a guide to capital budgeting and need for valuation
DESCRIPTION
How a finance manager takes investment and financing decision and why and under what circumstances valuation of business in necessary is described in this presentation. This presentation was made during my MBA program in GermanyTRANSCRIPT
By
Arpit amarCorporate Finance – 2011Georg Simon Ohm University of applied Science, Nuremberg
Introduction
Finance manager
Takes two decision
Investment or capital budgeting
decision
Where to invest or purchase of real assets
Financing decision
How to raise money or sale of financial
assets
Investment decision
Finance manager
Explores good investment
projects
Analyse NPV (net present
value)
The difference between Projects value and its cost
Takes opportunity cost
of capital as discount rate
Assumes all cost of financing is
equity financed
And calculates NPV
Financing decision
When Investment project is financed with equity capital as well as debt capital
Then this will represent the capital structure of the firm
Equity capital requires return to be paid to
shareholders or investors
The return should be more then the
opportunity cost of capital
Debt capital requires fixed interest to be paid
to the creditors
Interest is tax-deductible expense, so we calculate
after tax cost of debt
The weighted average of cost of debt and cost of equity taken together is called weighted average of capital
(WACC)
WACCAnalyse the cost of raising the equity and debt
capital
Takes the weighted average of cost
And value’s project
WACC = Rd( 1-Tc) D/V + RE E/V
Rd = cost of debtRe = cost of equity
D= market value of debtE= market value of equity
Tc = corporate tax rate
The formula of WACC works for average projects, where business risk from equity and debt ratio
remains constant
The managers use WACC to discount future cash flows but when equity and debt ratios are expected to change , then WACC may not give exact results
Calculating Sangria’s WACCSangria is a U.S.-based company whose products aim to promote happy ,
low stress lifestyles. The book value and market value are :
Assetsvalue
$1000 $500 Debt
$500 Equity
$1000 $1000
Assetsvalue
$1250 $500 Debt
$750 Equity
$1000 $1250
Book values , $million
Market values , $million
In book value : the value of debt and equity are equal
In market values : the value of debt remains same and value of equity changes from $ 500
to $750
The given cost of debt is 6%.This represent interest
paid on existing and on new borrowing debt
The given cost of equity is 12.4%.
This represent the expected rate of return demanded by investors
Sangria’s WACC
Taking market values for the calculation of
debt and equity ratios
Debt ratio = 500/1250 = .4
Equity ratio = 750/1250 = .6
The market share price changes from $5 to $7.5.This is the current market price and when it is multiplied by number of its outstanding
shares , then it increases the equity capital and changes equity ratio in overall capital structure. Sangria is constantly profitable and pays taxes
at the marginal rate of 35%
Therefore:Cost of debt (rd) = .06
Cost of equity (re)=0.124
Marginal tax rate (Tc) = .35
Debt ratio (d/v) = .4Equity ratio (e/v) = .6
The company’s after- tax WACC is:
WACC= .06*(1-.35)*.4 +.124*.6 =.090
OR 9%
Using Sangria’s WAAC for the valuation of project
Suppose there is an investment in the firm of $12.5 million in perpetual crushing machine. The machine never depreciates and generates a cash flow of $1.731 million
per year pre-tax. And overall the project is average risk
If the risk involved in project is average then we use WACC as a discount rate
that is 9%
Pre tax cash flow = $1.731 millionTax at 35% of $1.731 million = .606
After tax cash flow (c) = $1.125 million
NPV= -12.5 + 1.125 / .09NPV = 0
NPV= Initial investment + cash flow / discount rate of WACC
When NPV is zero then the project is barely acceptable as an investment.This states that return from investing $12.5 million in project generates the cash flow of $1.125 million which is equals to Sangria’s WACC OF 9%. That is: cash flow / investment =1.125/12.5*100 =9% Therefore return on investment is equal to cost
Assumptions about WACC
•When NPV is zero then project is barely acceptable stating that the cost of capital and return from investment are equal
•Pre tax cash flows are converted into after tax cash flows as if the project were all equity financed.
•The project cash flow’s are then discounted by WACC in order to capture the effect from tax shield
•When business risk and debt ratios are not constant or expected change ,then use of WACC is not exactly correct.
