Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter 8 Investment Analysis.

Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved

Chapter 8

Investment AnalysisInvestment Analysis


Chapter Overview

• Investment AnalysisInvestment Analysis

– Application of TVM and Market ValueApplication of TVM and Market Value

• WACCWACC

• Discount RateDiscount Rate

• Capitalization Method of ValuationCapitalization Method of Valuation


Chapter Overview

• Investment Analysis ToolsInvestment Analysis Tools

– Payback periodPayback period

– NPVNPV

– IRRIRR

– MIRRMIRR

• Factors Impacting Investment AnalysisFactors Impacting Investment Analysis


Components of Investment Analysis

• WACCWACC

• Discount RateDiscount Rate

• Capitalization Method of ValuationCapitalization Method of Valuation


WACC

• Used to calculate present value of an Used to calculate present value of an investmentinvestment

• Rate used to discount future cash flowsRate used to discount future cash flows

• Mix of debt and equity depends on how Mix of debt and equity depends on how much the company can borrow and pay much the company can borrow and pay debt servicedebt service


WACC Review

• Amount of interest expense and cash flow Amount of interest expense and cash flow allotted to equity investors divided by the allotted to equity investors divided by the amount of capitalamount of capital

• Takes into consideration:Takes into consideration:

– Capital mixCapital mix

– Tax effectTax effect

• Interest portion of debt service treated as an expense for tax purposes in the US


WACC Calculation

WACC = wWACC = wdd k kdd (1-T) + w (1-T) + wee k kee

Weight of debt = wWeight of debt = wdd

Cost of debt = kCost of debt = kdd (1-T) (1-T)

Tax rate of business = TTax rate of business = T

Tax effect = (1-T)Tax effect = (1-T)

Weighted cost of debt = wWeighted cost of debt = wdd k kdd (1-T) (1-T)

Weight of equity = wWeight of equity = wee

Cost of equity = kCost of equity = kee

Weighted cost of equity = wWeighted cost of equity = wee k kee


Discount Rate

• Includes the cost of debt and investor’s Includes the cost of debt and investor’s required ROIrequired ROI

• Used to calculate present value of an Used to calculate present value of an asset by discounting each year’s cash flowasset by discounting each year’s cash flow


Capitalization Method of Valuation

• Values the asset’s prior twelve months’ cash Values the asset’s prior twelve months’ cash flowflow

• Provides the asset’s approximate market valueProvides the asset’s approximate market value

Cap Rate Method EquationCap Rate Method Equation

CR (X) = CF or X = CF/CRCR (X) = CF or X = CF/CR

X = estimated current market valueX = estimated current market value

CR = cap rate (WAAC)CR = cap rate (WAAC)

CF = prior or trailing 12 months of cash flowCF = prior or trailing 12 months of cash flow


Investment Analysis Tools

• Payback PeriodPayback Period

– Amount of time a project requires to pay back Amount of time a project requires to pay back the initial equity investmentthe initial equity investment

• Advantage

– Easy to calculate

• Disadvantages

– Does not include the time value of money

– Ignores cash flow after the required payback period


Payback Period Calculation

Payback Period = cost / incremental cash flowPayback Period = cost / incremental cash flow

An asset costs $25,000 and will provide An asset costs $25,000 and will provide incremental cash flows of $10,000 per year.incremental cash flows of $10,000 per year.

= $25,000 / $10,000= $25,000 / $10,000

= 2.5 years= 2.5 years



• Net Present Value (NPV)Net Present Value (NPV)

– Calculates the difference between an asset’s Calculates the difference between an asset’s present value and purchase pricepresent value and purchase price

• Advantages

– Takes into account all cash flows

– Takes into consideration the TVM

• Disadvantage

– Difficult to compare multiple investment opportunities with different costs


NPV Calculation |----------|----------|----------|----------|----------||----------|----------|----------|----------|----------|

0 1 2 3 4 5 Years0 1 2 3 4 5 Years

50 100 300 305 320 at 10% interest50 100 300 305 320 at 10% interest

-800-800

Utilize [CF] button and enter:Utilize [CF] button and enter:CF0 = -800CF0 = -800CF1 = 50CF1 = 50CF2 = 100CF2 = 100CF3 = 300CF3 = 300CF4 = 305CF4 = 305CF5 = 320CF5 = 320

Now enter [CPT][NPV]Now enter [CPT][NPV]

I/Y = 10I/Y = 10

CPT NPV = -$39.49CPT NPV = -$39.49

Do not invest!Do not invest!



• Internal Rate of Return (IRR)Internal Rate of Return (IRR)

– Discount rate that makes the NPV of an Discount rate that makes the NPV of an investment equal to zeroinvestment equal to zero• Advantage

– Compare multiple deals with varying sales prices and costs

• Disadvantages– Assumes cash flows generated by the project are

reinvested at the IRR calculated

– Multiple IRRs when cash flows go from negative to positive


IRR Calculation |----------|----------|----------|----------|----------||----------|----------|----------|----------|----------|

0 1 2 3 4 5 Years0 1 2 3 4 5 Years

50 100 300 305 32050 100 300 305 320

-800-800

Utilize [CF] button and enter:Utilize [CF] button and enter:CF0 = -800CF0 = -800CF1 = 50CF1 = 50CF2 = 100CF2 = 100CF3 = 300CF3 = 300CF4 = 305CF4 = 305CF5 = 320CF5 = 320

CPT IRR = 8.5%CPT IRR = 8.5%



• Modified Internal Rate of Return (MIRR)Modified Internal Rate of Return (MIRR)

– Rate of return which assumes all cash flows Rate of return which assumes all cash flows are reinvested at the firm’s WACCare reinvested at the firm’s WACC

– MIRR is more conservative than IRRMIRR is more conservative than IRR


Factors ImpactingInvestment Analysis

• Cost of capital (WACC)Cost of capital (WACC)

• Cap rate used to calculate the assumed Cap rate used to calculate the assumed sale price at the end of the analysis periodsale price at the end of the analysis period

• Amount and timing of annual cash flows Amount and timing of annual cash flows projectedprojected

• Acquisition price or development cost of Acquisition price or development cost of the assetthe asset



• Cost of CapitalCost of Capital

– The more financial leverage used, the lower The more financial leverage used, the lower the cost of capitalthe cost of capital

– The lower the cost of capital, the lower the The lower the cost of capital, the lower the discount ratediscount rate

– The lower the discount rate, the higher the The lower the discount rate, the higher the present value and NPVpresent value and NPV



• Cap RateCap Rate

– The lower the cap rate, the higher the sales The lower the cap rate, the higher the sales price and PV, NPV, and IRRprice and PV, NPV, and IRR

– The higher the cap rate, the lower the PV, The higher the cap rate, the lower the PV, NPV, and IRRNPV, and IRR



• Amount and Timing of Projected Cash Amount and Timing of Projected Cash FlowsFlows

– The more cash flow projected in the early The more cash flow projected in the early years, the higher the PV, NPV, and IRRyears, the higher the PV, NPV, and IRR



• Acquisition PriceAcquisition Price

– The lower the price of the asset or total The lower the price of the asset or total project cost, the higher the NPV and IRRproject cost, the higher the NPV and IRR

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Copyright © 2007 by John Wiley & Sons, Inc. All rights reserved Chapter 8 Investment Analysis.

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