Session 14: Investment Returns I- Setting the Table

Measuring Investment Returns

In this session, the focus is on measuring investment returns and the importance of using cash flows over earnings for accurate assessment.

Cash Flows vs. Earnings

• Returns on investment should be based on cash flows rather than earnings.

• Cash flows need to reflect timing and include side benefits and costs with time-weighting.

• Accounting earnings follow accrual accounting principles, recording transactions when they occur, not when payment is made.

Adjustments from Earnings to Cash Flows

• Key adjustments from accounting earnings to cash flows: add back depreciation, subtract capital expenditures, adjust for change in working capital.

• Depreciation and amortization are added back as non-cash expenses.

• Capital expenditures are subtracted out as they represent actual cash outflows.

Investment Principle Illustration

The discussion delves into illustrating the investment principle through a hypothetical project example involving Disney theme parks.

Hypothetical Project Analysis

• Introduction of a hypothetical project resembling Disney theme parks - Magic Kingdom and Epcot variants.

• Details on construction timelines and costs associated with building the theme parks.

Disney Theme Park Financial Analysis

In this section, the financial analysis of Disney's theme parks is discussed, focusing on earnings, costs, and accounting statements.

Disney Theme Park Earnings and Costs

• Earnings from theme parks are not always reflected in accounting statements.

• Disney's theme park development over time is evident.

• Operating losses of $50 million are incurred initially.

• Off-tax operating losses can be offset against profits elsewhere in the company to save taxes.

• Claiming losses against profits can save around $18 million annually.

• Revenue generation and building up of resort properties lead to increasing revenues over time.

• Euro Disney's growth serves as a reference point for revenue increase.

Accounting Expenses and Profits

• Estimations based on existing theme parks guide revenue projections.

• Depreciation and amortization of capital expenditures impact expenses.

• Allocated GNA expenses are subtracted from earnings despite being non-incremental costs.

• Two-thirds of GNA expenses do not directly relate to the theme park operations.

Profit Scaling and Return on Capital

• Initial years show losses turning into significant profits by year 10 due to theme park success.

• Scaling profits relative to investments is crucial for evaluation.

• Return on capital fluctuates annually but averages around 4% for the theme park business.

• The return on capital metric aids in assessing investment performance.

Cash Flows vs. Returns in Theme Park Business

This segment delves into the importance of cash flows over returns in evaluating investments, emphasizing the relevance of cost-of-capital considerations.

Cash Flow Evaluation

• Cash flows supersede returns as a more accurate measure for investment assessment.

• Operating income rather than net income is pivotal for evaluating returns.

• Cost-of-capital considerations play a crucial role in determining hurdle rates for investments like theme parks.

• Hurdle rates should align with investment risks and timing of cash flows.

Accounting Principles Impacting Investments

• Expense breakdown into operating and financial expenditures influences investment evaluations.

• Operating expenses affect income statements directly, while financial expenditures impact net income indirectly.

• Risk diversification strategies help mitigate portfolio risks across different markets and industries.

Financial Analysis of Theme Parks

In this section, the speaker discusses the importance of considering country risk premiums in financial analysis and the impact on decision-making for investments in theme parks.

Country Risk Premium and Investment Decision

• Disney needs to account for potential shocks to the system when investing in a theme park outside the US.

• Utilizing a country risk premium is prudent to reflect the risks associated with operating in different countries.

• The speaker subtracts capital expenditures from calculations to assess true costs and returns accurately.

Earnings vs. Cash Flows in Theme Park Investments

This part delves into the significance of distinguishing between earnings and cash flows when evaluating theme park investments.

Importance of Cash Flows

• Emphasizes using cash flows over earnings due to their tangible nature for investment evaluation.

• Working capital changes are crucial as they represent shifts from earnings to actual cash earnings.

Equity Risk Premium and Cost of Equity Calculation

The discussion revolves around equity risk premiums, beta values, and their implications on cost of equity calculations.

Equity Risk Premium Considerations

• The equity risk premium influences the cost of equity calculation for companies like Disney.

• Beta remains constant for theme park investments despite variations in other factors.

Investment Hurdle Rates and Decision-Making

Evaluating hurdle rates, cash flow considerations, and decision-making processes regarding theme park investments.

Hurdle Rates Assessment

• Young companies may report negative cash flows despite positive earnings due to investment dynamics.

• Using reasonable hurdle rates is essential for making informed investment decisions.

Accounting Returns vs. Cash Flows Analysis

Comparing accounting returns with required hurdle rates for assessing project viability.

Project Viability Evaluation

• Accounting returns at 4% contrasted with an 8.5% hurdle rate indicate profitability thresholds for Disney's theme park projects.

New Section

In this section, the speaker discusses computing accounting return and capital in a company, highlighting the costs involved and potential savings.

Computing Accounting Return and Capital

• To compute the accounting return and capital in a company, consider the loss of $50 million. This loss can be offset by profits from other areas of the company, such as a theme park, potentially saving around $18 million.

New Section

The speaker delves into the concept of paying taxes on operating income and determining return and capital measures based on cost to capital calculations.

Taxation on Operating Income and Return Measures