CROWN SYDNEY CASHFLOW SCENARIO ANALYSIS

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

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• An investment’s Internal Rate of Return (IRR) is its expected annual compound rate of return.

• It answers a slightly different question to that addressed by NPV:

Net Present Value: Internal Rate of Return:

INTERNAL RATE OF RETURN

Is the NPV of the investment greater than zero, at our required rate of return?

• The IRR is the discount rate at which the PV of cash inflows equals the initial investment. It is the discount rate that results in an NPV of zero.

• To calculate the IRR, a ‘trial and error’ approach can be taken (using our NPV spreadsheet) or the IRR Excel function can be used.

Is the breakeven discount rate (NPV=0) greater than our required rate of return?

Accept investments with an IRR > required rate of return Reject investments with an IRR < required rate of return An investment is borderline when IRR = required rate of return

IRR DECISION

RULE

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

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CALCULATE THE INTERNAL RATE OF

RETURN FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY From our earlier Net Present Value analysis of the Crown Sydney hotel and casino, calculate the Internal Rate of Return.

Does the Crown Sydney Internal Rate of Return exceed the 9% required rate of return?

(HINT: Try progressively higher discount rates until NPV = 0)

NET PRESENT VALUE INTERNAL RATE OF RETURN

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Year Time

Annual

Cashflows

Discounted

Cashflows

2020 0 Initial Project Cost -1127.0 -1127.0

2021 1 Annual Cash Inflow 32.0 29.3

2022 2 Annual Cash Inflow 33.2 27.7

2023 3 Annual Cash Inflow 34.3 26.2

2024 4 Annual Cash Inflow 35.6 24.8

2025 5 Annual Cash Inflow 36.9 23.5

5 Estimated Market Value 1560.0 995.5

Internal Rate of Return 9.4%

NET PRESENT VALUE 0.0

CROWN SYDNEY INTERNAL RATE OF RETURN ANALYSIS

$m

CALCULATE THE INTERNAL RATE OF

RETURN FOR CROWN SYDNEY BY CROWN RESORTS

ACTIVITY: Answer

With an IRR of 9.4%, versus a required rate of return of 9.0%, the project satisfies the criteria for acceptance.

INTERNAL RATE OF RETURN

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• As with NPV, takes account of the time value of money.

• Gives a precise answer to what the annual rate of return on the investment is and, hence, is simple to interpret.

• Does not require a calculation of the cost of funds or required rate of return, with the IRR able to be compared to a ‘rough estimate’ of the required rate of return.

• Can compare the IRRs of alternative investment opportunities that differ in nature and size.

INTERNAL RATE OF RETURN – ADVANTAGESINVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

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Conclusion: both NPV and IRR are used widely in practice. Each has merits, though NPV is often regarded as superior.

• As with NPV, cashflow forecasts are required.

• Ignores the size of a project / investment, including the dollar value of benefits and costs.

• As with NPV, ignores the term of an investment (an investor may prefer a 10% IRR over 5 years to a 12% IRR over 3 years). Payback period takes more explicit account of investment term.

• When comparing mutually exclusive projects, IRR can (under certain circumstances) be misleading

• IRR implicitly assumes that cash inflows are reinvested at the IRR for the remaining duration of the project. This may not be valid.

INTERNAL RATE OF RETURN – DISADVANTAGESINVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

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INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE NPV AND IRR FOR

THE DYSART SOLAR ENERGY FARM

CASHFLOW PROFILE A AND B

ACTIVITY

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

Returning to the Tilt Renewables Dysart Solar Energy Farm, calculate the NPV and IRR for each of cashflow Profile A and B. Assume an 8% discount rate.

Do the results confirm our earlier assessment in favour of Profile B?

