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Will the benefits persist if investors hedge the risk instead of the firm?
NoYes
NoYes
Can marginal investors hedge this risk cheaper
than the firm can?
NoYes
Is there a significant benefit in terms of higher expected cash flows or a lower discount rate?
NoYes
Is there a significant benefit in terms of higher cash flows or a lower discount rate?
What is the cost to the firm of hedging this risk?
Negligible High
Do not hedge this risk. The benefits are small relative to costs
Hedge this risk. The benefits to the firm will exceed the costs
Hedge this risk. The benefits to the firm will exceed the costs
Let the risk pass through to investors and let them hedge the risk.
Hedge this risk. The benefits to the firm will exceed the costs
Indifferent to hedging risk
Cash flow benefits- Tax benefits- Better project choices
Discount rate benefits- Hedge "macro" risks (cost of equity)- Reduce default risk (cost of debt or debt ratio)
Survival benefits (truncation risk)- Protect against catastrophic risk- Reduce default risk
Value Trade Off
Earnings Multiple- Effect on multiple
Earnings- Level- Volatility
X
Pricing Trade
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AcquisitionsandProjects
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¨ Anacquisitionisaninvestment/projectlikeanyotherandalloftherulesthatapplytotraditionalinvestmentsshouldapplytoacquisitionsaswell.Inotherwords,foranacquisitiontomakesense:¤ ItshouldhavepositiveNPV.Thepresentvalueoftheexpectedcashflows
fromtheacquisitionshouldexceedthepricepaidontheacquisition.¤ TheIRRofthecashflowstothefirm(equity)fromtheacquisition>Costof
capital(equity)ontheacquisition¨ Inestimatingthecashflowsontheacquisition,weshouldcountin
anypossiblecashflowsfromsynergy.¨ Thediscountratetoassessthepresentvalueshouldbebasedupon
theriskoftheinvestment(targetcompany)andnottheentityconsideringtheinvestment(acquiringcompany).
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TataMotorsandHarmanInternational
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¨ HarmanInternationalisapubliclytradedUSfirmthatmanufactureshighendaudioequipment.TataMotorsisanautomobilecompany,basedinIndia.
¨ TataMotorsisconsideringanacquisitionofHarman,withaneyeonusingitsaudioequipmentinitsIndianautomobiles,asoptionalupgradesonnewcars.
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EstimatingtheCostofCapitalfortheAcquisition(nosynergy)
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1. Currency:EstimatedinUS$,sincecashflowswillbeestimatedinUS$.2. Beta:HarmanInternationalisanelectroniccompanyandweusetheunleveredbeta
(1.17)ofelectronicscompaniesintheUS.3. EquityRiskPremium:ComputedbasedonHarman’soperatingexposure:
4. Debtratio&costofdebt:TataMotorsplanstoassumetheexistingdebtofHarmanInternationalandtopreserveHarman’sexistingdebtratio.Harmancurrentlyhasadebt(includingleasecommitments)tocapitalratioof7.39%(translatingintoadebttoequityratioof7.98%)andfacesapre-taxcostofdebtof4.75%(basedonitsBBB- rating).
LeveredBeta=1.17(1+(1-.40)(.0798))=1.226CostofEquity=2.75%+1.226(6.13%)=10.26%
CostofCapital=10.26%(1-.0739)+4.75%(1-.40)(.0739)=9.67%
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EstimatingCashflows- FirstSteps
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¨ OperatingIncome:Thefirmreportedoperatingincomeof$201.25milliononrevenuesof$4.30billionfortheyear.Addingbacknon-recurringexpenses(restructuringchargeof$83.2millionin2013)andadjustingincomefortheconversionofoperatingleasecommitmentstodebt,weestimatedanadjustedoperatingincomeof$313.2million.Thefirmpaid18.21%ofitsincomeastaxesin2013andwewillusethisastheeffectivetaxrateforthecashflows.
¨ Reinvestment:Depreciationin2013amountedto$128.2million,whereascapitalexpendituresandacquisitionsfortheyearwere$206.4million.Non-cashworkingcapitalincreasedby$272.6millionduring2013butwas13.54%ofrevenuesin2013.
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Bringingingrowth
¨ WewillassumethatHarmanInternationalisamaturefirm,growing2.75%inperpetuity.
¨ Weassumethatrevenues,operatingincome,capitalexpendituresanddepreciationwillallgrow2.75%fortheyearandthatthenon-cashworkingcapitalremain13.54%ofrevenuesinfutureperiods.
