Unformatted text preview: Aswath Damodaran 0 Ca’ Foscari University of Venice MSc on Economics and Finance Advanced Corporate Finance Lecture 13/14 – Ch06 MEASURING INVESTMENT RETURNS II. INVESTMENT INTERACTIONS, OPTIONS AND REMORSE… Life is too short for regrets, right? First Principles 1 Aswath Damodaran 1 Independent investments are the excepSon… 2 In all of the examples we have used so far, the investments that we have analyzed have stood alone. Thus, our job was a simple one. Assess the expected cash ﬂows on the investment and discount them at the right discount rate. ! In the real world, most investments are not independent. Taking an investment can oYen mean rejecSng another investment at one extreme (mutually exclusive) to being locked in to take an investment in the future (pre-‐requisite). ! More generally, accepSng an investment can create side costs for a ﬁrm’s exisSng investments in some cases and beneﬁts for others. ! Aswath Damodaran 2 I. Mutually Exclusive Investments 3 ! ! We have looked at how best to assess a stand-‐alone investment and concluded that a good investment will have posiSve NPV and generate accounSng returns (ROC and ROE) and IRR that exceed your costs (capital and equity). In some cases, though, ﬁrms may have to choose between investments because They are mutually exclusive: Taking one investment makes the other one redundant because they both serve the same purpose ! The ﬁrm has limited capital and cannot take every good investment (i.e., investments with posiSve NPV or high IRR). ! ! Using the two standard discounted cash ﬂow measures, NPV and IRR, can yield diﬀerent choices when choosing between investments. Aswath Damodaran 3 Comparing Projects with the same (or similar) lives.. 4 ! When comparing and choosing between investments with the same lives, we can ! Compute the accounSng returns (ROC, ROE) of the investments and pick the one with the higher returns ! Compute the NPV of the investments and pick the one with the higher NPV ! Compute the IRR of the investments and pick the one with the higher IRR ! While it is easy to see why accounSng return measures can give diﬀerent rankings (and choices) than the discounted cash ﬂow approaches, you would expect NPV and IRR to yield consistent results since they are both Sme-‐weighted, incremental cash ﬂow return measures. Aswath Damodaran 4 Case 1: IRR versus NPV 5 ! Consider two projects with the following cash ows: Year Project 1 – CFs Project 2 – CFs 0 -‐1000 -‐1000 1 800 200 2 1000 300 3 1300 400 4 -‐2200 500 Aswath Damodaran 5 Project’s NPV Proﬁle 6 Aswath Damodaran 6 What do we do now? 7 Project 1 has two internal rates of return. The ﬁrst is 6.60%, whereas the second is 36.55%. Project 2 has one internal rate of return, about 12.8%. ! Why are there two internal rates of return on project 1? ! ! If your cost of capital is 12%, which investment would you accept? a.
b. ! Project 1 Project 2 Explain. Aswath Damodaran 7 Case 2: NPV versus IRR 8 Project A
$ 350,000 Cash Flow Investment $ 450,000 $ 600,000 $ 750,000 $ 1,000,000
NPV = $467,937
Project B Cash Flow Investment $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000 $ 10,000,000
NPV = $1,358,664
IRR=20.88% Aswath Damodaran 8 Which one would you pick? 9 ! Assume that you can pick only one of these two projects. Your choice will clearly vary depending upon whether you look at NPV or IRR. You have enough money currently on hand to take either. Which one would you pick? a. Project A. It gives me the bigger bang for the buck and more margin for error. b. Project B. It creates more dollar value in my business. ! If you pick A, what would your biggest concern be? ! If you pick B, what would your biggest concern be? Aswath Damodaran 9 Capital RaSoning, Uncertainty and Choosing a Rule 10 ! If a business has limited access to capital, has a stream of surplus value projects and faces more uncertainty in its project cash ﬂows, it is much more likely to use IRR as its decision rule. ! Small, high-‐growth companies and private businesses are much more likely to use IRR. If a business has substanSal funds on hand, access to capital, limited surplus value projects, and more certainty on its project cash ﬂows, it is much more likely to use NPV as its decision rule. ! As ﬁrms go public and grow, they are much more likely to gain from using NPV. ! Aswath Damodaran 10 The sources of capital raSoning… 11 Aswath Damodaran 11 Problems with Scale: Proﬁtability Index An AlternaSve to IRR with Capital RaSoning 12 The problem with the NPV rule, when there is capital raSoning, is that it is a dollar value. It measures success in absolute terms. ! The NPV can be converted into a relaSve measure by dividing by the iniSal investment. This is called the proﬁtability index. ! ! Proﬁtability Index (PI) = NPV/IniSal Investment ! In the example described, the PI of the two projects would have been: ! PI of Project A = $467,937/1,000,000 = 46.79% ! PI of Project B = $1,358,664/10,000,000 = 13.59% ! Project A would have scored higher. Aswath Damodaran 12 Reinvestment rate assumpSons Case 3: NPV versus IRR 13 Project A
$ 5,000,000 $ 4,000,000 Cash Flow Investment $ 3,200,000 $ 3,000,000 $ 10,000,000
NPV = $1,191,712
Project B Cash Flow Investment $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000 $ 10,000,000
NPV = $1,358,664
IRR=20.88% Aswath Damodaran 13 Why the diﬀerence? 14 ! ! These projects are of the same scale. Both the NPV and IRR use Sme-‐weighted cash ﬂows. Yet, the rankings are diﬀerent. Why? Which one would you pick? a.
