Measuring Investment Returns

Objective
To determine and analyze the investment returns.
This report analyzes the quality of the firms’ current investments and the
managers’ abilities to contribute to increasing the firms’ values. We will also
assess the quality of the companies’ future projects by considering what
characteristics the investments have within the industry.

This analysis relies on the valuation of the returns of the projects based on
accounting methods. In particular the return on equity (ROE) and the return on
capital (ROC), which we will define briefly, will be compared to the current
cost of equity in the first case, and to the cost of capital in the second. This will
enable us to determine whether the companies have excess returns over costs.
 Methodology

Step 1.Select 3 sectors - Telecommunication, IT and Automobile

Step 2 .Select 2 companies for each sector

Step 3: Calculation
The tool used for the calculation is Excel. This is followed by the WACC
calculations in Excel.
Rt: Returns on the Security
Rm: Market Returns
Ke: Cost of Equity
Kd: Cost of Debt
WACC: Weighted Average Cost of Capital
The CAPM Approach is used to calculate the Cost of Equity
 Analysis

We have analyzed 2 companies in 3 varied sectors namely

• Telecommunication (Bharti Airtel and MTNL)

• Automobile (Tata Motors and Ashok Leyland )

• IT(Infosys and Wipro)

In the analysis we have done the following:

• Characteristics of the Industry

• ROC and ROC Analysis

• Cash Flow Analysis

• Converting excess returns into EVA

• Intersectoral Comparison
 Characteristics of the Industry
The issues that we want to control which are related to the cash flows generated
by the projects are: time horizon, predictability, external variables affecting the
patterns of the flow and currency the cash flows are in
.

Industry Time Horizon Predictability External Variables Currency

Telecommunication Medium term Difficult to predict Macro-economic Mainly local Currency

trends, Mobile phone
prices, Government
Policies
IT Medium/Long Predictable Macro – economic Foreign Currency
term trends, Demand in mainly US dollar
Foreign Market

Automobile Long term Predictable Macro – economic Local Currency and

trends, Supporting Foreign Currency
industry like tyres,
Oil Prices

ROE and ROC analysis

This analysis looks backward to evaluate the companies’ past returns on the
capital employed in the firms. The ROE tells us the amount of income the
company was able to generate with the equity available. In a similar way, the
ROC identifies how much return the company was able to generate from the
capital employed. In order to have stronger explanatory power, these figures
must be compared to the cost of equity (in case of the ROE) and to the cost of
capital (in case of the ROC). If the returns are higher than the costs, the
companies are able to generate excess returns possibly leading to increases in
the firms’ values.

The CAPM Approach is used to calculate the Cost of Equity (Ke)

Theory

CAPITAL ASSET PRICING MODEL

A model that describes the relationship between risk and expected

return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk. The time value of money is represented by
the risk-free (rf) rate in the formula and compensates the investors for placing
money in any investment over a period of time. The other half of the formula
represents risk and calculates the amount of compensation the investor needs for
taking on additional risk. This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a period of time and to the
market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium. If this expected return does not
meet or beat the required return, then the investment should not be undertaken.
The security market line plots the results of the CAPM for all different risks
(betas).

Advantages
1. A project’s market risk is the most relevant risk to stockholders, hence to
determine the effect of the project on stock price.
2. It results in a definite hurdle rate for use in evaluating the project.

Disadvantages

1. It is virtually impossible to estimate betas for many projects.

 2. People sometimes focus on market risk to the exclusion of corporate risk,
and this may be a mistake.

Weighted Average Cost of Capital:

WACC : We*Ke + Wd*Kd

Where,
We: Weight of Equity
Ke: Cost of Equity
Wd: Weight of Debt
Kd: Cost of Capital

Telecommunication Industry

Bharti Airtel MTNL Industry Average

Cost of Equity (1) 8.16% 8.5% 8.33%

Return on Equity (ROE ) 28.13% 1.39% 14.76%

(2)

Excess Return on Equity 19.97% (7.11)% 6.43%

(3) = (2) – (1)

