• Share
  • Email
  • Embed
  • Like
  • Save
  • Private Content
Brad Simon - Finance Lecture - Project Valuation
 

Brad Simon - Finance Lecture - Project Valuation

on

  • 1,191 views

Brad Simon, Finance, Project Valuation, Capital Budgeting

Brad Simon, Finance, Project Valuation, Capital Budgeting

Statistics

Views

Total Views
1,191
Views on SlideShare
1,052
Embed Views
139

Actions

Likes
0
Downloads
11
Comments
0

1 Embed 139

http://vizedhtmlcontent.next.ecollege.com 139

Accessibility

Upload Details

Uploaded via

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

    Brad Simon - Finance Lecture - Project Valuation Brad Simon - Finance Lecture - Project Valuation Presentation Transcript

    • Finance Lecture:Project Valuation Brad Simon
    • Lecture Overview  Orientation  What projects do we invest in?  Estimating a Cost of Capital  Hurdle Rate  Weighted Average Cost of Capital  Estimating Incremental Free Cash flows  Time-weighted tools  NPV  IRR  Others  Summary2
    • Where we are in the course  The first two modules focused on the building blocks of finance which are common throughout the field.  Time Value of Money  Bonds and Stocks  Risk and Return (e.g. CAPM)  Starting this week and for the remainder of the course we will focus more on issues at the firm-level.  This week focuses on how managers select the projects a firm should undertake.  This is known as “Project Valuation” or3 “Capital Budgeting.”
    • What Projects Do We Invest In?  A firm can be thought of as a collection of projects.  We saw earlier in the course that the primary goal of the firm is to maximize shareholder value.  Selecting the right projects is the key to maximizing shareholder value.  Because of this managers need financial tools to help them evaluate among prospective projects.  We call this process, “Capital Budgeting,” as it involves the long-term allocation of a firm’s capital resources.4
    • What Projects Do We Invest In?  In order to decide what to invest in we need three things:  A return threshold or hurdle rate  The expected incremental cash flows related to the project  An analysis to stitch the above two items together5
    • Return Threshold (Hurdle Rate)  We have discussed previously the costs of debt and equity.  Cost of debt:  Interest rates,  Yield to Maturity  Yield to Call  Cost of equity:  The required return that equity holders need to be fairly compensated  This was estimated with the “CAPM”6
    • Return Threshold (Hurdle Rate)  Moreover, we know that firms raise their capital through some combination of these instruments. (The details of how they choose such a combination will be discussed in subsequent modules.)  A firm that employs Debt (D) and Equity (E), at rates of rd and re, respectively, should be investing in things that (at least) covers these capital costs.7
    • Weighted Average Cost of Capital (WACC)  We can calculate a blended cost that weighs the required returns of each source of capital by their weights.  We call this the Weighted Average Cost of Capital (WACC)  WACC = rd x Percentage of Debt + re x Percentage of Equity  This is often simply written as: rd x D + re x E  Note, the cost of debt (rd) should be the after-tax cost of debt, because interest on debt payments are deductable from a firm’s net income.8
    • Weighted Average Cost of Capital (WACC)  Example of the WACC  A company has debt of $200 million and equity of $300 million. The after-tax cost of debt is 6% and the cost of equity is 14%.  %Debt = $200 million / ($200 million + $300 million) = 40%  %Equity = 1 - %Debt = 60%  WACC = rd x D + re x E = 6% x 40% + 14% x 60% = 2.4% + 8.4% = 10.8%  This means the company must invest in projects that earn at least 10.8% annually, otherwise it is9 destroying value.
    • Cash Flows  The next item we need is an estimate of how much cash our new project is expected to provide over its life-time.  The most common way to create an estimate of the cash flow (the cash that will flow-in from our project) is to create pro forma financial statements (income statement, balance sheet, etc.) based on what we think is going to happen over the life of the project.  Once created, we can manipulate the financial statements to determine the cash that comes in or goes out in a given period.10
    • Free Cash Flows  The cash we are interested in estimating is the cash that will be available to be used to pay our financing (the debt and equity)  This is termed the Free Cash Flow (FCF) because we are free to use it to pay for the financing of the project.  FCF = Operating Cash Flow – Investment in Operating Capital  = (EBIT – Taxes + Depreciation) – (Investment in Fixed Assets + Investment in Working Capital)11
    • Incremental Cash Flows  Note, we are only interested in cash that relates specifically to undertaking this new venture (called the incremental cash flow).  For example, if we have already invested in R&D for the project we would not include that amount in our analysis because it has no bearing on our decision to move forward with the project – the money has already been spent (it’s a “sunk” cost).12
    • Putting these items together  Once we know:  Our cost of capital (as represented by the WACC)  Our estimate of the free cash flows related to the project  We can then use these in one of many techniques to make an informed capital budgeting decision.  The most common such techniques are the Net Present Value (NPV) and the Internal Rate of Return (IRR).  Fortunately, both of these relate directly to our13 Time-Value-of-Money calculations we worked with earlier in the course.
    • Net Present Value  Let’s say we have the following free cash flow projection for a project:  Year 0: -$100,000  Year 1: $20,000  Year 2: $25,000  Year 3: $50,000  Year 4: $75,000  Additionally, let’s say the WACC for the company is 9.0%.  We can use the TVM analysis to calculate the Present Value of each period and then add them up to get a Net Present Value estimate.14
    • Net Present Value Year Cash Flow PVIF PV 0 $ (100,000) $ (100,000)  Based on this 1 $ 20,000 0.917 $ 18,349 analysis the project 2 $ 25,000 0.842 $ 21,042 should generate 3 $ 50,000 0.772 $ 38,609 4 $ 75,000 0.708 $ 53,132 $31,132 of economic NPV $ 31,132 value in present value terms. WACC 9.00%15
    • Net Present Value  Positive NPV projects (i.e. where the value is greater than zero) create economic value because they pay for their capital costs.  Negative NPV projects destroy value because capital costs are not adequately covered.16
    • Internal Rate of Return  While the NPV has an output in dollar terms sometimes it is useful to have a rate (percentage) output from our capital budgeting tool.  The IRR analysis is most common for this.  The IRR is defined to be the discount rate which produces an NPV of 0.  The next slide shows this for our prior example.17
    • Internal Rate of Return Year Cash Flow PVIF PV  In this case the IRR is 0 $(100,000) $ (100,000) 19.63%. 1 $ 20,000 0.836 $ 16,718  We can then compare 2 $ 25,000 0.699 $ 17,467 the IRR to the required 3 $ 50,000 0.584 $ 29,201 hurdle rate (the 4 $ 75,000 0.488 $ 36,613 NPV $ - WACC).  When the IRR > WACC IRR 19.63% the project is creating value.  When the IRR < WACC the project is destroying value.18
    • Other Capital Budgeting Tools  While the NPV and IRR are the most important and commonly used capital budgeting tools, they are not the only ones.  Other common tools include:  Payback Period  Discounted Payback Period  Modified IRR  Profitability Index  Most frequently, financial analysts will use several of these tools to make an informed view on how to proceed with a project.19
    • Summary  This lecture more formally began our exploration into “Corporate Financial Management”  The first step is to determine what projects a firm should choose to undertake.  Deciding what to invest in (capital budgeting) involves:  Calculating the company’s WACC or relevant cost of capital.  Estimating the incremental Free Cash Flows from the project.  Using our capital budgeting tools to analytically determine value creation or value destruction:20  NPV, IRR and other tools