Aswath Damodaran 0

MEASURING RETURN ON INVESTMENT

“Show me the money”

from Jerry Maguire
 First Principles
1

Maximize the value of the business (firm)

The Investment Decision The Financing Decision The Dividend Decision

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

The hurdle rate The return How much How you

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

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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- 
(1+r)n 
 (1 + r) n -
A 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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Does the currency matter?

 The analysis was done in dollars. Would the

conclusions have been any different if we had done
the analysis in Brazilian Reais?
a. Yes
b. No

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 The ‘‘Consistency Rule” for Cash Flows
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 The cash flows on a project and the discount rate

used should be defined in the same terms.
🞑 If cash flows are in dollars ($R), the discount rate has to be
a dollar ($R) discount rate
🞑 If the cash flows are nominal (real), the discount rate has
to be nominal (real).
 If consistency is maintained, the project conclusions
should be identical, no matter what cash flows are
used.

Aswath Damodaran
45
 Disney Theme Park: Project Analysis in $R
46

 The inflation rates were assumed to be 9% in Brazil and 2% in the

United States. The $R/dollar rate at the time of the analysis was
2.35 $R/dollar.
 The expected exchange rate was derived assuming purchasing
power parity.
🞑 Expected Exchange Ratet = Exchange Rate today * (1.09/1.02)t
 The expected growth rate after year 10 is still expected to be the
inflation rate, but it is the 9% $R inflation rate.
 The cost of capital in $R was derived from the cost of capital in
dollars and the differences in inflation rates:
$R Cost of Capital = (1 US $ Cost of Capital)
(1 Exp InflationBrazil )
1
(1 Exp InflationUS )

= (1.0846) (1.09/1.02) – 1 = 15.91%

Aswath Damodaran
46
Disney Theme Park: $R NPV
Expected Exchange Ratet Discount at $R cost of capital
= Exchange Rate today * (1.09/1.02)t = (1.0846) (1.09/1.02) – 1 = 15.91%

NPV = R$ 7,745/2.35= $ 3,296 Million

Aswath Damodaran
NPV is equal to NPV in dollar terms 47
 Uncertainty in Project Analysis: What can we
do?
48

 Based on our expected cash flows and the estimated cost of capital, the
proposed theme park looks like a very good investment for Disney. Which
of the following may affect your assessment of value?
🞑 Revenues may be over estimated (crowds may be smaller and spend less)
🞑 Actual costs may be higher than estimated costs
🞑 Tax rates may go up
🞑 Interest rates may rise
🞑 Risk premiums and default spreads may increase
🞑 All of the above
 How would you respond to this uncertainty?
🞑 Will wait for the uncertainty to be resolved
🞑 Will not take the investment
🞑 Ask someone else (consultant, boss, colleague) to make the decision
🞑 Ignore it.
🞑 Other

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48
 One simplistic solution: See how quickly
you can get your money back…
 If your biggest fear is losing the billions that you invested in the project,
one simple measure that you can compute is the number of years it will
take you to get your money back.
Year Cash Flow Cumulated CF PV of Cash Flow Cumulated DCF
0 -$2,000 -$2,000 -$2,000 -$2,000
1 -$1,000 -$3,000 -$922 -$2,922
2 -$859 -$3,859 -$730 -$3,652
3 -$267 -$4,126 -$210 -$3,862
4 $340 -$3,786 $246 -$3,616
5 $466 -$3,320 $311 -$3,305
6 $516 -$2,803 $317 -$2,988
7 $555 -$2,248 $314 -$2,674
8 $615 -$1,633 $321 -$2,353
9 $681 -$952 $328 -$2,025
Payback = 10.3 years 10 $715 -$237 $317 -$1,708
11 $729 $491 $298 -$1,409
12 $743 $1,235 $280 -$1,129
13 $758 $1,993 $264 -$865
14 $773 $2,766 $248 -$617 Discounted Payback
15 $789 $3,555 $233 -$384 = 16.8 years
16 $805 $4,360 $219 -$165
Aswath Damodaran 17 $821 $5,181 $206 $41
49
A slightly more sophisticated approach:
Sensitivity Analysis & What-­if
‐ Questions…
 The NPV, IRR and accounting returns for an investment will change
as we change the values that we use for different variables.
 One way of analyzing uncertainty is to check to see how sensitive
the decision measure (NPV, IRR..) is to changes in key assumptions.
While this has become easier and easier to do over time, there are
caveats that we would offer.
 Caveat 1: When analyzing the effects of changing a variable, we
often hold all else constant. In the real world, variables move
together.
 Caveat 2: The objective in sensitivity analysis is that we make
better decisions, not churn out more tables and numbers.
🞑 Corollary 1: Less is more. Not everything is worth varying…
🞑 Corollary 2: A picture is worth a thousand numbers (and tables).

