Business Valuation

Rajiv Bhutani
IIM Sambalpur
2018
 Topics to be covered
• Valuation Principles
• Opportunity cost of capital
• Present Value (PV)
 Present Value, Real and Nominal Value
• Present Value:
• Cash Flows received at different times need to be adjusted because:
• If you receive $1 today, you can invest it at risk-free interest rate and after 1 year, it will be
worth more than $1. So, $1 today is not same as $1 received after a year
• If you want to compute “Present Value” of $1 received after a year, you need to discount it at
the “appropriate discounting rate”
• If interest rate is r, PV of risk-free cash flow received after t years = CF t/(1+r)t

• Real Vs Nominal:
• Note we are talking about effect of earning interest on the $1, we are not talking about
inflation reducing the value of $1
• When you consider inflation, it is a different concept. If you are going to receive $1 after a
year, then because of inflation that $1 will buy a smaller basket of good and services than $1
today. Let us say $1 after a year buys same basket of goods and services as 95 cents buy today
• Nominal CF after a year = $1
• Real cash flow after a year = 95 cents.
 Time Value of Money
• Assume interest rate r = 5% compounded annually, Principal = $100
• If you invest this principal, it grows like below:
• Yr 1: 100*(1+5/100)1 = 105
• Yr 2: 100*(1+5/100)2 = 110.25
• Yr 3: 100*(1+5/100)3 = 115.7625
• Yr n: 100*(1+5/100)n
• Assume interest rate r = 5% compounded semi-annually, Principal = $100
• Yr 1: 100*(1+5/(2*100))2 = 105.0625
• Yr 2: 100*(1+5/(2*100))4 = 110.3813
• Yr 3: 100*(1+5/(2*100))6 = 115.9693
• Assume interest rate r = 5% continuously compounding, Principal = $100
• Yr 1: 100*EXP(0.05*1) = 105.13
• Yr 2: 100*EXP(0.05*2) = 110.52
• Yr 3: 100*EXP(0.05*3) = 116.18
 Examples
• Tata Steel spends 80,00,000 annually for
electricity. A new computer-controlled lighting
system promises to reduce electrical bills by
roughly 9,00,000 in each of the next three
years. If the system costs 23,00,000, fully
installed, should you go ahead with the
investment?
Year 0 1 2 3
CF -23,00,000 9,00,000 9,00,000 9,00,000
 Examples
• Assume interest rate r = 4%

Year86538 0 1 2 3
4
CF -23,00,000 9,00,000 9,00,000 9,00,000
Divided by 1.04 1.042 1.043
PV -23,00,000 8,65,384 8,32,100 8,00,096

• Net Present Value = 1,97,580

• Invest in the new technology
 Examples – Alternative Analysis
• Let us put 23,00,000 in the bank and earn interest
on it, rather than making the capital investment
into new technology
Year 1 2 3
Begin Balance 23,00,000 14,92,000 6,51,680
Ending Balance 23,92,000 15,51,680 6,77,747
Withdrawal 9,00,000 9,00,000 6,77,747
Balance Forward 14,92,000 6,51,680 0

