The return on an investment is perhaps the most obvious aspect of the investment decision for corporate finance. However, there’s more to evaluating an investment than just looking at the earnings. In this post we will talk more in detail about how to evaluate an investment in light of its potential returns.
First Things First: Cash flow
Before we get into the process of evaluating returns, we must consider how we are measuring returns. There are various ways of quantifying earnings, but which one makes sense?
We use cash flow to calculate the returns of an investment. Cash flow allows us to both quantify the returns and evaluate the timing of the returns. Furthermore, cash is something we can actually spend as opposed to earnings which are merely available on the books.
Return mantra: time-weighted, incremental, cash flow return
- Cash flows, because you cannot “spend” earnings
- Incremental, because you want to evaluate returns related to the investment
- Time-weighted, because early returns are more convenient than later returns
What Impacts Returns?
The next question to ask is what actually impacts returns. Turns out there are several factors:
- Revenues may be overestimated
- Revenues may be delayed
- Operating costs and capital expenditure may be underestimated
- Tax rate may increase
- Interest rates may increase
- Risk premiums and default spreads may increase
- There may be unanticipated opportunity costs
- Synergy within the company may be overestimated
All of the variables above will have an impact on the evaluation of the return of an investment and must be considered before approving a new investment
Estimating Cash flow Returns
The two main drivers of estimating the return are projected revenues and projected expenses.
Estimating operating income
The revenues include all income related to the investment.
The expenses include the capital expenditure required to initiate the project (such as buying land or machines) as well as fixed and variable operating expenses. Also take into account the depreciation, amortization, G&A costs and the taxes to be paid on the operating income as these will directly affect the cash flows.
After-Tax Operating Income =
- Operating Expenses
- G&A expense
From operating income to cash flow to firm
The result of is an estimate of after-tax operating income related to the project. To get the cash flow view of the project we add back the non-cash charges, less the capital expenditures and change in non-cash work capital such as inventory and accounts receivable.
Cash flow to firm =
+ After-Tax Operating Income
+ Tax benefits received
- Capital Expenditures
- Change in non-cash work capital
From cash flow to incremental cash flow
To calculate the incremental cash flows on the project, we include the pre-project sunk investment, less the tax on depreciation and add back tax on allocated G&A.
Incremental cash flow to firm =
+ Cash flow to firm
+ Pre-project sunk investment
- Pre-project depreciation * tax rate
+ Non-incremental allocated expense (1 - tax rate)
From incremental to time-weighted cash flow
Now that we have an overview of the incremental cash flows to the firm, it’s time to factor in the time value of the cash flows. As said, we consider the timing of the cash flows because early returns are more convenient than later returns.
Net Present Value (NPV)
To calculate the time-weighted cash flow, we use Net Present Value of the cash flows. The NPV is the sum of the present value of all cash flows on the project including the initial investment.
The cash flows are discounted at the appropriate hurdle rate. Use cost of capital if the cash flows return to the firm, or use cost of equity of the cash flows return to equity investors.
If the Net Present Value is higher than Zero, then the project is acceptable.
Internal Rate of Return (IRR)
The internal rate of return is the discount rate for which the net present value is zero.
If the Internal Rate of Return is higher than the hurdle rate, then the project is acceptable
If a project or investment is finite and short life, then you can calculate a salvage value. It is the expected proceeds from selling all of the investment in the project at the end of the project life. Typically the salvage value is sum of the book value of fixed assets and the working capital.
For a project with undetermined or very long life, it is sometimes not reasonable to estimate the present value of all cash flows. It is reasonable to compute a terminal value which constitutes the present value of all cash flows beyond the estimated cash flows.
To calculate the terminal value, it is reasonable to use the inflation rate as growth rate. The terminal value in year n is then:
TV(n) = (Cash Flow in Year n+1) / (cost of capital – growth rate)
Uncertainty and Returns
In the beginning of the post we outlined the various factors that may impact the revenue. At the beginning of a project, we forecast revenues and costs as best as possible. But since we can never be sure about the future, there is always a certain degree of uncertainty. What can we do about it?
A simplistic approach to this problem is to calculate how quickly we earn back our money. Based on the projected cash flows we can determine the timing of investment payback.
Sadly, this method does not help us understand, value and mitigate the uncertainty. What degree of inaccuracy of which assumptions will are NPV and IRR most sensitive to?
With sensitivity analysis and what-if questions we can determine this. As sensitivity analysis can get complicated, we will cover this topic in a different post.
Side Costs and Benefits
Most projects or investments create side costs and benefits to the business that are not directly linked to the project.
The opportunity cost is allocated resources of a firm to a project that could otherwise have been allocated to another project. It represents the loss of opportunity of a project that could not be invested in.
Within the organization, multiple projects could create synergies that are not captured in the traditional capital budgeting analysis.
The returns on a project should incorporate these cost and benefits.