Aswath Damodaran 1
MEASURING INVESTMENT RETURNS
II. INVESTMENT INTERACTIONS,
OPTIONS AND REMORSE…
Life is too short for regrets, right?
First Principles
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Aswath Damodaran
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Independent investments are the exception…
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In all of the examples we have used so far, the
investments that we have analyzed have stood alone.
Thus, our job was a simple one. Assess the expected cash
flows on the investment and discount them at the right
discount rate.
In the real world, most investments are not
independent. Taking an investment can often mean
rejecting another investment at one extreme (mutually
exclusive) to being locked in to take an investment in the
future (pre-requisite).
More generally, accepting an investment can create side
costs for a firm’s existing investments in some cases and
benefits for others.
Aswath Damodaran
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I. Mutually Exclusive Investments
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We have looked at how best to assess a stand-alone
investment and concluded that a good investment will have
positive NPV and generate accounting returns (ROC and ROE)
and IRR that exceed your costs (capital and equity).
In some cases, though, firms may have to choose between
investments because
They are mutually exclusive: Taking one investment makes the other
one redundant because they both serve the same purpose
The firm has limited capital and cannot take every good investment
(i.e., investments with positive NPV or high IRR).
Using the two standard discounted cash flow measures, NPV
and IRR, can yield different choices when choosing between
investments.
Aswath Damodaran
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Comparing Projects with the same (or similar)
lives..
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When comparing and choosing between investments
with the same lives, we can
Compute the accounting returns (ROC, ROE) of the investments
and pick the one with the higher returns
Compute the NPV of the investments and pick the one with the
higher NPV
Compute the IRR of the investments and pick the one with the
higher IRR
While it is easy to see why accounting return measures
can give different rankings (and choices) than the
discounted cash flow approaches, you would expect NPV
and IRR to yield consistent results since they are both
time-weighted, incremental cash flow return measures.
Aswath Damodaran
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Case 1: IRR versus NPV
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Consider two projects with the following cash flows:
Year Project 1 CF Project 2 CF
0 -1000 -1000
1 800 200
2 1000 300
3 1300 400
4 -2200 500
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Project’s NPV Profile
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What do we do now?
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Project 1 has two internal rates of return. The first is
6.60%, whereas the second is 36.55%. Project 2 has one
internal rate of return, about 12.8%.
Why are there two internal rates of return on project 1?
If your cost of capital is 12%, which investment would
you accept?
a. Project 1
b. Project 2
Explain.
Aswath Damodaran
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Case 2: NPV versus IRR
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Project A
Cash Flow $ 350,000 $ 450,000 $ 600,000 $ 750,000
Investment $ 1,000,000
NPV = $467,937
IRR= 33.66%
Project B
Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%
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Which one would you pick?
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Assume that you can pick only one of these two projects.
Your choice will clearly vary depending upon whether
you look at NPV or IRR. You have enough money
currently on hand to take either. Which one would you
pick?
a. Project A. It gives me the bigger bang for the buck and more
margin for error.
b. Project B. It creates more dollar value in my business.
If you pick A, what would your biggest concern be?
If you pick B, what would your biggest concern be?
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Capital Rationing, Uncertainty and Choosing a
Rule
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If a business has limited access to capital, has a stream of
surplus value projects and faces more uncertainty in its
project cash flows, it is much more likely to use IRR as its
decision rule.
Small, high-growth companies and private businesses are much
more likely to use IRR.
If a business has substantial funds on hand, access to
capital, limited surplus value projects, and more
certainty on its project cash flows, it is much more likely
to use NPV as its decision rule.
As firms go public and grow, they are much more likely
to gain from using NPV.
Aswath Damodaran
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The sources of capital rationing…
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Cause Number of firms Percent of total
Debt limit imposed by outside agreement 10 10.7
Debt limit placed by management external to 3 3.2
firm
Limit placed on borrowing by internal 65 69.1
management
Restrictive policy imposed on retained 2 2.1
earnings
Maintenance of target EPS or PE ratio 14 14.9
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An Alternative to IRR with Capital Rationing
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The problem with the NPV rule, when there is capital
rationing, is that it is a dollar value. It measures success
in absolute terms.
