CAPITAL INVESTMENT ANALYSIS HANDOUTS

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Ashlie Harvey
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1 CAPITAL INVESTMENT ANALYSIS HANDOUTS 1

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3 Financial Market Overview Economic Evaluation of Business Investment Benefits must exceed Costs Must CORRECTLY assess ALL benefits/costs Must CORRECTLY incorporate dimensions of Risk Time Real (as opposed to financial) investment Investments in CAPITAL (plant, equipment, real estate), LABOR, MATERIALS, INFORMATION, ENERGY Capital Markets Role: Link buyers and sellers of capital Players Buyers Consumers Firms Sellers Consumers Firms Financial intermediaries Commercial and investment banks Savings and loan companies Insurance firms 3

4 Buyers and Sellers Buyers: consumers and firms Consumers borrow against future earnings Firms make real investments to grow earnings Firms finance via debt, equity Availability, but at what cost? Sellers: consumers and firms Consumers via savings Firms through retained earnings Return, but at what risk? Financial Intermediaries Link buyers and sellers Lower transaction costs Facilitate risk management via risk transfer Buyers who wish to reduce risk Sellers who are willing to take on risk, at a price 4

5 PRO FORMA CASH FLOW EXAMPLE Period Price Quantity UnitCost Revenue Cost GrossIncome Rent SGA EBITDA Depr EBIT Taxes NetIncome Depr Investment FreeCashFlow ContinueValue PresentValue NetPresentValue FCFPercentage

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7 Sports Park Business Case Study Business Idea Build top notch Sports Park Ice rink Softball fields Video games Concessions Success Factors Few recreational facilities in municipality Favorable demographics Youth-oriented population High population growth Strong municipality support Lease land in good location for free 7

8 Game Plan Write business plan Raise capital Build facility Hire, train and manage personnel Market and sell the products and services Business Plan: Nuts and Bolts Products and services What and where? Management team Who are you? Market analysis Sell the need Marketing plan and sales strategy How? Operations plan When? Business Plan: Economic Analysis Financial ProForma projection Running the numbers Long-term development and exit plan How do investors get their money out? Capitalization Raise equity and/or debt Competition Barriers to market entry? Risk factors What could go wrong and why? Client history 8

9 Sources and Uses of Capital Uses $5M to construct facility $1M for working capital Sources Bank Private equity Venture capital fund Private Equity Negotiation: Valuation Revenue projections (sources) Cost projections Operations, sales and marketing, admin, legal, travel, communications, insurance, equipment, etc. Interest Bonuses Taxes Quarterly after-tax cash flow Private Equity Negotiation: Cash Flow Division Equity splits When will I be whole? Cost of equity capital Risk Factor of two 9

10 Business Outcome: Capitalization Raise $1.5M via two equity partners Raise $4.5M via bank loan Two points above prime 10-yr horizon Equity partners guarantee loan 3:1 Debt/Equity ratio Highly levered Business Outcome: 1 st year Construction delays Cost overruns Lower revenue Competition stronger than expected More marketing effort required Not enough management personnel Can t make loan payments Need time to grow Business Outcome: 2 nd year Try to restructure loan Delay interest payments Extend life of loan Try to raise new equity Outside investors Original investors Sell the business Partners must agree Default on loan Collateral provided by equity partners 10

11 Final Outcome Legal battles among partners Bank forecloses Bank sells Sports Park to new investors for pennies on dollar Lessons Don t look through rose-colored glasses Operations plan inadequate Incorrect assessment of business risk Too much leverage in capital structure Expect problems, plan for contingencies Choose your partners wisely Investors did not understand this business Don t throw good money after bad 11

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13 Portfolio Investment ECONOMIC DECISION ANALYSIS EXAMPLES For each dollar invested (positive or negative) the following table records the total returns of several investment opportunities. How would you allocate your wealth? Scenario Probability I II III IV Up Down Real Estate Investment A company owns a parcel of land on which it can build either an 8-unit or a 16-unit condominium. The current real-estate price for a one-unit condominium is $200 thousand. Next year the price will, with equal probability, rise to either $260 thousand, if the market moves favorably, or decline to $150 thousand, if the market moves unfavorably. The construction cost (both now and next year) is $140 thousand per unit for an 8-unit building or $180 thousand for a 16-unit building. Assume construction is instantaneous. Rent covers operating expenses, so no free cash flow is generated. Risk-free rate is 2.5%. What is the value of the land? Multistage Capital Investment A biotech project involves a pioneer venture stage to first prove the new technology in order to establish its viability for future commercial development of spin-off products. The pioneer venture typically involves high initial costs and insufficient projected cash inflows. If the technology proves successful, subsequent product commercialization can be many times the size of the pioneer venture. Suppose a pioneer venture requires an initial investment outlay of I 0 = $100 million, and expected cash inflows over two years of C 1 = $54 million and C 2 = $36 million. The follow-on product commercialization will become available at the end of year two, and its expected cash flows are 10 times the size of the pioneer venture. That is, I 2 = $1,000 million, and the expected cash inflows over the subsequent two years are C 3 = $540 million and C 4 = $360 million. The cost of capital is 20% and the risk-free rate is 2.5%. Should the company invest in the pioneer venture? follow-on commercialization? this biotech project? Capacity Expansion A company is considering expanding its retail store to accommodate recent and projected business growth. The first option ( expand large ) expands the store by leasing additional floor space and then remodeling the entire store. The second option ( expand small ) expands the store by redoing the layout and making a small addition, this is less costly. Which option is best? Natural Resource Investment A company has the option to acquire a ten-year lease to extract gold from a gold mine. There is a fixed, known capacity of gold reserves. Operating costs reflect inherent nonlinearities in mining, namely, decreasing returns-to-scale and increasing costs as reserves are depleted. Should the lease be acquired? 13

CAPITAL INVESTMENT ANALYSIS HANDOUTS

CAPITAL INVESTMENT ANALYSIS HANDOUTS 1 2 ECONOMIC DECISION ANALYSIS EXAMPLES I. A Natural Resource Project A company has the option to acquire a ten-year lease to extract gold from a gold mine. The lease