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invanal - The Investment Principle Aswath Damodaran Stern...

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Aswath Damodaran The Investment Principle Aswath Damodaran Stern School of Business
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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.
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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
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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”
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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.
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Aswath Damodaran I. Estimating Discount Rates
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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. This hurdle will be higher for riskier projects than for safer projects.
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