Financial Modeling Notes

DCF Modeling: Capital Budgeting

Professor Iordanis Karagiannidis

© 2010 Iordanis Karagiannidis

Discounted Cash Flow Analysis
 Most Basic and Most widely used tool in financial modeling
 DCF Analysis: Convert future cash flows to present value
equivalents so that cash flows at different points in time can
be compared

 Formulas and Functions used: FV, PV and NPV

 Three Important steps

 Determine cash flows
 Determine timing of cash flows
 Determine appropriate discount rate

© 2010 Iordanis Karagiannidis

Capital Budgeting
 The process of choosing whether to undertake or not an
investment project
 Most widely used capital budgeting tools
 Net Present Value (NPV): The total value today (time 0) of all
the project’s cash flows, including the time 0 initial outlay
n
Cash Flow t
NPV  
t 0 1 r t

 Internal Rate of Return (IRR): The discount rate that if plugged

in the above formula makes the NPV=0. It is the compound
rate of return that you get from a series of cash flows.

© 2010 Iordanis Karagiannidis

Capital Budgeting Projects

 Investment Categories
 Equipment Replacement
 Expansion to Meet Growth in Existing Products
 Expansion Generated by New Products
 Projects Mandated by Law

 Project Interactions
 Independent Projects
 Mutually Exclusive Projects
 Contingent Projects

© 2010 Iordanis Karagiannidis

Capital Budgeting
 Making Choices in Capital Budgeting

© 2010 Iordanis Karagiannidis

Other Capital Budgeting Tools
 Payback Method
 How long it takes to recoup the initial investment
 Discounted Payback Method
 Use present values of the cash flows instead of nominal values
 Profitability Index
 Provides a measure of the dollar benefit per dollar of cost
n
Cash Flow t

$ Benefit t 1 1  r t
PI  
$Cost Cash Flow 0
 Modified Internal Rate of Return (MIRR)
 Calculates the average annual return with a reinvestment rate that is different
than the IRR.

© 2010 Iordanis Karagiannidis

Note on the discount rate
 The interest rate used to discount cash flows should depend
on the riskiness of cash flows and the cost of capital
 We will talk in detail about the cost of capital and discount
rate later in the course
 For more risky projects we use a higher discount rate
 How we define risk is an issue
 Soon we will explicitly model risk using probabilities and
simulation
 If risk is defined correctly, undertaking a positive-NPV
project should be shareholder-wealth increasing

© 2010 Iordanis Karagiannidis

Note on financing costs
 In capital budgeting, we don’t explicitly model the financing
costs– these are subsumed by the discount rate.
 If a project has a typical risk profile for our company, we
generally use the Weighted Average Cost of Capital (WACC).
The WACC incorporates factors such as the company’s
leverage and the debt tax shield.
 This allows us to separate the financing and investment
decisions, which makes our task a lot easier.

 Sometimes it is not possible to separate financing and

investment decisions

© 2010 Iordanis Karagiannidis

When do we need to model financing?
 There are cases when we need to explicitly model financing
arrangements.

 The prime example of this is if the decision we are trying to make

is of a financial nature (as opposed to an investment decision), e.g.
what type of security issue will minimize our financing cost?
Lease vs. purchase decisions also lie in this realm. Also an
entrepreneur seeking a bank loan will need to model the
company’s working capital needs and needs to know how much of
the company’s income he or she can consume in a given month.
Later in course will talk about how to model corporate financing
needs.

 Any complex financial transaction also needs to be modeled

explicitly, e.g. swaps, options trades, etc.

© 2010 Iordanis Karagiannidis

Financing and Investment may be
interconnected
 This is sometimes true in project financing: whether to start
a new mining venture might depend upon whether the local
government is willing to offer an equity investment which
may in turn depend on which contractors you use in
developing the project, etc., etc..

 Also, your method of production or production schedule

might affect your seasonal working capital needs which may
influence how much you rely on bank loans vs. long-term
debt or equity, which may affect your cost of capital.

© 2010 Iordanis Karagiannidis

Building the model (step 1)
 Determine Relevant and Irrelevant Cash flows

 Relevant Cash Flows

 Incremental – In addition to existing cash flows. For example:
cannibalization cost
 After-Tax – If Government gets, Investors don’t get

 Irrelevant Cash Flows

 Sunk Costs – Money spent in the past is irrelevant. For
example: Real estate investment
 Financing Costs – There are factored in the discount rate. If we
include as cash flow we are double counting

© 2010 Iordanis Karagiannidis

Building the model (step 2)
 Classify Cash flows

 Three types of cash flows

 Initial Outlay – (IO)
 Annual After-tax Cash Flows (ATCF)
 Terminal Cash Flow (TCF)

TCF

IO ATCF ATCF ATCF ATCF ATCF

0 1 2 3 4 5

© 2010 Iordanis Karagiannidis

The Initial Outlay

 Usually, cash flows like:

 Net Project Cost including shipping costs, training, etc
(presumed to occur at time 0)
 Increase in Working Capital (e.g. increase in raw materials
inventories)
 Reduced by salvage value of old equipment, if replacement
decision

 If we have an increase (decrease) in NWC because of the

project we need to have an equal decrease (increase) at the end
of the project’s life (TCF)

© 2010 Iordanis Karagiannidis

Annual After-Tax Cash Flows

 Assumed certain for now (later we will consider uncertainty)

 In a simple example, same every year, but cash flows may
change from year to year
 Four components
 Additional revenue (+)
 Cost Savings (+)
 Additional expenses (-)
 Additional depreciation benefits (+)

© 2010 Iordanis Karagiannidis

Terminal Cash Flows

 Non-operating cash flow events which occur only in the final

time period of the project
 Usually Consists of:
 Salvage Value less taxes
 Recovery of Working Capital (from IO)
 Shutdown Expenses

© 2010 Iordanis Karagiannidis

Building the model (step 3)

 Build the spreadsheet and calculate the cash flow for each
time period

 Then we can:
 Build the timeline of cash flows
 Use capital budgeting tools to make the decision
 Perform Sensitivity Analysis
 Assumptions are never going to be 100% correct
 Need to understand how final results change with different assumptions

© 2010 Iordanis Karagiannidis