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1. How good or bad is the firmâ€™s existing project portfolio?

2. What are the firmâ€™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 firmâ€™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 firmâ€™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 firmâ€™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 â€“ 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

â€¢

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

â€¢

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

â€¢

that for the remaining 4 years.

The cost of goods sold, excluding depreciation, is expected to be 50% of revenues.

â€¢

The tax rate is 40%.

â€¢

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%.

â€¢

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

â€¢

$2,000 at the end of year 2.

The working capital is anticipated to be 10% of revenues, and the working capital

â€¢

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

â€¢

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.

â€¢

(The tax rate is 40%.)

The depreciation will amount to $500,000 each year, and the salvage value of the

â€¢

equipment will be equal to the remaining book value at the end of year 30.

The cost of capital is 12.5%.

â€¢

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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