Valuation and Capital Budgeting

Part I Capital Budgeting

M. Lambert

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

Guidelines for an investment project or a firm valuation

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

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Guidelines for an investment project or a firm valuation

1. Cash flow forecasts

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

Cash flow forecasts

Creating pro-forma forecasts of financial statements - Cash flow forecasts are usually derived from forecasts of financial statements - Forecasts should be made about the income statement, cash flow statement and the balance sheet assets and liabilities

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

Cash flow forecasts

Creating pro-forma forecasts of financial statements Sales forecast - The sale forecast will drive forecasts over many other items on the income statement and the balance sheet - Trends based on past performance, firms plans for future products, competitive position of the firm, general trends affecting the industry (ex. attraction of substitute product)
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Cash flow forecasts

Creating pro-forma forecasts of financial statements Financing forecasts - The firms decisions on financing will have a major effect on the financial statement: the net amounts of debt and equity that the firm will issue are major assumptions Interest rate forecasts - The interest rate forecast should reflect the average interest rate that you expect the firm to be paying on its indebtedness during the forecast period
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Cash flow forecasts

Creating pro-forma forecasts of financial statements Expense forecasts - Fixed costs: more of the same approach - Variable costs: percentage of sales cost of good sold and the level of inventory are often direct function of sales percentage driven by past experience multiple scenario analysis
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Cash flow forecasts

Creating pro-forma forecasts income statement - EBIT: sales forecast cost of sales forecast - Interest: interest expense is a function of the expected future average interest rate and the expected future debt outstanding - Earnings/EBT: EBIT interest - Forecast of the tax rate
Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert 8

Cash flow forecasts

Creating pro-forma forecasts of cash flow statement Capital investment forecasts New PPE(net) = Old PPE + Capital investments Depreciation Sales of assets - If we assume that sales of assets are negligible, a reasonable assumption for a growing firm is Capital investments = (New PPE old PPE + Depreciation)
Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert 9

Cash flow forecasts

Creating pro-forma forecasts of cash flow statement Financing cash flow - Paying off debt represents a cash outflow and borrowing represents a cash inflow. For forecasting purposes you may wish to look at the net change in debt - Payment of dividends represents a cash outflow, sale of equity is an inflow, and buying equity back is an outflow
Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert 10

Cash flow forecasts

Creating pro-forma forecasts of balance sheet assets Cash - Many firms use a minimum of 15 to 30 days worth of sales around in cash and cash equivalents Trade receivable and inventories percentage of sales technique

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

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Cash flow forecasts

Creating pro-forma forecasts of balance sheet liabilities Current liabilities (trade and other payables, accrued expenses) percentage of sales technique Deferred taxes Since the bulk of deferred taxes arise from depreciation differences and since depreciation is tied to investment in PPE, it makes sense to forecast the deferred taxes as a function of your forecast of PPE
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Cash flow forecasts

Creating pro-forma forecasts of balance sheet assets Property, plant and equipment (PPE) Several methods 1. Direct method: forecast expenditures + old PPE estimate of next years depreciation expense and equipment sales 2. More of the same method: old PPE- depreciation expense for the coming year 3. Percentage of sales
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Guidelines for an investment project or a firm valuation

2. WACC approach and the beta comparable method

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WACC approach: guidelines

The Weighted Average Cost of Capital generates present value by (1) estimating a projects expected unlevered cash flows (2) valuing the expected cash flows in step 1 by discounting them at an appropriate risk-adjusted discount rate that varies with the degree of debt financing that can be attributed to the project

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WACC approach: guidelines

Risk-adjusted discount rate and asset risk - The weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firms new projects are in the same general risk class as its existing projects - If the project is not a small-scale representation of the firms asset and/or the firm is not traded, use the peer group method

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

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WACC approach: guidelines

Risk-adjusted discount rate and asset risk - The weighted average cost of capital is normally used as the risk-adjusted discount rate whenever a firms new projects are in the same general risk class as its existing projects - If the project is not a small-scale representation of the firms asset and/or the firm is not traded, use the peer group method

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

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Beta: Peer group approach

Peer group method and computing the cost of capital Stage 1 Collect financial data about a peer group of firms operating in the same business Stage 2 Compute their equity betas

Valuation and Capital Budgeting Part I, HEC-ULg 2013-2014 Marie Lambert

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Beta: Peer group approach

Peer group method and computing the cost of capital Stage 3 Correct their equity betas by first unlevering the equity betas and then relevering the betas for the appropriate D*/E* ratio of the project: (3.a) (3.b)

u =

E
[1 + (1 TC ) D / E ]

E = u [1 + (1 TC ) D * / E*]
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Beta: Peer group approach

Peer group method and computing the cost of capital Stage 4 Take the average or median equity betas values defined at stage 3 Stage 5 Plug the beta in the CAPM and determine the (levered) cost of equity Stage 6 Plug the cost of equity in the WACC formula and define the appropriate risk-adjusted discount rate for the project
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