Measuring Investment Returns

Aswath Damodaran

Stern School of Business

Aswath Damodaran

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First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

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Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
• The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.

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Measuring Returns Right: The Basic Principles
Use cash flows rather than earnings. You cannot spend earnings. Use “incremental” cash flows relating to the investment decision, i.e., cashflows that occur as a consequence of the decision, rather than total cash flows. Use “time weighted” returns, i.e., value cash flows that occur earlier more than cash flows that occur later.

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The Return Mantra: “Time-weighted, Incremental Cash Flow Return”

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Aswath Damodaran 4 .  Convert accounting earnings into cash flows • Use the cash flows to evaluate whether the investment is a good investment. • Measure the accounting return to see if the investment measures up to the hurdle rate. based upon the riskiness of the investment Estimate revenues and accounting earnings on the investment.  Time weight the cash flows • Use the time-weighted cash flows to evaluate whether the investment is a good investment.Steps in Investment Analysis   Estimate a hurdle rate for the project.

 If the firm is in more than one business.I. based upon the riskiness of the investment • Estimate a cost of debt and debt ratio for the investment based upon the costs of debt and debt ratios of other firms in the business Aswath Damodaran 5 . and all of its investments are homogeneous: • Use the company’s costs of equity and capital to evaluate its investments. Estimating the Hurdle Rate for an Investment  If a firm is in only one business. but investments within each of business are similar: • Use the divisional costs of equity and capital to evaluate investments made by that division  If a firm is planning on entering a new business: • Estimate a cost of equity for the investment.

32% that we estimated for the aerospace division of Boeing. • We will use The Home Depot’s cost of equity (9.42)(. We will use a much higher cost of debt for the project (7%) than InfoSoft’s existing debt (6%) • Cost of capital = 14.49% (.0662) = 13.725) and InfoSoft’s debt ratio.80% Aswath Damodaran 6 .Analyzing Project Risk: Three Examples  The Home Depot: A New Store • The Home Depot is a firm in a single business.  Boeing: A Super Jumbo Jet (capable of carrying 400+ people) • We will use the cost of capital of 9.78%) and capital (9.  InfoSoft: An Online Software Store • We will estimate the cost of equity based upon the beta for online retailers (1. with homogeneous investments (another store).9338) + 7% (1-.51%) to analyze this investment.

Aswath Damodaran 7 .II. Scenario Analysis: If the investment can be affected be a few external factors. The Estimation Process    Experience and History: If a firm has invested in similar projects in the past. it can use this experience to estimate revenues and earnings on the project being analyzed. the revenues and earnings can be analyzed across a series of scenarios and the expected values used in the analysis. Market Testing: If the investment is in a new market or business. you can use market testing to get a sense of the size of the market and potential profitability.

The Home Depot’s New Store: Experience and History

The Home Depot has 700+ stores in existence, at difference stages in their life cycles, yielding valuable information on how much revenue can be expected at each store and expected margins. At the end of 1999, for instance, each existing store had revenues of $ 44 million, with revenues starting at about $ 40 million in the first year of a store’s life, climbing until year 5 and then declining until year 10.

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The Margins at Existing Store

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Projections for The Home Depot’s New Store

For revenues, we will assume
 that the new store being considered by the Home Depot will have expected revenues of $ 40 million in year 1 (which is the approximately the average revenue per store at existing stores after one year in operation)  that these revenues to grow 5% a year • that our analysis will cover 10 years (since revenues start dropping at existing stores after the 10th year).

For operating margins, we will assume
• The operating expenses of the new store will be 90% of the revenues (based upon the median for existing stores)

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• We estimate the probability of each scenario. Aswath Damodaran 11 . average growth and low growth scenario. • Much of the growth from this market will come from whether Asia. We look at a high growth. • We estimate the number of planes that Boeing will sell under each scenario. Improves its existing large capacity plane (A300) or abandons this market entirely.Scenario Analysis: Boeing Super Jumbo  We consider two factors: • Actions of Airbus (the competition): Produces new large capacity plane to match Boeing’s new jet.  In each scenario.

125) 135 (0.15) 75 (0.05) (0.125+200*0+100*.10) 120 (0.25) 110 (0.125) Average Growth in Asia 100 Low Growth in Asia (0.125+150*.10) Expected Value = 120*0.25 +160*.15+135*. with the probabilities listed below each number.Scenario Analysis  The following table lists the number of planes that Boeing will sell under each scenario.00) 160 (0.10+ 75*. Airbus New large plane 120 Airbus A-300 150 Airbus abandons large airplane 200 High Growth in Asia (0.10) (0.05+110*.10+120*10 = 125 planes Aswath Damodaran 12 .

• Operating versus Capital Expenditures: Only expenses associated with creating revenues in the current period should be treated as operating expenses. Expenses that create benefits over several periods are written off over multiple periods (as depreciation or amortization)  Aswath Damodaran 13 . Measures of return: Accounting Earnings Principles Governing Accounting Earnings Measurement • Accrual Accounting: Show revenues when products and services are sold or provided. Show expenses associated with these revenues rather than cash expenses. not when they are paid for.III.

Consider the tax effect: Consider the tax liability that would be created by the operating income we have estimated 14 Aswath Damodaran . while capital expenses generate benefits over multiple periods. Depreciate or amortize the capital expenses over time: Once expenses have been categorized as capital expenses. Allocate fixed expenses that cannot be traced to specific projects: Expenses that are not directly traceable to a project get allocated to projects. are expenses designed to generate benefits only in the current period. they have to be depreciated or amortized over time.From Forecasts to Accounting Earnings     Separate projected expenses into operating and capital expenses: Operating expenses. projects that are expected to make more revenues will have proportionately more of the expense allocated to them. in accounting. based upon a measure such as revenues generated by the project.

(These expenses have been capitalized) If Boeing decides to proceed with the commercial introduction of the new plane.5 billion building a new plant and equipping it for production. developing the Super Jumbo. Year Now 1 2 3 4 Investment Needed $ 500 million $ 1.Boeing Super Jumbo Jet: Investment Assumptions   Boeing has already spent $ 2. 15 Aswath Damodaran . there will be a capital maintenance expenditure required of $ 250 million each year from years 5 through 15.500 million $ 1.500 million $ 1.5 billion in research expenditures. the firm will have to spend an additional $ 5.000 million $ 1.000 million  After year 4.

While the planes delivered in year 5 will be priced at $ 200 million each. the sales are expected to decline to 100 planes a year. this price is expected to grow at the same rate as inflation (which is assumed to be 3%) each year after that. For the next 15 years (from year 6-20). In the last five years of the project (from year 21-25). Boeing anticipates that its cost of production. • Boeing allocates general. • Based upon past experience.) Aswath Damodaran 16 . Boeing expects to sell 125 planes a year. (One-third of these expenses will be a direct result of this project and can be treated as variable. not including depreciation or General.Operating Assumptions • The sale and delivery of the planes is expected to begin in the fifth year. will be 90% of the revenue each year. selling and administrative expenses (G. Sales and Administrative (GS&A) expenses.S & A) to projects based upon projected revenues. The remaining two-thirds are fixed expenses that would be generated even if this project were not accepted. and this project will be assessed a charge equal to 4% of revenues. when 50 planes will be sold.

rather than waiting for the revenues to commence in year 5. the depreciation is computed to be 10% of the book value of the assets (other than working capital) at the end of the previous year. We begin depreciating the capital investment immediately.Other Assumptions    The project is expected to have a useful life of 25 years. Based upon a typical depreciable life of 20 years. Aswath Damodaran 17 . The corporate tax rate is 35%. Boeing uses a variant of double-declining balance depreciation to estimate the depreciation each year.

7 13.0 48.91 $ 34 .78 $ 27 6.33 $ 33 .9 49.00 $ 20 6.52 $ 31 1.0 70.13 $ 33 .55 $ 22 5.8 51.85 $ 31 .94 $ 33 0.Revenues: By Year Ye ar 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Nu mb er o f Pl an es 50 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 12 5 10 0 10 0 10 0 10 0 10 0 Pri ce pe r pl ane $ 20 0.22 Expecte d Revenu es $ 10 .97 $ 25 3.00 $ 25 .6 44.49 $ 35 0.85 $ 23 8.18 $ 28 .72 $ 28 .22 Aswath Damodaran 18 .3 18.10 $ 23 1.6 05.95 $ 26 8.70 $ 36 1.31 $ 30 .00 $ 21 2.59 $ 32 0.57 $ 34 0.7 50.15 $ 29 3.66 $ 35 .85 $ 28 5.18 $ 21 8.7 46.0 00.85 $ 35 .6 69.35 $ 26 0.71 $ 30 2.19 $ 32 .12 $ 36 .74 $ 38 .50 $ 27 .8 14.02 $ 36 .9 81.6 19.1 22.0 94.5 22.85 $ 29 .81 $ 24 5.25 $ 32 .34 $ 37 .0 56.00 $ 26 .5 97.1 37.95 $ 34 .

6 19 $ 33 .5 23 $ 27 .8 51 $ 30 .0 70 $ 36 .5 98 $ 34 .G & A: By Year Ye ar 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Re ven ues $ 10 .6 06 $ 35 .5 86 $ 25 .19 4 $ 1.3 57 $ 30 .6 72 $ 28 .0 42 $ 34 .1 75 $ 23 .0 33 $ 35 .0 00 $ 25 .30 5 $ 1.0 80 $ 33 .51 3 $ 1.7 51 $ 30 .28 4 $ 1.5 63 $ 32 .3 24 $ 26 .00 0 $ 23 .46 9 $ 1.8 85 $ 29 .3 18 $ 28 .6 69 $ 32 .8 15 $ 38 .5 10 GS& A E xpe nse $ 40 0 $ 1.0 57 $ 34 .5 02 $ 29 .6 44 $ 31 .09 3 $ 1.0 94 $ 33 .40 3 $ 1.32 2 $ 1.38 4 $ 1.1 38 $ 28 .0 54 $ 28 .44 5 Aswath Damodaran 19 .06 1 $ 1.55 8 $ 1.7 13 $ 37 .9 82 $ 29 .1 22 COGS $ 9.Operating Expenses & S.23 0 $ 1.12 6 $ 1.1 45 $ 32 .8 66 $ 27 .6 44 $ 36 .15 9 $ 1.8 70 $ 24 .7 50 $ 26 .9 49 $ 32 .42 6 $ 1.0 49 $ 35 .26 7 $ 1.0 84 $ 26 .03 0 $ 1.2 38 $ 31 .7 47 $ 31 .36 2 $ 1.34 4 $ 1.

