have traded prices.
d. An asset that is similar to other assets, many of which are
traded at regular intervals..
e. None of the above
 Post Class Test
• d. An asset that is similar to other assets, many of which are
traded. You need similar assets for the comparison and the
trading for the prices on these assets.
 Post Class Test

• One argument that is used by those who use

multiples/relative valuation is that there are
fewer assumptions in relative valuation than
in intrinsic valuation. Is this true or false?
a. True
b. False
 Post Class Test

• b. False.

You may make fewer explicit assumptions but

you ultimately make the remaining assumptions
implicitly. Put differently, the number of
assumption embedded in both approaches is
the same, but you may make judgments on
fewer of them.
 Post Class Test

• Asset-‐based valuation, where you value a

business by adding up the values of its
individual assets is an alternative to intrinsic
and relative valuation.
a. True
b. False
 Post Class Test

• b. False.

To get the values of the assets, you have to use

either intrinsic or relative valuation.
 The essence of intrinsic value
• In intrinsic valuation, you value an asset based upon its
fundamentals (or intrinsic characteristics).
• For cash flow generating assets, the intrinsic value will
be a function of the magnitude of the expected cash
flows on the asset over its lifetime and the uncertainty
about receiving those cash flows.
• Discounted cash flow valuation is a tool for estimating
intrinsic value, where the expected value of an asset is
written as the present value of the expected cash flows
on the asset, with either the cash flows or the discount
rate adjusted to reflect the risk.

13
 The drivers of value
Determinants of Value

Growth from new investments Efficiency Growth

Growth created by making new Growth generated by using
investments; function of amount and existing assets better
quality of investments
Terminal Value of firm (equity)
Current Cashflows
These are the cash flows from Expected Growth during high growth period
existing investment,s, net of any Stable growth firm,
reinvestment needed to sustain with no or very limited
future growth. They can be excess returns
computed before debt cashflo ws Length of the high growth period
(to the firm) or after debt Since value creating growth requires excess returns,
cashflows (to equity investors). this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages

Cost of financing (debt or capital) to apply to

discounting cashflows
Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing
 The two faces of discounted cash flow valuation
• The value of a risky asset can be estimated by discounting
the expected cash flows on the asset over its life at a risk-
adjusted discount rate:

where the asset has an n-year life, E(CFt) is the expected

cash flow in period t and r is a discount rate that reflects
the risk of the cash flows.

• Alternatively, we can replace the expected cash flows with

the guaranteed cash flows we would have accepted as an
alternative (certainty equivalents) and discount these at the
which rate?

15
 The two faces of discounted cash flow valuation
• The certainty equivalents cash flows have to be
discounted at the riskfree rate:

where CE(CFt) is the certainty equivalent of E(CFt) and

rf is the riskfree rate.

16
 Risk Adjusted Value: Three Basic Propositions
• The value of an asset is the risk-adjusted present value of the cash flows:

1. If the expected cash flows are not affected by changes in it structure or the riskiness
of the cash flows, IT cannot affect value.

2. For an asset to have value, the expected cash flows have to be positive some time
over the life of the asset and compensate all the negative cash flows over the life of
the asset.

2. Assets that generate cash flows early in their life will be worth more than assets that
generate cash flows later; the latter may however have greater growth and higher
cash flows to compensate.

17
DCF Choices: Equity Valuation versus Firm Valuation

Firm Valuation: Value the entire business

Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets

Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives

Equity valuation: Value just the

equity claim in the business

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 Equity Valuation
Figure 5.5: Equity Valuation
Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets,
after debt payments and
after making reinvestments
needed for future growth Discount rate reflects only the
Growth Assets Equity cost of raising equity financing

Present value is value of just the equity claims on the firm

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 Firm Valuation
Figure 5.6: Firm Valuation
Assets Liabilities

Assets in Place Debt

Cash flows considered are
cashflows from assets, Discount rate reflects the cost
prior to any debt payments of raising both debt and equity
but after firm has financing, in proportion to their
reinvested to create growth
assets use
Growth Assets Equity

Present value is value of the entire firm, and reflects the value of
all claims on the firm.

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 Firm Value and Equity Value
• To get from firm value to equity value, which of the following would you need
to do?
a. Subtract out the value of long-term debt
b. Subtract out the value of all debt
c. Subtract the value of any debt that was included in the cost of capital
calculation
d. Subtract out the value of all liabilities in the firm

• In general, you should maintain consistency in your definition of debt. If you

choose to call something debt in your cost of capital calculation - operating
leases, for instance - you should subtract the item out to get to the value of
equity.
• If you do it right (and it is tough to do- see fcfffcfe.xls spreadsheet on my web
site), you should get the same value for equity using both approaches. (The
requirement is that the assumptions about debt should be the same in both
approaches)

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 Firm Value and Equity Value
• Doing so, will give you a value for the equity
which is
a. greater than the value you would have got in an
equity valuation
b. lesser than the value you would have got in an
equity valuation
c. equal to the value you would have got in an
equity valuation

22
 Cash Flows and Discount Rates
• Assume that you are analyzing a company with the following cashflows for
the next five years.

Year CF to Equity Interest Expense (1-t) CF to Firm

1 $ 50 $ 40 $ 90
2 $ 60 $ 40 $ 100
3 $ 68 $ 40 $ 108
4 $ 76.2 $ 40 $ 116.2
5 $ 83.49 $ 40 $ 123.49

TV $ 1603.0 $760 $ 2363.008

TV= Terminal Value

• Assume also that the cost of equity is 13.625% and the firm can borrow long
term at 10%. (The tax rate for the firm is 50%.)

• The current market value of equity is $1,073 and the value of debt
outstanding is $800.
 Equity versus Firm Valuation
• Method 1: Discount CF to Equity at Cost of Equity to get
value of equity
▪ Cost of Equity = 13.625%
▪ Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +
76.2/1.136254 + (83.49+1603)/1.136255 = $1073

• Method 2: Discount CF to Firm at Cost of Capital to get value

of firm

▪ Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%

▪ Cost of Capital = 13.625% (1073/1873) + 5% (800/1873) = 9.94%
▪ PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 +
116.2/1.09944 + (123.49+2363)/1.09945 = $1873
▪ Value of Equity = Value of Firm - Market Value of Debt
▪ = $ 1873 - $ 800 = $1073

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 First Principle of Valuation
• Discounting Consistency Principle: Never mix and match
cash flows and discount rates.
• Mismatching cash flows to discount rates is deadly.
– Discounting cashflows after debt cash flows (equity
cash flows) at the weighted average cost of capital will
lead to an upwardly biased estimate of the value of
equity
– Discounting pre-debt cashflows (cash flows to the
firm) at the cost of equity will yield a downward biased
estimate of the value of the firm.

25
 The Effects of Mismatching Cash Flows and Discount Rates
• Error 1: Discount CF to Equity at Cost of Capital to get equity
value
▪ PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944
+ (83.49+1603)/1.09945 = $1248
▪ Value of equity is overstated by $175.

• Error 2: Discount CF to Firm at Cost of Equity to get firm value

▪ PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 +
116.2/1.136254 + (123.49+2363)/1.136255 = $1613
▪ PV of Equity = $1612.86 - $800 = $813
▪ Value of Equity is understated by $ 260.

• Error 3: Discount CF to Firm at Cost of Equity, forget to subtract

out debt, and get too high a value for equity
▪ Value of Equity = $ 1613
▪ Value of Equity is overstated by $ 540
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DCF: FIRST STEPS

27
 Discounted Cash Flow Valuation: The Steps
1. Estimate the discount rate or rates to use in the valuation
a. Discount rate can be either a cost of equity (if doing equity valuation) or a
cost of capital (if valuing the firm)
b. Discount rate can be in nominal terms or real terms, depending upon
whether the cash flows are nominal or real
c. Discount rate can vary across time.
2. Estimate the current earnings and cash flows on the asset, to either
equity investors (CF to Equity) or to all claimholders (CF to Firm)
3. Estimate the future earnings and cash flows on the firm being
valued, generally by estimating an expected growth rate in
earnings.
4. Estimate when the firm will reach “stable growth” and what
characteristics (risk & cash flow) it will have when it does.
5. Choose the right DCF model for this asset and value it.