NPV and IRR

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INVESTMENT EVALUATION I

• Return on Investment

• Residual Income

• Payback PeriodCALCULATE THE NPV AND IRR FOR

THE DYSART SOLAR ENERGY FARM

CASHFLOW PROFILE A AND B

ACTIVITY: Answers

Estimated Annual Cash Flows ($m)

Profile A Profile B

2022 (Year 0) -200 -200

2023 (Year 1) 40 80

2024 (Year 2) 80 80

2025 (Year 3) 85 80

2026 (Year 4) 90 80

2027 (Year 5) 95 70

NPV 103.9 112.6

IRR 23.9% 27.9%

Returning to the Tilt Renewables Dysart Solar Energy Farm, calculate the NPV and IRR for each of cashflow Profile A and B. Assume an 8% discount rate.

Do the results confirm our earlier assessment in favour of Profile B? Yes

NPV and IRR

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• The balance sheet shows the funding sources of a business: debt and equity. Debt and equity funds each have a corresponding cost.

• In the case of debt, the cost is explicitly represented by the interest rate (typically the average interest rate on the business’ borrowings).

• In the case of equity, the cost is not observable but is the return required in order to satisfy shareholders and/or maintain the share price.

• We can combine the cost of debt and the cost of equity into a cost of capital for use as the required rate of return in our NPV or IRR calculations.

COST OF CAPITALINVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

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• Our combined cost of capital is known as the Weighted Average Cost of Capital (WACC) and is given by the following formula:

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

WACC = (Cost of Debt x Debt Ratio) + (Cost of Equity x Equity Ratio)

• We can arrive at a simple estimate of WACC, as follows. From Workshop 2, the Debt Ratio is Liabilities/Assets and the Equity Ratio equals Equity/Assets. These two ratios should sum to one.

• To calculate the Cost of Equity, a simplified approach is to use the Earnings Yield from Workshop 2 (the inverse of the Price Earnings ratio). Our WACC calculation now becomes:

INVESTMENT EVALUATION (II)

• Time Value of Money

• Opportunity Cost & Discounting

• Net Present Value

• Cashflow Forecasting

• Internal Rate of Return

• Cost of Capital

WACC = (Interest Rate x Debt Ratio) + (Earnings Yield x Equity Ratio)

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FROM WOOLWORTHS’

FINANCIAL STATEMENTS IN THE MBA403 RESOURCES CALCULATE THE FY20

WACC

CALCULATION ACTIVITY

Calculate Woolworths’ FY20 Weighted Average Cost of Capital

• Calculate the Debt Ratio and Equity Ratio from Woolworths’ balance sheet

• Assuming an average loan interest rate of 3.6% and a P/E ratio of 19, calculate the WACC

This WACC could be used as the required rate of return in Woolworths’ NPV and IRR calculations when undertaking investment evaluation

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FROM WOOLWORTHS’

FINANCIAL STATEMENTS IN THE MBA403 RESOURCES CALCULATE THE FY20

WACC

Calculate Woolworths’ FY20 Weighted Average Cost of Capital

• Calculate the Debt Ratio and Equity Ratio from Woolworths’ balance sheet: 77% and 23%, respectively

• Assuming an average loan interest rate of 3.6% and a P/E ratio of 19, calculate the WACC: (0.77×3.6%)+(0.23×5.3%) = 4.0%

This 4.0% WACC could be used as the required rate of return in Woolworths’ NPV and IRR calculations when undertaking

investment evaluation

CALCULATION ACTIVITY: Answers

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INVESTMENT EVALUATION We have seen numerous techniques for investment evaluation (in addition to our ratios from Workshop 2):

• Return on Investment

• Payback Period

• Net Present Value

• Internal Rate of Return

Of these, Net Present Value and Internal Rate of Return are the most widely used.

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INVESTMENT EVALUATION Our focus to date has been exclusively financial. Increasingly, however, companies must adopt a broader perspective in business and investment decision making. Amongst the additional factors to consider are:

• corporate reputation considerations,

• alignment with the overall business strategy,

• sustainability and environmental impacts,

• social and community influences, and

• ethical aspects.

These are explored in the next section of the course.