The NPV can be converted into a relative measure by
dividing by the initial investment. This is called the
profitability index.
Profitability Index (PI) = NPV/Initial Investment
In the example described, the PI of the two projects
would have been:
PI of Project A = $467,937/1,000,000 = 46.79%
PI of Project B = $1,358,664/10,000,000 = 13.59%
Project A would have scored higher.
Aswath Damodaran
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Case 3: NPV versus IRR
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Project A
Cash Flow $ 5,000,000 $ 4,000,000 $ 3,200,000 $ 3,000,000
Investment $ 10,000,000
NPV = $1,191,712
IRR=21.41%
Project B
Cash Flow $ 3,000,000 $ 3,500,000 $ 4,500,000 $ 5,500,000
Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%
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Why the difference?
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These projects are of the same scale. Both the NPV
and IRR use time-weighted cash flows. Yet, the
rankings are different. Why?
Which one would you pick?
a. Project A. It gives me the bigger bang for the buck and
more margin for error.
b. Project B. It creates more dollar value in my business.
Aswath Damodaran
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NPV, IRR and the Reinvestment Rate
Assumption
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The NPV rule assumes that intermediate cash flows on
the project get reinvested at the hurdle rate (which is
based upon what projects of comparable risk should
earn).
The IRR rule assumes that intermediate cash flows on
the project get reinvested at the IRR. Implicit is the
assumption that the firm has an infinite stream of
projects yielding similar IRRs.
Conclusion: When the IRR is high (the project is creating
significant surplus value) and the project life is long, the
IRR will overstate the true return on the project.
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Solution to Reinvestment Rate Problem
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Why NPV and IRR may differ.. Even if projects
have the same lives
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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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Comparing projects with different lives..
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Project A
$400 $400 $400 $400 $400
-$1000
NPV of Project A = $ 442
IRR of Project A = 28.7%
Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350
-$1500 NPV of Project B = $ 478
IRR for Project B = 19.4%
Hurdle Rate for Both Projects = 12%
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Why NPVs cannot be compared.. When projects
have different lives.
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The net present values of mutually exclusive projects
with different lives cannot be compared, since there
is a bias towards longer-life projects. To compare the
NPV, we have to
replicate the projects till they have the same life (or)
convert the net present values into annuities
The IRR is unaffected by project life. We can choose
the project with the higher IRR.
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Solution 1: Project Replication
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Project A: Replicated
$400 $400 $400 $400 $400 $400 $400 $400 $400 $400
-$1000 -$1000 (Replication)
NPV of Project A replicated = $ 693
Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350
-$1500
NPV of Project B= $ 478
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Solution 2: Equivalent Annuities
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Equivalent Annuity for 5-year project
= $442 * PV(A,12%,5 years)
= $ 122.62
Equivalent Annuity for 10-year project
= $478 * PV(A,12%,10 years)
= $ 84.60
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What would you choose as your investment
tool?
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Given the advantages/disadvantages outlined for each of
the different decision rules, which one would you choose
to adopt?
a. Return on Investment (ROE, ROC)
b. Payback or Discounted Payback
c. Net Present Value
d. Internal Rate of Return
e. Profitability Index
Do you think your choice has been affected by the
events of the last quarter of 2008? If so, why? If not, why
not?
Aswath Damodaran
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What firms actually use ..
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Decision Rule % of Firms using as primary decision rule in
1976 1986 1998
IRR 53.6% 49.0% 42.0%
Accounting Return 25.0% 8.0% 7.0%
NPV 9.8% 21.0% 34.0%
Payback Period 8.9% 19.0% 14.0%
Profitability Index 2.7% 3.0% 3.0%
Aswath Damodaran
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II. Side Costs and Benefits
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Most projects considered by any business create side
costs and benefits 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 firm may have.
The benefits that may not be captured in the traditional capital
budgeting analysis include project synergies (where cash flow
benefits may accrue to other projects) and options embedded in
projects (including the options to delay, expand or abandon a
project).