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Generic DCF Valuation Model

29
 Same ingredients, different
approaches…
Input Dividend Discount FCFE (Potential FCFF (firm)
Model dividend) discount valuation model
model
Cash flow Dividend Potential dividends FCFF = Cash flows
= FCFE = Cash flows before debt
after taxes, payments but after
reinvestment needs reinvestment needs
and debt cash and taxes.
flows
Expected growth In equity income In equity income In operating
and dividends and FCFE income and FCFF
Discount rate Cost of equity Cost of equity Cost of capital
Steady state When dividends When FCFE grow at When FCFF grow at
grow at constant constant rate constant rate
rate forever forever forever

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Start easy: The Dividend Discount
Model

31
Moving on up: The “potential dividends” or FCFE
model

32
To valuing the entire business: The
FCFF model

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ACCOUNTING FIRST STEPS

34
The Accountant’s Role

o From a Finance view (and many accountants will

disagree), it is the role of accounting
o To check transactions and operations, as they occur
o To record them in a consistent manner
o To report the results in standardized form
o Much as accounting wants to makes itself more relevant
and central to businesses, it is not the role of accounting:
o Forecast the future, no matter how tempted.
o Value assets or operations.
o In general perspective, an accountant is a historian,
chronicling events that have already occurred, not
predicting the future. 3
5
The Accounting Questions..

 What do you own? List out the assets that a business has
invested in, and how much it spent on those investments
and perhaps what these assets are worth today.
 What do you owe? Specify the contractual commitments
that a business has to meet, to stay in business. Simply
put, this should include all borrowings, but is not
restricted to those.
 How much money did you make? Measure the
profitability of the business, both with accounting
judgments on expenses, and based upon cash in and cash
out.
3
6
The Accounting Statements

! The balance sheet, which summarizes what a firm

owns and owes at a point in time, as well as an
estimate of what equity is worth (through accounting
eyes).
! The income statement, which reports on how much
a business earned in the period of analysis, while
providing detail on revenues and expenses.
! The statement of cash flows, which reports on cash
inflows and outflows to the firm during the period of
analysis and allows for a measure of cash earnings
3
(as opposed to accounting earnings) and cash flows.
7
1. Balance Sheet

3
8
 2. Income Statement

Item Explanation

Start with Revenues Accountant's estimate of the revenues/sales generated by any

transactions made the business during the period.

Net out Cost of Goods Sold Expenses associated with producing products or services that
represent top line sales
To get Gross Profit Production profitability

Includes selling, general and administrative and other

Net out Other Operating Expenses
expenses associated with operations, but not directly tied to
producing goods and services
To get Operating Profit Profitability of business

Net out Financial Expenses Expenses associated with the use of non-equity capital,
especially debt.
To get Taxable Income Income for equity investors, prior to taxes
Net out Taxes Taxes due on taxable income
3
To get Net Income Income for equity investors, after taxes 9
3. Statement of Cash Flows

4
0
The Interconnections

4
1
The Accounting Standards

❑ Accounting is a rule-driven process, and over time, those rules

have been formalized, especially for publicly traded companies.
This formalization is driven by two considerations:
❑ Standardization, to allow for comparisons across companies
❑ First principles, to ensure that earnings, asset value and cash flows
measure what they are supposed to measure.
❑ While accounting standards around the world remain different,
they have converged (for the most part) around two standards:
❑ GAAP (Generally Accepted Accounting Principles), representing rules
developed by FASB (Financial Accounting Standards Board) to cover US
financial reporting.
❑ IFRS (International Financial Reporting Standards), representing rules
developed by IASB (International Accounting Standards Board) for
companies listed globally, followed by about 90 countries as of 2020.
4
2
 The Bottom Line

 The raw material that we use to do financial

analysis and valuation almost always takes the
form of accounting statements.
 Consequently, it behooves us all to understand how
accountants think (even if we disagree with them)
in putting these statements together.
 The challenge is that accounting thinking keeps
changing, as we move through time, and we have
to understand those changes (both the what and
the why), to keep up with them.

11
INCOME STATEMENTS &
PROFITABILITY MEASURES

45
Measuring Income: Accrual versus Cash
Accounting
❑ In accrual accounting, you record transactions when they
occur, rather than when cash flows occur.
❑ Revenues are recorded when a product or service is sold, not
when the customer pays for that product or service.
❑ Expenses are recorded consistently, with the expenses
associated with producing the sold product or service shown in
the period, even though you may have spent the money in a
prior period or will not pay until a future period.
❑ In cash accounting, you record revenues when you get
paid for providing a product or service, and expenses
when you pay.
❑ Unless you are a small or personal business, you will have
to follow accrual accounting rules.
46
Classifying Expenses: Operating, Financing
and Capital Expenses
 Operating expenses are expenses associated with the
operations of the business. That includes not only the direct
costs of producing the product or service the firm sells, but also
other expenses associated with production, including S, G & A
expenses.
 Financing expenses are expenses associated with the use of
non-equity financing. Most often, this takes the form of
interest expenses on debt.
 Capital expenses are expenses that provide benefits over many
years. For a manufacturing company, these can take the form
of plant and equipment. For non-manufacturing companies,
they can take on less conventional and tangible forms (and
accounting has never been good at dealing with these).
47
Everything has a place….

48
 Revisiting the Income Statement

Item Explanation

Start with Revenues Accountant's estimate of the revenues/sales generated by any

transactions made the business during the period.

Net out Cost of Goods Sold Expenses associated with producing products or services that
represent top line sales
To get Gross Profit Production profitability

Includes selling, general and administrative and other

Net out Other Operating Expenses
expenses associated with operations, but not directly tied to
producing goods and services
To get Operating Profit Profitability of business

Net out Financial Expenses Expenses associated with creating products or services that
represent top line sales
To get Taxable Income Income for equity investors, prior to taxes
Net out Taxes Taxes due on taxable income
To get Net Income Income for equity investors, after taxes 49
 Revenue Recognition
 For many firms, revenue recognition is a simple process,
where once a product or service is sold, it is recorded as
revenues.
 For some firms, especially those that sell products or
services over many years, it becomes trickier, since the
question of how much of the revenue to record in the
year of the sale and how much in subsequent years
becomes debatable.

¤ Under ASC 606: “The new model’s core principle for revenue recognition is to
“depict the transfer of promised goods or services to customers in an amount
that reflects the consideration to which the entity expects to be entitled in
exchange for those goods or services.”
¤ Thus, for a real estate developer working on a multi-year construction,50 revenues
should be recognized as construction progresses, and for a software firm that
enters in a contract over many years, performance obligations will determine
when revenues get recognized.
Revenue Breakdowns

 As companies enter multiple businesses and

different geographies, it is useful to know where
they generate their revenues.
 While the breakdown can sometimes by provided in
income statements, they are more likely to be part
of the footnotes to the financial statements:
¤ Companies generally break down revenues by geography,
though the degree of detail can vary.
¤ Companies also break down revenues by business segment,
though there is an element of subjectivity to the segment
categorization. 51
Operating Expenses: A Break Down

 COGS versus Other Operating Expenses: Operating

expenses are broadly broken down into expenses directly
related to producing the goods or services that give rise
to revenues, i.e. cost of goods sold, and expenses that are
related to operations, but which are not as directly tied
to revenues.
¤ The former are netted out from revenues to get to gross profits
¤ The latter get netted out of gross profits to get to operating
income
 Selling, General and Administrative Costs: In many
companies, the largest non-operating expense is S,G &A,
an amorphous item which can include everything but the
proverbial kitchen sink. 52
Depreciation: Accounting, Tax and
Economic Forms
• Economic depreciation reflects the loss in value (earning
power) in an asset, as it ages. It requires nuance, and will
vary across even the same type of assets, depending on
how it is used.
• Accounting depreciation is more mechanical and is driven
largely by the aging of the asset, with the differences
often being in whether it happens uniformly over the life
of the asset or is more accelerated.
• Tax depreciation reflects what the tax authorities will
allow as depreciation for purposes of computing taxable
income.
53
 Financial Expenses

