Project Cash Flows. IAG PUC-Rio. Disney - Pinocchio. Disney - Pinocchio. Disney executives were analyzing the release of Pinocchio in video format.

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1 IAG PUC-Rio Project Cash Flows 1984 Disney executives were analyzing the release of Pinocchio in video format. Prof. Luiz Brandão BRANDÃO Disney - Pinocchio First released in 1939, Pinocchio was only the second feature animation film of Disney. Typically, these films were re-released in movie theaters every 7 to 8 years. In 1984 a new Disney management team was discussing the re-release of this classic film. The question was whether they should also release the film in video tape format. Disney - Pinocchio Project Assumptions: Movies and video projects are mutually exclusive. Estimated sales of video: 7.5 million copies. Results: Movies Project Value: $ 25 M Video Project Value: $ 100 M Decision based on projected cash flow of each alternative 3 BRANDÃO 4 BRANDÃO

2 What happened What happened Disney Videos Sales (million) Disney - Videos Sales (million) 12,5 10,0 7,5 Cinderella Bambi 40,0 30,0 Mogli Beauty and the Beast The Lion King Alladin 20,0 5,0 2,5 Sleeping Beauty Pinocchio Lady and the Tramp 10, BRANDÃO 6 BRANDÃO Project Cash Flows Incremental Flows x Total Flows Project Cash Flows Depreciation Opportunity Costs Collateral effects Sunk Costs 7 BRANDÃO 8 BRANDÃO

3 9 BRANDÃO 10 BRANDÃO Project Cash Flows Working capital Indirect Costs Interest expenses Inflation 11 BRANDÃO 12 BRANDÃO

4 Efeitos Colaterais Canibalização One of the bigger surprises of Apple s 2012 earnings was the revelation that Mac sales declined. Compared to the same quarter a year ago when it sold 5.2 million Macs, Apple sold 22 percent fewer, or 4.1 million. The quick explanation about why Apple sold fewer Macs was that the ipad and new ipad mini were favored by buyers CEO Tim Cook explains: We know ipad is cannibalizing the Mac, but that doesn t worry us. On ipad in particular, we have the mother of all opportunities here because the Windows market is much larger than the Mac market. It s clear it s already cannibalizing some. I ve said for three years now that I believe the tablet market will be larger than the PC market at some point, and I still believe that. 13 BRANDÃO Convention Cash Flow representations Continuous CF Continuous CF Continuous CF Discrete Cash Flows 14 BRANDÃO Problems with Cash Flow Projections Case Study: Iridium Project 15 BRANDÃO

5 Original document with the first description of the Iridium system (1988) Collection: Smithsonian Museum, Washington DC 18 BRANDÃO Iridium World Comunications Global mobile satellite designed by Motorola Objective: To allow access to the worldwide phone network from anywhere in the globe. Planned investment: $ 2.5 billion, including 66 communication satellites and seven ground stations. Forecast: 5 million subscribers by BRANDÃO Iridium 1991: Motorola sets Iridium as an independent company through a "Project Finance" to develop and operate the network. This allows other partners to join the business, reducing the risk for Motorola. 1992: Iridium hires Motorola for U.S. $ 3.37 billion to develop, build and implement the system. Motorola becomes the main supplier of Iridium. 20 BRANDÃO

6 The Consortium An International Consortium of 19 companies is formed to make the project viable Motorola, Siemens, Raytheon, HP Great Wall of China Industry Corporation Khrunichev Space Center of Russia Korea Mobile Telecomm Corp. Lockheed, McDonnell Douglas, Sprint Italian STET and 15 regional operating franchises 21 BRANDÃO 22 BRANDÃO Project Financing With the establishment of Iridium LLC and the entry of new participants, Motorola reduced its stake in the business to 25% Large geographic and technological diversity of the participants. Project starts with equity investment 1993: Partners provided US$800 million 1994: $1.6 billion of equity, plus $800 million of debt. 1995: Iridium receives operating license 23 BRANDÃO 24 BRANDÃO