The returns on a project should incorporate these costs
and benefits.
Aswath Damodaran
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A. Opportunity Cost
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An opportunity cost arises when a project uses a
resource that may already have been paid for by the
firm.
When a resource that is already owned by a firm is being
considered for use in a project, this resource has to be
priced on its next best alternative use, which may be
a sale of the asset, in which case the opportunity cost is the
expected proceeds from the sale, net of any capital gains taxes
renting or leasing the asset out, in which case the opportunity
cost is the expected present value of the after-tax rental or
lease revenues.
use elsewhere in the business, in which case the opportunity
cost is the cost of replacing it.
Aswath Damodaran
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Case 1: Foregone Sale?
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Assume that Disney owns land in Rio already. This land is
undeveloped and was acquired several years ago for $ 5
million for a hotel that was never built. It is anticipated,
if this theme park is built, that this land will be used to
build the offices for Disney Rio. The land currently can be
sold for $ 40 million, though that would create a capital
gain (which will be taxed at 20%). In assessing the theme
park, which of the following would you do:
Ignore the cost of the land, since Disney owns its already
Use the book value of the land, which is $ 5 million
Use the market value of the land, which is $ 40 million
Other:
Aswath Damodaran
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Case 2: Incremental Cost?
An Online Retailing Venture for Bookscape
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The initial investment needed to start the service, including the
installation of additional phone lines and computer equipment, will be $1
million. These investments are expected to have a life of four years, at
which point they will have no salvage value. The investments will be
depreciated straight line over the four-year life.
The revenues in the first year are expected to be $1.5 million, growing
20% in year two, and 10% in the two years following. The cost of the
books will be 60% of the revenues in each of the four years.
The salaries and other benefits for the employees are estimated to be
$150,000 in year one, and grow 10% a year for the following three years.
The working capital, which includes the inventory of books needed for the
service and the accounts receivable will be10% of the revenues; the
investments in working capital have to be made at the beginning of each
year. At the end of year 4, the entire working capital is assumed to be
salvaged.
The tax rate on income is expected to be 40%.
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Cost of capital for investment
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We will re-estimate the beta for this online project by looking at
publicly traded online retailers. The unlevered total beta of online
retailers is 3.02, and we assume that this project will be funded
with the same mix of debt and equity (D/E = 21.41%, Debt/Capital
= 17.63%) that Bookscape uses in the rest of the business. We will
assume that Bookscape’s tax rate (40%) and pretax cost of debt
(4.05%) apply to this project.
Levered Beta Online Service = 3.02 [1 + (1 – 0.4) (0.2141)] = 3.41
Cost of Equity Online Service = 2.75% + 3.41 (5.5%) = 21.48%
Cost of CapitalOnline Service= 21.48% (0.8237) + 4.05% (1 – 0.4) (0.1763) =
18.12%
This is much higher than the cost of capital (10.30%) we computed
for Bookscape earlier, but it reflects the higher risk of the online
retail venture.
Aswath Damodaran
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Incremental Cash flows on Investment
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0 1 2 3 4
Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating Expenses
Labor $150,000 $165,000 $181,500 $199,650
Materials $900,000 $1,080,000 $1,188,000 $1,306,800
Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550
Taxes $80,000 $122,000 $144,200 $168,620
After-tax Operating Income $120,000 $183,000 $216,300 $252,930
+ Depreciation $250,000 $250,000 $250,000 $250,000
- Change in Working
Capital $150,000 $30,000 $18,000 $19,800 -$217,800
+ Salvage Value of
Investment $0
Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730
Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
NPV of investment = $76,375
Aswath Damodaran
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The side costs…
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It is estimated that the additional business associated with
online ordering and the administration of the service itself
will add to the workload for the current general manager of
the bookstore. As a consequence, the salary of the general
manager will be increased from $100,000 to $120,000 next
year; it is expected to grow 5 percent a year after that for the
remaining three years of the online venture. After the online
venture is ended in the fourth year, the manager’s salary will
revert back to its old levels.
