INVESTMENT
RETURNS
III:
LOOSE
ENDS
No
garnishing
allowed
in
investment
analysis.
Set Up and Objective
1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate
4. Define & Measure Risk
5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights
The Financing Decision
Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations
Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing
Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends
36. Closing Thoughts
The Dividend Decision
If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business
Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game
Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation
Rio
Disney:
The
US
Dollar
Assessment
Discounted at Rio Disney cost
of capital of 8.46%
Does
the
currency
maCer?
The
analysis
was
done
in
dollars.
Would
the
conclusions
have
been
any
dierent
if
we
had
done
the
analysis
in
Brazilian
Reais?
a.
b.
Yes
No
Disney
Theme
Park:
$R
NPV
Expected Exchange Ratet
= Exchange Rate today * (1.09/1.02)t
Discount at $R cost of capital
= (1.0846) (1.09/1.02) 1 = 15.91%
NPV
=
R$
7,745/2.35=
$
3,296
Million
NPV
is
equal
to
NPV
in
dollar
terms
Uncertainty
in
Project
Analysis:
What
can
we
do?
Based
on
our
expected
cash
ows
and
the
es^mated
cost
of
capital,
the
proposed
theme
park
looks
like
a
very
good
investment
for
Disney.
Which
of
the
following
may
aect
your
assessment
of
value?
a.
b.
c.
d.
e.
f.
Revenues
may
be
over
es^mated
(crowds
may
be
smaller
and
spend
less)
Actual
costs
may
be
higher
than
es^mated
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?
a.
b.
c.
d.
Will
wait
for
the
uncertainty
to
be
resolved
Will
not
take
the
investment
Ignore
it.
Other
One
simplis^c
solu^on:
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.
Payback = 10.3 years
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!
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!
15!
$789!
$3,555!
$233!
-$384!
16!
$805!
$4,360!
$219!
-$165!
17!
$821!
$5,181!
$206!
$41!
Discounted Payback
= 16.8 years
7
A
slightly
more
sophis^cated
approach:
Sensi^vity
Analysis
&
What-if
Ques^ons
The
NPV,
IRR
and
accoun^ng
returns
for
an
investment
will
change
as
we
change
the
values
that
we
use
for
dierent
variables.
One
way
of
analyzing
uncertainty
is
to
check
to
see
how
sensi^ve
the
decision
measure
(NPV,
IRR..)
is
to
changes
in
key
assump^ons.
While
this
has
become
easier
and
easier
to
do
over
^me,
there
are
caveats
that
we
would
oer.
Caveat
1:
When
analyzing
the
eects
of
changing
a
variable,
we
ohen
hold
all
else
constant.
In
the
real
world,
variables
move
together.
Caveat
2:
The
objec^ve
in
sensi^vity
analysis
is
that
we
make
beCer
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).
And
here
is
a
really
good
picture
The
nal
step
up:
Incorporate
probabilis^c
es^mates..
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%)
10
The
resul^ng
simula^on
Average = $3.40 billion
Median = $3.28 billion
!
NPV ranges from -$1 billion to +$8.5 billion. NPV is negative 12% of the
time.
11
A
side
bar:
Should
you
hedge
risks?
a.
b.
c.
Disney
can
reduce
the
risk
in
this
project
by
hedging
against
exchange
rate
risk.
Should
it?
Yes
No
Maybe
12
Value Trade Off
Cash flow benefits
- Tax benefits
- Better project choices
What is the cost to the firm of hedging this risk?
Negligible
High
Is there a significant benefit in
terms of higher cash flows or
a lower discount rate?
Yes
Is there a significant benefit in
terms of higher expected cash
flows or a lower discount rate?
No
Hedge this risk. The
benefits to the firm will
exceed the costs
Yes
Indifferent to
hedging risk
No
Can marginal investors
hedge this risk cheaper
than the firm can?
Yes
Let the risk pass
through to investors
and let them hedge
the risk.
Discount rate benefits
- Hedge "macro" risks (cost of equity)
- Reduce default risk (cost of debt or debt ratio)
Do not hedge this risk.
The benefits are small
relative to costs
Yes
No
Will the benefits persist if investors hedge
the risk instead of the firm?
Survival benefits (truncation risk)
- Protect against catastrophic risk
- Reduce default risk
Hedge this risk. The
benefits to the firm will
exceed the costs
No
Hedge this risk. The
benefits to the firm will
exceed the costs
Pricing Trade
Earnings Multiple
X
- Effect on multiple
Earnings
- Level
- Volatility
A
nal
thought:
Side
Costs
and
Benets
Most
projects
considered
by
any
business
create
side
costs
and
benets
for
that
business.
The
side
costs
include
the
costs
created
by
the
use
of
resources
that
the
business
already
owns
(opportunity
costs)
and
lost
revenues
for
other
projects
that
the
rm
may
have.
The
benets
that
may
not
be
captured
in
the
tradi^onal
capital
budge^ng
analysis
include
project
synergies
(where
cash
ow
benets
may
accrue
to
other
projects)
and
op^ons
embedded
in
projects
(including
the
op^ons
to
delay,
expand
or
abandon
a
project).
The
returns
on
a
project
should
incorporate
these
costs
and
benets.
14
First
Principles
Maximize the value of the business (firm)
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The hurdle rate
should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should relfect the
magnitude and
the timing of the
cashflows as welll
as all side effects.
The Financing Decision
Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations
The optimal
mix of debt
and equity
maximizes firm
value
The right kind
of debt
matches the
tenor of your
assets
The Dividend Decision
If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend whether
they prefer
dividends or
buybacks
15
Task
Draw
up
a
risk
prole
for
your
company
&
make
a
judgment
on
which
risks,
if
any,
you
would
hedge.
16
Read
Chapter
6
