Session 7

1. Session 7 Topics to be covered: Capital Budgeting 101 Projected Cash Flows Discount Rate Debt and Equity Costs Figures of Merit NPV IRR Payback Project Analysis

2. Capital Budgeting 101 • The most simple valuation exercise is when a firms decides to invest in real assets: capital budgeting. • The simplest form of capital budgeting proceeds in 3 steps: • Step 1: Estimate cash flows. • Step 2: Estimate discount rate. • Step 3: Accept or reject project.

3. Step 1: Estimate Cash Flows • We want to estimate net after-tax cash flows incremental to a project. • Include: • Working capital requirements • Incidental effects • Opportunity costs • Exclude: • (Pre-existing) Overhead allocations • Sunk costs

4. Depreciation Tax Shield • Depreciation expense represents a non-cash reduction in accounting net income. • Depreciation expense itself is NOT a cash flow • The reduction in taxes paid as a result of the depreciation expense IS a cash flow. Depreciation tax shield = Depreciation * tax rate

5. Depreciation Example • Assume annual cash flows are as follows: Revenues = $100 Operating expenses = 20 Depreciation = 10 Tax rate = 40%

6. Terminal Value • If the asset has any remaining cash value at the end of the investment horizon, this value should be included. • Liquidation value • Salvage value • Terminal value • If the remaining market value does not equal the remaining book value, there will also be a gain or loss on the sale of the asset (and associated tax liability or benefit).

7. Terminal Value • Terminal values are also used to value projects with infinite lifetimes (i.e. firms). • Analysts prepare detailed projections for a few years. • 10 years (manufacturing firm) • 2-3 years (technology firm) • The terminal value reflects the value at the end of the detailed projections of all future cash flows.

8. Step 2: Discount Rate • We want to compute the NPV using an appropriate risk adjusted discount rate. • Riskier projects should have higher returns. • Each project may be evaluated with its own risk adjusted discount rate. • In practice, • Some firms require different returns from different categories of investments. • Some firms use a single rate for all projects. • The simplest project (and a special case) is a project that is similar to the overall firm.

9. Weighted Average Cost of Capital • WACC is defined as • This discount rate is appropriate for projects that are like the firm. • Business risk • Capital structure

10. WACC Example • Suppose a firm has $40 million of outstanding debt and 2 million outstanding shares selling for $30 per share. • Its current borrowing rate is 8%, and the financial manager thinks that the stock is priced to offer a 15% return (E(rE) = 15%). The tax rate is 34%. • D = $40 million • E = (2 million)($30)=$60 million

11. Debt Costs • The pre-tax interest rate on debt is multiplied by (1-tax rate) to reflect the tax deductibility of interest expense. • In most circumstances, WACC should be estimated using market values. It may be difficult to obtain market values of debt. Usually, the market value of debt is closely approximated by the book value. • Try to use current market interest rates.

12. Cost of Equity • “What’s the true cost of your capital? You know the cost of your borrowed capital; at least in the short term it’s the interest you pay, adjusted to reflect its tax deductibility… But what about equity capital, the money shareholders provided? Since you aren’t required to pay for it, you may think it’s free. But it isn’t - and its cost is much more than many managers would imagine. Your true cost of equity is what your shareholders would be getting in price appreciation and dividends if they invested instead in a portfolio of companies about as risky as yours. It’s what economists call the opportunity cost. Many managers resist this idea--how can it be a real cost if I don’t have to write a check every month?” (Fortune, Sept. 20, 1993, p. 33)

13. Cost of Equity • It is very difficult to estimate the cost of equity for a firm. • We typically use • historical averages, • assessment of investors’ required return, or • an asset pricing model.

14. Capital Budgeting • WACC is used in capital budgeting decisions to find the present value of projects that are similar to the firm’s typical project. • We must assume: • The new project has similar business risk to the average project undertaken historically by the firm. • The new project is financed with a similar capital structure as the firm.

15. Alternative Discount Rates • These assumptions may be violated if • the project has higher (or lower) business risk than the firm. • The project is financed in ways different from the firm (an LBO). • General Rule: Use a discount rate that reflects the business risk and capital structure of the project, once it is implemented.

