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from that of the firm, we have to be more cautious. Using the firm™s financing
mix to compute the cost of capital for these projects can be misleading, since the
project being analyzed may be riskier than the firm as a whole and thus incapable
of carrying the firm™s debt ratio. In this case, we would argue for the use of the
average debt ratio of the other firms in the business in assessing the cost of capital
of the project.
The financing weights for stand-alone projects that are large enough to issue their

own debt should be based upon the actual amounts borrowed by the projects. For


firms with such projects, the financing weights can vary from project to projects,
as will the cost of debt.
In summary, the cost of debt and debt ratio for a project will reflect the magnitude of the
project relative to the firm, and its risk profile, again relative to the firm. Table 5.1
summarizes our analyses:

Table 5.1: Cost of Debt and Debt Ratio: Project Analyses
Project Characteristics Cost of Debt Debt Ratio
Project is small and has Firm™s cost of debt Firm™s debt ratio
cash flow characteristics
similar to the firm
Project is large and has cash Cost of debt of comparable Average debt ratio of
flow characteristics firms comparable firms
different from the firm
Stand-alone Project Cost of debt for project Debt ratio for project
(based upon actual or
synthetic ratings)

Illustration 5.2: Estimating hurdle rates for individual projects
Using the principles of estimation laid out in the last few pages, we can estimate
the hurdles rates for the three projects that we are analyzing in this chapter:
Bookscape Online Information & Ordering Service: Since the beta and cost of

equity that we estimated for Bookscape as a company reflect its status as a book
store, we will re-estimate the beta for this online project by looking at publicly
traded internet retailers. The unlevered total beta1 of internet retailers is 4.20 and
we assume that this project will be funded with the same mix of debt and equity
(D/E=20.33%) that Bookscape uses in the rest of the business. We will also
assume that Bookscape™s tax rate of 40% and pre-tax cost of debt of 5.5% apply
to this project as well.

1 The unlevered market beta for internet retailers is 2.10 and the average correlation of these stocks with the
market is 0.50. The unlevered total beta is therefore 2.10/0.5 = 4.20.


Levered Beta for Online Service = 4.20 (1 + (1-.4) (.2033)) = 4.712
Cost of Equity for Online Service = 4% + 4.712 (4.82%) = 26.71%
Cost of Capital for Online Service = 26.71% (.831) + 5.5% (1-.4) (.169) = 22.76%
Disneyworld Bangkok: We did estimate a cost of capital of 9.12% for the Disney

theme park business in the last chapter, using a bottom-up levered beta of 1.0625
for the business. The only concern we would have with using this cost of capital
for this project is that it may not adequately reflect the additional risk associated
with the theme park being in an emerging market. To counter this risk, we
compute the cost of equity for the theme park using a risk premium that includes a
country risk premium for Thailand:2
Cost of Equity in US $= 4% + 1.0625 (4.82% + 3.30%) = 12.63%
Cost of Capital in US $ = 12.63% (.7898) + 3.29% (.2102) = 10.66%
Note that we have assumed that Disney will maintain its overall mix of debt and
equity of 21.02% and its current after-tax cost of debt in funding this project.
Aracruz Paper Plant: We estimated the cost of equity and capital for Aracruz™s

paper business in chapter 4 in real, U.S. dollar and nominal BR terms. In this
chapter, we will use the real costs of equity and capital because our cash flows
will be estimated in real terms as well:
Real Cost of Equity for Paper Business = 11.46%
Real Cost of Capital for Paper Business = 9.00%

In Practice: Exchange Rate Risk, Political Risk and Foreign Projects
When computing the cost of capital for the Disney Bangkok project, we adjusted
the cost of capital for the additional risk associated with investing in Thailand. While it
may seem obvious that an Thai investment will carry more risk for Disney than an
investment in the United States, the question of whether discount rates should be adjusted
for country risk is not an easy one to answer. It is true that a Thai investment will carry

