Financial Management
8. Corporate Valuation and Value-Based
Management.
9. Capital budgeting. Risks Analysis.
Liliya N. Zhilina, World Economy and Inrernational
Relations Department, Vladivostok State University of
Economic and Services (VSUES).
liliya.zhilina@vvsu.ru
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

VOp  
t 1
FCFt
t
(1  WACC)
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 flow
Forecast
2001
2002
1. Net operating working capital (NOWC)
2. Net fix capital
3. Total operational capital (TOC)
4. Investments to TOC (Invest.)
5. Net operational profit after tax(NOPAT)
6. Free cash flow (FCF = NOPAT - Invest.)
Step 2. Value of operations
Long-term growth rate, g (from 2004)
WACC
FCF
2003
2004
$800 $839 $769 $702
$1 000 $1 100 $1 188 $1 271
$1 800 $1 939 $1 957 $1 973
$345 $139
$17
$16
$170 $211 $228 $244
-$175
$72 $211 $228
2001
Forecast
2002 2003 2004
5%
11,0
%
$72
$211
$228
Calculation of value of operations
0 k =11%
c
1
2
3
4
g = 5%
FCF=
72
211
228
239
65
171
167
Vop at 3
2 928
3 330
=
Vop
239
 4 001.

0 .11  0.05
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
0
1
CFt
-100
Accumulated -100
CFt
PaybackL
= 2
2
10
-90
+
2.4
60 100
-30
0
30/80
3
80
50
= 2.375 years
PbP of a shot project
0
CFt
-100
Accumulated
-100
CFt
Paybacks
1.6 2
3
70 100 50
20
-30
40
1
0 20
= 1 + 30/50 = 1.6 year
Projects evaluation techniques
DCF methods because they explicitly
recognize the time value of money.
• Discounted Payback Period (DPbP).
• Net Present Value (NPV).
• Profitability Index (PI).
• Internal Rate of Return (IRR).
• Modified Internal Rate of Return (MIRR).
Discounted Payback Period (DPbP)
0
CFt
-100
PVCFt
-100
Accumulated
-100
PVCFt
DPbP
= 2
10%
1
2
3
10
60
80
9.09
49.59
60.11
-90.91
-41.32
18.79
+ 41.32/60.11 = 2.7 years
Net Present Value (NPV)
NPV is a direct measure of the value of the
project to shareholders.
NPV: Sum of present (discounted) values of
cash inflows and outflows
n
CFt
NPV  
.
t
t  0 1  k 
Investment costs – negative cash flow in a
zero period – CF0
n
CFt
NPV  
 CF0 .
t
t 1 1  k 
NPV of projects L (long) and S (short)
0
10%
-100.00
9.09
72.73
1
2
10
80
60
60
49.59
49.59
60.11
7.51
18.78 = NPVL
NPVS = $29.83
3
80 L
10 S
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.
I0
- investment in the 0-period, I0 = 100
PI L = 118,78/100 = 1,19
PI S = 129,98/100 = 1,20
Internal Rate of Return, IRR
The discount rate that equates the present
value of the expected future cash inflows and
outflows.
0
CF0
Costs
1
CF1
2
CF2
Cash Inflows
3
CF3
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
0
IRR = ? 1
-100.00
PV1
10
80
2
60
60
3
80 L
10
PV2
PV3
0 = NPV
IRRL = 18,1 %
IRRS = 31,4 %
S
Decision by IRR on S and L projects
WACC = 10%
• 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 (IRRS > IRRL).
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
k < 8.7: NPVL> NPVS , IRRS > IRRL
NPV
60
k > 8.7: NPVS> NPVL , IRRS > IRRL
50
40
30
20
IRRS
10
0
-10
-20
0%
5%
8.7%
10%
15%
18.13% 23.56
20%
%25%
IRR
L
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 of project L (i = 10%)
0
10%
-100.0
1
2
3
10.0
60.0
80.0
10%
10%
-100.0
MIRR = 16.5%
$100 =
PV of outflows
$158.1
(1+MIRR)3
MIRR = 16.5%
66.0
12.1
158.1
TV of inflows
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.
Cash Flow Estimation and Risk
Analysis
• Relevant cash flows
• Working capital treatment
• Inflation
• Risk Analysis: Sensitivity Analysis,
Scenario Analysis, and Simulation
Analysis
Set up without numbers a time line
for the project CFs.
0
1
2
3
4
Initial
Outlay
OCF1
OCF2
OCF3
OCF4
NCF0
NCF1
+ Terminal
CF
NCF2
NCF3
NCF4
Incremental Cash Flow
= Corporate cash flow
with project
minus
Corporate cash flow
without project
Suppose $100,000 had been spent last
year to improve the production line site.
Should this cost be included in the
analysis?
• No. This is a sunk cost. Focus on
incremental investment and
operating cash flows.
Suppose the plant space could be leased
out for $25,000 a year. Would this affect
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.
If the new product line would decrease
sales of the firm’s other products by
$50,000 per 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.
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.
Real vs. Nominal Cash flows
• 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.
Risk in capital budgeting
• 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.
Sensitivity analysis
• 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%?”
Illustration
Change from
Resulting NPV (000s)
Base Level Unit Sales Salvage
k
-30%
$ 10
$78
$105
-20
35
80
97
-10
58
81
89
0
82
82
82
+10
105
83
74
+20
129
84
67
+30
153
85
61
NPV
(000s)
Unit Sales
Salvage
82
k
-30
-20
-10 Base 10
Value
20
30
Results of Sensitivity Analysis
• 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.
Weaknesses 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.
Why is sensitivity analysis useful?
• Gives some idea of stand-alone
risk.
• Identifies dangerous variables.
• Gives some breakeven
information.
Scenario analysis
• Examines several possible
situations, usually worst case,
most likely case, and best case.
• Provides a range of possible
outcomes.
Scenario analysis
Probability, p
25%
50%
25%
Scenarios
Best
Base
Worst
Scenarios
Best
Base
Worst
Probability, p
25%
50%
25%
Price
3,5
3
2,5
Sales
25000
20000
16000
Variables Cost
1,6
2,1
2,6
Expected NPV
Standard deviation
Variation Coefficient
Net Cash Flow
2011
2012
2013 2014
-27000 24991
27716 30435
-24800
7493
8612 9577
-23200 -4120,427 -4068 -4267
NPV
83383
13285
-33210
19186
41642
2,17
NPV NPV x p
2015 2016
33768 51213 83 383 20846
10995 22936 13 285 6643
-4119 3953 -33 210 -8302
19186
Probability
50%
25%
NPV
0
-33 210
Most probable
13 285
83 383
Average Density
Are there any problems with
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.
Simulation 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.
Distribution models for a project variables in
Monte Carlo simulation
Probability Density (NPV)
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0
E(NPV)
NPV
Also gives NPV, CVNPV, probability
of NPV > 0.
Advantages of simulation analysis
• Reflects the probability distributions
of each input.
• Shows range of NPVs, the expected
NPV, NPV, and CVNPV.
• Gives an intuitive graph of the risk
situation.
Disadvantages of simulation
• 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.