Post on 16-Feb-2018
7/23/2019 Mod 14 - ROI
1/33
!"!"#$
#
Michael R. Roberts
William H. Lawrence Professor of Finance
The Wharton School, University of Pennsylvania
Return on Investment
&'()*+,-. / 0+1-234 56 5'73*.8
&'()*+,-. / 0+1-234 56 5'73*.8
Last TimeDiscounted Cash Flow (DCF) Decision making Free cash flow Forecast drivers
Forecasting free cash flow Sensitivity analysis Decision criteria
7/23/2019 Mod 14 - ROI
2/33
!"!"#$
9
&'()*+,-. / 0+1-234 56 5'73*.8
This TimeReturn on investment IRR versus NPV
IRR
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
3/33
!"!"#$
:
REC LL
&'()*+,-. / 0+1-234 56 5'73*.8
The internal rate of return of an asset is theone discount rate such that the NPV of theassets free cash flows equals zero.
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
4/33
!"!"#$
;
The internal rate of return of an asset is theone discount rate such that the NPV of theassets free cash flows equals zero.
NPV =CF
1
1+ IRR( )+
CF2
1+ IRR( )2 +
CF3
1+ IRR( )3 + ...+
CFT
1+ IRR( )T =0
&'()*+,-. / 0+1-234 56 5'73*.8
The IRR Decision Rule says accept allprojects whose IRR > R, reject all projectswhose IRR < R where Ris the hurdle rate
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
5/33
!"!"#$
$
Rates of return are popular measures usedfor making decisions
&'()*+,-. / 0+1-234 56 5'73*.8
0%20%
40%60%
80%
Internal rate of return
Net present value
Payback
Discounted payback
Accounting rate of return
Profitability index
? @2*A3)B 9CC#B D-3 .-3'*) 2>? (*21E13 'F 1'*('*2.3
G>2>13H IA+?3>13 F*'= .-3 G34?B!"#$%&' ") *+%&%,+&' -,"%".+,/
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
6/33
!"!"#$
J
K-2. ?' L*+A2.3 IMN+.) O+*=8 P2) .-3) Q'R SL2N4
7/23/2019 Mod 14 - ROI
7/33
!"!"#$
!
Lesson: The IRR rule leads to thesame decisions accept or reject asthe NPV rule if all negative cash flows
precede all positive cash flows
&'()*+,-. / 0+1-234 56 5'73*.8
Examples of CF sequences where IRRand NPV rules will coincide:-, +, +, +, +-, -, -, +, +, +, +, +, +-, -, -, -, - , +
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
8/33
!"!"#$
X
Examples of CF sequences where IRRand NPV rules may not coincide:-, +, -, +, -, +
+, +, +, +, +, +, -, -, -, --, +, +, +, +, -
&'()*+,-. / 0+1-234 56 5'73*.8
Can we compare projects using IRR?
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
9/33
!"!"#$
Y
Comparing Projects
&'()*+,-. / 0+1-234 56 5'73*.8
Wharton wants to upgrade IT systemand overhaul network infrastructure
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
10/33
!"!"#$
#C
Wharton wants to upgrade IT systemand overhaul network infrastructure
Puts out request for proposals (RFP)
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1 from Cisco
Generate $60 million in cost savingsover three years for up front cost of$100 million
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
11/33
!"!"#$
##
Bid #1 from CiscoGenerate $60 million in cost savingsover three years for up front cost of$100 million
If Whartons cost of capital is 12%,what is your assessment of this bid?
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1 from Cisco
Generate $60 million in cost savingsover three years for up front cost of$100 million
Cash flows first:
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
12/33
!"!"#$
#9
Bid #1 from CiscoGenerate $60 million in cost savingsover three years for up front cost of$100 million
0 = !100+60
1+ IRR( )+
60
1+ IRR( )2 +
60
1+ IRR( )3
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1 from Cisco
Generate $60 million in cost savingsover three years for up front cost of$100 million
IRR > Rand CFs signs proper!Looks good!
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
13/33
!"!"#$
#:
Bid #1 from CiscoGenerate $60 million in cost savingsover three years for up front cost of$100 million
NPV =!100+60
1+ 0.12( )+
60
1+ 0.12( )2 +
60
1+ 0.12( )3
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1 from Cisco
Generate $60 million in cost savingsover three years for up front cost of$100 million
NVP > 0!Looks good!
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
14/33
!"!"#$
#;
Bid #1a from CiscoSame cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1a from Cisco
Same cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
Cash flows first:
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
15/33
!"!"#$
#$
Bid #1a from CiscoSame cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
Cash flows first:
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1a from Cisco
Same cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
Cash flows first:
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
16/33
!"!"#$
#J
Bid #1a from CiscoSame cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
0 = !20+25
1+ IRR( )+
25
1+ IRR( )2 +
25
1+ IRR( )3
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1a from Cisco
Same cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
Bid #1a IRR (112%) > Bid #1 IRR (36%)
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
17/33
!"!"#$
#!
Bid #1a from CiscoSame cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
NPV =!20+25
1+ 0.12( )+
25
1+ 0.12( )2 +
25
1+ 0.12( )3
&'()*+,-. / 0+1-234 56 5'73*.8
Bid #1a from Cisco
Same cost savings ($60 mil over threeyears) but costs spread over time: $20mil today, $35 mil over three years
Bid #1 NPV ($44.11) > Bid #1a NPV ($40.05)
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
18/33
!"!"#$
#X
What is going on?