 The most common financial expense is interest expense on

debt, either in the form of bank loans or corporate bonds.
 As accountants classify other commitments (such as leases)
as debt, some of the interest expense is implicit, i.e., it is
calculated by accountants based upon their assessment of
the debt equivalent value of commitments and current
interest rates.
 In some companies, interest expenses are netted out against
interest income earned by the company on its cash holdings
and financial investments, and reported as a net interest
expense. If interest income exceeds interest expense, this
number will measure net interest income. 54
 Income from non-operating investments
 Cash & Marketable Securities: Income earned on cash
holdings (which is invested in marketable securities, like
treasury bills and commercial paper in most companies)
will be reported either as a stand alone income or netted
against interest expenses.
 Cross holdings in other companies: The reporting can
vary depending upon the magnitude of your holding:
¤ When you hold a (small or minority) portion of another company, the
income from that holding will usually be reported in the income
statement.
¤ However, if you hold a majority stake of another company, you will
generally have to consolidate your financials. That will require you to
count 100% of the subsidiary’s revenues, operating expenses and
operating income as your own. 55
Extraordinary Income/ Expenses

 As the term implies, extraordinary income and expenses

are designed to capture what a company does not face in
the ordinary course of operations.
 Extraordinary items include
¤ One-time expense or gain from sale of assets or divisions
¤ Write offs or charges associated with past project, lawsuits or
fines
¤ Impairment of goodwill from acquisitions in the past
 If an item is truly extraordinary, it should show up
infrequently and the amount associated with it should
vary. If it shows up every year, it is not extraordinary, even
if switches signs (goes from profits in some years to losses
in others). 56
Pro-forma Accounting: Con game or legitimate
restatement?
 In recent years, companies have become creative in
reporting pro-forma financial statements.
¤ In some cases, they do so to correct for what they believe are
accounting inconsistencies.
¤ In other cases, they are motivated by the desire to increase
their profitability.
 As investors, you should never take pro-forma financials
at face value but devise your own smell test on what
should be added back and what should not to get to
proforma income. In general, there are two items you
should focus the most attention to:
¤ The movement of expenses from operating to capital, 57
sometimes merited, sometimes not.
¤ The removal of expenses because they are one time or
extraordinary.
BALANCE SHEETS - ASSETS OWNED &
MONEY OWED

58
The Balance Sheet: Dueling Views

❑ Record of capital invested: There are some (including me)

who believe that the main function of a balance sheet is
to record how much a business has invested in its assets-
in-place, i.e., the assets that allow for its current
operations to occur.
❑ Measure of current value: There is a large and perhaps
dominant school of thought among accountants, or at
least accounting rule writers, that a balance sheet should
reflect the value of the business today.
❑ Liquidation value: There is a third school, with lenders to
the firm among its primary members, who feel that a
balance should reflect what you would get for the assets
of the firm, if you liquidated them today. 59
Revisiting the Balance Sheet

60
Fixed and Current Assets

❑ The Old Way: If you are old enough to learned your

accounting two or three decades ago, the way you were
taught to value fixed and current assets was to show
them at original cost, net of accounting depreciation.
❑ The New Way: As accounting has increasingly adopted
the fair value standard, there has been a move to mark
assets to current market value.
❑ Divergent Effects: The difference in values that you get
for assets, using the two approaches, varies. It is
❑ Greater on older assets than on newer ones
❑ Greater on fixed assets than current assets
61
 Financial Assets
 Financial assets can take the form of holdings of securities
or part ownership of other companies, private or public.
 With holdings of publicly traded securities, the movement
to using current market prices to mark up their values is
almost complete.
 With equity ownership in other companies, the rules can
vary depending on
¤Whether the stake is viewed as a majority stake (>50%) or a minority
stake.
The former will lead to full consolidation (where 100% of the subsidiaries
revenues and operating income will be included in the parent company’s
financials, with the portion that is not owned shown as minority or non-
controlling interest on the liability side) and with the latter, the actual
stake will be shown as an asset.
¤ With a minority stake, whether it is held for trading or as a long-term
investment. With the former, the holding will be marked to market.
62

With the latter, it will be shown at book value terms.

Intangible Assets

 Big game: Accountants talk a big game when it

comes to intangible assets, and from that talk, you
would think that they have figured out how to value
the big intangibles (brand name, management
quality etc.).
 But different reality: In reality, accountants are
much better at valuing small-bore intangibles like
licenses and customer lists, where the earnings and
cash flows from the intangible are observable and
forecastable than they are at valuing the big
intangibles. 63
Goodwill: The Most Dangerous Intangible
 After all the talk of intangibles in accounting, it is
telling that the bulk of intangible assets on
accounting balance sheets across the world take
the form of one item: goodwill.
 Goodwill may sound good, but it is a plug variable
that signifies little.
¤ For goodwill to manifest itself on a balance sheet, a
company has to do an acquisition.
¤ When that acquisition occurs, goodwill is measured as
the difference between the price paid on the
acquisition and the target company’s asset value
(dressed up book value).
¤ It shows up as an asset because without it in place,
balance sheets would not balance. 64
 Goodwill Impairment: Valuable information or Make-
work-for-accountants?
 Old rules: For much of the last century, goodwill once created in an
acquisition, was written off on autopilot, often amortized over long
periods in equal installments.
 New Rules: In the late 1990s, both GAAP and IFRS rewrote the
rules, requiring accountants to revisit goodwill estimates each year,
and make judgments on whether the goodwill had been impaired
or not. To make that judgment, accountants would have to revisit
the target company valuations and decide whether the value had
increased (in which case goodwill would be left unchanged) or
decreased (and goodwill would be impaired).
 Is it informational? The rationale for this rule change was to
provide information to markets, but since goodwill impairments are
often based upon market pricing movements (in the sector) and lag
65
them by months and sometimes years, the effect of goodwill
impairments on stock prices has been negligible.
 Current Liabilities
❑ Current liabilities can be broadly broken into three
groups:
❑ Non-interest-bearing liabilities, such as accounts
payable and supplier credit, which represent part of
normal operations.
❑ Interest-bearing short-term borrowings such as
commercial paper, short term debt and the short
term portion (<1 year) of long term debt.
❑ Deferred salaries, taxes and other amounts due in the
short term.
❑ When computing non-cash working capital, we do not
include interest-bearing short term debt in the 66

calculation, moving it instead into the debt column.

 Debt Due
 When companies borrow money, it can take three forms:
¤ Corporate bonds, represent debt raised from public
markets
¤ Bank loans, debt raised from banks and other lending
institiutions
¤ Lease debt, arising out of lease contracts requiring lease
payments in future years. Until 2019, only leases
classified as capital leases qualified, but since 2019,
operating lease commitments are also debt.
 The mark-to-market movement on the asset side of the
balance sheet has been muted on the liability side of the
balance sheet. Bank debt, for the most part, is recorded
67

as originally borrowed, and corporate bonds due, are for

the most part not marked to market.
 Debt details

 While balance sheets are the repositories for total debt due,
broken down into current and long term, there is additional
information on debt in the footnotes, for most companies.

 This additional information can be on two fronts:

¤ Individual debt due, with stated interest rates and maturities.
¤ Additional features on the debt, including floating/fixed and
straight/convertible provisions.
¤ A consolidated table of when debt repayments come due, by
year.
68
Shareholder’s Equity

❑ Old ways: The shareholders’ equity in a business was a

reflection of its entire history, since it started with the
equity brought in to start the business, adds on equity
augmentations over time as well as the cumulation of
retained earnings.
❑ New ways: The shareholders’ equity in a business reflects
the jumbled mess of mark-to-market accounting, with all of
its contradictions.
❑ A cynical view: Old or new ways, shareholders’ equity (or
book equity) has little hope of ever being a measure of the
intrinsic value of equity in a business. This quixotic (having
or showing ideas that are different and unusual but not
practical or likely to succeed), quest on the part of 69

accounting will do more damage than good.

