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DCF Theory Training Chess

The document provides an overview of discounted cash flow (DCF) analysis and net present value (NPV) calculations. It begins with introductions to basic DCF principles and levels from 1 to 3, similar to levels in chess. It discusses key concepts like time value of money, relevant versus irrelevant cash flows, and how to calculate weighted average cost of capital (WACC) and NPV. The document aims to provide both fundamentals and more advanced strategies for analyzing investments using DCF.

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Discounted Cash Flow / Net Present Value October 2011
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3 DCF Thought DCF is like Chess. The concept is relatively easy to understand. Becoming good at DCF / NPV analysis takes practice. To become a master takes dedication, time, and effort. Today, we will focus on learning the fundamentals, and introduce you to some of the more advanced concepts. For those who wish to become a Grand Master, we have plenty of resources to guide you.
4 Objective:Objective: Provide an overview of DCF / NPVProvide an overview of DCF / NPV Agenda:Agenda: Basic DCF Principles: Level 1, 2, 3 NPV (Net Present Value) Various methods to evaluate projects Watchouts / Tips Q&A
5 DCF Level 1 = Castling Castling •A special move involving both the king and one rook. Its purpose is generally to protect the king and develop the rook. Castling on the kingside is sometimes called castling short and castling on the queenside is called castling long; the difference is based on whether the rook moves a short distance (two squares) or a long distance (three squares).
6 DCF / Chess Thought: diagrams / pictures help drive home the thought. Move Rook immediately next to the King on its opposite side:
7 DCF: Investment A Investment B Cash is a scarce resource. Discounted Cash Flow Analysis provides a basis to compare different investment options. Which investment is better?
8 DCF Level 1 Principles: Discounted cash flow (DCF) analysis is a method of valuing a project (or a Company) using the concept of time value of money and risk: • $1 today is worth more than $1 a year from today; • Cash invested in a project is riskier than a US T-Bill, or some other ‘risk free’ investment.
9 DCF Level 2 = En Passant En passant •("in the act of passing"; derived from French) The rule that allows a pawn that has just advanced two squares to be captured by a pawn on the same rank and adjacent file. The pawn is therefore taken as if it had only moved one space. It is only possible to take en passant on the next move.
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11 DCF Level 2 Thoughts: • WACC • Beta • Market Risk Premium • Risk Free Rate
12 Fianchetto •Refers to a bishop developed to the second square and the longest diagonal on the file of the adjacent knight (that is, b2 or g2 for white, b7 or g7 for black), or the process of developing a bishop to such a square. It usually occurs after moving the pawn on that file ahead one square (or perhaps two). The Italian word is actually a noun ("in fianchetto") and not a verb.
13 Fianchetto means “to flank”. It refers to a move where the bishop is placed on the longest diagonal it can attack.
14 DCF Level 3 Thoughts: • Monte Carlo Simulation • Decision Tree + NPV
Name the Movie and the Character: Test Your Knowledge
Movie: Searching for Bobby Fischer Character: Josh Waitzkin
17 DCF: Level 1 Money  Cash Discount Rate / Interest Rate / Equity Premium
Determining Cash Flows
19 Cash Flow versus Earnings? Why and when did the use of Cash Flows versus Earnings come into practice?
20 Cash Flow versus Earnings? Discounted cash flow was first formally articulated in 1938 after the market became wary of relying on reported income, or any measure of value besides cash.
21 Why Cash Flows vs Accounting Earnings? Accounting Earnings One cannot spend earnings. Shows revenues when products and services are sold or provided, not when they are paid for. Shows expenses associated with these revenues, not when expenses are paid. Net income includes a number of non-cash adjustments to approximate economic activity as of (or over) a period of time. Accounting adjustments do not necessarily reflect the company’s ability to pay its obligations or invest for future growth. Cash Flows Cash flow reflects the company’s ability to generate funds in order to pay its obligations or invest for future growth Various Cash Flow measures (i.e. - Free Cash Flow) adjusts accounting income to arrive at the funds available to pay stock and debt holders. For example, taking out Dividends provides one way to compare cash flows across Companies. Ca$$h is King
22 DCF Level 1 Principles: Invest in projects that yield a return greater than the minimum acceptable hurdle rate Return on projects should be measured based on: • cash flows generated: Why cash flows and not earnings? • the timing of these cash flows: cash flows that occur earlier value more than cash flows that occur later. • incremental cash flows: use cash flows that are incremental related to the investment decision.
23 Depreciation / Amortization / Capital While depreciation reduces taxable income and taxes, it does not reduce cash flows. It is a non-cash expense; therefore, it needs to be added back. There is a cash flow benefit associated with depreciation – the tax benefit. In general, the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate Capital expenditures (CAPEX) are not treated as accounting expenses, but they do cause cash outflows.
24 Working Capital Intuitively, money invested in inventory or in accounts receivable cannot be used elsewhere. Therefore, it represents a drain on cash flows.
25 To get from accounting earnings to cash flows: Free Cash Flow = Before Tax Profit (BTP) or EBIT - Taxes + Add back Depreciation/Amortization +/- Change in Working Capital - Capital Expenditures Ca$$h is King
26 Relevant & Irrelevant Cash Flows  Flows that will be incurred as a direct result of the project (incremental cash flows)  Tax benefits (tax shield on depreciation)  Flows that do not change as a results of the project  Flows that have already occurred (sunk costs)  Flows that would be incurred regardless of the project activities (replace equipment)  Non-cash items (depreciation) Irrelevant Cash FlowsRelevant Cash Flows
Net Present Value Time Value of Money
28 Basic Principles Getting cash now is better than getting it later
29 Time Value of Money Providers of investment capital require a return of their principal and an amount of interest which is commensurate with the risk and the length of time until their investment is returned Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 TotalTotal Car Loan from Bank -30,000 -30,000 Principle Payment 10,000 10,000 10,000 30,000 Interest Payment 2,100 1,400 700 4,200 Total Payment -30,000 12,100 11,400 10,700 4,200
30 What is Net Present Value (NPV) Net Present Value is the value of future cash flows in today’s dollars Cash Flow Year 0 Total in today’s $ Cash Flow Year 1 Cash Flow Year 2 Cash Flow Year 3 Note: the number of years used in the analysis varies depending on the project type.