Weighted Average Cost 7.56% 8.5% 8.03%

of Capital (WACC) (4)

Return on Capital 28.40% 3.8% 16.1%

Employed (ROCE) (5)

Excess Return on Capital 20.8% (4.7)% 8.07%

(6) = (5)-(4)

The Telecommunication Industry has shown an Excess Return on Equity and

Capital. Bharti Airtel has fallen the Industry’s trend but MTNL has shown
negative excess returns. This may be due to strict Government policies , MTNL
being a Public Sector Unit. Plus, MTNL Rates are very much low as compared
to Bharti Airtel during the period 2008-2009, hence reducing the profit of
MTNL. This also indicates that Bharti Airtel has made good investments. These
investments are good from the point of view of both the shareholders and that of
the firm
Automobile Industry
Tata Motors Ashok Leyland Industry Average

Cost of Equity (1) 8.61% 8.4% 8.505%

Return on Equity 8.07% 5.5% 6.785%

(ROE ) (2)

Excess Return on Equity (.54)% (2.9)% (1.72)%

(3) = (2) – (1)

Weighted Average Cost 6.9% 7.98% 7.44%

of Capital (WACC) (4)

Return on Capital 11.77% 11.23% 11.5%

Employed (ROCE) (5)

Excess Return on 4.87% 3.25% 4.06%

Capital (6) = (5)-(4)

The Automobile Industry has shown that there is no excess returns on equity.
Infact , the Cost of Equity is higher than the Return on Equity ,thus showing a
negative excess returns on equity.
Both the Companies Tata Motors and Ashok Leyland has followed Industry’s
trend showing negative excess returns on equity.
Return on Capital of both the Companies is almost the same as the Industry
indicating that the Companies has made some good investments and is
following the Industry. These investments are good from the point of view of
the firm but not from the point of view of shareholders.
IT Industry
Infosys Wipro Industry A5verage

Cost of Equity (1) 8.51% 8.72% 8.615%

Return on Equity 32.67% 23.7% 28.185%

(ROE ) (2)
Excess Return on 24.16% 14.98% 19.57%
Equity (3) = (2) – (1)

Weighted Average 8.5% 7.2% 7.85%

Cost of Capital
(WACC) (4)

Return on Capital 35.9% 21.36% 28.63%

Employed (ROCE) (5)

Excess Return on 27.4% 14.16% 20.78%

Capital (6) = (5)-(4)

The Industry has shown excess returns on capital and equity. Infosys has shown
an Excess Return on Equity which is higher than the Industry Average thus
indicating that Infosys has made good investments which has given higher
returns to both the shareholders and the firm as a whole. Wipro has shown
excess return on equity and capital, but the excess returns are not higher than
the Industry Average indicating that the overall performance of Wipro is not
above industry.

Cash Flow Analysis

The cash flows of the companies have been analyzed over 5 years to determine
whether the investments made by the company are showing good returns or not.
We have calculated the Net Present Value with the calculated Weighted
Average Cost of Capital as the hurdle rate.
For the companies analyzed the results follow:
Cash Flow of Bharti Airtel

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009

Cash Inflows 3005.89 4923.55 8448.08 11357.88 11853.15

Cash Outflows 2753.39 5000.26 7975.05 11648.4 11566.4

Net Increase/ 252.5 (76.71) 473.03 (290.53) 286.77

(decrease)
 • Hurdle Rate = 7.56%
• NPV = 555.53 crores
• Inferences:
• Good Investment since NPV is > 0
• Investments are increasing and are on a huge scale – Company has
always been investing
• Returns have increased massively over the years
• Cash in hand has decreased

Cash Flow of MTNL

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009

Cash Inflows 1212.71 213.31 357.64 2487.81 1562.45

Cash Outflows 1248.41 672.32 547.23 987.15 129.01

Net Increase/ (35.7) (459.01) (189.59) 1500.66 1433.44

(decrease)

