Valuation Methods & Capital

Budgeting

• Payback/Discounted Payback
• IRR
• MIRR
• Benefit Cost Ratio (BCR)
• NPV (DCF)
– FCF: Free cash flow
– FTE: Flow to equity
– APV: Adjusted present value
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 Payback Rule

• Payback period: The amount of time it

takes to recover the original cost.

• Payback rule: If the calculated payback

period is less than or equal to some pre-
specified payback period, then accept the
project. Otherwise reject it.

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 The Payback Rule

$200 $420 $645 $855

Time
0 1 2 3 4

$-600

Payback period=2+((600-420)/225)=2.8 years

Accept because payback < 3 years 3
 Advantages and Disadvantages of
the Payback Rule
• Advantages
– Easy
– Biased toward liquidity
– Quick evaluation
– Adjusts long term cash flow uncertainty (by ignoring them)
• Disadvantages
– Ignores TVM
– Ignores cash flow beyond payback period
– Biased against long term projects
• Popular among many large companies
– Commonly used when the:
• capital investment is small
• merits of the project are obvious so more formal analysis is unnecessary
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 The Discounted Payback Rule
Accumulated discounted cash flows
200 220 225 210
(1 + 0.2)1 (1 + 0.2) 2 (1 + 0.2)3 (1 + 0.2) 4
166.67 319.44 449.65 550.93

Time
0 1 2 3 4

$-600

The project never pays back so reject.

What is the NPV? 5
 Discounted Payback Rule?
• Things to Consider
– Involves discounting
– How do you choose r?
– How do you choose the cut-off period?
• Advantages
– If project ever pays back then NPV>0
– Biased toward liquidity
– Easy
• Disadvantages
– May reject NPV>0 projects
– Cut-off period is arbitrary
– Biased against long term projects
• Bottom Line: Why not just use NPV? 6
 Benefit-Cost Ratio (BCR)

Pr esent Value of Cash Inflows

BCR =
Pr esent Value of Cash Outflows

Rato of discounted inflows to outflows.

Rule: Accept project if BCR greater than 1.

Use caution if using to compare mutually exclusive

projects.
Similar BCRs can have radically different NPV’s.
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 Internal Rate of Return (IRR) Rule
T CFt
NPV = ∑ t IRR is that r that makes the NPV=0
t = 0 (1 + r)

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 IRR Rule
• Accept the project if the IRR is greater than
the required rate of return. Otherwise, reject
the project.

• Comparison of NPV and IRR

– If cash flows are conventional and project is
independent, then NPV and IRR lead to same accept
and reject decisions.

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 IRR Rule and Unconventional
Cash Flows
• Unconventional cash flows: A negative cash
flow after a positive one.

• Strip Mining Project

• Year Cash Flows
• 0 -60
• 1 155
• 2 -100 10
 Problems with the IRR Rule
Unconventional cash flows lead to multiple IRR’s
25% and 33.33%
0.2 0.06
0
0
0
-0.2 0 10 20 30 40 50
-0.31
-0.4
-0.6 -0.28
-0.8
-1
-1.2
-1.4
-1.6
-1.8 -1.74
-2

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 Mutually Exclusive
• Taking one project means another is not taken
• The highest IRR may not have the highest NPV

• To evaluate we need to find the crossover rate

– Take the differences between the two projects cash
flows and compute the IRR for those incremental
flows

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 Mutually Exclusive Cash Flows
Period Proj. A Proj. B Incremental
(A - B)
0 -500 -400 -100

1 325 325 0

2 325 200 125

IRR 19.43 22.17 11.8

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 NPV Profiles of Mutually
Exclusive Projects
$150.00
$130.00
$110.00
$90.00
$70.00
Crossover Rate = 11.8
$50.00
$30.00 IRRB=22.17
$10.00
($10.00)
0 5 10 15 20 25
($30.00)
($50.00)
Project A Project B IRRA=19.43

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 Reinvestment Rate Assumption
• During the life of a project, what are the
investment assumptions of the intermediate
cash flows?
• Implicitly the PV oriented methods assume
that the cash flows can be reinvested at r.
• Is this reasonable?
– NPV
– IRR

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 Modified IRR (MIRR)
• Solves the PV (outflows ) = ∑
T
Ct
if Ct < 0
t = 0 (1 + r )
t
reinvestment rate
400
problem PV (outflows ) = 0
= 400
(1.12)
• Example: A project’s
cash flows are -400, T
FV (inf lows ) = ∑ Ct (1 + r )T −t if Ct > 0
325 and 200. t =0

FV (inf lows ) = 325(1 + 0.12) 2−1 + 200(1 + 0.12) 2− 2 = 564

Appropriate r is 12%
• Accept the project
1/ T
because 18.74%>12% PV =
FV  FV 
MIRR =  −1
(1 + MIRR)T 
 PV 
• Note: The IRR on 1/ 2
 564 
this project is 22.16% MIRR =  − 1 = 0.1874
 400 
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 Summary of IRR/MIRR
• Advantages: Easy to understand
– Conventional Cash Flows and Independent Projects:
• Same Decisions as NPV Rule
– Required Rate of Return Benchmark
• Often same discount rate in NPV
– MIRR has more realistic reinvestment rate (use instead of IRR if possible)
• Disadvantages:
– Unconventional cash flows may result multiple answers
– If projects are mutually exclusive may lead to incorrect decisions
– Not always easy to calculate
– Difficult to interpret (particularly if the project has multiple r’s)
– IRR may have unrealistic reinvestment rate
• Very Popular: People like to talk in terms of returns
– Survey of 100 largest Fortune 500 Ind.
• 99% use IRR Rule
• 85% use NPV Rule 17
 NPV(DCF) Valuation Methods
• FCF: All relevant cash flows excluding financing costs
discounted by the “whole firm” r (typically estimated
with WACC(adjusted for taxes))
• FTE: FCF minus payments to other finance sources
(typically debt holders) discounted by re
• APV: All relevant cash flow components separately
discounted by the appropriate r’s

