CA Magni New Book : Investment Decisions and the Logic of Valuation Linking Finance, Accounting, and Engineering

Dear Readers,

Prof. CA. Magni just launched a new book under the title of:

Investment Decisions and the Logic of Valuation Linking Finance, Accounting, and Engineering

I am just about to read this book, and quite delighted that finally Prof. CA. Magni’s releasing the book on valuation topic, though I know that he is a real zen for Average IRR (internal rate of return), a topic that he has written in many papers.

I found out that this AIRR’s exposition is briefly talked about and commented by the author.

Average Internal Rate of Return (AIRR)

Personally I am looking for a book sort of having practical atmosphere that I could use to teach people. In my experience, people tends to find a short cut, something “so” easy to understand. We could come up with very technical things, but it doesn’t work for sure…it’s good if we talk with somebody that aims to publish his/her papers into many prestigious finance journals. However, unfortunately, this IS NOT my audience.

As far as it relates to Valuation using NPV, my approach will start from some of very simple questions, instead of going thru the maze of cost of capital (and discussion of the discount rate for tax shield):

1. From where the positive NPV comes from: I did remember the first book that introduced me to this simple question is Principles of Corporate Finance by Brealy Myers (without Allen at that time as the co-author). The author even dedicated the whole ONE CHAPTER discussing this topic. This nailed to me up to now. It is so natural for us to put more time to explain away for the forecast cash flows and discount rate, yet less for the long good look into from where the project could have positive NPV. There should be something “special”, “unique”, “competitive advantage” about that project to give us positive NPV. Are they monopoly concession, technological edge, etc.

2. How about the growth in the first early years….how fast they could reach the economic of scale and scope. In the long term, it is said in many many books, that the growth in the business can’t grow higher than the economy growth rate, but this is BS…from the entrepreneurs’s eyes…they will only willingly commit their money into one venture, if the growth of that business is fast enough to give them ample time to harvest the competitive advantage in the near term (called quick “traction”), not in the long term. And as Maynard Keynes said, in the long-term, we all are dead.. But there is always an exception to this group of entrepreneurs, one of them, Steve Jobs,  which has funded PIXAR long enough almost 10 years our of his own pocket via personal checks to US$ 50 million worth. I hope he goes to heaven for just that alone (Alan Kay).

If somebody gave us the valuation with 80% of the value sitting in the long term, my kind suggestion, better to leave as it is and go.

3. The growth in the near term, should give the company return bigger than the cost.

4. Do we discount the forecast “expected” cash flows with the “expected” discount rate?

Back to valuation, in many examples, I found out, the author is talking about what happens to the capital market, but this is not “apple to apple”, since in capital market, it IS NOT VALUATION, it is PRICING, since the supply of the shares to buy is LIMITED. Even if the investor is zilloinaire, probably, the owner of the company won’t want to change hands in ownership.

Jumping to CAPM as part of Valuation discussion,

(i) In Bill Sharpe’s words…we are juxtaposing “ex-ante” vs “ex-post”. And as you probably, knew, even CAPM propositions up to now, can’t be proved satisfactorily. It doesn’t mean, then we cannot use that. We could use that with precautions that this theory is not perfect, and put both of our feet on the ground is a necessity or a must.

(ii) the proposition gave us correct way of thinking…if the investor wants to have higher reward, then he/she should take up higher risk. There is no free lunch, and as Bill Sharpe again said, we can’t beat the market on average. We need a very special skill, again, something unique, that other people doesn’t have, to exploit the market to get higher return, if not we are better to check whether the higher return carries with it with higher risk. This again, could be applied to all NPV-based valuation, whether higher positive NPV could indicate that the venture has carried with it, higher underlying risk.

Question:

Did you notice, that some do credit excel for positive NPVs?

Response:

For Project Financing, NPV is not always used in the calculation, mostly IRR, CFADS, DSCR, PLCR, LLCR, Cash Flow tail. However, implicit in capital budgeting (and financing), from finance perspective, lending could make sense be extended to projects with positive NPVs.

Talking about NPV,  as you already know, that under perfect market (particularly as long as we can borrow and lend at the same interest rate), then having a project with positive NPVs, this will not depend on our cash holdings (or cash needs). If the project owner doesn’t have money, he/she could always borrow the money to finance it, have the project cash flows along the way, repay the debt and service the interest charge, and then pocket the difference. NPV is “equivalent” to cash today. In other words, under perfect markets, project value will depend ONLY on the project, and not on us personally or on our cash position. We have here what many finance theorists coin it “the separation of the investment and financing decisions”. The inputs to the project valuation will ONLY involve the project’s cash flows and the return rate on other alternative investment (with the comparable risk and tenor).

Let’s say, we have an investment opportunity with an initial cost of US$ 10k and within 1 year, it will give us US$ 12k. The risk-free interest rate per annum is 6%.

Assuming we don’t have cash at all, then how to finance this investment opportunity?

Borrow the Money!

Next question: how much money do we need to borrow? US$10k? or even bigger?

The answer: the amount to borrow is bigger than US$10k.

Here is the elementary math:

PV of the opportunity = US$ 12k/(1+6%) = US$11.3k

We borrow US$ 11.3k and invest US$10k = the difference of US$1.3k is the money that we could pocket in…

Within one year, we need to pay US$ 11.3k x (1+6%) = US$ 12k to the creditor, which money we will get from the cash flow of the investment opportunity.

Then what is this difference of US$ 1.3k that we could pocket in?

It is the NPV of the investment opportunity…=

PV Benefits = US$ 12k/(1+6%) = US$ 11.3

PV Costs = US$ 10k

NPV = US$ 1.3k

So NPV is equal to having “Cash” today.