 More on shareholders’ equity
 Par value: This is a throwback in time and should be ignored.
 Company Age: Since shareholders’ equity reflects a company’s
cumulated history of equity raises and retained earnings, young
companies will tend to have far less shareholders’ equity than older
companies, of equivalent market value.
 Capitalization effects: Since only capitalized expenses become part
of assets, shareholders’ equity can be skewed by accounting rules
and corporate actions on what is capitalized and what is expensed.
 Buyback effects: Both dividends and buybacks reduce shareholders’
equity, by reducing it, but the magnitude of buybacks makes their
effect more dramatic.
 Negative equity? There is no mathematical reason why
shareholders’ equity cannot become negative, either because a
70

company has lost money for an extended period or because of

large buyback/write off.
CASH FLOW STATEMENTS – CASH IN
AND CASH OUT

71
 The End Game with Cash Flows
❑ The surface level objective of a statement of cash flows is to explain
how much the cash balance of a business changed during a period and
why it changed.
❑ Embedded in the statement of cash flows, though, is other information
including:
❑ How much cash earnings the company had during the period, as
contrasted with accrual earnings (in income statements)
❑ How much and where the company reinvested cash during the
period to sustain and grow its business
❑ How much cash it raised from or returned to its debt and equity
investors
❑ The statement of cash flows preserves the signs on cash flows, with
negative cash flows shown as minuses and positive cash flows as
72
pluses. It also looks at cash flows through the eyes of equity investors
in the company.
Revisiting the Cash Flow Statement

73
1. Cash flows from Operations

Change in non-cash working capital

74
 The Working Capital Effect?
 Embedded in the cash flow from operations is the
change in working capital items, excluding cash
¤ Non-cash Working capital = Non-cash current assets –
Non-debt current liabilities
¤ An increase in non-cash working capital will decrease
cash flows, whereas a decrease in non-cash working
capital will increase cash flows.
 To the extent that non-cash working capital ties up cash
and capital, a firm with higher needs for that working
capital will have lower cash flows from operations, for
any given level of net income, than a firm with lower
75

needs.
2. Cash Flows from Investing

76
 Operating or Non-operating Assets
❑ The investing activities section includes investments in both
operating and non-operating assets, except for investment in
liquid, close to riskless securities, which is treated as cash &
marketable securities.
❑ The investments into operating assets, whether internal (cap ex,
net of divestitures) or external (acquisitions of other companies)
are the engine that drives growth in the operating line items
(revenues, operating income etc.) Note that acquisitions funded
with stock will not show up here for obvious reasons.
❑ The investments into non-operating assets create a separate
source of value, where the payoff will not show up in the operating
line items but below the operating income line, as income from
77

cross holdings or securities.

3. Cash flows from Financing

78
 Debt Cash Flows
 While interest expenses show up in the operating cash
flow section, by reducing net income and showing up in
deferred taxes, debt repayments are part of the
financing section.
 To the extent that some or all of these debt repayments
are funded with debt issuances, the net effect on cash
flows can be neutralized or become positive.
 If total debt increases during a period, it will represent
a cash inflow, and if it decreases, it will be a cash
outflow. Companies that embark on plans to bring their
79

debt down (up) over time should therefore expect

these consequences.
 Dividends and Buybacks
❑ Until the 1980s, the only cash flow that was received by equity
investors in publicly traded companies was dividends. The effect
of paying dividends is simple: it reduces the cash balance at the
company and increases the cash in the pockets of every
shareholder who receives dividends.
❑ Starting in the 1980s, US companies have returned increasing
amounts to their shareholders in the form of buybacks.
❑ The effect of buying back stock is exactly the same as paying
dividends, to the company, with cash leaving the company.
❑ For shareholders, though, the cash flow effect is disparate.
Those shareholders who sell their shares back get cash from
the company, and those that do not get no cash, but get a
larger share of the equity left in the company. 80

❑ Both dividends and buybacks reduce shareholder equity on

the balance sheet.
Potential Dividends (Free CF to Equity)

81
CLEANING UP ACCOUNTING
Accounting for Finance
 The Accountant’s Role
❑ Accountants like order and consistency, as can be seen in their
propensity to write rules.
❑ That said, much of accounting as practiced today was developed
in detail in the 20th century for the manufacturing firms that
dominated that century.
❑ As the center of economic gravity has shifted from manufacturing
to technology & service companies, and corporate financial
behavior has changed over time, accountants have struggled with
four key issues:
❑ Taxes, and the actions that companies take to avoid or delay
paying them.
❑ Managerial compensation in the form of equity (stock)
83

❑ Commitments that are contractual but are not debt

❑ Investments for long term benefits that are not in physical
 1. Taxes: Dueling Tax Rates

1. Marginal tax rate: The marginal tax rate is the tax rate in the
statutory tax codes. Thus, in 2020, a US company should be
paying 21% of its taxable income in the US as federal taxes.
Since US companies now operate on a regional tax model, the
marginal tax rate for multinationals will reflect where they make
(or report to make) their taxable income.
2. Effective Tax Rate: The effective tax rate for a company reflects
the taxes and taxable income it reports in its income statement,
which is based on accrual accounting:
¤ Effective tax rate = Taxes/ Taxable Income
3. Cash Tax Rate: The cash tax rate for a company reflects the taxes
84

it actually pays on its taxable income.

 Deferred Tax Assets & Liabilities

❑ For most companies, the effective tax rate will be lower than
the marginal tax rate, reflecting:
❑ Operations in countries with lower tax rates
❑ (Legal) Tax deferral and avoidance strategies

❑ When there are differences between what is expensed and

what is reported as taxable income between the reporting and
tax books, the resulting difference in taxes is reported as a
deferred tax liability (asset) if the company pays less (more) in
taxes on its tax books than it reports in its financial
statements.
❑ The logic for doing so is simple. The items that give rise to less
85

(more) taxes paid in the current period will reverse and result
in more (less) taxes paid in future periods.
 Net Operating Losses & Carryforwards

 When a US company loses money, it is allowed to carry those

losses forward and use them to reduce taxes paid in future
years.
¤ Until the Tax Reform Act of 2017, the NOL could be carried
back two years and used to reduce taxes paid in prior years
(as a tax credit) and forward 20 years.
¤ The Tax Reform Act of 2017 removed the carry back provision
and allows losses to be carried forward indefinitely.
 When a company has losses that are over multiple years, these
losses are cumulated over time as a Net Operating Loss (NOL)
and should be disclosed in a company’s financials. 86
 2. Stock Based Compensation is an
Operating Expense…
❑ Companies have used stock-based compensation to reward
employees for decades for two reasons:
❑ To align the interests of employees & managers with those of
the shareholders
❑ To make up for the absence of cash (to provide compensation
packages that are competitive)
❑ Stock-based compensation primarily takes two forms:
❑ Options to buy the company’s stock (or invest in its equity) at
a fixed price for a specified period.
❑ Shares in the company, sometimes with restrictions on
trading on those shares (restricted shares)
 What type of expense is it?
 No matter what the motive for providing stock-based compensation (to
align interests or to make up for lack of cash), it is clearly a compensation
expense.
¤ If a grant is large and occasional, and primarily driven by the desire to
align interests, there is an argument that it should be spread out over
time.
¤ If a company uses stock-based compensation consistently, and more to
make up for its cash poor status than to align interests, it is an annual
expense.
 To expense stock-based compensation, you have to value of the options
or stock given to employees, at the time they are granted.
¤ Until 2004, companies were allowed leeway to estimate the value of
option grants based upon exercise value at the time of the grant.
¤ After 2004, FAS 123 requires companies to value options based upon
88

their time premium (using option pricing models) and show that
expense in the year the options are granted.
 Is it a cash flow?

❑ Now that options and restricted stock are treated (correctly) as

compensation, and expensed in the years they are granted, the
debate has shifted to the question of whether they are non-
cash expenses (like depreciation), deserving of being added
back to get to cash flows.
❑ Most companies and analysts seem to have come down on yes
as the answer, and many companies add back stock-based
compensation to get to adjusted earnings.
❑ We disagree strongly. There is a fundamental difference
between a non-cash expense like depreciation, where you pay
nothing, and giving a share of equity (options or shares) in lieu
89

of cash.
 3. Leases are debt
 The Essence of Debt: When you borrow money, you create contractual
obligations for the future, and a failure to meet them can put your
survival as a going concern at risk.
 Lease contracts: When you sign a lease contract, you create commitments

for the future, and a failure to meet these commitments will put your
survival at risk. Put simply, there is no reason (and there never has been)
to treat leases as debt.
 Accounting for leases: Until 2019, accountants disagreed and broke leases

down into two groups:

¤ Capital leases, where the lessee has effective ownership of the asset, is
treated as debt, with a counter asset.
¤ Operating leases, where the lessee has (temporary) use of the asset for
a period, were treated as operating expenses, with no debt or counter
assets on the balance sheet. 90

Starting in 2019, both GAAP and IFRS are requiring companies to treat all
lease commitments as debt, no matter how structured.
 Capitalizing Leases
 The process of converting lease commitments to debt follows a simple process,
akin to how any bank debt or corporate bond can be valued.
 Here are the steps:
¤ Start with the contractual lease commitments for future years, by year.

