Finance ROI and Other Metrics

Fall 2012

“A bird in hand is worth two in the bush”

“If you can’t measure it you can’t manage it”

From Last Time What is the most important time in a new

job? What are the traits/characteristics of CEOs

and managers?

New Job Our judgments of others are often far less

accurate then we think We tend simplify: we size people up right

away and stick to first impressions Self fulfilling prophecy: beliefs lead to

expectations that are transmitted via cues – people adjust behavior accordingly – fulfillment

We tend to view things as good or bad

Successful CEOs “Thin slicing” from Malcolm Gladwell’s

Blink Snap judgments can save us time but are

inaccurate in many instances Nevertheless, we have associations

deeply-rooted in our subconscious which may be in conflict with our stated conscious values

Implicit Association Test (IAT)

IAT Test Results

https://implicit.harvard.edu/implicit/demo/selectatest.html

What’s the Point You have inherent biases and tendencies

whether you think you do or not A “good” CEO is tall, good looking, dark

haired and has a British accent You are subject to the same biases – so if

you don’t have the aforementioned, you are at an inherent disadvantage if you want to become a CEO

Back to Finance

The Basics of Finance ROI – Return on Investment IRR – Internal Rate of Return DCF – Discounted Cash Flow WACC – Weighted Average Cost of Capital EBITDA – Earnings Before Interest, Tax,

Depreciation and Amortization P/E Ratio – Price to Earnings Ratio

ROI Simple way of determining profitability ROI = Investment Gain/Investment Doesn’t account for time (when will I get

paid) Good for short term analysis

IRR IRR is the rate at which the NPV of all cash

flows is zero Good way of comparing alternative

projects “Standardizes” investment to other types

of investments (e.g. bonds) Word of caution – IRR can be manipulated,

the devil is in the details

IRR Examples Excel has IRR function Hand Calc is an iterative calculation so use

Excel Go to spreadsheet

DCF Analysis Discounts all future cash flows to the

present Gives a value of a project/opportunity in

today’s value Good tool for comparisons Independent Example

WACCGetting capital for your business costs money

WACC (Cont.) All capital budgeting decisions should be

weighed against WACC (e.g. if the IRR doesn’t meet WACC, you shouldn’t do it)

WACC Example You own firm that is 50% debt and 50%

equity Cost of debt is 8% TEV – Total Enterprise Value is $10M Corporate Tax Rate is 35% Cost of Equity is 12% You have a 1 yr project that will require

$1M investment. Expected ROI is 10%

WACC Calculation

WACC = (5/10)*(0.12)+(5/10)(0.08)*(1-0.35)

WACC = 8.6%

Would you do project with ROI of 10 percent?

WACC of CE Firms Should be mostly Re Can’t “leverage up” CE firms – there are

no assets to borrow against Re should be around 8-15 percent

EBITDA A measure of how much money a

company generates Used frequently as a “true” measure of

profitability Used to value companies in acquisitions Takes accounting practices out of valuation

Stock Prices

Stocks (Cont.) Lots of theories on stock prices (perfectly

efficient, inefficient etc.) Stocks generally valued on their earnings

and prospect for growth Can be valued on Dividends (D/Re)

Price to Earnings Ratio of Price of Stock to Earnings per

Share Tells you how “expensive” a stock is Average is 14-16 (it would take this many

years to recoup investment) If growth is anticipated, expect high PE PEG or Price/Earnings to Growth

normalizes P/E for growth

P/E Cont.

Valuation Lots of ways to value a company P/E EBITDA DCF Multiples

Valuation (Cont.)

Finance in CE Where does this apply? CE Firm acquisition Project selection New Revenue Line Decisions These are the tools to help “quantify”

decision making process

Finance Assignment OK to discuss assignment with others in

the class – but, do your own work There is ambiguity – you have to learn to

deal with this. State assumptions and come up with an answer.

Something for Next Time Authority: Is wearing a uniform give you

more authority?