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ValueofHarmanInternational:BeforeSynergy
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¨ Earlier,weestimatedthecostofcapitalof9.67%astherightdiscountratetoapplyinvaluingHarmanInternationalandthecashflowtothefirmof$166.85millionfor2014(nextyear),assuminga2.75%growthrateinrevenues,operatingincome,depreciation,capitalexpendituresandtotalnon-cashworkingcapital.Wealsoassumedthatthesecashflowswouldcontinuetogrow2.75%ayearinperpetuity.
¨ Addingthecashbalanceofthefirm($515million)andsubtractingouttheexistingdebt($313million,includingthedebtvalueofleases)yieldsthevalueofequity inthefirm:
¨ ValueofEquity =ValueofOperatingAssets+Cash– Debt
=$2,476+$515- $313million=$2,678million
¨ ThemarketvalueofequityinHarmaninNovember2013was$5,428million.
¨ TotheextentthatTataMotorspaysthemarketprice,itwillhavetogeneratebenefitsfromsynergythatexceed$2750million.
MeasuringInvestmentReturnsII.InvestmentInteractions,OptionsandRemorse…
Lifeistooshortforregrets,right?
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Independentinvestmentsaretheexception…
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¨ Inalloftheexampleswehaveusedsofar,theinvestmentsthatwehaveanalyzedhavestoodalone.Thus,ourjobwasasimpleone.Assesstheexpectedcashflowsontheinvestmentanddiscountthemattherightdiscountrate.
¨ Intherealworld,mostinvestmentsarenotindependent.Takinganinvestmentcanoftenmeanrejectinganotherinvestmentatoneextreme(mutuallyexclusive)tobeinglockedintotakeaninvestmentinthefuture(pre-requisite).
¨ Moregenerally,acceptinganinvestmentcancreatesidecostsforafirm’sexistinginvestmentsinsomecasesandbenefitsforothers.
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I.MutuallyExclusiveInvestments
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¨ Wehavelookedathowbesttoassessastand-aloneinvestmentandconcludedthatagoodinvestmentwillhavepositiveNPVandgenerateaccountingreturns(ROCandROE)andIRRthatexceedyourcosts(capitalandequity).
¨ Insomecases,though,firmsmayhavetochoosebetweeninvestmentsbecause¤ Theyaremutuallyexclusive:Takingoneinvestmentmakestheother
oneredundantbecausetheybothservethesamepurpose¤ Thefirmhaslimitedcapitalandcannottakeeverygoodinvestment
(i.e.,investmentswithpositiveNPVorhighIRR).¨ Usingthetwostandarddiscountedcashflowmeasures,NPV
andIRR,canyielddifferentchoiceswhenchoosingbetweeninvestments.
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ComparingProjectswiththesame(orsimilar)lives..
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¨ Whencomparingandchoosingbetweeninvestmentswiththesamelives,wecan¤ Computetheaccountingreturns(ROC,ROE)oftheinvestmentsandpicktheonewiththehigherreturns
¤ ComputetheNPVoftheinvestmentsandpicktheonewiththehigherNPV
¤ ComputetheIRRoftheinvestmentsandpicktheonewiththehigherIRR
¨ Whileitiseasytoseewhyaccountingreturnmeasurescangivedifferentrankings(andchoices)thanthediscountedcashflowapproaches,youwouldexpectNPVandIRRtoyieldconsistentresultssincetheyarebothtime-weighted,incrementalcashflowreturnmeasures.
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Case1:IRRversusNPV
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¨ Considertwoprojectswiththefollowingcashflows:Year Project1CF Project2CF0 -1000 -10001 800 2002 1000 3003 1300 4004 -2200 500
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Project’sNPVProfile
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Whatdowedonow?
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¨ Project1hastwointernalratesofreturn.Thefirstis6.60%,whereasthesecondis36.55%.Project2hasoneinternalrateofreturn,about12.8%.
¨ Whyaretheretwointernalratesofreturnonproject1?
¨ Ifyourcostofcapitalis12%,whichinvestmentwouldyouaccept?a. Project1b. Project2
¨ Explain.
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Case2:NPVversusIRR
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Cash Flow
Investment
$ 350,000
$ 1,000,000
Project A
Cash Flow
Investment
Project B
NPV = $467,937IRR= 33.66%
$ 450,000 $ 600,000 $ 750,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whichonewouldyoupick?
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¨ Assumethatyoucanpickonlyoneofthesetwoprojects.YourchoicewillclearlyvarydependinguponwhetheryoulookatNPVorIRR.Youhaveenoughmoneycurrentlyonhandtotakeeither.Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckandmore
marginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
¨ IfyoupickA,whatwouldyourbiggestconcernbe?
