Capital Budgeting

FIN3701
National University of Singapore

Reference: RWJJ Chapter 6 and 7

Last Update: 10 Aug. 2022

1
 Survey Published in 2002
• Survey of the Fortune 1000 CFOs finds NPV to be
the most preferred tool over IRR and all other
capital budgeting tools.
• Most financial managers utilize multiple tools in
the capital budgeting process.

• If interested, please see

“Capital Budgeting Practices of the Fortune 1000:
How Have Things Changed?” Patricia A. Ryan &
Glenn P. Ryan; Journal of Business and
Management, Volume 8, Number 4, Fall 2002
3
 Steps in Valuation

1. Estimate future cash flows (CF) from

project (how much and when)
2. Assess risk and determine a required
return
3. Compute present value of expected CF
4. If present value is more than the cost,
project will create value

Accept if: Benefit > Cost

4
Example: Growth Enterprises Inc

Growth Enterprises Inc

Table 1
Type of Cash Flow Year 0 Year 1 Year 2 Year 3

Project A Investment -10,000

Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555

Project B Investment -10,000

Revenue 30,000 10,000 5,000
Operating expenses 15,555 5,555 2,222

All revenues and expenses are cash items.

Depreciated to zero on straight line basis.
Marginal tax rate of 40%. No salvage value at end.
Assume projects have equivalent risk.

What are the cash flows for project A in

years 0, 1, 2, and 3, respectively?
 Calculate Cash Flow

Type of Cash Flow Year 0 Year 1 Year 2 Year 3

Project A Investment -10,000

Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555

Project A Investment -10,000

Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555
Depreciation 3,333 3,333 3,333
Profit before taxes 1,111 2,778 11,112
Taxes @ 40% 444 1,111 4,445
Profit after taxes 667 1,667 6,667
Depreciation 3,333 3,333 3,333
Cash Flow 4,000 5,000 10,000

6
 Type of Cash Flow Year 0 Year 1 Year 2 Year 3

Project B Investment -10,000

Revenue 30,000 10,000 5,000
Operating expenses 15,555 5,555 2,222

Project B Investment -10,000

Revenue 30,000 10,000 5,000
Operating expenses 15,555 5,555 2,222
Depreciation 3,333 3,333 3,333
Profit before taxes 11,112 1,112 -555
Taxes @ 40% 4,445 445 -222
Profit after taxes 6,667 667 -333
Depreciation 3,333 3,333 3,333
Cash Flow 10,000 4,000 3,000

Q: How is it possible to
have negative taxes
here?
7
 Net Present Value

• NPV = - initial cost + PV (free cash flows)

𝐹𝐶𝐹" 𝐹𝐶𝐹# 𝐹𝐶𝐹$
𝑁𝑃𝑉 = −𝐼! + " + # + ⋯+
1+𝑟 1+𝑟 1+𝑟 $
• (Unlevered) FCF = EBIT
– Taxes on EBIT
+ Depreciation & Amortization
– Change in Net Working Capital
– Capex
• If project is an expansion, discount rate is the
weighted average cost of capital (WACC)
()*+,- /01,
𝑟%&'' = 𝑟 + 𝑟 (1 − 𝑇2 )
()*+,-./01, ()*+,- ()*+,-./01, /01,

8
 Rationale for the NPV method
• NPV = PV (cash inflows) – cost
= Net gain in value

• Accept project if NPV > 0

• A positive NPV adds value to the firm
• Higher NPV adds more value
• For mutually exclusive projects, choose higher
NPV
• What is the NPV for projects A and B,
respectively? (at r = 10%)

9
 Project Cash Flows NPV
Type of Cash Flow Year 0 Year 1 Year 2 Year 3 10%

Project A Investment -10,000

Cash Flow 4,000 5,000 10,000 5,281

Project B Investment -10,000

Cash Flow 10,000 4,000 3,000 4,650

• Which project/projects to accept?

At r=10%
• If A and B are independent, accept both because
NPV > 0
• If A and B are mutually exclusive, accept A
because
NPVA(5281) > NPVB(4650)
 Cash Flows, not accounting numbers
Costs of fixed assets
§ When an asset is purchased, the cost is considered as
cash outflow at the time the firm pays for it.

§ In accounting, this cost is not deducted as expense

immediately. It sits on the balance sheet and is
deducted as depreciation expense over a few years.

Year 0
Project A Investment -10,000
Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555
Depreciation 3,333 3,333 3,333
Profit before taxes 1,111 2,778 11,112
Cost of fixed assets Taxes @ 40% 444 1,111 4,445
Profit after taxes 667 1,667 6,667
– paid at time 0, Depreciation 3,333 3,333 3,333
consider as CF at Cash Flow 4,000 5,000 10,000
time 0!
11
 Cash Flows, not accounting numbers
Depreciation
§ Depreciation is deducted from revenue to arrive at
profit before tax. It reduces tax payable. It is a tax
shield.

§ However, depreciation itself is not a cash outflow.

Year 0
Project A Investment -10,000
Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555
Depreciation 3,333 3,333 3,333
If depreciation Profit before taxes 1,111 2,778 11,112
has been Taxes @ 40% 444 1,111 4,445
Profit after taxes 667 1,667 6,667
deducted to Depreciation 3,333 3,333 3,333
compute tax Cash Flow 4,000 5,000 10,000

payable, add it
back! 12
 Only Incremental Cash Flows

• Only incremental Cash Flows are relevant.

