Finamce

1. SESSION 1
CAPITAL BUDGETING:
• CORPORATE CAPITAL BUDGETING DECISIONS
• CAPITAL BUDGETING TECHNIQUES
• COMPARISON
• PITFALLS
• CASH FLOWS
MBA FT
February to March 2019
1

2. Time value of
Money
Tools Operating
Activities
Profitability
Analysis
Financing
Activities
Capital Structure
& Cost of Capital
Access to Investors
Capital Markets
2
Framework
CAPEX
M&A
Investments
Activities
Enterprise Value
Valuation
Methods
Tools

3. 3
Assets
Liabilities
Equity
Book Value
EV
Debt
Marketcap
Market Value
Enterprise Value

4. 4
How to calculate EV
How to calculate EV?
1. Market Value:
Market capitalization + Net Debt
2. Intrinsic or Fundamental Value:
Multiple Method: EBITDA x Multiple
DCF Method: Present Value of future Cash-Flows

5. 5
Marketcap Equity BV MV/BV
Amazon 840.4 bn $ 27.7 30.3
Walmart 278.4 bn $ 77.9 3.6
Carrefour 13.4 bn € 10.1 1.3
Tesla 52.7 bn $ 4.2 12.5
VW 75.2 bn 114.3 0.65
Examples

6. 6
INVESTMENTS: CAPITAL BUDGETING DECISION
1. Should we launch a new product?
Cannibalization. 2/3 the sales of Gillette’s Sensor razor:
consumers who would otherwise buy the company’s other razors.
2. Should we buy out another company?
 Buying growth from outside, rather than generating it organically,
may be the easiest option.
 Financial services (consolidation as a result of choice, not
necessity); Retailing and food manufacturing (costs cuts allow them
to invest cash in acquisitions to boost growth).
3. Should we use a new technology?
 Competitive pressure:

7. 7
PHYSICAL: In projects:
• Expansion
• Innovation
• Replacement
• Strategic
FINANCIAL: Rights and liabilities
TYPES OF INVESTMENT

8. 8
• CASH FLOW: We are interested in the “money”
generated, not the accounting profit, usually
affected by:
– Depreciation & Amortization (D&A)
– Goodwill
– Provisions
– Periodifications
– etc
• DISCOUNT RATE
Opportunity cost
FIGURES OF MERIT
“Cash is King”

9. 9
CAPITAL BUDGETING TECHNIQUES
Most popular:
Net Present Value (NPV)
Alternative techniques:
Payback period.
Internal Rate of Return (IRR)

10. 10
• Investment is worth undertaking if benefits > costs
• NPV = Present Value of all benefits – Present Value of all costs
• If NPV > 0
• Then Benefits > Costs
• Decision: “Accept the Project”
• Implication: Increase Firm Value
NET PRESENT VALUE (NPV): BASIC IDEA

11. 11
THREE POINTS TO REMEMBER ABOUT NPV
(1) NPV recognizes that
a dollar today is worth more than a dollar tomorrow,
because the dollar today can be invested to start earning
interest immediately.
(2) NPV depends solely
on the forecasted cash flows from the project and the
opportunity cost of capital
(i.e., more accurate as compared to others).
(3) Because present values are all measured in today’s dollars,
you can add them up.
(Note: Additivity properties: Adding up NPV of different
projects).

12. 12
A corporation which maximizes shareholder value should
undertake all investments with NPV > 0
Capital Budgeting: the search for projects with positive NPV
NPV AND THE GOALS OF THE CORPORATION

13. 13
• Step 1: Plot cash flows in a timeline.
• Step 2: Move all cash flows to the same point
(discount all cash flows).
• Step 3: Sum the discounted cash flows at this point, today.
CALCULATING NPV: Three steps

14. 14
• CF = net cash receipt at the end of year t
• I = original investment
• r = discount rate / required minimum rate of return on investment
• n = number of periods
NPV rule:
– If NPV is positive (+): accept the project
– If NPV is negative(-): reject the project
     n
n
r
CF
r
CF
r
CF
I
NPV