¨ IfyoupickB,whatwouldyourbiggestconcernbe?
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CapitalRationing,UncertaintyandChoosingaRule
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¨ Ifabusinesshaslimitedaccesstocapital,hasastreamofsurplusvalueprojectsandfacesmoreuncertaintyinitsprojectcashflows,itismuchmorelikelytouseIRRasitsdecisionrule.¤ Small,high-growthcompaniesandprivatebusinessesaremuchmorelikelytouseIRR.
¨ Ifabusinesshassubstantialfundsonhand,accesstocapital,limitedsurplusvalueprojects,andmorecertaintyonitsprojectcashflows,itismuchmorelikelytouseNPVasitsdecisionrule.
¨ Asfirmsgopublicandgrow,theyaremuchmorelikelytogainfromusingNPV.
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Thesourcesofcapitalrationing…
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Cause Number of firms Percent of total Debt limit imposed by outside agreement 10 10.7 Debt limit placed by management external to firm
3 3.2
Limit placed on borrowing by internal management
65 69.1
Restrictive policy imposed on retained earnings
2 2.1
Maintenance of target EPS or PE ratio 14 14.9
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AnAlternativetoIRRwithCapitalRationing
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¨ TheproblemwiththeNPVrule,whenthereiscapitalrationing,isthatitisadollarvalue.Itmeasuressuccessinabsoluteterms.
¨ TheNPVcanbeconvertedintoarelativemeasurebydividingbytheinitialinvestment.Thisiscalledtheprofitabilityindex.¤ ProfitabilityIndex(PI)=NPV/InitialInvestment
¨ Intheexampledescribed,thePIofthetwoprojectswouldhavebeen:¤ PIofProjectA=$467,937/1,000,000 =46.79%¤ PIofProjectB=$1,358,664/10,000,000 =13.59%¤ ProjectAwouldhavescoredhigher.
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Case3:NPVversusIRR
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Cash Flow
Investment
$ 5,000,000
$ 10,000,000
Project A
Cash Flow
Investment
Project B
NPV = $1,191,712IRR=21.41%
$ 4,000,000 $ 3,200,000 $ 3,000,000
NPV = $1,358,664IRR=20.88%
$ 10,000,000
$ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
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Whythedifference?
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¨ Theseprojectsareofthesamescale.BoththeNPVandIRRusetime-weightedcashflows.Yet,therankingsaredifferent.Why?
¨ Whichonewouldyoupick?a. ProjectA.Itgivesmethebiggerbangforthebuckand
moremarginforerror.b. ProjectB.Itcreatesmoredollarvalueinmybusiness.
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NPV,IRRandtheReinvestmentRateAssumption
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¨ TheNPVruleassumesthatintermediatecashflowsontheprojectgetreinvestedatthehurdlerate(whichisbaseduponwhatprojectsofcomparableriskshouldearn).
¨ TheIRRruleassumesthatintermediatecashflowsontheprojectgetreinvestedattheIRR.ImplicitistheassumptionthatthefirmhasaninfinitestreamofprojectsyieldingsimilarIRRs.
¨ Conclusion:WhentheIRRishigh(theprojectiscreatingsignificantsurplusvalue)andtheprojectlifeislong,theIRRwilloverstatethetruereturnontheproject.
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SolutiontoReinvestmentRateProblem
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WhyNPVandIRRmaydiffer..Evenifprojectshavethesamelives
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¨ AprojectcanhaveonlyoneNPV,whereasitcanhavemorethanoneIRR.
¨ TheNPVisadollarsurplusvalue,whereastheIRRisapercentagemeasureofreturn.TheNPVisthereforelikelytobelargerfor“largescale” projects,whiletheIRRishigherfor“small-scale” projects.
¨ TheNPVassumesthatintermediatecashflowsgetreinvestedatthe“hurdlerate”,whichisbaseduponwhatyoucanmakeoninvestmentsofcomparablerisk,whiletheIRRassumesthatintermediatecashflowsgetreinvestedatthe“IRR”.
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Comparingprojectswithdifferentlives..
AswathDamodaran
288Project A
-$1500
$350 $350 $350 $350$350
-$1000
$400 $400 $400 $400$400
$350 $350 $350 $350$350
Project B
NPV of Project A = $ 442IRR of Project A = 28.7%
NPV of Project B = $ 478IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%
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WhyNPVscannotbecompared..Whenprojectshavedifferentlives.
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¨ Thenetpresentvaluesofmutuallyexclusiveprojectswithdifferentlivescannotbecompared,sincethereisabiastowardslonger-lifeprojects.TocomparetheNPV,wehaveto¤ replicatetheprojectstilltheyhavethesamelife(or)¤ convertthenetpresentvaluesintoannuities
¨ TheIRRisunaffectedbyprojectlife.WecanchoosetheprojectwiththehigherIRR.