What are incremental Cash Flows?
– firm’s Cash Flows with the project minus firm’s Cash
Flows without the project

• “Will this Cash Flow occur ONLY if the firm

accepts the project?”
– If “yes”, it is incremental and should be included in the
analysis
• Need additional staff in production and HR
– If “no”, it is not incremental because it will occur anyway
– If “part of it”, then only that part of it is incremental
• Additional utilities, overtime pay
13
Changes in Net Working Capital matter

• A company sold $5,000 in 2019. Only received

payment for $4,000. Thus, the account receivable is
$1,000. What is the company's cash flow in 2019?
Zero taxes and COGS.

• A company sold $5,000 in 2019 and 2020. Account

receivable is $1,000 for both 2019 and 2020. What is
the company's cash flow in 2019 and 2020? Zero
taxes and COGS.

14
 Credit Sales
§ Recognized as revenue in financial statements at the time of
sale but, for investment decisions, the sale will not be
considered cash inflows until cash is received.
Expenses
§ Matched to the revenue in financial statements but, for
investment decisions, the expense will not be considered as
cash outflows until cash is paid.
Growth Enterprises Inc

Type of Cash Flow Year 0 Year 1 Year 2 Year 3

Assume
Project A Investment -10,000
revenues and Revenue 10,000 11,000 30,000
expenses are in Operating expenses 5,555 4,889 15,555
cash terms. Project B Investment -10,000
Revenue 30,000 10,000 5,000
Operating expenses 15,555 5,555 2,222

In our example, revenues and expenses were in cash otherwise

adjustments have to be made through changes in net working
capital. 15
 Changes in Net Working Capital matter
Current Assets
§ Additional accounts receivable may result because of more
sales

§ Additional inventories in the form of raw materials may be

needed, or they may sit in the warehouse as finished goods

§ These additional Current Assets mean less cash inflow

because of receivables or more cash outflow because of
inventory (less cash in the firm)

§ Note that at the end of the project’s life, the inventories

and receivables will return to their original levels
• Changes in net working capital - consider!
• Additional current assets è more cash required

16
Current Liabilities
§ Additional payables may result when firm orders more
raw materials. Suppliers provide additional credit

§ These additional Current Liabilities reduce cash needed

§ At the end of the project’s life, the payables will return

to their original levels

Changes in net working capital - consider!

Additional current liabilitiesè more cash in the
firm

17
 Sunk Costs Do Not Matter

• A cost that has already been incurred and cannot be

altered by the project under consideration.
• It is not incremental in nature.
• Example 1:
• Extensive R&D done in the past few years have
resulted in a new product.
• In evaluating whether to launch the new product,
should the costs of the R&D be charged as a cash
outflow?
• No, it is a sunk cost.
• Example 2:
• Test marketing cost incurred.

18
 Sunk Cost Example (cont’d)

• General Dairy Company hired a

financial consultant to help evaluate
whether to launch a new line of
chocolate milk.
• When the consultant turned in the
report, General Dairy observed that the
consultant had left out its hefty
consulting fee from the analysis.
• Is this correct?
• Yes, it should be left out. It is a sunk
cost. 19
 Opportunity Costs Matter
• Cash Flows that can be generated from an asset
(that the firm already owns) if it is not used for
the project in question.
• A company has an existing factory which is
vacant. It can rent out the factory or use it for a
new project.
• If the company decides to use it for the project,
the lost rental is an opportunity cost.
• The value that the project really adds is
therefore smaller.
• How to account for this?
• Deduct the rental from the project’s cash flows.
20
 Side Effects or Externalities
Matter
• If a new product affects the sales of the
firm’s other products, there is an
“externality”.

• Externalities can be positive (in the case of

complements) or negative (substitutes).
o Complement
If a new product is likely to increase sales of an
existing product, the Cash Flow gain must be added
to the new product at the evaluation stage.

o Substitute / Cannibalization / Erosion

If a new product is likely to take away sales from an
existing product, the Cash Flow loss must be charged
to the new product at the evaluation stage.
• Are iPhone 13 and iPhone 13 Pro substitutes or
21
complements?
 Complement Example

• If a company launches a printer, the sales

of its computers may increase.
• This additional sales from its computers
must be added to the printer project in
evaluating its attractiveness.
• Another example – introduce iPod, improve
sales of iTunes

22
 Substitute (or Erosion) Example

• McDonald is evaluating the

possibility of opening a new branch.
Some of the customers at nearby
branches may switch over to the new
branch.
• The reduction of sales revenue at
these nearby branches must be
deducted from the Cash Flow of the
new branch at the evaluation stage.

23
 Will the erosion occur anyway?
-- not clearcut
• If a new iPhone is launched, the sales of
older models may be eroded. Should the
drop in sales of these older models be
deducted from the new iPhone project?
• You should ask the following question
instead: will the drop in sales or erosion of
older models occur anyway?
– If yes (because competitors will
introduce new models), then the drop is
not due to the new iPhone èshould not
be deducted from the new iPhone
project.
24
 Taxes matter

• When the company makes profits, it has to pay

taxes

• Always consider after tax cash flows

Project A Investment -10,000

Revenue 10,000 11,000 30,000
Operating expenses 5,555 4,889 15,555
Depreciation 3,333 3,333 3,333
Profit before taxes 1,111 2,778 11,112
Taxes @ 40% 444 1,111 4,445
Profit after taxes 667 1,667 6,667
Depreciation 3,333 3,333 3,333
Cash Flow 4,000 5,000 10,000