322 $ 500 $ 167 $ 333 $508 14 $ 250 $ 332 $ 3.410 $ 1.667 $629 6 $ 250 $ 441 $ 4.833 $ 167 $ 1.667 $ 167 $ 1.000 $447 4 $ 1.000 $ 167 $ 1.167 $571 9 $ 250 $ 389 $ 3.450 $ 2.167 $312 3 $ 1.Depreciation and Amortization: By Year Year Capital Depreciaton Book Value R&D Amortization Ending Value Deprecn & Expenditu res Investment of R&D Amortization 0 $ 500 $ 500 2500 0 2500 1 $ 1.849 $317 17 $ $ 285 $ 2.363 $151 24 $ $ 136 $ 1.333 $ 167 $ 1.805 $ 2.753 $ 1.500 $ 281 $ 4.000 $556 10 $ 250 $ 375 $ 3.500 $ 167 $ 2.000 $ 167 $ 833 $542 11 $ 250 $ 363 $ 3.564 $285 18 $ $ 256 $ 2.025 $ 2.333 $589 8 $ 250 $ 405 $ 3.166 $ 167 $ 167 $ $491 16 $ $ 317 $ 2.683 $187 22 $ $ 168 $ 1.333 $ 167 $ 2.167 $ 167 $ 2.104 $123 Aswath Damodaran 20 .047 $ 1.308 $256 19 $ $ 231 $ 2.219 $ 1.622 $ 2.500 $ 167 $ 1.500 $608 7 $ 250 $ 422 $ 4.333 $217 2 $ 1.413 $ 667 $ 167 $ 500 $518 13 $ 250 $ 341 $ 3.869 $208 21 $ $ 187 $ 1.628 $ 1.227 $136 25 $ $ 123 $ 1.515 $ 833 $ 167 $ 667 $529 12 $ 250 $ 351 $ 3.500 $ 145 $ 2.240 $ 333 $ 167 $ 167 $499 15 $ 250 $ 324 $ 3.514 $168 23 $ $ 151 $ 1.833 $569 5 $ 250 $ 462 $ 4.892 $ 1.000 $ 50 $ 1.000 $ 402 $ 4.077 $231 20 $ $ 208 $ 1.167 $ 167 $ 1.

3 05 $1 .949 $3 2.866 $2 7.3 22 $1 .672 $2 8.2 65 $1 .1 26 $1 .122 COGS $0 $0 $0 $0 $9 .598 $3 4.747 $3 1.5 58 $1 .750 $2 6.606 $3 5.510 GS&A E xpe nse De pre cn & Amo rti zati on EBIT $0 $0 $0 $0 $4 00 $1 .000 $2 5.1 97 $1 .2 84 $1 .033 $3 5.851 $3 0.2 05 $1 .523 $2 7.3 29 Aswath Damodaran 21 .3 92 $1 .5 13 $1 .2 79 $1 .4 58 $1 .3 84 $1 .0 45 EBIT(1-t) ($14 1) ($20 3) ($29 1) ($37 0) ($19 ) $6 09 $6 52 $6 94 $7 36 $7 78 $8 20 $8 62 $9 05 $9 48 $9 91 $1 .3 84 $1 .084 $2 6.145 $3 2.0 61 $1 .1 29 $1 .644 $3 6.3 27 $1 .0 68 $1 .9 46 $2 .502 $2 9.1 94 $1 .2 30 $1 .238 $3 1.751 $3 0.0 30 $1 .5 25 $1 .870 $2 4.4 03 $1 .0 93 $1 .0 03 $1 .175 $2 3.1 30 $1 .080 $3 3.586 $2 5.815 $3 8.2 67 $1 .357 $3 0.3 25 $1 .982 $2 9.1 44 $1 .7 39 $1 .318 $2 8.669 $3 2.1 80 $1 .9 68 $2 .0 38 $2 .324 $2 6.054 $2 8.1 32 $1 .4 45 $2 17 $3 12 $4 47 $5 69 $6 29 $6 08 $5 89 $5 71 $5 56 $5 42 $5 29 $5 18 $5 08 $4 99 $4 91 $3 17 $2 85 $2 56 $2 31 $2 08 $1 87 $1 68 $1 51 $1 36 $1 23 ($21 7) ($31 2) ($44 7) ($56 9) ($29 ) $9 37 $1 .885 $2 9.3 62 $1 .049 $3 5.Earnings on Project Ye ar 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Re ven ues $0 $0 $0 $0 $1 0.563 $3 2.057 $3 4.8 91 $1 .4 69 $1 .7 60 $1 .070 $3 6.2 62 $1 .0 00 $2 3.138 $2 8.713 $3 7.2 29 $1 .644 $3 1.8 15 $1 .8 54 $1 .1 59 $1 .094 $3 3.4 26 $1 .042 $3 4.3 44 $1 .619 $3 3.

6 8% 19 .68 $1 .63% -5.3 80.55 $5 71.86 $5 .46 $3 .12 $6 28.4 55.4 06.2 2% 12 .0 0 De pre ci ati on $2 16.44 $5 18.50 $6 .00 $2 50.33 $2 .54 $1 .9 13.7 06.3 8% 26 .0 0 $0 .64 $3 .65 En din g BV $3 .87 $6 07.8 98.50 $1 .1 65.7 7) $6 09.7 84.54 Ca pital Exp $1 .2 29.50 $1 .96 $2 .3 80.9 85.2 26.55 $3 .88 $9 91.16 $5 08.0 77.1 79.3 07.44 $2 30.91 $1 .0 00.7 18.5 31.3 05.0 58.7 18.1 92.0 6% 25 .32 $9 04.5 75.73 Be gin ni ng BV $3 .8 2% 12 .00 $4 .18 $2 .56 $1 .47 $3 .1 03.6 7% 24 .5 64.3 59.26% 7.00 $1 .2 79.65 $5 88.00 $2 .30 $1 .94 $1 68.77 $2 .4 36.8 94.0 74.2 04.59 $2 84.7 83.68 $3 .6 07.96 $2 .7 5% Aswath Damodaran 22 .6 4% 27 .92 $2 .0 47.73 % 9.00 $1 .1 1% 13 .3 7% 11 .2 26.8 13.83 $1 .00 $2 50.58 $3 .84 $1 .88 $4 90.6 37.45 $1 .86 $1 .0 00.93% -0.13 $3 .79 $3 .50 $6 .4 60.0 24.8 49.9 2% 17 .6 12.89 $5 41.02 $3 .54 $1 .95 $5 .47 $3 .5 8% 22 .5 14.67 $4 .38 $1 .63 $2 .5 64.89 $9 47.7 31.97 $5 29.1 30.86 $5 .47 $1 .46 $3 .3 84.36 $4 .05 $4 .22 $2 .53 % 10 .25 $1 .16 $1 .00 $0 .47 $3 .7 81.25 $1 51.80 $2 07.9 71.43 $1 36.00 $2 50.6 82.0 24.51 $5 .9 06.38 $6 .6 55.2 19.08 $4 .94 $4 .1 8% 23 .83 $1 .13 $1 .0 07.5 00.05 $4 .0 0 $0 .6 71.31 $5 .2 94.0 2% 13 .9 5% 14 .6 52.0 0 $0 .64 $3 .00 $2 50.04 $7 77.93) ($18 .39 $1 .67 $3 11.45 $1 .26 Re turn on Capi tal -4.04 $7 78.4 06.40 $2 .33 $3 .67 $4 47.3 29.8 49.And the Accounting View of Return Ye ar 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Average EBIT(1-t) ($14 0.1 81.7 75.00 $2 50.0 0 $0 .82 $2 .8 69.6 20.06 $8 62.0 0 $0 .2 86.5 07.0 77.7 53.86 $2 .69 $5 .00 $2 50.0 0 $0 .0 58.0 76.29% -5.2 65.0 00.1 81.25 $3 .3 21.08 $4 .40 $2 .1 65.15 $1 .51 $5 .1 66.28 $6 51.1 65.4 38.00 $1 .19 % 7.25 $2 .08 $6 .0 0 $0 .76 $1 .33 $4 .67 $6 .47 $3 .3 91.16 $1 .0 00.2 39.52 Worki ng Capi ta l $0 .5 98.58 $5 .28 $1 22.16 $1 .02 $7 36.97 $1 .95 % 8.66) ($36 9.0 0 $1 .00 $2 50.2 09.06 $4 .92 $3 .31 $5 .6 55.01 $3 .00 $2 50.7 1% 22 .00 $2 .15% -4.67 $6 .19 $2 .9 71.58 $3 .01 $8 20.8 97.3 24.00 $1 .0 76.70 $3 .5 00.22 $3 .6 82.33 $4 .94 $6 .00 $2 50.8 69.72 $1 86.40 $3 .4 55.4 61.50 $5 .92 $2 .3 77.5 64.58 $3 .3 07.2 1% 20 .2 61.94 $4 .93 $3 .3 62.17 $5 69.5 14.93 $3 .82 $6 94.0 0 $0 .58) ($29 0.33 $2 .5 49.36 $5 55.4 61.7 83.00 $2 50.9 13.63 $4 .93 $2 56.87 $3 .00 $2 50.38 $6 .0 0 $0 .01 $4 98.89 Average BV $3 .66 $3 16.9 73.0 0 $0 .4 98.4 04.83) ($20 2.1 43.25 $1 .7 53.0 0 $0 .2 65.3 62.00 $3 .41 $3 .0 0 $0 .

Invest in the Super Jumbo Jet The return on capital of 12.75% is greater than the cost of capital for aerospace of 9.Would lead use to conclude that.32%..  Aswath Damodaran 23 . This would suggest that the project should not be taken..

