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Key Questions:
1. How good or bad is the firm™s existing project portfolio?
2. What are the firm™s competitive strengths and differential advantages, if any?
3. Does this firm earn excess returns on its existing projects? If yes, can it maintain the
competitive strengths that allowed it to earn these excess returns? If not, what can it
do to start earning excess returns on its projects?
4. Does the firm have poor investments? If so, what might be the reasons for the poor
returns?

Framework for Analysis:
1. Analyzing Existing Investments

1.1. What is the accounting return that the firm earns on its existing investments?
How does this compare with the cost of equity and capital?
1.2. What was the firm™s economic value added in the most recent financial year?
How does it compare with the previous year?
1.3. What, if anything, do the accounting returns and economic value added tell you
about the quality of the firm™s existing investments?
2. Assessing Competitive Strengths

2.1. Who are the primary competitors to this firm and how does the firm compare to
them in terms of both quantitative (size, profitability, risk) and qualitative measures
(quality of management, service)?
2.2. Does the firm have any special strength that no other firm in the sector
possesses?
2.3. Does the firm lag other firms in the sector on any of the measures?
3. Evaluating Sustainability of Competitive Strengths



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3.1. Are the firm™s competitors catching up with the firm on its strengths?
3.2. Are there new competitors either in the market or on the horizon who could
compete with the firm on its strengths?
4. Poor Investments
3.1. If the firm has investments that earn less than the hurdle rate, what is the most
likely reason for the poor returns?
3.2. What alternatives does the firm have with these poor investments? In
particular, can it sell these investments to a third party or will it have to liquidate
these investments?

Getting Information on Competitive Strengths and Excess Returns
This is primarily a qualitative assessment. Reading articles on the firm and the
sector in which it operates is a good starting point. Looking at the differences across
firms in the sector on size, margins, working capital ratios and risk can also provide a
basis for the competitive analysis. A useful comparison would be between the excess
return (return on capital “ cost of capital) earned by your firm and the average excess
return earned by the sector.
Online sources of information:
http://www.stern.nyu.edu/˜adamodar/cfin2E/project/data.htm




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Questions and Exercises
1. You have been given the following information on a project:
It has a 5-year lifetime

The initial investment in the project will be $25 million, and the investment will be

depreciated straight line, down to a salvage value of $10 million at the end of the fifth
year.
The revenues are expected to be $20 million next year and to grow 10% a year after

that for the remaining 4 years.
The cost of goods sold, excluding depreciation, is expected to be 50% of revenues.

The tax rate is 40%.

a. Estimate the pre-tax return on capital, by year and on average, for the project.
b. Estimate the after-tax return on capital, by year and on average, for the project.
c. If the firm faced a cost of capital of 12%, should it take this project.

2. Now assume that the facts in problem 1 remain unchanged except for the depreciation
method, which is switched to an accelerated method with the following depreciation
schedule:
Year % of Depreciable Asset
1 40%
2 24%
3 14.4%
4 13.3%
5 13.3%
Depreciable Asset = Initial Investment - Salvage Value
a. Estimate the pre-tax return on capital, by year and on average, for the project.
b. Estimate the after-tax return on capital, by year and on average, for the project.
c. If the firm faced a cost of capital of 12%, should it take this project?

3. Consider again the project described in problem 1 (assume that the depreciation reverts
to straight line). Assume that 40% of the initial investment for the project will be
financed with debt, with an annual interest rate of 10% and a balloon payment of the
principal at the end of the fifth year.


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a. Estimate the return on equity, by year and on average, for this project.
b. If the cost of equity is 15%, should the firm take this project?

4. Answer true or false to the following statements:
a. The return on equity for a project will always be higher than the return on capital on
the same project.
b. If the return on capital is less than the cost of equity, the project should be rejected.
c. Projects with high financial leverage will have higher interest expenses and lower net
income than projects with low financial leverage and thus end up with a lower return on
equity.
d. Increasing the depreciation on an asset will increase the estimated return on capital and
equity on the project.
e. The average return on equity on a project over its lifetime will increase if we switch
from straight line to double declining balance depreciation.

5. Under what conditions will the return on equity on a project be equal to the internal
rate of return, estimated from cashflows to equity investors, on the same project?

6. You are provided with the projected income statements for a project:
Year 1 2 3 4
Revenues $ 10,000 $ 11,000 $12,000 $13,000
- Cost of Goods Sold $ 4,000 $ 4,400 $ 4,800 $ 5,200
- Depreciation $ 4,000 $ 3,000 $ 2,000 $ 1,000
= EBIT $ 2,000 $ 3,600 $ 5,200 $ 6,800
The tax rate is 40%.