25
 Ignore Financing Charges
- Do not minus interest expense or dividends

• Financing costs (cost of debt and cost of

equity) have already been taken into
account when the Cash Flows are
discounted using the Weighted Average
Cost of Capital.
Equity Debt
rwacc = re + rd (1 - T)
Debt + Equity Debt + Equity

CF1 CF2 CFn

NPV = CF0 + + + ... +
(1 + r )1 (1 + r )2 (1 + r )n
• Deducting interest expense and
dividends will result in “double
counting” financing costs.
26
 Growth Enterprises Inc

Type of Cash Flow Year 0 Year 1 Year 2 Year 3

Project A Revenue 10,000 11,000 30,000

Operating expenses -5,555 -4,889 -15,555
Investment -10,000

Project A Revenue 10,000 11,000 30,000

Operating expenses -5,555 -4,889 -15,555
Depreciation -3,333 -3,333 -3,333
Profit before taxes 1,111 2,778 11,112
Taxes @ 40% -444 -1,111 -4,445
Profit after taxes 667 1,667 6,667
Depreciation 3,333 3,333 3,333
Investment -10,000
Cash Flow -10,000 4,000 5,000 10,000

Interest expense not deducted

27
 In summary, what are the relevant Cash Flows?

• Consider
• Costs to get the project up and running
• Additional revenue
• Additional costs
• Reduction in costs
• Changes in net working capital
• Opportunity costs
• Side effects or Externalities
• Taxes
• Ignore
• Sunk costs
• Side effects that are not incremental in nature
• Financing costs

28
 Analyze a Proposed Project

• First, classify cash flows as follows:

§ Initial
• up-front cost of fixed assets + increases in Net
Working Capital
§ Operating Cash Flows over project’s life
• after-tax operating income + depreciation
§ Terminal
• salvage value of fixed assets,
• tax on salvage value
• recovery of Net Working Capital (sometimes,
NWC is recovered gradually over the project’s
life)

29
Then, set up a time line for the project’s cash flows

0 1 2 3 4 5

Initial OperatingCF1 OperatingCF2 OperatingCF3 OperatingCF4 OperatingCF5

CF
+
Terminal CF

CF0 CF1 CF2 CF3 CF4 CF5

30
 Example
• Capital expenditure of $500,000. Fully
depreciated in 5 years. Equipment can be sold
for $5,000 at the end of 5 years.
• Change in net working capital: 27% of change in
sales. Incurred at beginning of year.
• Sales: $10m, $13m, $13m, $8.667m, $4.333m
• Cost of goods sold: 60% of sales
• Selling, general & admin expenses: 23.5% of
sales
• Introductory expense at time 1= $200,000
• Already spent $1m on research and development
• Tax=40%
• weighted average cost of capital = 20% 31

• NPV of the project after R&D?

Capital expenditure of $500,000.
Net working capital: 27% of change in sales.
Incurred at beginning of year

Initial Cash Flows

Equipment -$500,000

Change in net working capital=

27% of change in sales (0 in Year -$2,700,000
0 and $10m in year 1)

CF0 -$3,200,000

32
 Operating cash flows over project’s life (in ‘000s)

1 2 3 4 5
Sales 10,000 13,000 13,000 8,667 4,333
Cost of Good Sold (60% of sales) -6,000 -7,800 -7,800 -5,200 -2,600
Selling, general & admin expenses (23.5% of sales) -2,350 -3,055 -3,055 -2,037 -1,018
Introductory expenses -200
Depreciation -100 -100 -100 -100 -100
Profit before taxes 1,350 2,045 2,045 1,330 615
Taxes (40%) -540 -818 -818 -532 -246
Profit after taxes 810 1,227 1,227 798 369
Add depreciation 100 100 100 100 100
Change in net working capital (27% of change in sales) -810 0 1,170 1,170 1,170
Operating Cash Flow 100 1,327 2,497 2,068 1,639

Note that Net Working Capital is recovered eventually:

-2700 – 810 + 0 + 1170 + 1170 + 1170 = 0

33
Terminal Cash Flows

Salvage Value of Equipment $5,000

Tax on salvage value -$2,000

40% of (salvage value – book
value)
CF5 $3,000

34
 Depreciation
• Two methods:
use method 1
• 1) depreciate at 100 for 5 years
– cash flow from depreciation = 0.4*100
– the book value at year 5 will be 0
– cash flow from asset sales
= SV – tax rate * (SV-BV) = 3
– sum cash flows (undiscounted) = 5*0.4*100 + 3 = 203
• 2) depreciate at 99 for 5 years
– cash flow from depreciation = 0.4*99
– the book value will be 5 at year 5
– cash flow from asset sales
= SV – tax rate * (SV-BV) = 5
– sum cash flows (undiscounted) = 5*0.4*99 + 5 = 203

35
 Depreciation
• Both methods are fine.
• The undiscounted cashflows are the
same.
• The discounted cashflows are different,
however.
• The second method is more conservative
for calculating NPV, since cashflows are
realized at a later date.
• What should we do for this class?
– We will use method 1 (to be consistent
with prior courses)
36
 Here are all the project’s net Cash Flows
(in thousands) on a time line
0 r = 20% 1 2 3 4 5

-3200 100 1327 2497 2068 1642

NPV = $907 thousand

Cash Flowscumulate PV at t=0 cumulate
CF0 -3200 -3200 -3200
CF1 100 -3100 83.33 -3116.67
CF2 1327 -1773 921.53 -2195.14
CF3 2497 724 1445.02 -750.12
CF4 2068 2792 997.30 247.18
CF5 1642 4434 659.88 907.07