7 Project Financing 1997: A $ 750 million line of credit is secured, and $240 million in company stock are offered to the public at a price of $ 21 per share. In a few months the stock price rises to $ 70. Technical difficulties increase the project cost to $ 5.5 billion. 1998: All satellites already in orbit and commercial operation begins Launched a worldwide marketing campaign at a cost of $160 million Market & Target Audience Target Audience: Travelers needing constant phone access, such as businessmen and professionals. Population of remote areas with no other form of phone service. Break even point: 600,000 subscribers needed by the end of BRANDÃO 26 BRANDÃO Problems Portable device availability delays delivery to subscribers. Connection problems because Iridium requires line of sight to satellite, and thus does not work in closed areas such as vehicles and offices. Marketing error by offering Iridium as a substitute to cell phone. Service had significantly higher rates than the competitor (about 10X greater), and phone weighted over one pound. Low quality analog signal when the phones were already migrating to digital service. As a manufacturer, the main goal of Motorola, as sponsor of the project, was to sell equipment. Iridium is a company that provides services, which is outside of Motorola s field of expertise. High cost of service put itout of reach part of their target audience. Problems 27 BRANDÃO 28 BRANDÃO

8 By July 1999 only 15,000 units had been sold. The expected monthly revenue of $30 million was only $1.5 million In July 1999, the shortterm debt was $800 million that the company failed to honor. Problems In August 1999, Iridium filed for bankruptcy, but failed to recover and was declared bankrupt in March BRANDÃO Conclusions Technical difficulties on an ambitious project substantially increased costs originally budgeted. Marketing error when Iridium was sold as a substitute for ordinary cell phones. Technological evolution on cell phones during the ten years of maturation became a serious competitor to Iridium, which is an analog system, with maximum speed of 2400 baud. Actual Cash Flow different from initial estimates. The assets of Iridium LLC company, now bankrupt, were bought by a group of private investors who founded Iridium Satellite LLC operating system that continues to this day. 30 BRANDÃO Ex 1: Item Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Gross Revenues Exercises Expenses (4.000) (6.000) (8.000) (8.000) (8.000) (6000) Depreciation (1.500) (1.500) (1.500) (1.500) (1.500) (1.500) EBIT Tax (35%) Net Income Depreciation Changes in WC (500) (1.000) (1.000) (2.000) (0) CAPEX (3.000) (6.000) Residual Value Free Cash Flow 31 BRANDÃO 32 BRANDÃO

9 SpectroMed Ltd. Managers of SpectroMed are meeting with the shareholders to decide on a new project investment opportunity. If the project is implemented, the initial investment will be $120,000 for the new facilities and $25,000 for working capital, which will be fully funded by the shareholders. The project has a four year life, gross revenues of $70,000 in the first year and $ 200,000 in each of the remaining years, and a tax rate of 25%. Costs represent 65% of gross revenue and depreciation is linear during this period. The shareholders expect a return of 20%. Do you recommend investing in this project? Project You are analyzing a project that has a total duration of 7 years. The required investment is $600,000, with another $1.2 million to be invested by the end of the third year of operation for a projected expansion. Depreciation is $200,000 per year, increasing to $300,000 starting in year 4. The incremental net revenue (revenue - expenses) to be generated by this project is $400,000 per year, before depreciation, increasing to $600,000 from year 4 onwards. If the company's cost of capital is 15% per year, and the tax rate is 35%, what is the NPV and IRR of this project? Should the company invest in it? Graph the NPV for discount rates between 0 and 40%. 33 BRANDÃO 34 BRANDÃO ErgoSoft Ergosoft is analyzing the feasibility of a five year project. The project requires an immediate investment of $600,000, followed by another $900,000 by the end of the third year. The initial investment with be depreciated linearly in three years at the rate of $200,000 per year, followed by a $450,000 depreciation in years 4 and 5. The net incremental revenues (revenues expenses) generated by the project are constant at $400,000 per year before depreciation, and increase to $600,000 per year from year 4 onwards. Assume that the firm s cost of capital is 17% per year, and that the tax bracket is 30%. What is the NPV and IRR of this project? What is your recommendation to the firm? 35 BRANDÃO IAG PUC-Rio Project Cash Flows Prof. Luiz Brandão BRANDÃO