Valuation Methods & Capital Budgeting

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## Valuation Methods & Capital Budgeting

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**Valuation Methods & Capital Budgeting**• Payback/Discounted Payback • IRR • MIRR • Benefit Cost Ratio (BCR) • NPV (DCF) • FCF: Free cash flow • FTE: Flow to equity • APV: Adjusted present value**Payback Rule**• Payback period: The amount of time it takes to recover the original cost. • Payback rule: If the calculated payback period is less than or equal to some pre-specified payback period, then accept the project. Otherwise reject it.**The Payback Rule**$200 $420 $645 $855 Time 0 4 1 2 3 $-600 Payback period=2+((600-420)/225)=2.8 yearsAccept because payback < 3 years**Advantages and Disadvantages of the Payback Rule**• Advantages • Easy • Biased toward liquidity • Quick evaluation • Adjusts long term cash flow uncertainty (by ignoring them) • Disadvantages • Ignores TVM • Ignores cash flow beyond payback period • Biased against long term projects • Popular among many large companies • Commonly used when the: • capital investment is small • merits of the project are obvious so more formal analysis is unnecessary**The Discounted Payback Rule**Accumulated discounted cash flows Time 0 4 1 2 3 $-600 The project never pays back so reject.What is the NPV?**Discounted Payback Rule?**• Things to Consider • Involves discounting • How do you choose r? • How do you choose the cut-off period? • Advantages • If project ever pays back then NPV>0 • Biased toward liquidity • Easy • Disadvantages • May reject NPV>0 projects • Cut-off period is arbitrary • Biased against long term projects • Bottom Line: Why not just use NPV?**Benefit-Cost Ratio (BCR)**Rato of discounted inflows to outflows. Rule: Accept project if BCR greater than 1. Use caution if using to compare mutually exclusive projects. Similar BCRs can have radically different NPV’s.**Internal Rate of Return (IRR) Rule**IRR is that r that makes the NPV=0**IRR Rule**• Accept the project if the IRR is greater than the required rate of return. Otherwise, reject the project. • Comparison of NPV and IRR • If cash flows are conventional and project isindependent, then NPV and IRRlead to same accept and reject decisions.**IRR Rule and UnconventionalCash Flows**• Unconventional cash flows: A negative cash flow after a positive one. • Strip Mining Project • Year Cash Flows • 0 -60 • 1 155 • 2 -100**Problems with the IRR RuleUnconventional cash flows lead to**multiple IRR’s25% and 33.33%**Mutually Exclusive**• Taking one project means another is not taken • The highest IRR may not have the highest NPV • To evaluate we need to find the crossover rate • Take the differences between the two projects cash flows and compute the IRR for those incremental flows**NPV Profiles of Mutually Exclusive Projects**Crossover Rate = 11.8 IRRB=22.17 IRRA=19.43**Reinvestment Rate Assumption**• During the life of a project, what are the investment assumptions of the intermediate cash flows? • Implicitly the PV oriented methods assume that the cash flows can be reinvested at r. • Is this reasonable? • NPV • IRR**Modified IRR (MIRR)**• Solves the reinvestment rate problem • Example: A project’s cash flows are -400, 325 and 200. Appropriate r is 12% • Accept the project because 18.74%>12% • Note: The IRR on this project is 22.16%**Summary of IRR/MIRR**• Advantages: Easy to understand • Conventional Cash Flows and Independent Projects: • Same Decisions as NPV Rule • Required Rate of Return Benchmark • Often same discount rate in NPV • MIRR has more realistic reinvestment rate (use instead of IRR if possible) • Disadvantages: • Unconventional cash flows may result multiple answers • If projects are mutually exclusive may lead to incorrect decisions • Not always easy to calculate • Difficult to interpret (particularly if the project has multiple r’s) • IRR may have unrealistic reinvestment rate • Very Popular: People like to talk in terms of returns • Survey of 100 largest Fortune 500 Ind. • 99% use IRR Rule • 85% use NPV Rule**NPV(DCF) Valuation Methods**• FCF: All relevant cash flows excluding financing costs discounted by the “whole firm” r (typically estimated with WACC(adjusted for taxes)) • FTE: FCF minus payments to other finance sources (typically debt holders) discounted by re • APV: All relevant cash flow components separately discounted by the appropriate r’s • Note: • re (e=equity) is the same as rS (S=stock) • rd (d=debt) is the same as rB (B=bond)**Compare Methods**• FCF • Very strict