37
 Here are all the project’s net Cash Flows
(in thousands) on a time line if we include R&D
0 r = 20% 1 2 3 4 5

-4200 100 1327 2497 2068 1642

NPV = -$92,932

38
 Dividend Discount Model (DDM)
• The value of a common share is the PV
of all future expected dividends.
𝐸(𝐷" ) 𝐸(𝐷$ ) 𝐸(𝐷% )
𝑃! = + $
+ %
+⋯
1 + 𝑟# 1 + 𝑟# 1 + 𝑟#
(
𝐸(𝐷& )
=+
1 + 𝑟# &
&'"
– where 𝑟# is the required return of
shareholders.
• In practice, it is difficult to project all the future
dividends.
• Hence, we need some simplifying assumptions.
– Zero growth model
39
– Constant growth model
 DDM: Constant Growth Model

• If the dividends are expected to grow

forever at a constant rate, g:
𝐸 𝐷" = 𝐷! 1 + 𝑔
𝐸 𝐷$ = 𝐷! 1 + 𝑔 $
𝐸 𝐷% = 𝐷! 1 + 𝑔 %
𝐸 𝐷& = 𝐷! 1 + 𝑔 &
• Then, the share will be worth:

𝐸(𝐷" ) 𝐷! (1 + 𝑔)
𝑃! = =
𝑟) − 𝑔 𝑟) − 𝑔 40
NPV Analysis: More
Advanced Topics

41
 NPV Analysis

• How reliable are the NPV estimates?

• What can we do about forecasting risks?
– Projects with Unequal Lives
– Sensitivity Analysis
– Scenario Analysis
– Break-even Analysis
• Non-traditional NPV analysis
– Decision Trees
– Options

42
 Projects with Unequal Lives

Projects S and L are mutually exclusive and will

be repeated. Which is better? Use r = 10%

0 1 2 3 4

S L
Project S NPV 4.132 6.190
60 60
(100)
NPVL > NPVS
But is L better?
Project L 33.5
33.5 33.5 33.5
(100)

43
• Project S can be repeated after 2
years to generate additional profits

• Use either
§ replacement chain (common life)
§ equivalent annual annuity (EAA)

44
 Replacement Chain Approach
S L
NPV 7.547 6.190
Project S with replication NPVS > NPVL
S is better

0 1 2 3 4

Project S
(100) 60 60
repeat (100) 60 60

(100) 60 (40) 60 60

NPVs = $7.547

45
Equivalent Annual Annuity (EAA) Approach

• How do we compare one project that

has a 6-year life with another that
has a 10-year life?
Need common life of 30 years

• Simpler to use EAA

– Find the EAA whose PV is equal to
the project’s NPV
– Note:
o Choose higher EAV (value)
o Choose lower EAC (cost) 46
 S L
Project S (EAA): NPV 4.132 6.190

0 1 2
10%

2.381 2.381

PV1
PV2

4.132 = NPVS

47
Project L (EAA): NPV
S
4.132
L
6.190

0 1 2 3 4
10%

1.953 1.953 1.953 1.953

PV1
PV2
PV3
PV4
6.190 = NPVL

48
 S L
NPV 4.132 6.190
NPV (common life) 7.547 6.190
EAV 2.381 1.953
EAVS > EAVL
S is better
i*npv / (1- (1+i)^-n

• Project S has higher NPV using

common life, and higher EAV.

• Replacement chain approach and

EAA approach always lead to the
same decision.

49
 Example: Drug companies
• Drug companies spend billions on R&D
(early stage) but produce few new
medicines
• Example: Vaccine for COVID-19
Ø100s of R&D (biotech, academia,
govt, pharma)
ØMore than 200 vaccine candidates
Ø30 human trials (Phase 1, 2, 3)
Ø a few products, billions of doses
• How should we assess whether it is
worth it to experiment with a new
drug? 50
 Decision Tree (Real Options)

The firm has a two stage decision making process. Invest:

Stage 1: early stage drug development.
Exercise
Success Option

Stage 1: Do not
creates invest
option to
invest Failure

Stage 2: to invest more in drug

development if early results are Invest?
good. 51
 Singapore Pharmaceuticals

• The Singapore Pharmaceuticals Corporation is

considering investing in developing a drug that
cures a new flu.
• A corporate planning group, including
representatives from production, marketing, and
engineering, has recommended that the firm go
ahead with the test and development phase.
• This preliminary phase will last one year and cost
$1billion. Furthermore, the group believes that
there is a 60% chance that tests will prove
successful. (Cost of capital = 10%)
• If the initial tests are successful, S’pore
Pharmaceuticals can go ahead with full-scale
production. This investment phase will cost
$1.6billion. Production and sales will occur over
the next 4 years.
52
 S’pore Pharma. NPV of Full-scale
Production Following Successful Test

Investment Year 1 Years 2-5

Revenues $7,000
Variable Costs (3,500)
Fixed Costs (1,800)
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow -$1,600

What is the NPV of testing? (in million

dollars)
53
 S’pore Pharma. NPV of Full-scale
Production Following Successful Test

Investment Year 1 Years 2-5

Revenues $7,000
Variable Costs (3,500)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,300
Tax (34%) (442)
Net Profit $858
Cash Flow -$1,600 $1,258
4
$1,258
NPV = -$1,600 + å t
= $2,388
t =1 (1.10)
Note that the NPV is calculated as of date 1, the date at which the
investment of $1,600 million is made. Later we bring this number back 54
to date 0.
Decision Tree for S’pore Pharma.

