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Shouldtherebeariskpremiumforforeignprojects?¨  Theexchangerateriskshouldbediversifiablerisk(andhence

shouldnotcommandapremium)if¤  thecompanyhasprojectsisalargenumberofcountries(or)¤  theinvestorsinthecompanyaregloballydiversified.¤  ForDisney,thisriskshouldnotaffectthecostofcapitalused.

Consequently,wewouldnotadjustthecostofcapitalforDisney’sinvestmentsinothermaturemarkets(Germany,UK,France)

¨  ThesamediversificaJonargumentcanalsobeappliedagainstsomepoliJcalrisk,whichwouldmeanthatittooshouldnotaffectthediscountrate.However,thereareaspectsofpoliJcalriskespeciallyinemergingmarketsthatwillbedifficulttodiversifyandmayaffectthecashflows,byreducingtheexpectedlifeorcashflowsontheproject.

¨  ForDisney,thisistheriskthatweareincorporaJngintothecostofcapitalwhenitinvestsinBrazil(oranyotheremergingmarket)

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EsJmaJngahurdlerateforRioDisney

¨  WedidesJmateacostofcapitalof6.61%fortheDisneythemeparkbusiness,usingaboVom-upleveredbetaof0.7537forthebusiness.

¨  ThiscostofequitymaynotadequatelyreflecttheaddiJonalriskassociatedwiththethemeparkbeinginanemergingmarket.

¨  TheonlyconcernwewouldhavewithusingthiscostofequityforthisprojectisthatitmaynotadequatelyreflecttheaddiJonalriskassociatedwiththethemeparkbeinginanemergingmarket(Brazil).WefirstcomputedtheBrazilcountryriskpremium(bymulJplyingthedefaultspreadforBrazilbytherelaJveequitymarketvolaJlity)andthenre-esJmatedthecostofequity:¤  CountryriskpremiumforBrazil=5.5%+3%=8.5%¤  CostofEquityinUS$=2.75%+0.7537(8.5%)=9.16%

¨  UsingthisesJmateofthecostofequity,Disney’sthemeparkdebtraJoof10.24%anditsader-taxcostofdebtof2.40%(seechapter4),wecanesJmatethecostofcapitalfortheproject:¤  CostofCapitalinUS$=9.16%(0.8976)+2.40%(0.1024)=8.46%

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Wouldleadustoconcludethat...

¨  Donotinvestinthispark.Thereturnoncapitalof4.18%islowerthanthecostofcapitalforthemeparksof8.46%;Thiswouldsuggestthattheprojectshouldnotbetaken.

¨  Giventhatwehavecomputedtheaverageoveranarbitraryperiodof10years,whilethethemeparkitselfwouldhavealifegreaterthan10years,wouldyoufeelcomfortablewiththisconclusion?¤  Yes¤ No

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ATangent:FromNewtoExisJngInvestments:ROCfortheenJrefirm

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

How “good” are the existing investments of the firm?

Measuring ROC for existing investments..

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Oldwineinanewbo,le..Anotherwayofpresen6ngthesameresults…¨  Thekeytovalueisearningexcessreturns.Over6me,therehavebeen

a,emptstorestatethisobviousfactinnewanddifferentways.Forinstance,EconomicValueAdded(EVA)developedawidefollowinginthethe1990s:

¨  EVA=(ROC–CostofCapital)(BookValueofCapitalInvested)¨  Theexcessreturnsforthefourfirmscanberestatedasfollows:

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ReturnSpreadsGlobally….217

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6ApplicaJonTest:AssessingInvestmentQuality

¨  Forthemostrecentperiodforwhichyouhavedata,computetheader-taxreturnoncapitalearnedbyyourfirm,whereader-taxreturnoncapitaliscomputedtobe

¨  Ader-taxROC=EBIT(1-taxrate)/(BVofdebt+BVofEquity-Cash)previousyear

¨  Forthemostrecentperiodforwhichyouhavedata,computethereturnspreadearnedbyyourfirm:

¨  ReturnSpread=Ader-taxROC-CostofCapital¨  Forthemostrecentperiod,computetheEVAearnedbyyourfirmEVA=ReturnSpread*((BVofdebt+BVofEquity-

Cash)previousyear

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Thecashflowviewofthisproject..