31 Time Value Factor Calculation ( )PV Factor 1 r t== +1 r = discount rate* t = Time (years) ( )FV Factor r t == +1 If r = 9%, then the present value of $1 earned three years from now is $0.77 $1* / (1+0.09)^3 If r = 9%, then the value of $1 invested today will equal $1.30 three years from now $1* X (1+0.09)^3 NoteNote: Clorox uses its Weighted Average Cost of Capital (WACC) as its discount rate
32 What is required for determining NPV? Project YearProject Year 00 11 22 33 Cash Flows CF0 CF1 CF2 CF3 (Multiplied by) Discount factor 1 1/(1+r)^1 1/(1+r)^2 1/(1+r)^3 (Equals) Discounted Cash Flows DCF0 DCF1 DCF2 DCF3 Sum the discounted cash flows to getSum the discounted cash flows to get the Net Present Value of future cash flowsthe Net Present Value of future cash flows 1 2
33 What is required for determining NPV? Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor 1 1/ (1+r)^1 1/ (1+r)^2 1/ (1+r)^3 1/(1+r)^4 1/ (1+r)^5 1/ (1+r)^6 1/(1+r)^7 (Equals) Discounted Cash Flows DCF0 DCF1 DCF2 DCF3 DCF4 DCF5 DCF6 DCF7 1 2 The first step in calculating Net Present Value requires the determination of relevant,relevant, incrementalincremental cash flows
34 Net Present Value Conclusion If NPV is negative, reject the project; otherwise, further consideration is required. Having cash flows and present value factors, the Net Present Value can be calculated Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor (10%) 1 .91 .83 .75 .68 .62 .56 .51 (Equals) Discounted Cash Flows -3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566 Cumulative Cash Flows (NPV) -3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728
DCF Level 2: What Rate Should We Use to Discount Cash Flows?
36 Weighted Average Cost of Capital Definition Weighted Average Cost of Capital (WACC) is the minimum rate of return that must be realized in order to satisfy investors: both debt holders and shareholders. Cost ofCost of EquityEquity Cost ofCost of DebtDebt++>> ProjectProject ReturnsReturns
37 Calculating WACC Key WACC concepts: • Debt Cost • Risk Free Rate • Beta • Equity Market Risk Premium
38 Calculating WACC Cost of Capital has two components: Cost of equity (rk) After tax Cost of debt (rd) These are multiplied by the relative weight of their market values to arrive at an average cost: WACC = rk * (E/(D+E)) + rd * (D/(D+E)) E = market value of equity D = market value of debt WACC = rk * (E/(D+E)) + rd * (D/(D+E))
DCF Level 2: Debt Cost
40 “The AAA rating has made the U.S. Treasury bond one of the world’s safest investments — and has helped the nation borrow at extraordinarily cheap rates to finance its government operations, including two wars and an expensive social safety net for retirees. Treasury bonds have also been a stalwart of stability amid the economic upheaval of the past few years. The nation has had a AAA rating for 70 years. Analysts say that, over time, the downgrade could push up borrowing costs for the U.S. government, costing taxpayers tens of billions of dollars a year. It could also drive up interest rates for consumers and companies seeking mortgages, credit cards and business loans.” (Washington Post, August 5, 2011)
41 DCF Level 2 Clorox: BBB+ rating So what does that mean?
42 DCF Level 2 Principles: • ‘AAA’ Extremely strong capacity to meet financial commitments. • ‘A’ Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances • ‘BBB’ Adequate capacity to meet financial commitments, but more subject to adverse economic conditions • ‘BBB-’ Considered lowest investment grade by market participants
43 Standard & Poors Ratings: •‘BB+’ Considered highest speculative grade by market participants •‘B’ More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments •‘CCC’ Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments •‘CC’ Currently highly vulnerable •‘C’ A bankruptcy petition has been filed or similar action •‘D’ Payments default on financial commitments
44 DCF Level 2 Principles: What factors do the Rating Agencies take into account in the Consumer Products arena?
45 Market share, including its market position and the ability to sustain or increase share; Strength, breadth, and diversity of brands in the product portfolio; Degree of competition from private label and/or house- branded products within each product category and country market; Product portfolio life cycle, i.e., the balance of well- established products and new product introductions; Degree of operating efficiency, including size and economies of scale, which in turn may translate into greater purchasing power with suppliers; Extent of geographic diversification; and Management's track record of product innovation and brand building, including efficiency and effectiveness of marketing spend.
46 Degree of concentration of manufacturing plants or operating lines and procurement, including high exposure to particular raw materials or suppliers (this may be a critical factor for smaller, or more narrowly focused companies); Customer concentration, (this may be a critical factor for smaller, or more narrowly focused companies); Reach and degree of penetration of distribution network, including costs of developing efficient distribution networks in faster-growing emerging markets; Legal and regulatory environment, including taxation and restrictions on consumption and marketing of certain products; and History of managing product liability, reputational risks, and business interruptions.