b. Project A. It gives me the bigger bang for the buck and more margin for error. Project B. It creates more dollar value in my business. Aswath Damodaran 14 NPV, IRR and the Reinvestment Rate AssumpSon 15 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. Implicit is the assumpSon that the ﬁrm has an inﬁnite stream of projects yielding similar IRRs. ! Conclusion: When the IRR is high (the project is crea8ng signiﬁcant surplus value) and the project life is long, the IRR will overstate the true return on the project. ! Aswath Damodaran 15 SoluSon to Reinvestment Rate Problem 16 Aswath Damodaran 16 Why NPV and IRR may diﬀer.. Even if projects have the same lives 17 A project can have only one NPV, whereas it can have more than one IRR. ! The NPV is a dollar surplus value, whereas the IRR is a percentage measure of return. The NPV is therefore likely to be larger for “large scale” projects, while the IRR is higher for “small-‐scale” projects. ! 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, while the IRR assumes that intermediate cash ﬂows get reinvested at the “IRR”. ! Aswath Damodaran 17 Comparing projects with diﬀerent lives.. 18 Project A
$400 $400 -$1000 $400 $400 $400 NPV of Project A = $ 442
IRR of Project A = 28.7%
$350 $350 -$1500 $350 $350 $350 $350 $350 $350 $350 $350 NPV of Project B = $ 478
IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12% Aswath Damodaran 18 Why NPVs cannot be compared.. When projects have diﬀerent lives.
19 ! The net present values of mutually exclusive projects with diﬀerent lives cannot be compared, since there is a bias towards longer-‐life projects. To compare the NPV, we have to ! replicate the projects Sll they have the same life (or) ! convert the net present values into annuiSes ! The IRR is unaﬀected by project life. We can choose the project with the higher IRR. Aswath Damodaran 19 SoluSon 1: Project ReplicaSon 20 Project A: Replicated
$400 $400 $400 $400 -$1000 $400 $400 $400 $400 $400 $400 $350 $350 -$1000 (Replication)
NPV of Project A replicated = $ 693
$350 $350 $350 $350 $350 $350 $350 $350 -$1500
NPV of Project B= $ 478 Aswath Damodaran 20 SoluSon 2: Equivalent AnnuiSes 21 ! Equivalent Annuity for 5-‐year project ! = $442 * PV(A,12%,5 years) ! = $ 122.62 ! Equivalent Annuity for 10-‐year project ! = $478 * PV(A,12%,10 years) ! = $ 84.60 Aswath Damodaran 21 What would you choose as your investment tool? 22 ! Given the advantages/disadvantages outlined for each of the diﬀerent decision rules, which one would you choose to adopt? a.
