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CoFin - Lecture 4
CoFin - Lecture 4
Corporate
Finance
Project
Corporate Finance
Analysis 2019
Theodosios Dimopoulos
HEC Lausanne
Swiss Finance Institute
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Capital Budgeting
Lectures 4-5
Corporate
Finance
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Computing NPV
Lectures 4-5
Corporate
Finance Steps:
Capital 1 Estimate future cash flows
Budgeting
Project
Analysis
E (C1 ), E (C2 ), . . . , E (Ct ), . . . , E (CT )
r ∗ = rf + β[E (rm ) − rf ]
3 Calculate
X E (Ct )
NPV = −I
t
(1 + r ∗ )t
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What goes in the numerator?
Lectures 4-5
Corporate
Finance
Project
Analysis
1 Incremental
What you learn in Business School: Think on the margin!
2 Cash
Much of what credit analysts, M&A analysts, etc., do is
undoing the accounting to recover the cash
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Project Example
Lectures 4-5
Corporate
Finance Linksys has completed a $300,000 feasibility study to
Capital
assess the attractiveness of a new product, HomeNet.
Budgeting
Project
The project has an estimated life of four years.
Analysis
Revenue Estimates
- Sales = 100,000 units/year
- Per Unit Price = $260
- Cost Estimates
* Up-Front R&D = $15,000,000
* Up-Front New Equipment = $7,500,000
* Expected life of the new equipment is 5 years. Housed in
existing lab.
* Annual Overhead = $2,800,000
* Per Unit Cost = $110
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Incremental Earnings Forecast
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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Valuing Projects
Lectures 4-5
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a) Cash Flows
Cash Flows vs. Earnings
Lectures 4-5
Cash flows: difference between cash received and cash
Corporate
Finance paid out
Capital
Budgeting
In finance, you must use cash flows rather than earnings.
Project
Analysis Indeed, you cannot spend earnings
Lectures 4-5
Corporate
Finance
X E (Ct )
Capital
NPV = −I
Budgeting
t
(1 + r ∗ )t
Project
Analysis
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b) Taxes
Before or after tax?
Lectures 4-5
Corporate
Finance Market rates of return are earned on payoffs from
securities:
Capital
Budgeting
Project
Analysis
after corporate tax
before personal tax
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b) Taxes
The tax bill
Lectures 4-5
Corporate
Finance
Marginal Corporate Tax Rate
Capital
Budgeting
- The tax rate on the marginal or incremental dollar of
Project
Analysis pre-tax income. Note: A negative tax is equal to a tax
credit.
Income Tax=EBIT × τ
In real life, corporate taxes are a more complicated issue
Tax Carrybacks
Tax Carryforwards
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b) Taxes
Carrybacks and Carryforwards
Lectures 4-5
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b) Taxes
Tax Loss Carryforward: Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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b) Taxes
Tax Loss Carryforward: Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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c) Treatment of Inflation
Nominal or Real?
Lectures 4-5
Corporate
Finance
Inflation refers to the rise in the general price level as
Capital
Budgeting measured against a standard level of purchasing power
Project
Analysis
There is inflation (deflation) when the quantity of
consumption goods that a fixed amount of money can buy
decreases (increases) over time
Be consistent in your treatment of inflation!
Use a real discount rate to discount real cash flows
Use a nominal discount rate to discount nominal cash flows
The nominal approach is often preferable, since returns
from financial markets are nominal
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c) Treatment of Inflation
What’s real?
Lectures 4-5
Real Measured in units of account with a constant
Corporate
Finance purchasing power
Capital Nominal Measured in units of account with purchasing
Budgeting
power that depends on inflation
Project
Analysis
Examples:
Lease: Nominal
Lectures 4-5
i Inflation rate
Corporate
Finance CFtn Nominal cash flow at date t
Capital CFtr Real cash flow at date t
Budgeting
Project
rr Real discount rate
Analysis
rn Nominal discount rate
Fisher’s formula:
1 + rn = (1 + rr )(1 + i)
or
rn ≈ rr + i
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c) Treatment of Inflation
Example
Lectures 4-5
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d) Non-Cash Items
Depreciation
Lectures 4-5
Corporate
Finance
Forget non-cash items (i.e., depreciation)
Capital
Budgeting ... but...