2 We use the same approach we used to estimate the country risk premium for Brazil in the last chapter.
The rating for Thailand is Baa1 and the default spread for the country bond is 1.50%. Multiplying this by
the relative volatility of 2.2 of the equity market in Thailand (strandard deviation of equity/standard
devaiation of country bond) yields a country risk premium of 3.3%.


more risk for Disney than an investment in the United States, both because of exchange
rate risk (the cashflows will be in Thai Baht and not in US dollars) and because of
political risk (arising from Thailand™s emerging market status). However, this risk should
affect the discount rate only if it cannot be diversified away by the marginal investors in
In order to analyze whether the risk in Thaliand is diversifiable to Disney, we
went back to our assessment of the marginal investors in the company in chapter 3, where
we noted that they were primarily diversified institutional investors. Not only does
exchange rate risk affect different companies in their portfolios very differently “ some
may be hurt by a strengthening dollar and others may be helped “ but these investors can
hedge exchange rate risk, if they so desire. If the only source of risk in the project were
exchange rate, we would be inclined to treat it as diversifiable risk and not adjust the cost
of capital. The issue of political risk is more confounding. To the extent that political risk
is not only more difficult to hedge but also more likely to carry a non-diversifiable
component, especially when we are considering risky emerging markets, the cost of
capital should be adjusted to reflect it.
In short, whether we adjust the cost of capital for foreign projects will depend
both upon the firm that is considering the project and the country in which the project is
located. If the marginal investors in the firm are diversified and the project is in a country
with relatively little or no political risk, we would be inclined not to add a risk premium
on to the cost of capital. If the marginal investors in the firm are diversified and the
project is in a country with significant political risk, we would add a political risk
premium to the cost of capital. If the marginal investors in the firm are not diversified, we
would adjust the discount rate for both exchange rate and political risk.

Measuring Returns: The Choices
On all of the investment decisions described above, we have to choose between
alternative approaches to measuring returns on the investment made. We will present our
argument for return measurement in three steps. First, we will contrast accounting
earnings and cash flows, and argue that cash flows are much better measures of true
return on an investment. Second, we will note the differences between total cash flows


and incremental cash flows and present the case for using incremental cash flows in
measuring returns. Finally, we will argue that returns that occur earlier in a project life
should be weighted more than returns that occur later in a project life, and that the return
on an investment should be measured using time-weighted returns.

A. Accounting Earnings versus Cash Flows
The first and most basic choice we have to make when it comes to measuring
returns is the one between the accounting measure of income on a project - measured in
accounting statements, using accounting principles and standards - and the cash flow
generated by a project - measured as the difference between the cash inflows in each
period and the cash outflows.

Why are accounting earnings different from cashflows?
Accountants have invested substantial time and resources in coming up with ways
of measuring the income made by a project. In doing so, they subscribe to some generally
accepted accounting principles (GAAP). Generally accepted accounting principles
require the recognition of revenues when the service for which the firm is getting paid
has been performed in full or substantially, and has received in return either cash or a
receivable that is both observable and measurable. For expenses that are directly linked to
the production of revenues (like labor and materials), expenses are recognized in the
same period in which revenues are recognized. Any expenses that are not directly linked
to the production of revenues are recognized in the period in which the firm consumes the
services. While the objective of distributing revenues and expenses fairly across time is a
worthy one, the process of accrual accounting does create an accounting earnings number
which can be very different from the cash flow generated by a project in any period.
There are three significant factors that account for this difference.

1. Operating versus Capital Expenditure
Accountants draw a distinction between expenditures that yield benefits only in
the immediate period or periods (such as labor and material for a manufacturing firm) and
those that yield benefits over multiple periods (such as land, buildings and long-lived
plant). The former are called operating expenses and are subtracted from revenues in
computing the accounting income, while the latter are capital expenditures and are not


subtracted from revenues in the period that they are made. Instead, the expenditure is
spread over multiple periods and deducted as an expense in each period - these expenses
are called depreciation (if the asset is a tangible asset like a building) or amortization (if
the asset is an intangible asset like a patent or a trade mark).
While the capital expenditures made at the beginning of a project are often the
largest and most prominent, many projects require capital expenditures during their
lifetime. These capital expenditures will reduce the cash available in each of these