47 US: We have lowered our long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA‘
48 Standard & Poors Ratings: • United States AA+ • Canada AAA • Hong Kong AAA • New Zealand AA+ • China AA- • Italy A • Bahamas BBB+ • Greece CC
49 DCF Level 2 Principles:
50 DCF Level 2 Principles:
51 Cost of Debt Clorox’s cost of debt includes short term notes and long term debt After tax cost of debt is 5.00% * (1-38%) = 3.1% Pretax rate Balance ($MM) US Commercial Paper 4.78% $487 Debt 2-3 years 5.21% $500 Debt 4-5 years 4.26% $575 Debt 5-10 years 5.42% $1,029 Total 5.00% $2,590
DCF Level 2: Equity Cost
53 CAPM Formula: Cost of equity = Risk free rate + Beta * Market risk premium • Risk free rate is equal to the return on long term government securities; e.g. 30 year treasury bond yield. • Beta is a measure of risk defined by the correlation between Clorox’s stock price movement and the stock market in total. • Equity market risk premium is the premium investors require for purchasing stock vs. debt instruments. Cost of Equity - CAPM
54 Cost of Equity Assumptions • Risk Free RateRisk Free Rate: 5.5% • BetaBeta: in the range of 0.65 to 0.85 range for cost of capital calculations, in line with industry averages. Average = 0.75.
55 Cost of Equity Assumptions
56 Cost of Equity Assumptions •Market risk premium = expected market return - risk-free rate. •Determine the "risk-free" rate of return. Treasuries are considered to be risk free as they are backed by the "full faith and credit" of the U.S. government. For this reason, we can use them as a proxy for the risk-free rate.
57 Cost of Equity Assumptions •Determine the expected return of the market. According to Ibbotson Associates, the S&P has returned an average of 10.3 percent a year, compounded, since 1926 (CNN, 2008). This is a good proxy for expected return of the market. •The market risk premium equals the average expected return from the market minus the risk free rate. The risk premium = 6.5 percent.
58 Cost of Equity Assumptions • Market risk premiumMarket risk premium: ranges from 5.5% to 7.5% for cost of capital calculations: call it +6.5% Cost of equity = Risk free rate + Beta * Market risk premium 10.5% = 5.5% 0.75+ 6.5%* Cost of equity = Risk free rate + Beta * Market risk premium
59 Equity Risk Profile Concept No risk investment Government T-Bill Inflation risk Government Bond Equity market risk (Beta = 1.0) S&P 500 Clorox Risk Type Example Company specific risk (Beta = .75) Yield Curve Cost of Equity 4.0 1.5 6.5 -1.5 % Rate 4.0 5.5 12.0 10.5 % Rate Cumulative
DCF Level 2: Bringing WACC together
61 Capital Structure Market value of debt = $3 Billion Total shares outstanding = 153MM Stock price = $65 Market value of equity = $9 B EquityEquityDebtDebt  Total capital = $12 billion  Debt : Total Capital Ratio = 22% Total CapitalTotal Capital
62 Bringing it all together: WACC  Cost of Equity of 10.5%  Total Capital ratio equal to 78% Equity / 22% Debt  After Tax Cost of Debt of 3.1% 8.8%=10.5% 3.1%+ 22%*78%*
63 Quick Quiz: What if….. WACC goes: Interest Rates go up Total Debt Goes up
64 Quick Quiz: What if….. WACC goes: Interest Rates go up Up Total Debt Goes up Down
How do various firms evaluate Projects, Or “What are various opening moves used by the Grand Masters?”
1. Sicilian Defense 2. Caro-Kann Defense 3. Italian Game 4. Ruy Lopez 5. Queen’s Gambit 6. Co-Lo Gambit 7. Indian Defense 8. English Opening Chess Openings
67 What Firms actually used as primary decision rule MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse Est. % Firms usingEst. % Firms using as primary ruleas primary rule Net Present Value $ The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows) Values greater than $0 indicate the amount of value added to the company. 20% Internal Rate of Return % The relative return a project generates over time compared to its cost Should be equal to or greater than hurdles to ensure adequate returns 50% Payback Period (using discounted cash flows) Years The amount of time it takes for a project to pay for itself given the cost of financing. Should be less than or equal to hurdles to ensure timely returns 20% Clorox uses some common approaches to evaluate individual value enhancing opportunities
68 How does Clorox evaluate opportunities? MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse Net Present Value $ The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows) Values greater than $0 indicate the amount of value added to the company. Internal Rate of Return % The relative return a project generates over time compared to its cost Should be equal to or greater than hurdles to ensure adequate returns Payback Period (using discounted cash flows) Years The amount of time it takes for a project to pay for itself given the cost of financing. Should be less than or equal to hurdles to ensure timely returns Clorox uses some common approaches to evaluate individual value enhancing opportunities
Payback Period
70 What is the payback period? Payback period is the number of years required to recover a project’s cost. It is also the answer to how long does it take to get the business’ money back? Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor (10%) 1 .91 .83 .75 .68 .62 .56 .51 (Equals) Discounted Cash Flows -3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566 Cumulative Cash Flows (NPV) -3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728
Internal Rate of Return
72 Internal Rate of Return Internal Rate of Return (IRR) is the discount rate at which NPV is $0.
Recap
74 Recap Project evaluation is done to help ensure that investors’ goals are being considered in go / no-go decisions NPV (DCF), IRR, and Payback period are measures used by Clorox to estimate a project’s ability to add value Only incremental cash flows are considered in the analysis WACC is used as the discount rate to calculate the present value
75 Fundamentals – Decision Rules Revisited General Clorox Decision Rules NPVNPV – If NPV is negative, reject the project; otherwise, further consideration is required. IRRIRR – If IRR is less than the cost of capital, reject the project; otherwise, further consideration is required. PaybackPayback – Generally, the shorter the payback period the less risky the project.