• Note:
– re (e=equity) is the same as rS (S=stock)
– rd (d=debt) is the same as rB (B=bond) 18
 Compare Methods
• FCF
– Very strict assumptions of constant proportion capital structure (from
WACC)
– Can adjust r if risk or capital structure is different from existing firm
– Tax debt shield must be τcD (for WACC(adjusted))
• FTE
– Probability of payments to other finance sources, i.e. debt holders
• Option to default usually not considered so FTE value is usually low
– Difficult to extrapolate entire firm value
• APV
– Flexible and works well for changing capital structure
– Usually will need an estimate of unlevered r
• Potential for estimation error depending on NPV of financing

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 Relevant Cash Flows
•Incremental cash flows: Only the incremental portion
of any flow is relevant

•Otherwise known as the Stand-Alone Principle

•Project = "Mini-firm"
•Allows us to evaluate the investment project
separately from other activities of the firm
•Allows us to make optimal decisions with a
relatively simple process

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 Relevant Cash Flows?
•Sunk Costs
—No
•Opportunity Costs
—Yes
•Side Effects (Erosion)
—Yes
•Net Working Capital
—Yes
•Value of cash flow volatility change
—Yes
•Financing Costs
—No (there are some methods where this is relevant)
•Allocated Overhead Costs
―No

All Cash Flows should be after-tax cash flows 21

 How do we make reasonable cash flow estimates?
•Estimate them from scratch
•Pro forma financial statements
•Probably the best current estimate of future flows.
•Make sure you adjust the financial statements for the difference
between accounting flows and finance flows.
•Finance flows are based on the principle of opportunity
costs and the timing of the flows is based on when the
money is actually paid/received
•Accounting flows (as presented in financial statements) are
based on historical costs and the timing of the flows is
usually based on accrual (not cash) accounting
•Use statements to get the basic project cash flow
•Need an after tax terminal value
•Assume the project goes on forever and use a perpetuity
•Assume the project ends and the balance sheet is zeroed out
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(everything is sold and settled)
 Two Approaches
•Item by item Discounting: Separately forecast relevant flows then
discount them
•Very flexible: Can use different discount rates for each flow

•Whole Project Discounting: determine project’s relevant cash

flows, sum them in each year then discount the yearly sum
•FCF=OCF + Net Capital Spending - Changes in NWC
•Operating Cash Flows (OCF): EBIT+Depreciation+Other
Non-Cash Expenses-Taxes
•Net Capital Spending
•Project specific assets, initial costs
•After tax salvage value (if project ends)
•Changes in NWC
•NWC=CA-CL
•Changes in NWC = NWC(t)-NWC(t-1)
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•Recover all NWC at the end of the project (if project ends)
 Alternate Ways to Compute OCF
• GOAL: Make sure that all relevant cash inflows
and outflows are included (Holden shows several
of these methods)
• Bottom Up: OCF=Net Income + Non-cash
deductions
– CAUTION: This method only works if there are no
financing costs already taken out of net income!
• Top Down: OCF=Sales - Costs - Taxes
– Subtract all deductions except non-cash items
• Tax Shield: OCF=(Sales-Costs) x (1-tc) + (non-
cash deductions x tc)
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 Scenario Analysis
• WHAT IF?
• Estimate NPV with various assumptions
– Statistical distribution
– Best case, worst cast, most likely case

• Sensitivity analysis: Change in NPV due to

one or a few items

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 Capital Rationing
• NPV>0 then accept, is based on unlimited capital

• NPV is still the best criteria but we need to ration

• Profitability Index is NPV per investment dollar
• Order the projects by PI
– Choose projects until PI<0 or you run out of money

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 You have $500,000 to spend
Project Investment NPV PI

A 500,000 80,000 16%

B 200,000 45,000 22.5%

C 300,000 55,000 18.3%

D 250,000 50,000 20%

• Project B, $200,000
• Project D, $250,000
• Project C, $50,000 (partial investment)

• What if you can’t do partial investments? 27

 Evaluating projects
with different economic lives
• Assumptions
– Different lives
– The project can go on forever

• Equivalent Annual Cash (EAC) flows

EAC  1 
PV = 1 − (1 + r ) t 
r  
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 EAC Example
• Assume you need to EAC  1 
PV = 1 - 
r  (1 + r)t 
choose between two
production processes EAC  1 
4,402,679 = 1 − 
0.12  (1 + 0.12)8 
– Original process:
NPV=4,402,679, 8 year
life EAC = 886,272

– Alternative:
NPV=3,200,000, 4 year EAC  1 
3,200,000 = 1 - 
life 0.12  (1 + 0.12 )4 
• Which process is better?
EAC = 1,053,550

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 Biases
• Systematic deviation from the actual value

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 Cognitive Bias
• When conscious beliefs do not reflect the
information
– Easy to recall/available information is used
– Adjustment and anchoring
– Representative

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 Motivational Bias
• Statements do not reflect beliefs
– Dishonesty
– Greed
– Asymmetric Reward
– Brown-nosing
– Fear

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 Managing Bias
• Recognize it!
• Keep going back to the economics
• Sensitivity analysis
• Information management
• Check and recheck assumptions

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