invanal - Aswath Damodaran The Investment Principle Aswath...

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Unformatted text preview: Aswath Damodaran The Investment Principle Aswath Damodaran Stern School of Business Aswath Damodaran 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. ■ 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. Aswath Damodaran What is a investment or a project? ■ Any decision that requires the use of resources (financial or otherwise) is a project. ■ Broad strategic decisions • Entering new areas of business • Entering new markets • Acquiring other companies ■ Tactical decisions ■ Management decisions • The product mix to carry • The level of inventory and credit terms ■ Decisions on delivering a needed service • Lease or buy a distribution system • Creating and delivering a management information system Aswath Damodaran 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. The Return Mantra: “Time-weighted, Incremental Cash Flow Return” Aswath Damodaran Steps in Investment Analysis ■ Estimate a hurdle rate for the project, based upon the riskiness of the investment ■ Estimate revenues and accounting earnings on the investment. • Measure the accounting return to see if the investment measures up to the hurdle rate. ■ Convert accounting earnings into cash flows • Use the cash flows to evaluate whether the investment is a good investment. ■ Time weight the cash flows • Use the time-weighted cash flows to evaluate whether the investment is a good investment. ■ Consider all side-costs and side-benefits when analyzing project. Aswath Damodaran I. Estimating Discount Rates Aswath Damodaran The Essence of Discount Rates: The notion of a benchmark ■ Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable....
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This note was uploaded on 12/01/2011 for the course FINANCE 350 taught by Professor Aswath during the Summer '10 term at NYU.

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invanal - Aswath Damodaran The Investment Principle Aswath...

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