¤ Compute the pre-tax cost of borrowing for the firm today, based upon its
default risk.
¤ Take the present value of lease commitments, using the pre-tax cost of debt
as your discount rate.
 The present value of lease commitments is treated as debt, with the same value
shown as a counter-asset.
 To complete the cycle, you compute interest expenses on the lease debt and
depreciation on the counter asset and bring them into your income statement.
¤ Interest expense on lease debt = PV of lease commitments * Pre-tax cost of
debt 91

¤ Depreciation on lease asset is computed using the life of the lease (as the life
of the asset) and the depreciation method chosen.
 Other Contractual Commitments
 While accounting has (finally) come to terms with
treating leases as debt, there are a whole host of
contractual commitments that share the same
characteristics as leases, and require the same
treatment.
 Here are some examples:
1. Purchase commitments for many manufacturing
firms
2. Content commitments at a streaming company (like
Netflix) 92

3. Player contracts for a sports team

 4. R&D is a cap ex
 If the essence of a capital expenditure is that it is an expense whose
expected benefits are not just in the current period, but in future
periods, research and development (R&D) expenses clearly fit the bill.
 That said, accounting rules around the world, for the most part, require
companies to expense R&D, using one of two rationale:
¤ The benefits of R&D are too uncertain. Consequently, they should be
expensed until the R&D is closer to commercial development.
¤ It is better to be conservative in estimating earnings.
 Neither justification makes sense.
¤ Uncertainty is never used with other types of capital expenditure
(building a factory to make a new and untested product) as the
divining rod for capital vs operating expenses.
¤ Accounting should deliver the most realistic estimate of earnings, not
93

the most conservative.

 Capitalizing R&D
 To capitalize R&D, there are three steps:
¤ Step 1: Estimate an amortizable life for R&D by making your best
judgment on how long it takes, on average, for R&D to pay off (as
commercial success).
¤ Step 2: Collect R&D expenses from past years (going back as long as
the amortizable life). If your company has not been in existence for
that long, collect as many years as you can.
¤ Step 3: For each of the past years of R&D, estimate
◼ How much you will be amortizing this year
◼ How much of the R&D expense remains unamortized
 To complete the cycle, here are the last steps:
¤ Adjust earnings by adding back the current year’s R&D expense and
subtracting out the amortization of past years R&D
¤ Show the unamortized R&D as an asset, and show the same amount
94

as an increase in book equity.

 Other Capital Investments
 There are other expenses that fit the R&D profile, i.e.,
expenses designed to create benefits over many years,
but since these investments are not in physical assets,
they are treated as operating expenses.
 Here are some examples:
¤ Advertising expenses by a consumer product company
to build up brand name
¤ Recruiting and training expenses by a consulting firm to
build its consulting practice
¤ Exploration costs for an oil company 95

¤ Customer acquisition costs for a subscriber or user

based company.
 The Bottom Line: Trust, but verify…

 Accounting statements reflect not only an

“accounting” view of the company, but the burden
of accounting history and legacy rules.
 When analyzing a company, you should start with
accounting statements, but you should have no
qualms about changing, modifying or redoing them
to reflect what you are trying to do with the data in
those statements.
96
ACCOUNTING FINANCIAL RATIOS –
PROFITABILITY MEASURES
Accounting for Finance
 From Absolutes to Ratios

❑ Financial statements measure operations in absolute terms,

i.e., in dollars, rupees or reais, depending upon the currency
of denomination.
❑ Absolute measures are difficult, if not impossible, to compare
across companies, since bigger companies, all else held
constant, should have higher dollar profits and carry more
debt.
❑ Ratios scale absolute values to each other, and allow for:
❑ Comparisons across companies
❑ Comparisons across time
98
❑ Comparison to benchmarks
1. Profit Margins

99
Contribution & Gross Margins: The
Costs of Production
• Contribution margin measures the pure profits that you
generate with every marginal unit you sell, since it nets
out only the variable cost associated with producing that
unit, giving many software companies close to 100%
contribution margins.
• Gross margins are a close relative, providing a direct
measure of marginal profitability and an indirect
measure of how revenue increases flow into profits. To
illustrate, Zoom, one of the few stocks that has seen its
value increase during the crisis, reported a gross margin
of 92% in 2019.
• Companies with high contribution and high gross
margins have much more profit potential, other things
remaining equal, than companies with low margins.
100
Operating Margins: Measures and
Implications
• Operating margins measure what is left after the other
operating expenses of the company, which cannot be
directly traced to individual unit sales, but are
nevertheless necessary for its operations.
• To the extent that these other operating costs (like SG&A)
are fixed (or more fixed) than the costs of production, the
difference between gross and operating margins becomes
a simple proxy for potential economies of scale.
• Companies with high gross margins and low operating
margins should see operating profits (and margins)
improve much faster as they scale up than companies
where operating and gross margins are similar.
101
 EBITDA Margin: Measures and Implications

 The EBITDA is a rough measure of operating cash flows, rough

because it is before taxes and capital expenditures.
 Notwithstanding that, it remains a measure of the cash generating
capacity of a company, prior to discretionary choices (on how much
to reinvest and borrow) and is used by
¤ Lenders to determine whether the company can afford to borrow
money, since debt has to be paid before capital expenditures are
made.
¤ Equity investors to decide whether the entire business is fairly
valued, before it tries to expand its asset base.
 Companies with high EBITDA margins generate higher cash flows
102

per dollar of revenues and should be able to borrow more than

companies with lower EBITDA margins.
Net Margins: Measures and Implications

 Netting out taxes and interest expenses, and adding back

income from cash and cross holdings, yields net margin, a
measure of what equity investors get to keep out of every
dollar of revenues.
 It is a mixed and noisy measure, reflecting a company's
operating model, its tax liabilities and its financial leverage
(since debt creates interest expenses and affects taxes), as
well as non-operating assets.
 Companies with high net margins deliver more profits for
equity investors, in the aggregate, but perhaps not a per
share basis (if debt is the reason why net margins are lower
than operating margins).
A Life Cycle View of Margins

10
4
 2. Accounting Returns
 With accounting returns, profits are scaled to measures of investment in a
project or business.
 Broadly speaking, there can be differences in how accounting returns are
measured based upon
¤ How profits are measured, i.e., to just equity investors (net income) or to
both debt and equity investors and whether profits are before or after
taxes. In most cases, it is accrual income that is the basis for returns.
¤ How investment is measured, i.e., investment made just by equity investors
or by debt and equity investors. In most cases, accounting returns use the
book value as the basis of investment measurement.
¤ With any measure of accounting return, you can get different values
depending upon timing, i.e., start of the period, end of the period or
average for invested capital.
 Consistency rule: A consistent measure of accounting return will measure
105
both
profits and investment to the same group (equity or capital).
Return on Equity

10
6
Return on Invested Capital

10
7
 3. Efficiency Ratios

 Efficiency ratios measure the revenue payoff that companies

get from reinvesting back in their businesses.
 Turnover ratios, with revenues in the numerator are the
most widely used measured of efficiency, though the
denominator can vary:
¤ Working Capital Turnover = Sales/ Non-cash Working capital (or
individual items of working capital, like inventory or receivables)
¤ Asset Turnover = Sales/ Total Assets
¤ Capital Turnover = Sales/ Invested Capital
108
 4. Measuring Financial Leverage

 Debt Ratios measure how much a company has borrowed,

relative to overall capital or to earnings/cashflows.
 Debt can be scaled to overall capital or just to equity
¤ Debt to Capital = Debt/ (Debt + Equity): This is a measure of how much
of the capital in a company comes from debt.
¤ Debt to Equity = Debt/Equity: This is a close variant of debt to capital,
with debt stated as a percent of equity.
 Debt can also be measured relative to earnings/cashflows:
¤ Debt to EBITDA = Debt/EBITDA: This measures how much debt a
company has relative to the cash it generates from operations, before
taxes and capital expenditures. 109
 Variants on calculation

 What to include in debt

¤ Only long term debt
¤ All interest bearing debt
¤ Debt inclusive of commitments (like leases)
 Book or Market
¤ Book values for debt and equity (from balance sheet)

¤ Market values, measured as market cap for equity in a

publicly traded firm, and if doable, market value of debt
 Gross or Net
¤ Gross debt is all debt 110

¤ Net debt is all debt minus cash & marketable securities

 5. Measuring Liquidity/ Credit Risk
 Coverage Ratios: These ratios measure how much buffer or
coverage a company has in meeting commitments.
¤ With interest coverage ratio, the commitment is interest expenses, and it
is scaled to operating income.
¤ With a fixed charge coverage ratio, the commitment is expanded to
include debt payments, and it is scaled to operating income + fixed
charges.
 Liquidity Ratios: These ratios measure how much liquidity
companies have, to cover near-term needs or expenses:
¤ Current ratio, measure current assets relative to current liabilities.
¤ Quick ratio, looks at only liquid current assets relative to current liabilities.
(Inventory is usually excluded.) 111
Discount Rates

The D in the DCF..