The firm has two decisions to make: Invest

To test or not to test.
NPV = $2,388m
To invest or not to invest.
Success

Test Do not
NPV = $0
invest
Failure

Do not Invest
NPV = $0 NPV ?
test
55
S’pore Pharmaceutical: Decision to Test
• Let’s move back to the first stage, where the
decision boils down to the simple question:
should we invest?
• The expected payoff evaluated at date 1 is:

Expected æ Prob. Payoff ö æ Prob. Payoff ö

= çç ´ ÷÷ + çç ´ ÷÷
payoff è sucess given success ø è failure given failure ø
Expected
= (.60 ´ $2,388) + (.40 ´ $0 ) = $1433
payoff
• The NPV evaluated at date 0 is:
$1,433
NPV = -$1,000 + = $302.40
1.10
Should we test? 56
 Sensitivity Analysis

• Analysis of the effect of the project if

there are some changes in the critical
variables like sales and costs.
• Also known as “what if” analysis; we
examine how sensitive a particular
NPV calculation is to changes in the
underlying assumptions.
• It shows that NPV varies under
different assumptions for one
parameter and provides a sense of the
project’s risk.

57
 Sensitivity Analysis

In the S’pore Pharma. Investment Year 1 Years 2-5

example, revenues
were projected to be Revenues $6,000
$7,000 million per Variable Costs
year. What if it is (3,000)
only $6,000 million Fixed Costs
per year due to drop (1,800)
in price? Depreciation (400)
Pretax profit $800
Tax (34%) (272)
Net Profit $528
è NPV falls to Cash Flow -$1,600 $928
$1,341.64
4
$928
NPV = -$1,600 + å t
= $1,341.64
t =1 (1.10)
58
 Sensitivity Analysis

• We can see that NPV is very sensitive to

changes in revenues. For example, a 14%
drop in revenue leads to a 44% drop in NPV
$6,000 - $7,000
%DRev = = -14.29%
$7,000

$1,341.64 - $2,387.69
%DNPV = = -43.81%
$2,387.69
• For every 1% drop in revenue we can
expect roughly a 3.07% drop in NPV
- 0.4381
3.07 =
- 0.1429
%change NPV/
%change rev

59
 Scenario Analysis
• A variation on sensitivity analysis is scenario
analysis.
• For example, the following three scenarios
could apply to S’pore Pharmaceuticals:
1. The next years each have heavy flu
infections, and sales exceed expectations,
but labor costs skyrocket.
2. The next years are normal and sales meet
expectations.
3. The next years each have lighter than
normal flu infections, so sales fail to meet
expectations.
• Other scenarios could apply to govt. approval
for the drug.
• For each scenario, calculate the NPV. 60
 Break-Even Analysis
• Another way to examine variability in
our forecasts is break-even analysis.
• In the S’pore Pharmaceuticals example,
we could be concerned with break-even
revenue, break-even sales volume or
break-even price.
• What is the break-even sales volume?
(for a price per dose of $10)
• The break-even incremental after-tax
cash flow is given by:
𝑿
• 𝑵𝑷𝑽 = 𝟎 = −𝟏𝟔𝟎𝟎 + ∑𝒕'𝟏,𝟐,𝟑,𝟒
𝟏.𝟏𝒕
𝟏 𝟏𝟔𝟎𝟎
• ∑𝒕4𝟏,𝟐,𝟑,𝟒 = 𝟑. 𝟏𝟔𝟗𝟖𝟕 → 𝑿 = = 𝟓𝟎𝟒. 𝟕𝟓 61
𝟏.𝟏𝒕 𝟑.𝟏𝟔𝟗𝟖𝟕
 Break-Even Analysis
• We can start with the break-even incremental after-tax
cash flow and work backwards through the income
statement to back out break-even revenue:
Investment
Investment calculation Cash
calculation Cash Flow
Flow
Investment calculation Cash Flow
Revenues
Revenues
Revenues 92

Variable
Variable Costs
Variable Costs
Costs 41

Fixed
Fixed Costs
Costs 320 000

Depreciation
Depreciation 104 000

Pretax
Pretax profit
profit = 104.75 ÷ (1-.34) $158.72 178336.56

Tax
Tax (34%)
(34%)
Net
Net Profit
Profit = 504 - depreciation $104.75
Cash
Cash Flow
Flow $504.75
$504.75
$504.75 1319102

62
 Break-Even Analysis
• We can start with the break-even incremental after-tax
cash flow and work backwards through the income
statement to back out break-even revenue:
Investment
Investment calculation Cash
calculation Cash Flow
Flow
Investment calculation Cash Flow
Revenues
Revenues = 158.72+0.5Rev+FC+D $4,717.44
Revenues
Variable
Variable Costs
Variable Costs
Costs (2,358.72)
Fixed
Fixed Costs
Costs (1,800)
Depreciation
Depreciation (400)
Pretax
Pretax profit
profit = =104.75
104.75÷ ÷(1-.34)
(1-.34) $158.72
$158.72
Tax
Tax (34%)
(34%)
Net
Net Profit
Profit = =504
504- depreciation
- depreciation $104.75
$104.75
Cash
Cash Flow
Flow $504.75
$504.75
$504.75
63
 Break-Even Analysis

• If we have break-even revenue as $4,717 million we

can calculate break-even price and sales volume.
• If the original plan was to generate revenues of
$7,000 million by selling the cold cure at $10 per
dose and selling 700 million doses per year, we can
reach break-even revenue with a sales volume of
only:
$4717.44 = price ´ (sales volume)
$4717.44
Break - even sales volume = = 471.74 million per year
$10

• We can reach break-even revenue with a price of

only:
• Break-even price = 4717.44/700 = 6.74 per dose
64
 Real Options

• One of the fundamental insights of modern

finance theory is that options have value.
• Because corporations make decisions in a
changing environment, they have options that
should be considered in project valuation.