But once we move to imperfect market, in which the lending and borrowing rates are not the same, then the value of the project will also depend on our cash holdings as well. Who owns the project become matters!

Another Comment:

I believe the basic NPV rule holds in an imperfect world, just with an addition “up to concomitant frictions” (i.e. costs of obtaining external financing, distress & agency losses, etc).

Who owns the project, who owns the cash, available borrowing and interest rates, project finance structure … do not affect the project’s economic potential (NPV) per se. It’s all about how the project’s economic output is redistributed among the parties involved. Each party’s desire to evaluate its proprietary return and set up acceptable terms before making a decision gives rise to a plethora of acronyms with specific measures (ex-ante and ex-post) behind.

Response to above comment:

What I meant, once we moved to imperfect market, then NPV project will not be unique again, we will not have one value anymore, and somehow the cash holdings will play its role.

For example,

The deposit (lending) rate is 4% and the borrowing rate is 9%.

There is one  project opportunity with initial investment US$ 1,000 and will return us within one year US$ 1,070.

NPV of the project?

This will depend what whether we have money or not.

Let’s say we have that US$1,000. Then we are better off to take up the project, if the only other alternative is to put the money in the deposit. We will only reap US$ 30 in one year, compared to that project which will return us US$ 70, with US$ 40 difference.

But how about if we don’t have the money, then we need to borrow US$1,000 from the bank and then repay US$ 1,090. But this taking up the project will make us US$20 in cash lower than not taking up, since we have to pay bank US$1,090 while the project will only return us US$ 1,070.

In this case, we see the separation between the investing decision and financial position is now not working well.

Reader’s comment:

What I meant, once we moved to imperfect market, then NPV project will not be unique again, we will not have one value anymore, and somehow the cash holdings will play its role.

Agree, there could be as many NPV, as the number of people making evaluations, and this will depend on an individual perception of project’s cash flows and risk. However, it is not the availability of cash or the cost of financing that determine the project’s NPV, They are the cash flows from assets and their risk, while availability and terms of financing set up the pattern of the project’s cash and risk distribution among the parties involved, That could make doing a project meaningless to the project owner, however, it doesn’t turn the project per se from good to bad (or visa versa). Assume, for example, one period project with the upfront investment INV0=900, expected cash flow CF1=1100 and risk adjusted discount rate R=10%. NPV=100 and the project is economically sound. Clearly, what part of benefits will go to the project owner depends on terms of financing. If the only option available is the bank credit at a rate 12%, then undertaking the project makes no sense. But, the project on its own stays profitable at NPV=100 🙂  Separation principle still works: NPV(owner) = NPV(project) + NPV(financing). Perfect market imply NPV(financing)=0 and NPV(owner) = NPV(project), which are not the immanent properties of a real world. 

For example,

My general comment is in the paragraph above. Yet, there’s another debatable point.

May I suggest that the layout below overlooks one crucial variable – RISK? Should we compare investment opportunities or financing options solely on the basis of returns? My faith – we should not. 

 
the deposit (lending) rate is 4% and the borrowing rate is 9%.
There is one  project opportunity with initial investment US$ 1,000 and will return us within one year US$ 1,070.

Assume the cash flow is certain and the risk free rate is 7% 

NPV of the project?

Under assumption above, NPV=0 

this will depend what whether we have money or not.

and that does not depend on whether we have money or not 

Let’s say we have that US$1,000. Then we are better off to take up the project, if the only other alternative is to put the money in the deposit. We will only reap US$ 30 in one year, compared to that project which will return us US$ 70, with US$ 40 diffference.

Putting 1,000 in the deposit at 4% we lose -1,000 + 1,040/(1+7%)= -28 in terms of current dollars. That is disappointing, but better than losing -65 with 1,000 under the mattress. Clearly, investing in a project is the best alternative. 

But how about if we don’t have the money, then we need to borrow US$1,000 from the bank and then repay US$ 1,090. But this taking up the project will make us US$20k in cash lower than not taking up, since we have to pay bank US$1,090 while the project will only return us US$ 1,070.

Borrowing at 9% (as well as lending from the bank perspective) makes no sense, since the project earns less than required to retire the debt. Pretty obvious that this scenario is just not feasible.

Let’s assume the project owner has 20 in cash. In this case she may wish to borrow 980 at 9%, invest 1,000 in a project, return 980*(1+9%)=1,068.2 to the bank in one year and end up with 1.8 on hand. NPV(owner) = -20 + 1.8/(1+7%) = -18.3. (Clearly, putting 20 in the deposit is a better choice: NPV = – 20 + 20/(1+7%) = -0.56) 

One can obtain the same figure with the “separation” approach as well:

NPV(owner) = NPV(project) + NPV(financing) = 0 + [+980 – 1068.2/(1+7%) ] = 0 + (-18.3) = -18.3.

In this case, we see the separation between the investing decision and financial position is now not working well.

Not sure. Would say it looks ok. 

What do you think?

Though not that trivial, the example could be extended to a risky cash flows.

Note: Bolded sentences are comments from reader via email

Prof. Peter DeMarzo’s comment:

Just as with any good, once there is a bid-ask spread, preferences and endowments will matter.  We give such an example in Chapter 3.   For a simple two period investment, if NPV is positive with both rates, or Negative with both rates, nothing changes.  But if NPV is positive at the low rate and negative at the high rate, then things become ambiguous.  You would not borrow to invest, but you would invest rather than save.  So it depends on how much cash (or debt) you already have.  We also discuss this in the appendix of Chapter 12 in the context of CAPM.

Note: Prof. Peter DeMarzo referred to his book : Corporate Finance, which is now on the 4th Edition.

#StayatHome and #StayWell.

Karnen

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