• Hurdle Rate = 8.5%

• NPV = 2270.36 crores
• Analysis:
• Good Investment since NPV is > 0
• Investments decreased, but are on the increase again
• Returns are fluctuating
• Cash in hand has increased over the years
Cash Flow of Tata Motors

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009
Cash Inflows 2190.49 0 2513.71 7306.96 9399.72

Cash Outflows 956.57 1077.36 2805.1 5721.86 10644.7

Net Increase/ 1233.92 (1077.36) (291.39) 1585.1 (1244.95)

(decrease)

• Hurdle Rate = 6.9%

• NPV = 45.81 crores
• Analysis:
• Good Investment since NPV is > 0
• Investments are increasing massively ( Expansion plan ) inspite of
decrease in the amount of cash in hand
• Returns have fallen over the years but are again on the increase
now
Cash Flow of Ashok Leyland

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009

Cash Inflows 727.73 322.02 499.95 1430.21 459.18

Cash Outflows 155.45 391.19 1039.07 809.68 1189.76

Net Increase/ 572.28 (69.17) (539.12) 620.53 (730.58)

(decrease)

• Hurdle Rate = 7.98%

• NPV = -252.27 crores
• Analysis:
• Bad Investment since NPV is < 0
• Investments are increasing inspite of decreasing cash in hand and
returns
• Returns are decreasing
Cash Flow of Infosys

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009

Cash Inflows 1359.7 2481 3256 3816 5152

Cash Outflows 1519.98 392 1381 1755 2625

Net Increase/ (160.28) 2089 1875 2061 2527

(decrease)

• Hurdle Rate = 8.5%

• NPV = 7539.10 crores
• Analysis:
• Good Investment since NPV is > 0
• Investments are increasing
• Returns are increasing
Cash Flow of Wipro

In crores Mar 2005 Mar 2006 Mar 2007 Mar 2008 Mar 2009

Cash Inflows 1666.42 1972.05 2913.1 3006.8 4344.5

Cash Outflows 1425.19 1694.42 1881.9 1127.5 3733.4

Net Increase/ 241.23 277.63 1031.2 1879.3 611.1

(decrease)

• Hurdle Rate = 7.18%

• NPV = 3670.46 crores
• Analysis:
• Good Investment since NPV is > 0
• Investments are increasing
 • Returns are increasing indicating good investments with enough
cash in hand

Converting the excess returns into monetary values

Once we have determined the excess returns (for the latest period) it is
interesting to see how they contributed to increasing the value of the firms. This
is the concept of Economic Value Added (EVA). It is calculated both in terms
of equity (EVA for equity) and in terms of the entire firm value (EVA for firm).
The computation is:
EVA for equity = Excess Return on Equity x Book Value of Equity
EVA for the firm = Excess Return on Capital x Book Value of the Firm

For the companies analyzed the results follow:

In Crore Excess Book Value of EVA for Excess Return Book Value of EVA for the
Return on Equity (2) equity (3) = on Capital the Firm firm
Equity (1) (1)*(2)
(4) (5) (6) = (4) * (5)

Bharti Airtel 19.97% 1898.24 379.07 20.8% 145.01 30.16

MTNL (7.11)% 630 (44.79) (4.7)% 191.42 (8.99)

Tata Motors (.54)% 514.05 (2.77) 4.87% 240.64 11.71

Ashok Leyland (2.9)% 133.03 (3.85) 3.25% 15.85 .515

Infosys 24.16% 286 69.09 27.4% 310.9 85.18

Wipro 14.98% 293 43.89 14.16% 85.42 12.09

Intersectoral Comparison
The 3 sectors are compared over WACC , EPS and ROE& ROC Analysis
WACC of Telecom is highest because almost the entire industry is equity
financed , hence making the overall cost of capital is high

WACC of IT is also higher than automobile Industry as the automobile industry

is almost debt financed which is a costly source of capital

The EPS of Infosys is highest as the company has reported very high profits and
also the number of equity shareholders is very less as compared to Wipro.
Bharti Airtel has reported very high profits when compared with MTNL. Also
Airtel doesn’t give dividends thus giving higher earnings to share holders ,
hence making the EPS very high.