It is also estimated that Bookscape Online will utilize an office
that is currently used to store financial records. The records
will be moved to a bank vault, which will cost $1000 a year to
rent.
Aswath Damodaran
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NPV with side costs…
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Additional salary costs = PV of $34,352
Office Costs
After-Tax Additional Storage Expenditure per Year = $1,000 (1 – 0.40) = $600
PV of expenditures = $600 (PV of annuity, 18.12%,4 yrs) = $1,610
NPV with Opportunity Costs = $76,375 – $34,352 – $1,610= $ 40,413
Opportunity costs aggregated into cash flows
Year Cashflows Opportunity costs Cashflow with opportunity costs Present Value
0 ($1,150,000) ($1,150,000) ($1,150,000)
1 $340,000 $12,600 $327,400 $277,170
2 $415,000 $13,200 $401,800 $287,968
3 $446,500 $13,830 $432,670 $262,517
4 $720,730 $14,492 $706,238 $362,759
Adjusted NPV $40,413
Aswath Damodaran
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Case 3: Excess Capacity
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In the Vale example, assume that the firm will use its
existing distribution system to service the production
out of the new iron ore mine. The mine manager
argues that there is no cost associated with using
this system, since it has been paid for already and
cannot be sold or leased to a competitor (and thus
has no competing current use). Do you agree?
a. Yes
b. No
Aswath Damodaran
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A Framework for Assessing The Cost of Using
Excess Capacity
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If I do not add the new product, when will I run out
of capacity?
If I add the new product, when will I run out of
capacity?
When I run out of capacity, what will I do?
Cut back on production: cost is PV of after-tax cash flows
from lost sales
Buy new capacity: cost is difference in PV between earlier
& later investment
Aswath Damodaran
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Product and Project Cannibalization: A Real
Cost?
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Assume that in the Disney theme park example, 20% of the
revenues at the Rio Disney park are expected to come from
people who would have gone to Disney theme parks in the
US. In doing the analysis of the park, you would
a. Look at only incremental revenues (i.e. 80% of the total revenue)
b. Look at total revenues at the park
c. Choose an intermediate number
Would your answer be different if you were analyzing
whether to introduce a new show on the Disney cable
channel on Saturday mornings that is expected to attract 20%
of its viewers from ABC (which is also owned by Disney)?
a. Yes
b. No
Aswath Damodaran
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B. Project Synergies
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A project may provide benefits for other projects within the firm.
Consider, for instance, a typical Disney animated movie. Assume
that it costs $ 50 million to produce and promote. This movie, in
addition to theatrical revenues, also produces revenues from
the sale of merchandise (stuffed toys, plastic figures, clothes ..)
increased attendance at the theme parks
stage shows (see “Beauty and the Beast” and the “Lion King”)
television series based upon the movie
In investment analysis, however, these synergies are either left
unquantified and used to justify overriding the results of
investment analysis, i.e,, used as justification for investing in
negative NPV projects.
If synergies exist and they often do, these benefits have to be
valued and shown in the initial project analysis.
Aswath Damodaran
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Case 1: Adding a Café to a bookstore:
Bookscape
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Assume that you are considering adding a café to the bookstore. Assume
also that based upon the expected revenues and expenses, the café
standing alone is expected to have a net present value of -$87,571.
The cafe will increase revenues at the book store by $500,000 in year 1,
growing at 10% a year for the following 4 years. In addition, assume that
the pre-tax operating margin on these sales is 10%.
1 2 3 4 5
Increased Revenues $500,000 $550,000 $605,000 $665,500 $732,050
Operating Margin 10.00% 10.00% 10.00% 10.00% 10.00%
Operating Income $50,000 $55,000 $60,500 $66,550 $73,205
Operating Income after Taxes $30,000 $33,000 $36,300 $39,930 $43,923
PV of Additional Cash Flows $27,199 $27,126 $27,053 $26,981 $26,908
PV of Synergy Benefits $135,268
The net present value of the added benefits is $135,268. Added to the
NPV of the standalone Café of -$87,571 yields a net present value of
$47,697.
Aswath Damodaran
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Case 2: Synergy in a merger..