65
• The Option to Expand
– Has value if demand turns out to be
higher than expected
• The Option to Abandon
– Has value if demand turns out to be
lower than expected
• The Option to Delay
– Has value if the underlying variables
are changing with a favourable trend

66
 Example 1: Option to Abandon
• Suppose that we are drilling an oil well.
The drilling rig costs $300 today.
• In 1 year, we will know whether the well
is a success or a failure.
• The outcomes are equally likely. The
discount rate is 10%.
• The PV of a successful payoff at time 1 is
$575.
• The PV of an unsuccessful payoff at time
1 is $0.

67
Traditional NPV analysis

Success: PV = $575
0.5
Drill

-$300
0.5 Failure: PV=0

Traditional NPV analysis

Do not would indicate rejection of
N PV = $0 the project.
drill
NPV0
0.5(575) + 0.5(0)
= -$300 + = -$38.64
1.10
Traditional NPV analysis

Success: PV = $575
0.5
-$38.64
Drill

-$300
0.5 Failure: PV=0

Do not
drill N PV = $0
Traditional NPV analysis overlooks the option to
abandon by selling the rig.

Success: PV = $575

Drill Stay and stare

at empty pit:
-$300 PV = $0.
Failure

Sell the rig;

Do not salvage value
drill N PV = $0
= $250

The firm has two decisions to make: drill or

not, abandon or stay.
 0.5 Success: PV = $575

Sit on rig; stare

Drill at empty hole:
0.5 PV = $0.
-$300
Failur
e
Sell the rig;
Do not salvage value
N PV = $0
drill = $250
What is the value of the option = project value with the
option – project value without the option?
When we include the value of the option to abandon,
the drilling project should proceed:
0 .5 (5 7 5 ) + 0 .5 ( 2 5 0 )
N P V0 = - $300 + = $ 7 5 .0 0
1 .1 0
 Success: PV = $575

Sit on rig; stare

Drill at empty hole:
$75 -$300 PV = $0.

Failure

Sell the rig;

Do not salvage value
N PV = $0
drill = $250
Value of Option =
Project value with the option – Project
value without the option

Value of Option = $75 – (-$38.64)

!.2($2!)
= $113.64 (given by "."!
)
 Example 2: Option to Delay
StartingYe
ar Cost PV NPV t NPV 0
0 $ 20,000 $ 25,000 $ 5,000 $ 5,000
$ 7 , 900
1 $ 18,000 $ 25,000 $ 7,000 $ 6,364 $ 6 , 529 = 2
2 $ 17,100 $ 25,000 $ 7,900 $ 6,529 (1 . 10 )
3 $ 16,929 $ 25,000 $ 8,071 $ 6,064
4 $ 16,760 $ 25,000 $ 8,240 $ 5,628
• Consider the above project, which can be undertaken in
any of the next 4 years. The discount rate is 10%.
• PV is the future value of all future cashflows (and is not
the per period cashflow.)
• The PV of the benefits at the time the project is launched
remains constant at $25,000, but since costs are
declining, the NPV at the time of launch steadily rises.
• The best time to launch the project is in year 2 —this
schedule yields the highest NPV when judged today.
74
 Example 3: Option to expand
Magna Charter is considering providing an
executive flying service. There is a 40% chance
that the demand in the 1st year will be low. If it is
low, there is a 60% chance that it will remain low
in subsequent year. On the other hand, if the
initial demand is high, there is a 80% chance
that it will stay high.
Immediate problem: what plane to buy?
A turboprop costs $550,000. A piston engine
costs only $250,000 but has less capacity and
customer appeal, and is likely to depreciate
rapidly. Next year, a secondhand piston engine
will be available for only $150,000.
More (necessary) details are in the next slides.
75
 Idea: Start with a piston engine and
buy another piston engine if demand
is high.
It will cost only $150,000 to expand.
If the demand is low, Magna can sit
tight with one small relatively
inexpensive aircraft.
The discount rate is 10%.
What should the airline do? (payoffs for
each decision are on the next page)
More (necessary) details are in the next
slide. 76
There is a 40% chance that the demand in the 1st year will be low. If it is
low, there is a 60% chance that it will remain low in subsequent years. On
the other hand, if the initial demand is high, there is a 80% chance that it
will stay high.
Year 0 Year 1 Year 2
960 (.8)
Turboprop +150(.6)
220(.2)
-550 930(.4)
low +30(.4)
low 140(.6)
800(.8)
-150 100(.2)
+100(.6)
410(.8)
180(.2)
-250 220(.4)
Piston low +50(.4)
low 100(.6)
What is the NPV of buying the most profitable plane?
 960 (.8)
Turboprop +150(.6)
220(.2)
-550 930(.4)
NPV= ? +30(.4)
140(.6)

0.6(150) + 0.4(30)
NPV = -550 +
1.10
0.6[0.8(960) + 0.2( 220)] + 0.4[0.4(930) + 0.6(140)]
+
1.10 2
102 669.6
= -550 + + 2
= $96.16
1.10 1.10
 Year 0 Year 1 Year 2
960 (.8)
Turboprop +150(.6)
220(.2)
-550 930(.4)
low +30(.4)
low 140(.6)
800(.8)
-150 100(.2)
+100(.6)
410(.8)
180(.2)
-250
220(.4)
Piston low +50(.4)
low 100(.6)
- If the demand is high, Magna can buy another piston engine
for $150,000.
- If the demand is low, Magna can sit tight with one small
relatively inexpensive aircraft.