Aswath Damodaran
50
And here is a really good picture…

Aswath Damodaran
51
The final step up: Incorporate probabilistic
estimates.. Rather than expected values..
Actual Revenues as % of Forecasted Revenues (Base case = 100%)

Country Risk Premium (Base Case = 3%

(Brazil))

Operating Expenses at Parks as % of

Revenues (Base Case = 60%)

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52
The resulting simulation…
Average = $3.40 billion
Median = $3.28 billion

NPV ranges from -$1 billion to +$8.5 billion. NPV is negative 12% of the
time.

Aswath Damodaran
53
 You are the decision maker…
54

 Assume that you are the person at Disney who is given

the results of the simulation. The average and median
NPV are close to your base case values of $3.29 billion.
However, there is a 10% probability that the project
could have a negative NPV and that the NPV could be a
large negative value? How would you use this
information?
🞑I would accept the investment and print the results of this
simulation and file them away to show that I exercised due
diligence.
🞑 I would reject the investment, because it is too risky (there is a
10% chance that it could be a bad project)
🞑 Other

Aswath Damodaran
54
 Equity Analysis: The Parallels
55

 The investment analysis can be done entirely in equity

terms, as well. The returns, cashflows and hurdle rates
will all be defined from the perspective of equity
investors.
 If using accounting returns,
Return will be Return on Equity (ROE) = Net Income/BV of
🞑
Equity
🞑 ROE has to be greater than cost of equity
 If using discounted cashflow models,
Cashflows will be cashflows after debt payments to equity
🞑
investors
🞑 Hurdle rate will be cost of equity

Aswath Damodaran
55
 A Vale Iron Ore Mine in Canada Investment
Operating Assumptions
56

1. The mine will require an initial investment of $1.25 billion and is expected to have a production
capacity of 8 million tons of iron ore, once established. The initial investment of $1.25 billion will
be depreciated over ten years, using double declining balance depreciation, down to a salvage
value of $250 million at the end of ten years.
2. The mine will start production midway through the next year, producing 4 million tons of iron
ore for year 1, with production increasing to 6 million tons in year 2 and leveling off at 8 million
tons thereafter (until year 10). The price, in US dollars per ton of iron ore is currently $100 and is
expected to keep pace with inflation for the life of the plant.
3. The variable cost of production, including labor, material and operating expenses, is expected to
be $45/ton of iron ore produced and there is a fixed cost of $125 million in year 1. Both costs,
which will grow at the inflation rate of 2% thereafter. The costs will be in Canadian dollars, but
the expected values are converted into US dollars, assuming that the current parity between the
currencies (1 Canadian $ = 1 US dollar) will continue, since interest and inflation rates are similar
in the two currencies.
4. The working capital requirements are estimated to be 20% of total revenues, and the
investments have to be made at the beginning of each year. At the end of the tenth year, it is
anticipated that the entire working capital will be salvaged.
5. Vale’s corporate tax rate of 34% will apply to this project as well.

