Session 16: Investment Returns III - Wrapping up Loose Ends

Summary

In this corporate finance class, the lecturer discusses various critical aspects of investment analysis, focusing on the treatment of different currencies, side costs, side benefits, and uncertainty. The importance of consistent currency usage for accurate project valuation is emphasized, particularly when converting cash flows across different currencies. The session also addresses how to deal with uncertainty in financial predictions, offering strategies like payback periods, sensitivity analysis, and Monte Carlo simulations. Finally, the discussion concludes with the importance of incorporating side costs and benefits into investment return calculations to create accurate and comprehensive financial assessments.

Takeaways

• 😀 Understand the importance of consistency in currency selection for investment analysis. It's crucial to use the same currency for both cash flows and the discount rate to avoid misleading conclusions.
• 😀 📉 When converting cash flows between different currencies, it's important to use expected exchange rates, not just the current rates. This can be done using purchasing power parity to account for inflation differentials between countries.
• 😀 💰 For multinational investments, ensure that both cash flow and capital cost (discount rate) are properly adjusted for each currency to prevent skewed results.
• 😀 💡 Dealing with uncertainty is a key aspect of investment analysis. You can approach it by calculating a payback period, which helps manage risk and uncertainty by tracking how long it takes for an investment to pay back its initial costs.
• 😀 🛠️ Use ‘What-If’ analysis to explore various scenarios and test how different assumptions (like revenue or expenses) could impact the investment outcome. However, avoid overwhelming decision-makers with excessive data.
• 😀 🔮 Monte Carlo simulation is a powerful tool for understanding risk and uncertainty. By running multiple simulations with different assumptions, you can generate a range of possible outcomes, helping you make more informed decisions.
• 😀 ⚖️ Side costs and side benefits (e.g., employee transfers, increased brand sales) must be included in your investment analysis. They impact the overall return and should be accounted for as part of the cash flows.
• 😀 🌍 When considering foreign investments, managing exchange rate risk is important. The decision to hedge risk should depend on whether it's more cost-effective for the company or its investors to do so.
• 😀 🤖 The key to effective investment analysis is focusing on a few critical inputs. Instead of asking a large number of ‘What-If’ questions, focus on two or three key variables that will most influence your decision.
• 😀 📊 Creative visualizations, like charts and graphs, can help convey complex data in a simpler way. A well-designed chart can make it easier for decision-makers to grasp the key insights and refine their strategy.
• 😀 🧠 Remember that every investment decision is based on assumptions. Constantly reassess and adjust your models as new information becomes available to account for shifting uncertainties and external factors.

Q & A

What is the main focus of the session discussed in the transcript?

The session focuses on refining the measurement of investments, including how to deal with different currencies, side costs and benefits, and uncertainty during investment analysis.

Why did the speaker choose to use US dollars for cash flow and discount rate in the Disney example?

The speaker assumed that the decision-makers at Disney would be more comfortable with dollar-based numbers, even though the cash flows would nominally be in reais (Brazilian currency).

What does the speaker mean by 'cheating' in the context of currency in the analysis?

The speaker refers to 'cheating' because they used US dollars for both the cash flows and discount rate, even though the analysis should have considered the nominal reais for accuracy.

How did the speaker convert US dollar cash flows into nominal reais?

The speaker used the purchasing power parity principle, which incorporates the differential inflation rates between US dollars and reais to calculate an expected exchange rate over time.

What was the outcome of converting the Disney park's analysis to nominal reais?

After converting to nominal reais, the net present value (NPV) in reais turned out to be the same as in US dollars, which the speaker considered an ideal result.

How does the speaker suggest handling uncertainty in investment analysis?

The speaker suggests several approaches to handle uncertainty, such as waiting for uncertainty to resolve (which is impractical), being conservative and avoiding investments, or using methods like payback periods, sensitivity analysis, and Monte Carlo simulations.

What is the payback period, and why is it used in capital budgeting?

The payback period is the time it takes for an investment to return its initial cost. It is used as a way to manage uncertainty by setting a limit on the number of years it takes to recover the investment.

What is the key advice when using Excel or spreadsheets for sensitivity analysis?

The key advice is to avoid asking too many 'what if' questions that can overwhelm the analysis. Instead, focus on two or three key inputs and present findings in a clear, visual way to aid decision-making.

What is Monte Carlo simulation, and how does it help in dealing with uncertainty?

Monte Carlo simulation is a method that runs many simulations to account for variability in key inputs. It produces a distribution of outcomes (such as NPVs), helping decision-makers assess the range of possible outcomes and the probability of different scenarios.

What is the speaker's stance on hedging exchange rate risk in investment analysis?

The speaker argues that hedging exchange rate risk may be beneficial if it is inexpensive to do so. However, if hedging is costly, it may be more efficient for investors to handle the risk instead of the company itself.