76 The cash flow analysis should be from 3 to 10 years depending on the project gear: Rapid Response: 3 year Core Growth: 5 year Game Changer: 10 year Perpetuity Cash Flow/NPV: Primarily calculated for Acquisitions where value is realized over a longer period of time Not recommended for new products since sustainability of product is hard to predict past 10 years Clorox Guidelines
77 Case Study Results Comparison ResultResult DecisionDecision RuleRule RecommendatiRecommendati onon Net Present Value $4,728 >$0 Internal Rate of Return 26% >10% Payback Period 6 years <4 years
Shortcomings
79 Shortcomings / Watchouts “Discounted Cash Flow models are powerful, but they do have shortcomings. DCF is a mechanical valuation tool, which makes it subject to the axiom “garbage in, garbage out”. Small changes in inputs can result in large change in the value.” - Wikipedia 8/31/2011
80 Shortcomings / Watchouts “Real Estate: straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually lasts less than ten years.” - Wikipedia 8/31/2011
81 DCF: Level 3 Monte Carlo simulators
82 Net Present Value: in reality, is a range of outcomes….
83 Furthermore, the range of NPV’s associated with different projects is different depending on factors such as whether it’s a new category or an existing category….
84 Tips  Retrospective analysis:Retrospective analysis: looks at the financial impacts after the project has been implemented • It can be used to confirm benefits realization • To identify opportunities to improve estimates for future analyses
85 Tips Vision Simplified / Standardized Complex Project Project Criteria: Select Customization Rapid Response Core Growth Game Changer+ Model Type: HVR-simplified model Monte Carlo
Questions ????
Thank You
Appendix
89 Appendix - Comparison of Internal & External WACC Estimates Morgan Stanley Historical FY04 Current Jan 03 Apr-04 Apr-05 Jan-04 Apr-05 Apr-05 Apr-05 Risk Free Rate (1) 6.0% 6.0% 5.5% 4.9% 5.3% 4.7% 4.1% 4.5% 4.3% 4.5% Clorox Beta (2) 0.95 0.75 0.75 0.69 0.75 0.75 0.72 0.62 0.64 0.9 Market Premium 5.0% 6.5% 6.5% 6.5% 6.5% 6.5% 6.0% 6.0% 4.0% 4.5% Cost of Equity 10.8% 10.9% 10.4% 9.4% 10.2% 9.6% 8.4% 8.2% 6.9% 8.5% After Tax Cost of Debt 4.0% 2.1% 2.8% 3.0% 3.1% 3.1% 3.0% 3.3% 3.4% 2.9% Debt/ Total Capital 10% 10% 25% 11% 10% 21% 10% 21% 20% 21% Cost of Capital 10.1% 10.0% 8.5% 8.7% 9.4% 8.2% 7.9% 7.2% 6.2% 7.3% Notes: (1) Clorox & Citigroup use forecasted 30 year treasuries while the other bamks use current 10 year treasuries (2) JP Morgan uses a judgement beta of 0.9. JP Morgan also calculated WACC using a market derived capital pricing model (MCPM) to calculate cost of equity. Using this methodology, JP Morgan calculated WACC to be 7.3-7.9% JP MorganClorox Citigroup Goldman
90 Appendix - WACC Estimates Summary 5.5% 6.5% 7.5% 5.5% 6.5% 7.5% Risk Free Rate = 4.5% Beta = 0.65 8.1% 8.7% 9.4% 7.0% 7.5% 8.0% Beta = 0.75 8.6% 9.4% 10.1% 7.4% 8.0% 8.6% Beta = 0.85 9.2% 10.0% 10.9% 7.8% 8.5% 9.2% Risk Free Rate = 5.5% Beta = 0.65 9.1% 9.7% 10.4% 7.8% 8.3% 8.8% Beta = 0.75 9.6% 10.4% 11.1% 8.2% 8.8% 9.4% Beta = 0.85 10.2% 11.0% 11.9% 8.6% 9.3% 9.9% Risk Free Rate = 6.5% Beta = 0.65 10.1% 10.7% 11.4% 8.5% 9.0% 9.5% Beta = 0.75 10.6% 11.4% 12.1% 9.0% 9.5% 10.1% Beta = 0.85 11.2% 12.0% 12.9% 9.4% 10.1% 10.7% Equity Market Risk Premium Equity Market Risk Premium Cost of Equity WACC
91 Appendix – Continuous Compounding Continuous Compounding Factor:  A method of discounting which recognizes ongoing cash flows as they occur not at the end of the period  Discount Rate = .09 = 1.044 ln (1 + Disc Rate) ln(1+.09)
92 Perpetuity Cash Flow/NPV  Primarily calculated for Acquisitions where value is realized over a longer period of time  Not recommended for new products since sustainability of product is hard to predict past 10 years Calculation: PV of Perpetuity = CFn+1 /(WACC-g); where G is the constant growth rate Useful when valuing equity, where CFn+1 is replaced with Dividends estimate for next year Appendix – Perpetuity
93 Quick Question: Budget Constraints ProjectProject NetNet FlowsFlows Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 Year 4Year 4 Year 5Year 5 TotalTotal New packaging in US -30 -20 80 -40 -30 100 60 Product expansion in Asia -125 25 35 50 55 60 100 Outsourcin g production -500 -250 150 150 150 150 150 Acquisition in Latin America -250 -50 50 100 125 125 100 How would a manager provide a recommendation if there were only enough budget to fund two of the four projects below?

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DCF Theory Training Chess

  • 1.
    Discounted Cash Flow/ Net Present Value October 2011
  • 2.
  • 3.
    3 DCF Thought DCF islike Chess. The concept is relatively easy to understand. Becoming good at DCF / NPV analysis takes practice. To become a master takes dedication, time, and effort. Today, we will focus on learning the fundamentals, and introduce you to some of the more advanced concepts. For those who wish to become a Grand Master, we have plenty of resources to guide you.
  • 4.
