CAPITAL INVESTMENT ANALYSIS HANDOUTS

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Silvia Lamb
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1 CAPITAL INVESTMENT ANALYSIS HANDOUTS 1

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3 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 should be acquired if its cost is less than the value of the lease. There is a fixed, known capacity in ounces. Operating costs reflect inherent nonlinearities in mining, namely, decreasing returns-to-scale, and increasing costs as reserves are depleted. Specifically, when the begin-of-year mine inventory is I, the cost to mine Q ounces for the upcoming year is proportional to Q 2 /I. Production occurs instantaneously, and profits each year accrue at the beginning of the year. Questions: 1. What decisions must be made? 2. What is an appropriate measure for the value of the lease? 3. What additional data, if any, is required to make a valuation? 4. How can this problem be solved? 3

4 II. A Real Estate Investment The real-estate price for a one-unit condominium, P, is currently $100 thousand. Next year the price will, with equal probability, rise to either $150 thousand, if the market moves favorably, or decline to $90 thousand, if the market moves unfavorably. The construction cost (both now and next year) for a 6-unit building is $80 thousand per unit, and $90 thousand for a 9-unit building. Construction is instantaneous, and rent covers operating expenses, so no free cash flow is generated now or next year. The risk-free rate is 10%. Questions: 1. Should the company invest in this real estate construction project? 2. What is the value of this real estate construction project? 4

5 III. A Biotech 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 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. Consider the following data for a particular biotech project. The 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 stage 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%. (All rates are compounded annually.) Questions: 1. Should the company invest in the pioneer venture? 2. Should the company invest in the follow-on product commercialization stage? 3. Should the company invest in this biotech project? 5

6 IV. An Expansion Project A company is considering expanding its retail store to accommodate recent and projected business growth. There are two options. The first option ( expand large ) will expand the store by leasing additional floor space and then remodeling the entire store. The second option ( expand small ) is far less costly. It will expand the store by redoing the layout and making a small addition. The incremental revenues critically depend on two factors: (i) the type of option taken, and (ii) the future business condition (either Good, Moderate or Poor). Based on past experience, the company has assessed the likelihood of each business scenario. Questions: 1. What are the economic tradeoffs? 2. What strategy can the company take? 3. How should the company decide which option is best (if any)? 6

7 V. Investment Opportunities There are two investment opportunities, I, II under consideration each requiring a total investment of 100. You have 100 to invest, and you can invest any portion of each project s initial investment. The payoffs of each investment opportunity in each scenario as well as the probability of each scenario are listed in the following table. Investment Payoffs Scenario Probability I II Scenario Scenario Measured in terms of the total return on initial investment, we have: Return Data I II Scenario Scenario Return Mean Return Variance Return Std Dev Questions: 1. Which project(s) would you invest in? 2. Why? 7

8 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 8

9 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 9

10 PRO FORMA EXAMPLE Expected Cash Flows Price Quantity UnitCost Revenue Cost GrossIncome Rent SGA EBITDA Depr EBT Taxes NetIncome Depr Investment FreeCashFlow ContinuationValue PresentValue NetPresentValue FCFPercentage

11 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 11

12 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 12

13 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 13

14 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 14

15 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 15

CAPITAL INVESTMENT ANALYSIS HANDOUTS

CAPITAL INVESTMENT ANALYSIS HANDOUTS 1 2 Financial Market Overview Economic Evaluation of Business Investment Benefits must exceed Costs Must CORRECTLY assess ALL benefits/costs Must CORRECTLY incorporate