To get from income to cash flow, weI.  added back all non-cash charges such as depreciation. Tax

benefits:II.  subtracted out the capital expendituresIII.  subtracted out the change in non-cash working capital

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  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

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TheDepreciaJonTaxBenefit

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¨  WhiledepreciaJonreducestaxableincomeandtaxes,itdoesnotreducethecashflows.

¨  ThebenefitofdepreciaJonisthereforethetaxbenefit.Ingeneral,thetaxbenefitfromdepreciaJoncanbewriVenas:

¨  TaxBenefit=DepreciaJon*TaxRate¨  DisneyThemePark:DepreciaJontaxsavings(Taxrate=36.1%)

¨  ProposiJon1:ThetaxbenefitfromdepreciaJonandothernon-cashchargesisgreater,thehigheryourtaxrate.

¨  ProposiJon2:Non-cashchargesthatarenottaxdeducJble(suchasamorJzaJonofgoodwill)andthusprovidenotaxbenefitshavenoeffectoncashflows.

1 2 3 4 5 6 7 8 9 10Depreciation $50 $425 $469 $444 $372 $367 $364 $364 $366 $368Tax Bendfits from Depreciation $18 $153 $169 $160 $134 $132 $132 $132 $132 $133

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DepreciaJonMethods

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¨  Broadlycategorizing,depreciaJonmethodscanbeclassifiedasstraightlineoracceleratedmethods.InstraightlinedepreciaJon,thecapitalexpenseisspreadevenlyoverJme,InaccelerateddepreciaJon,thecapitalexpenseisdepreciatedmoreinearlieryearsandlessinlateryears.Assumethatyoumadealargeinvestmentthisyear,andthatyouarechoosingbetweenstraightlineandaccelerateddepreciaJonmethods.Whichwillresultinhighernetincomethisyear?¤  StraightLineDepreciaJon¤  AcceleratedDepreciaJon

¨  Whichwillresultinhighercashflowsthisyear?¤  StraightLineDepreciaJon¤  AcceleratedDepreciaJon

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TheCapitalExpendituresEffect

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¨  CapitalexpendituresarenottreatedasaccounJngexpensesbuttheydocausecashouslows.

¨  Capitalexpenditurescangenerallybecategorizedintotwogroups¤  New(orGrowth)capitalexpendituresarecapitalexpenditures

designedtocreatenewassetsandfuturegrowth¤  Maintenancecapitalexpendituresrefertocapitalexpenditures

designedtokeepexisJngassets.¨  BothiniJalandmaintenancecapitalexpendituresreduce

cashflows¨  Theneedformaintenancecapitalexpenditureswillincrease

withthelifeoftheproject.Inotherwords,a25-yearprojectwillrequiremoremaintenancecapitalexpendituresthana2-yearproject.

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Tocapexornottocapex?

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¨  Assumethatyourunyourownsodwarebusiness,andthatyouhaveanexpensethisyearof$100millionfromproducinganddistribuJonpromoJonalCDsinsodwaremagazines.Youraccountanttellsyouthatyoucanexpensethisitemorcapitalizeanddepreciateitoverthreeyears.WhichwillhaveamoreposiJveeffectonincome?¤  Expenseit¤  CapitalizeandDepreciateit

¨  WhichwillhaveamoreposiJveeffectoncashflows?¤  Expenseit¤  CapitalizeandDepreciateit

224

TheWorkingCapitalEffect

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¨  IntuiJvely,moneyinvestedininventoryorinaccountsreceivablecannotbeusedelsewhere.It,thus,representsadrainoncashflows

¨  Tothedegreethatsomeoftheseinvestmentscanbefinancedusingsuppliercredit(accountspayable),thecashflowdrainisreduced.

