2. Lecture Overview
Orientation
What projects do we invest in?
Estimating a Cost of Capital
Hurdle Rate
Weighted Average Cost of Capital
Estimating Incremental Free Cash flows
Time-weighted tools
NPV
IRR
Others
Summary
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3. Where we are in the course
The first two modules focused on the building
blocks of finance which are common
throughout the field.
Time Value of Money
Bonds and Stocks
Risk and Return (e.g. CAPM)
Starting this week and for the remainder of the
course we will focus more on issues at the
firm-level.
This week focuses on how managers select
the projects a firm should undertake.
This is known as “Project Valuation” or
3 “Capital Budgeting.”
4. What Projects Do We Invest In?
A firm can be thought of as a collection of
projects.
We saw earlier in the course that the primary goal
of the firm is to maximize shareholder value.
Selecting the right projects is the key to
maximizing shareholder value.
Because of this managers need financial tools to
help them evaluate among prospective projects.
We call this process, “Capital Budgeting,” as it
involves the long-term allocation of a firm’s capital
resources.
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5. What Projects Do We Invest In?
In order to decide what to invest in we need three
things:
A return threshold or hurdle rate
The expected incremental cash flows related to the
project
An analysis to stitch the above two items together
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6. Return Threshold (Hurdle Rate)
We have discussed previously the costs of debt
and equity.
Cost of debt:
Interest rates,
Yield to Maturity
Yield to Call
Cost of equity:
The required return that equity holders need to be fairly
compensated
This was estimated with the “CAPM”
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7. Return Threshold (Hurdle Rate)
Moreover, we know that firms raise their capital
through some combination of these instruments.
(The details of how they choose such a
combination will be discussed in subsequent
modules.)
A firm that employs Debt (D) and Equity (E), at
rates of rd and re, respectively, should be
investing in things that (at least) covers these
capital costs.
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8. Weighted Average Cost of Capital
(WACC)
We can calculate a blended cost that weighs the
required returns of each source of capital by their
weights.
We call this the Weighted Average Cost of Capital
(WACC)
WACC = rd x Percentage of Debt + re x Percentage
of Equity
This is often simply written as: rd x D + re x E
Note, the cost of debt (rd) should be the after-tax cost of
debt, because interest on debt payments are deductable
from a firm’s net income.
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9. Weighted Average Cost of Capital
(WACC)
Example of the WACC
A company has debt of $200 million and equity of
$300 million. The after-tax cost of debt is 6% and
the cost of equity is 14%.
%Debt = $200 million / ($200 million + $300 million) = 40%
%Equity = 1 - %Debt = 60%
WACC = rd x D + re x E
= 6% x 40% + 14% x 60%
= 2.4% + 8.4%
= 10.8%
This means the company must invest in projects
that earn at least 10.8% annually, otherwise it is
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10. Cash Flows
The next item we need is an estimate of how
much cash our new project is expected to provide
over its life-time.
The most common way to create an estimate of
the cash flow (the cash that will flow-in from our
project) is to create pro forma financial
statements (income statement, balance
sheet, etc.) based on what we think is going to
happen over the life of the project.
Once created, we can manipulate the financial
statements to determine the cash that comes in
or goes out in a given period.
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11. Free Cash Flows
The cash we are interested in estimating is the
cash that will be available to be used to pay our
financing (the debt and equity)
This is termed the Free Cash Flow (FCF)
because we are free to use it to pay for the
financing of the project.
FCF = Operating Cash Flow – Investment in
Operating Capital
= (EBIT – Taxes + Depreciation) – (Investment in
Fixed Assets + Investment in Working Capital)
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12. Incremental Cash Flows
Note, we are only interested in cash that relates
specifically to undertaking this new venture
(called the incremental cash flow).
For example, if we have already invested in R&D for
the project we would not include that amount in our
analysis because it has no bearing on our decision
to move forward with the project – the money has
already been spent (it’s a “sunk” cost).
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13. Putting these items together
Once we know:
Our cost of capital (as represented by the WACC)
Our estimate of the free cash flows related to the
project
We can then use these in one of many
techniques to make an informed capital budgeting
decision.
The most common such techniques are the Net
Present Value (NPV) and the Internal Rate of
Return (IRR).
Fortunately, both of these relate directly to our
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Time-Value-of-Money calculations we worked with
earlier in the course.
14. Net Present Value
Let’s say we have the following free cash flow
projection for a project:
Year 0: -$100,000
Year 1: $20,000
Year 2: $25,000
Year 3: $50,000
Year 4: $75,000
Additionally, let’s say the WACC for the company
is 9.0%.
We can use the TVM analysis to calculate the
Present Value of each period and then add them
up to get a Net Present Value estimate.
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15. Net Present Value
Year Cash Flow PVIF PV
0 $ (100,000) $ (100,000) Based on this
1 $ 20,000 0.917 $ 18,349 analysis the project
2 $ 25,000 0.842 $ 21,042
should generate
3 $ 50,000 0.772 $ 38,609
4 $ 75,000 0.708 $ 53,132
$31,132 of economic
NPV $ 31,132 value in present
value terms.
WACC 9.00%
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16. Net Present Value
Positive NPV projects (i.e. where the value is greater than
zero) create economic value because they pay for their
capital costs.
Negative NPV projects destroy value because capital
costs are not adequately covered.
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17. Internal Rate of Return
While the NPV has an output in dollar terms
sometimes it is useful to have a rate (percentage)
output from our capital budgeting tool.
The IRR analysis is most common for this.
The IRR is defined to be the discount rate which
produces an NPV of 0.
The next slide shows this for our prior example.
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18. Internal Rate of Return
Year Cash Flow PVIF PV In this case the IRR is
0 $(100,000) $ (100,000) 19.63%.
1 $ 20,000 0.836 $ 16,718 We can then compare
2 $ 25,000 0.699 $ 17,467 the IRR to the required
3 $ 50,000 0.584 $ 29,201
hurdle rate (the
4 $ 75,000 0.488 $ 36,613
NPV $ -
WACC).
When the IRR > WACC
IRR 19.63% the project is creating
value.
When the IRR < WACC
the project is destroying
value.
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19. Other Capital Budgeting Tools
While the NPV and IRR are the most important and
commonly used capital budgeting tools, they are not the
only ones.
Other common tools include:
Payback Period
Discounted Payback Period
Modified IRR
Profitability Index
Most frequently, financial analysts will use several of
these tools to make an informed view on how to
proceed with a project.
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20. Summary
This lecture more formally began our exploration
into “Corporate Financial Management”
The first step is to determine what projects a firm
should choose to undertake.
Deciding what to invest in (capital budgeting)
involves:
Calculating the company’s WACC or relevant cost
of capital.
Estimating the incremental Free Cash Flows from
the project.
Using our capital budgeting tools to analytically
determine value creation or value destruction:
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NPV, IRR and other tools