1
...
1
1
2
2
1
1
0
NET PRESENT VALUE (NPV): FORMULA

15. 15
Payback Period
Length of time until the accumulated cash flows equal or
exceed the original investment;
Payback Rule: “Quicker is Better”
Accept if payback is less than some pre-specified number of
years;
Limitation: Payback used on its own is inconsistent with
maximization of shareholder value.
PAYBACK

16. 16
PAYBACK: EXAMPLE
Three projects: A, B, C
Initial investment
of 2,000
Opportunity
cost of 10%
Cash inflow
for three years
Source: B&M, Chapter 5

17. 17
PAYBACK: EXAMPLE
Three projects: A, B, C
• Summary:
The NVP rule: accept project A and C but reject project B. Payback
(cut-off rule: 2 year):
• Misleading answers:
Payback (a) ignores all cash flows after the cutoff date, and (b)
gives equal weight to all cash flows before the cutoff date.
• Major problem: when applied regardless of the project life.
• Partial solution: discounted payback.

18. 18
INTERNAL RATE OF RETURN (IRR)
• Relation between NPV and IRR
Discount rate that makes NPV=0 if the rate of return.
• No wholly satisfactory way of defining the true rate of return of a
long-lived asset: discounted cash- flow (DCF) rate of return or
internal rate of return (IRR).

19. 19
IRR Rule:
If IRR > required rate : accept the project
If IRR < required rate: reject the project
INTERNAL RATE OF RETURN (IRR)

20. 20

0  10
5
1 IRR
 

5
1 IRR
 
2

5
1 IRR
 
3
IRR = 23%
We need calculator or spreadsheet to solve this problem.
Do we accept the project?
- What else do we need to know?
INTERNAL RATE OF RETURN: EXAMPLE

21. 21
0 3% 5% 8% 10% 13% 15% 18% 20% 23% 25% 28% 30%
-2.00 €
-1.00 €
0.00 €
1.00 €
2.00 €
3.00 €
4.00 €
5.00 €
6.00 €
5.00 €
4.14 €
3.62 €
2.89 €
2.43 €
1.81 €
1.42 €
0.87 €
0.53 €
0.06 €
-0.24 €
-0.66 €
-0.92 €
Discount rate
NPV
NPV and IRR

22. 22
• CASH FLOW: We are interested in the “money”
generated, not the accounting profit, usually
affected by:
– Depreciation & Amortization (D&A)
– Goodwill
– Provisions
– Periodifications
– etc
• DISCOUNT RATE
Risk adjusted Return (cost of capital topic)
FIGURES OF MERIT
“Cash is King”

23. 23
CASH FLOWS (CF)
• Cash vs earnings
• “money coming in or going out”
LIQUID
RELEVANT
• The CFs that vary when a project is made
• Remember incremental CFs
• Expected problems :
– Cannibalisation
– Sunk costs
– Opportunity costs
– ….
Two main characteristics:

24. Sales
-Costs with payment
=EBITDA
- D&A
EBIT
- Tax
=EBIAT
24
HOW TO ESTIMATE FREE CASH FLOW (FCF)
We begin with
EBITDA and we
deduct investment
in both fixed capital
and current assets
from the operating
cash flow.
+D&A
=Operating CF
- FA Inv. (Capex)
- WC Inv. (WC)
Free Cash Flow (FCF)

25. 25
ACCOUNTING
Fixed
Assets
Current
Assets
Equity
Debt
Suppliers
(Account
Payables)
CORPORATE FINANCE
BALANCE TRANSFORMATION
Assets Liabilities
Fixed
Assets
WC
Equity
Debt
Assets Liabilities
Suppliers are transferred to assets deducting working capital
(WC) from current assets

26. 26
Stocks (-):
Customers (-)
Suppliers (+)
Working capital
Increase (WC
investment)
CALCULATING INVESTMENT IN WORKING CAPITAL
IN A GIVEN PERIOD
Let’s look at the increase (investment) in working capital accounts in
two periods :
NB. (-) means an investment for the company. (+) means that suppliers finance us
Year 1
COGS/360 x days in stock
Sales / 360 x collection days
COGS / 360 x payment days
Year 2
100
60
50
110
120
75
55
140
30

