Shouldtherebeariskpremiumforforeign
projects?
211
¨
Theexchangerateriskshouldbediversifiablerisk(andhence
shouldnotcommandapremium)if
¤
¤
¤
¨
¨
thecompanyhasprojectsisalargenumberofcountries(or)
theinvestorsinthecompanyaregloballydiversified.
ForDisney,thisriskshouldnotaffectthecostofcapitalused.
Consequently,wewouldnotadjustthecostofcapitalforDisney’s
investmentsinothermaturemarkets(Germany,UK,France)
Thesamediversificationargumentcanalsobeappliedagainst
somepoliticalrisk,whichwouldmeanthatittooshouldnotaffect
thediscountrate.However,thereareaspectsofpoliticalrisk
especiallyinemergingmarketsthatwillbedifficulttodiversifyand
mayaffectthecashflows,byreducingtheexpectedlifeorcash
flowsontheproject.
ForDisney,thisistheriskthatweareincorporatingintothecostof
capitalwhenitinvestsinBrazil(oranyotheremergingmarket)
AswathDamodaran
211
Shouldtherebeariskpremiumforforeign
projects?
¨
Theexchangerateriskshouldbediversifiablerisk(andhence
shouldnotcommandapremium)if
¤
¤
¤
¨
¨
thecompanyhasprojectsisalargenumberofcountries(or)
theinvestorsinthecompanyaregloballydiversified.
ForDisney,thisriskshouldnotaffectthecostofcapitalused.
Consequently,wewouldnotadjustthecostofcapitalforDisney’s
investmentsinothermaturemarkets(Germany,UK,France)
Thesamediversificationargumentcanalsobeappliedagainst
somepoliticalrisk,whichwouldmeanthatittooshouldnotaffect
thediscountrate.However,thereareaspectsofpoliticalrisk
especiallyinemergingmarketsthatwillbedifficulttodiversifyand
mayaffectthecashflows,byreducingtheexpectedlifeorcash
flowsontheproject.
ForDisney,thisistheriskthatweareincorporatingintothecostof
capitalwhenitinvestsinBrazil(oranyotheremergingmarket)
Aswath Damodaran
212
EstimatingahurdlerateforRioDisney
¨
¨
¨
Wedidestimateacostofcapitalof6.61%fortheDisneythemepark
business,usingabottom-upleveredbetaof0.7537forthebusiness.
Thiscostofequitymaynotadequatelyreflecttheadditionalrisk
associatedwiththethemeparkbeinginanemergingmarket.
Theonlyconcernwewouldhavewithusingthiscostofequityforthis
projectisthatitmaynotadequatelyreflecttheadditionalriskassociated
withthethemeparkbeinginanemergingmarket(Brazil).Wefirst
computedtheBrazilcountryriskpremium(bymultiplyingthedefault
spreadforBrazilbytherelativeequitymarketvolatility)andthenreestimatedthecostofequity:
¤
¤
¨
CountryriskpremiumforBrazil=5.5%+3%=8.5%
CostofEquityinUS$=2.75%+0.7537(8.5%)=9.16%
Usingthisestimateofthecostofequity,Disney’sthemeparkdebtratio
of10.24%anditsafter-taxcostofdebtof2.40%(seechapter4),wecan
estimatethecostofcapitalfortheproject:
¤
CostofCapitalinUS$=9.16%(0.8976)+2.40%(0.1024)=8.46%
Aswath Damodaran
213
Wouldleadustoconcludethat...
¨
¨
Donotinvestinthispark.Thereturnoncapitalof
4.18%islowerthanthecostofcapitalfortheme
parksof8.46%;Thiswouldsuggestthattheproject
shouldnotbetaken.
Giventhatwehavecomputedtheaverageoveran
arbitraryperiodof10years,whilethethemepark
itselfwouldhavealifegreaterthan10years,would
youfeelcomfortablewiththisconclusion?
Yes
¤ No
¤
Aswath Damodaran
214
ATangent:FromNewtoExisting
Investments:ROCfortheentirefirm
Assets
How “good” are the
existing investments
of the firm?
Existing Investments
Generate cashflows today
Includes long lived (fixed) and
short-lived(working
capital) assets
Expected Value that will be
created by future investments
Liabilities
Assets in Place
Debt
Growth Assets
Equity
Fixed Claim on cash flows
Little or No role in management
Fixed Maturity
Tax Deductible
Residual Claim on cash flows
Significant Role in management
Perpetual Lives
Measuring ROC for existing investments..
Aswath Damodaran
215
Thereturnoncapitalisanaccountingnumber,
though,andthatshouldscareyou.
Aswath Damodaran
216
ReturnSpreadsGlobally….