87% 11.37% 23.55% ROC . a comparison can be made at the firm level.From Project to Firm Return on Capital Just as a comparison of project return on capital to the cost of capital yields a measure of whether the project is acceptable. Boeing Home Depot InfoSoft Return on Capital 5. to judge whether the existing projects of the firm are adding or destroying value.13%  Aswath Damodaran 24 .17% 9.67% Cost of Capital 9.51% 12.82% 16.35% 6.Cost of Capital -3.

compute the return spread earned by your firm: Return Spread = After-tax ROC .Cost of Capital  For the most recent period. compute the aftertax return on capital earned by your firm. compute the EVA earned by your firm EVA = Return Spread * (BV of Debt +BV of Equity)  Aswath Damodaran 25 .6 Application Test: Assessing Investment Quality For the most recent period for which you have data. where after-tax return on capital is computed to be After-tax ROC = EBIT (1-tax rate)/ (BV of debt + BV of Equity)previous year  For the most recent period for which you have data.

IV. From Earnings to Cash Flows  To get from accounting earnings to cash flows: • you have to add back non-cash expenses (like depreciation and amortization) • you have to subtract out cash outflows which are not expensed (such as capital expenditures) • you have to make accrual revenues and expenses into cash revenues and expenses (by considering changes in working capital). Aswath Damodaran 26 . • Working capital will be 10% of revenues. and the investment has to be made at the beginning of each year. we will assume that • The depreciation used for operating expense purposes is also the tax depreciation.  For the Boeing Super Jumbo.

00 0 1.38 3 1.31 0 6.16 8 $ 4.32 9 De pre ci ati on $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 21 7 31 2 44 7 56 9 62 9 60 8 58 9 57 1 55 6 54 2 52 9 51 8 50 8 49 9 49 1 31 7 28 5 25 6 23 1 20 8 18 7 16 8 15 1 13 6 12 3 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Ca p E x 3.13 0 1.09 9 1.35 7 1.22 9 1.00 0 1.22 1 1.71 6 Aswath Damodaran 27 .26 5 1.00 0 1.13 1 1.57 5 77 80 82 84 87 90 92 95 98 10 1 10 4 10 7 11 0 11 3 (686 ) 96 99 10 2 10 5 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ FCFF (3.32 5 1.00 0 25 0 25 0 25 0 25 0 25 0 25 0 25 0 25 0 25 0 25 0 25 0 Ch ange i n WC Sa lvage Va lu e $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 1.06 8 1.000 ) (924 ) (1.44 2 2.343 ) (1.801 ) (1.50 0 1.14 4 1.27 9 1.24 9 1.01 0 1.41 1 1.27 9 1.20 5 1.215 ) 89 0 91 1 93 3 95 8 98 3 1.Estimating Cash Flows: The Boeing Super Jumbo Ye ar 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 EBIT(1-t) $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ (141 ) (203 ) (291 ) (370 ) (19) 60 9 65 2 69 4 73 6 77 8 82 0 86 2 90 5 94 8 99 1 1.391 ) (1.03 8 1.38 4 1.50 0 1.27 7 1.18 0 1.

in year 2. Proposition 2: Non-cash charges that are not tax deductible (such as amortization of goodwill) and thus provide no tax benefits have no effect on cash flows.35) = $ 76 million Proposition 1: The tax benefit from depreciation and other non-cash charges is greater. the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate For example. The benefit of depreciation is therefore the tax benefit. the higher your tax rate.The Depreciation Tax Benefit While depreciation reduces taxable income and taxes. 28      Aswath Damodaran . In general. it does not reduce the cash flows. the tax benefit from depreciation to Boeing from this project can be written as: Tax Benefit in year 2 = $ 217 million (.

In accelerated depreciation. depreciation methods can be classified as straight line or accelerated methods. the capital expense is depreciated more in earlier years and less in later years. and that you are choosing between straight line and accelerated depreciation methods.Depreciation Methods Broadly categorizing. the capital expense is spread evenly over time. In straight line depreciation. Which will result in higher net income this year?  Straight Line Depreciation  Accelerated Depreciation Which will result in higher cash flows this year?  Straight Line Depreciation  Accelerated Depreciation  Aswath Damodaran 29 . Assume that you made a large investment this year.

a 25-year project will require more maintenance capital expenditures than a 2-year asset.     Both initial and maintenance capital expenditures reduce cash flows The need for maintenance capital expenditures will increase with the life of the project. Aswath Damodaran 30 . Capital expenditures can generally be categorized into two groups • New (or Growth) capital expenditures are capital expenditures designed to create new assets and future growth • Maintenance capital expenditures refer to capital expenditures designed to keep existing assets.The Capital Expenditures Effect Capital expenditures are not treated as accounting expenses but they do cause cash outflows. In other words.

Which will have a more positive effect on income?  Expense it  Capitalize and Depreciate it Which will have a more positive effect on cash flows?  Expense it  Capitalize and Depreciate it  Aswath Damodaran 31 . and that you have an expense this year of $ 100 million from producing and distribution promotional CDs in software magazines.To cap ex or not to cap ex Assume that you run your own software business. Your accountant tells you that you can expense this item or capitalize and depreciate.

Aswath Damodaran 32 . working capital investments need to be salvaged at the end of the project life. represents a drain on cash flows To the degree that some of these investments can be financed using suppliers credit (accounts payable) the cash flow drain is reduced.The Working Capital Effect Intuitively. It. money invested in inventory or in accounts receivable cannot be used elsewhere. Investments in working capital are thus cash outflows • Any increase in working capital reduces cash flows in that year • Any decrease in working capital increases cash flows in that year     To provide closure. thus.

if it accepts the investment. From Cash Flows to Incremental Cash Flows   The incremental cash flows of a project are the difference between the cash flows that the firm would have had. and the cash flows that the firm would have had. if it does not accept the investment. The Key Questions to determine whether a cash flow is incremental: • What will happen to this cash flow item if I accept the investment? • What will happen to this cash flow item if I do not accept the investment?  If the cash flow will occur whether you take this investment or reject it.V. Aswath Damodaran 33 . it is not an incremental cash flow.

Sunk Costs Any expenditure that has already been incurred. how can a firm ensure that these costs are covered?    Aswath Damodaran 34 . sunk costs should not be considered since they are incremental By this definition. market testing expenses and R&D expenses are both likely to be sunk costs before the projects that are based upon them are analyzed. If sunk costs are not considered in project analysis. and cannot be recovered (even if a project is rejected) is called a sunk cost When analyzing a project.

    How. • Thus. do we know how much of the costs are fixed and how much are variable? Aswath Damodaran 35 . it is only the incremental component of allocated costs that should show up in project analysis.Allocated Costs Firms allocate costs to individual projects from a centralized pool (such as general and administrative expenses) based upon some characteristic of the project (sales is a common choice) For large firms. this makes the firm worse off. these allocated costs can result in the rejection of projects To the degree that these costs are not incremental (and would exist anyway). looking at these pooled expenses.

Aswath Damodaran 36 .5 billion already expended on the jet is a sunk cost.G&A expenses are fixed expenses and would exist even if this project is not accepted. and it is entitled to the latter even if the investment is rejected) Two-thirds of the S. (Boeing has spent the first. as is the amortization related that expense.Boeing: Super Jumbo Jet   The $2.

6 06 $1 .00 0) ($98 3) ($1.2 21 $1 .3 29 De pre ci ati on $0 $5 0 $1 45 $2 81 $4 02 $4 62 $4 41 $4 22 $4 05 $3 89 $3 75 $3 63 $3 51 $3 41 $3 32 $3 24 $3 17 $2 85 $2 56 $2 31 $2 08 $1 87 $1 68 $1 51 $1 36 $1 23 Ca p E x $3 .The Incremental Cash Flows: Boeing Super Jumbo Ye ar 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 EBIT(1-t) $0 ($33 ) ($94 ) ($18 2) ($26 2) $9 0 $7 18 $7 60 $8 02 $8 44 $8 86 $9 28 $9 71 $1 .9 18 $6 .4 42 $2 .85 9) ($1.3 57 $1 .2 79 $1 .44 9) ($1.4 27 $1 .0 00 $1 .27 3) $8 31 $8 52 $8 75 $8 99 $9 25 $9 52 $9 80 $1 .5 00 $1 .4 11 $1 .1 00 $1 .2 29 $1 .3 10 $6 .7 77 $1 .0 56 $1 .3 49 $1 .5 75 $0 $7 7 $0 $8 0 $0 $8 2 $0 $8 4 $0 $8 7 $0 $9 0 $0 $9 2 $0 $9 5 $0 $9 8 $0 $1 01 $0 $1 04 $0 $1 07 $0 $1 10 $0 $1 13 $0 ($68 6) $0 $9 6 $0 $9 9 $0 $1 02 $0 $1 05 $0 $0 $4 .2 78 $1 .1 68 Su nk Co st ($2.7 16 FCFF ($3.8 22 $1 .0 10 $1 .1 44 $1 .1 80 $1 .0 00 $1 .8 69 $1 .3 25 $1 .40 2) ($1.9 52 $1 .5 00 $1 .7 94 Aswath Damodaran 37 .3 87 $1 .2 65 $1 .85 9) ($1.3 84 $1 .9 56 $2 .0 98 $2 .6 55 $1 .44 9) ($1.2 77 $1 .2 05 $1 .0 01 $2 .3 12 $1 .2 49 $1 .3 83 $1 .5 13 $1 .2 79 $1 .50 0) $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Fi xe d GS&A(1-t) $0 $0 $0 $0 $1 73 $4 46 $4 60 $4 74 $4 88 $5 02 $5 17 $5 33 $5 49 $5 65 $5 82 $6 00 $6 18 $6 36 $6 55 $6 75 $5 56 $5 73 $5 90 $6 08 $6 26 Increme ntal FCFF ($50 0) ($98 3) ($1.40 2) ($1.0 00 $0 $1 .0 41 $1 .4 69 $1 .1 30 $1 .0 73 $1 .0 48 $2 .0 13 $1 .10 0) $1 .0 00 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $2 50 $0 $0 $0 $0 $0 $0 $0 $0 $0 $0 Ch ange i n WC Sa lvage Va lu e $0 $0 $0 $0 $0 $0 $0 $0 $1 .5 58 $1 .

In fact. This process of moving cash flows through time is • discounting. when present cash flows are taken to the future     The discount rate is the mechanism that determines how cash flows across time will be weighted. cash flows across time cannot be added up.VI. They have to be brought to the same point in time before aggregation. Aswath Damodaran 38 . To Time-Weighted Cash Flows Incremental cash flows in the earlier years are worth more than incremental cash flows in later years. when future cash flows are brought to the present • compounding.

