Session 15: Investment Returns II - Getting to Time Weighted Cash Flows

New Section

In this section, the speaker discusses the process of transitioning from earnings to cash flows, incremental cash flows, and time-weighted incremental cash flow returns in the context of measuring investment returns on a project.

Transitioning from Earnings to Cash Flows

• The speaker emphasizes the importance of moving from accounting earnings to cash flows and outlines a three-step process for this transition.

• Detailed steps are provided for converting accounting earnings into cash flows by considering factors such as depreciation, amortization, capital expenditures, and changes in working capital.

• The impact of depreciation and amortization on taxes is highlighted as it influences cash flows despite seeming to cancel out in accounting earnings.

Understanding Incremental Cash Flows

• Incremental cash flows are discussed with a focus on adjustments needed, including ignoring sunk costs and identifying non-incremental expenses like allocated GNA.

• The concept of sunk costs is explained, emphasizing the need to exclude unrecoverable costs from decision-making processes.

Time-Weighting Cash Flows

• Adjustments for tax benefits related to allocated GNA are detailed as part of transitioning from cash flows to incremental cash flows.

New Section

In this section, the speaker discusses different types of cash flows and how to compute their present values.

Understanding Cash Flows

• Present value is calculated using an equation for future cash flows.

• Growing annuity involves a constant growth rate over a period, with its present value computed using specific equations.

• Perpetuity refers to a constant cash flow forever, with its present value determined by dividing the cash flow by the discount rate.

• Growing perpetuity entails a cash flow growing at a constant rate forever, with its present value dependent on the difference between the discount rate and growth rate.

• Five types of cash flows are discussed: ordinary annuity, growing annuity, perpetuity, growing perpetuity, and terminal value.

New Section

This part focuses on time-weighted incremental cash flow measures of return - net present value and internal rate of return.

Time-Weighted Incremental Cash Flow Measures

• Net Present Value (NPV) involves calculating the present value of each project's cash flow and summing them up; if NPV is above zero, it indicates a good project.

• Internal Rate of Return (IRR) is the discount rate where the present value equals zero; comparing IRR to cost of capital determines investment viability.

• NPV reflects earnings above cost of capital; even a positive NPV as low as one dollar signifies profitability.

• IRR compares returns to required rates; if IRR exceeds hurdle rates, it signals a favorable investment opportunity.

New Section

The speaker addresses extending project analysis beyond initial years by considering future growth assumptions.

Extending Project Analysis

• Assumption made to extend project life beyond initial years by projecting cash flows' growth at inflation rates while stabilizing other factors post-year 10.

Financial Analysis of a Theme Park

In this section, the speaker conducts a financial analysis of a theme park project, discussing the net present value (NPV) and internal rate of return (IRR) as evaluation metrics.

Net Present Value (NPV) Analysis

• The NPV for the theme park project is approximately 3.3 billion dollars when using a perpetuity assumption.

• Using perpetuity simplifies calculations without significantly altering the value.

• Positive NPV indicates that taking on the project will increase Disney's value by 3.3 billion.

Internal Rate of Return (IRR) Analysis

• The IRR for the theme park project is calculated at 12.6%, higher than the cost of capital at 8.46%.

• IRR profile helps understand sensitivity to discount rate changes and project duration.

• Comparing IRR to cost of capital confirms that the project is favorable.

NPV vs. IRR Comparison

This part delves into comparing Net Present Value (NPV) with Internal Rate of Return (IRR), highlighting key differences and considerations in financial analysis.

Differences Between NPV and IRR

• Scale disparity can influence favorability towards larger projects in NPV and smaller projects in IRR due to absolute value measurement.

• Multiple IRRs can exist if there are changes in cash flow signs, posing challenges in decision-making for projects with fluctuating cash flows.

• Varied assumptions about reinvestment: NPV assumes reinvestment at hurdle rate, while IRR implies reinvestment at its own rate, potentially leading to different outcomes.