Project
Analysis
don’t forget the tax consequences of non-cash items
Types of depreciation:
Straight-line depreciation
Accelerated depreciation (MACRS)
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d) Non-Cash Items
Tax Implications
Lectures 4-5
Corporate
Finance Project generates:
Capital CtPT pre-tax operating cash flow at date t
Budgeting
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d) Non-Cash Items
HomeNet Depreciation Example
Capital MACRS Depr. Rate 20% 32% 19.20% 11.52% 11.52% 5.76%
Budgeting Depr. Expense (1500) (2400) (1440) (864) (864) (432)
Project
Analysis Assume that cash flows occur at the end of each year.
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d) Non-Cash Items
MACRS depreciation
Lectures 4-5
only need for tax computation
Corporate
Finance
Capital
Budgeting
Project
Analysis
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e) Sunk Costs
Lectures 4-5
Forget sunk costs!
Corporate
Finance
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f) Overhead
Overhead Often Not Incremental
Lectures 4-5
Corporate
Finance
Capital
Examples of overhead costs:
Budgeting Administrative staff in head office
Project
Analysis
Rent, heat, light...
Accountants want to find places and ways to allocate
overhead
Principle of incremental cash flows: include only the extra
expenses that would result from the project
A project may or may not generate extra overhead
expenses
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g) Opportunity Costs
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Opportunity costs: The value a resource could have
Project provided in its best alternative use
Analysis
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g) Opportunity Costs
HomeNet Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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h) Project Externalities
Lectures 4-5
Externalities are indirect effects of the project that may
Corporate
Finance
affect the profits of other business activities of the firm.
Capital
Budgeting Example: Cannibalization,i.e. a new product displacing
Project sales of an existing product.
Analysis
HomeNet Example:
25% of sales come from customers who would have
purchased an existing Linksys wireless router if HomeNet
were not available.
This reduction in sales of the existing wireless router is a
consequence of the decision to develop HomeNet
The following table takes into account both the
opportunity costs (in SG&A) and the cannibalization effect
(Sales).
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Opportunity costs &Externalities
HomeNet Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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i) Working Capital Requirements
Lectures 4-5
Corporate
Finance Working capital: difference between short term assets and
Capital
liabilities
Budgeting
Principal short term assets: accounts receivable and
Project
Analysis
inventories of raw materials and finished goods
Principal short term liabilities: accounts payable
Don’t forget added working capital!
Classic mistake for small business
Working capital is a permanent investment in your
business, as long as you expect it to operate
If you expect the business to grow, additional investments
in working capital will be required
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i) Working Capital Requirements
HomeNet Example
Lectures 4-5
Corporate
Finance
Assume that Sales are as in the ”Opportunity Costs &
Capital Externalities” slide.
Budgeting
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Free Cash Flows
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis Free Cash Flow=(Revenue-Cost-Depreciation)× (1 − τ )
+Depreciation-Capex-∆NWC
Free Cash Flow= (Revenue-Cost)× (1 − τ )
-Capex+τ ×Depreciation-∆NWC
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Free Cash Flows
HomeNet Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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j) Liquidation
Lectures 4-5
Corporate
Finance
At the end of their life, projects may generate cash flows
Capital
Budgeting from selling equipment and other assets.
Project
Analysis Those cash flows generate a liquidation or salvage value.
In some cases these can be negative (e.g. cost of
scrapping obsolete equipment).
Capital Gain=Sale Price - Book value, where
Book value=Purchase Price- Accumulated depreciation
After tax cash flow= Sale Price-τ × Capital Gain
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i) Liquidation
HomeNet Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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j) Liquidation
HomeNet Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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k) Continuation value
Lectures 4-5
Corporate
Finance
Projects may have an infinite maturity
Capital
Budgeting
In this case, the practice is to forecast cash flows up to a
Project
Analysis
year and then project cash flows into the future using an
assumption (e.g. constant growth).
That means we need to find the terminal value of the
project and discount it to present
We will return to this subject later
For now let’s see a simple example
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k) Continuation value
Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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k) Continuation value
Example
Lectures 4-5
Corporate
Finance
Capital
Budgeting
Project
Analysis
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Summary
Lectures 4-5
Only Cash Flow is relevant
Corporate
Finance Always estimate cash flows on an incremental basis
Capital Do not include non-cash expenses (depreciation, amortization,
Budgeting
etc.)
