Aswath Damodaran 0

MEASURING RETURN ON INVESTMENT

“Show me the money”

from Jerry Maguire
 First Principles
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Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash to
rate fund your operations owners of your business

The hurdle rate The return should How much How you choose
should reflect the The optimal The right kind
reflect the cash you can to return cash to
riskiness of the mix of debt and of debt
magnitude and the return depends the owners will
investment and equity matches the
timing of the upon current & depend on
the mix of debt maximizes firm tenor of your
cashflows as welll potential whether they
and equity used to value assets
as all side effects. investment prefer dividends
fund it. opportunities or buybacks

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 What is a Project?
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 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.

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 Setting the table: What is an investment/
project?
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 An investment/project can range the spectrum from big to

small, money making to cost saving:
🞑 Major strategic decisions to enter new areas of business or new
markets.
🞑 Acquisitions of other firms are projects as well, notwithstanding
attempts to create separate sets of rules for them.
🞑 Decisions on new ventures within existing businesses or
markets.
🞑 Decisions that may change the way existing ventures and
projects are run.
🞑 Decisions on how best to deliver a service that is necessary for the
business to run smoothly.
 Put in broader terms, every choice made by a firm can be
framed as an investment.
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 Measures of return: earnings versus cash flows
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 Principles Governing Accounting Earnings Measurement

🞑 Accrual Accounting: Show revenues when products and services are
sold or provided, not when they are paid for. Show expenses associated
with these revenues rather than cash expenses.
🞑 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)
 To get from accounting earnings to cash flows:
🞑 you have to add back non-­‐cash expenses (like depreciation)
🞑 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).

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 Measuring Returns Right: The Basic Principles
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 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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 Here are four examples…
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 Rio Disney: We will consider whether Disney should invest in its first
theme parks in South America. These parks, while similar to those that
Disney has in other parts of the world, will require us to consider the
effects of country risk and currency issues in project analysis.
 New iron ore mine for Vale: This is an iron ore mine that Vale is
considering in Western Labrador, Canada.
 An Online Store for Bookscape: Bookscape is evaluating whether it should
create an online store to sell books. While it is an extension of their basis
business, it will require different investments (and potentially expose
them to different types of risk).
 Acquisition of Harman by Tata Motors: A cross-­‐border bid by Tata for
Harman International, a publicly traded US firm that manufactures high-­‐
end audio equipment, with the intent of upgrading the audio upgrades on
Tata Motors’ automobiles. This investment will allow us to examine
currency and risk issues in such a transaction.

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 Earnings versus Cash Flows: A Disney Theme
Park
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 The theme parks to be built near Rio, modeled on

Euro Disney in Paris and Disney World in
Orlando.
 The complex will include a “Magic Kingdom” to be

constructed, beginning immediately, and becoming

operational at the beginning of the second year, and
a second theme park modeled on Epcot Center at
Orlando to be constructed in the second and third
year and becoming operational at the beginning of
the fourth year.
 The earnings and cash flows are estimated in

nominal
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U.S. Dollars.
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 Key Assumptions on Start Up and Construction
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 Disney has already spent $0.5 Billion researching the proposal and
getting the necessary licenses for the park; none of this investment
can be recovered if the park is not built. This expenditure has been
capitalized and will be depreciated straight line over ten years to a
salvage value of zero.
 Disney will face substantial construction costs, if it chooses to build
the theme parks.
🞑 The cost of constructing Magic Kingdom will be $3 billion, with $ 2 billion
to be spent right now, and $1 Billion to be spent one year from now.
🞑 The cost of constructing Epcot II will be $ 1.5 billion, with $ 1 billion to be
spent at the end of the second year and $0.5 billion at the end of the third
year.
🞑 These investments will be depreciated based upon a depreciation
schedule in the tax code, where depreciation will be different each year.

