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ProductandProjectCannibalization:ARealCost?

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¨ AssumethatintheDisneythemeparkexample,20%oftherevenuesattheRioDisneyparkareexpectedtocomefrompeoplewhowouldhavegonetoDisneythemeparksintheUS.Indoingtheanalysisofthepark,youwoulda. Lookatonlyincremental revenues (i.e.80%ofthetotalrevenue)b. Lookattotalrevenues attheparkc. Chooseanintermediate number

¨ WouldyouranswerbedifferentifyouwereanalyzingwhethertointroduceanewshowontheDisneycablechannelonSaturdaymorningsthatisexpectedtoattract20%ofitsviewersfromABC(whichisalsoownedbyDisney)?a. Yesb. No

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B.ProjectSynergies

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¨ Aprojectmayprovidebenefits forotherprojectswithin thefirm.Consider, forinstance,atypicalDisneyanimatedmovie.Assumethatitcosts$50million toproduceandpromote.Thismovie, inadditiontotheatricalrevenues, alsoproducesrevenues from¤ thesaleofmerchandise(stuffedtoys,plasticfigures,clothes..)¤ increasedattendanceatthethemeparks¤ stageshows(see“BeautyandtheBeast” andthe“LionKing”)¤ televisionseriesbaseduponthemovie

¨ Ininvestment analysis,however, thesesynergies areeither leftunquantified andusedtojustifyoverriding theresultsofinvestmentanalysis, i.e,,usedasjustificationforinvestinginnegativeNPVprojects.

¨ Ifsynergies existandtheyoftendo,thesebenefitshavetobevaluedandshownintheinitial projectanalysis.

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Case1:AddingaCafétoabookstore:Bookscape

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¨ Assumethatyouareconsidering addingacafé tothebookstore.Assumealsothatbasedupontheexpected revenues andexpenses, thecaféstandingaloneisexpected tohaveanetpresentvalueof-$87,571.

¨ Thecafewillincrease revenues atthebookstoreby$500,000inyear1,growingat10%ayearforthefollowing4years.Inaddition,assumethatthepre-taxoperatingmarginonthesesales is10%.

¨ Thenetpresentvalueoftheaddedbenefits is$135,268.AddedtotheNPVofthestandaloneCafé of-$87,571yieldsanetpresent valueof$47,697.

1 2 3 4 5Increased Revenues $500,000 $550,000 $605,000 $665,500 $732,050Operating Margin 10.00% 10.00% 10.00% 10.00% 10.00%Operating Income $50,000 $55,000 $60,500 $66,550 $73,205Operating Income after Taxes $30,000 $33,000 $36,300 $39,930 $43,923PV of Additional Cash Flows $27,199 $27,126 $27,053 $26,981 $26,908PV of Synergy Benefits $135,268

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Case2:Synergyinamerger..

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¨ WevaluedHarman International foranacquisitionbyTataMotorsandestimatedavalueof$2,476millionfortheoperatingassets and$2,678millionfortheequityinthefirm,concludingthatitwouldnotbeavalue-creatingacquisitionatitscurrentmarketcapitalizationof$5,248million.Inestimating thisvalue,though,wetreatedHarman Internationalasastand-alone firm.

¨ AssumethatTataMotorsforesees potentialsynergies inthecombinationofthetwofirms,primarilyfromusingitsusingHarman’shigh-endaudiotechnology(speakers, tuners)asoptionalupgrades forcustomersbuyingnewTataMotorscarsinIndia.Tovalue thissynergy,letusassumethefollowing:¤ ItwilltakeTataMotorsapproximately3yearstoadaptHarman’sproducts toTata

Motorscars.¤ TataMotorswillbeabletogenerateRs10billion inafter-taxoperating income in

year4fromsellingHarmanaudioupgrades toitsIndiancustomers, growingatarateof4%ayearafterthatinperpetuity (butonly inIndia).

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Estimatingthecostofcapitaltouseinvaluingsynergy..

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¨ Business risk:Theperceived synergies flowfromoptional add-onsinautosales.Wewillbeginwiththeleveredbetaof1.10,thatweestimated forTataMotorsinchapter4,inestimating thecostofequity.

¨ Geographicrisk:Thesecondisthatthesynergies areexpected tocomefromIndia;consequently, wewilladdthecountryriskpremium of3.60%forIndia,estimated inchapter4(forTataMotors)tothematuremarketpremiumof5.5%.