    4 Objective:Objective: Provide an overviewof DCF / NPVProvide an overview of DCF / NPV Agenda:Agenda: Basic DCF Principles: Level 1, 2, 3 NPV (Net Present Value) Various methods to evaluate projects Watchouts / Tips Q&A
  • 5.
    5 DCF Level 1= Castling Castling •A special move involving both the king and one rook. Its purpose is generally to protect the king and develop the rook. Castling on the kingside is sometimes called castling short and castling on the queenside is called castling long; the difference is based on whether the rook moves a short distance (two squares) or a long distance (three squares).
  • 6.
    6 DCF / ChessThought: diagrams / pictures help drive home the thought. Move Rook immediately next to the King on its opposite side:
  • 7.
    7 DCF: Investment A InvestmentB Cash is a scarce resource. Discounted Cash Flow Analysis provides a basis to compare different investment options. Which investment is better?
  • 8.
    8 DCF Level 1Principles: Discounted cash flow (DCF) analysis is a method of valuing a project (or a Company) using the concept of time value of money and risk: • $1 today is worth more than $1 a year from today; • Cash invested in a project is riskier than a US T-Bill, or some other ‘risk free’ investment.
  • 9.
    9 DCF Level 2= En Passant En passant •("in the act of passing"; derived from French) The rule that allows a pawn that has just advanced two squares to be captured by a pawn on the same rank and adjacent file. The pawn is therefore taken as if it had only moved one space. It is only possible to take en passant on the next move.
  • 10.
  • 11.
    11 DCF Level 2Thoughts: • WACC • Beta • Market Risk Premium • Risk Free Rate
  • 12.
    12 Fianchetto •Refers to abishop developed to the second square and the longest diagonal on the file of the adjacent knight (that is, b2 or g2 for white, b7 or g7 for black), or the process of developing a bishop to such a square. It usually occurs after moving the pawn on that file ahead one square (or perhaps two). The Italian word is actually a noun ("in fianchetto") and not a verb.
  • 13.
    13 Fianchetto means “toflank”. It refers to a move where the bishop is placed on the longest diagonal it can attack.
  • 14.
    14 DCF Level 3Thoughts: • Monte Carlo Simulation • Decision Tree + NPV
  • 15.
    Name the Movieand the Character: Test Your Knowledge
  • 16.
    Movie: Searching forBobby Fischer Character: Josh Waitzkin
  • 17.
    17 DCF: Level 1 Money Cash Discount Rate / Interest Rate / Equity Premium
  • 18.
  • 19.
    19 Cash Flow versusEarnings? Why and when did the use of Cash Flows versus Earnings come into practice?
  • 20.
    20 Cash Flow versusEarnings? Discounted cash flow was first formally articulated in 1938 after the market became wary of relying on reported income, or any measure of value besides cash.
  • 21.
    21 Why Cash Flowsvs Accounting Earnings? Accounting Earnings One cannot spend earnings. Shows revenues when products and services are sold or provided, not when they are paid for. Shows expenses associated with these revenues, not when expenses are paid. Net income includes a number of non-cash adjustments to approximate economic activity as of (or over) a period of time. Accounting adjustments do not necessarily reflect the company’s ability to pay its obligations or invest for future growth. Cash Flows Cash flow reflects the company’s ability to generate funds in order to pay its obligations or invest for future growth Various Cash Flow measures (i.e. - Free Cash Flow) adjusts accounting income to arrive at the funds available to pay stock and debt holders. For example, taking out Dividends provides one way to compare cash flows across Companies. Ca$$h is King
  • 22.
    22 DCF Level 1Principles: Invest in projects that yield a return greater than the minimum acceptable hurdle rate Return on projects should be measured based on: • cash flows generated: Why cash flows and not earnings? • the timing of these cash flows: cash flows that occur earlier value more than cash flows that occur later. • incremental cash flows: use cash flows that are incremental related to the investment decision.
  • 23.
    23 Depreciation / Amortization/ Capital While depreciation reduces taxable income and taxes, it does not reduce cash flows. It is a non-cash expense; therefore, it needs to be added back. There is a cash flow benefit associated with depreciation – the tax benefit. In general, the tax benefit from depreciation can be written as: Tax Benefit = Depreciation * Tax Rate Capital expenditures (CAPEX) are not treated as accounting expenses, but they do cause cash outflows.
  • 24.
    24 Working Capital Intuitively, moneyinvested in inventory or in accounts receivable cannot be used elsewhere. Therefore, it represents a drain on cash flows.
  • 25.
    25 To get fromaccounting earnings to cash flows: Free Cash Flow = Before Tax Profit (BTP) or EBIT - Taxes + Add back Depreciation/Amortization +/- Change in Working Capital - Capital Expenditures Ca$$h is King
  • 26.
    26 Relevant & IrrelevantCash Flows  Flows that will be incurred as a direct result of the project (incremental cash flows)  Tax benefits (tax shield on depreciation)  Flows that do not change as a results of the project  Flows that have already occurred (sunk costs)  Flows that would be incurred regardless of the project activities (replace equipment)  Non-cash items (depreciation) Irrelevant Cash FlowsRelevant Cash Flows
  • 27.
    Net Present Value TimeValue of Money
  • 28.
    28 Basic Principles Getting cashnow is better than getting it later
  • 29.
    29 Time Value ofMoney Providers of investment capital require a return of their principal and an amount of interest which is commensurate with the risk and the length of time until their investment is returned Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 TotalTotal Car Loan from Bank -30,000 -30,000 Principle Payment 10,000 10,000 10,000 30,000 Interest Payment 2,100 1,400 700 4,200 Total Payment -30,000 12,100 11,400 10,700 4,200
  • 30.
    30 What is NetPresent Value (NPV) Net Present Value is the value of future cash flows in today’s dollars Cash Flow Year 0 Total in today’s $ Cash Flow Year 1 Cash Flow Year 2 Cash Flow Year 3 Note: the number of years used in the analysis varies depending on the project type.