Perpetuity A/r 5. Growing Annuity 4. Simple CF 2. Annuity Discounting Formula CFn / (1+r)n 1  1  (1+ r)n  A  r     (1 + g)n  1  (1 + r)n  A(1 + g)   r -g     Compounding Formula CF0 (1+r)n (1 + r) .1 A   r   n 3. Growing Perpetuity A(1+g)/(r-g) Aswath Damodaran 39 .Present Value Mechanics Cash Flow Type 1.

including the initial investment. and cost of equity.Discounted cash flow measures of return Net Present Value (NPV): The net present value is the sum of the present values of all cash flows from the project (including initial investment). based upon incremental time-weighted cash flows. • Decision Rule: Accept if IRR > hurdle rate Aswath Damodaran 40 . if cash flow is cash flow to the firm. if cash flow is to equity investors) • Decision Rule: Accept if NPV > 0   Internal Rate of Return (IRR): The internal rate of return is the discount rate that sets the net present value equal to zero. with the cash flows being discounted at the appropriate hurdle rate (cost of capital. It is the percentage rate of return. NPV = Sum of the present values of all cash flows on the project.

which is the expected proceeds from selling all of the investment in the project at the end of the project life.   Aswath Damodaran 41 . It is usually set equal to book value of fixed assets and working capital In a project with an infinite or very long life.Closure on Cash Flows In a project with a finite and short life. you would need to compute a salvage value.. we compute cash flows for a reasonable period. and then compute a terminal value for this project. which is the present value of all cash flows that occur after the estimation period ends.

612 million Salvage Value at end of year 25 = $4.Salvage Value on Boeing Super Jumbo We will assume that the salvage value for this investment at the end of year 25 will be the book value of the investment.716 million  Aswath Damodaran 42 .104 million Book value of working capital investments: yr 25 = $3. Book value of capital investments at end of year 25 = $1.

09 8 $ 2.77 7 $ 27 4 1.46 9 $ 55 1 1.46 9 $ 1.86 9 $ 1.04 8 $ 41 2 2.04 8 $ 2.65 5 $ 1.31 2 $ 70 3 1.55 8 $ 48 9 1.00 1 $ 44 0 2.42 7 $ 1.Considering all of the Cashflows… The NPV Ye ar 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 FCFF $ (500 ) $ (983 ) $ (1.60 6 $ 46 1 1.82 2 $ 1.95 2 $ 49 7 1.073 ) (1.859 ) $ (1.449 ) $ (1.34 9 $ 66 1 1.91 8 $ 2.31 2 $ 1.09 8 $ 38 6 2.42 7 $ 58 5 1.38 7 $ 62 2 1.51 3 $ 1.95 2 $ 1.38 7 $ 1.77 7 $ 1.100 ) $ 1.51 3 $ 51 9 1.01 9 Ne t Present Val ue = Aswath Damodaran 43 .302 ) (1.32%) (500 ) $ (500 ) (983 ) $ (899 ) (1.82 2 $ 25 7 1.27 8 $ 1.00 1 $ 2.95 6 $ 47 0 2.402 ) $ (1.34 9 $ 1.79 4 $ 73 2 $ 4.402 ) $ (1.91 8 $ 22 6 6.95 6 $ 2.55 8 $ 1.07 8 Sa lvage Va lu e FCFF + $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 4.100 ) $ (704 ) 1.27 8 $ 74 9 1.86 9 $ 24 1 1.449 ) $ (1.213 ) (1.859 ) $ (1.60 6 $ 1.65 5 $ 43 5 1.71 6 $ Sal va ge Present Val ue (@9.

and earn a return in excess of the cost of capital.Which makes the argument that. The positive net present value suggests that the project will add value to the firm.   Aswath Damodaran 44 . Boeing will increase its value as a firm by $4.. The project should be accepted.019 million. By taking the project.

The IRR of this project Internal Rate of Return Aswath Damodaran 45 .

incremental cash flows. Using time-weighted.32%.. This is greater than the cost of capital of 9.88%. though there are differences between the two approaches that may cause project rankings to vary depending upon the approach used. The IRR and the NPV will yield similar results most of the time. The project is a good one. this project provides a return of 14.   Aswath Damodaran 46 .The IRR suggests.

Case 1: IRR versus NPV Consider a project with the following cash flows: Year Cash Flow 0 -1000 1 800 2 1000 3 1300 4 -2200  Aswath Damodaran 47 .

0 0 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34% 36% 38% 40% 42% 44% 46% 48% NPV ($20.00 ) ($80.0 0) Discoun t Rate Aswath Damodaran 50% 0% 2% 4% 6% 8% 48 .00 ) ($100 .00 ) ($40.00 $2 0.00 $4 0.00 ) ($60.00 $0 .Project’s NPV Profile $6 0.

 Aswath Damodaran 49 . Why are there two internal rates of return on this project?   If your cost of capital is 12. whereas the second is 36.32%.What do we do now? This project has two internal rates of return.55%. would you accept or reject this project?  I would reject the project  I would accept this project Explain.60%. The first is 6.

000 Investment $ 10.500.000.664 IRR=20.000.000 $ 600.66% Project B Cash Flow $ 3.000 Investment $ 1.000 $ 750.358.000 $ 5.000 $ 450.Case 2: NPV versus IRR Project A Cash Flow $ 350.500.937 IRR= 33.000.000 NPV = $467.500.000 $ 3.000 NPV = $1.000 $ 4.88% Aswath Damodaran 50 .

If you pick A. what would your biggest concern be? Aswath Damodaran 51 . You have enough money currently on hand to take either. Which one would you pick?  Project A. It creates more dollar value in my business. Your choice will clearly vary depending upon whether you look at NPV or IRR.Which one would you pick? Assume that you can pick only one of these two projects. what would your biggest concern be?  If you pick B. It gives me the bigger bang for the buck and more margin for error.  Project B.

Aswath Damodaran 52 . they are much more likely to gain from using NPV. As firms go public and grow. high-growth companies and private businesses are much more likely to use IRR. If a business has substantial funds on hand. Uncertainty and Choosing a Rule   If a business has limited access to capital. limited surplus value projects. access to capital. it is much more likely to use IRR as its decision rule.Capital Rationing. and more certainty on its project cash flows. it is much more likely to use NPV as its decision rule. has a stream of surplus value projects and faces more uncertainty in its project cash flows. Small.

000. This is called the profitability index. The NPV can be converted into a relative measure by dividing by the initial investment.000 = 46. Aswath Damodaran 53 .358. is that it is a dollar value.937/1. the PI of the two projects would have been: • PI of Project A = $467. • Profitability Index (PI) = NPV/Initial Investment    In the example described.79% • PI of Project B = $1. when there is capital rationing.An Alternative to IRR with Capital Rationing The problem with the NPV rule.000.664/10. It measures success in absolute terms.59% Project A would have scored higher.000 = 13.

000 NPV = $1.000.000 $ 3.000 $ 3.500.88% Aswath Damodaran 54 .358.41% Project B Cash Flow $ 3.000 Investment $ 10.000 Investment $ 10.712 IRR=21.500.000.200.000 NPV = $1.191.500.000 $ 4.Case 3: NPV versus IRR Project A Cash Flow $ 5.000 $ 5.664 IRR=20.000.000.000.000 $ 4.000.000 $ 3.

Yet. Why? Which one would you pick?  Project A. Both the NPV and IRR use timeweighted cash flows. It creates more dollar value in my business. Aswath Damodaran 55 . It gives me the bigger bang for the buck and more margin for error.Why the difference? These projects are of the same scale. the rankings are different.  Project B.

Conclusion: When the IRR is high (the project is creating significant surplus value) and the project life is long. Implicit is the assumption that the firm has an infinite stream of projects yielding similar IRRs. the IRR will overstate the true return on the project.NPV. IRR and the Reinvestment Rate Assumption    The NPV rule assumes that intermediate cash flows on the project get reinvested at the hurdle rate (which is based upon what projects of comparable risk should earn). The IRR rule assumes that intermediate cash flows on the project get reinvested at the IRR. Aswath Damodaran 56 .

89% Modified Internal Rate of Return = 21.Solution to Reinvestment Rate Problem Cash Flow Investment <$ 1000> $ 300 $ 400 $ 500 $ 600 $500(1.23% $600 $575 $529 $456 $2160 Aswath Damodaran 57 .15) 2 $400(1.15) Terminal Value = Internal Rate of Return = 24.15) 3 $300(1.

Why NPV and IRR may differ. while the IRR is higher for “small-scale” projects. while the IRR assumes that intermediate cash flows get reinvested at the “IRR”. whereas it can have more than one IRR. whereas the IRR is a percentage measure of return.. The NPV assumes that intermediate cash flows get reinvested at the “hurdle rate”. which is based upon what you can make on investments of comparable risk. A project can have only one NPV. The NPV is therefore likely to be larger for “large scale” projects. The NPV is a dollar surplus value.    Aswath Damodaran 58 .

Case: NPV and Project Life Project A $400 -$1000 $400 $400 $400 $400 NPV of Project A = $ 442 Project B $350 -$1500 $350 $350 $350 $350 $350 $350 $350 $350 $350 NPV of Project B = $ 478 Hurdle Rate for Both Projects = 12% Aswath Damodaran 59 .

Choosing Between Mutually Exclusive Projects The net present values of mutually exclusive projects with different lives cannot be compared. To do the comparison. since there is a bias towards longer-life projects. we have to • replicate the projects till they have the same life (or) • convert the net present values into annuities   Aswath Damodaran 60 .

Solution 1: Project Replication Project A: Replicated $400 -$1000 $400 $400 $400 $400 $400 $400 $400 $400 $400 -$1000 (Replication) NPV of Project A replicated = $ 693 Project B $350 -$1500 NPV of Project B= $ 478 $350 $350 $350 $350 $350 $350 $350 $350 $350 Aswath Damodaran 61 .

12%.12%.Solution 2: Equivalent Annuities Equivalent Annuity for 5-year project = $442 * PV(A.10 years) = $ 84.62   Equivalent Annuity for 10-year project = $478 * PV(A.60 Aswath Damodaran 62 .5 years) = $ 122.