Aswath Damodaran
56
 Financing Assumptions
57

Vale plans to borrow $0.5 billion at its current cost of debt of 4.05% (based
upon its rating of A-­),
‐ using a ten-­year
‐ term loan (where the loan will be paid
off in equal annual increments). The breakdown of the payments each year
into interest and principal are provided below:

Aswath Damodaran
57
 The Hurdle Rate
58

 The analysis is done US dollar terms and to equity

investors. Thus, the hurdle rate has to be a US $ cost
of equity.
 In the earlier section, we estimated costs of equity,
debt and capital in US dollars and $R for Vale’s iron
ore business.
Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
Business equity debt ratio US$) $R)
Metals &
Mining 11.35% 2.67% 35.48% 8.27% 15.70%
Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%

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58
 Net Income: Vale Iron Ore Mine
59

1 2 3 4 5 6 7 8 9 10
Production (millions of tons) 4.00 6.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
* Price per ton 102 104.04 106.12 108.24 110.41 112.62 114.87 117.17 119.51 121.9
= Revenues (millions US$) $408.00 $624.24 $848.97 $865.95 $883.26 $900.93 $918.95 $937.33 $956.07 $975.20
- Variable Costs $180.00 $275.40 $374.54 $382.03 $389.68 $397.47 $405.42 $413.53 $421.80 $430.23
- Fixed Costs $125.00 $127.50 $130.05 $132.65 $135.30 $138.01 $140.77 $143.59 $146.46 $149.39
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
EBIT -$97.00 $61.34 $216.37 $248.86 $276.37 $299.91 $307.22 $314.68 $322.28 $330.04
- Interest Expenses $20.25 $18.57 $16.82 $14.99 $13.10 $11.13 $9.07 $6.94 $4.72 $2.41
Taxable Income -$117.25 $42.77 $199.56 $233.87 $263.27 $288.79 $298.15 $307.74 $317.57 $327.63
- Taxes ($39.87) $14.54 $67.85 $79.51 $89.51 $98.19 $101.37 $104.63 $107.97 $111.40
= Net Income (millions US$) -$77.39 $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
Book Value and Depreciation
Beg. Book Value $1,250.00 $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
+ Capital Exp. $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
End Book Value $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54 $250.00
- Debt Outstanding $458.45 $415.22 $370.24 $323.43 $274.73 $224.06 $171.34 $116.48 $59.39 $0.00
End Book Value of Equity $591.55 $474.78 $391.76 $336.17 $302.95 $288.08 $275.27 $264.60 $256.14 $250.00

Aswath Damodaran
59
 A ROE Analysis
60
BV of
Year Net Income Beg. BV: Depreciation Capital Ending Debt BV: Equity Average ROE
Workin
Assets Expense BV: BV:
g
Assets Equity
Capital
0 $0.00 $0.00 $1,250.00 $1,250.00 $81.60 $500.00 $831.60
1 ($77.39) $1,250.00 $200.00 $0.00 $1,050.00 $124.85 $458.45 $716.40 $774.00 -10.00%
2 $28.23 $1,050.00 $160.00 $0.00 $890.00 $169.79 $415.22 $644.57 $680.49 4.15%
3 $131.71 $890.00 $128.00 $0.00 $762.00 $173.19 $370.24 $564.95 $604.76 21.78%
4 $154.35 $762.00 $102.40 $0.00 $659.60 $176.65 $323.43 $512.82 $538.89 28.64%
5 $173.76 $659.60 $81.92 $0.00 $577.68 $180.19 $274.73 $483.13 $497.98 34.89%
6 $190.60 $577.68 $65.54 $0.00 $512.14 $183.79 $224.06 $471.87 $477.50 39.92%
7 $196.78 $512.14 $65.54 $0.00 $446.61 $187.47 $171.34 $462.74 $467.31 42.11%
8 $203.11 $446.61 $65.54 $0.00 $381.07 $191.21 $116.48 $455.81 $459.27 44.22%
9 $209.59 $381.07 $65.54 $0.00 $315.54 $195.04 $59.39 $451.18 $453.50 46.22%
10 $216.24 $315.54 $65.54 $0.00 $250.00 $0.00 $0.00 $250.00 $350.59 61.68%
Average ROE over the ten-year period = 31.36%