  • 31.
    31 Time Value FactorCalculation ( )PV Factor 1 r t== +1 r = discount rate* t = Time (years) ( )FV Factor r t == +1 If r = 9%, then the present value of $1 earned three years from now is $0.77 $1* / (1+0.09)^3 If r = 9%, then the value of $1 invested today will equal $1.30 three years from now $1* X (1+0.09)^3 NoteNote: Clorox uses its Weighted Average Cost of Capital (WACC) as its discount rate
  • 32.
    32 What is requiredfor determining NPV? Project YearProject Year 00 11 22 33 Cash Flows CF0 CF1 CF2 CF3 (Multiplied by) Discount factor 1 1/(1+r)^1 1/(1+r)^2 1/(1+r)^3 (Equals) Discounted Cash Flows DCF0 DCF1 DCF2 DCF3 Sum the discounted cash flows to getSum the discounted cash flows to get the Net Present Value of future cash flowsthe Net Present Value of future cash flows 1 2
  • 33.
    33 What is requiredfor determining NPV? Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor 1 1/ (1+r)^1 1/ (1+r)^2 1/ (1+r)^3 1/(1+r)^4 1/ (1+r)^5 1/ (1+r)^6 1/(1+r)^7 (Equals) Discounted Cash Flows DCF0 DCF1 DCF2 DCF3 DCF4 DCF5 DCF6 DCF7 1 2 The first step in calculating Net Present Value requires the determination of relevant,relevant, incrementalincremental cash flows
  • 34.
    34 Net Present ValueConclusion If NPV is negative, reject the project; otherwise, further consideration is required. Having cash flows and present value factors, the Net Present Value can be calculated Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor (10%) 1 .91 .83 .75 .68 .62 .56 .51 (Equals) Discounted Cash Flows -3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566 Cumulative Cash Flows (NPV) -3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728
  • 35.
    DCF Level 2:What Rate Should We Use to Discount Cash Flows?
  • 36.
    36 Weighted Average Costof Capital Definition Weighted Average Cost of Capital (WACC) is the minimum rate of return that must be realized in order to satisfy investors: both debt holders and shareholders. Cost ofCost of EquityEquity Cost ofCost of DebtDebt++>> ProjectProject ReturnsReturns
  • 37.
    37 Calculating WACC Key WACCconcepts: • Debt Cost • Risk Free Rate • Beta • Equity Market Risk Premium
  • 38.
    38 Calculating WACC Cost ofCapital has two components: Cost of equity (rk) After tax Cost of debt (rd) These are multiplied by the relative weight of their market values to arrive at an average cost: WACC = rk * (E/(D+E)) + rd * (D/(D+E)) E = market value of equity D = market value of debt WACC = rk * (E/(D+E)) + rd * (D/(D+E))
  • 39.
    DCF Level 2:Debt Cost
  • 40.
    40 “The AAA ratinghas made the U.S. Treasury bond one of the world’s safest investments — and has helped the nation borrow at extraordinarily cheap rates to finance its government operations, including two wars and an expensive social safety net for retirees. Treasury bonds have also been a stalwart of stability amid the economic upheaval of the past few years. The nation has had a AAA rating for 70 years. Analysts say that, over time, the downgrade could push up borrowing costs for the U.S. government, costing taxpayers tens of billions of dollars a year. It could also drive up interest rates for consumers and companies seeking mortgages, credit cards and business loans.” (Washington Post, August 5, 2011)
  • 41.
    41 DCF Level 2 Clorox:BBB+ rating So what does that mean?
  • 42.
    42 DCF Level 2Principles: • ‘AAA’ Extremely strong capacity to meet financial commitments. • ‘A’ Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances • ‘BBB’ Adequate capacity to meet financial commitments, but more subject to adverse economic conditions • ‘BBB-’ Considered lowest investment grade by market participants
  • 43.
    43 Standard & PoorsRatings: •‘BB+’ Considered highest speculative grade by market participants •‘B’ More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments •‘CCC’ Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments •‘CC’ Currently highly vulnerable •‘C’ A bankruptcy petition has been filed or similar action •‘D’ Payments default on financial commitments
  • 44.
    44 DCF Level 2Principles: What factors do the Rating Agencies take into account in the Consumer Products arena?
  • 45.
    45 Market share, includingits market position and the ability to sustain or increase share; Strength, breadth, and diversity of brands in the product portfolio; Degree of competition from private label and/or house- branded products within each product category and country market; Product portfolio life cycle, i.e., the balance of well- established products and new product introductions; Degree of operating efficiency, including size and economies of scale, which in turn may translate into greater purchasing power with suppliers; Extent of geographic diversification; and Management's track record of product innovation and brand building, including efficiency and effectiveness of marketing spend.
  • 46.
    46 Degree of concentrationof manufacturing plants or operating lines and procurement, including high exposure to particular raw materials or suppliers (this may be a critical factor for smaller, or more narrowly focused companies); Customer concentration, (this may be a critical factor for smaller, or more narrowly focused companies); Reach and degree of penetration of distribution network, including costs of developing efficient distribution networks in faster-growing emerging markets; Legal and regulatory environment, including taxation and restrictions on consumption and marketing of certain products; and History of managing product liability, reputational risks, and business interruptions.
  • 47.
    47 US: We have loweredour long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA‘
  • 48.
    48 Standard & PoorsRatings: • United States AA+ • Canada AAA • Hong Kong AAA • New Zealand AA+ • China AA- • Italy A • Bahamas BBB+ • Greece CC
  • 49.
    49 DCF Level 2Principles:
  • 50.
    50 DCF Level 2Principles:
  • 51.