What would you choose as your investment tool?       Given the advantages/disadvantages outlined for each of the different decision rules. which one would you choose to adopt? Return on Investment (ROE. ROC) Payback or Discounted Payback Net Present Value Internal Rate of Return Profitability Index Aswath Damodaran 63 .

What firms actually use .0% Aswath Damodaran 64 .8% 21. Decision Rule IRR Accounting Return NPV Payback Period Profitability Index % of Firms using as primary decision rule in 1976 1986 53..0% 9.6% 49.0% 2.7% 3.0% 25.0% 8.9% 19.0% 8.

Assuming that the price is set in U.Boeing 747: What about exchange rate risk? A substantial portion of Boeing’s cash flows on the Super Jumbo will come from sales to foreign airlines. Should there be a premium added on to the discount rate for exchange rate risk? (Should we use a cost of capital higher than 9. dollars. this exposes Boeing to exchange rate risk.32%?) Yes No    Aswath Damodaran 65 .S.

however. For Boeing. insurance costs) can be built into the cash flows. which would mean that it too should not affect the discount rate. For Boeing. It may. it can be argued that this risk is diversifiable. by reducing the expected life or cash flows on the project. Any expenses associated with protecting against political risk (say. Aswath Damodaran 66 .Should there be a risk premium for projects with substantial foreign exposure?  The exchange rate risk may be diversifiable risk (and hence should not command a premium) if • the company has projects is a large number of countries (or) • the investors in the company are globally diversified. this risk too is assumed to not affect the cost of capital.  The same diversification argument can also be applied against political risk. affect the cash flows.

• Return will be Return on Equity (ROE) = Net Income/BV of Equity • ROE has to be greater than cost of equity    If using discounted cashflow models.Equity Analysis: The Parallels The investment analysis can be done entirely in equity terms. as well. If using accounting returns. • Cashflows will be cashflows after debt payments to equity investors • Hurdle rate will be cost of equity Aswath Damodaran 67 . The returns. cashflows and hurdle rates will all be defined from the perspective of equity investors.

The pre-tax operating margin. using a 10-year term loan. During that period. 68      Aswath Damodaran . The Home Depot plans to borrow $ 5 million. the investments are expected to have a salvage value of $ 7. is expected to be 10% for the entire period.80%. building and fixtures.A New Store for the Home Depot It will require an initial investment of $20 million in land. at an interest rate of 5. the store investment will be depreciated using straight line depreciation. and these revenues are expected to grow 5% a year for the remaining 9 years of the store’s life. The store will have a life of 10 years.5 million. At the end of the tenth year. at the store prior to depreciation. The store is expected to generate revenues of $40 million in year 1.

08 $3.448.917.126.848.342.75 $0.917.19 $1.36 $4.027.77 $104.448.57 $4.061.59 $672.617.45 $672.75 $636.14 $135.08 $4.805.082.850.889.64 $4.36 $507.917.332.36 $405.786.160.Interest and Principal Payments Year 1 2 3 4 5 6 7 8 9 10 Outstanding debt Interest Expense Total Payment Principal Repaid Remaining Principal $5.77 $2.08 $193.36 $428.956.61 $672.848.917.027.237.00 $672.92 $672.77 $1.293.332.000.917.329.342.623.392.917.790.917.64 $267.917.00 $290.19 $672.000.392.805.99 $672.36 $537.783.433.783.917.79 $672.027.36 $636.237.082.188.36 $601.17 $2.061.36 $382.917.861.329.91 $165.37 $1.000.36 $568.211.303.188.14 $2.756.055.36 $453.19 $71.211.484.613.36 $479.91 $3.917.204.850.91 $2.09 $3.44 $636.712.75 $36.58 $1.17 $3.956.617.17 $219.00 Aswath Damodaran 69 .08 $244.78 $672.131.27 $672.

273.000 $1.402 $104.250.250.161.250.791 $1.946.690.605.209 $2.250.689.051.000 $1.757 $4.588.599.250.713 $4.000 $46.822 $71.613 $1.693 $2.438 $1.025 $193.855.689 $4.000 $938.000 $267.250.847.000 $244.000 $1.196.250.000 $1.378.000 $1.823 $4.284.398.612.106.890 $4.385 $2.750.065 $4.773 $1.655.500 $48.000 $2.126 $165.000 $1.436 $1.758.000.054.209 $3.895.222.433 $3.396 $62.707 $3.129 $55.110.620.721.Net Income on The Home Depot Store Year 1 2 3 4 5 6 7 8 9 10 Revenues Operating Expenses $40.423 Taxes $861.305.615 $59.826 $48.017 $50.000 $36.136 $53.250 $43.975 Aswath Damodaran 70 .263 $45.281 $2.250.000.020.438 $2.188.500 $219.915.250.448 Net Income $1.383 $135.293 $2.000 $290.777.218 $53.067 $3.000 $42.225 $51.443 $56.862 $3.373 $1.196.160.250.131 $3.000 $2.950.000 $1.682.800.000 $44.000 EBIT Interest Expense Taxable Income $2.898 $2.659.000 $1.743.000 $39.380.100.521 $4.603.823 $1.291.918.391.000 $41.982.313 $36.242 $3.000 $37.460.098.495.674.894 $3.053.000 $1.082 $1.243.304 $3.000 $1.791 $2.497 $1.974.955.583.000.816 Depreciat ion $1.418.

the cost of equity for this project is also assumed to be 9.78%. the hurdle rate has to be a cost of equity The cost of equity for the Home Depot is 9.   Aswath Damodaran 71 . Thus.The Hurdle Rate The analysis is done in equity terms.78%. Since the Home Depot’s investments are assumed to be homogeneous.

6 06.0 3% 16 .000 $ 1.77 7.0 70.386 13 .4 05.0 3% 14 .6 4% 16 .431 13 .7 71.236 15 .481 16 .00 % 10 .0 89.7 72.4 2% 22 .356 15 .459 17 .898 $ 2.693 $ 2.846 14 .39 8.22 2.89 5.4 1% 18 .249 12 .ROE on this Project Ye ar 0 1 2 3 4 5 6 7 8 9 10 Average Average BV o f Equ ity $ $ $ $ $ $ $ $ $ $ $ 17 .7 66.5 5% 13 .810 15 .74 3.438 $ 2.6 12.242 $ 3.281 $ 2.975 $ 2.1 66.385 $ 2.592 Ne t In co me $ 1.356 Re turn on E qui ty 9.19 6.05 4.209 $ 2.3 4% 20 .1 74.58 3.665 14 .34 5.0 43.6 5% 25 .436 $ 1.2 1% 11 .1 3% Aswath Damodaran 72 .98 2.59 9.

78% 13. where we used return on capital and cost of capital to measure the overall quality of projects. we can compute return on equity and cost of equity to pass judgment on whether a firm is creating value to its equity investors.19% ROE .28%  Aswath Damodaran 73 .From Project ROE to Firm ROE As with the earlier analysis.58% 22.59% 20.58% 9.47% Cost of Equity 10. Boeing Home Depot InfoSoft Return on Equity 7.37% 33.Cost of Equity -2.99% 12.

the book value of the store is assumed to be equal to the salvage value. Aswath Damodaran 74 . At the end of the project life. At the end of the project life. the working capital is fully salvaged.Additional Assumptions   Working capital is assumed to be 8% of revenues and the investment in working capital is at the beginning of each year.

436 $1.209 $2.250.975 Depreciat ion $1.000 Capital Expenditures Debt Issued/PrincipalChange in Working CapitSalvage Value Repayment al ($20.400) ($453.000 $1.982.000 $1.306.000) $2.000) ($428.540.624) ($176.136) ($601.250.786) ($194.000 FCFE ($18.000 $1.394.250.000 $1.665.200.250.055) ($214.081.222.964.000.242 $3.000) ($405.415) ($568.743.898 $2.798.250.500.000) $5.054.275.185 $2.014 $2.438 $2.000 $1.693 $2.000 $1.250.689 $16.281 $2.557 $3.220) ($479.566 $3.000 $1.484) ($185.An Incremental CF Analysis Year 0 1 2 3 4 5 6 7 8 9 10 Net Income $1.000 $1.936.000 $1.420.205) ($225.196.205) ($537.000 ($3.200.895.583.398.917) ($160.777.000 $1.385 $2.234.250.250.599.250 $7.083 $2.250.028) $4.309 $2.198 Aswath Damodaran 75 .000.127) ($168.481) ($507.393) ($636.968 $3.989 $2.160) ($236.000) ($382.250.614) ($204.

613 76 Aswath Damodaran .000) $2.566 $3.008.936.000) $2.101.465.968 $3.825 $1.798.401.640 $2.603.856 $1.014 $2.100.855 $6.540.081.281 $1.420.835.557 $3.309 $2.754.665.394.275.919.083 $2.NPV of the Store Year 0 1 2 3 4 5 6 7 8 9 10 FCFE ($18.677.198 PV at Cost of Equit y ($18.307 $1.533.200.976 $1.200.681 $4.989 $2.306.234.689 $16.185 $2.547 $1.646 $1.

Internal Rate of Return: The Home Depot Store Aswath Damodaran 77 .

) is to changes in key assumptions.    Aswath Damodaran 78 .. our conclusions can also be wrong.The Role of Sensitivity Analysis Our conclusions on a project are clearly conditioned on a large number of assumptions about revenues. IRR. One way to gain confidence in the conclusions is to check to see how sensitive the decision measure (NPV. costs and other variables over very long time periods. To the degree that these assumptions are wrong.

Viability of New Store: Sensitivity to Operating Margin Aswath Damodaran 79 .

Aswath Damodaran 80 . Is this the right thing to do?  Yes  No Explain. She looks at the sensitivity analysis and decides not to take the project because the NPV would turn negative if the operating margin drops below 8%.What does sensitivity analysis tell us? Assume that the manager at The Home Depot who has to decide on whether to take this plant is very conservative.