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We valued Harman International for an acquisition by Tata Motors and
estimated a value of $ 2,476 million for the operating assets and $ 2,678
million for the equity in the firm, concluding that it would not be a value-
creating acquisition at its current market capitalization of $5,248 million.
In estimating this value, though, we treated Harman International as a
stand-alone firm.
Assume that Tata Motors foresees potential synergies in the combination
of the two firms, primarily from using its using Harman’s high-end audio
technology (speakers, tuners) as optional upgrades for customers buying
new Tata Motors cars in India. To value this synergy, let us assume the
following:
It will take Tata Motors approximately 3 years to adapt Harman’s products to Tata
Motors cars.
Tata Motors will be able to generate Rs 10 billion in after-tax operating income in
year 4 from selling Harman audio upgrades to its Indian customers, growing at a
rate of 4% a year after that in perpetuity (but only in India).
Aswath Damodaran
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Estimating the cost of capital to use in valuing
synergy..
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Business risk: The perceived synergies flow from optional add-ons
in auto sales. We will begin with the levered beta of 1.10, that we
estimated for Tata Motors in chapter 4, in estimating the cost of
equity.
Geographic risk: The second is that the synergies are expected to
come from India; consequently, we will add the country risk
premium of 3.60% for India, estimated in chapter 4 (for Tata
Motors) to the mature market premium of 5.5%.
Debt ratio: Finally, we will assume that the expansion will be
entirely in India, with Tata Motors maintain its existing debt to
capital ratio of 29.28% and its current rupee cost of debt of 9.6%
and its marginal tax rate of 32.45%.
Cost of equity in Rupees = 6.57% + 1.10 (5.5%+3.60%) = 16.59%
Cost of debt in Rupees = 9.6% (1-.3245) = 6.50%
Cost of capital in Rupees = 16.59% (1-.2928) + 6.50% (.2928) = 13.63%
Aswath Damodaran
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Estimating the value of synergy… and what Tata
can pay for Harman
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Value of synergyYear 3 =
Value of synergy today =
Converting the synergy value into dollar terms at the prevailing
exchange rate of Rs 60/$, we can estimate a dollar value for the
synergy from the potential acquisition:
Value of synergy in US $ = Rs 70,753/60 = $ 1,179 million
Adding this value to the intrinsic value of $2,678 million that we
estimated for Harman’s equity in chapter 5, we get a total value for
the equity of $3,857 million.
Value of Harman = $2,664 million + $1,179 million = $3,843 million
Since Harman’s equity trades at $5,248 million, the acquisition still
does not make sense, even with the synergy incorporated into
value.
Aswath Damodaran
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III. Project Options
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One of the limitations of traditional investment analysis
is that it is static and does not do a good job of capturing
the options embedded in investment.
The first of these options is the option to delay taking a project,
when a firm has exclusive rights to it, until a later date.
The second of these options is taking one project may allow us
to take advantage of other opportunities (projects) in the future
The last option that is embedded in projects is the option to
abandon a project, if the cash flows do not measure up.
These options all add value to projects and may make a
“bad” project (from traditional analysis) into a good one.
Aswath Damodaran
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The Option to Delay
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When a firm has exclusive rights to a project or product for a specific
period, it can delay taking this project or product until a later date. A
traditional investment analysis just answers the question of whether the
project is a “good” one if taken today. The rights to a “bad” project can
still have value.
PV of Cash Flows
Initial Investment in
Project NPV is positive in this section
Present Value of Expected
Cash Flows on Product
Aswath Damodaran
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Insights for Investment Analyses
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Having the exclusive rights to a product or project is
valuable, even if the product or project is not viable
today.
The value of these rights increases with the volatility
of the underlying business.
The cost of acquiring these rights (by buying them or
spending money on development - R&D, for
instance) has to be weighed off against these
benefits.
Aswath Damodaran
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The Option to Expand/Take Other Projects
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Taking a project today may allow a firm to consider and take other
valuable projects in the future. Thus, even though a project may have a
negative NPV, it may be a project worth taking if the option it provides the
firm (to take other projects in the future) has a more-than-compensating
value.