• Project creates more value than investing in risk-

free assets
 Opportunity Cost of Capital
• When discounting, is discounting using risk-free rate justified?
• What if cash-flows are not 100% certain, rather there is uncertainty associated with the
cash-flows
• Consider a very risk project: Say, there is a 99% probability that in future a project might
not do well and in this case it will have 0 cashflow, and 1% chance that it might do well and
it will have 1,00,000 cashflow. If we discount 1,00,000 at risk free interest rate, will this be
the PV of the project? What about the 99% case that project does not work out?
• Question is: Should we adjust it for the uncertainty somehow?
• Solution: What if we discount using the interest rate adjusted for this uncertainty!
• So, if a project is risky, it creates value only if it generates a higher rate than similar risk
investments in the financial market (like stocks of similar risk)
• So, the “appropriate discount rate” for an investment equals the rate of return that could
be earned in the financial markets on an asset with similar risk
• r is called “opportunity cost of capital” or “required rate of return” on the project
• A project creates value only if it generates higher return than similar risk investments in
the markets
 Examples with uncertainty
• Electricity prices can fluctuate, so the amount of savings
due to installation of new technology is not 100%
certain. The best guess is Tata Steel will save 9,00,000
per annum, but savings could be higher or lower.
• Risk seems to be comparable to investing in a utility
stock, which have a 7% expected return
• So, NPV = -23,00,000 + 9,00,000/1.07 + 9,00,000/1.072 +
9,00,000/1.073 = 61,884
• Note NPV has reduced from earlier case, but it is still
positive. Since NPV > 0, project creates value
 Discount Rates in Real Life
• Real life projects are way more complex and finding a comparable firm with
equal risk characteristics is not easy
• Rule of thumb is “To find NPV of a project, use discounting rate appropriate for
the project at hand” and do not use historical or average discounting rate for
your firm
• Examples
– Merger and Acquisition of a firm in a different industry. When computing NPV, use risk
profile of the firm that is going to be acquired to use as r
– Conglomerate or a Diversified Firm: Use separately appropriate discount rates for each
business. Respective industry comparisons are helpful to determine r
– International Projects: Share holders of a company are in US and Co is considering a
new project in Nigeria. Business environment in Nigeria is way more risker than US, so
appropriate discount rate comes from discount rate of comparable firms in Nigeria
– What if Nigerian currency appreciates/depreciates against USD. This does not affect
discount rates
 Discount Rates in Real Life – Inflation

• It is simple to treat inflation.

• Rule: Discount real cash flows with real
discount rates, Discount nominal cash flows
with nominal discount rates
• We know, real CF = nominal CF/(1+inf)t
• 1+real int rate = (1+nom int rate)/(1+ inflation)
• real int rate approx = nom int rate - inflation
 Example – PV of a career-time
• Current Annual Salary = 5,00,000
• Annual Growth = 2% pa in real terms
• Career length = 30 years
• Current interest rate = 5%, Inflation = 2%
• Real interest rate = 1.05/1.02-1 = 2.94%
Year 1 2 … 30
Cash flow 5,10,000 5,20,200 … 9,05,681
Divided by 1.0294 1.02942 … 1.029430
PV 4,95,434 4,90,910 … 3,79,708

• Present Value = 1,30,52,915

Discount Rates in Real Life – MNCs
• Question: How to discount cash flows in
different currencies?
• Rule: Discount each currency at its own
discount rate
• This gives PV of each project in its own
currency
• Now, use FX to convert to domestic currency
Discount Rates in Real Life – MNCs
• You set up a small IT company and you signed a
deal with 2 companies in EU and Europe who will
pay you for next 2 years like below. You will get
1,00,000 USD revenue from US and 85,000 EUR
revenue from Eurozone countries for your
services
• USD interest rate = 5%, EUR interest rate = 3%
• USDINR = 67, EURINR = 74
• Question: Find the NPV
Discount Rates in Real Life – MNCs
• PV from US sales = 1,00,000/1.05 +
1,00,000/1.052 = 95,238 + 90,703 = 1,85,941
• PV in INR = 1,85,941*67 = 1,24,58,043

• PV from Euro sales = 85,000/1.03 +

85,000/1.032 = 82,524 + 80,121 = 1,62,645
• PV in INR = 1,62,645*74 = 1,20,35,730
 Discount Rates in Real Life – Compounding
Frequency
• A company invests its free cash in XYZ bank fixed deposits
which has a monthly compounding frequency and bonds,
which have semi-annual compounding frequency
• So, what kind of discount rate should we use?
• Rule: Use the same compounding frequency in discount
rates as the frequency of payment. So, divide APR by number
of compounding periods
• So, if bank pays monthly interest rate on fixed deposit,
discount monthly cash flows by APR/12
• If bonds pay semi-annual interest rate, discount semi-annual
cash flows by APR/2
 Discount Rates in Real Life – Compounding
Frequency
• Effective Annual Rate (EAR) can be very different from Annual percentage
rate (APR)
• Example: You take loan from a money-lender who charges you interest using
a daily compounding frequency, at 6.75%
• Loan Amount = 10,000
• Daily interest rate = 6.75/365 = 0.0185%
• Day 1: Balance = 10,000*1.00085 = 10,001.85
• Day 2: Balance = 10,001.85*1.00085 = 10,003.7
• …
• Day 365: Balance = 10000*(1.00085)365 = 10,698.5
• EAR = 6.985%
• Effective Annual Rate = (1+APR/k)k – 1
• Continuous Compounding EAR = eAPR - 1