    51 Cost of Debt Clorox’scost of debt includes short term notes and long term debt After tax cost of debt is 5.00% * (1-38%) = 3.1% Pretax rate Balance ($MM) US Commercial Paper 4.78% $487 Debt 2-3 years 5.21% $500 Debt 4-5 years 4.26% $575 Debt 5-10 years 5.42% $1,029 Total 5.00% $2,590
  • 52.
    DCF Level 2:Equity Cost
  • 53.
    53 CAPM Formula: Cost ofequity = Risk free rate + Beta * Market risk premium • Risk free rate is equal to the return on long term government securities; e.g. 30 year treasury bond yield. • Beta is a measure of risk defined by the correlation between Clorox’s stock price movement and the stock market in total. • Equity market risk premium is the premium investors require for purchasing stock vs. debt instruments. Cost of Equity - CAPM
  • 54.
    54 Cost of EquityAssumptions • Risk Free RateRisk Free Rate: 5.5% • BetaBeta: in the range of 0.65 to 0.85 range for cost of capital calculations, in line with industry averages. Average = 0.75.
  • 55.
    55 Cost of EquityAssumptions
  • 56.
    56 Cost of EquityAssumptions •Market risk premium = expected market return - risk-free rate. •Determine the "risk-free" rate of return. Treasuries are considered to be risk free as they are backed by the "full faith and credit" of the U.S. government. For this reason, we can use them as a proxy for the risk-free rate.
  • 57.
    57 Cost of EquityAssumptions •Determine the expected return of the market. According to Ibbotson Associates, the S&P has returned an average of 10.3 percent a year, compounded, since 1926 (CNN, 2008). This is a good proxy for expected return of the market. •The market risk premium equals the average expected return from the market minus the risk free rate. The risk premium = 6.5 percent.
  • 58.
    58 Cost of EquityAssumptions • Market risk premiumMarket risk premium: ranges from 5.5% to 7.5% for cost of capital calculations: call it +6.5% Cost of equity = Risk free rate + Beta * Market risk premium 10.5% = 5.5% 0.75+ 6.5%* Cost of equity = Risk free rate + Beta * Market risk premium
  • 59.
    59 Equity Risk ProfileConcept No risk investment Government T-Bill Inflation risk Government Bond Equity market risk (Beta = 1.0) S&P 500 Clorox Risk Type Example Company specific risk (Beta = .75) Yield Curve Cost of Equity 4.0 1.5 6.5 -1.5 % Rate 4.0 5.5 12.0 10.5 % Rate Cumulative
  • 60.
    DCF Level 2:Bringing WACC together
  • 61.
    61 Capital Structure Market valueof debt = $3 Billion Total shares outstanding = 153MM Stock price = $65 Market value of equity = $9 B EquityEquityDebtDebt  Total capital = $12 billion  Debt : Total Capital Ratio = 22% Total CapitalTotal Capital
  • 62.
    62 Bringing it alltogether: WACC  Cost of Equity of 10.5%  Total Capital ratio equal to 78% Equity / 22% Debt  After Tax Cost of Debt of 3.1% 8.8%=10.5% 3.1%+ 22%*78%*
  • 63.
    63 Quick Quiz: Whatif….. WACC goes: Interest Rates go up Total Debt Goes up
  • 64.
    64 Quick Quiz: Whatif….. WACC goes: Interest Rates go up Up Total Debt Goes up Down
  • 65.
    How do variousfirms evaluate Projects, Or “What are various opening moves used by the Grand Masters?”
  • 66.
    1. Sicilian Defense 2.Caro-Kann Defense 3. Italian Game 4. Ruy Lopez 5. Queen’s Gambit 6. Co-Lo Gambit 7. Indian Defense 8. English Opening Chess Openings
  • 67.
    67 What Firms actuallyused as primary decision rule MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse Est. % Firms usingEst. % Firms using as primary ruleas primary rule Net Present Value $ The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows) Values greater than $0 indicate the amount of value added to the company. 20% Internal Rate of Return % The relative return a project generates over time compared to its cost Should be equal to or greater than hurdles to ensure adequate returns 50% Payback Period (using discounted cash flows) Years The amount of time it takes for a project to pay for itself given the cost of financing. Should be less than or equal to hurdles to ensure timely returns 20% Clorox uses some common approaches to evaluate individual value enhancing opportunities
  • 68.
    68 How does Cloroxevaluate opportunities? MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse Net Present Value $ The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows) Values greater than $0 indicate the amount of value added to the company. Internal Rate of Return % The relative return a project generates over time compared to its cost Should be equal to or greater than hurdles to ensure adequate returns Payback Period (using discounted cash flows) Years The amount of time it takes for a project to pay for itself given the cost of financing. Should be less than or equal to hurdles to ensure timely returns Clorox uses some common approaches to evaluate individual value enhancing opportunities
  • 69.
  • 70.
    70 What is thepayback period? Payback period is the number of years required to recover a project’s cost. It is also the answer to how long does it take to get the business’ money back? Project YearProject Year 00 11 22 33 44 55 66 77 Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000 (Multiplied by) Discount factor (10%) 1 .91 .83 .75 .68 .62 .56 .51 (Equals) Discounted Cash Flows -3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566 Cumulative Cash Flows (NPV) -3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728
  • 71.
  • 72.
    72 Internal Rate ofReturn Internal Rate of Return (IRR) is the discount rate at which NPV is $0.
  • 73.
  • 74.
    74 Recap Project evaluation isdone to help ensure that investors’ goals are being considered in go / no-go decisions NPV (DCF), IRR, and Payback period are measures used by Clorox to estimate a project’s ability to add value Only incremental cash flows are considered in the analysis WACC is used as the discount rate to calculate the present value
  • 75.