¨ Debtratio:Finally,wewillassume thattheexpansionwillbeentirely inIndia,withTataMotorsmaintainitsexistingdebttocapitalratioof29.28%anditscurrentrupeecostofdebtof9.6%anditsmarginal taxrateof32.45%.¤ CostofequityinRupees=6.57%+1.10(5.5%+3.60%) =16.59%¤ CostofdebtinRupees=9.6%(1-.3245) =6.50%¤ CostofcapitalinRupees=16.59%(1-.2928) +6.50%(.2928)=13.63%

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Estimatingthevalueofsynergy…andwhatTatacanpayforHarman

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¨ ValueofsynergyYear3 =

¨ Valueofsynergy today=¨ Converting thesynergy valueintodollartermsattheprevailing

exchange rateofRs60/$,wecanestimateadollarvalue forthesynergy fromthepotential acquisition:¤ ValueofsynergyinUS$=Rs70,753/60=$1,179million

¨ Addingthisvalue totheintrinsicvalueof$2,678million thatweestimated forHarman’sequity inchapter5,wegetatotalvaluefortheequityof$3,857million.¤ ValueofHarman=$2,678million+$1,179million=$3,857million

¨ SinceHarman’s equity tradesat$5,248million, theacquisition stilldoesnotmake sense, evenwiththesynergy incorporatedintovalue.

Expected Cash FlowYear 4

(Cost of Capital - g)=

10,000(.1363-.04)

= Rs 103,814 million

Value of Synergyyear 3

(1+Cost of Capital)3 =103,814(1.1363)3 = Rs 70,753 million

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III.ProjectOptions

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¨ Oneofthelimitationsoftraditionalinvestmentanalysisisthatitisstaticanddoesnotdoagoodjobofcapturingtheoptionsembeddedininvestment.¤ Thefirstoftheseoptionsistheoptiontodelay takingaproject,whenafirmhasexclusive rightstoit,untilalaterdate.

¤ Thesecondoftheseoptionsistakingoneprojectmayallowustotakeadvantageofotheropportunities (projects) inthefuture

¤ Thelastoptionthatisembedded inprojectsistheoptiontoabandonaproject,ifthecashflowsdonotmeasureup.

¨ Theseoptionsalladdvaluetoprojectsandmaymakea“bad” project(fromtraditionalanalysis)intoagoodone.

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TheOptiontoDelay

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¨ Whenafirmhasexclusiverightstoaprojectorproductforaspecificperiod, itcandelaytakingthisprojectorproductuntilalaterdate.Atraditionalinvestment analysisjustanswers thequestionofwhether theprojectisa“good” oneiftakentoday.Therightstoa“bad” projectcanstillhavevalue.

Present Value of Expected Cash Flows on Product

PV of Cash Flows

Initial Investment in Project NPV is positive in this section

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InsightsforInvestmentAnalyses

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¨ Havingtheexclusiverightstoaproductorprojectisvaluable,eveniftheproductorprojectisnotviabletoday.

¨ Thevalueoftheserightsincreaseswiththevolatilityoftheunderlyingbusiness.

¨ Thecostofacquiringtheserights(bybuyingthemorspendingmoneyondevelopment- R&D,forinstance)hastobeweighedoffagainstthesebenefits.

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TheOptiontoExpand/TakeOtherProjects

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¨ Takingaprojecttodaymayallowafirmtoconsiderandtakeothervaluableprojects inthefuture.Thus,even thoughaprojectmayhaveanegativeNPV,itmaybeaprojectworthtakingiftheoptionitprovides thefirm(totakeotherprojects inthefuture)hasamore-than-compensatingvalue.

Cash Flows on Expansion

PV of Cash Flows from Expansion

Additional Investment to Expand

Firm will not expand inthis section

Expansion becomes attractive in this section

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TheOptiontoAbandon

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¨ Afirmmaysometimeshavetheoptiontoabandonaproject, ifthecashflowsdonotmeasureuptoexpectations.

¨ Ifabandoningtheprojectallowsthefirmtosave itselffromfurtherlosses, thisoptioncanmakeaprojectmorevaluable.

Present Value of Expected Cash Flows on Project

PV of Cash Flows from Project

Cost of Abandonment

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IV.AssessingExistingorPastinvestments…

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¨ Whilemuchofourdiscussionhasbeenfocusedonanalyzingnewinvestments,thetechniquesandprinciplesenunciatedapplyjustasstronglytoexistinginvestments.

¨ Withexistinginvestments,wecantrytoaddressoneoftwoquestions:¤ Post–mortem:Wecanlookbackatexistinginvestmentsandseeiftheyhavecreatedvalueforthefirm.

