Question Before we get the ball rolling!

Faraday Enterprises is a publicly traded company. It

currently has 10 million shares trading at $12/share and
$150 million in book value of equity. The firm also has
book value of debt of $ 75 million and market value of
debt of $ 80 million. The cost of equity for the company is
9%, the pre-tax cost of debt is 4% and the marginal tax
rate is 40%. What is the cost of capital?
a. 7.4%
b. 7.0%
c. 7.7%
d. 6.36%
e. None of the above
What is the right measure?
Earnings Vs. Cash Flows
Can you go out and spend your earnings? Rupee for a Rupee?
We follow accrual accounting method which is different from
Cash Accounting. Think A/R and A/P
We do not expense out Capital Expenditure as it provides
benefit over future years (With R&D We are not consistent)
What is the right measure?
Earnings Vs. Cash Flows
Can you go out and spend your earnings? Rupee for a Rupee?
We follow accrual accounting method which is different from
Cash Accounting. Think A/R and A/P
We do not expense out Capital Expenditure as it provides
benefit over future years (With R&D We are not consistent)
What is the right measure?
From Earnings to Cash Flows
You add back all the non cash expenses back Which is the
single biggest non cash item we encounter?
In the year which you do the Capital Expenditure, you should
net them out
Shift from accrual to cash numbers would require you to take
change in Working Capital
Investment Analysis 101
Use Cash Flows

Use Incremental Cash Flows

Use Time weighted average cash flows Why??

In Class Example
Disney bites Imagica
First investment in India
Scale and project similar to what it has in Orlando
Issues: Currency Risks || Country Risks
The Project
Currency: INR
Cash Flows: Nominal
Key Assumptions:
INR 100 Cr already spent on research, understanding the
market, getting approvals and other formalities. You cannot
recover it back if you dont go ahead with the project. This
expense would be depreciated over 10 years
Construction Costs:
Magic Kingdom: 6,000 Crs now and 1,500 Crs a year from now
Epcot: 4,500 Crs a year from now and 1,500 Crs two years from now
Total Investment: 13,500 Crs
Revenue Projections

Year
1 2 3 4 5 6 7 8 9 10

Magic Kingdom
- 1,500 1,950 2,535 3,296 4,284 5,141 5,655 6,221 6,843

Epcot
- - 1,000 1,300 1,690 2,197 2,417 2,658 2,924 3,217

Resort Properties
- 100 140 168 202 242 266 293 322 354

Total
- 1,600 3,090 4,003 5,187 6,723 7,824 8,606 9,467 10,413
Cost and Other Assumptions
Operating Expenses

Theme Parks % of Revenues 50%

Resort % of Revenues 70%

Year
1 2 3 4 5 6 7 8 9 10
Depreciation 0% 13% 11% 10% 8% 8% 8% 8% 8% 8%
Maintenance Capital
0% 20% 30% 45% 60% 80% 80% 90% 100% 110%
Expenditure

Working Capital as a
5%
% of Revenues

Tax Rate 38%

Allocated Costs 10%
Fixed Costs of
75%
Allocated Costs
Invested Capital
Year 0
1 2 3 4 5 6 7 8 9 10
Book Value of Pre
Project Inv 100 90 80 70 60 50 40 30 20 10 -
Depreciation: Pre
Project 10 10 10 10 10 10 10 10 10 10

Magic Kingdom
6,000 1,500 - - - - - - - - -
Epcot
4,500 1,500 - - - - - - - -
Capital
Maintanance 300 406 485 516 667 656 726 800 880
Depreciation
1,500 1,353 1,079 861 833 820 807 800 800
Book Value of
New Fixed Assets 6,000 12,000 12,300 11,353 10,760 10,415 10,249 10,085 10,004 10,004 10,084

Book value of
Working Capital - 80 155 200 259 336 391 430 473 521
Total Capital
Invested in Project 6,100 12,080 12,450 11,567 11,010 10,715 10,615 10,496 10,444 10,477 10,595
 Operating Income
Year 0 1 2 3 4 5 6 7 8 9 10
Magic Kingdom 1,500 1,950 2,535 3,296 4,284 5,141 5,655 6,221 6,843

Epcot 0 1,000 1,300 1,690 2,197 2,417 2,658 2,924 3,217

Resort Properties 100 140 168 202 242 266 293 322 354
Total 1,600 3,090 4,003 5,187 6,723 7,824 8,606 9,467 10,413

Direct Expenses - MK 750 975 1,268 1,648 2,142 2,571 2,828 3,111 3,422
Direct Expenses - EPCOT 0 500 650 845 1,099 1,209 1,329 1,462 1,609

Direct Expenses - RP 70 98 118 141 169 186 205 225 248

Total Direct Expenses 820 1,573 2,035 2,634 3,410 3,965 4,362 4,798 5,278

Depreciation and Amortization PP 10 10 10 10 10 10 10 10 10 10

Depreciation and Amortization Current 1,500 1,353 1,079 861 833 820 807 800 800
Allocated G&A 0 160 309 400 519 672 782 861 947 1,041

