Chapter 9 When evaluating a capital budgeting project make decision that maximizes NPV o to compute PV for a project need to estimate incremental FCF and choose a discount rate Sensitivity Analysis asses the effect of uncertainty in forecasts breaks NPV calculation into its component assumptions and show how the NPV varies as the underlying assumptions change allows us to explore the effects of error in our NPV estimates learn which assumptions are most important reveals with aspects of a project are most critical during management of project By graphing the NPV of a project as a function of the discount rate we are assessing the sensitivity of our NPV calculation to uncertainty about the correct cost of capital to use as a discount rate Break Even Analysis the value at which the NPV of a project is zero Difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision EBIT breakeven for sales the level of sales for which the projects EBIT is zero EBIT rev costs dep Where costs include COGS SG A Scenario Analysis considers the effect on NPV of changing multiple project parameters Real Options in Capital Budgeting Real option the right but not the obligation to make a particular business decision you will only act if it increases the NPV of the project allow a decision maker to choose the most attractive alternative after new information has been learned the presence of real options adds value to an investment opportunity Option to Delay Commitment the option to time the investment gather more information only delay if doing so increases NPV of project Option to Expand option to start with limited production and expand only if product is successful test market first reduces upfront commitment Abandonment Option walk away can add value to a project because a firm can drop a project if it turns out to be unsuccessful IF YOU CAN BUILD GREATER FLEXIBILITY INTO YOUR PROJECT YOU WILL INCREASE NPV OF PROJECT Chapter 10 Stock Valuation Discounted cash flows of a project determine the value of a project to the firm the discounted cash flows of the firm as a whole determine its value to its investors Discounted free cash flow model Focuses on the cash flows to all of the firms investors both debt and equity holders avoids the difficulties associated with estimating the impact of the firms borrowing decisions on earnings important connection between the capital budgeting analysis and its implications for the firms stock price dividend discount model values a single share of stock but in the total payout model we first value the firms equity rather than just a single share Discounted Free Cash Flow Model determines the total value of the firm to all investors both equity and debt holders allows us to value a firm without explicitly forecasting its dividends share repurchases or use of debt first estimate the firms enterprise value o Enterprise Value Market Value of Equity Debt Cash o Because the EV is the value of the firms underlying business unencumbered by debt and separate from any cash or marketable securities it is also the value of the underlying business to all investors o EV the net cost of acquiring the firms equity paying off all debt and taking its cash in essence it is equivalent to owning the unlevered business Valuing the Enterprise To estimate the value of the firms equity we compute the PV of the firms total payouts to equity holders Likewise to estimate a firms EV we compute the PV of the FCF that the firm has available to pay all investors both debt and equity holders FCF EBIT x 1 tax rate dep CapEx Increase in NWC FCF measures the cash generated by the firm before any payments to debt or equity holders are considered We estimate a firms current EV V0 by computing the PV of the firms FCF V0 PV Future FCF of Firm Estimate the share price P0 VO Cash0 Debt0 Shares Outstanding In the divided discount model the firms cash and debt are included indirectly through the effect of interest income and expenses on earnings By contrast in the discounted FCF model we ignore interest income and expenses because FCF is based on EBIT but then we adjust for cash and debt directly A key different between the discounted FCF model and the earlier models is the discount rate o Before we used the firms equity cost of capital rE cuz we were discounting the cash flows to equity holders o Now we are discounting the FCF that will be paid to both debt and equity holders by using the firms weighted average cost of capital WACC it is the cost of capital that reflects the risk of the overall business and which is the combined risk of the firms equity and debt o Rwacc expected return the firm must pay to investors to compensate them for the risk of holding the firms debt and equity together o If the firm has no debt then rwacc rE TERMINAL VALUE WITH AND WITHOUT LONG RUN GROWTH RATE Long run growth rate is typically based on the expected long run growth rate of the firms revenues V 0 V N 1 FCF 1 1 r wacc FCF N 1 g r wacc FCF 2 r wacc FCF 2 FCF N r wacc N 1 1 V N r wacc N 1 g r wacc FCF g FCF FCF N Because the firms FCF is equal to the sum of the FCF from the firm s current and future investments we can interpret the firms EV as the sum of the PV of its existing projects and the NPV of the future new ones Hence the NPV of any investment decision represent its contribution to the firms EV To maximize the firms share price we should therefore accept those projects that have a positive NPV We must forecast a firm s future sales operating expenses taxes capital requirement and other factors to obtain its FCF Estimating FCF this way gives us flexibility to incorporate many specific detail about the future prospects of the firm but uncertainty surrounds each assumption so its important to conduct a sensitivity analysis to translate this uncertainty into a range of potential values for the stock We can use the PV of a stock s future dividends to determine its value We can estimate the total market capitalization of the firms equity from the PV of the firms total payouts which includes dividends and share repurchases The PV of the firms FCF which is the amount of cash the firm has available to make payments to equity or debt holders determines the firm s EV PIC Method of comparables rather than value the firms cash flows directly we estimate the value of the firm based on the value of other comparable firms or