The project required an initial investment of $15,000 and an additional investment of

$2,000 at the end of year 2.
The working capital is anticipated to be 10% of revenues, and the working capital

investment has to be made at the beginning of each period.
a. Estimate the free cash flow to the firm for each of the 4 years.
b. Estimate the payback period for investors in the firm.
c. Estimate the net present value to investors in the firm, if the cost of capital is 12%.
Would you accept the project?


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d. Estimate the internal rate of return to investors in the firm. Would you accept the
project?

7. Consider the project described in problem 6. Assume that the firm plans to finance
40% of its net capital expenditure and working capital needs with debt.
a. Estimate the free cash flow to equity for each of the 4 years.
b. Estimate the payback period for equity investors in the firm.
c. Estimate the net present value to equity investors if the cost of equity is 16%.
Would you accept the project?
d. Estimate the internal rate of return to equity investors in the firm. Would you
accept the project?

8. You are provided with the following cash flows on a project:
Year Cash Flow to Firm
0 - 10,000,000
1 $ 4,000,000
2 $ 5,000,000
3 $ 6,000,000
Plot the net present value profile for this project. What is the internal rate of return? If
this firm had a cost of capital of 10% and a cost of equity of 15%, would you accept this
project?

9. You have estimated the following cash flows on a project:
Year Cashflow to Equity
0 -$ 5,000,000
1 $4,000,000
2 $ 4,000,000
3 - $3,000,000
Plot the net present value profile for this project. What is the internal rate of return? If the
cost of equity is 16%, would you accept this project?

10. Estimate the modified internal rate of return for the project described in problem 8.
Does it change your decision on accepting this project?

11. You are analyzing two mutually exclusive projects with the following cash flows:

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Year A B
0 -$4,000,000 -$4,000,000
1 $2,000,000 $1,000,000
2 $1,500,000 $1,500,000
3 $ 1,250,000 $1,700,000
4 $1,000,000 $2,400,000
a. Estimate the net present value of each project, assuming a cost of capital of 10%.
Which is the better project?
b. Estimate the internal rate of return for each project. Which is the better project?
c. What reinvestment rate assumptions are made by each of these rules? Can you show
the effect on future cash flows of these assumptions?
d. What is the modified internal rate of return on each of these projects?

12. You have a project that does not require an initial investment but has its expenses
spread over the life of the project. Can the IRR be estimated for this project? Why or why
not?

13. Businesses with severe capital rationing constraints should use IRR more than NPV.
Do you agree? Explain.

14. You have to pick between three mutually exclusive projects with the following cash
flows to the firm:
Year Project A Project B Project C
0 -$10,000 $ 5,000 -$15,000
1 $ 8,000 $ 5,000 $ 10,000
2 $ 7,000 -$8,000 $10,000
The cost of capital is 12%.
a. Which project would you pick using the net present value rule?
b. Which project would you pick using the internal rate of return rule?
c. How would you explain the differences between the two rules? Which one would you
rely on to make your choice?




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15. You are analyzing an investment decision, in which you will have to make an initial
investment of $10 million and you will be generating annual cash flows to the firm of $2
million every year, growing at 5% a year, forever.
a. Estimate the NPV of this project, if the cost of capital is 10%.
b. Estimate the IRR of this project.

16. You are analyzing a project with a 30-year lifetime, with the following
characteristics:
The project will require an initial investment of $20 million and additional

investments of $ 5 million in year 10 and $ 5 million in year 20.
The project will generate earnings before interest and taxes of $3 million each year.

(The tax rate is 40%.)
The depreciation will amount to $500,000 each year, and the salvage value of the

equipment will be equal to the remaining book value at the end of year 30.
The cost of capital is 12.5%.

a. Estimate the net present value of this project.
b. Estimate the internal rate of return on this project. What might be some of the
problems in estimating the IRR for this project?

17. You are trying to estimate the NPV of a 3-year project, where the discount rate is
expected to change over time.
Year Cash Flow to Firm Discount Rate
0 -$15,000 9.5%
1 $5,000 10.5%
2 $ 5,000 11.5%
3 $ 10,000 12.5%
a. Estimate the NPV of this project. Would you take this project?
b. Estimate the IRR of this project. How would you use the IRR to decide whether to take
this project or not?

18. Barring the case of multiple internal rates of return, is it possible for the net present
value of a project to be positive, while the internal rate of return is less than the discount
rate. Explain.


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19. You are helping a manufacturing firm decide whether it should invest in a new plant.
The initial investment is expected to be $ 50 million, and the plant is expected to generate

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