5.1. ˜: What are research and development expenses?
Research and development expenses are generally considered to be operating expenses
by accountants. Based upon our categorization of capital and operating expenses, would
you consider research and development expenses to be
a. operating expenses
b. capital expenses
c. could be operating or capital expenses, depending upon the type of research being

2. Non-Cash Charges
The distinction that accountants draw between operating and capital expenses
leads to a number of accounting expenses, such as depreciation and amortization, which
are not cash expenses. These non-cash expenses, while depressing accounting income, do
not reduce cash flows. In fact, they can have a significant positive impact on cash flows,
if they affect the tax liability of the firm. Some non-cash charges reduce the taxable
income and the taxes paid by a business. The most important of such charges is
depreciation, which, while reducing taxable and net income, does not cause a cash
outflow. Consequently, depreciation is added back to net income to arrive at the cash
flows on a project.
For projects that generate large depreciation charges, a significant portion of the
cash flows can be attributed to the tax benefits of depreciation, which can be written as


Tax Benefit of Depreciation = Depreciation * Marginal Tax Rate
While depreciation is similar to other tax deductible expenses in terms of the tax benefit
it generates, its impact is more positive because it does not generate a concurrent cash
Amortization is also a non-cash charge, but the tax effects of amortization can
vary depending upon the nature of the amortization. Some amortization, such as the
amortization of the price paid for a patent or a trade mark, are tax deductible and reduce
both accounting income and taxes. Thus, they provide tax benefits similar to
depreciation. Other amortization, such as the amortization of the premium paid on an
acquisition (called goodwill), reduces accounting income but not taxable income. This
amortization does not provide a tax benefit.
While there are a number of different depreciation methods used by firms, they
can be classified broadly into two groups. The first is straight line depreciation, whereby
equal amounts of depreciation are claimed each period for the life of the project. The
second group includes accelerated depreciation methods such as double-declining
balance depreciation, which result in more depreciation early in the project life and less
in the later years.

3. Accrual versus Cash Revenues and Expenses
The accrual system of accounting leads to revenues being recognized when the
sale is made, rather than when the customer pays for the good or service. Consequently,
accrual revenues may be very different from cash revenues for three reasons. First, some
customers, who bought their goods and services in prior periods, may pay in this period;
second, some customers who buy their goods and services in this period (and are
therefore shown as part of revenues in this period) may defer payment until future
periods. Finally, some customers who buy goods and services may never pay (bad debts).
In some cases, customers may even pay in advance for products or services that will not
be delivered until future periods.
A similar argument can be made on the expense side. Accrual expenses, relating
to payments to third parties, will be different from cash expenses, because of payments
made for material and services acquired in prior periods and because some materials and


services acquired in current periods will not be paid for until future periods. Accrual
taxes will be different from cash taxes for exactly the same reasons.
When material is used to produce a product or deliver a service, there is an added
consideration. Some of the material that is used may have been acquired in previous
periods and was brought in as inventory into this period, and some of the material that is
acquired in this period may be taken into the next period as inventory.
Accountants define net working capital as the difference between current assets
(such as inventory and accounts receivable) and current liabilities (such as accounts
payable and taxes payable). Differences between accrual earnings and cash earnings, in
the absence of non-cash charges, can be captured by changes in the net working capital.
In Practice: The Payoff to Managing Working Capital
Firms that are more efficient in managing their working capital will see a direct
payoff in terms of cash flows. Efficiency in working capital management implies that the
firm has reduced its net working capital needs without adversely affecting its expected
growth in revenues and earnings. Broadly defined, there are four ways in which net
working capital can be reduced:
1. While firms need to maintain an inventory to both produce goods and meet customer
demand, minimizing this inventory while meeting these objectives can produce a
lower net working capital. In fact, recent advances in technology which allow for
just-in-time production have helped U.S. firms reduce their inventory needs


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