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Solution1:ProjectReplication
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Project A: Replicated
-$1500
$350 $350 $350 $350$350 $350 $350 $350 $350$350
Project B
-$1000
$400 $400 $400 $400$400 $400 $400 $400 $400$400
-$1000 (Replication)
NPV of Project A replicated = $ 693
NPV of Project B= $ 478
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Solution2:EquivalentAnnuities
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¨ EquivalentAnnuityfor5-yearproject¤ =$442*PV(A,12%,5years)¤ =$122.62
¨ EquivalentAnnuityfor10-yearproject¤ =$478*PV(A,12%,10years)¤ =$84.60
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Whatwouldyouchooseasyourinvestmenttool?
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¨ Giventheadvantages/disadvantagesoutlinedforeachofthedifferentdecisionrules,whichonewouldyouchoosetoadopt?a. ReturnonInvestment(ROE,ROC)b. PaybackorDiscountedPaybackc. NetPresentValued. InternalRateofReturne. ProfitabilityIndex
¨ Doyouthinkyourchoicehasbeenaffectedbytheeventsofthelastquarterof2008?Ifso,why?Ifnot,whynot?
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Whatfirmsactuallyuse..
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DecisionRule %ofFirmsusingasprimarydecisionrulein1976 1986 1998
IRR 53.6% 49.0% 42.0%AccountingReturn 25.0% 8.0% 7.0%NPV 9.8% 21.0% 34.0%PaybackPeriod 8.9% 19.0% 14.0%ProfitabilityIndex 2.7% 3.0% 3.0%
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II.SideCostsandBenefits
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¨ Mostprojectsconsideredbyanybusinesscreatesidecostsandbenefitsforthatbusiness.¤ Thesidecostsincludethecostscreatedbytheuseofresourcesthatthebusinessalreadyowns(opportunitycosts)andlostrevenuesforotherprojectsthatthefirmmayhave.
¤ Thebenefitsthatmaynotbecapturedinthetraditionalcapitalbudgetinganalysisincludeprojectsynergies(wherecashflowbenefitsmayaccruetootherprojects)andoptionsembeddedinprojects(includingtheoptionstodelay,expandorabandonaproject).
¨ Thereturnsonaprojectshouldincorporatethesecostsandbenefits.
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A.OpportunityCost
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¨ Anopportunitycostariseswhenaprojectusesaresourcethatmayalreadyhavebeenpaidforbythefirm.
¨ Whenaresourcethatisalreadyownedbyafirmisbeingconsideredforuseinaproject,thisresourcehastobepricedonitsnextbestalternativeuse,whichmaybe¤ asaleoftheasset,inwhichcasetheopportunitycostistheexpectedproceedsfromthesale,netofanycapitalgainstaxes
¤ rentingorleasingtheassetout,inwhichcasetheopportunitycostistheexpectedpresentvalueoftheafter-taxrentalorleaserevenues.
¤ useelsewhereinthebusiness,inwhichcasetheopportunitycostisthecostofreplacingit.
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Case1:ForegoneSale?
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¨ AssumethatDisneyownslandinRioalready.Thislandisundevelopedandwasacquiredseveralyearsagofor$5millionforahotelthatwasneverbuilt.Itisanticipated,ifthisthemeparkisbuilt,thatthislandwillbeusedtobuildtheofficesforDisneyRio.Thelandcurrentlycanbesoldfor$40million,thoughthatwouldcreateacapitalgain(whichwillbetaxedat20%).Inassessingthethemepark,whichofthefollowingwouldyoudo:¤ Ignorethecostoftheland,sinceDisneyownsitsalready¤ Usethebookvalueoftheland,whichis$5million¤ Usethemarketvalueoftheland,whichis$40million¤ Other:
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Case2:IncrementalCost?AnOnlineRetailingVentureforBookscape
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¨ Theinitialinvestmentneededtostarttheservice,includingtheinstallationofadditionalphonelinesandcomputerequipment,willbe$1million.Theseinvestmentsareexpectedtohavealifeoffouryears,atwhichpointtheywillhavenosalvagevalue.Theinvestmentswillbedepreciatedstraightlineoverthefour-yearlife.
¨ Therevenuesinthefirstyearareexpectedtobe$1.5million,growing20%inyeartwo,and10%inthetwoyearsfollowing.Thecostofthebookswillbe60%oftherevenuesineachofthefouryears.
