LECTURE 2

Alminas Žaldokas

alminas@ust.hk
 WHERE ARE WE?
• Valuation Tools
– NPV, capital budgeting (L2)
– Cost of equity (L3-4)
– Equity valuation (L5-7)
– Capital structure, WACC (L7-10)
– Key frictions (L12)
• Valuation Applications
– Raising debt (L14)
– Raising public equity (L15-17)
– Raising private equity (L18-19)
– Integrating (L20-21)
– Returning equity (L22)

• Putting Theory into Practice

– Reuters training (L11)
– Mid-term case (L13)
– Guest lectures
– Individual projects (L23-24)

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 PLAN
• Present Value
• Risky Cash Flows
• Special Cases
• NPV, IRR, Payback
• Relevant Cash Flows

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 APPLICATIONS
• A marketing campaign

PROJECT
• Operating decisions
• An R&D investment for a new drug
• Buying a certain company’s stock
• The acquisition or divestiture of a company

COMPANY
• Fundraising from venture capital investors
• Bank financing for a small start-up
• Restructuring of your own firm
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 PROJECT VALUATION
• Capital budgeting:
– Decide which investments are good
• Compare benefits and costs
– Cost: investment
– Benefit: cash flows (will accrue in the future)
• Need to know how to value future cash flows

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TO FIRM X STRATEGY BOARD
As per the annual strategy review, and the concerns
raised during the (very productive!) November 2016
retreat by the Head of Marketing notwithstanding, as
management of the Shenzhen facility we believe the
inputs could be sourced at a cost of $100,000 or so, an
amount that our suppliers would be amenable to given
the current economic environment. After netting out
operating expenses (including salaries), sales would then
leave a revenue at year-end of almost surely $105,000.
We are thus backing the project and recommend to start
approaching our suppliers ASAP.
Robert W.E. Jones
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 TIMELINE
First year Second year

Date 0 1 2

Cash flow -$100,000 $105,000 $0

• How do we value this investment?

• We need to know the values today:
– The cash value of $100,000 today is… $100,000
– What is the cash value of $105,000 next year?
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 TIME VALUE
• Future value
– How many $1 next year can you get for $1 today?
– Competitive financial market
– Borrow/invest at risk free interest rate of 3%
– Invest $1 today  Get 1×(1+3%) = $1.03 next year
• Present value
– How much must you pay today to get $1 next year?
– To get $1 next year, invest 1 × 1/(1+3%) = $0.96
– The cash value of $1 next year is $0.96
– Easy: the price today of “$1 next year” is 1/(1+3%)

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 INVESTMENT VALUE
• Benefit
– Next year: $105,000
– Value today: $105,000 × 1/(1+3%) = $101,942
• Cost
– Value today: $100,000
• Net present value
$101,942 - $100,000 = $1,942  Invest

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 PRESENT VALUE
Date 0 t

Cash flow Ct

Ct
PV 
(1  r)
t

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 MULTIPLE YEARS
Date 0 1 2 3 4 5 6

Cash flow C1 C2 C3 C4 C5 C6

C1 C2 CT
PV = + +…+
1+r 1 1+r 2 1+r T

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 RISKY CASHFLOWS
• Riskier in the future = smaller value today
– Present value of a cash flow C next year must be less
than C/(1+ rf)
– Discount rate r = rf + risk premium
– Risk ↑ Premium ↑  Rate r ↑  PV ↓
– We will look at how to set the risk premium (CAPM) in L3
• Back to the question
– Say, risk premium is 4%
– Today’s value of an average future cash flow of $105,000
is $105,000 × 1/(1+7%) = $98,131
– NPV: $98,131 - $100,000 = -$1,869  Forget about it
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 SUMMARY
• What determines the value of the cash flows an
investment is expected to generate?
– How big they are
– How certain they are
– When they are expected to be realized

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 CONSTANT CASH FLOWS
• Suppose you plan to do a 2-year MBA starting 4 years
from now. You need to save from now on by
depositing a constant amount at the end of each year
till year 4. Tuitions ($80,000 per year) are paid at the
year-end in year 5 and year 6. How much should you
deposit each year from year 1 to year 4? Assume that
the discount rate is 10%.
Date 0 1 2 3 4 5 6

Cash flow D D D D $80,000 $80,000

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 SPECIAL CASES
• Annuity
– Cash flows are constant for T periods: C1=C2=…=CT
• Perpetuity
– Infinite series of equal payments: C1=C2=..=CT=CT+1=..
• Growing Annuity
– Ct+1=(1+g)Ct
– Cash flows that are growing at a constant rate
• Growing Perpetuity
– Infinite series of cash flows that are growing at a
constant rate

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 SPECIAL CASES

g > 0% g = 0% (No growth)