e. ! Return on Investment (ROE, ROC) Payback or Discounted Payback Net Present Value Internal Rate of Return Proﬁtability Index Do you think your choice has been aﬀected by the events of the last quarter of 2008? If so, why? If not, why not? Aswath Damodaran 22 What ﬁrms actually use .. 23 Decision Rule % of Firms using as primary decision rule in 1976 IRR 53.6% 49.0% 42.0% 1986 1998 AccounSng Return 25.0% 8.0% NPV 9.8% 21.0% 34.0% Payback Period 8.9% 19.0% 14.0% Proﬁtability Index 2.7% 3.0% Aswath Damodaran 7.0% 3.0% 23 II. Side Costs and Beneﬁts 24 ! Most projects considered by any business create side costs and beneﬁts for that business. ! 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 tradiSonal capital budgeSng analysis include project synergies (where cash ﬂow beneﬁts may accrue to other projects) and opSons embedded in projects (including the opSons to delay, expand or abandon a project). ! The returns on a project should incorporate these costs and beneﬁts. (cf. Week 2 – FCFF computaSon) Aswath Damodaran 24 A. Opportunity Cost 25 An opportunity cost arises when a project uses a resource that may already have been paid for by the ﬁrm. ! When a resource that is already owned by a ﬁrm is being considered for use in a project, this resource has to be priced on its next best alternaSve use, which may be ! ! a sale of the asset, in which case the opportunity cost is the expected proceeds from the sale, net of any capital gains taxes ! renSng or leasing the asset out, in which case the opportunity cost is the expected present value of the aYer-‐tax rental or lease revenues. ! use elsewhere in the business, in which case the opportunity cost is the cost of replacing it. Aswath Damodaran 25 Examples.. 26 Foregone Sale ! Incremental Cost ! Excess Capacity ! Product and Project CannibalizaSon ! Project Synergies ! Aswath Damodaran 26 Example: Synergy in a merger.. 27
! ! We valued Harman InternaSonal for an acquisiSon by Tata Motors and esSmated a value of $ 2,476 million for the operaSng assets and $ 2,678 million for the equity in the ﬁrm, concluding that it would not be a value-‐
creaSng acquisiSon at its current market capitalizaSon of $5,248 million. In esSmaSng this value, though, we treated Harman InternaSonal as a stand-‐alone ﬁrm. Assume that Tata Motors foresees potenSal synergies in the combinaSon of the two ﬁrms, primarily from using its using Harman’s high-‐end audio technology (speakers, tuners) as opSonal upgrades for customers buying new Tata Motors cars in India. To value this synergy, let us assume the following: ! It will take Tata Motors approximately 3 years to adapt Harman’s products to Tata Motors cars. ! Tata Motors will be able to generate Rs 10 billion in aYer-‐tax operaSng income in year 4 from selling Harman audio upgrades to its Indian customers, growing at a rate of 4% a year aYer that in perpetuity (but only in India). Aswath Damodaran 27 EsSmaSng the cost of capital to use in valuing synergy.. 28 ! ! ! Business risk: The perceived synergies ﬂow from opSonal add-‐ons in auto sales. We will begin with the levered beta of 1.10, that we esSmated for Tata Motors in chapter 4, in esSmaSng the cost of equity. Geographic risk: The second is that the synergies are expected to come from India; consequently, we will add the country risk premium of 3.60% for India, esSmated in chapter 4 (for Tata Motors) to the mature market premium of 5.5%. Debt raSo: Finally, we will assume that the expansion will be enSrely in India, with Tata Motors maintain its exisSng debt to capital raSo of 29.28% and its current rupee cost of debt of 9.6% and its marginal tax rate of 32.45%. !
! Cost of equity in Rupees = 6.57% + 1.10 (5.5%+3.60%) = 16.59% Cost of debt in Rupees = 9.6% (1-‐.3245) = 6.50% Cost of capital in Rupees = 16.59% (1-‐.2928) + 6.50% (.2928) = 13.63% Aswath Damodaran 28 EsSmaSng the value of synergy… and what Tata can pay for Harman 29 ! !
! Value of synergyYear 3 = Value of synergy today = ConverSng the synergy value into dollar terms at the prevailing exchange rate of Rs 60/$, we can esSmate a dollar value for the synergy from the potenSal acquisiSon: ! ! Adding this value to the intrinsic value of $2,678 million that we esSmated for Harman’s equity in chapter 5, we get a total value for the equity of $3,857 million. ! ! Value of synergy in US $ = Rs 70,753/60 = $ 1,179 million Value of Harman = $2,664 million + $1,179 million = $3,843 million Since Harman’s equity trades at $5,248 million, the acquisiSon sSll does not make sense, even with the synergy incorporated into value. Aswath Damodaran 29 III. Project OpSons 30 ! One of the limitaSons of tradiSonal investment analysis is that it is staSc and does not do a good job of capturing the opSons embedded in investment. ! The ﬁrst of these opSons is the opSon to delay taking a project, when a ﬁrm has exclusive rights to it, unSl a later date. ! The second of these opSons is taking one project may allow us to take advantage of other opportuniSes (projects) in the future ! The last opSon that is embedded in projects is the opSon to abandon a project, if the cash ﬂows do not measure up. ! These opSons all add value to projects and may make a “bad” project (from tradiSonal analysis) into a good one. Aswath Damodaran 30 The OpSon to Delay 31
! When a ﬁrm has exclusive rights to a project or product for a speciﬁc period, it can delay taking this project or product unSl a later date. A tradiSonal investment analysis just answers the quesSon of whether the project is a “good” one if taken today. The rights to a “bad” project can sSll have value. PV of Cash Flows Initial Investment in