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 Key Revenue Assumptions
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Revenue estimates for the parks and resort properties (in millions)
Year Magic Kingdom Epcot II Resort Properties Total
1 $0 $0 $0 $0
2 $1,000 $0 $250 $1,250
3 $1,400 $0 $350 $1.750
4 $1,700 $300 $500 $2.500
5 $2,000 $500 $625 $3.125
6 $2,200 $550 $688 $3,438
7 $2,420 $605 $756 $3,781
8 $2,662 $666 $832 $4,159
9 $2,928 $732 $915 $4,575
10 $2,987 $747 $933 $4,667


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 Key Expense Assumptions
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 The operating expenses are assumed to be 60% of

the revenues at the parks, and 75% of revenues
at the resort properties.
 Disney will also allocate corporate general and

administrative costs to this project, based upon

revenues; the G&A allocation will be 15% of the
revenues each year. It is worth noting that a
recent analysis of these expenses found that only
one-­‐third of these expenses are variable (and a
function of total revenue) and that two-­‐thirds are
fixed.
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 Depreciation and Capital Maintenance
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 The capital maintenance expenditures are low in the

early years, when the parks are still new but increase as
the parks age.

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 Other Assumptions
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 Disney will have to maintain non-­‐cash working

capital (primarily consisting of inventory at the
theme parks and the resort properties, netted
against accounts payable) of 5% of revenues, with
the investments being made at the end of each year.
 The income from the investment will be taxed at
Disney’s marginal tax rate of 38%.

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 Laying the groundwork:
Book Capital, Working Capital and Depreciation
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12.5% of book
value at end
of prior year
($3,000)

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 Step 1: Estimate Accounting Earnings on Project
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 And the Accounting View of Return
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(a)Based upon book capital at the start of each year

(b)Based upon average book capital over the year
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What should this return be compared to?

 The computed return on capital on this investment

is about 4.18%. To make a judgment on whether this
is a sufficient return, we need to compare this return
to a “hurdle rate”. Which of the following is the
right hurdle rate? Why or why not?
a. The riskfree rate of 2.75% (T. Bond rate)
b. The cost of equity for Disney as a company (8.52%)
c. The cost of equity for Disney theme parks (7.09%)
d. The cost of capital for Disney as a company (7.81%)
e. The cost of capital for Disney theme parks (6.61%)
f. None of the above
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 Should there be a risk premium for foreign
projects?
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 The exchange rate risk should 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.
🞑 For Disney, this risk should not affect the cost of capital used.
Consequently, we would not adjust the cost of capital for Disney’s
investments in other mature markets (Germany, UK, France)
 The same diversification argument can also be applied against
some political risk, which would mean that it too should not affect
the discount rate. However, there are aspects of political risk
especially in emerging markets that will be difficult to diversify and
may affect the cash flows, by reducing the expected life or cash
flows on the project.
 For Disney, this is the risk that we are incorporating into the cost of
capital when it invests in Brazil (or any other emerging market)

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Should there be a risk premium for foreign
projects?
 The exchange rate risk should 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.
🞑 For Disney, this risk should not affect the cost of capital used.
Consequently, we would not adjust the cost of capital for Disney’s
investments in other mature markets (Germany, UK, France)
 The same diversification argument can also be applied against
some political risk, which would mean that it too should not affect
the discount rate. However, there are aspects of political risk
especially in emerging markets that will be difficult to diversify and
may affect the cash flows, by reducing the expected life or cash
flows on the project.
 For Disney, this is the risk that we are incorporating into the cost of
capital when it invests in Brazil (or any other emerging market)

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Estimating a hurdle rate for Rio Disney
 We did estimate a cost of capital of 6.61% for the Disney theme park
business, using a bottom-­‐up levered beta of 0.7537 for the
business.
 This cost of equity may not adequately reflect the additional risk
associated with the theme park being in an emerging market.
 The only concern we would have with using this cost of equity for this
project is that it may not adequately reflect the additional risk associated
with the theme park being in an emerging market (Brazil). We first
computed the Brazil country risk premium (by multiplying the default
spread for Brazil by the relative equity market volatility) and then re-­‐
estimated the cost of equity:
🞑 Country risk premium for Brazil = 5.5%+ 3% = 8.5%
🞑 Cost of Equity in US$= 2.75% + 0.7537 (8.5%) = 9.16%
 Using this estimate of the cost of equity, Disney’s theme park debt ratio
of 10.24% and its after-­‐tax cost of debt of 2.40% (see chapter 4), we can
estimate the cost of capital for the project:
🞑 Cost of Capital in US$ = 9.16% (0.8976) + 2.40% (0.1024) = 8.46%
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Would lead us to conclude that...