US $ ROE of 31.36% is greater than

Vale Iron Ore US$ Cost of Equity of 11.13%

Aswath Damodaran
60
 From Project ROE to Firm ROE
61

 As with the earlier analysis, where we used return on capital and cost of
capital to measure the overall quality of projects at firms, we can
compute return on equity and cost of equity to pass judgment on
whether firms are creating value to its equity investors.
 Specifically, we can compute the return on equity (net income as a
percentage of book equity) and compare to the cost of equity. The return
spread is then:
 Equity Return Spread = Return on Equity – Cost of equity
 This measure is particularly useful for financial service firms, where
capital, return on capital and cost of capital are difficult measures to nail
down.
 For non-­financial
‐ service firms, it provides a secondary (albeit a more
volatile measure of performance). While it usually provides the same
general result that the excess return computed from return on capital,
there can be cases where the two measures diverge.

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61
 An Incremental CF Analysis
62

0 1 2 3 4 5 6 7 8 9 10
Net Income ($77.39) $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
+ Depreciation & Amortization $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
- Capital Expenditures $750.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
- Change in Working Capital $81.60 $43.25 $44.95 $3.40 $3.46 $3.53 $3.60 $3.68 $3.75 $3.82 ($195.04)
- Principal Repayments $41.55 $43.23 $44.98 $46.80 $48.70 $50.67 $52.72 $54.86 $57.08 $59.39
+ Salvage Value of mine $250.00
Cashflow to Equity ($831.60) $37.82 $100.05 $211.33 $206.48 $203.44 $201.86 $205.91 $210.04 $214.22 $667.42

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62
 Discounted at US$ cost of
An Equity NPV equity of 11.13% for Vale’s
iron ore business
63

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63
 An Equity IRR
64

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64
 Real versus Nominal Analysis
65

In computing the NPV of the plant, we estimated US $

cash flows and discounted them at the US $ cost of
equity. We could have estimated the cash flows in real
terms (with no inflation) and discounted them at a real
cost of equity. Would the answer be different?
 Yes
 No
 Explain

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65
 Dealing with Macro Uncertainty: The Effect of
Iron Ore Price
66

 Like the Disney Theme Park, the Vale Iron Ore Mine’s actual value will be
buffeted as the variables change. The biggest source of variability is an
external factor –the price of iron ore.
Vale Paper Plant: Effect of Changing Iron Ore Prices

$1,50 40.00
0 %
30.00
$1,00 %
0
20.00
%
$50
0 10.00
%
NPV

NP
$ 0.00
0 $5 $6 $7 $8 $9 $10 $11 $12 $13 %
0 0 0 0 0 0 0 0 0
-
- 10.00%
$500
-
20.00%
-
$1,000 -
30.00%
- Price per ton of iron ore -
Aswath Damodaran
$1,500 40.00%
66
 And Exchange Rates…
67

Exchange Rate effects on Iron Ore Plant

$700 25.00%

$600

20.00%
$500

Internal Rate of Return

$400
Net Present Value

15.00%

$300
NPV

10.00% IRR
$200

$100
5.00%

$0

-­$100
‐ 0.00%

Canadian $ versus US $

Aswath Damodaran
67
 Should you hedge?
68

 The value of this mine is very much a function iron ore prices. There are futures,
forward and option markets iron ore that Vale can use to hedge against price
movements. Should it?
🞑 Yes
🞑 No
Explain.
 The value of the mine is also a function of exchange rates. There are forward,
futures and options markets on currency. Should Vale hedge against exchange
rate risk?
🞑 Yes
🞑 No
Explain.
 On the last question, would your answer have been different if the mine were in
Brazil.
🞑 Yes
🞑 No

Aswath Damodaran
68
 Value Trade Off

What is the cost to the firm of hedging Cash flow benefits

- Tax benefits
this risk?
- Better project choices
Negligible High

Survival benefits (truncation risk)