    75 Fundamentals – DecisionRules Revisited General Clorox Decision Rules NPVNPV – If NPV is negative, reject the project; otherwise, further consideration is required. IRRIRR – If IRR is less than the cost of capital, reject the project; otherwise, further consideration is required. PaybackPayback – Generally, the shorter the payback period the less risky the project.
  • 76.
    76 The cash flowanalysis should be from 3 to 10 years depending on the project gear: Rapid Response: 3 year Core Growth: 5 year Game Changer: 10 year Perpetuity Cash Flow/NPV: Primarily calculated for Acquisitions where value is realized over a longer period of time Not recommended for new products since sustainability of product is hard to predict past 10 years Clorox Guidelines
  • 77.
    77 Case Study ResultsComparison ResultResult DecisionDecision RuleRule RecommendatiRecommendati onon Net Present Value $4,728 >$0 Internal Rate of Return 26% >10% Payback Period 6 years <4 years
  • 78.
  • 79.
    79 Shortcomings / Watchouts “DiscountedCash Flow models are powerful, but they do have shortcomings. DCF is a mechanical valuation tool, which makes it subject to the axiom “garbage in, garbage out”. Small changes in inputs can result in large change in the value.” - Wikipedia 8/31/2011
  • 80.
    80 Shortcomings / Watchouts “RealEstate: straight line assumptions about income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually lasts less than ten years.” - Wikipedia 8/31/2011
  • 81.
    81 DCF: Level 3 MonteCarlo simulators
  • 82.
    82 Net Present Value:in reality, is a range of outcomes….
  • 83.
    83 Furthermore, the rangeof NPV’s associated with different projects is different depending on factors such as whether it’s a new category or an existing category….
  • 84.
    84 Tips  Retrospective analysis:Retrospectiveanalysis: looks at the financial impacts after the project has been implemented • It can be used to confirm benefits realization • To identify opportunities to improve estimates for future analyses
  • 85.
  • 86.
  • 87.
  • 88.
  • 89.
    89 Appendix - Comparisonof Internal & External WACC Estimates Morgan Stanley Historical FY04 Current Jan 03 Apr-04 Apr-05 Jan-04 Apr-05 Apr-05 Apr-05 Risk Free Rate (1) 6.0% 6.0% 5.5% 4.9% 5.3% 4.7% 4.1% 4.5% 4.3% 4.5% Clorox Beta (2) 0.95 0.75 0.75 0.69 0.75 0.75 0.72 0.62 0.64 0.9 Market Premium 5.0% 6.5% 6.5% 6.5% 6.5% 6.5% 6.0% 6.0% 4.0% 4.5% Cost of Equity 10.8% 10.9% 10.4% 9.4% 10.2% 9.6% 8.4% 8.2% 6.9% 8.5% After Tax Cost of Debt 4.0% 2.1% 2.8% 3.0% 3.1% 3.1% 3.0% 3.3% 3.4% 2.9% Debt/ Total Capital 10% 10% 25% 11% 10% 21% 10% 21% 20% 21% Cost of Capital 10.1% 10.0% 8.5% 8.7% 9.4% 8.2% 7.9% 7.2% 6.2% 7.3% Notes: (1) Clorox & Citigroup use forecasted 30 year treasuries while the other bamks use current 10 year treasuries (2) JP Morgan uses a judgement beta of 0.9. JP Morgan also calculated WACC using a market derived capital pricing model (MCPM) to calculate cost of equity. Using this methodology, JP Morgan calculated WACC to be 7.3-7.9% JP MorganClorox Citigroup Goldman
  • 90.
    90 Appendix - WACCEstimates Summary 5.5% 6.5% 7.5% 5.5% 6.5% 7.5% Risk Free Rate = 4.5% Beta = 0.65 8.1% 8.7% 9.4% 7.0% 7.5% 8.0% Beta = 0.75 8.6% 9.4% 10.1% 7.4% 8.0% 8.6% Beta = 0.85 9.2% 10.0% 10.9% 7.8% 8.5% 9.2% Risk Free Rate = 5.5% Beta = 0.65 9.1% 9.7% 10.4% 7.8% 8.3% 8.8% Beta = 0.75 9.6% 10.4% 11.1% 8.2% 8.8% 9.4% Beta = 0.85 10.2% 11.0% 11.9% 8.6% 9.3% 9.9% Risk Free Rate = 6.5% Beta = 0.65 10.1% 10.7% 11.4% 8.5% 9.0% 9.5% Beta = 0.75 10.6% 11.4% 12.1% 9.0% 9.5% 10.1% Beta = 0.85 11.2% 12.0% 12.9% 9.4% 10.1% 10.7% Equity Market Risk Premium Equity Market Risk Premium Cost of Equity WACC
  • 91.
    91 Appendix – ContinuousCompounding Continuous Compounding Factor:  A method of discounting which recognizes ongoing cash flows as they occur not at the end of the period  Discount Rate = .09 = 1.044 ln (1 + Disc Rate) ln(1+.09)
  • 92.
    92 Perpetuity Cash Flow/NPV Primarily calculated for Acquisitions where value is realized over a longer period of time  Not recommended for new products since sustainability of product is hard to predict past 10 years Calculation: PV of Perpetuity = CFn+1 /(WACC-g); where G is the constant growth rate Useful when valuing equity, where CFn+1 is replaced with Dividends estimate for next year Appendix – Perpetuity
  • 93.
    93 Quick Question: BudgetConstraints ProjectProject NetNet FlowsFlows Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 Year 4Year 4 Year 5Year 5 TotalTotal New packaging in US -30 -20 80 -40 -30 100 60 Product expansion in Asia -125 25 35 50 55 60 100 Outsourcin g production -500 -250 150 150 150 150 150 Acquisition in Latin America -250 -50 50 100 125 125 100 How would a manager provide a recommendation if there were only enough budget to fund two of the four projects below?