¨  Investmentsinworkingcapitalarethuscashouslows¤  Anyincreaseinworkingcapitalreducescashflowsinthatyear¤  Anydecreaseinworkingcapitalincreasescashflowsinthatyear

¨  Toprovideclosure,workingcapitalinvestmentsneedtobesalvagedattheendoftheprojectlife.

¨  ProposiJon1:ThefailuretoconsiderworkingcapitalinacapitalbudgeJngprojectwilloverstatecashflowsonthatprojectandmakeitlookmoreaVracJvethanitreallyis.

¨  ProposiJon2:Otherthingsheldequal,areducJoninworkingcapitalrequirementswillincreasethecashflowsonallprojectsforafirm.

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Theincrementalcashflowsontheproject

$ 500 million has already been spent & $ 50 million in depreciation will exist anyway

2/3rd of allocated G&A is fixed.Add back this amount (1-t)Tax rate = 36.1%

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Amoredirectwayofgetngtoincrementalcashflows

  0 1 2 3 4 5 6 7 8 9 10Revenues   $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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227

SunkCosts

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¨  Whatisasunkcost?Anyexpenditurethathasalreadybeenincurred,andcannotberecovered(evenifaprojectisrejected)iscalledasunkcost.AtestmarketforaconsumerproductandR&Dexpensesforadrug(forapharmaceuJcalcompany)wouldbegoodexamples.

¨  Thesunkcostrule:Whenanalyzingaproject,sunkcostsshouldnotbeconsideredsincetheyarenotincremental.

¨  ABehavioralAside:Itisawellestablishedfindinginpsychologicalandbehavioralresearchthatmanagersfinditalmostimpossibletoignoresunkcosts.

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TestMarkeJngandR&D:TheQuandaryofSunkCosts

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¨  Aconsumerproductcompanyhasspent$100millionontestmarkeJng.Lookingatonlytheincrementalcashflows(andignoringthetestmarkeJng),theprojectlookslikeitwillcreate$25millioninvalueforthecompany.Shouldittaketheinvestment?¤  Yes¤  No

¨  NowassumethateveryinvestmentthatthiscompanyhassharesthesamecharacterisJcs(Sunkcosts>ValueAdded).Thefirmwillclearlynotbeabletosurvive.WhatisthesoluJontothisproblem?

229

AllocatedCosts

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¨  Firmsallocatecoststoindividualprojectsfromacentralizedpool(suchasgeneralandadministraJveexpenses)baseduponsomecharacterisJcoftheproject(salesisacommonchoice,asisearnings)

¨  Forlargefirms,theseallocatedcostscanbesignificantandresultintherejecJonofprojects

¨  Tothedegreethatthesecostsarenotincremental(andwouldexistanyway),thismakesthefirmworseoff.Thus,itisonlytheincrementalcomponentofallocatedcoststhatshouldshowupinprojectanalysis.

230

BreakingoutG&ACostsintofixedandvariablecomponents:Asimpleexample

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¨  AssumethatyouhaveaJmeseriesofrevenuesandG&Acostsforacompany.

¤ WhatpercentageoftheG&Acostisvariable?

231

ToTime-WeightedCashFlows

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¨  Incrementalcashflowsintheearlieryearsareworthmorethanincrementalcashflowsinlateryears.

¨  Infact,cashflowsacrossJmecannotbeaddedup.TheyhavetobebroughttothesamepointinJmebeforeaggregaJon.

¨  ThisprocessofmovingcashflowsthroughJmeis¤  discounJng,whenfuturecashflowsarebroughttothepresent

¤  compounding,whenpresentcashflowsaretakentothefuture

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PresentValueMechanics

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¨  CashFlowType DiscounJngFormula CompoundingFormula1.SimpleCF CFn/(1+r)n CF0(1+r)n

2.Annuity 3.GrowingAnnuity4.Perpetuity A/r5.GrowingPerpetuity ExpectedCashflownextyear/(r-g)

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