C1  1 g   C1   1  
T T

Annuity PV  1     PV  1    
rg   1  r   r   1  r  
 

C1 C1
Perpetuity if g  r PV  PV 
r g r

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 EXCEL MAGIC
• Annuity present value
– PV(r, T, C) (Note: NO period 0 cash flow)
• Annuity future value
– FV(r, T, C) (Note: NO period T cash flow)
• Present value of uneven cash flows
– NPV(r, value1:valueT) (Note: NO period 0 cash flow)
• Return on an annuity - r
– Rate(T, C, PV, FV)
• Number of periods - T
– NPER(r , C, PV, FV)
• Constant payment - C
– PMT(r, T, PV, FV)
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BACK TO MBA QUESTION
1. Compute the PV of tuitions as of the end of
year 4 (PV of annuity)
2. Discount the PV as of the end of year 4 in step
1 to the beginning of year 1 (single cash flow
PV problem)
3. Compute the annual deposits, so that their PV
(as of year 0) is equal to the PV in the step 2
• Answer: $29,916.61

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 SPECIAL CASE USES
• Annuity
– Pension: Contribution of HKD 80,000 from age 30 to 60
– Bonds: Constant “coupon payment” over 10 years
– Bank loan: Monthly payments of £3,600 over 15 years
• Perpetuity
– Approximates a “long and indefinite time”
– Firm’s terminal value: “Past the next 8 years, we
forecast the firm B’s profit to be £100 M in year 9 and to
grow at 4% thereafter. Its cost of capital is 10%. What is
the terminal value in year 8?”
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 g>r

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Source: Dilbert

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 IRR
• Internal Rate of Return (IRR)
– The discount rate at which NPV = 0
– Accept if IRR > required rate of return
– IRR in Excel: IRR(cashflow1:cashflowT, guess)

C1 C2 CT
0= + +…+
1+IRR 1 1+IRR 2 1+IRR T

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 IRR vs NPV
• For a single project:
– IRR and NPV will agree whether to invest or not
• Mutually exclusive projects:
– IRR ignores scale of the project
– Choose NPV
• Other drawbacks of IRR:
– Multiple IRR possible
– No IRR possible

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 PAYBACK
• Payback period
– Length of time until the accumulated cash flows
equals or exceeds the original investment
– Quicker is better: Accept if payback is less than
some pre-specified number of years
– No need for discounting

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PAYBACK PERIOD vs NPV
• Drawbacks of payback period
– How to determine the cut-off?
– Bias against long term projects
– Ignores time value of money
– Ignores cash flows after cutoff point
– Inconsistent with maximization of shareholder value
• Advantages
– Simple to use
– No need to estimate discount rate
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 REAL WORLD?
• (Other) CEOs say that they rely on the following method:
0 10 20 30 40 50 60 70 80

Internal rate of return

Net present value
Payback period
Hurdle rate
Sensitivity analysis
Earnings multiple approach
Discounted payback period
Real options
Accounting rate of return
Value-at-risk
Adjusted present value
Profitability index
Source: J. Graham and C. Harvey, 2001, The theory and practice of corporate finance: Evidence from the
field, Journal of Financial Economics

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 NPV FIRST
• NPV is the right capital budgeting technique
– Tells us if a particular project is a good investment
– Consistent with maximization of shareholder value
– But you must make sure you are using it correctly
by identifying the right cash flows and using the
correct discount rate
• Other methods can be used as the supplements
• Let us look at how to identify the right cash
flows now
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 RELEVANT CASH FLOWS
• Relevant cash flows = incremental cash flows
associated with the decision to invest in a project
– Any and all changes in the firm’s future cash flows
that are a direct consequence of undertaking the
project
• These are the only cash flows that should be
considered while evaluating the project

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 ONLY
• You should always ask yourself “Will this cash
flow occur ONLY if we accept the project?”
– If the answer is “yes”, it should be included in the
analysis because it is incremental
– If the answer is “no”, it should not be included in the
analysis because it will occur anyway
– If the answer is “part of it”, then we should include
the part that occurs because of the project

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 RELEVANT CASH FLOWS
• Sunk costs
– Costs that have been incurred and are not affected
by decision of accepting the project or not
– Sunk costs should NOT be considered
– Exploration (mining), R&D costs incurred
• Opportunity costs
– Cost of lost options and/or their alternate use
– Opportunity costs SHOULD be considered
– Renting unused space, taking into account forgone
income when analyzing education investments
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 QUESTION
• After spending $0.3m on market research last year, Sai
Kung Fishermen Association has estimated that there
will be demand for a smart fish finder
• Three years ago, they purchased some land for $1.5m.
Today, the land is valued at $1.3m
• Six years ago, the association purchased some
equipment for $1.9m. This equipment has a current
book value $0.7m and a current market value of $0.5m
• This land and equipment can be used for this project
• What is the initial cash flow for capital budgeting
analysis whether to start manufacturing this product?
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 RELEVANT CASH FLOWS
• Synergy effects
– Benefits to existing projects
– MTR, Apple (iPhone sales leading to laptop
sales), etc.
• Cannibalization effects
– Reduction in sales of one product as a result of
the introduction of a new product by the same
producer
– New flavor of Coke, Starbucks coffee shops
that are too close to each other, etc.
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 SYNERGIES IN M&A
• Chiquita and Fyffes:
“By eliminating
duplication in shipping
efforts, among other
things, the firms expect
the merger to save at
least $40m a year by
the end of 2016.”

