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CHAPTER 5

MEASURING RETURN ON INVESTMENTS
In chapter 4, we developed a process for estimating costs of equity, debt and
capital and presented an argument that the cost of capital is the minimum acceptable
hurdle rate. We also argued that a project has to earn a return greater than this hurdle rate
to create value to the owners of a business. In this chapter, we turn to the question of how
best to measure the return on a project. In doing so, we will attempt to answer the
following questions:
What is a project? In particular, how general is the definition of an investment and

what are the different types of investment decisions that firms have to make?
In measuring the return on a project, should we look at the cash flows generated by

the project or at the accounting earnings?
If the returns on a project are unevenly spread over time, how do we consider (or

should we not consider) differences in returns across time?
We will illustrate the basics of investment analysis using three hypothetical projects “ an
online book ordering service for Bookscape, a new theme park in Thailand for Disney
and a plant to manufacture linerboard for Aracruz Cellulose.


What is a project?

Investment analysis concerns which projects to accept and which to reject;
accordingly, the question of what comprises a “project” is central to this and the
following chapters. The conventional project
Salvage Value: This is the estimated
analyzed in capital budgeting has three criteria: (1)
liquidation value of the assets invested in
a large up-front cost, (2) cash flows for a specific the projects at the end of the project life.
time period, and (3) a salvage value at the end,
which captures the value of the assets of the project when the project ends. While such
projects undoubtedly form a significant proportion of investment decisions, especially for
manufacturing firms, it would be a mistake to assume that investment decision analysis
stops there. If a project is defined more broadly to include any decision that results in
using the scarce resources of a business, then everything from strategic decisions and

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acquisitions to decisions about which air conditioning system to use in a building would
fall within its reach.
Defined broadly then, any of the following decisions would qualify as projects:

1. Major strategic decisions to enter new areas of business (such as Disney™s foray into
real estate or Deutsche Bank™s into investment banking) or new markets (such as
Disney television™s expansion into Latin America)
2. Acquisitions of other firms (such as Disney™s acquisition of Capital Cities or
Deutsche Bank™s acquisition of Morgan Grenfell)
3. Decisions on new ventures within existing businesses or markets, such as the one
made by Disney to expand its Orlando theme park to include an Animal Kingdom or
the decision to produce a new animated children™s movie.
4. Decisions that may change the way existing ventures and projects are run, such as
decisions on deciding programming schedules on the Disney channel or changing
inventory policy at Bookscape.
5. Decisions on how best to deliver a service that is necessary for the business to run
smoothly. A good example would be Deutsche Bank™s decision on what type of
financial information system to acquire to allow traders and investment bankers to do
their jobs. While the information system itself might not deliver revenues and profits,
it is an indispensable component for other revenue Mutually Exclusive Projects: A
generating projects. group of projects is said to be
mutually exclusive, when acceptance
Investment decisions can be categorized on a
of one of the projects implies that the
number of different dimensions. The first relates to
rest have to be rejected.
how the project affects other projects the firm is
considering and analyzing. While some projects are independent of the analysis of any
other projects, and thus can be analyzed separately, other projects are mutually exclusive
““ i.e., taking one project will mean rejecting other projects; in this case, all of the
projects will have to be considered together. At the other extreme, some projects are pre-
requisites for other projects down the road. In general, projects can be categorized as
falling somewhere on the continuum between pre-requisites and mutually exclusive, as
depicted in Figure 5.1.



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The second dimension that can be used to classify is the ability of the project to
generate revenues or reduce costs. The decision rules that analyze revenue generating
projects attempt to evaluate whether the earnings or cash flows from the projects justify
the investment needed to implement them. When it comes to cost-reduction projects, the
decision rules examine whether the reduction in costs justifies the up-front investment
needed for the projects.

Illustration 5.1: Project Descriptions “ Disney, Aracruz and Bookscape
In this chapter and parts of the next, we will use three hypothetical projects to
illustrate the basics of investment analysis.
The first project we will look at is a proposal by Bookscape to add an on-line book

ordering and information service. While the impetus for this proposal comes from the
success of on-line book stores like Amazon, this on-line service will be more focused
on helping customers research books and find the ones they need rather than on price.
Thus, if Bookscape decides to add this service, it will have to hire and train two well
qualified individuals to answer customer queries, in addition to investing in the
computer equipment and phone lines that the service will require. This project
analysis will help illustrate some of the issues that come up when private businesses
look at investments and also when businesses take on projects that have a different
risk profile.
The second project we will analyze is a proposed theme park for Disney in Bangkok,

Thailand. Bangkok Disneyworld, which will be patterned on Euro Disney in Paris and
Disney World in Florida, will require a huge investment in infrastructure and take
several years to complete. This project analysis will bring several issues to the
forefront, including questions of how to deal with projects when the cash flows are in
a foreign currency and what to do when projects have very long lives.




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The third project we will consider is a plant in Brazil to manufacture linerboard for

Aracruz Cellulose. Linerboard is a stiffened paper product that can be transformed
into cardboard boxes. This investment is a more conventional one, with an initial
investment, a fixed lifetime and a salvage value at the end. We will, however, do the
analysis for this project from an equity standpoint to illustrate the generality of
investment analysis. In addition, in light of concerns about inflation, we will do the
analysis entirely in real terms.

Hurdle rates for firms versus Hurdle rates for projects
In the last chapter, we developed a process for estimating the costs of equity and
capital for firms. In this chapter, we will extend the discussion to hurdle rates in the
context of new or individual investments.

