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

8. Corporate Valuation and Value-Based Management

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

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.

Value of Operations

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.

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

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

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.

Value of operations for MicroDrive Step 1. Free cash flow2001 Forecast Net operating working capital (NOWC) $800$839$769$ Net fix capital $1 000$1 100$1 188$ Total operational capital (TOC) $1 800$1 939$1 957$ Investments to TOC (Invest.) $345$139$17$16 5. Net operational profit after tax(NOPAT) $170$211$228$ Free cash flow (FCF = NOPAT - Invest.) -$175$72$211$228 Step 2. Value of operations2001 Forecast Long-term growth rate, g (from 2004)5% WACC 11,0 % FCF $72$211$228

V op at 3 Calculation of value of operations k c =11% = V op g = 5% FCF=    0

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)

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

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

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

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.

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.

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).

PbP of a long project = CF t Payback L 2+30/80 = years Accumulated CF t

PbP of a shot project CF t /50 = 1.6 year = Accumulated CF t Payback s

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

CF t Accumulated PVCF t DPbP /60.11 = 2.7 years Discounted Payback Period (DPbP) PVCF t % =

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 – CF 0 Net Present Value (NPV)

NPV of projects L (long) and S (short) % = NPV L NPV S = $29.83 LSLS

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

Internal Rate of Return, IRR 0123 CF 0 CF 1 CF 2 CF 3 Costs Cash Inflows 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.

IRR проектов L и S IRR = ? PV 3 PV 2 PV 1 0 = NPV IRR L = 18,1 %IRR S = 31,4 % LSLS

Decision by IRR on S and L projects 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 (IRR S > IRR L ). WACC = 10%

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.

Mutually exclusive projects 8.7% NPV IRR S IRR L k NPV S, IRR S > IRR L k > 8.7: NPV S > NPV L, IRR S > IRR L 18.13%23.56 %

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.

MIRR = 16.5% % MIRR of project L (i = 10%) % TV of inflows PV of outflows MIRR = 16.5% $100 = $158.1 (1+MIRR) 3

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.

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

Set up without numbers a time line for the project CFs Initial Outlay OCF 1 OCF 2 OCF 3 OCF 4 + Terminal CF NCF 0 NCF 1 NCF 2 NCF 3 NCF 4

= Corporate cash flow with project minus Corporate cash flow without project Incremental Cash Flow

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

Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. A.T. opportunity cost = $25,000 (1 - T) = $15,000 annual cost. Suppose the plant space could be leased out for $25,000 a 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. If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis?

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.

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. Real vs. Nominal Cash flows

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. Risk in capital budgeting

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%?” Sensitivity analysis

Change from Base Level Resulting NPV (000s) Unit SalesSalvagek -30%$ 10$78$ Illustration

Base Value 82 NPV (000s) Unit Sales Salvage k

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. Results of Sensitivity 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. Weaknesses of sensitivity analysis

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

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

Average Density Most probable NPV Probability 50% 25% ScenariosProbability, pPriceSalesVariables CostNPV Best 25%3, , Base 50% , Worst 25%2, , Expected NPV19186 Standard deviation41642 Variation Coefficient2,17 Scenarios Probability, p Net Cash Flow NPVNPV x p Best25% Base50% Worst25% , Scenario analysis

Only considers a few possible out-comes. Assumes that inputs are perfectly correlated--all “bad” values occur together and all “good” values occur together. Focuses on stand-alone risk, although subjective adjustments can be made. Are there any problems with scenario analysis?

A computerized version of scenario analysis which uses continuous probability distributions. Computer selects values for each variable based on given probability distributions. NPV and IRR are calculated. Process is repeated many times (1,000 or more). End result: Probability distribution of NPV and IRR based on sample of simulated values. Generally shown graphically. Simulation analysis

Distribution models for a project variables in Monte Carlo simulation

Probability Density (NPV) Also gives  NPV, CV NPV, probability of NPV > 0. 0E(NPV) NPV

Reflects the probability distributions of each input. Shows range of NPVs, the expected NPV,  NPV, and CV NPV. Gives an intuitive graph of the risk situation. Advantages of simulation analysis

Difficult to specify probability distributions and correlations. If inputs are bad, output will be bad: “Garbage in, garbage out.” Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a project’s expected return is sufficient to compensate for its risk. Sensitivity, scenario, and simulation analyses all ignore diversification. Thus they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting. Disadvantages of simulation