 Do not invest in this park. The return on capital of

4.18% is lower than the cost of capital for theme
parks of 8.46%; This would suggest that the project
should not be taken.
 Given that we have computed the average over an
arbitrary period of 10 years, while the theme park
itself would have a life greater than 10 years, would
you feel comfortable with this conclusion?
🞑 Yes
🞑 No

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A Tangent: From New to Existing
Investments: ROC for the entire firm
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
How “good” are the Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
existing capital) assets

investments of the Expected Value that will be Growth Assets Equity Residual Claim on cash flows
firm? created by future investments Significant Role in management
Perpetual Lives

Measuring ROC for existing investments..

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Old wine in a new bottle.. Another way of
presenting the same results…
 The key to value is earning excess returns. Over time, there have been
attempts to restate this obvious fact in new and different ways. For
instance, Economic Value Added (EVA) developed a wide following in the
the 1990s:
 EVA = (ROC – Cost of Capital ) (Book Value of Capital Invested)
 The excess returns for the four firms can be restated as follows:

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 Return Spreads Globally….
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ROIC versus Cost of Capital: A Global Assessment for 2013

80.00%

70.00%

60.00%
% of firms in the group

50.00% ROC more than 5% below cost of capital

ROC between 2% and 5% below cost of capital

40.00% ROC between 2% and 0% below cost of capital

ROC between 0 and 2% more than cost of capital

30.00%
ROC between 2% and 5% above cost of capital
20.00% ROC more than 5% above cost of capital

10.00%

0.00%
Australia, Europe Emerging Japan US Global
NZ & Markets
Canada

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

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 The cash flow view of this project..
0 1 2 3 4 5 6 7 8 9 10
After-tax Operating Income -­‐$32 -­‐$96 -­‐$54 $68 $202 $249 $299 $352 $410 $421
+ Depreciation & Amortization $0 $50 $425 $469 $444 $372 $367 $364 $364 $366 $368
- Capital Expenditures $2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
- Change in non-cash Work Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashflow to firm ($2,500) ($982) ($921) ($361) $198 $285 $314 $332 $367 $407 $434

To get from income to cash flow, we

I. added back all non-cash charges such as depreciation. Tax
benefits:
II. subtracted out the capital expenditures
III. subtracted out the change in non-cash working capital

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 The Depreciation Tax Benefit
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 While depreciation reduces taxable income and taxes, it does not reduce the
cash flows.
 The benefit of depreciation is therefore the tax benefit. In general, the tax
benefit from depreciation can be written as:
 Tax Benefit = Depreciation * Tax Rate
 Disney Theme Park: Depreciation tax savings (Tax rate = 36.1%)
1 2 3 4 5 6 7 8 9 10
Depreciation $50 $425 $469 $444 $372 $367 $364$364 $366 $368
Tax Bendfits from Depreciation $18 $153 $169 $160 $134 $132 $132$132 $132 $133
 Proposition 1: The tax benefit from depreciation and other non-­‐cash
charges is greater, the higher your tax rate.
 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.

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 Depreciation Methods
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 Broadly categorizing, depreciation methods can be classified as

straight line or accelerated methods. In straight line depreciation,
the capital expense is spread evenly over time, In accelerated
depreciation, the capital expense is depreciated more in earlier
years and less in later years. Assume that you made a large
investment this year, and that you are choosing between straight
line and accelerated depreciation methods. 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

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 The Capital Expenditures Effect
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 Capital expenditures are not treated as accounting expenses but

they do cause cash outflows.
 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.
 Both initial and maintenance capital expenditures reduce
cash flows
 The need for maintenance capital expenditures will increase with
the life of the project. In other words, a 25-­‐year project will
require more maintenance capital expenditures than a 2-­‐ year
project.

