Capital budgeting and valuation

Capital Budgeting and Corporate Valuation

Pricing your expansion and determining the value of your company.

Capital Budgeting

Income statement provides some indication of profitability but not of true return value or value of capital investment.

Return on capital should be measured on a cash-flow basis and take time into account.

Economic value added

Measuring whether a business or investment is justified because its earnings exceed its cost of capital.

Sometimes other factors justify investment or capital expansion, i.e. goodwill, business strategies, or personnel resources.

Quantitative perspective includes

The time value of money Discounted cash flow analysis Evaluation of projects

NPV – Net Present Value Internal rate of return Payback Profitability index

Time value of money

Hurdle Rate – (Reinvestment rate or opportunity cost of funds)

Common rate used is 12%, but too low for start-ups.

First calculate future value Value plus interest

Calculate Present value factor 1 ÷ Future value

Multiply present value and present value factor

Year 0 1 2 3 4 5

Future Value 1.00 1.12 1.25 1.41 1.57 1.76

Present ValueFactor

1.00 .893 .797 .712 .635 .567

Present value factor is equal to present value/future value

Discounted Cash Flow

Identify cash outflows and inflows

Estimate Risk

Utilize the time value of money

Net Present Value

Present value of all cash inflows and outflows from a capital expansion

A positive NPV is desirable

Machinery Cost Savings Project

Year 0 1 2 3 4 5

PVF 1 .8929 .7972 .7118 .6355 .5674

Base

Cash Flows

(100000) 30000 30000 30000 30000 20000

Present Value

(100000) 26786 23916 21353 19066 11349

Net Present Value

2469 Exceeds the 12% hurdle

PRESENT VALUE TOTAL IS 102469

Comparing Different Investment Opportunities

Never done exclusively on a quantitative approach. Strategy Marketing assumptions Competition Risk Legal Regulatory Human Resources Environment

Internal Rate of Return (IRR)

Calculate the NPV to a zero factor

Excel offers formulas for both NPV and IRR

Payback

How long will it take to repay the amount of the capital investment.

This includes cash inflow from the project

Profitability Index

Ratio of the present value of cash inflows divided by the present value of cash outflows

A $100,000 investment will yield a $30,000 cash inflow for the next five years. 150000/100000 = 1.5

Calculating a Hurdle Rate

Usually is determined by WACC or weighted average cost of capital

Can become subjective Based on the portion of debt to

equity and then using an asset pricing model (comparison) for weighting. Rather complicated.

A common and accepted rate is 10-15%

Corporate Valuation

Book Value Market Value Liquidation Value Replacement Value Discounted Cash Flow Value of Future Earnings Off Balance Valuation

Book Value

Not the market value

Equals the total equity on the balance sheet

Does not accurately depict depreciated assets

Very straight forward

Market Value

Market value verses Book value

Use a P-E ratio Price to earnings ratio

Total Assets – Liabilities in liquidations = Market value

Liquidation Value

Expected net proceeds after expenses and taxes of selling a company’s assets

Usually the bottom line

Replacement Value

Sometimes the cost of starting your own business rather than buying into one is desirable.

When starting a new business, one must compensate for marketing cost to meet sales projected. Very easy to underestimate.

Discounted Cash Flow

Based on a three to five year cash projection much like a start-up business

Utilizing proven marketing history and weighted valuations to calculate the expected cash flow

Value of Future Earnings

Calculating a multiplier

Usually 2-4%

Then income is increased each year

Total of three years is accepted valued price

Off Balance Valuation

Values that are not identified as assets Location Lease or rental contract Customer mailing list Intellectual Property Experienced Staff Computer Software