217
217
6 ApplicationTest:AssessingInvestment
Quality
¨
¨
¨
¨
¨
Forthemostrecentperiodforwhichyouhavedata,
computetheafter-taxreturnoncapitalearnedbyyour
firm,whereafter-taxreturnoncapitaliscomputedtobe
After-taxROC=EBIT(1-taxrate)/(BVofdebt+BVof
Equity-Cash)previousyear
Forthemostrecentperiodforwhichyouhavedata,
computethereturnspreadearnedbyyourfirm:
ReturnSpread=After-taxROC- CostofCapital
Forthemostrecentperiod,computetheEVAearnedby
yourfirm
EVA=ReturnSpread*((BVofdebt+BVofEquityCash)previousyear
Aswath Damodaran
218
Thecashflowviewofthisproject..
0
After-tax Operating Income
+ Depreciation & Amortization
- Capital Expenditures
- Change in non-cash Work Capital
Cashflow to firm
$0
1
2
3
4
5
6
7
8
9
10
-$32
-$96
-$54
$68
$50
$425
$469 $444 $372 $367 $364 $364 $366 $368
$202 $249 $299 $352 $410 $421
$2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
$0
$63
$25
$38
$31
$16
$17
$19
$21
$5
($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
Aswath Damodaran
219
TheDepreciationTaxBenefit
220
¨
¨
¨
¨
Whiledepreciationreducestaxableincomeandtaxes,itdoesnotreduce
thecashflows.
Thebenefitofdepreciationisthereforethetaxbenefit.Ingeneral,thetax
benefitfromdepreciationcanbewrittenas:
TaxBenefit=Depreciation*TaxRate
DisneyThemePark:Depreciationtaxsavings(Taxrate=36.1%)
Depreciation
Tax Bendfits from Depreciation
¨
¨
1
$50
$18
2
$425
$153
3
$469
$169
4
5
6
7
8
9
10
$444 $372 $367 $364 $364 $366 $368
$160 $134 $132 $132 $132 $132 $133
Proposition1:Thetaxbenefitfromdepreciationandothernon-cash
chargesisgreater,thehigheryourtaxrate.
Proposition2:Non-cashchargesthatarenottaxdeductible(suchas
amortizationofgoodwill)andthusprovidenotaxbenefitshavenoeffect
oncashflows.
AswathDamodaran
220
DepreciationMethods
221
¨
Broadlycategorizing,depreciationmethodscanbeclassified
asstraightlineoracceleratedmethods.Instraightline
depreciation,thecapitalexpenseisspreadevenlyovertime,
Inaccelerateddepreciation,thecapitalexpenseis
depreciatedmoreinearlieryearsandlessinlateryears.
Assumethatyoumadealargeinvestmentthisyear,andthat
youarechoosingbetweenstraightlineandaccelerated
depreciationmethods.Whichwillresultinhighernetincome
thisyear?
¤
¤
¨
StraightLineDepreciation
AcceleratedDepreciation
Whichwillresultinhighercashflowsthisyear?
¤
¤
StraightLineDepreciation
AcceleratedDepreciation
AswathDamodaran
221
TheCapitalExpendituresEffect
222
¨
¨
Capitalexpendituresarenottreatedasaccountingexpenses
buttheydocausecashoutflows.
Capitalexpenditurescangenerallybecategorizedintotwo
groups
¤
¤
¨
¨
New(orGrowth)capitalexpendituresarecapitalexpenditures
designedtocreatenewassetsandfuturegrowth
Maintenancecapitalexpendituresrefertocapitalexpenditures
designedtokeepexistingassets.
Bothinitialandmaintenancecapitalexpendituresreduce
cashflows
Theneedformaintenancecapitalexpenditureswillincrease
withthelifeoftheproject.Inotherwords,a25-yearproject
willrequiremoremaintenancecapitalexpendituresthana2yearproject.
AswathDamodaran
222
Tocapexornottocapex?
223
¨
Assumethatyourunyourownsoftwarebusiness,and
thatyouhaveanexpensethisyearof$100millionfrom
producinganddistributionpromotionalCDsinsoftware
magazines.Youraccountanttellsyouthatyoucan
expensethisitemorcapitalizeanddepreciateitover
threeyears.Whichwillhaveamorepositiveeffecton
income?
¤
¤
¨
Expenseit
CapitalizeandDepreciateit
Whichwillhaveamorepositiveeffectoncashflows?
¤
¤
Expenseit
CapitalizeandDepreciateit
AswathDamodaran
223
TheWorkingCapitalEffect
224
¨
¨
¨
Intuitively,moneyinvestedininventoryorinaccountsreceivablecannot
beusedelsewhere.It,thus,representsadrainoncashflows
Tothedegreethatsomeoftheseinvestmentscanbefinancedusing
suppliercredit(accountspayable),thecashflowdrainisreduced.
Investmentsinworkingcapitalarethuscashoutflows
¤
¤
¨
¨
¨
Anyincreaseinworkingcapitalreducescashflowsinthatyear
Anydecreaseinworkingcapitalincreasescashflowsinthatyear
Toprovideclosure,workingcapitalinvestmentsneedtobesalvagedat
theendoftheprojectlife.
Proposition1:Thefailuretoconsiderworkingcapitalinacapital
budgetingprojectwilloverstatecashflowsonthatprojectandmakeit
lookmoreattractivethanitreallyis.