16. Step 3: Decision • The remaining step is to decide whether or not to accept the project. • NPV Criterion: • accept projects with positive NPVs • reject projects with negative NPVs

17. IRR Criterion • The internal rate of return (IRR) is the discount rate that makes the NPV = 0. • Accept projects with IRRs greater than the cost of capital. • Reject projects with IRRs lower than the cost of capital.

18. Payback • Payback is the number of years before cumulative cash flows equal the investment. • Criteria: Accept projects with a payback less than X years. Project C0C1C2C3PaybackNPV(10%) A -2,000 +2,000 0 0 1 -182 B -2,000 +1,950 +50 +5,000 2 3,571 C -2,000 +50 +1,950 +5,000 2 3,414

19. Payback • Project A has the shortest payback. • Projects B and C have positive NPVs. • Payback • Ignores cash flows after the payback period. • Ignores the timing of cash flows within the payback period.

20. Other Criteria • There are may criteria that depend on accounting figures (ROE, ROA, ROI, etc.) • Accounting figures are subject to rules and regulations that may have little to do with actual cash flows.

21. Review Example • Jennifer’s Cookies is considering acquisition of Morning Glory Muffins. • Jennifer’s cookies has 20 retail outlets (cookies and juice). • MGM operates 5 muffin stores in downtown Seattle. • MGM’s cash flows: • Revenues of $20,000 per year • Operating expenses of $8,000 per year • Depreciation of $2,500 • Management expects these cash flows will grow 2% per year, forever.

22. Step 1: Estimate Cash Flows • Cash flows for the first year: • The project will generate $8,200 next year, and an amount growing by 2% per year forever thereafter.

23. Step 2: Estimate Discount Rate • We should use a discount rate that reflects the risk of the project: MGM • MGM is capitalized as follows: • 50% equity • E(re) = .15 • 50% debt • pretax E(rd) = .07 • The tax rate is 40%. WACC = .50(0.07)(1 - .40) + .50(0.15) = .096

24. Step 3: Compute PV • Jennifer’s Cookies should be willing to pay a price up to $107,895. Such a purchase price would result in a NPV greater than zero, and the project would be acceptable.

25. Project Analyses • So far, capital budgeting seems very simple. • Managers may want to know much more about a project than just whether it has a positive NPV. • Possible risks • Range of outcomes • Dependence on assumptions • Worst case analysis • Several more techniques address these questions.

26. Sensitivity Analysis • “Sensitivity analysis boils down to expressing cash flows in terms of unknown variables and then calculating the consequences of misestimating the variables.” • Example: • Otobai Company plans to introduce an electric scooter. • Using a 10% cost of capital, the project has a positive NPV of 3.43 billion yen. • You want to explore the assumptions used to compute this.

27. Otobai Company • Revenue is estimated as follows: • Unit sales = market share * size of market • Revenue = unit sales * price per unit • Variable costs are estimated at 300,000 yen per scooter. • Fixed costs are 3 billion yen per year. • The following table explores the sensitivity of results to most of these key inputs. • A positive NPV is not very certain.

28. Otobai Company • Suppose the variable cost estimate reflects concern about a particular machine. • There is a 10% chance that an extra 20,000 yen per unit will be necessary to correct a mistake. • This additional cost would reduce NPV by 6.14 billion yen. • For an additional 10 million yen, you can learn whether or not the machine will work correctly. • Is this extra investment worthwhile? • Assumptions about market size, for example, are not nearly as critical.

29. Break-Even Analysis • Sensitivity asks how different results would be if assumptions are misestimated. • Alternatively, we may ask how different assumptions could be before the project looks bad. • The break-even for unit sales is 85,000 scooters. • It is incorrect to compute break-even points in terms of accounting profits.

30. Simulation • Sensitivity and break-even allow you to examine the effect of changes in one variable at a time. • Monte Carlo simulation allows you to change all possible variables. • Specify how cash flows are computed. • Specify probabilities for various outcomes. • Simulate cash flows for a given set of assumptions. • The simulation may be run thousands of times, to derive distributions for possible outcomes. • It is a powerful tool, but only as good as the underlying model.

31. Decision Trees • Decision trees may detail sequential decision choices. • Drawing a decision tree forces managers to think carefully about all states in the decision making process. • For even simple problems, however, trees become extremely complex.