¨ Thesalariesandotherbenefitsfortheemployeesareestimatedtobe$150,000inyearone,andgrow10%ayearforthefollowingthreeyears.
¨ Theworkingcapital,whichincludestheinventoryofbooksneededfortheserviceandtheaccountsreceivablewillbe10%oftherevenues;theinvestmentsinworkingcapitalhavetobemadeatthebeginningofeachyear.Attheendofyear4,theentireworkingcapitalisassumedtobesalvaged.
¨ Thetaxrateonincomeisexpectedtobe40%.
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Costofcapitalforinvestment
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¨ Wewillre-estimatethebetaforthisonlineprojectbylookingatpubliclytradedonlineretailers.Theunleveredtotalbetaofonlineretailersis3.02,andweassumethatthisprojectwillbefundedwiththesamemixofdebtandequity(D/E=21.41%,Debt/Capital=17.63%)thatBookscapeusesintherestofthebusiness.WewillassumethatBookscape’staxrate(40%)andpretaxcostofdebt(4.05%)applytothisproject.LeveredBetaOnlineService =3.02[1+(1– 0.4)(0.2141)]=3.41CostofEquityOnlineService =2.75%+3.41(5.5%)=21.48%CostofCapitalOnlineService=21.48%(0.8237)+4.05%(1– 0.4)(0.1763)=18.12%
¨ Thisismuchhigherthanthecostofcapital(10.30%)wecomputedforBookscapeearlier,butitreflectsthehigherriskoftheonlineretailventure.
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IncrementalCashflowsonInvestment
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NPV of investment = $76,375
0 1 2 3 4Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating ExpensesLabor $150,000 $165,000 $181,500 $199,650Materials $900,000 $1,080,000 $1,188,000 $1,306,800Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550Taxes $80,000 $122,000 $144,200 $168,620After-tax Operating Income $120,000 $183,000 $216,300 $252,930+ Depreciation $250,000 $250,000 $250,000 $250,000- Change in Working
Capital $150,000 $30,000 $18,000 $19,800 -$217,800+ Salvage Value of
Investment $0Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
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Thesidecosts…
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¨ Itisestimatedthattheadditionalbusinessassociatedwithonlineorderingandtheadministrationoftheserviceitselfwilladdtotheworkloadforthecurrentgeneralmanagerofthebookstore.Asaconsequence,thesalaryofthegeneralmanagerwillbeincreasedfrom$100,000to$120,000nextyear;itisexpectedtogrow5percentayearafterthatfortheremainingthreeyearsoftheonlineventure.Aftertheonlineventureisendedinthefourthyear,themanager’ssalarywillrevertbacktoitsoldlevels.
¨ ItisalsoestimatedthatBookscapeOnlinewillutilizeanofficethatiscurrentlyusedtostorefinancialrecords.Therecordswillbemovedtoabankvault,whichwillcost$1000ayeartorent.
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NPVwithsidecosts…
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¨ Additionalsalarycosts=PVof$34,352
¨ OfficeCosts¤ After-TaxAdditionalStorageExpenditureperYear=$1,000(1– 0.40)=$600¤ PVofexpenditures=$600(PVofannuity,18.12%,4yrs)=$1,610
¨ NPVwithOpportunityCosts=$76,375– $34,352– $1,610=$40,413¨ Opportunitycostsaggregatedintocashflows
Year Cashflows Opportunity costs Cashflow with opportunity costs Present Value0 ($1,150,000) ($1,150,000) ($1,150,000)1 $340,000 $12,600 $327,400 $277,170 2 $415,000 $13,200 $401,800 $287,968 3 $446,500 $13,830 $432,670 $262,517 4 $720,730 $14,492 $706,238 $362,759 Adjusted NPV $40,413
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Case3:ExcessCapacity
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¨ IntheValeexample,assumethatthefirmwilluseitsexistingdistributionsystemtoservicetheproductionoutofthenewironoremine.Theminemanagerarguesthatthereisnocostassociatedwithusingthissystem,sinceithasbeenpaidforalreadyandcannotbesoldorleasedtoacompetitor(andthushasnocompetingcurrentuse).Doyouagree?a. Yesb. No
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AFrameworkforAssessingTheCostofUsingExcessCapacity
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¨ IfIdonotaddthenewproduct,whenwillIrunoutofcapacity?
¨ IfIaddthenewproduct,whenwillIrunoutofcapacity?
¨ WhenIrunoutofcapacity,whatwillIdo?¤ Cutbackonproduction:costisPVofafter-taxcashflowsfromlostsales
¤ Buynewcapacity:costisdifferenceinPVbetweenearlier&laterinvestment
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