Financial Management

1. Financial Management 8. Corporate Valuation and Value-Based Management. 9. Capital budgeting.Risks Analysis. Liliya N. Zhilina, World Economy and Inrernational Relations Department, Vladivostok State University of Economic and Services (VSUES). liliya.zhilina@vvsu.ru

2. 8. Corporate Valuation and Value-Based Management

3. Corporate Valuation: List the two types of assets that a company owns. • Assets-in-place • Financial, or nonoperating, assets

4. Assets-in-Place • Assets-in-place are tangible, such as buildings, machines, inventory. • Usually they are expected to grow. • They generate free cash flows. • The PV of their expected future free cash flows, discounted at the WACC, is the value of operations.

5. Value of Operations

6. Nonoperating Assets • Marketable securities • Ownership of non-controlling interest in another company • Value of nonoperating assets usually is very close to figure that is reported on balance sheets.

7. Total Corporate Value • Total corporate value is sum of: • Value of operations • Value of nonoperating assets

8. Claims on Corporate Value • Debtholders have first claim. • Preferred stockholders have the next claim. • Any remaining value belongs to stockholders.

9. Applying the Corporate Valuation Model • Forecast the financial statements. • Calculate the projected free cash flows. • Model can be applied to a company that does not pay dividends, a privately held company, or a division of a company, since FCF can be calculated for each of these situations.

10. Value of operations forMicroDrive

11. Calculation of value of operations 0 1 2 3 4 kc=11% g = 5% FCF= 72 211 228239 65 171 167 239 Vop at 3   4 001. 2 928 . 11  0 . 05 0 3 330 = Vop

12. Value-Based Management (VBM) • VBM is the systematic application of the corporate valuation model to all corporate decisions and strategic initiatives. • The objective of VBM is to increase Market Value Added (MVA)

13. MVA and the Four Value Drivers • MVA is determined by four drivers: • Sales growth • Operating profitability (OP=NOPAT/Sales) • Capital requirements (CR=Operating capital / Sales) • Weighted average cost of capital

14. 9. Capital budgeting. Cash Flow Estimation. Risk Analysis.

15. What is capital budgeting? • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

16. Steps of Capital Budgeting Analysis 1. Estimate CFs (inflows & outflows). 2. Assess riskiness of CFs. 3. Determine k = WACC for project. 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC.

17. Mutually exclusive projects vs Independent projects • Mutually exclusive projects cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both. • Independent projects can be accepted or rejected individually.

18. Payback period, PbP • The number of years it takes a firm to recover its project investment. • May be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback).

19. PbP of a long project 2.4 0 1 2 3 CFt -100 10 60 100 80 Accumulated CFt -100 -90 -30 0 50 PaybackL = 2 + 30/80 = 2.375 years

20. PbP of a shot project 1.6 0 1 2 3 CFt -100 70 100 50 20 Accumulated CFt -100 -30 0 20 40 = 1 + 30/50 = 1.6 year Paybacks

21. Projects evaluation techniques DCF methods because they explicitly recognize the time value of money. • Discounted Payback Period (DPbP). • Net Present Value (NPV). • Profitability Index (PI). • Internal Rate of Return (IRR). • Modified Internal Rate of Return (MIRR).

22. Discounted Payback Period (DPbP) 0 1 2 3 10% CFt -100 10 60 80 PVCFt -100 9.09 49.59 60.11 Accumulated PVCFt -100 -90.91 -41.32 18.79 2 + 41.32/60.11 = 2.7 years = DPbP

23. Net Present Value (NPV) NPV is a direct measure of the value of the project to shareholders. NPV: Sum of present (discounted) values of cash inflows and outflows Investment costs – negative cash flow in a zero period – CF0

24. NPVS = $29.83 18.78 = NPVL NPVof projects L (long) and S (short) 0 1 2 3 L S 10% -100.00 10 80 60 60 80 10 9.09 72.73 49.59 49.59 60.11 7.51

25. Profitability Index, PI PI – income at a unit of costs доход на PI = sumof PV inflows / sumof PV outflows PI = sum of PVnet profit / I0 A profitability index greater than 1 is equivalent to a positive NPV project. I0- investment in the 0-period, I0 = 100 PI L = 118,78/100 = 1,19 PI S = 129,98/100 = 1,20