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Cash Flows on Expansion
Expansion becomes
Firm will not expand in attractive in this section
this section
Aswath Damodaran
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The Option to Abandon
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A firm may sometimes have the option to abandon a project, if the cash
flows do not measure up to expectations.
If abandoning the project allows the firm to save itself from further
losses, this option can make a project more valuable.
PV of Cash Flows
from Project
Cost of Abandonment
Present Value of Expected
Cash Flows on Project
Aswath Damodaran
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IV. Assessing Existing or Past investments…
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While much of our discussion has been focused on
analyzing new investments, the techniques and
principles enunciated apply just as strongly to
existing investments.
With existing investments, we can try to address one
of two questions:
Post –mortem: We can look back at existing investments
and see if they have created value for the firm.
What next? We can also use the tools of investment
analysis to see whether we should keep, expand or
abandon existing investments.
Aswath Damodaran
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Analyzing an Existing Investment
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In a post-mortem, you look at the actual cash You can also reassess your expected cash
flows, relative to forecasts. flows, based upon what you have learned,
and decide whether you should expand,
continue or divest (abandon) an investment
Aswath Damodaran
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a. Post Mortem Analysis
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The actual cash flows from an investment can be greater than or less than
originally forecast for a number of reasons but all these reasons can be
categorized into two groups:
Chance: The nature of risk is that actual outcomes can be different from
expectations. Even when forecasts are based upon the best of information, they
will invariably be wrong in hindsight because of unexpected shifts in both macro
(inflation, interest rates, economic growth) and micro (competitors, company)
variables.
Bias: If the original forecasts were biased, the actual numbers will be different from
expectations. The evidence on capital budgeting is that managers tend to be over-
optimistic about cash flows and the bias is worse with over-confident managers.
While it is impossible to tell on an individual project whether chance or
bias is to blame, there is a way to tell across projects and across time. If
chance is the culprit, there should be symmetry in the errors – actuals
should be about as likely to beat forecasts as they are to come under
forecasts. If bias is the reason, the errors will tend to be in one direction.
Aswath Damodaran
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b. What should we do next?
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........ Liquidate the project
........ Terminate the project
........ Divest the project
........ Continue the project
Aswath Damodaran
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Example: Disney California Adventure –
The 2008 judgment call
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Disney opened the Disney California Adventure (DCA) Park in 2001, at a cost of
$1.5 billion, with a mix of roller coaster rides and movie nostalgia. Disney
expected about 60% of its visitors to Disneyland to come across to DCA and
generate about $ 100 million in annual after-cash flows for the firm.
By 2008, DCA had not performed up to expectations. Of the 15 million people
who came to Disneyland in 2007, only 6 million visited California Adventure, and
the cash flow averaged out to only $ 50 million between 2001 and 2007.
In early 2008, Disney faced three choices:
Shut down California Adventure and try to recover whatever it can of its initial investment. It is
estimated that the firm recover about $ 500 million of its investment.
Continue with the status quo, recognizing that future cash flows will be closer to the actual values ($
50 million) than the original projections.
Invest about $ 600 million to expand and modify the par, with the intent of increasing the number of
attractions for families with children, is expected to increase the percentage of Disneyland visitors
who come to DCA from 40% to 60% and increase the annual after tax cash flow by 60% (from $ 50
million to $ 80 million) at the park.
Aswath Damodaran
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DCA: Evaluating the alternatives…
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Continuing Operation: Assuming the current after-tax cash flow of
$ 50 million will continue in perpetuity, growing at the inflation rate
of 2% and discounting back at the theme park cost of capital in
2008 of 6.62% yields a value for continuing with the status quo
Value of DCA =
Abandonment: Abandoning this investment currently would allow
Disney to recover only $ 500 million of its original investment.
Abandonment value of DCA = $ 500 million
Expansion: The up-front cost of $ 600 million will lead to more
visitors in the park and an increase in the existing cash flows from $
50 to $ 80 million.
Value of CF from expansion =
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First Principles
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