Using the firm™s hurdle rate for individual projects
Can we use the costs of equity and capital that we have estimated for the firms for
these projects? In some cases we can, but only if all investments made by a firm are
similar in terms of their risk exposure. As a firm™s investments become more diverse, in
terms of their risk exposure, the firm is less able to use its cost of equity and capital to
evaluate these projects. Projects that are riskier have to be assessed using a higher cost of
equity and capital than projects that are safer. In this chapter, we consider how to
estimate project costs of equity and capital.
What would happen if a firm chose to use its cost of equity and capital to evaluate
all projects? This firm would find itself over investing in risky projects and under
investing in safe projects. Over time, the firm will become riskier, as its safer businesses
find themselves unable to compete with riskier businesses.

Cost of Equity for Projects
In assessing the beta for a project, we will consider three possible scenarios. The
first scenario is the one where all the projects considered by a firm are similar in their
exposure to risk; this homogeneity makes risk assessment simple. The second scenario is
one where a firm is in multiple businesses with different exposures to risk, but projects




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within each business have the same risk exposure. The third scenario is the most
complicated one, where each project considered by a firm has a different exposure to risk.

1. Single Business; Project Risk similar within business
When a firm operates in only one business and all projects within that business
share the same risk profile, the firm can use its overall cost of equity as the cost of equity
for the project. Since we estimated the cost of equity using a beta for the firm in the last
chapter, this would mean that we would use the same beta to estimate the cost of equity
for each project that the firm analyzes. The advantage of this approach is that it does not
require risk estimation prior to every project, providing managers with a fixed benchmark
for their project investments. The approach is restricting, though, since it can be usefully
applied only to companies that are in one line of business and take on homogeneous
projects.

2. Multiple Businesses with Different Risk Profiles: Project Risk similar within each
Business
When firms operate in more than one line of business, the risk profiles are likely
to be different across different businesses. If we make the assumption that projects taken
within each business have the same risk profile, we can estimate the cost of equity for
each business separately and use that cost of equity for all projects within that business.
Riskier businesses will have higher costs of equity than safer businesses, and projects
taken by riskier businesses will have to cover these higher costs. Imposing the firm™s cost
of equity on all projects in all businesses will lead to over investing in risky businesses
(since the cost of equity will be set too low) and under investing in safe businesses (since
the cost of equity will be set too high).
How do we estimate the cost of equity for individual businesses? When the
approach requires equity betas, we cannot fall back on the conventional regression
approach (in the CAPM) or factor analysis (in the APM), since these approaches require
past prices. Instead, we have to use one of the two approaches that we described in the
last section as alternatives to regression betas “ bottom-up betas based upon other
publicly traded firms in the same business or accounting betas, estimated based upon the
accounting earnings for the division.


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3. Projects with Different Risk Profiles
As a purist, you could argue that each project™s risk profile is, in fact, unique, and that
it is inappropriate to use either the firm™s cost of equity or divisional costs of equity to
assess projects. While this may be true, we have to consider the trade off. Given that
small differences in the cost of equity should not make a significant difference in our
investment decisions, we have to consider whether the added benefits of analyzing each
project individually exceed the costs of doing so.
When would it make sense to assess a project™s risk individually? If a project is large
in terms of investment needs, relative to the firm assessing it, and has a very different risk
profile from other investments in the firm, it would make sense to assess the cost of
equity for the project independently. The only practical way of estimating betas and costs
of equity for individual projects is the bottom-up beta approach.

Cost of Debt for Projects
In the last chapter, we noted that the cost of debt for a firm should reflect its
default risk. At the level of individual projects, the assessment of default risk becomes
much more difficult, since projects seldom borrow on their own; most firms borrow
money for all the projects that they undertake. There are three approaches to estimating
the cost of debt for a project:
One approach is based on the argument that since the borrowing is done by the

firm rather than by individual projects, the cost of debt for a project should be the
cost of debt for the firm considering the project. This approach makes the most
sense when the projects being assessed are small relative to the firm taking them
and thus have little or no appreciable effect on the firm™s default risk.
Look at the project™s capacity to generate cash flows relative to its financing

costs, and to estimate a default risk and cost of debt for the project. The most
common approach used to estimate this default risk is to look at other firms that
take similar projects, and use the typical default risk and cost of debt for these
firms. This approach generally makes sense when the project is large in terms of
its capital needs relative to the firm and has different cash flow characteristics




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(both in terms of magnitude and volatility) from other investments taken by the
firm.
The third approach applies when a project actually borrows its own funds, with

lenders having no recourse against the parent firm, in case the project defaults.
While this is unusual, it can occur when investments have significant tangible
assets of their own, and the investment is large relative to the firm considering it.
In this case, the cost of debt for the project can be assessed using its capacity to
generate cash flows relative to its financing obligations. In the last chapter, we
used the bond rating of a firm to come up with the cost of debt for the firm. While
projects may not be rated, we can still estimate a rating for a project based on
financial ratios, and this rating can be used to estimate default risk and the cost of
debt.

Financing Mix and Cost of Capital for Projects
To get from the costs of debt and equity to the cost of capital, we have to weight
each by their relative proportions in financing. Again, the task is much easier at the firm
level, where we use the current market values of debt and equity to arrive at these
weights. We may borrow money to fund a project, but it is often not clear whether we are
using the debt capacity of the project or the firm™s debt capacity. The solution to this
problem will again vary depending upon the scenario we face.
When we are estimating the financing weights for small projects that do not affect

a firm™s debt capacity, the financing weights should be those of the firm.
When assessing the financing weights of large projects, with risk profiles different

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