Project NPV is positive in this section
Present Value of Expected
Cash Flows on Product Aswath Damodaran 31 Insights for Investment Analyses 32 Having the exclusive rights to a product or project is valuable, even if the product or project is not viable today. ! The value of these rights increases with the volaSlity of the underlying business. ! The cost of acquiring these rights (by buying them or spending money on development -‐ R&D, for instance) has to be weighed oﬀ against these beneﬁts. ! Aswath Damodaran 32 An example: A PharmaceuScal patent Assume that a pharmaceuScal company has been approached by an entrepreneur who has patented a new drug to treat ulcers. The entrepreneur has obtained FDA approval and has the patent rights for the next 17 years. ! While the drug shows promise, it is sSll very expensive to manufacture and has a relaSvely small market. Assume that the iniSal investment to produce the drug is $ 500 million and the present value of the cash ﬂows from introducing the drug now is only $ 350 million. ! The technology and the market is volaSle, and the annualized standard deviaSon in the present value, esSmated from a simulaSon is 25%. ! 33 Valuing the Patent Inputs to the opSon pricing model (Black and Scholes) ! ! Value of the Underlying Asset (S) = PV of Cash Flows from Project if introduced now = $ 350 million ! Strike Price (K) = IniSal Investment needed to introduce the product = $ 500 million Variance in Underlying Asset’s Value = (0.25)2 = 0.0625 ! Time to expiraSon = Life of the patent = 17 years ! ! ! Dividend Yield = 1/Life of the patent = 1/17 = 5.88% (Every year you delay, you lose 1 year of protecSon) Assume that the 17-‐year riskless rate is 4%. The value of the opSon can be esSmated as follows: Call Value= 350 exp(-‐0.0588)(17) (0.5285) -‐500 (exp(-‐0.04)(17) (0.1219)= $ 37.12 million ! 34 The OpSon to Expand/Take Other Projects 35
! Taking a project today may allow a ﬁrm to consider and take other valuable projects in the future. Thus, even though a project may have a negaSve NPV, it may be a project worth taking if the opSon it provides the ﬁrm (to take other projects in the future) has a more-‐than-‐compensaSng value. PV of Cash Flows
from Expansion Additional Investment
to Expand Cash Flows on Expansion
Firm will not expand in
this section Aswath Damodaran Expansion becomes
attractive in this section 35 The OpSon to Abandon 36
! ! A ﬁrm may someSmes have the opSon to abandon a project, if the cash ﬂows do not measure up to expectaSons. If abandoning the project allows the ﬁrm to save itself from further losses, this opSon can make a project more valuable. PV of Cash Flows
from Project Cost of Abandonment
Present Value of Expected
Cash Flows on Project Aswath Damodaran 36 IV. Assessing ExisSng or Past investments… 37 While much of our discussion has been focused on analyzing new investments, the techniques and principles enunciated apply just as strongly to exisSng investments. ! With exisSng investments, we can try to address one of two quesSons: ! ! Post –mortem: We can look back at exisSng investments and see if they have created value for the ﬁrm. ! What next? We can also use the tools of investment analysis to see whether we should keep, expand or abandon exisSng investments. Aswath Damodaran 37 Analyzing an ExisSng Investment 38 In a post-mortem, you look at the actual cash
flows, relative to forecasts. Aswath Damodaran You can also reassess your expected cash
flows, based upon what you have learned,
and decide whether you should expand,
continue or divest (abandon) an investment 38 a. Post Mortem Analysis 39 ! The actual cash ﬂows from an investment can be greater than or less than originally forecast for a number of reasons but all these reasons can be categorized into two groups: Chance: The nature of risk is that actual outcomes can be diﬀerent from expectaSons. Even when forecasts are based upon the best of informaSon, they will invariably be wrong in hindsight because of unexpected shiYs in both macro (inﬂaSon, interest rates, economic growth) and micro (compeStors, company) variables. ! Bias: If the original forecasts were biased, the actual numbers will be diﬀerent from expectaSons. The evidence on capital budgeSng is that managers tend to be over-‐opSmisSc about cash ﬂows and the bias is worse with over-‐
conﬁdent managers. ! ! While it is impossible to tell on an individual project whether chance or bias is to blame, there is a way to tell across projects and across Sme. If chance is the culprit, there should be symmetry in the errors – actuals should be about as likely to beat forecasts as they are to come under forecasts. If bias is the reason, the errors will tend to be in one direcSon. Aswath Damodaran 39 b. What should we do next? 40 ........ Liquidate the project ........ Terminate the project ........ Divest the project ........ ConSnue the project Aswath Damodaran 40 Example: Disney California Adventure –
The 2008 judgment call 41
! ! ! Disney opened the Disney California Adventure (DCA) Park in 2001, at a cost of $1.5 billion, with a mix of roller coaster rides and movie nostalgia. Disney expected about 60% of its visitors to Disneyland to come across to DCA and generate about $ 100 million in annual aYer-‐cash ﬂows for the ﬁrm. By 2008, DCA had not performed up to expectaSons. Of the 15 million people who came to Disneyland in 2007, only 6 million visited California Adventure, and the cash ﬂow averaged out to only $ 50 million between 2001 and 2007. In early 2008, Disney faced three choices: ! Shut down California Adventure and try to re...
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