Proposition2:Otherthingsheldequal,areductioninworkingcapital
requirementswillincreasethecashflowsonallprojectsforafirm.
AswathDamodaran
224
Theincrementalcashflowsontheproject
$ 500 million has
already been spent & $
50 million in
depreciation will exist
anyway
Aswath Damodaran
2/3rd of allocated G&A is fixed.
Add back this amount (1-t)
Tax rate = 36.1%
225
Amoredirectwayofgettingto
incrementalcashflows
226
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
$1,000
$1,188
$752
$276
$258
$285
$314
$330
$347
$350
$0
$63
$25
$38
$31
$16
$17
$19
$21
$5
($859)
($267)
$340
$466
$516
$555
$615
$681
$715
- Capital Expenditures
- Change in non-cash Working Capital
Cashflow to firm
AswathDamodaran
$2,000
($2,000) ($1,000)
226
SunkCosts
227
¨
¨
¨
Whatisasunkcost? Anyexpenditurethathasalready
beenincurred,andcannotberecovered(evenifa
projectisrejected)iscalledasunkcost.Atestmarketfor
aconsumerproductandR&Dexpensesforadrug(fora
pharmaceuticalcompany)wouldbegoodexamples.
Thesunkcostrule:Whenanalyzingaproject,sunkcosts
shouldnotbeconsideredsincetheyarenotincremental.
ABehavioralAside:Itisawellestablishedfindingin
psychologicalandbehavioralresearchthatmanagers
finditalmostimpossibletoignoresunkcosts.
AswathDamodaran
227
TestMarketingandR&D:TheQuandaryofSunk
Costs
228
¨
Aconsumerproductcompanyhasspent$100millionon
testmarketing.Lookingatonlytheincrementalcash
flows(andignoringthetestmarketing),theprojectlooks
likeitwillcreate$25millioninvalueforthecompany.
Shouldittaketheinvestment?
¤
¤
¨
Yes
No
Nowassumethateveryinvestmentthatthiscompany
hassharesthesamecharacteristics(Sunkcosts>Value
Added).Thefirmwillclearlynotbeabletosurvive.What
isthesolutiontothisproblem?
AswathDamodaran
228
AllocatedCosts
229
¨
¨
¨
Firmsallocatecoststoindividualprojectsfroma
centralizedpool(suchasgeneralandadministrative
expenses)baseduponsomecharacteristicofthe
project(salesisacommonchoice,asisearnings)
Forlargefirms,theseallocatedcostscanbe
significantandresultintherejectionofprojects
Tothedegreethatthesecostsarenotincremental
(andwouldexistanyway),thismakesthefirmworse
off.Thus,itisonlytheincrementalcomponentof
allocatedcoststhatshouldshowupinproject
analysis.
AswathDamodaran
229
BreakingoutG&ACostsintofixedandvariable
components:Asimpleexample
230
¨
Assumethatyouhaveatimeseriesofrevenuesand
G&Acostsforacompany.
¤
WhatpercentageoftheG&Acostisvariable?
AswathDamodaran
230
ToTime-WeightedCashFlows
231
¨
¨
¨
Incrementalcashflowsintheearlieryearsareworth
morethanincrementalcashflowsinlateryears.
Infact,cashflowsacrosstimecannotbeaddedup.
Theyhavetobebroughttothesamepointintime
beforeaggregation.
Thisprocessofmovingcashflowsthroughtimeis
discounting,whenfuturecashflowsarebroughttothe
present
¤ compounding,whenpresentcashflowsaretakentothe
future
¤
AswathDamodaran
231
PresentValueMechanics
232
CashFlowType
1.SimpleCF
¨
2.Annuity
3.GrowingAnnuity
4.Perpetuity
5.GrowingPerpetuity
AswathDamodaran
DiscountingFormula
CFn /(1+r)n
CompoundingFormula
CF0 (1+r)n
!
1 $
#1 - (1+r)n &
A#
&
r
#
&
#"
&%
!
(1+g)n $
#1 n &
(1+r)
&
A(1+g) #
r-g
#
&
#"
&%
" (1 + r) n - 1 %
A$
'
r
#
&
€
A/r
ExpectedCashflow nextyear/(r-g)
232
Discountedcashflowmeasuresofreturn
233
¨
NetPresentValue(NPV):Thenetpresentvalueisthe
sumofthepresentvaluesofallcashflowsfromthe
project(includinginitialinvestment).
¤
¤
¨
NPV=Sumofthepresentvaluesofallcashflowsontheproject,
includingtheinitialinvestment,withthecashflowsbeing
discountedattheappropriatehurdlerate(costofcapital,ifcash
flowiscashflowtothefirm,andcostofequity,ifcashflowisto
equityinvestors)
DecisionRule:AcceptifNPV>0
InternalRateofReturn(IRR):Theinternalrateofreturn
isthediscountratethatsetsthenetpresentvalueequal
tozero.Itisthepercentagerateofreturn,basedupon
incrementaltime-weightedcashflows.
¤
DecisionRule:AcceptifIRR>hurdlerate
AswathDamodaran
233