•The formula works for average projects where business risk and debt ratios are expected to be constant
•WACC formula uses after tax cost of debt thereby capturing the value of interest shield
WACC and financial crisisCost of capital assumes risk free rate of return but in practice its not risk
free
Cost of equity capital
Return investors expects
Cost of debt capital
Interest to be paid by company
High cost of equity capital makes it compulsory for
company to pay risk premium rate of return which has to
be more than its beta
High Cost of debt capital creates inflation , increase investors expectations to cover this inflation rate
Incapacity to pay back huge debt may lead to defaults and
so credit institution will not lend more money, investors
loose faith and may invest in government bonds, there will
be refinancing problems
Need to analyse good investment projects.
Zero NPV or low NPV projects may not be able pay high returns to shareholders.Share price and valuation of company may get affected
Valuing Businesses
When valuing a business as a whole is necessary:
• Mergers & Acquisition• Selling of a business unit• Going Public
WACC can be used to value businesses that are financed by debt & equity
Assumption: constant debt ratio
Present Value (free cash flow) Present value (horizon value)
Valuing Businesses
Example: Valuing Rio Corporation
Input data:• Rio Corporation is a similar corporation like Sangria• Same line of business like Sangria (Assumption: same proportion of debt like
Sangria)
Sangria's WACC can be used – 9%
Goal: Calculating the present value of Rio Corporation
Steps to do:1. Calculation of free cash flows (FCF)2. Estimating horizon value3. Calculation of present value
Valuing Businesses
Latest year0 1 2 3 4 5 6 7
1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.72 Cost of goods sold 63.1 66.2 71.3 76.3 79.9 83.1 87 90.23 EBITDA (1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.54 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.15 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.46 Tax 6 4.7 4.8 5.2 5.2 5.4 5.4 5.47 Profit after tax (5-6) 11.2 8.7 9 9.6 9.7 10 10.1 108 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 16.2 15.99 Investment in working capital 1 0.5 0.8 0.9 0.5 0.6 0.6 0.4
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 20.3 113.4 (Horizon value in year 6)PV Horizon value 67.6PV of company 87.9
Forecast
Example: Valuing Rio Corporation
Valuing Businesses
Example: Valuing Rio Corporation
Valuing BusinessesExample: Valuing Rio Corporation
Determination of free cash flows:
FCF = profit after tax + depreciation – investment in fixed assets – - investment in working capital
FCF1= 8,7 + 9,9 – (109,6 - 95,0) – (11,6 -11,1) = 3,5 (million $)FCF2 = …
Calculation of PV (FCF)
3.20
1.09
0.6
1.09
1.6
1.09
9.5
1.09
4.3
1.09
2.3
1.09
3.5PV(FCF) 65432
Valuing Businesses
Example: Valuing Rio Corporation
Determination of horizon value:
•Long run growth rate: 3%
6.67$4.113
1.09
1 value)PV(horizon
4.11303.09.
8.6PV ValueHorizon
6
1H
gwacc
FCFH
million $87.9
6.673.02
value)PV(horizonPV(FCF)s)PV(busines
Value of equity = PV(business) – value of debt = 87,9 – 36,0 = $51,9 million
Valuing BusinessesTricks of the Trade
More than two sources of financing:
EPD r
V
Er
V
Pr
V
DTcWACC )1(
Valuing BusinessesTricks of the Trade
What about short term debt?
• Leaving short term debt out of calculation is an error• No serious error if debt is only temporary or compensated by holdings of cash
and marketable securities
What about other current liabilities?
• Usually "netted out" (Net working capital = current assets – current liabilities)• Net working capital is entered on the left hand side of balance sheet
Valuing BusinessesTricks of the Trade
How are the costs of financing calculated?
• Interrest rate for equity can be retrieved by looking at the stock market (typical demand by investors)
• Getting borrowing rate and D/V and E/V is not difficult• Convertible, junk debt,
Valuing BusinessesImpact of the Euro Crisis on valuing businesses
• Inflation leads to increasing interest rates• WACC is increasing with increasing interest rates
•Present value decreases with increasing WACC
•Key interest rate may increase higher interest rates (like mentioned above)•Influence of rating agencies•Influence of currency exchange rates Increase / decrease of FCF
EPD r
V
Er
V
Pr
V
DTcWACC )1(
APV -Adjusted present value
APV = Base Case NPV + sum of PV Impact
Base Case = All equity finance firm NPV PV Impact = all costs/benefits directly resulting from project
PV impact : Interest rate tax shields (plus) Issuing cost of securities ( minus) Financing packages subsidized ( plus)
Estimating the firm or project base case value assuming it is all equity financed and then adjust this base case value to account for the financing side effects .