The ‘‘Consistency Rule” for Cash Flows The cash flows on a project and the discount rate used should be defined in the same terms. the discount rate has to be nominal (real).   If consistency is maintained. no matter what cash flows are used. • If cash flows are in one currency. Aswath Damodaran 81 . the project conclusions should be identical. the discount rate has to be a dollar (baht) discount rate • If the cash flows are nominal (real).

the store will be depreciated using straight line depreciation. The store is expected to generate revenues of 7.350 million pesos. and these revenues are expected to grow 12% a year for the remaining 9 years. 82      Aswath Damodaran . The Home Depot plans to borrow 1880 million pesos. The working capital requirements are estimated to be 10% of total revenues.050 million pesos in year 1. and investments will be made at the beginning of each year.02%. prior to depreciation. The pre-tax operating margin at the store. is expected to be 6% for the entire period. During that period.The Home Depot: A New Store in Chile It will require an initial investment of 4700 million pesos for land. The store will have a life of 10 years. using a 10-year term loan. building and fixtures. At the end of the tenth year. at an interest rate of 12. the investments are expected to have a salvage value of 2.

09) 116.880.39 235.36 235.350.08 Aswath Damodaran 83 .48) (166.00 (119.784.47) 206.12) 52.11 235.700.00 (107.55 8 362.39) (209.00 (188.00 6 219.00) 1.00 (297.525.70 4 106.The Home Depot Chile Store: Cashflows in Pesos Year Net Income Depreciat ion Capital Expenditures Debt Issued/Principal Repayment Change in Working Capit al Salvage Value FCFE 0 (4.00 235.43) (118.64 235.52) (133.00 (236.00) 1 (22.60) 20.99) 143.00 (211.00 (150.72 3 58.78) (149.02) 173.01 235.29) (106.00 (134.81 235.45 9 446.02 2.00 (705.75) 35.87) (94.00 (168.94 10 541.86) 71.01) (84.00 (265.955.30) 1.72 235.00 4.91) (187.84 7 287.35 235.00) (3.83) 235.12) 93.57 2 15.71 5 159.

The Home Depot Chile Store: Cost of Equity in Pesos
 

Cost of Equity for a U.S. store = 9.78% Estimating the Country Risk Premium for Chile
• Default spread based on Chilean Bond rating = 1.1% • Relative Volatility of Chilean Equity to Bond Market = 2.2 • Country risk premium for Chile = 1.1% * 2.2 = 2.42%

Cost of Equity for a Chilean Store (in U.S. $) = 5% + 0.87 (5.5% + 2.42%) = 11.88%  Assume that the expected inflation rate in Chile is 8% and the expected inflation rate in the U.S. is 2%.  Cost of Equity for a Chilean Store (in Pesos) = [(1 + Cost of Equity in $)* (1 + inflationChile)/ (1 + inflationUS)] - 1 =[ 1.1188* (1.08/1.02)] -1 = 18.46%

Aswath Damodaran 84

NPV in Pesos
Year 0 1 2 3 4 5 6 7 8 9 10 FCFE in pesos (millions)PV at Peso Cost of Equit y -3,525.00 -3,525.00 20.57 17.36 35.72 25.46 52.70 31.70 71.71 36.41 93.00 39.86 116.84 42.28 143.55 43.84 173.45 44.72 206.94 45.04 4,784.08 878.90 -2,319
85

Aswath Damodaran

Converting Pesos to U.S. dollars
 

This entire analysis can be done in dollars, if we convert the peso cash flows into U.S. dollars. If you want the analysis to yield consistent conclusions, expected exchange rates have to be estimated based upon expected inflation rates:
• Current Exchange Rate = 470 pesos • Expected Ratet = Exchange Rate* (1 + inflationChile)/ (1 + inflationUS)] • Expected Exchange Rate in year 1 = 470 pesos * (1.08/1.02) = 497.65

Aswath Damodaran

86

612 $ 26 3.16 83 2.48 78 6.28 70 1. Dollars Ye ar FCFE in p eso s (mil l io ns) 0 -352 5 1 21 2 36 3 53 4 72 5 93 6 11 7 7 14 4 8 17 3 9 20 7 10 47 84 Expecte d Exchan ge Rate 47 0.92 55 7.235 $ 5.7 97 $ 94 .500 .23 74 2.4 57 $ 12 1.92 59 0.0 00) $ 41 .65 52 6.306 Aswath Damodaran 87 .3 27 $ 67 .40 FCFE in $ $ (7.707 $ 23 3.Analyzing the Project: U.00 49 7.48 66 2.686 $ 17 6.73 62 5.428 $ 20 4.74 7.391 $ 14 8.S.

4 57 $ 12 1.3 27 $ 67 .0 00) $ 36 .74 7.500 .9 49 $ 93 .NPV in U.1 48 $ 95 .686 $ 17 6.8 26 $ 1.391 $ 14 8. Dollars Ye ar 0 1 2 3 4 5 6 7 8 9 10 FCFE in $ $ (7.612 $ 26 3.4 71 $ 84 .4 45 $ 77 .8 12 $ 89 .87 0.306 NPV (i n U.S .9 38 $ 54 . $) In Pesos PV at $ cost o f eq ui ty $ (7.707 $ 23 3.235 $ 5.934 .008 $ (4.9 60) -231 9 Aswath Damodaran 88 .428 $ 20 4.S.0 00) $ 41 .1 61 $ 67 .2 82 $ 95 .500 .7 97 $ 94 .

Dealing with Inflation In our analysis. Would the NPV have been different if we had used real cash flows instead of nominal cash flows? It would be much lower. we used nominal dollars and pesos. since real cash flows are lower than nominal cash flows It would be much higher It should be unaffected     Aswath Damodaran 89 .

78% • Expected Inflation rate = 2% • Real Cost of Equity = (1.From Nominal to Real : The Home Depot  To do a real analysis.59%  To estimate cash flows in real terms • Real Cash flowt = Nominal Cash flowt / (1+ Expected Inflation rate)t Aswath Damodaran 90 .02)-1 = 7.0978/1. you need a real cost of equity or capital • Nominal cost of equity for The Home Depot = 9.

2 67.000 ) ($18.Nominal versus Real Year 0 1 2 3 4 5 6 7 8 9 10 NPV FCFE (n omin al) PV (nominal) Deflat io n ($18.200 .0 56.95 4 $2 .3 76.299 2.94 15 $2 .86 87 $3 .49 7 $3 .0 00) 2.6 00.90 44 $3 .23 4 $3 .48 5 $2 .60 3 $1 7.35 3.25 0.8 49.1 13.29 9 $3 .96 6.96 3 $ 0.92 27 $3 .8 88 $6 .0 10.2 82.07 7 $2 .81 7 $1 .1 02.57 4.98 01 $2 .1 62.2 50.7 16 $ $ (18.081 .9 66.20 0.00 00 ($18.4 73.5 74.31 5 $2 .83 45 $3 .1 91.7 18.30 9 $2 .71 8.8 80.09 8 $ 0.9 66.9 31.21 9 fact or FCFE (Real) PV (Real) 1.79 7.157 1.003 2.20 0.88 0.90 0 $ 0.970 .7 78.331 2.33 1 $3 .15 7 $4 .219 Aswath Damodaran 91 .88 64 $3 .42 9 $ 0.796 1.24 2 $ 0.01 0.85 14 $3 .46 1.497 1.000 ) $2 .72 0 $ 0.0 15.603 6.79 6 $3 .4 30.83 0 $ 0.9 66.1 51.02 5 $ 0.96 06 $2 .000 ) $ 0.00 3 $3 .7 97.39 7 $ 0.24 9 $1 .4 61.315 2.98 4 $8 .96 6 $1 .15 1.81 79 $1 3.984 8.23 2 $2 .8 26.3 53.05 6.20 0.234 2.08 3 $2 .7 69.

The returns on a project should incorporate these costs and benefits.Side Costs and Benefits Most projects considered by any business create side costs and benefits for that business.     Aswath Damodaran 92 . The side costs include the costs created by the use of resources that the business already owns (opportunity costs) and lost revenues for other projects that the firm may have. The benefits that may not be captured in the traditional capital budgeting analysis include project synergies (where cash flow benefits may accrue to other projects) and options embedded in projects (including the options to delay. expand or abandon a project).

  Aswath Damodaran 93 . When a resource that is already owned by a firm is being considered for use in a project. which may be • a sale of the asset. in which case the opportunity cost is the cost of replacing it. this resource has to be priced on its next best alternative use. in which case the opportunity cost is the expected present value of the after-tax rental or lease revenues. in which case the opportunity cost is the expected proceeds from the sale.Opportunity Cost An opportunity cost arises when a project uses a resource that may already have been paid for by the firm. net of any capital gains taxes • renting or leasing the asset out. • use elsewhere in the business.

In assessing the Boeing Super Jumbo. which is $ 100 million Other:      Aswath Damodaran 94 . The land currently can be sold for $ 100 million.Case 1: Opportunity Costs Assume that Boeing owns the land that will be used to build the plant for the Super Jumbo Jet already. This land is undeveloped and was acquired several years ago for $40 million. which of the following would you do: Ignore the cost of the land. though that would create a capital gain (which will be taxed at 20%). which is $ 40 million Use the market value of the land. since Boeing owns its already Use the book value of the land.

The project analyst argues that there is no cost associated with using these facilities. assume that the firm will use its existing storage facilities. to hold inventory associated with the Super Jumbo.Case 2: Excess Capacity In the Boeing example. since they have been paid for already and cannot be sold or leased to a competitor (and thus has no competing current use). Do you agree? Yes No    Aswath Damodaran 95 . which have excess capacity.

CM per unit = $4/unit Basic Framework • If I do not take this product.000.000 (50% of Capacity). 50% Excess Capacity. what will I do? – cut back on production: cost is PV of after-tax cash flows from lost sales – buy new capacity: cost is difference in PVbetween earlier & later investment Aswath Damodaran 96       .000 units Current Usage = 50.000 Cost of Capital = 12% Current product sales growing at 10% a year. CM per unit = $5/unit Book Value = $1.Estimating the Cost of Excess Capacity Existing Capacity = 100.500.000 Cost of a building new capacity = $1. when will I run out of capacity • When I run out of capacity. Sales growth at 5% a year. when will I run out of capacity? • If I take thisproject. New Product will use 30% of Capacity.