¤ Whatnext?Wecanalsousethetoolsofinvestmentanalysistoseewhetherweshouldkeep,expandorabandonexistinginvestments.

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AnalyzinganExistingInvestment

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In a post-mortem, you look at the actual cash flows, relative to forecasts.

You can also reassess your expected cash flows, based upon what you have learned, and decide whether you should expand, continue or divest (abandon) an investment

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a.PostMortemAnalysis

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¨ Theactualcashflowsfromaninvestmentcanbegreater thanorless thanoriginallyforecast foranumberofreasons butallthese reasonscanbecategorized intotwogroups:¤ Chance:Thenatureofriskisthatactualoutcomescanbedifferent from

expectations.Evenwhenforecastsarebasedupon thebestof information, theywillinvariablybewrong inhindsight becauseofunexpectedshiftsinbothmacro(inflation, interestrates,economicgrowth)andmicro(competitors, company)variables.

¤ Bias:Iftheoriginal forecastswerebiased, theactualnumberswillbedifferent fromexpectations.Theevidenceoncapitalbudgeting isthatmanagerstendtobeover-optimisticaboutcashflowsandthebiasisworsewithover-confident managers.

¨ Whileitisimpossible totellonanindividualprojectwhetherchanceorbiasistoblame,there isawaytotellacrossprojectsandacross time.Ifchanceistheculprit,thereshouldbesymmetryintheerrors– actualsshouldbeaboutaslikelytobeat forecastsastheyaretocomeunderforecasts. Ifbiasisthereason, theerrorswilltendtobeinonedirection.

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b.Whatshouldwedonext?

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........ Liquidatetheproject

........ Terminatetheproject

........ Divesttheproject

........ Continuetheproject

€

NFn

(1 + r)nt =0

t =n

∑ > 0 > Divestiture Value€

NFn

(1 + r)nt =0

t =n

∑ < Divestiture Value

€

NFn(1+ r)nt=0

t=n

∑ < 0

€

NFn

(1 + r)nt =0

t =n

∑ < Salvage Value

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Example:DisneyCaliforniaAdventure–The2008judgmentcall

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¨ Disneyopened theDisneyCaliforniaAdventure (DCA)Parkin2001,atacostof$1.5billion,withamixofrollercoasterridesandmovienostalgia.Disneyexpectedabout60%ofitsvisitorstoDisneyland tocomeacrosstoDCAandgenerateabout$100millioninannualafter-cash flowsforthefirm.

¨ By2008,DCAhadnotperformed uptoexpectations.Ofthe15millionpeoplewhocametoDisneyland in2007,only6millionvisitedCaliforniaAdventure, andthecashflowaveragedouttoonly$50millionbetween2001and2007.

¨ Inearly2008,Disneyfaced threechoices:¤ ShutdownCaliforniaAdventureandtrytorecoverwhateveritcanofitsinitial

investment.Itisestimatedthatthefirmrecoverabout$500millionofitsinvestment.¤ Continuewiththestatusquo,recognizingthatfuturecashflowswillbeclosertothe

actualvalues($50million)thantheoriginalprojections.¤ Investabout$600milliontoexpandandmodifythepark,withtheintentofincreasing

thenumberofattractionsforfamilieswithchildren,isexpectedtoincreasethepercentageofDisneylandvisitorswhocometoDCAfrom40%to60%andincreasetheannualaftertaxcashflowby60%(from$50millionto$80million)atthepark.

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DCA:Evaluatingthealternatives…

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¨ ContinuingOperation:Assuming thecurrentafter-taxcashflowof$50million willcontinueinperpetuity, growingattheinflationrateof2%anddiscountingbackatthethemeparkcostofcapitalin2008of6.62%yields avalue forcontinuingwiththestatusquo

ValueofDCA=¨ Abandonment: Abandoning thisinvestment currentlywouldallow

Disney torecoveronly$500millionofitsoriginal investment. Abandonment valueofDCA=$500million

¨ Expansion: Theup-frontcostof$600million will leadtomorevisitorsintheparkandanincrease intheexistingcashflowsfrom$50to$80million.

ValueofCFfromexpansion=

€

Expected Cash Flow next year(Cost of capital - g)

=50(1.02)

(.0662 − .02)= $1.103 billion

€

Increase in CF next year(Cost of capital - g)

=30(1.02)

(.0662 − .02)= $662 million

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FirstPrinciples

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