27. PROJECT CASH-FLOWS
• Only incremental cash flows are relevant
Assume that a company launched a new product which is going to
compete with an existing product and will possibly reduce its sales. In
determining the CFs associated with the proposed launch we need to
only consider the incremental sales brought to the company as a
whole.
• Expected problems:
• Sunk costs
• Opportunity costs
• Erosion and spillover effects
• Inflation
• Overhead costs
• Financing costs
• Depreciation
• Investment liquidation and taxes

28. • Ignore sunk costs: a sunk cost is a cashflow that must be incurred whether or
not the project is accepted.
• Remember opportunity costs: any cashflow that the firm gives up if it takes the
project.
• Project interactions: recognize project interactions and strategic issues in the
cashflow forecasts. Loss leaders, cannibalization of existing products
• Inflation: discount nominal values using nominal rates and real values using
real rates
• Incremental Overhead costs: only relevant to the project
• Financing costs are included in the discount rate, deducting them from CFs is
doublecounting them
PROJECT CASH-FLOWS

29. • Depreciation: is an accounting expense not a cashflow. But
there tax consequences (tax shield)
• Investment Liquidation: value at the end of the Project
• Tax consequences (capital gains or losses)
• Sale of equipment and WC
PROJECT CASH-FLOWS

30. COMPREHENSIVE EXAMPLE
• You are considering launching a new product. You estimate
you can sell 100,000 units every year during 4 years for the
price of $6 each, with variable costs of $3 for each item. Annual
fixed costs are $90,000. Purchase of equipment is $200,000 and
one time initial investment in WC is $30,000. Tax rate is 34%
• Calculate FOCF

31. CALCULATING FOCF
INCOME STATEMENT Year 0 Year 1 Year 2 Year 3 Year 4
Sales (100,000@ $6.00) 600,000.00 600,000.00 600,000.00 600,000.00
- Variable costs at $3.00 -300,000.00 -300,000.00 -300,000.00 -300,000.00
- Fixed costs of $90,000 -90,000.00 -90,000.00 -90,000.00 -90,000.00
EBITDA 210,000.00 210,000.00 210,000.00 210,000.00
- Depreciation -50,000.00 -50,000.00 -50,000.00 -50,000.00
EBIT 160,000.00 160,000.00 160,000.00 160,000.00
- Taxes -54,400.00 -54,400.00 -54,400.00 -54,400.00
EBIAT 105,600.00 105,600.00 105,600.00 105,600.00
FCF CALCULATION Year 1 Year 2 Year 3 Year 4
EBIAT 105,600.00 105,600.00 105,600.00 105,600.00
+ Depreciation 50,000.00 50,000.00 50,000.00 50,000.00
- CAPEX -200,000.00 0.00 0.00 0.00 0.00
- NWI -30,000.00 0.00 0.00 0.00 30,000.00
FOCF -230,000.00 155,600.00 155,600.00 155,600.00 185,600.00
Discount rate 10%
NPV ($) 283,721.47
IRR 58%

32. CALCULATING NPV AND IRR
Proposed solution:
INCOME STATEMENT Year 0 Year 1 Year 2 Year 3 Year 4
Sales (100,000@ $6.00) 600,000.00 600,000.00 600,000.00 600,000.00
- Variable costs at $3.00 -300,000.00 -300,000.00 -300,000.00 -300,000.00
- Fixed costs of $90,000 -90,000.00 -90,000.00 -90,000.00 -90,000.00
EBITDA 210,000.00 210,000.00 210,000.00 210,000.00
- Depreciation -50,000.00 -50,000.00 -50,000.00 -50,000.00
EBIT 160,000.00 160,000.00 160,000.00 160,000.00
- Taxes -54,400.00 -54,400.00 -54,400.00 -54,400.00
EBIAT 105,600.00 105,600.00 105,600.00 105,600.00
FCF CALCULATION Year 1 Year 2 Year 3 Year 4
EBIAT 105,600.00 105,600.00 105,600.00 105,600.00
+ Depreciation 50,000.00 50,000.00 50,000.00 50,000.00
- CAPEX -200,000.00 0.00 0.00 0.00 0.00
- NWI -30,000.00 0.00 0.00 0.00 30,000.00
FOCF -230,000.00 155,600.00 155,600.00 155,600.00 185,600.00
Discount rate 10%
NPV ($) 283,721.47
IRR 58%