Also , Tata Motors reported profits is almost 10 times of that Ashok Leyland .

Source of data is MoneyControl.com

Conclusion

After the calculation and analysis we see that most of the companies are
following the Industry trend. If the Industry overall has done bad, then the
companies also haven’t performed that well. But this cannot be the reason to
indicate that the companies have not invested in good projects.

We believe that the Companies in the Telecom Industry have invested in Good
Projects and will continue to do so due to the following reasons:

• High level of entry barrier gives them an edge over the start ups.

• The advent of 3G in the country will give an edge to the already existing
2G players

• With the current price wars in the Industry, companies are looking
towards investing outside the country or to diversify the profile
 • The companies are mature and stable in their cash flows and enjoy strong
brand equities

• The companies have access to various sources of capital to engage in

good projects.

The companies in the Automobile Industry overall has not done well with not
showing any excess returns. This is in resonance with the Industry as such.

But it does not indicate that the companies have not invested in good projects.
There could be many reasons why the industry and the companies have not
done well in the financial year 2008 -2009, the supreme being the recession or
the overall slowdown in the industry. Tata Motors is investing massively with
Nano to be launched very soon. The company overall is doing good with
enough cash in hand and an impressive brand equity. This indicates that the
company will keep investing in good projects.

Ashok Leyland has not done well and the investments have not shown good
returns. The companies cash in hand is decreasing over the years, showing a
hard time in the future and the company trying to make sound investments.

The IT industry has shown good results inspite of the slowdown in the year
2008 and 2009. Infosys has shown very good results , higher than the industry
average indicating that the company is making sound investments with good
returns. We believe that the company will continue to do so due to the following
reasons:

• High level of entry barrier gives them an edge over the start ups.

• With the current slowdown in US, companies are looking towards

investing outside US or to diversify the profile

• The companies are mature and stable in their cash flows and enjoy strong
brand equities

The companies have access to various sources of capital to engage in good

projects.

Wipro has shown good returns but not higher than the Industry as such. This
gives an indication that the company ‘s investments are giving good returns and
the company will keep trying to make investments giving much better returns
owing to the same reasons as mentioned above.
 Appendix

WACC, ROC and ROE of Bharti Airtel:

Calculating Cost of debt In Crores

Interest Paid 434.16

Total debt 7713.65
Cost of debt before tax 0.056285
Tax Rate 4%
Cost of debt after tax ( Kd)0.054033

Calculating Cost of Equity

Return on
Risk Free Interest Rate ( the Market
Rf) Beta Rm Cost of Equity Ke Ke /100
7.075 0.714934 8.6 8.16527435 0.081652744

Calculating Weighted Average Cost of Capital

Total Weight of Debt Weight of

Capital in Capital Equity in Cost of Cost of
Debt Equity Employed ( Structure Capital debt (Kd) Equity(Ke) WACC
7713.65 27,527.75 35241.4 0.218880351 0.781119649 0.054033 0.08165274 0.075607
Total Assets - Current
Liabilities = 21525.13

Calculating Returns
Profit After Tax ( PAT) 7743.84
Earnings Before Interest Tax(8568.82
EBIT )
Return on Equity ( ROE ) 0.28131
Return on Capital ( ROC ) ( %) 28.4

WACC,ROC & ROE of MTNL

Calculating Cost of debt In Crores

Interest Paid 0
Total debt 1
Cost of debt before tax 0
Tax Rate 4%
Cost of debt after tax ( Kd) 0

Calculating Cost of Equity

Risk Free Interest Rate ( Rf) Beta Return on the Market Rm Cost of Equity Ke Ke /100
7.075 0.936648 8.6 8.5033882 0.085033882