26. Internal Rate of Return, IRR The discount rate that equates the present value of the expected future cash inflows and outflows. IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate. 0 1 2 3 CF0 CF1 CF2 CF3 Cash Inflows Costs

27. IRR проектов L и S 0 1 2 3 IRR = ? L S -100.00 10 60 80 PV1 80 60 10 PV2 PV3 0 = NPV IRRL = 18,1 % IRRS = 31,4 %

29. Decision by IRR on S and L projects WACC = 10% • If S and L are independent projects they can be accepted (IRR > WACC). • If S и L mutually exclusive projects we can choose Project S (IRRS > IRRL).

30. The hurdle rate • The hurdle rate is the project cost of capital, or discount rate. • It is the rate used in discounting future cash flows in the NPV method, and it is the rate that is compared to the IRR.

31. Mutually exclusive projects k < 8.7: NPVL> NPVS , IRRS > IRRL NPV k > 8.7: NPVS> NPVL , IRRS > IRRL IRRS 18.13% 23.56% 8.7% IRRL

32. Modified Internal Rate of Return (MIRR) • The modified internal rate of return (MIRR) assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. • This makes the modified internal rate of return a better indicator of a project's true profitability.

33. $158.1 (1+MIRR)3 $100 = MIRR of project L (i = 10%) 0 1 2 3 10% -100.0 10.0 60.0 80.0 10% 66.0 12.1 10% MIRR = 16.5% -100.0 158.1 TV of inflows PV of outflows MIRR = 16.5%

34. Normal and nonnormal cash flows • A project has normal cash flows if one or more cash outflows (costs) are followed by a series of cash inflows. • Capital projects with nonnormal cash flows have a large cash outflow either sometime during or at the end of their lives. • A common problem encountered when evaluating projects with nonnormal cash flows is multiple IRRs.

35. Cash Flow Estimation and Risk Analysis • Relevant cash flows • Working capital treatment • Inflation • Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis

36. Set up without numbers a time line for the project CFs. 0 1 2 3 4 Initial Outlay OCF1 OCF2 OCF3 OCF4 + Terminal CF NCF0 NCF1 NCF2 NCF3 NCF4

37. Incremental Cash Flow = Corporate cash flow withproject minus Corporate cash flow without project

38. Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? • No. This is a sunk cost. Focus on incremental investment and operating cash flows.

39. Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? • Yes. Accepting the project means we will not receive the $25,000. This is an opportunity costand it should be charged to the project. • A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost.

40. If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis? • Yes. The effects on the other projects’ CFs are “externalities”. • Net CF loss per year on other lines would be a cost to this project. • Externalities will be positive if new projects are complements to existing assets, negative if substitutes.

41. What if you terminate a project before the asset is fully depreciated? Cash flow from sale = Sale proceeds - taxes paid. Taxes are based on difference between sales price and tax basis, where: Basis = Original basis - Accum. deprec.

42. Real vs. Nominal Cash flows • In DCF analysis, k includes an estimate of inflation. • If cash flow estimates are not adjusted for inflation (i.e., are in today’s dollars), this will bias the NPV downward. • This bias may offset the optimistic bias of management.

43. Risk in capital budgeting • Uncertainty about a project’s future profitability. • Measured by NPV, IRR, beta. • Risk of a project increases the firm’s and stockholders’ risk. • Risk analysis in capital budgeting is usually based on subjective judgments.

44. Sensitivity analysis • Shows how changes in a variable such as unit sales affect NPV or IRR. • Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. • Answers “what if” questions, e.g. “What if sales decline by 30%?”

45. Illustration

46. NPV (000s) Unit Sales Salvage 82 k -30 -20 -10 Base 10 20 30 Value

47. Results of Sensitivity Analysis • Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV. • Unit sales line is steeper than salvage value or k, so for this project, should worry most about accuracy of sales forecast.

48. Weaknesses ofsensitivity analysis • Does not reflect diversification. • Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales won’t fall. • Ignores relationships among variables.

49. Why is sensitivity analysis useful? • Gives some idea of stand-alone risk. • Identifies dangerous variables. • Gives some breakeven information.

50. Scenario analysis • Examines several possible situations, usually worst case, most likely case, and best case. • Provides a range of possible outcomes.