Valuation Free Cash Flows Katharina Lewellen Finance Theory II April 2 2003 Valuation Tools A key task of managers is to undertake valuation exercises in order to allocate capital between mutually exclusive projects Is project A better than doing nothing Is project A better than project B Is the project s version A than its modified version A The process of valuation and ultimately of capital budgeting generally involves many factors some formal some not experience hard to formalize information politics etc We will focus on financial tools for valuation 2 Valuation Tools cont These tools provide managers with numerical techniques to keep score and assist in the decision making process They build on modern finance theory and deal with cash flows time and risk All rely on often highly simplified models of the business Technical limitations less now with computers Versatility Understandable and discussible 3 How to Value a Project Firm Calculate NPV Estimate the expected cash flows Estimate the appropriate discount rate for each cash flow Calculate NPV Look up the price of a comparable project Use alternative criteria e g IRR payback method You need to be an educated user of these 4 Comparables method Suppose you want to value a private company going public EBITDA 100 million For a similar public company P E 10 You value the IPO company at 1 000 million What are the implicit assumptions Suppose that P E r g Then P E 1 r g Thus we assume that Earnings are expected to grow in perpetuity at a constant rate Growth rates and discount rates are the same for both firms 5 Internal Rate of Return IRR One period project Investment 100 at time 0 Payoff 150 at time 1 Rate of return 150 100 1 50 NPV 100 150 discount rate 0 Discount rate 150 100 50 Rate of return is the discount rate that makes NPV 0 Multiple period projects IRR is the discount rate that makes NPV 0 NPV I o C1 C2 CT 0 2 T 1 IRR 1 IRR 1 IRR Basic rule Chose projects with IRR opportunity costs of capital 6 Internal Rate of Return IRR cont Suppose you choose among two mutually exclusive projects E g alternative ways to use a particular piece of land Project 1 Project 2 cash flows cash flows 10 20 20 35 IRR 100 IRR 75 Which project would you choose costs of capital 10 Project 2 because it has a higher NPV Other pitfalls BM Chapter 5 E g multiple IRR lending vs borrowing Bottom line NPV is easier to use than IRR If used properly IRR should give you the same answer as NPV 7 1 Calculating Cash Flows The Free Cash Flow FCF Approach FCF The expected after tax cash flows of an all equity firm These cash flows ignore the tax savings the firm gets from debt financing the deductibility of interest expense Plan of Attack Step 1 Estimating the Free Cash Flows Step 2 Account for the effect of financing on value Preview Two ways to account for tax shield Adjust the discount rate WACC method Adjust the cash flow estimate APV method 9 Count all incremental after tax cash flows allowing for reasonable inflation All Don t just look at operating profits in the out years If project requires follow on CAPX or additional working capital take these into account After tax The rest goes to the IRS Be consistent in your treatment of inflation Discount nominal cash flows at nominal discount rates Reasons Nominal rates reflect inflation in overall economy but inflation in cash flows may be different In fact some items in cash flows e g depreciation may have no inflation 10 Treatment of Inflation Example T Bill rate nominal 8 Expected inflation rate 6 Expected real rate 1 08 1 06 1 9 Sales of widgets next year 100 measured in today s dollars You expect that the price of the widgets will go up by 6 What s the PV of the widgets nominal cash flows PV 100 1 06 1 08 98 2 real cash flows PV 100 1 08 1 06 98 2 11 Equivalent Expressions for Free Cash Flows see Finance Theory I FCF 1 t EBIT Depreciation CAPX Change in NWC FCF 1 t EBITD t Depreciation CAPX Change in NWC FCF 1 t EBIT Change in Net Assets Note EBIT Earnings before interest and taxes EBITD Earnings before interest and taxes and depreciation EBIT Depreciation Change in NWC is sometimes called Investment in NWC 12 Example of Free Cash Flow Calculation Sales Cost of Goods Sold Depreciation Interest Expense Taxes 38 Profit After taxes Capital Expenditures Accounts Receivable Inventories Accounts Payable 1998 1 000 700 30 40 80 150 40 50 50 20 1999 1 200 850 35 50 90 175 40 60 60 25 In 1999 FCF EBIT 1 t Depreciation CAPX Change in NWC EBIT 1 200 850 35 315 Ch NWC 60 60 25 50 50 20 15 FCF 315 1 38 35 40 15 175 3 13 Beware Note We ignored interest payments We computed taxes on EBIT Do not take the effect of financing e g interest into account at this stage Remember our plan First determine the expected cash flows as if the project were 100 equity financed Later we will adjust for financing If you count financing costs in cash flow you count them twice 14 TW Example XYZ a profitable widget producer 100M annual after tax profit contemplates introducing new Turbo Widgets TWs developed in its labs at an R D cost of 1M over the past 3 years New plant to produce TW would TWs need painting Use 40 of the capacity of a painting machine cost 20M today last 10 years with salvage value of 5M be depreciated to 0 over 5 years using straight line currently owned and used by XYZ at 30 capacity with maintenance costs of 100 000 regardless of capacity used Annual operating costs 400 000 operating income generated 42M operating income of regular widgets would decrease by 2M Working capital WC 2M needed over the life of the project Corporate tax rate 36 15 TW Example cont Ignore the 100M after tax profit and focus on incremental cash flows R D cost of 1M over the past three years Sunk cost Ignore it The plant s 20M cost It s a CAPX Count it Machine s 100K maintenance cost Not incremental Ignore it Incurred with or without TW production True even if accounting charges TW production a fraction of these Op income of regular widgets decrease by 2M due to cannibalization Would not occur without TW production It is an opportunity cost Count it Year CAPX RW Inc decrease 0 20 0 1 2 0 2 3 0 2 4 0 2 5 0 2 6 0 2 7 0 2 8 0 2 9 0 2 10 0 2 0 2 16 Use Incremental Cash Flows Compare firm value with and without the project V project V firm w project V firm w o project Use only cash flows in and out attributable to the project Sunk …