assumptions of constant proportion capital structure (from WACC) • Can adjust r if risk or capital structure is different from existing firm • Tax debt shield must be tcD (for WACC(adjusted)) • FTE • Probability of payments to other finance sources, i.e. debt holders • Option to default usually not considered so FTE value is usually low • Difficult to extrapolate entire firm value • APV • Flexible and works well for changing capital structure • Usually will need an estimate of unlevered r • Potential for estimation error depending on NPV of financing**Relevant Cash Flows**• Incremental cash flows: Only the incremental portion of any flow is relevant • Otherwise known as the Stand-Alone Principle • Project = "Mini-firm" • Allows us to evaluate the investment project separately from other activities of the firm • Allows us to make optimal decisions with a relatively simple process**Relevant Cash Flows?**• Sunk Costs • No • Opportunity Costs • Yes • Side Effects (Erosion) • Yes • Net Working Capital • Yes • Value of cash flow volatility change • Yes • Financing Costs • No (there are some methods where this is relevant) • Allocated Overhead Costs • No All Cash Flows should be after-tax cash flows**How do we make reasonable cash flow estimates?**• Estimate them from scratch • Pro forma financial statements • Probably the best current estimate of future flows. • Make sure you adjust the financial statements for the difference between accounting flows and finance flows. • Finance flows are based on the principle of opportunity costs and the timing of the flows is based on when the money is actually paid/received • Accounting flows (as presented in financial statements) are based on historical costs and the timing of the flows is usually based on accrual (not cash) accounting • Use statements to get the basic project cash flow • Need an after tax terminal value • Assume the project goes on forever and use a perpetuity • Assume the project ends and the balance sheet is zeroed out (everything is sold and settled)**Two Approaches**• Item by item Discounting: Separately forecast relevant flows then discount them • Very flexible: Can use different discount rates for each flow • Whole Project Discounting: determine project’s relevant cash flows, sum them in each year then discount the yearly sum • FCF=OCF + Net Capital Spending - Changes in NWC • Operating Cash Flows (OCF): EBIT+Depreciation+Other Non-Cash Expenses-Taxes • Net Capital Spending • Project specific assets, initial costs • After tax salvage value (if project ends) • Changes in NWC • NWC=CA-CL • Changes in NWC = NWC(t)-NWC(t-1) • Recover all NWC at the end of the project (if project ends)**Alternate Ways to Compute OCF**• GOAL: Make sure that all relevant cash inflows and outflows are included (Holden shows several of these methods) • Bottom Up: OCF=Net Income + Non-cash deductions • CAUTION: This method only works if there are no financing costs already taken out of net income! • Top Down: OCF=Sales - Costs - Taxes • Subtract all deductions except non-cash items • Tax Shield: OCF=(Sales-Costs) x (1-tc) + (non-cash deductions x tc)**Scenario Analysis**• WHAT IF? • Estimate NPV with various assumptions • Statistical distribution • Best case, worst cast, most likely case • Sensitivity analysis: Change in NPV due to one or a few items**Capital Rationing**• NPV>0 then accept, is based on unlimited capital • NPV is still the best criteria but we need to ration • Profitability Index is NPV per investment dollar • Order the projects by PI • Choose projects until PI<0 or you run out of money**You have $500,000 to spend**• Project B, $200,000 • Project D, $250,000 • Project C, $50,000 (partial investment) • What if you can’t do partial investments?**Evaluating projects with different economic lives**• Assumptions • Different lives • The project can go on forever • Equivalent Annual Cash (EAC) flows**EAC Example**• Assume you need to choose between two production processes • Original process: NPV=4,402,679, 8 year life • Alternative: NPV=3,200,000, 4 year life • Which process is better?**Biases**• Systematic deviation from the actual value**Cognitive Bias**• When conscious beliefs do not reflect the information • Easy to recall/available information is used • Adjustment and anchoring • Representative**Motivational Bias**• Statements do not reflect beliefs • Dishonesty • Greed • Asymmetric Reward • Brown-nosing • Fear**Managing Bias**• Recognize it! • Keep going back to the economics • Sensitivity analysis • Information management • Check and recheck assumptions