112
 Estimating Inputs: Discount Rates
• While discount rates obviously matter in DCF valuation, they
don’t matter as much as most analysts think they do.
• At an intuitive level, the discount rate used should be
consistent with both the riskiness and the type of cashflow
being discounted.
– Equity versus Firm: If the cash flows being discounted are cash flows
to equity, the appropriate discount rate is a cost of equity. If the cash
flows are cash flows to the firm, the appropriate discount rate is the
cost of capital.
– Currency: The currency in which the cash flows are estimated should
also be the currency in which the discount rate is estimated.
– Nominal versus Real: If the cash flows being discounted are nominal
cash flows (i.e., reflect expected inflation), the discount rate should
be nominal

113
Risk in the DCF Model

114
 Not all risk is created equal…
• Estimation versus Economic uncertainty
– Estimation uncertainty reflects the possibility that you could have the “wrong
model” or estimated inputs incorrectly within this model.
– Economic uncertainty comes the fact that markets and economies can change
over time and that even the best models will fail to capture these unexpected
changes.
• Micro uncertainty versus Macro uncertainty
– Micro uncertainty refers to uncertainty about the potential market for a firm’s
products, the competition it will face and the quality of its management team.
– Macro uncertainty reflects the reality that your firm’s fortunes can be affected by
changes in the macro economic environment.
• Discrete versus continuous uncertainty
– Discrete risk: Risks that lie dormant for periods but show up at points in time.
(Examples: A drug working its way through the FDA pipeline may fail at some stage
of the approval process or a company in Venezuela may be nationalized)
– Continuous risk: Risks changes in interest rates or economic growth occur
continuously and affect value as they happen.

115
Risk and Cost of Equity: The role of the
marginal investor
• Not all risk counts: While the notion that the cost of equity should
be higher for riskier investments and lower for safer investments is
intuitive, what risk should be built into the cost of equity is the
question.
• Risk through whose eyes? While risk is usually defined in terms of
the variance of actual returns around an expected return, risk and
return models in finance assume that the risk that should be
rewarded (and thus built into the discount rate) in valuation should
be the risk perceived by the marginal investor in the investment
• The diversification effect: Most risk and return models in finance
also assume that the marginal investor is well diversified, and that
the only risk that he or she perceives in an investment is risk that
cannot be diversified away (i.e, market or non-diversifiable risk). In
effect, it is primarily economic, macro, continuous risk that should
be incorporated into the cost of equity.

116
The Cost of Equity: Competing “ Market Risk” Models
Model Expected Return
CAPM E(R) = Rf + b (Rm- Rf)
APM E(R) = Rf + Sb j (Rj- Rf)
Multi E(R) = Rf + Sb j (Rj- Rf)
factor
Proxy E(R) = a + S b j Yj
Inputs Needed
Riskfree Rate
Beta relative to market portfolio
Market Risk Premium
Riskfree Rate; # of Factors;
Betas relative to each factor
Factor risk premiums
Riskfree Rate; Macro factors
Betas relative to macro factors
Macro economic risk premiums
Proxies
Regression coefficients
117
 Classic Risk & Return: Cost of Equity
• In the CAPM, the cost of equity:
• Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk Premium)
• In APM or Multi-factor models, you still need a risk free rate,
as well as betas and risk premiums to go with each factor.
• A pricing model that seeks to calculate the appropriate price
of an asset while taking into account systemic risks common
across a class of assets.
• The APM describes a relationship between a single asset and a
portfolio that considers many different macroeconomic variables.
• Any security with a price different from the one predicted by the
model is considered mispriced and is an arbitrage opportunity.
• An investor may use the arbitrage pricing model to find
undervalued securities and assets and take advantage of them. The
APT isconsidered an alternative to the capital asset pricing model.

118
 Classic Risk & Return: Cost of
Equity
• In the CAPM, the cost of equity:
• Cost of Equity = Riskfree Rate + Equity Beta * (Equity Risk Premium)
• In APM or Multi-factor models, you still need a risk
free rate, as well as betas and risk premiums to go
with each factor.
• To use any risk and return model, you need
– A risk free rate as a base
– A single equity risk premium (in the CAPM) or factor risk
premiums, in the the multi-factor models
– A beta (in the CAPM) or betas (in multi-factor models)

119
Capital Budgeting

Cash is king… 120

Capital Budgeting

121
What is a Project?

122
 Independent investments are the
272
exception…
 In all of the examples we have used so far, the investments that
we have analyzed have stood alone. Thus, our job was a simple
one. Assess the expected cash flows on the investment and
discount them at the right discount rate.
 In the real world, most investments are not independent. Taking
an investment can often mean rejecting another investment at
one extreme (mutually exclusive) to being locked in to take an
investment in the future (pre-requisite).
 More generally, accepting an investment can create side costs
for a firm’s existing investments in some cases and benefits for
others.
272
 I. Mutually ExclusiveInvestments

273 We have looked at how best to assess a stand-alone investment
and concluded that a good investment will have positive NPV
and generate accounting returns (ROC and ROE) and IRR that
exceed your costs (capital and equity).
 In some cases, though, firms may have to choose between
investments because
¤ They are mutually exclusive: Taking one investment makes
the other one redundant because they both serve the same
purpose
¤ The firm has limited capital and cannot take every good
investment (i.e., investments with positive NPV or high IRR).
 Using the two standard discounted cash flow measures, NPV
and IRR, can yield different choices when choosing between
investments.

273
Alternative Decision Rules

125
Accounting Measure: Retun on
Investment (ROI or ROA)

126
Payback

127
NPV

128
Internal Rate of Return (IRR)

129
Comparing Projects with the same
(or similar) lives..
274
 When comparing and choosing between investments with
the same lives, we can
¤ Compute the accounting returns (ROC, ROE) of the investments and
pick the one with the higher returns
¤ Compute the NPV of the investments and pick the one with the
higher NPV
¤ Compute the IRR of the investments and pick the one with the
higher IRR
 While it is easy to see why accounting return measures
can give different rankings (and choices) than the
discounted cash flow approaches, you would expect NPV
and IRR to yield consistent results since they are both
time-weighted, incremental cash flow return measures.
274
 Case 1: IRR versusNPV
275

 Consider two projects with the following cash flows:

Year Project 1 CF Project 2 CF
0 -1000 -1000
1 800 200
2 1000 300
3 1300 400
4 -2200 500

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 Project’s NPV Profile
26

276
Why NPV and IRR may differ?

133
IRR vs NPV: Multiple Rates of Return

134
 IRR vs NPV
Mutually Exclusive Projects - Scale of Cash Flows

135
IRR vs NPV: Timing of Cash Flows

136
Which one would you pick?

137
Why the difference?

138
Capital Rationing, Uncertainty and
choosing a rule

Small firms, High growth companies and Private business

are more likely to use IRR

As Firms go Public and grow are more likely to gain

from using NPV

139
NPV, IRR and the Reinvestment Rate

140
Profitability Index

141
 A. OpportunityCost
 An opportunity cost arises when a project uses a resource
that may already have been paid for by the firm.
295

 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
¤ a sale of the asset, in which case the opportunity cost is
the expected proceeds from the sale, net of any capital
gains taxes
¤ 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.
¤ use elsewhere in the business, in which case the
opportunity cost is the cost of replacing it.
295
 Case 1: Foregone Sale?
 Assume that Disney owns land in Rio already. This land is
undeveloped and was acquired several years ago for $ 5
296

million for a hotel that was never built. It is anticipated, if

this theme park is built, that this land will be used to build
the offices for Disney Rio. The land currently can be sold
for $ 40 million, though that would create a capital gain
(which will be taxed at 20%). In assessing the theme park,
which of the following would you do:
¤ Ignore the cost of the land, since Disney owns its already
¤ Use the book value of the land, which is $ 5 million
¤ Use the market value of the land, which is $ 40 million
¤ Other

296
 What would you choose as your
investment tool?
292
 Given the advantages/disadvantagesoutlined for each
of the different decision rules, which one would you
choose to adopt?
a. Return on Investment (ROE, ROC)
b. Payback or Discounted Payback
c. Net Present Value
d. Internal Rate of Return
e. Profitability Index
 Do you think your choice could have been affected by
the events of the last quarter of 2008? If so, why? If
not, why not?