FINA 3303/LECTURE 2 33
 RELEVANT CASH FLOWS
• Taxes
– Marginal tax rate
• Financing costs
– We will adjust in denominator
• Salvage value of machinery
– Sale of assets at the end of the project (aka
scrap/residual value)

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EXPECTED SALVAGE VALUE
• In determining expected salvage value, futures
market can help
• Take shipping industry:
– Ships have long useful lives (25-30 years)
– Rule of thumb: demolition value is 15% of initial cost
– Scrap value correlates with the steel price
– Infer future scrap value from steel futures or Baltic
Demolition Assessment Index

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 STEEL FUTURES

Source: London Metal Exchange, 15 month seller steel billet futures

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SALVAGE VALUE AND TAX
• If the asset’s eventual salvage value (SV) is
different from the net book value (BV) at the
time of sale, then there is also a tax effect
• Net book value = initial cost – accumulated
depreciation
• After-tax salvage value = SV – t ∙ (SV – BV)
– If SV > BV  asset over-depreciated  tax outflow
– If SV < BV  asset under-depreciated  tax inflow

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 QUESTION
• You purchase equipment for $110,000 and you
believe that you can sell the equipment for
$17,000 when you are done with it in 6 years
• The company’s marginal tax rate is 40%
• Suppose, however, at the end of year 6, the
market value of the equipment is $25,000
• What is the tax implication and the after-tax
salvage value of the equipment?

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Source: Dilbert

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 FINAL TOUCHES
• Compounding
• Inflation
• Projects with Unequal Lifetimes
• Timing

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 COMPOUNDING
• How do we compound interest rates in CF?
– One $ invested for one year at 5% at different
compounding frequencies:
Compounding Number of $ value after
periods per year one year
Annually 1 1+ 5.0000%
Semi-annually 2 1+ 5.0625%
Quarterly 4 1+ 5.0945%
Monthly 12 1+ 5.1162%
Weekly 52 1+ 5.1246%
Daily 365 1+ 5.1267%
Hourly 4380 1+ 5.1271%
Per minute 262800 1+ 5.1271%
Continuously Infinite 1+ 5.1271%

• So, do we use continuously compounded rate?

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 COMPOUNDING
• Depends on whether you assume that you can
reinvest the interest rate continuously
• In most corporate finance cases, use discrete
compounding:
– Yes, you use continuous compounding for options,
also the options for executive compensation
– Because of math tricks, option formulas rely on
continuous compounding
• In this course, we’ll use annual compounding

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 INFLATION
• Inflation has an impact on both the cash flows
and the discount rate
• Cash flows
– Actual cash flows go up with inflation
– Other P/L items, e.g. depreciation are based on
historical cost and usually do not change with inflation
but we do not care about them
• Fisher equation
– (1+nominal rate) = (1+real rate)*(1+inflation rate)
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 SAME SAME
• Consistency of cash flows & discount rate:
– Discount nominal cash flows with a nominal rate
– Discount real cash flows with a real rate
– Either one will give the same result

FCF t (1  i )
t

PV 
(1  r) (1  i )
t t

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 UNEQUAL LIFETIMES
• Comparing present values can be misleading
when projects have different economic lives and
the projects are part of an ongoing business
– A machine that costs $100,000 per year and lasts 5
years is not necessarily more expensive than a
machine that costs $75,000 per year but lasts 3 years
• Calculate equivalent annual cost
– Annuity with the same time horizon and present
value

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EQUIVALENT ANNUAL COST
• Equipment A:
– Initial cost = $7,500
– Per-year maintenance cost = $150
– Economic life = 5 years
• Equipment B:
– Initial cost = $9,000
– Per-year maintenance cost = $120
– Economic life = 7 years
• Which equipment to choose if discount rate is 9%?
– Equipment B costs more but also lasts longer
– EAC(A) = $2,078.2 and EAC(B) = $1,908.2 (double check)
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 TIMING
• Even projects with positive NPV may be more
valuable if deferred
• In DCF, you assume that the firm will hold the
assets passively
• Do managers just watch future unfold?
• The more uncertain the outlook, the more
valuable is the flexibility to modify

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 TIMING
• Real options approach:
– Option to expand
– Option to abandon
– Timing (waiting) option
– Flexible production facilities

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 OPTIONS
• Profit at expiration date:

Payoff

Profit

Oil Price

Exercise price = land

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OIL PRODUCTION

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 NPV FIRST
• NPV is the right capital budgeting technique
– Tells us if a particular project is a good investment
– Consistent with maximization of shareholder value
– But you must make sure you are using it correctly
by identifying the right cash flows and using the
correct discount rate
This class
Next week

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 TAKEAWAYS
• Today
– PV of $1 in the future is less than $1
– Use NPV as the main method for deciding if to invest
– Use incremental cash flows for capital budgeting
• Homework
– Optional: Ch 5: Q11, Q15, Q23; Ch 6: Q19, Q21, Q33a
– Attempt to solve Kokonuzz case
• On Monday
– More on NPV
– Kokonuzz
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