- Protect against catastrophic risk
Is there a significant Is there a significant
- Reduce default risk
benefit in terms of higher benefit in terms of higher
cash flows or a lower expected cash flows or a
discount rate? lower discount rate? Discount rate benefits
- Hedge "macro" risks (cost of equity)
Yes No Yes No - Reduce default risk (cost of debt or debt
ratio)
Hedge this risk. The Indifferent Can marginal Do not hedge this risk.
benefits to the firm will to investors hedge The benefits are
exceed the costs hedging this risk cheaper relative to costs
small
risk than the firm can? Pricing Trade
Earnings Multiple Earnings
- Effect on X - Level
Yes No
multiple - Volatilit
y
Will the benefits persist if investors Hedge this risk. The
hedge the risk instead of the firm? benefits to the firm will
exceed the costs
Yes No

Let the risk pass Hedge this risk. The

through to investors benefits to the firm will
and let them hedge exceed the costs
the risk.

69 Aswath Damodaran
 Acquisitions and Projects
70

 An acquisition is an investment/project like any other and all of the

rules that apply to traditional investments should apply to
acquisitions as well. In other words, for an acquisition to make
sense:
🞑 It should have positive NPV. The present value of the expected cash flows
from the acquisition should exceed the price paid on the acquisition.
🞑 The IRR of the cash flows to the firm (equity) from the acquisition > Cost of
capital (equity) on the acquisition
 In estimating the cash flows on the acquisition, we should count in
any possible cash flows from synergy.
 The discount rate to assess the present value should be based
upon the risk of the investment (target company) and not the
entity considering the investment (acquiring company).

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70
 Tata Motors and Harman International
71

 Harman International is a publicly traded US firm

that manufactures high end audio equipment. Tata
Motors is an automobile company, based in India.
 Tata Motors is considering an acquisition of Harman,
with an eye on using its audio equipment in its
Indian automobiles, as optional upgrades on new
cars.

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71
 Estimating the Cost of Capital for the
Acquisition (no synergy)
72

1. Currency: Estimated in US $, since cash flows will be estimated in US $.

2. Beta: Harman International is an electronic company and we use the unlevered beta
(1.17) of electronics companies in the US.
3. Equity Risk Premium: Computed based on Harman’s operating exposure:

4. Debt ratio & cost of debt: Tata Motors plans to assume the existing debt of Harman
International and to preserve Harman’s existing debt ratio. Harman currently has a debt
(including lease commitments) to capital ratio of 7.39% (translating into a debt to equity
ratio of 7.98%) and faces a pre-­tax
‐ cost of debt of 4.75% (based on its BBB-­‐ rating).
Levered Beta = 1.17 (1+ (1-­.40)
‐ (.0798)) = 1.226
Cost of Equity= 2.75% + 1.226 (6.13%) = 10.26%
Cost of Capital = 10.26% (1-­.0739)
‐ + 4.75% (1-­.40)
‐ (.0739) = 9.67%

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72
 Estimating Cashflows-­‐ First Steps
73

 Operating Income: The firm reported operating income of

$201.25 million on revenues of $4.30 billion for the year.
Adding back non-­recurring
‐ expenses (restructuring charge of
$83.2 million in 2013) and adjusting income for the
conversion of operating lease commitments to debt, we
estimated an adjusted operating income of $313.2 million.
The firm paid 18.21% of its income as taxes in 2013 and we
will use this as the effective tax rate for the cash flows.
 Reinvestment: Depreciation in 2013 amounted to $128.2
million, whereas capital expenditures and acquisitions for the
year were $206.4 million. Non-­cash
‐ working capital increased
by $272.6 million during 2013 but was 13.54% of revenues in
2013.
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73
 Bringing in growth
74

 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.

Aswath Damodaran
74
 Value of Harman International: Before Synergy
75

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

The hurdle rate The return How much How you

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

Aswath Damodaran
76