292
 What firms actually use
293

Decision Rule % of Firms using as primary decision rule in

1976 1986 1998

IRR 53.6% 49.0% 42.0%

Accounting Return 25.0% 8.0% 7.0%
NPV 9.8% 21.0% 34.0%
Payback Period 8.9% 19.0% 14.0%
Profitability Index 2.7% 3.0% 3.0%

293
New Doll Heritage Company
147
 Central Issues
• In mid-September of 2010, Emily Harris, vice
president of New Heritage Doll Company’s
production division, was weighing project
proposals for the company’s upcoming capital
budgeting meetings in October.
• Two proposals stood out based on their potential
to strengthen the division’s innovative product
lines and drive future growth.
 Central Issues
• Due to constraints on financial and managerial
resources, it was possible that the firm’s capital
budgeting committee would decline to approve
both projects. She also knew that New Heritage’s
licensing and retail divisions would promote
compelling projects of their own.

• Consequently, Harris had to be prepared to

recommend one of her projects over the other
 The Doll Industry
• Revenues in the U.S. toy and game industry totaled
$42 billion in 2008 and were projected to increase
by 4.6% per year to $52.5 billion by 2013.
• The market was divided into two broad segments:
– 1.- First Segment video games (48%) and traditional
toys and games (52%).
– 2.- Second segment was further divided into
infant/preschool toys (14.5%), dolls (14.1%), outdoor &
sports toys (12.3%), and other toys & games (59.1%)
including arts and crafts, plush toys, action figures,
vehicles, and youth electronics.
 The Doll Industry
• The U.S. market for toys and games was
dominated by large global enterprises that
enjoyed economies of scale in design, production,
and distribution.
• Revenues were highly seasonal; the largest
selling season in the United States coincided with
the winter holiday period.
 The Doll Industry
• Within the toy and game segment, U.S. retail
sales of dolls totaled $3.1 billion in 2008 and
were projected to grow by 3% per year to $3.6
billion by 2013.

• The doll category included large, soft, and mini

dolls, as well as doll clothing and other
accessories.
 The Doll Industry
• The phenomenon of “age compression”— the
tendency of younger children to acquire dolls
that had traditionally been designed for older
girls—reduced growth in the “baby-doll” sub-
segment.
• Competition among doll producers was vigorous,
as a small number of large producers targeted
similar demographics and marketed their dolls
through the same media.
 The Doll Industry
• Lasting franchise value for a branded line of dolls
was rare; the enormous success of Barbie® dolls
was an obvious exception.

• More recently and on a much smaller scale, New

Heritage also had created a durable franchise for
its line of heirloom dolls. But the popularity of
most doll lines waned after a few years.
 Conclusion
• The doll market is a mature, slow-growing
business, expected to grow at only 3% in the near
future. New Heritage has grown faster than the
industry since its founding, but its 2009 operating
margin of 6% is not particularly high. This helps
explain why the production division may be
forced to pick one project or the other—the
company presumably has decided not to issue
new external equity to fund its growth, and
internally generated funds are not sufficient to
fund all projects.
 New Heritage Doll Company
• The New Heritage Doll Company was founded in
1985 by Ingrid Beckwith.
• By 2009, New Heritage had grown to 450
employees and generated approximately $245
million of revenue1 and $27 million of operating
profit from three divisions: production, retailing,
and licensing.
 New Heritage Doll Company
• The production division, discussed further below,
designed and produced dolls and doll accessories.
• The retailing division offered a unique
“intergenerational experience” for grandmothers,
mothers, and daughters, centered upon the
character histories and storylines of the company’s
dolls and delivered through an online website (42%),
a mail-order paper catalog (33%), and a network of
retail stores (25%). In fiscal 2009, the retailing
division generated roughly $190 million of revenue
and $4.8 million of operating profit.
 New Heritage Doll Company
• New Heritage’s dolls and accessories were offered under
distinct brands with different price points, targeting girls
between the ages of 3 and 12 years.
• The company’s baby dolls were generally priced
from $15–$30.
• For the $75–$150 price range, New Heritage
produced a line of heirloom-quality dolls and
accessories
 New Heritage Doll Company
• Production was New Heritage’s largest division as
measured by total assets, and easily its most asset-
intensive. Approximately 75% of the division’s sales were
made to the company’s retailing division, with the
remaining 25% comprising private label goods
manufactured for other firms
 Facts
• The company’s products are branded, relatively high-
priced dolls and accessories aimed at a specific market
niche.
• Though moderately successful to date, New Heritage
needs to be concerned about imitations from larger toy
producers whose cost structures and product
development budgets New Heritage cannot match.
• Data in Table 1 show a higher operating margin for
private label manufacturing than for New Heritage’s
branded products
 Capital Budgeting at New Heritage
• Large and/or strategic spending proposals were
reviewed at the corporate level by a capital budgeting
committee consisting of the CEO, CFO, COO, the
controller, and the division presidents.
• The committee examined projects for consistency with
New Heritage’s business strategy and sought to balance
the needs and priorities of each division against practical
financial and organizational constraints.
• The committee also sought to understand project
interdependencies and the potential for a given
investment to strengthen the whole company, not solely
the division proposing it.
 Capital Budgeting at New Heritage
• The capital and operating budgets were linked;
historically, the capital budget comprised approximately
15% of the company’s EBITDA.
• The committee had limited discretion to expand or
contract the budget, according to its view of the quality
of the investment opportunities, competitive dynamics,
and general industry conditions.
 Capital Budgeting at New Heritage
• Projects were described, analyzed, and summarized in
self-contained proposal documents prepared by each
division.
• These contained business descriptions, at least five
years of operating and cash flow forecasts, spending
requirements by asset category, personnel requirements,
calculations of standard investment metrics, and
identification of key project risks and milestones.
 Financial Analyses
• Financial analysis began with operating forecasts
developed with oversight from New Heritage operating
managers.
• Revenue projections were derived from forecasts of
future prices and volumes. Fixed and variable costs were
estimated separately, by expense category. Forecasts of
working capital requirements were likewise vetted by
line managers, who paid particular attention to a
project’s requirements for various types of inventory.
Forecasts for fixed assets and related depreciation
charges were developed in cooperation with analysts
reporting to the controller.
 Financial Analyses
• Operating projections for a given project were used to
develop cash flow forecasts that would underpin
calculations of net present value (NPV), internal rates of
return (IRR), payback period, and other investment
metrics.
• New Heritage assigned discount rates to projects
according to a subjective assessment of each project’s
risk. High-, medium-, and low-risk categories for each
division were associated with a corresponding discount
rate
 Financial Analyses
• In 2010, “medium”-risk projects in the production division
received a discount rate of 8.4%. High- and low-risk projects
were assessed at 9.0% and 7.7%, respectively.
• Projects that created value indefinitely, given continuing
investment, were treated as going concerns with a perpetual
life. That is, NPV calculations included a terminal value
computed as the value of a perpetuity growing at a constant
rate.
• However, to preserve an element of conservatism, the capital
committee generally insisted on relatively low perpetual
growth rates – lower than New Heritage’s historical growth
and lower than near-term growth forecasts for a given
division.
 Match My Doll Clothing Line
Expansion
• The Match My Doll Clothing line originally consisted of a
few sets of matching doll and child clothing and
accessories for warm weather.