0.8(800) + 0.2(100)
- 150 = 450 at time 1
1.10
*450 800(.8)
-150 100(.2)
+100(.6)
410(.8)
Piston 331 180(.2)
-250 220(.4)
+50(.4)
NPV= ? 100(.6)
 0.6(100 + 450) + 0.4(50) 0.4[0.4(220) + 0.6(100)]
NPV = -250 + +
1.10 1.10 2
350 59.2
= -250 + +
1.10 1.10 2
= $117.11
*450 800(.8)
-150 100(.2)
+100(.6)
410(.8)
Piston 331 180(.2)
-250 220(.4)
+50(.4)
NPV= ? 100(.6)
 Year 0 Year 1 Year 2
960 (.8)
Turboprop +150(.6)
220(.2)
-
550 930(.4)
NPV=96.16 low +30(.4)
low 140(.6)
800(.8)
-150 100(.2)
NPV=117.11 +100(.6)
410(.8)
Piston
180(.2)
-250
220(.4)
low +50(.4)
low 100(.6)
Summary

• Sensitivity analysis gives managers a better

feel for a project’s risks.
• Scenario analysis considers the joint
movement of several different factors to give
a richer sense of a project’s risk.
• Break-even analysis, calculated on a net
present value basis, gives managers
minimum targets.
• The options in capital budgeting, such as the
option to expand, the option to abandon, and
timing options affect value of project.

83
Discounted Cash Flow

84
 Valuation:
Discounted Cash Flow (DCF)
• FCF refers to cash that the firm is free
to distribute to creditors and
stockholders because it is not needed for
working capital or fixed asset
investment (CapEx).
• FCF = EBIT * (1-t) + Depreciation
- change in operating working capital
- change in fixed assets
= EBIT * (1-t) – (DNWC + CapEx -
Depreciation)
85
 Free cash flows
1 2 3 4 5
Sales
less variable cost
less Depreciation
Earnings before interest and tax (EBIT)
less Tax
Earnings before interest but after tax
Add Depreciation
Operating Cash Flow
less Change in NWC
less Net Capital Spending
Free Cash Flow

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 = 𝑃𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑓𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠

86
 DCF (cont’d)

• By definition, EV = Value of Equity + Value of Debt –

Excess Cash0

𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐸𝑉 + 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ! − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡

where, Excess Cash0 is today’s cash above and beyond

the firm’s liquidity needs.
• If the growth rate is constant and perpetual, then
𝐹𝐶𝐹! ∗ (1 + 𝑔)
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = + 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ! − 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡
𝑟"#$$ − 𝑔

• DCF method is often preferred to the dividend growth

model because
– a large number of firms do not pay dividends;
– dividends are hard to forecast.

87
 Firm Valuation -- Discounted Cash Flow

• Enterprise value is equal to the sum of the PV of:

– Unlevered free cash flows throughout the projection period
– Terminal value - estimated value beyond the projection
period assuming the company is in steady state

– Where VN represents the Terminal Value, and can be

calculated using the following equation:

FCFN + 1 æ 1 + g FCF ö
VN = = ç ÷ ´ FCFN
rwacc - g FCF è (rwacc - g FCF ) ø

88
 Firm Valuation -- Discounted Cash Flow

Enterprise Value, V0 = PV(Future Free Cash Flows)

Enterprise Value + Cash = Market Value of Equity + Debt

• Add excess cash, subtract debt, and divide by the

shares outstanding to get price per share:

𝐸𝑛𝑡𝑒𝑟𝑝𝑟𝑖𝑠𝑒 𝑉𝑎𝑙𝑢𝑒 + 𝐸𝑥𝑐𝑒𝑠𝑠 𝐶𝑎𝑠ℎ − 𝐷𝑒𝑏𝑡

𝑃! =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠

89
 Forecasting Financial Statements

• In order to calculate the projected unlevered FCFs, a

forecast of the financial statements is required
– Typically, a 5-year or 10-year forecast is used; you want
to select a time period to reach a performance level
characteristic of steady state
• The key to developing a good forecast is to understand the
industry and to understand the business
• Projections can be based on 4 items:
– Analysis of historical financial statements – last 3 to 5
years; provides a perspective on growth rates and
margins
– Company projections
– Equity research analyst estimates – this is used a lot
when you don’t have access to company or client
projections
– Industry data – benchmark growth and margin
development against comparable companies
90
 Estimating Cost of Capital – WACC

• To value a company using DCF, the forecasted

unlevered FCF needs to be discounted by the risk
associated with the company – this discount rate is
referred to as WACC
• WACC is the market-based weighted average of the
after-tax cost of debt and the cost of equity
𝐷 𝐸
𝑊𝐴𝐶𝐶 = 𝑟! 1 − 𝑇 + 𝑟
𝐷+𝐸 (𝐷 + 𝐸) "

Target level of debt Target level of equity

as a proportion of the as a proportion of the
total firm value total firm value

91
 Components of WACC

Weighted Average Cost of

Capital

Cost of Debt, rd Cost of Equity, re

• Return of the interest- • Return required by the
bearing debt that the equity holders of the
company has on its balance company
sheet • Type of securities
ü Secured or unsecured; ü Common Stock
long-term or short-
term
• Type of securities
ü Bank loans
ü Credit facilities
ü Corporate bonds