Calculating Weighted Average Cost of Capital

Weight of Debt Weight of

Total Capital Employed ( in Capital Equity in Cost of Cost of
Debt Equity Debt +Equity ) Structure Capital debt (Kd) Equity(Ke) WACC
0 12,059.00 12059 0 1 0 0.08503388 0.085034
Total Assets - Current Liabilities = 5928.71

Calculating Returns
Profit After Tax ( PAT) 168.33
Earnings Before Interest Tax( EBIT ) 225.59
Return on Equity ( ROE) 0.013959
Return on Capital ( ROC ) 0.03805

WACC,ROC & ROE of Tata Motors

Calculating Cost of debt In Crores

Interest Paid 704.92

Total debt 13165.56
Cost of debt before tax 0.053543
Tax Rate 1%
Cost of debt after tax ( Kd) 0.0529

Calculating Cost of Equity

Risk Free Interest Rate ( Rf) Beta Return on the Market Rm

Cost of Equity Ke
Ke / 100
7.5 1.01688 8.6 8.618568 0.08618568

Calculating Weighted Average Cost of Capital

Weight of Debt Weight of

Total Capital Employedin
( Capital Equity in Cost of Cost of
Debt Equity Debt +Equity ) Structure Capital debt (Kd)Equity(Ke) WACC
13165.5612394.27 25559.83 0.5150879330.484912067 0.0529 0.086185680.069041
Total Assets - Current Liabilities14590.88
=

Calculating Returns
Profit After Tax ( PAT) 1001.26
Earnings Before Interest Tax( EBIT1718.68
)
Return on Equity ( ROE ) 0.080784
Return on Capital ( ROC ) 0.117791

WACC, ROC &ROE of Ashok Leyland

Calculating Cost of debt In Crores

Interest Paid 154.27

Total debt 1961.98
Cost of debt before tax 0.07863
Tax Rate 9%
Cost of debt after tax ( Kd) 0.07171

Calculating Cost of Equity

Risk Free Interest Rate ( Rf)Beta Return on the M arket

Cost
Rmof Equity Ke in Percentage
Ke / 100
7.5 0.85377 8.6 8.4391470.08439147

Calculating W eighted Average Cost of Capital

W eight of
Total Capital Employed
W eight
( of Debt in Capital
Equity in Cost of Cost of
Debt Equity Debt + Equity ) Structure Capital debt (Kd) Equity(Ke)W ACC
1961.983473.86 5435.84 0.3609340970.6390659030.071710.08439147
0.079814
Total Assets - Current Liabilities
3228.58
=

Calculating Returns
P rofit A fter Tax ( PA T) 190
Earnings Before Interest Tax(362.73
EBIT )
Return on Equity ( ROE ) 0.054694
Return on Capital ( ROC ) 0.11235

WACC,ROC & ROE of Infosys

Calculating Cost of debt In Crores

Interest Paid 0
Total debt 1
Cost of debt before tax 0
Tax Rate 4%
Cost of debt after tax ( Kd) 0

Calculating Cost of Equity

Risk Free Interest Rate ( Rf)Beta Return on the M arket

Cost
Rmof EquityKe
Ke/ 100
7.850.883526 8.6 8.51264450.085126445

Calculating W eighted Average Cost of Capital

W eight of Debt
W eight of
Total Capital Employed
in Capital
( Equity in Cost of Cost of
Debt Equity Debt + Equity ) Structure Capital debt (Kd) Equity(Ke)W ACC
0 17,809.00 17809 0 1 0 0.085126450.085126
Total Assets - Current Liabilities
16265
=

Calculating Returns
Profit After Tax ( PAT) 5819
Earnings Before Interest Tax( EBIT
6716)
Return on Equity ( ROE ) 0.326745
Return on Capital ( ROC ) 0.412911

WACC,ROC & ROE of Wipro

CalculatingCost of debt In Crores

Interest Paid 196.8

Total debt 5013.9
Cost of debt before tax 0.039251
Tax Rate 15%
Cost of debt after tax ( Kd) 0.033363

CalculatingCost of Equity

Risk Free Interest Rate ( Rf) Beta Return on the Market Rm Cost of Equity Ke Ke /100
7.36 1.099 8.6 8.72276 0.0872276