Project
Analysis Do include the corresponding cash flows (capex, changes in WC,
etc.)
Do include the tax gains from non-cash expenses
Do not include financing flows such as interests, nor their
associated tax deduction
Do not subtract personal taxes
Be consistent with the treatment of inflation
Forget sunk costs, beware of overhead costs
Account for opportunity costs and externalities
Include the liquidation or continuation value
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Project Analysis
Lectures 4-5
Corporate
Finance
“A project is not a black box”
Capital
Budgeting What are the crucial assumptions in project valuation?
Project
Analysis
‘What if’ techniques:
i. Sensitivity analysis: what is the effect of a change in one
of the variables (sales, costs, etc.) on project’s NPV?
ii. Scenario analysis: effect on project NPV of changing
several variables at a time.
iii. Break-even analysis: Analysis of the level of sales (or other
variable) at which the company breaks even.
iv. Monte Carlo simulation: Estimation of the probabilities of
different possible outcomes.
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Example
Lectures 4-5
Project
Analysis
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i. Sensitivity Analysis
Lectures 4-5
Corporate How does the NPV of the project changes if one of the
Finance
cash flow components changes?
Capital
Budgeting Possible outcomes:
Project
Analysis
NPVs:
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ii. Scenario Analysis
Lectures 4-5
Corporate
What would be the effect of a sharp rise in oil prices on the NPV of
Finance the project?
Capital
This would affect several variables at the same time.
Budgeting
Project
Analysis
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iii. Break-Even Analysis
Lectures 4-5
Point at which NPV=0 is the break even point.
Corporate
Finance Otobai Motors has a breakeven point of 85,000 units sold.
Capital
Budgeting
Project
Analysis
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iv. Monte Carlo Simulation
Lectures 4-5
Corporate
Finance
Scenario analysis considers the effect of a limited number
Capital
Budgeting of plausible combinations of variables.
Project
Analysis
MC enables to inspect the entire distribution of project
outcomes.
Modeling process:
Step 1: Modeling the Project
Step 2: Specifying Probabilities
Step 3: Simulate the Cash Flows
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iv. Monte Carlo Simulation
Lectures 4-5
- To analyze the effect of future decisions to the present value
Corporate
Finance today, one needs to integrate out uncertainty, which is usually
done by Monte Carlo Simulation
Capital
Budgeting
Project
Analysis - The modern version of the Monte Carlo method was invented in
the late 1940s by Stanislaw Ulam, while he was working on
nuclear weapon projects at the Los Alamos National Laboratory.
Lectures 4-5
- Monte-Carlo Simulation is a technique for computing
Corporate
Finance probabilities and statistical moments
Capital
- Imagine that x ∼ N (0, 1) with density φ(x) and that you want
Budgeting to compute E (h(x))
Project
Analysis - If h(x) = x, this is easily done analytically
- If h(x) = cos(x(exp(sin(x − log (4 + x))))) then... good luck
- Still numerical integration techniques could provide an accurate
method for evaluating integrals
- Assume a real valued function g (x) : [a, b] → R
- The numerical methods devise a sequence of quadrature points
xk ∈ [a, b] , k = 1, .., n and associated weights wk such that
Pn Rb
k=1 wk g (xk ) u a g (x)dx
- Setting g (x) = h(x)φ(x), we can approximate the value of the
expectation E (h(x))
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iv. Monte Carlo Simulation
Lectures 4-5
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iv. Monte Carlo Simulation
Lectures 4-5
Corporate
Finance
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iv. Monte Carlo Simulation
Lectures 4-5
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iv. Monte Carlo Simulation
Lectures 4-5
Useful Excel Commands: RAND(), NORMINV()
Corporate
Finance
Example
Capital
Budgeting Simulate
Project
Analysis
- a N (1, 2) random variable
- the autoregressive process xt+1 = 0.5xt + 0.8εt+1 , x1 = 1 where
εt+1 ∼ N (0, 1)
1
- a trivariate normal with mean 2
3
1 0.3 −0.1
and covariance matrix 0.3 2 −0.4
−0.1 −0.4 3
See file Simulation Guide.xlsx
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