73% 36.67% $38.00% $0 86.81% $75.115 109.32% 46.595 151.50% $ 206.58% 97.286 82.44% $ 257.47% 38.28% $5.50% $0 93.000 164.21% 80.18% 117.58% $0 101.500.65% $158.000/1.50% 66.54% Old + New Lost ATCF 80.124 139.500.29% 40.054 74.21% 44.127 52.50% 33.251 21.53% 88.000/1.08% 34.Opportunity Cost of Excess Capacity Year 1 2 3 4 5 6 7 8 9 10 Old 50.760 PV(LOST SALES)= PV(ATCF) $ $ $ $ $ $ $ $ 3.734  PV (Building Capacity In Year 3 Instead Of Year 8) = 1.78% $115.992 336.55% 73.90% New 30.20% 42.681 118.949 38.128 = $ 461.846  Opportunity Cost of Excess Capacity = $ 336.00% 60.256 128.076 64.44% 107.00% 55.734 Aswath Damodaran 97 .00% 31.123 1.

Aswath Damodaran 98 . This is referred to as cannibalization. some of the revenues may come from existing investments of the firm. Examples would be: • A New Starbucks that is opening four blocks away from an existing Starbucks • A personal computer manufacturer like Apple or Dell introducing a new and more powerful PC  The key question to ask in this case is • What will happen if we do not make this new investment? – If the sales on existing products would have been lost anyway (to competitors). there is no incremental effect and the lost sales should not be considered. the cannibalization is a real cost. – If the sales on existing products would remain intact.Product and Project Cannibalization  When a firm makes a new investment.

In doing the analysis of the store.e.Product and Project Cannibalization: A Real Cost? Assume that in the Home Depot Store analysis. would you  Look at only incremental revenues (i. 20% of the revenues at the store are expected to come from people who would have gone to a existing store nearby. 80% of the total revenue)  Look at total revenues at the park  Choose an intermediate number Would your answer be different if you were analyzing whether introducing the Boeing Super Jumbo would cost you sales on the Boeing 747?  Yes  No Aswath Damodaran 99 .

these benefits have to be valued and shown in the initial project analysis.Project Synergies A project may provide benefits for other projects within the firm. when it considers opening a new restaurant at one of its stores. If this is the case.   Aswath Damodaran 100 . the Home Depot. For instance. will have to examine the additional revenues that may accrue to this store from people who come to the restaurant.

they will destroy value. bonds) – Corporate bonds – Equities of other companies  The investment principle continues to apply to these investments. • Marketable securities. If not.Other Investments  Firms often make investments in • Short term assets. such as inventory and accounts receivable. If they make a return that exceeds the hurdle rate (given their riskiness). they will create value. Aswath Damodaran 101 . such as – Government securities (Treasury Bills.

they cannot be viewed as a wasting asset. • We eliminate debt from current liabilities because we consider debt to be part of our financing and include it in our cost of capital calculations. Thus. We modify that definition to make it the difference between non-cash current assets and non-debt current liabilities and call it non-cash working capital. Aswath Damodaran 102 . • We eliminate cash from current assets because large cash balances today earn a fair market return.I. Investments in Non-Cash Working Capital   The difference between current assets and current liabilities is often titled working capital by accountants.

076 Current Assets Current Liabilities Working Capital Non-cash Current Assets Inventory Accounts Receivable Non-cash Current Liabilities Accounts Payables Other Current Liabilities Non-cash Working Capital $8.349 $5.564 $10.857 $2.820 $1.953 The Home Depot $4.Distinguishing between Working Capital and Non-cash Working Capital Boeing $16.733 $1.586 $1.360 $4.257 $1.422 $2.293 $469 $1.933 $2.375 $13.919 Aswath Damodaran 103 .

because the cash flows to a firm are also after non-cash working capital cash flows. Aswath Damodaran 104 .Why investments in non-cash working capital matter. while any decreases can be viewed as a cash inflow. This affects • The analysis of investments. any increases in non-cash working capital can be viewed as a cash outflow. Thus. • Firm value.   Any investment in non-cash working capital can be viewed as cash that does not earn a return. because the incremental cash flows on a project are after non-cash working capital cash flows..

we assume that the entire working capital investment is salvaged.32%. At the end of the 25th year. The cost of capital for the project is 9.The Effect of Non-cash working capital on a Project: Boeing Super Jumbo    Boeing is assumed to invest 10% of its revenues in non-cash working capital at the beginning of each year on the Super Jumbo project. Aswath Damodaran 105 .

619 $33.000 $25.671 ($110) $3.895 $686 $3.075 ($92) $3.306 ($99) $3.138 $28.669 $32.747 $31.461 ($104) $3.575) $2.000) $1.982 $29.167 ($95) $3.209 ($96) $3.070 $36.009) ($45) ($43) ($40) ($38) ($36) ($34) ($32) ($30) ($28) ($26) ($25) ($24) ($22) ($21) $115 ($15) ($14) ($13) ($12) $3.262 ($98) $3.851 $30.606 $35.898 ($87) $2.507 ($105) $3.701) Aswath Damodaran 106 .814 ($84) $2.652 ($80) $2.049 $35.612 Salv age Value Present Value $0 $0 $0 $0 ($700) ($1.598 $34.000 ($1.612 $389 ($1.405 ($102) $3.985 ($90) $3.Present Value Effect of Working Capital Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Rev enues $0 $0 $0 $0 $0 $10.094 $33.360 ($101) $3.781 ($113) $3.713 $37.523 $27.644 $36.057 $34.732 ($82) $2.575 ($77) $2.949 $32.122 Working Capital Inv estment in Working Capital $0 $0 $0 $0 $0 $0 $0 $0 $0 ($1.750 $26.564 ($107) $3.318 $28.815 $38.

NPV of Boeing Super Jumbo and Working Capital as % of Revenues Aswath Damodaran 107 .

reduce the value of the firm. but • Potentially decrease revenues. because of lost sales. they • Increase their cash flows. When firms reduce their investments in non-cash working capital (hold less inventory. and other things remaining equal. cash flows and expected growth. they might also make themselves riskier firms. grant less credit or use more supplier credit). Aswath Damodaran 108 .Firm Value and Working Capital Investments   Investments in working capital drain cash flows.

its operating profits after taxes are expected to grow 3% a year forever and the firm will have a cost of capital of 12. If the firm maintains no working capital. at a decreasing rate.Working Capital and Value: A Simple Example    A mail-order retail firm has current revenues of $ 1 billion and operating profits after taxes of $ 100 million. and the cost of capital will decrease by . Aswath Damodaran 109 .05% for every 10% increase in working capital as a percent of revenues. As the working capital increases as a percent of revenues. the expected growth in operating profits will increase.50%.

59% 12.08% 12.77 $ 1.25% 60% 5.00% 12.78 $ 1.83% 12.93% 12.06 $ 1.23 Aswath Damodaran 110 .50% 10% 4.10% 90% 5.45% 12.132.15% 80% 5.72% 12.208.084.201.87 $ 768.86 $ 1.077.174.30% 50% 5.00% 12.45% 20% 4.013.20% 70% 5.21 $ 1.05% 100% 5.73 $ 857.36 $ 1.43 $ 1.40% 30% 4.29 $ 939.183.50% 12.00% Value of Firm $ 1.83% 12.Firm Value Schedule as a function of Working Capital Working Capital Expected Growth Cost of Capital as a % of Revenues in Operating Income 0% 3.28% 12.35% 40% 5.

The Trade Off on Elements of Working Capital Effect of Increasing Element Positive Aspects Negative Aspects Fewer lost sales *Storage Costs Lower re-ordering costs *Cash tied up in inventory More Revenues *Bad Debts (Default) *Cash tied up in receivables *Increased credit risk *Implicit Cost (if there is a discount for prompt payment) Element Inventory Accounts Receivable Accounts Payable Used to finance inventory & accounts receivable Aswath Damodaran 111 .

the optimal level of inventory can be estimated simply by trading off the two costs. Aswath Damodaran 112 .Managing Inventory   Economic Order Quantity Models: For firms with a homogeneous products and clearly defined ordering and storage costs. Peer Group Analysis: Firms can compare their inventory holdings to those of comparable firms in the sector to see if they are holding too much in inventory.

Inventory Trade Off   For firms with a single product that knows what the demand for its product is with certainty. Aswath Damodaran 113 . the optimal level of inventory can be estimated by trading off the carrying costs against the ordering costs. the inventory will have to be augmented by a safety inventory that will cover excess demand. The optimal amount that the firm should order can be written as: Economic Order Quantity = 2 * Annual Demand in Units * Ordering Cos t per Order Carrying Cost per Unit  If there is uncertainty about future demand.

Delivery Lag = .000 1000 = 155 cars  Safety Inventory: Assuming that the firm wants to ensure.000. is $1. that it does not run out of inventory. is 1200 cars. and monthly sales are normally distributed with a mean of 100 cars and a standard deviation of 15 cars.000.5(100) = 50 cars Safety Inventory = Delivery Lag + Uncertainty = 50 + 30 = 80 cars Aswath Damodaran 114 . in units.A Simple Example  A new car dealer reports the following:  The annual expected sales.  The Economic order quantity for this firm can be estimated as follows: Economic Order Quantity = 2 * 1200 * 10. there is some uncertainty associated with this forecast. on an annualized basis. • The carrying cost per car.5(Monthly Sales) = . with 99% probability.  The cost per order is $ 10. and it takes 15 days for new cars to be delivered by the manufacturer. the safety inventory would have to be increased by 30 cars (which is twice the standard deviation).

Inventory in an EOQ Model Aswath Damodaran 115 .

59 5.56% 43.66 7.72% 24.14 5.93% 35. Westburne Inc.46% 14.91% 21.54 9.76 6.09 4.72% 70.27% 18. Home Depot HomeBase Inc. Wolohan Lumber Average Aswath Damodaran Inventory/Sales 10.30% 116 .05 s: Operating Earnings 35.50% 39.65% ln(Revenues) 6.50% 19.76% 14.74% 17. National Home Centers Waxman Industries.24% 16.41% 24.93% 112.09 7. Inc.02 4.14% 24.57% 25.22 5.82% 52.90% 33.68% 43. Hughes Supply Lowe's Cos.76% 25.Peer Group Analysis Company Name Building Materials Catalina Lighting Cont'l Materials Corp Eagle Hardware Emco Limited Fastenal Co.15% 36.59 6.43% 16.88% 16.96% 14.79% 9.99 10.88 7.15% 45.91% 12.58% 20.30 7.