Less Risky More Risky

Lower Cost Higher Cost
92

92
 WACC – Key Considerations
• The Company’s target capital structure, not
the current capital structure, is most relevant
for determining WACC
– The current capital structure may not reflect the capital
structure expected to prevail over the life of the business
• Market value, not book value, is more relevant
– Reflects more accurately the true economic claim of each
type of financing
– Exception: You can use the book value of debt; debt may
not be publicly traded
• WACC must be computed after corporate taxes
– The unlevered FCF calculation is also on after-tax terms

93
 Cost of Equity – CAPM

• The cost of equity, re, is calculated by

using the Capital Asset Pricing Model
(CAPM). CAPM defines a stock’s risk as its
contribution to the overall market risk
𝑟! = 𝑟" + 𝛽# (𝑟$ − 𝑟" )
where:
re = cost of equity – expected rate of return on the security
rf = risk-free rate
βL = company’s levered beta
(rM – rf) = equity risk premium (ERP)

• The risk-free rate and equity risk premium

are common to all companies in a given
market; only beta varies across companies.

94
 Cost of Equity – How to Determine
the Components
Component Comments Source
Risk-free rate • Use government default-free • U.S. Dollar:
bonds Federal Reserve
• In the U.S., the 10-year • Data available in
Treasury bond is most Bloomberg, Capital
commonly used. IQ, Factset,
• The currency denomination of Thomson Reuters
the bond should match that of
the cash flows.
Equity Risk • Represents the return above • Bloomberg, Aswath
Premium (ERP) the risk-free rate of the overall Damodaran
stock market.
• It should be the ERP of the
market where the company
does business.
Beta • Measure of a company’s risk • Bloomberg
relative to the stock market. • Yahoo Finance
• Beta is usually referred to as
levered beta (stock beta), since
it takes into account how the
assets are financed. 95
 Terminal Value Calculation

FCF Perpetuity Growth Rate

• Assumes the business continues to

generate free cash flows that grow
at a constant rate g in perpetuity

• Terminal value at the end of year n

= FCFn x (1 + g) / (WACC – g)

• Perpetuity growth rate should

never exceed the GDP growth rate
of the country

96
 Terminal Year Normalization

• The terminal value calculation should be based on

financials reflective of a long-term steady-state which
the company can be expected to achieve.
– Terminal value can represent between 75% to 90%
of the DCF calculated value.
• It is advisable and common practice to normalize the
FCF for terminal value calculation for highly cyclical
businesses.
• Question: If there is no normalization of the
terminal year, how do you think it will impact the
DCF results?

97
Relative Valuation

98
 Relative Valuation
• This is also known as market multiple method, peer
comparison method, or comparable valuation.
• Price multiples involve standardizing prices by earnings,
book value, or sales (like psf)
– Price/Earnings, Price/Book, Price/Sales
• The share price of a company can be estimated by
multiplying the peers’ mean (or median) multiple by its
earnings, book value, or sales:
– share price of A = peers’ mean P/E * company A’s
earnings per share
– share price of A = peers’ mean P/B * company A’s book
equity per share
– share price of A = peers’ mean P/S * company A’s sales
per share

99
 Price Earning Multiple
𝑃 𝑠ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒
=
𝐸 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
– High P/E means that the market expects the firm to do
well in the future. You will only buy a high P/E share if
you believe that it will be much more profitable in the
future.
– Limitations of P/E Multiple
• Difficult to compare P/E across different countries
with different accounting rules.
• P/E can be extremely large for firms with very small
earnings per share.
• P/E multiple cannot be used when earnings are
negative.

100
 P/E across industries in the U.S.,
2015

• Source: WRDS Classroom.

• All of the data reflect financials and pricing available as of 12/31/15. The application uses
median for all industry sector averages.
 Price to Book Multiple

𝑃 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

=
𝐵 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

– High P/B means that the market values

the share highly.
– High P/B = growth stocks
– Low P/B = value stocks

102
 Price to Sales Revenue Multiple
𝑃 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
=
𝑆 𝑠𝑎𝑙𝑒𝑠

Advantages of P/S Approach

– Since the denominator revenue is less affected
by accounting choices (vs. earnings or book
value), it is easier to compare firms that are
under different accounting regimes.
– Since revenue is non-negative, it is also useful
in sectors comprising young companies, where
most or all are losing money.

103
 Enterprise Value to EBITDA
Multiple
𝐸𝑉
𝐸𝐵𝐼𝑇𝐷𝐴
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ
=
𝐸𝐵𝐼𝑇𝐷𝐴

à From EV/EBITDA to share price:

– Company A’s EV = peers’ mean
EV/EBITDA * company A’s EBITDA
– A’s share price = (A’s EV + Excess Cash –
Debt)/ No. of shares outstanding

104
 Enterprise Value to Book Value
Multiple
𝐸𝑉 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝒅𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ
=
𝐵𝑉 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ
– Note: the denominator BV means the book value of all
invested capital (rather than just the equity).

Enterprise Value to Sales Revenue Multiple

𝐸𝑉 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡 − 𝑒𝑥𝑐𝑒𝑠𝑠 𝑐𝑎𝑠ℎ
=
𝑆𝑎𝑙𝑒𝑠 𝑠𝑎𝑙𝑒𝑠

105
 Relative Valuation
• Limitations of multiples
– Peer firms are not identical. Differences
may be due to
• Expected growth rates
• Profitability
• Risk (cost of capital)
• Accounting conventions
• Management & Technology
– Relative valuation (entire industry
maybe misvalued)

106