• “All Seasons Collection” of apparel and gear covering all

four seasons of the year
 Match My Doll Clothing Line Expansion
• The investment proposal contained relatively large
outlays for R&D, market research, and marketing to
maximize the probability of quick acceptance and longer-
term success for the follow-on line. Sunk Costs
Match My Doll Clothing Line Expansion
• The R&D and marketing expenditures would be
deductible for tax purposes at New Heritage’s 40%
corporate tax rate. The property, plant and equipment
was expected to have a useful life of 10 years; the
associated depreciation charges.
• Working capital requirements, for subsequent years were
based largely on recent historical experience with the
original Match My Doll Clothing line.
• Match My Doll Clothing, entailed moderate risk—that is,
about the same degree of risk as the production division’s
existing business as a whole.
 Design Your Own Doll
• This initiative targeted existing New Heritage customers,
many of whom owned several of the company’s heirloom
dolls. The company’s research showed that, when asked
what features (e.g., appearance, ethnicity, “life story,”
etc.)
• New Heritage should give to future dolls, loyal customers’
responses had a high correlation with their own personal
data
 Design Your Own Doll
• This initiative targeted existing New Heritage customers,
many of whom owned several of the company’s heirloom
dolls. The company’s research showed that, when asked
what features (e.g., appearance, ethnicity, “life story,”
etc.)
• New Heritage should give to future dolls, loyal customers’
responses had a high correlation with their own personal
data.
• This in turn further cemented customer loyalty.
 Design Your Own Doll
• The customization process would begin with a new
section of New Heritage’s website, where proprietary
design software enabled the customer to select physical
attributes of the doll such as hair color, hair length &
style, skin color, eye shape, eye color, and other facial
features.
• Even a limited degree of customization increased
manufacturing complexity and expense. Further, because
of the low production runs and volume, fixed costs on a
per unit basis were expected to be relatively high.
Consequently, the breakeven volume for the project was
also expected to be high.
•
 Design Your Own Doll
• The development time involved, including product
testing, was expected to be approximately 12 months.
Initial outlays, some of which occurred in 2010 and some
in 2011. Sunk Costs
 Design Your Own Doll
• As with Match My Doll Clothing, the required R&D and
marketing costs would be tax deductible.
• To complete development work, Holtz planned to use
some of the company’s existing IT staff.
• These costs were not included by Holtz in the initial
outlays or in the forecasts presented.
 Design Your Own Doll

• Design Your Own Doll had a relatively long payback

period, introduced some untested elements into the
manufacturing process, and depended on near-flawless
operation of new customer-facing software and user
interfaces.
• High Risk
176
 Projects
• The two projects described in the case represent
somewhat different means of boosting the branded
goods’ growth and profitability
 Design Your Own Doll

• Both appear compatible with New Heritage’s strategy, and

absent constraints we would expect the company to fund
both projects, assuming both have positive NPVs. I
• n the presence of budget or personnel constraints,
choosing between them is more difficult.
• DYOD requires nearly twice the upfront outlay as MMDC
and appears to be riskier as well. Nevertheless, it is
entirely possible that DYOD is the more valuable
opportunity.
 Match My Doll Clothing

• The first line in NPV Analysis is EBIT(1-t). This is simply

operating profit as project in the case multiplied by 0.60,
which is one minus NH’s tax rate of 40%. Note that these
calculations assume 40% is the cash tax rate.
180
 Match My Doll Clothing

• The operating margins for MMDC (~ 15%) are much

better than NH’s margins for branded accessories shown
in Table 1 (~ 4%).
• This is good. Still, the margins don’t seem that great for a
fashion accessory recently seen in paparazzi shots of
celebrities. Should the line be more aggressively priced?
 Match My Doll Clothing
• SG&A is about 25% of sales, not including the $1.25
million spent upfront. Is this too high, given the recent
publicity garnered by the line?
• Would it be more prudent to introduce the line with
lower levels of marketing support and hope for a viral hit
supported by free media (which could be rescued if
necessary by heavier marketing outlays)?
• Or is it more prudent to support the initiative heavily
from the start, as Ms. McAdams wants to, and thereby
ensure at least modest success?
 Match My Doll Clothing
• The time pattern of FCF is a bit odd. Negative early cash
flows are logical, if perhaps large, but then cash flow dips
in 2014-15 after becoming solidly positive in 2013.
• The explanation is not in growth rates or operating
margins, but rather the more-than-doubling of capital
expenditures in 2014 and the heavy spending continues
thereafter.
• This is one of the follow- up questions that Emily Harris
should put to Ms. McAdams: Why the heavy capital
spending in 2014 and afterwards? What’s it for? Is it
discretionary? What would happen to sales and operating
profit if this spending was trimmed?
184
 Design Your Own Doll

• The operating margins in Exhibit 2 are higher than for

New Heritage’s existing branded dolls (~13% versus ~6%).
On the one hand, they are helped by premium pricing
(which should be studied carefully by Holtz and Harris to
consider whether it has been optimized) but on the other,
they are hurt by higher manufacturing costs.
 Design Your Own Doll

• Harris should ask Holtz to what extent she believes DYOD

will cannibalize sales of other New Heritage Dolls. The
case says DYOD will stimulate loyal customers to purchase
another doll. But might they have purchased an existing
New Heritage doll if DYOD were not offered?
• We should consider, at least qualitatively, how this
possibility would affect the projections and financial
analyses.
 Design Your Own Doll

• We don’t know what Holtz ultimately told Harris about

the riskiness of DYOD, but the case suggests that it is
riskier than MMDC.
• The figures in NPV reflect this view and apply a discount
rate of 9.0%—the rate given in the case for riskier-than-
average projects in the production division.
• Once again, the case does not provide enough
information (and there is not enough class time) to
develop a cost of capital from scratch.
188
 March My Doll Clothing

• New Heritage generally uses perpetuities to estimate a

terminal value for projects with going concern value. It
certainly is debatable whether MMDC qualifies as such,
but assuming it does, the basic calculations are
straightforward: they require a perpetual growth rate, a
beginning cash flow, and the discount rate of 8.4%. Many
students will have chosen 3% as a growth rate because it
appears in the case text (U.S. dolls sales are projected to
grow at 3%, but NH has been growing faster, and the top-
line growth shown in Exhibit 1 is quite a bit higher).
 Design Your Own Doll
• Despite the higher discount rate, DYOD has a higher
terminal value than MMDC (~$24.7 million versus ~
$16.3 million) using the same 3% perpetual growth rate.
Does this large discrepancy make economic sense?
• It does if one believes that DYOD represents a larger,
more durable contribution to the NH franchise than
MMDC by further cementing the relationship between
the firm and its most loyal customers. Note, though,
that both figures reflect an expectation of long-term
value creation.
• The sole differences are the size and risk of the cash
flow contribution in 2020.
191
192
193
 Project Comparison
• Which project should Harris recommend? The
obvious, easy answer is “both.” The case tells us
that she does not actually have this luxury, but
it’s worthwhile to remind students that, absent
constraints, the correct decision is to accept all
projects for which NPV>0.
• But what if the division is forced to pick one or
the other?
195
 Project Comparison
• Which project should Harris recommend? The
obvious, easy answer is “both.” The case tells us
that she does not actually have this luxury, but
it’s worthwhile to remind students that, absent
constraints, the correct decision is to accept all
projects for which NPV>0.
• But what if the division is forced to pick one or
the other?
 Project Comparison
• Some texts recommend the profitability index be
used as an arbiter when a capital constraint
effectively makes two projects mutually
exclusive. The intuition is simple; in this instance,
the NPVs of the two projects are nearly the
same, but MMDC requires after-tax outlays in
the first five year of only $3.0 million compared
to DYOD’s $5.3 million
 Project Comparison
• So MMDC creates more NPV per dollar of the
capital budget expended: 2.37 versus 1.32. This
would be a compelling argument if the projects
could be re-scaled to make the requirement
investment the same for each. For example, if NH
could scale up MMDC by a factor of 1.77, its
required investment would match DYOD’s, but
the re-scaled NPV for MMDC would be almost
$12.7 million—clearly superior.
 Project Comparison
• Another potentially important point of comparison is
the effect of each project on future budget constraints.
The case mentions that New Heritage’s constraint
depends at least in part on EBITDA—the more you earn,
the more you get to spend (the case does not say
whether this rule applies at the division or corporate
level). Table shows that DYOD’s cumulative EBITDA
during 2011–2015 is $8.8 million compared with
MMDC’s $6.5 million. Accordingly, DYOD may have a
relatively more positive effect on future spending limits
than MMDC.
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