Capital Budgeting and Valuation

Before we do any of the capital budgeting or valuation, we need to understand the

difference between these two. Before that we need to do have our cost of equity and
WACC calculated.
Step 1: Let’s do the common basic things first. First, we will determine a cost of equity.
Using the CAPM (Capital Asset Pricing Model) is the simplest.
Re = rf + 𝛽(rm – rf)
• Re = Cost of Equity
• rf = Risk free rate
• rm – rf = Market Risk Premium
• 𝛽 = Beta of the company. A number that determines how sensitive something
is compared to a benchmark like whole market. Lower beta means less
volatile compared to market.
Then we will calculate WACC which is Weighted Average Cost of Capital. This is the
value we will use to discount the cash flows.
WACC = Weight of debt * Cost of debt * (1 – tax rate) + Weight of equity * Cost of equity
Higher the WACC, lower the potential value created, for the same project.

Step 2: Calculate all the cash inflows of the project/company. Follow the format –
EBIT = Sales/Revenue – Expenses*
FCFF = EBIT(1-Tax rate) + D&A – ΔNWC – CAPEX
*(include every expenses except capex)

• EBIT = Earning Before Internet and Tax

• FCFF = Free Cash Flow to the Firm
• D&A = Depreciation and Amortization
• CAPEX = Capital Expenditures
• Δ NWC = Net Change in Working capital
Do this for every year and the final value is the cash inflow of each year.

These are common steps in both Valuation and Capital Budgeting. The rest are
different.
Difference
The difference between Capital budgeting and Valuation is that Capital Budgeting is
done by managers while valuation is done by investors. While the cash inflows are
same, outflows are different for each cases.
What the company or the manager spends in the outflow in Capital budgeting. What the
investor invests in equity is the cash outflow for the Valuation. On surface, both seems
the same but more often than not, the amount of money available to managers is not
the same as the market price of the company.
From now on, we will simply call the company or project we are evaluating as
investment.

Capital Budgeting
Managers can use three ways to evaluate an investment.
1. Payback Period – Just calculate how many years would it take to get the initial
investment back using the cash flow. Don’t discount the cash flows to present value.
This is pure accounting value because it doesn’t count time value of money.
2. NPV Method – Rule of thumb: In Capital Budgeting, outflows are what managers
spends but are not reflected in FCFF. Almost every outflow is reflected in FCFF except
the the capital investments in the company. To find the NPV, we first need discount
every cash inflow and outflow to present time using WACC. Subtracting present value of
outflow from the present value of inflow will result in the NPV or Net Present Value.
Highest NPV is the investment managers will choose.
3. IRR method – IRR means Internal Rate of Return. It’s the maximum discount rate for
investment to break even. For example, let’s assume we discount every cash flow at
15% and get the NPV of 0. 15% is the IRR. Another similar project with same risk profile
has an IRR of 10%. We will take the investment with highest IRR because it means the
investment is generating so much cash flow that we can discount using a large rate upto
15% and still get a positive NPV.

Stock Valuation
Valuation is similar but from investors point of view instead of managers. So we won’t
use the company outflows of cash like initial investment. We just need to calculate all
the inflow and discount it using our WACC. The present value we get is the value we
think the investment is worth. We can find the intrinsic market value by dividing it over
total number of shares. If the market price is below the value we calculated, we will buy
it. If market price is over the value, then we will avoid it. Because It would mean that we
are overpaying for something that is worth less. DCF approach should be enough for
the exam.

Bond Valuation
Bond valuation is pretty straight forward and way simple. Bond has a coupon rate which
is the rate used to calculate payment every period, and a face value which is the value
we will multiply with coupon rate to get payment.

If bond 1 has a face value of 1 million and 10% coupon rate then the payment every
year is 100,000 from the bond. Now, suppose the interest rate rises to 20%, then all
newly issued bonds worth 1 million will have a coupon rate of 20% and will pay 200,000
every year. Why would you buy bond 1 for 1 million then, when you can invest the same
amount and get double the payment. So, bond 1 value is now lower. We can easily
calculate the value using unitary method.
If, we get 200,000 from 1 mil bond
1∗ 100,000
We get 100,000 from bond
200,000

= .5 million bond
We are now getting 100,000 from bonds with face value of .5 million so bond 1 will have
a market value of .5 million.

We can go more deeper and use the cash flow approach. We will get 100,000 every
year and we will discount it at 20% rate because that’s the current rate. The present
value is the value of the bond. Try it out and you will get a value of .5 million as well.
Remember to take a terminal value. You will only get the value .5 million if the bond is
perpetual meaning doesn’t have a maturity. If there’s a maturity then you’ll get a
different value because it will not deliver payments forever. In maturity year, add the
face value to your cash flow because you get the whole amount of face value back
when bond matures.
So, if there’s a maturity, always use the cash flow approach. If not, any of the above is
alright. I wish we could go deeper but we have only 1 day left. If you found any error,
mail me to tanimistiaque@gmail.com. Good luck.