Operating Income -10 -890 -155 479 1,163 1,798 2,246 2,567 2,912 3,284

Taxes -4 -338 -59 182 442 683 854 975 1,107 1,248
Operating Income after Taxes -6 -552 -96 297 721 1,115 1,393 1,591 1,806 2,036
Accounting Returns
Operating Income Book Value of Pre Book Value of New Book value of Total Capital Based on Based on
Year
after Taxes Project Inv Fixed Assets Working Capital Invested in Project Previous Year Average
-
100 6,000 6,100
1 -0.1% -0.1%
(6) 90 12,000 - 12,080
2 -4.6% -4.5%
(552) 80 12,300 80 12,450
3 -0.8% -0.8%
(96) 70 11,353 155 11,567
4 2.6% 2.6%
297 60 10,760 200 11,010
5 6.6% 6.6%
722 50 10,415 259 10,715
6 10.4% 10.5%
1,115 40 10,249 336 10,615
7 13.1% 13.2%
1,393 30 10,085 391 10,496
8 15.2% 15.2%
1,592 20 10,004 430 10,444
9 17.3% 17.3%
1,805 10 10,004 473 10,477
10 19.4% 19.3%
2,036 - 10,084 521 10,595
Average 7.9% 7.9%
Find me a comparable!!
The ROC should be compared to which return??

Cost of Capital || Cost of Equity

Overall Operations
Parks and Resorts
The Hurdle Rate

RF 6.57%

Beta 0.75

MMP 5.38%

Lambda 1.33

CRP 2%

COE 13%

COD 9.34%

Debt to Capital 0.1

Equity to Capital 0.9

Cost of Capital 12.88%

From Earnings to Cash Flows!!
Sunk Costs

Allocated Costs
From Earnings to Cash Flows
Incremental Cash
Flow
Year
- 1 2 3 4 5 6 7 8 9 10
After Tax
Operating Income - (6) (552) (96) 297 722 1,115 1,393 1,592 1,805 2,036
Depreciation
- 10 1,510 1,363 1,089 871 843 830 817 810 810
Capital
Expenditure (6,100) (6,000) (1,800) (406) (485) (516) (667) (656) (726) (800) (880)
Change in WC
- 80 75 46 59 77 55 39 43 47
CF
(6,100) (5,996) (922) 787 855 1,017 1,214 1,512 1,643 1,772 1,919
Sunk Costs
100
Pre Project Dep
- 6 6 6 6 6 6 6 6 6 6
Non Incremental
Allocated
- - 74 144 186 241 313 364 400 440 484
Expenses
Incremental CFs
(6,000) (6,002) (854) 924 1,035 1,252 1,521 1,869 2,037 2,206 2,397
Key Things to take care of!!
Non Cash Expenses

Depreciation Methods

What you should capitalize and what you shouldnt?

Working Capital Effect

Cash Flows to Time Weighted Cash Flows
Remember Present Value Calculations??

Should you forecast forever or how do you get closure in

Cash Flows??
Salvage Value
Cash Flows in Perpetuity:
CF in year 10 * (1+g)/(Cost of capital growth rate)
And you get what you already knew!!
Year Incremental CFs Terminal Value PV
-
(6,000) (6,000)

1 (6,002) (5,318)

2 (854) (670)

3 924 642

4 1,035 637

5 1,252 683

6 1,521 735

7 1,869 801

8 2,037 773

9 2,206 742

10 2,397 53,062 16,514

NPV
9,540
IRR Profile
120000

100000

80000

60000

40000

20000

0
9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%

-20000

-40000

-60000
Does the Currency Matter??
From INR to USD
Difference between two cost of capital is only inflation
(1+ INR COC)*(1+USD Inflation)/(1+ INR Inflation)
Exchange Rate:
Expected Exchange Ratet = Exchange Rate today *
(1.08/1.02)t
 NPV in USD
Year
1 2 3 4 5 6 7 8 9 10
Cost of Capital in
7%
Dollars

INR to USD
0.02 0.02 0.02 0.01 0.01 0.01 0.01 0.01 0.01 0.01 0.01

USD to INR
59 62 66 70 74 78 83 88 93 98 104
Cash Flows in
-102.00 -96.37 -12.94 13.23 13.99 15.99 18.35 21.30 21.92 22.42 23.01
USD

PV
(102) (90) (11) 11 11 12 12 14 13 13 12

Terminal Value
509

PV of TV
269
Summation of
CFs 162

In INR
9,540
Dealing with Uncertainties
Adjusting cash flows

Using sophisticated methods

Mountains beyond Mountains
Setting the Expectations Bar!

Why Mountains Beyond Mountains?

Its a Crime to Live an Ordinary Life
Quit Early and Quit Often
Build And Cultivate
Relationships
Convenience vs. Compassion

Do you Deserve the Fourth Cookie?

Cultivate Greater Empathy
 Be in Touch (With Teachers)
Its Makes Us Happy If We Hear From You!
Try and Look At The World Through Gentler Eyes
Thank You