Business Valuation

Rajiv Bhutani
IIM Sambalpur
2018
 Topics to be covered
• Project Evaluation
• Taxes
• Depreciation
• Working Capital
 Introduction
• How to evaluate and select from multiple
competing/mutually exclusive projects
• Examples include:
– Marketing/Advertising projects
– Research and Development
– Choices from different production processes
– Evaluation of different sales channels
– Launching new products, expansion into new markets
– Acquisitions
 Basic Approach
• Value of any project equals the net present value of the expected
cashflows
• NPV = CF0 + CF1/(1+r) + CF2/(1+r)2 + CF2/(1+r)2 +…
• r = opportunity cost of capital
• Rate of return available in the financial market with similar risk as the
project
• NPV > 0 for a value adding project Or,
• Project creates value only if it has a higher return than other investments
with the same risk
 Measuring Cash Flows
• Measure incremental cash flows and compute the NPV
• Incremental cash flows are the difference between firm’s overall cash flows with
and without the project
• Include any strategic advantage or a competitive advantage
• Main considerations are:
– Sunk Costs
– Opportunity Costs
– Average Vs Marginal Costs
– Depreciation
– Project Interactions
– Inflation
– Working capital changes
– Taxes
– Real options
– Projects with different lives
 Measuring Cash Flows
• Sunk Costs – Ignore sunk costs as they are there with you whether or
not project is undertaken
• Since they represent past decisions which cannot be changed, they are
irrelevant costs for future choice
• They are unavoidable and irrecoverable historical costs, and should be
ignored in analysis
• A firm has invested USD 2 million on R&D expenditure for a new
product. After doing market research, firm is considering whether to
launch the product or not. Setting up the production processes will
cost USD 1 million and revenue per year for next 4 years is projected
to be USD 250,000 per year, growing at 10% per year. Assume
opportunity cost of capital is 5%. Should the firm go ahead with the
new product?
 Measuring Cash Flows
• Opportunity costs – are the expected benefits that the company
would have derived from these resources if they were not
committed to the project at hand
• Example – A company is considering a project that will require
7000 sq feet of space. Company has vacant 10,000 sq feet of
space, which can be lent out for Rs 18 per sq feet. Should the
opportunity cost be considered?
• Option 1: Since no cash outlay is involved and the area is lying
unused, so we can ignore it in measuring cash flows
• Option 2: Since firm could have given this space on rent at Rs 18
per sq feet, we should take into account this opportunity cost
 Measuring Cash Flows
• Consider Marginal Costs, do not consider average
costs to make project evaluation decisions
• Because when you are considering average costs,
you are taking into account possibly historical
costs also
• If you just want to decide between say project A
and B, you want to computer marginal revenues
and marginal costs of these 2 projects
 Measuring Cash Flows
• Inflation – Discount nominal cash flows with
nominal rates, discount real cash flows with
real rates.
• Typically discount rates are nominal rates, so
cash flows should also be nominal
• Some cash flows are by definition nominal e.g.
depreciation tax shields
 Measuring Cash Flows
• Working Capital: Working Capital consists of short term
assets and short term liabilities that happen in course
of doing the business
• Current Assets – Inventory, Accounts Receivable and
Cash
• Current Liabilities – Accounts Payable
• Net Working Capital (NWC) = Current Assets – Current
Liabilities
• When NWC increases, it leads to outflow of cash and
when NWC decreases, it leads to an inflow of cash
 Example – Working Capital
• Maruti has just designed a new Swift Dzire. It
forecasts sales of 200,000 cars per year at an
average price of 580,000. Costs are expected to
be 550,000 / car. The model will sell for 4 years
and Maruti expects an inventory of 40,000 cars
• Let us compute the cash flows
Year 1 2 3 4
Sales (crores) 11600 11600 11600 11600
COGS (crores) 11000 11000 11000 11000
Profit (crores) 600 600 600 600
 Example – Working Capital
Year 1 2 3 4
Sales (crores) 11600 11600 11600 11600
COGS (crores) 11000 11000 11000 11000
Profit (crores) 600 600 600 600
Beg Inventory 0 2200 2200 2200
End Inventory 2200 2200 2200 0
• Change
Discount rate
2200
= 8%0 Then PV0 of WC is-2200
-420 cr
Cash Flow -1600 600 600 2800

Year 1 2 3 4
Inventory Change -2200 0 0 2200
Disc Rate 1.08 1.082 1.083 1.084
PV -2037 0 0 1617
 Example – Depreciation
• Depreciation – An accounting expense, not a real
cash outflow
• So, income gets reduced after applying depreciation
and then taxes are charged from this reduced
income. So, we save taxes, this is called depreciation
tax shield
• Depreciation methods – Straight line, double decline
method
• Depreciation methods in India – Written down value
 Example – Depreciation
• Maruti must invest 4,100 crores in new
equipment to produce new Swift Dzire. The
equipment will be used for the full production
cycle of the car, expected to be 4 years, and will
have a salvage value of 100 crores at the end. The
tax rate is 40%. What are depreciation expense
and tax shields using straight-line and double-
declining balance methods?
 Example – Depreciation
• Straight line depreciation
• Depreciable Value = 4,100 – 100 = 4,000 crore
• Annual Depreciation = 4000/4 = 1000 crore
Year 1 2 3 4
Beg Bk Value 4100 3100 2100 1100
Depreciation 1000 1000 1000 1000
End Bk Value 3100 2100 1100 100
Cash Flows
Purchase/Sale -4100 100
Dep. Tax Shld 400 400 400 400
Total CFs -3700 400 400 500
 Example – Depreciation
• Double Declining Method
• If life is k years, depreciate 2/k of the remaining
book value each year. So, Maruti would
depreciate the equipment 50% = 2/4 each year.
Year 1 2 3 4
Beg Bk Value 4100 2050 1025 512.5
Depreciation 2050 1025 512.5 412.5
End Bk Value 2050 1025 512.5 100
Cash Flows
Purchase/Sale -4100 100
Dep. Tax Shld 820 410 205 165
Total CFs -3280 410 205 265
 Comprehensive Example
• Baldwin, a profitable widget maker, has developed an
innovative new product called the Turbo-Widget (TW).
Baldwin has invested $300,000 in R&D to develop TWs, and
expects that TWs will capture a large share of the market.
• Forecasts :
– Baldwin will have to invest $2 million in new equipment. The
machines have a 5-year useful life, with an expected salvage value
of $250,000. The machines will require a major overhaul after 3
years, costing $100,000.
– Over the five-year product life-cycle, unit sales are expected to be
5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000 units.
Prices in the first year will be $480, and then will grow 2% annually.
 Comprehensive Example
• Sales and administrative costs will be $150,000 every year.
Production costs will be $500 / unit in the first year, but will
decline 8% annually.
• Baldwin must maintain approximately 2 weeks inventory of TWs,
or 4% (2 / 52) of forecasted annual sales. Inventory can be stored
in one of Baldwin’s existing warehouses. The firm estimates that
inventory will require 3,000 square feet and warehouse space
costs $80 / s.f. / year.
• Customers don’t pay immediately. Baldwin expects to have 30-
days of sales outstanding as accounts receivable. Raw materials
must be paid for immediately.
• The tax rate is 34% and the after-tax cost of capital is 12%