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 rd.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

WACC Getting 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 (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?