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 To cap ex or not to cap ex?
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 Assume that you run your own software business, and

that you have an expense this year of $ 100 million from
producing and distribution promotional CDs in software
magazines. Your accountant tells you that you can
expense this item or capitalize and depreciate it over
three years. 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

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 The Working Capital Effect
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 Intuitively, money invested in inventory or in accounts receivable cannot be

used elsewhere. It, thus, represents a drain on cash flows
 To the degree that some of these investments can be financed using
supplier credit (accounts payable), the cash flow drain is reduced.
 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, working capital investments need to be salvaged at the
end of the project life.
 Proposition 1: The failure to consider working capital in a capital budgeting
project will overstate cash flows on that project and make it look more
attractive than it really is.
 Proposition 2: Other things held equal, a reduction in working capital
requirements will increase the cash flows on all projects for a firm.

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 The incremental cash flows on the project

$ 500 million has

already been spent & $
50 million in 2/3rd of allocated G&A is
depreciation will exist fixed. Add back this amount (1-
anyway t)
Tax rate = 36.1%

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 A more direct way of getting to
incremental cash flows
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0 1 2 3 4 5 6 7 8 9 10
Revenues $0 $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,159 $4,575 $4,667
Direct Expenses $0 $788 $1,103 $1,575 $1,969 $2,166 $2,382 $2,620 $2,882 $2,940
Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
Incremental G&A $0 $63 $88 $125 $156 $172 $189 $208 $229 $233
Incremental Operating Income $0 $25 $141 $406 $678 $783 $896 $1,017 $1,148 $1,175
- Taxes $0 $9 $51 $147 $245 $283 $323 $367 $415 $424
Incremental after-tax Operating income $0 $16 $90 $260 $433 $500 $572 $650 $734 $751
+ Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
- Capital Expenditures $2,000 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
- Change in non-cash Working Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashflow to firm ($2,000) ($1,000) ($859) ($267) $340 $466 $516 $555 $615 $681 $715

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 Sunk Costs
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 What is a sunk cost? Any expenditure that has already

been incurred, and cannot be recovered (even if a
project is rejected) is called a sunk cost. A test market for
a consumer product and R&D expenses for a drug (for a
pharmaceutical company) would be good examples.
 The sunk cost rule: When analyzing a project, sunk costs
should not be considered since they are not incremental.
 A Behavioral Aside: It is a well established finding in
psychological and behavioral research that managers
find it almost impossible to ignore sunk costs.

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 Test Marketing and R&D: The Quandary of Sunk
Costs
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 A consumer product company has spent $ 100 million on

test marketing. Looking at only the incremental cash
flows (and ignoring the test marketing), the project looks
like it will create $25 million in value for the company.
Should it take the investment?
🞑 Yes
🞑 No
 Now assume that every investment that this company
has shares the same characteristics (Sunk costs > Value
Added). The firm will clearly not be able to survive. What
is the solution to this problem?

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 Allocated Costs
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 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, as is earnings)
 For large firms, these allocated costs can be
significant and result in the rejection of projects
 To the degree that these costs are not incremental (and
would exist anyway), this makes the firm worse off.
Thus, it is only the incremental component of allocated
costs that should show up in project analysis.

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 Breaking out G&A Costs into fixed and variable
components: A simple example
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 Assume that you have a time series of revenues and

G&A costs for a company.

🞑 What percentage of the G&A cost is variable?

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 To Time-­‐Weighted Cash Flows
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 Incremental cash flows in the earlier years are worth

more than incremental cash flows in later years.
 In fact, cash flows across time cannot be added up.
They have to be brought to the same point in time
before aggregation.
 This process of moving cash flows through time is
🞑 discounting, when future cash flows are brought to the
present
🞑 compounding, when present cash flows are taken to the
future
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 Present Value Mechanics
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 Cash Flow Type Discounting Formula Compounding Formula

1. Simple CF CFn / (1+r)n CF0 (1+r)n
 1
2. Annuity
1-
A  (1+r)n   (1 + r) n -
A
 r


 r  1
 
 
 