APV- Base case Example : Sangria Perpetual crusher project
Cost of capital r = 9.84% Investment = $ 12.5 million Project cash flow = $ 1.125 million (perpetual).
Base –case NPV= -12.5 + 1.125 = -$1.067 million .0984Project is not worthwhile with all equity financing.
APV-PV (interest tax shield)Condition I The project support with debt of $ 5 million 6% borrowing rate rD =.06
35 % tax rate ( Tc=.35)
Annual tax shield = .35 X.06 X 5 = .0105 or $ 105,000.
Tax shields are constantly rebalanced with debt and with discount rate r =9.84% PV ( interest tax shields, debt rebalanced) = $ 105, 000 = $ 1.067 million .0984APV = sum of base –case value and PV( interest tax shield)APV = -1.067 million + 1.067 million = 0
APV-PV (interest tax shield)Condition IISuppose sangria plans to keep project debt fixed at $5 million The risk of tax shield is the same of the risk o the debt and we discount at the
rate of 6% rate on debt.PV( tax shields, debt fixed) = – 105,000 = $ 1.75 million. .06APV = -1.067 + 1.75 =$ .683 millionNow the project is more attractive with fixed debt , the interest tax shields
are safe and therefore worth more .( if perpetual crusher project fails , the $ 5 million of fixed debt may end up as a burden on sangria’s other asset)
APV -Other financial side effects Suppose finance by issuing debt and equity $ 7.5 million equity with issue cost of 7% = $ 525.000 $ 5 million of debt issue cost of 2% = $ 100,000 Assume debt s fixed once is issued and tax shield worth $1.75 million
APV = -1.067+ 1.75- 0.525 -0.100 = 0.58 million
Note : other financial side affects Leasing ( plus) with base case NPV subsidies loan from government ( plus)
APV for business
Latest year0 1 2 3 4 5 6 7
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6 horizon value 6 year 113.4Base-case PV of company 84.3
Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97
PV Interest tax shields 5
APV 89.3
Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%
After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79
ForecastLatest year
0 1 2 3 4 5 6 7
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6 6.8
PV Free cash flow, years 1-6 19.7Pv Horizon value 64.6 horizon value 6 year 113.4Base-case PV of company 84.3
Debt 51 50 49 48 47 46 453.06 3 2.94 2.88 2.82 2.761.07 1.05 1.03 1.01 0.99 0.97
PV Interest tax shields 5
APV 89.3
Tax rate, percent 35%Opportunity cost of capital 9.84%WACC (To discount horizon value to year 6) 9%Lomg term growth forecast 3%Interest rate (years 1-6) 6%
After tax debt service 2.99 2.95 2.91 2.87 2.83 2.79
Forecast
Rio corporation APV valuation
APV for business
Opportunity cost of capital= 9.84%APV = base –case NPV + PV ( interest tax shields)If the debt levels are taken as fixed and tax shield discounted by 6% borrowing
rate
=$ 84.3 + 5.0 = $ 89.3 million. There is an increase of $1.4 million from NPV , this increase is higher early debt
levels. APV explore financial strategies with out looking the fixed debt ratio or having
to calculate the WACC for every scenario. APV useful when debt for a project is tied to book value or has to repaid on
fixed schedule. Leverage buyouts( LBO) – generating cash by selling assets , shaving cost and
improving profit margins APV works fine for LBOs but for WACC can’t use the discount rate to evaluate
an LBOs because its debt ratio will not be constant.
APV for international investments Custom tailored project financing, special contracts with suppliers,
customers and governments. When debt ratio will not be constant , turn to APV Example1- In project ,if the competing supplier offers low interest rate project loans
or lease of the plant in their bids, then NPVs of this loans or lease should be included in project analysis
2- A manufacture agrees a guarantee to provide in minimum price this value is also addition to project APV –if the market price varies
3- if the government impose cost or restriction such as the investors should park their part of incoming money in non interest bearing accounts e.g 2 years, then this period calculate the cost of this requirement and subtract it from APV.
Thank you