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ch5thru8 - 1 CHAPTER 5 MEASURING RETURN ON INVESTMENTS In...

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5.1 1 CHAPTER 5 MEASURING RETURN ON INVESTMENTS In Chapter 4, we developed a process for estimating costs of equity, debt, and capital and presented an argument that the cost of capital is the minimum acceptable hurdle rate when considering new investments. We also argued that an investment has to earn a return greater than this hurdle rate to create value for the owners of a business. In this chapter, we turn to the question of how best to measure the return on a project. In doing so, we will attempt to answer the following questions: What is a project? In particular, how general is the definition of an investment and what are the different types of investment decisions that firms have to make? In measuring the return on a project, should we look at the cash flows generated by the project or at the accounting earnings? If the returns on a project are unevenly spread over time, how do we consider (or should we not consider) differences in returns across time? We will illustrate the basics of investment analysis using four hypothetical projects: an online book ordering service for Bookscape, a new theme park in Brazil for Disney, a plant to manufacture linerboard for Aracruz Celulose and an acquisition of a US company by Tata Chemicals. What Is a Project? Investment analysis concerns which projects a company should accept and which it should reject; accordingly, the question of what makes up a project is central to this and the following chapters. The conventional project analyzed in capital budgeting has three criteria: (1) a large up-front cost, (2) cash flows for a specific time period, and (3) a salvage value at the end, which captures the value of the assets of the project when the project ends. Although such projects undoubtedly form a significant proportion of investment decisions, especially for manufacturing firms, it would be a mistake to assume that investment analysis stops there. If a project is defined more broadly to include any decision that results in using the Salvage Value : The estimated liquidation value of the assets invested in the projects at the end of the project life.
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5.2 2 scarce resources of a business, then everything from strategic decisions and acquisitions to decisions about which air conditioning system to use in a building would fall within its reach. Defined broadly then, any of the following decisions would qualify as projects: 1. Major strategic decisions to enter new areas of business (such as Disney’s foray into real estate or Deutsche Bank’s into investment banking) or new markets (such as Disney television’s expansion into Latin America). 2. Acquisitions of other firms are projects as well, notwithstanding attempts to create separate sets of rules for them.
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