3. Growing Annuity (1+g)n 
A(1+g) 1 - (1+r)n 
 r-g 

 
 
4. Perpetuity A/r
5. Growing Perpetuity Expected Cashflow next year/(r-­‐g)

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 Discounted cash flow measures of return
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 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).
🞑 NPV= Sum of the present values of all cash flows on the project,
including the initial investment, with the cash flows being
discounted at the appropriate hurdle rate (cost of capital, if cash
flow is cash flow to the firm, and cost of equity, 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. It is the percentage rate of return, based
upon incremental time-­‐weighted cash flows.
🞑 Decision Rule: Accept if IRR > hurdle rate

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Closure on Cash Flows
 In a project with a finite and short life, you would need to compute a
salvage value, which is the expected proceeds from selling all of the
investment in the project at the end of the project life. It is usually set
equal to book value of fixed assets and working capital
 In a project with an infinite or very long life, 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..
 Assuming the project lasts forever, and that cash flows after year 10
grow 2% (the inflation rate) forever, the present value at the end of
year 10 of cash flows after that can be written as:
🞑 Terminal Value in year 10= CF in year 11/(Cost of Capital -­‐ Growth Rate)
=715 (1.02) /(.0846-­‐.02) = $ 11,275 million

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Which yields a NPV of..

Discounted at Rio Disney cost

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of capital of 8.46% 40
Which makes the argument that..

 The project should be accepted. The positive net

present value suggests that the project will add
value to the firm, and earn a return in excess of the
cost of capital.
 By taking the project, Disney will increase its value
as a firm by $3,296 million.

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The IRR of this project

$5,000.00

$4,000.00

$3,000.00

$2,000.00
Internal Rate of Return=12.60%
NPV

$1,000.00

$0.00
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27%
28% 29% 30%

-$1,000.00

-$2,000.00

-$3,000.00
Discount Rate

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The IRR suggests..
 The project is a good one. Using time-­‐weighted, incremental cash
flows, this project provides a return of 12.60%. This is greater than
the cost of capital of 8.46%.
 The IRR and the NPV will yield similar results most of the time,
though there are differences between the two approaches that
may cause project rankings to vary depending upon the approach
used. They can yield different results, especially why comparing
across projects because
🞑 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”.

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 Bringing in growth
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 We will assume that Harman International is a mature firm, growing

2.75% in perpetuity.
 We assume that revenues, operating income, capital expenditures and
depreciation will all grow 2.75% for the year and that the non-­‐cash
working capital remain 13.54% of revenues in future periods.

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 Value of Harman International: Before Synergy
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 Earlier, we estimated the cost of capital of 9.67% as the right discount rate to apply in
valuing Harman International and the cash flow to the firm of $166.85 million for 2014 (next
year), assuming a 2.75% growth rate in revenues, operating income, depreciation, capital
expenditures and total non-­‐cash working capital. We also assumed that these cash flows
would continue to grow 2.75% a year in perpetuity.

 Adding the cash balance of the firm ($515 million) and subtracting out the existing debt
($313 million, including the debt value of leases) yields the value of equity in the firm:
 Value of Equity = Value of Operating Assets + Cash – Debt
= $2,476 + $ 515 -­‐ $313 million = $2,678 million
 The market value of equity in Harman in November 2013 was $5,428 million.
 To the extent that Tata Motors pays the market price, it will have to generate benefits from
synergy that exceed $2750 million.

Aswath Damodaran
75
 First Principles
76

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

Invest in assets that earn a Find the right kind of debt If you cannot find investments
return greater than the for your firm and the right that make your minimum
minimum acceptable hurdle mix of debt and equity to acceptable rate, return the cash to
rate fund your operations owners of your business

The hurdle rate The return should How much How you choose
should reflect the The optimal The right kind
reflect the cash you can to return cash to
riskiness of the mix of debt and of debt
magnitude and the return depends the owners will
investment and equity matches the
timing of the upon current & depend on
the mix of debt maximizes firm tenor of your
cashflows as welll potential whether they
and equity used to value assets
as all side effects. investment prefer dividends
fund it. opportunities or buybacks

Aswath Damodaran
76