&'()*+,-. / 0+1-234 56 5'73*.8
NPV!Bid #1 is better
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
19/33
!"!"#$
#Y
NPV!Bid #1 is better
IRR!Bid #1a is better
&'()*+,-. / 0+1-234 56 5'73*.8
A closer look
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
20/33
!"!"#$
9C
A closer look
Bid 1a incorporates a loan from Cisco
&'()*+,-. / 0+1-234 56 5'73*.8
A closer look
Bid 1a incorporates a loan from CiscoWhat is the interest rate?
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
21/33
!"!"#$
9#
A closer look
80 =35
1+R( )+
35
1+R( )2 +
35
1+R( )3 !R= 15%
&'()*+,-. / 0+1-234 56 5'73*.8
A closer look
0 = !80+35
1+ IRR( )+
35
1+ IRR( )2 +
35
1+ IRR( )3" IRR= 15%
Note: This is also the IRRof the loan
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
22/33
!"!"#$
99
A closer look
Note: This is also the Yield-to-Maturityof the loan
80=35
1+YTM( )+
35
1+YTM( )2 +
35
1+YTM( )3 !YTM = 15%
&'()*+,-. / 0+1-234 56 5'73*.8
A closer look
Is this high or low?
80=35
1+YTM( )+
35
1+YTM( )2 +
35
1+YTM( )3!YTM = 15%
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
23/33
!"!"#$
9:
A closer look
Loan interest rate (15%) > Cost of Capital (12%)
80=35
1+YTM( )+
35
1+YTM( )2 +
35
1+YTM( )3 !YTM = 15%
&'()*+,-. / 0+1-234 56 5'73*.8
Lesson: IRR increased because initialinvestment fell more than future cash flows.
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
24/33
!"!"#$
9;
Lesson: IRR increased because initialinvestment fell more than future cash flows.
(Intuition: Small payoffs on a smaller
investment can generate very large returnsbecause of division by small numbers.)
&'()*+,-. / 0+1-234 56 5'73*.8
Lesson: NPV fell because Cisco is lendingyou money at an interest rate that is greaterthan your cost of capital.
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
25/33
!"!"#$
9$
Lesson: IRR can mislead when decidingamong projects.
&'()*+,-. / 0+1-234 56 5'73*.8
Lesson: NPV wi l l not mislead incomparisons. The larger the NPV, thegreater the value
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
26/33
!"!"#$
9J
DDITION L BIDS
&'()*+,-. / 0+1-234 56 5'73*.8
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
27/33
!"!"#$
9!
How would you rank the bids according
to the IRR and the NPV criterion?
&'()*+,-. / 0+1-234 56 5'73*.8
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
28/33
!"!"#$
9X
IRR: #3 > #2 > #1
NPV: #1 > #2 > #3
&'()*+,-. / 0+1-234 56 5'73*.8
ZJC
Z;C
Z9C
C
9C
;C
JC
XC
#CC
C[ #C[ 9C[ :C[ ;C[ $C[ JC[ !C[ XC[ YC[ #CC[
!"#$%&'( *+(,
-./
@N2\3+
]N>+(3*
&+81'
#9[ &'8. 'F &2(+.24
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
29/33
!"!"#$
9Y
Intuition:Huawei has small upfront cost!IRR "Juniper has front-loaded CFs!IRR "
&'()*+,-. / 0+1-234 56 5'73*.8
Lesson: IRR does not address differencesin scale.
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
30/33
!"!"#$
:C
Lesson: IRR does not address differencesin scale.
Would you rather earn 100% on a $1
investment or 10% on a $1,000,000investment?
&'()*+,-. / 0+1-234 56 5'73*.8
Intuition:Junipers bid is like Ciscos with anembedded loan
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
31/33
!"!"#$
:#
Intuition:Junipers bid is like Ciscos with anembedded loanwith a 23% interest rate!
&'()*+,-. / 0+1-234 56 5'73*.8
Summary
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
32/33
!"!"#$
:9
Lessons
The internal rate of return of an asset isthe one discount rate such that the NPVof the assets free cash flows equalszero.
The IRR Decision Rule says accept all
projects whoseIRR
>R
, reject allprojects whose IRR < R where R is thehurdle rate
NPV =CF
1
1+ IRR( )+
CF2
1+ IRR( )2 +
CF3
1+ IRR( )3 + ...+
CFT
1+ IRR( )T =0
&'()*+,-. / 0+1-234 56 5'73*.8
Lessons IRR Rule can mislead decision making
when cash flow signs are anything otherthan all negatives before all positives
IRR Rule can mislead decision makingwhen comparing projects even when
cash flow signs are proper.IRR does not account for differences in
scale
&'()*+,-. / 0+1-234 56 5'73*.8
7/23/2019 Mod 14 - ROI
33/33
!"!"#$
Lessons
IRR should be used in conjunctionwith NPV analysis
&'()*+,-. / 0+1-234 56 5'73*.8
Coming up next Fixed Income Securities
Institutional environment
Valuation
Risk analysis
&'()*+,-. / 0+1-234 56 5'73*.8