0082 (10. 117 Aswath Damodaran . We regressed inventory as a percent of sales against firm size (measured as ln(Revenues)) and risk (measured using standard deviation in operating earnings) for this sector: Inventory/Sales = 0.09) + .65%.1283 (.1283 (Standard Deviation) (0.91% is slightly lower than this predicted value.51)  Plugging in the values of each of these variables for the Home Depot yields a predicted inventory/sales ratio: Inventory/SalesHome Depot = 0.0082 ln(Revenues) + 0.87) (1.11) (2.Analyzing The Home Depot’s Inventory   Inventory at the Home Depot is 14.1697  The actual inventory/sales ratio of 14. However.91% of sales. which would lead us to expect a lower inventory holding at the firm. while the average for the sector is slightly higher at 16.2415) = 0.056 + .056 +. The Home Depot is larger and less risky than the average firm in the sector.

Aswath Damodaran 118 .Managing Accounts Receivable   Cash Flow Analysis: Compare the present value of the cash flows (from higher sales) that will be generated from easier credit to the present value of the costs (higher bad debts. more cash tied up in accounts receivable) Peer Group Analysis: Compare the accounts receivable as a percent of revenues at a firm to the same ratio at other firms in the business.

with the pre-tax operating margin remaining at 20% on these incremental sales. In the current year. The computerized system will be depreciated straight line over 10 years.Cash Flow Analysis: A Simple Example  Stereo City. If Stereo City offers 30-day credit to its customers. it had revenues of $10 million and pre-tax operating income of $ 2 million.  The store expects to charge an annualized interest rate of 12% on these credit sales. along with an initial investment in a computerized credit-tracking system of $100. it is expected that 95% of the accounts receivable will be collected (and salvaged)  The store is expected to face a cost of capital of 10%.  The bad debts (including the collection costs and net of any repossessions) are expected to be 5% of the credit sales. at the end of that period.  The store is expected to be in business for 10 years. it expects these changes to occur:  Sales are expected to increase by $ 1 million each year. has historically not extended credit to its customers and has accepted only cash payments.000. an electronics retailer. Aswath Damodaran 119 .  The cost of administration associated with credit sales is expected to be $25.000 a year.  The tax rate is 40%.

The Cash Flows: Investment in System

The initial investment needed to generate the credit consists of two outlays.
• The first is the cost of the computerized system needed for the credit sales, which is $100,000. • The second is the investment of $ 1 million in accounts receivable created as a consequence of the credit sales.

Aswath Damodaran

120

Incremental After-tax Cash Flows
Incremental Revenues $ 1,000,000 Incremental Pre-tax Operating Income (20%) $ 200,000 + Interest Income from Credit $ 114,000 - Bad Debts $ 50,000 - Annual Administrative Costs $ 25,000 Incremental Pre-tax Operating Profit $ 239,000 - Taxes (at 40%) $ 95,600 Incremental After-tax Operating Profit $ 143,400 + Tax Benefit from Depreciation $ 4,000 [$10,000 * 0.4] Incremental After-tax Cash Flow $ 147,400

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121

NPV of Credit Decision

The salvage value comes from the collection of outstanding accounts receivable at the end of the store’s life, which amounts to 95% of $1 million. We can find the present value of the credit decision, using the cost of capital of 10%:
NPV of Credit Decision = - 1,100,000 + $147,400 (PV of Annuity, 10 years, 10%) + $950,000/1.1010 = $171,975

Aswath Damodaran

122

Investments In Marketable Securities  Firms often invest in marketable securities. These marketable securities can range from short-term government securities (with no default or price risk) to equity in other firms (which can have substantial risk) Risky Riskless Treasuries Commercial Paper Corporate Bonds Equity in Publicly Traded firms Equity in Private Businesses Aswath Damodaran 123 .

Aswath Damodaran 124 .Investments in Riskless Securities   Investments in riskless securities will generally earn much lower returns than investments in risky projects. These low returns notwithstanding. investments in riskless securities are value neutral because the required return (hurdle rate) for these projects is the riskless rate.

these investments are value neutral.Investments in Risky Securities   Risky securities can range from securities with default risk (corporate bonds) to securities with equity risk (equity in other companies) The investment principle continues to apply. Aswath Damodaran 125 . investments in marketable securities can create value (have positive net present value) • If securities are over valued. • If securities are fairly priced. investments in marketable securities are value destroying. • If securities are under priced. If the expected return on these investments is equal to the required return. investments in the marketable securities are value neutral.

Aswath Damodaran 126 . • The second of these options is taking one project may allow us to take advantage of other opportunities (projects) in the future • The last option that is embedded in projects is the option to abandon a project.Project Options One of the limitations of traditional investment analysis is that it is static and does not do a good job of capturing the options embedded in investment. until a later date. • The first of these options is the option to delay taking a project.   These options all add value to projects and may make a “bad” project (from traditional analysis) into a good one. if the cash flows do not measure up. when a firm has exclusive rights to it.

   Aswath Damodaran 127 .The Option to Delay When a firm has exclusive rights to a project or product for a specific period. the fact that a project does not pass muster today (because its NPV is negative. A traditional investment analysis just answers the question of whether the project is a “good” one if taken today. or its IRR is less than its hurdle rate) does not mean that the rights to this project are not valuable. it can delay taking this project or product until a later date. Thus.

Valuing the Option to Delay a Project PV of Cash Flows from Project Initial Investment in Project Present Value of Expected Cash Flows on Product Project has negative NPV in this section Project's NPV turns positive in this section Aswath Damodaran 128 .

   Aswath Damodaran 129 . for instance) has to be weighed off against these benefits.Insights for Investment Analyses Having the exclusive rights to a product or project is valuable.R&D. The cost of acquiring these rights (by buying them or spending money on development . The value of these rights increases with the volatility of the underlying business. even if the product or project is not viable today.

These are the options that firms often call “strategic options” and use as a rationale for taking on “negative NPV” or even “negative return” projects. it may be a project worth taking if the option it provides the firm (to take other projects in the future) provides a more-than-compensating value.    Aswath Damodaran 130 . even though a project may have a negative NPV. Thus.The Option to Expand/Take Other Projects Taking a project today may allow a firm to consider and take other valuable projects in the future.

The Option to Expand PV of Cash Flows from Expansion Additional Investment to Expand Present Value of Expected Cash Flows on Expansion Firm will not expand in this section Expansion becomes attractive in this section Aswath Damodaran 131 .

  Aswath Damodaran 132 . The cost of expansion will be 200 million FF. Assume. The store will cost 100 million French Francs (FF) to build. that by opening this store. and there is considerable uncertainty about this estimate.An Example of an Expansion Option Assume that The Home Depot is considering opening a small store in France. The variance in the estimate is 0. and the present value of the expected cash flows from the store is 120 million FF. the Home Depot will acquire the option to expand its operations any time over the next 5 years. and it will be undertaken only if the present value of the expected cash flows from expansion exceeds 200 million FF.08. however. Thje store has a negative NPV of 20 million FF. At the moment. The Home Depot still does not know much about the market for home improvement products in France. this present value is believed to be only 150 million FF.

3833)= 37.Valuing the Expansion Option Value of the Underlying Asset (S) = PV of Cash Flows from Expansion.08  Time to expiration = Period for which expansion option applies = 5 years Call Value= 150 (0. if done now =150 million FF  Strike Price (K) =Cost of Expansion = 200 million FF  Variance in Underlying Asset’s Value = 0.06)(20) (0.91 million FF  Aswath Damodaran 133 .6314) -200 (exp(-0.

91 mil FF Accept the project    Aswath Damodaran 134 .91 million FF NPV of store with option to expand = -20 million + 37.Considering the Project with Expansion Option NPV of Store = 80 million FF .100 million FF = -20 million Value of Option to Expand = 37.91 million = 17.

The Option to Abandon A firm may sometimes have the option to abandon a project. If abandoning the project allows the firm to save itself from further losses. if the cash flows do not measure up to expectations. PV of Cash Flows from Project   Cost of Abandonment Present Value of Expected Cash Flows on Project Aswath Damodaran 135 . this option can make a project more valuable.

To illustrate the effect of the option to abandon.Valuing the Option to Abandon Assume that the Home Depot is considering a new store that requires a net initial investment of $ 9. The net present value of -$937. assume that the Home Depot has the option to close the store any time over the next 10 years and sell the land back to the original owner for $ 5 million.   Aswath Damodaran 136 . assume that the standard deviation in the present value of the cash flows is 22%.5 million and generates cash flows with a present value of $8. In addition.287 would lead us to reject this project.563 million.

562.713 Strike Price (K) = Salvage Value from Abandonment = $ 5 million Variance in Underlying Asset’s Value = 0.       Aswath Damodaran 137 .10 (We are assuming that the project’s present value will drop by roughly 1/n each year into the project) The riskless rate is 5%.222 = 0.Project with Option to Abandon Value of the Underlying Asset (S) = PV of Cash Flows from Project = $ 8.0484 Time to expiration = Life of the Project = 10 years Dividend Yield = 1/Life of the Project = 1/10 = 0.

831  The value of this abandonment option has to be added to the net present value of the project of -$ 937. NPV without abandonment option = -$937.000 exp(-0.05)(10) (1-0.10)(10) (1-0.Should The Home Depot take this project? Value of Put = 5. Aswath Damodaran 138 .831 NPV with abandonment option = -$462.287.287 Value of abandonment option = +$474.713 exp(0.456  Notwithstanding the abandonment option. this store should not be opened.562.-8.4977) . yielding a total net present value that remains negative.000.7548) = $ 474.

• The form of returns .will depend upon the stockholders’ characteristics.First Principles  Invest in projects that yield a return greater than the minimum acceptable hurdle rate.dividends and stock buybacks .   Choose a financing mix that minimizes the hurdle rate and matches the assets being financed. Aswath Damodaran 139 . return the cash to stockholders. If there are not enough investments that earn the hurdle rate.owners’ funds (equity) or borrowed money (debt) • Returns on projects should be measured based on cash flows generated and the timing of these cash flows. they should also consider both positive and negative side effects of these projects. • The hurdle rate should be higher for riskier projects and reflect the financing mix used .

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