CalculatingWeighted Average Cost of Capital

Weight of Debt Weight of

Total Capital Employed ( in Capital Equity in Cost of Cost of
Debt Equity Debt +Equity ) Structure Capital debt (Kd) Equity(Ke) WACC
5013.9 12,513.50 17527.4 0.286060682 0.713939318 0.033363 0.0872276 0.071819
Total Assets - Current Liabilities = 11812.5

CalculatingReturns
Profit After Tax ( PAT) 2973.8
Earnings Before Interest Tax( EBIT ) 3744.7
Return on Equity ( ROE) 0.237647

Return on Capital ( ROC ) 21.36

Cash Flows of Bharti Airtel

 Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09

4923.5 8448.0 11357. 11853.

Cash Inflows 3005.89 5 8 88 15
- - - -
5000.2 7975.0 11648. 11566.
Cash Outflows -2753.39 6 5 4 4
Net Cash Flow Increase/ -
(decrease) 252.5 -76.71 473.03 290.53 286.77

Hurdle Rate = 7.56%

0.8036 0.8643 0.9297
74.71% 14 67 14 1
NPV = 552.5373969

Cash Flows of MTNL

Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09
Cash Inflows 1,212.71 213.31 357.64 2,487.81 1,562.45
Cash Outflows -1248.41 -672.32 -547.23 -987.15 -129.01
Net Cash Flow
Increase/(decrease) -35.70 -459.01 -189.59 1500.66 1433.44

Hurdle Rate = 8.50%

72.16% 0.7829081 0.849455287 0.921658986 1
NPV = 2270.365698

Cash Flows of Tata Motors

 Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09
Cash Inflows 2190.49 0 2513.71 7306.96 9399.72
Cash Outflows -956.57 -1077.36 -2805.1 -5721.86 -10644.7
Net Cash Flow
Increase/(decrease) 1233.92 -1077.36 -291.39 1585.1 -1244.95

Hurdle Rate = 6.90%

76.58% 0.818591 0.875074 0.935454 1
NPV = 45.81189

Cash Flows of Ashok Leyland

Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09
Cash Inflows 727.73 322.02 499.95 1430.21 459.18
Cash Outflows -155.45 -391.19 -1039.07 -809.68 -1189.76
Net Cash Flow
Increase/(decrease) 572.28 -69.17 -539.12 620.53 -730.58

Hurdle Rate = 7.98%

73.56% 0.794273 0.857656 0.926097 1
-
NPV = 252.2737821

Cash Flows of Infosys

Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09
Cash Inflows 1359.7 2481 3256 3816 5152
Cash Outflows -1519.98 -392 -1381 -1755 -2625
Net Cash Flow
Increase/(decrease) -160.28 2089 1875 2061 2527

Hurdle Rate = 8.50%

72.16% 0.782908098 0.849455287 0.921658986 1
NPV = 7539.108925

Cash Flows of Wipro

Mar ' 05 Mar ' 06 Mar ' 07 Mar ' 08 Mar ' 09
Cash Inflows 1666.42 1972.05 2913.1 3006.8 4344.5
Cash Outflows -1425.19 -1694.42 -1881.9 -1127.5 -3733.4
Net Cash Flow
Increase/(decrease) 241.23 277.63 1031.2 1879.3 611.1

Hurdle Rate = 7.18%

75.78% 0.812192 0.870507 0.93301 1
NPV = 3670.461704

In crores Bharti Airtel MTNL Wipro Infosys Tata Motors Ashok Leyland
EVA Equity 379.07 -44.79 43.89 69.09 -2.77 -3.85
EVA Firm 30.16 -8.99 12.09 85.18 11.71 0.515

EPS Bharti Airtel MTNL Wipro Infosys Tata Motors Ashok Leyland
EPS 22.42 8.16 19.23 80.84 39.18 2.65
EPS 40.79 2.67 20.3 101.58 19.48 1.43