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?
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