Valuation Methods

1
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

2
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.

3
The Payback Rule
200
420
855
645
Time
0
4
1
3
2
-600
Payback period2((600-420)/225)2.8 yearsAccept
because payback lt 3 years
4
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

5
The Discounted Payback Rule
Accumulated discounted cash flows
Time
0
4
1
3
2
-600
The project never pays back so reject.What is
the NPV?
6
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 NPVgt0
• Biased toward liquidity
• Easy
• Disadvantages
• May reject NPVgt0 projects
• Cut-off period is arbitrary
• Biased against long term projects
• Bottom Line Why not just use NPV?

7
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 NPVs.
8
Internal Rate of Return (IRR) Rule

• IRR is that r that makes the NPV0

9
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 is
  independent, then NPV and IRR lead to same accept
  and reject decisions.

10
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

11
Problems with the IRR RuleUnconventional cash
flows lead to multiple IRRs25 and 33.33
12
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

13
Mutually Exclusive Cash Flows
14
NPV Profiles of Mutually Exclusive Projects
Crossover Rate 11.8
IRRB22.17
IRRA19.43
15
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

16
Modified IRR (MIRR)

• Solves the reinvestment rate problem
• Example A projects cash flows are -400, 325
  and 200. Appropriate r is 12
• Accept the project because 18.74gt12
• Note The IRR on this project is 22.16

17
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 rs)
• 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

18
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 rs
• Note
• re (eequity) is the same as rS (Sstock)
• rd (ddebt) is the same as rB (Bbond)

19
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

20
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

21
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
22
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)

23
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 projects
  relevant cash flows, sum them in each year then
  discount the yearly sum
• FCFOCF Net Capital Spending - Changes in NWC
• Operating Cash Flows (OCF) EBITDepreciationOth
  er Non-Cash Expenses-Taxes
• Net Capital Spending
• Project specific assets, initial costs
• After tax salvage value (if project ends)
• Changes in NWC
• NWCCA-CL
• Changes in NWC NWC(t)-NWC(t-1)
• Recover all NWC at the end of the project (if
  project ends)

24
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 OCFNet Income Non-cash deductions
• CAUTION This method only works if there are no
  financing costs already taken out of net income!
• Top Down OCFSales - Costs - Taxes
• Subtract all deductions except non-cash items
• Tax Shield OCF(Sales-Costs) x (1-tc)
  (non-cash deductions x tc)

25
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

26
Capital Rationing

• NPVgt0 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 PIlt0 or you run out of money

27
You have 500,000 to spend
Project Investment NPV PI
A 500,000 80,000 16
B 200,000 45,000 22.5
C 300,000 55,000 18.3
D 250,000 50,000 20

• Project B, 200,000
• Project D, 250,000
• Project C, 50,000 (partial investment)
• What if you cant do partial investments?

28
Evaluating projects with different economic lives

• Assumptions
• Different lives
• The project can go on forever
• Equivalent Annual Cash (EAC) flows

29
EAC Example

• Assume you need to choose between two production
  processes
• Original process NPV4,402,679, 8 year life
• Alternative NPV3,200,000, 4 year life
• Which process is better?

30
Biases

• Systematic deviation from the actual value

31
Cognitive Bias

• When conscious beliefs do not reflect the
  information
• Easy to recall/available information is used
• Adjustment and anchoring
• Representative

32
Motivational Bias

• Statements do not reflect beliefs
• Dishonesty
• Greed
• Asymmetric Reward
• Brown-nosing
• Fear

33
Managing Bias

• Recognize it!
• Keep going back to the economics
• Sensitivity analysis
• Information management
• Check and recheck assumptions