© 2008 pearson addison wesley. all rights reserved chapter two project analysis using discounted...

© 2008 Pearson Addison Wesley. All rights reserved

Chapter Two

Project AnalysisUsing DiscountedCash Flow (DCF)

© 2008 Pearson Addison Wesley. All rights reserved 1-2

Chapter Outline

• Discounted Cash Flows and Valuation– The Three-Step DCF Process

• Defining Investment Cash Flows– Relevant Cash Flows

• Example: Frito Lay– Conservative and Optimistic Cash Flows– Equity Free Cash Flow (EFCF) vs. Project Free Cash Flow (PFCF)

• Financial Leverage and the Volatility of EFCFs• Comprehensive Example

– Forecasting Project Free Cash Flows• Example: Lecion Electronics Corporation

• Valuing Investment Cash Flows– Using NPV and IRR to Evaluate the Investment– Mutually Exclusive Projects


Discounted Cash Flow Valuation (DCF)

• DCF valuation analysis is simple:– The value of an investment is determined by

the magnitude and the timing of the cash flows it is expected to generate.

– The DCF approach provides a basis for assessing the value of these cash flows

– It is a cornerstone of financial analysis


The 3-Step DCF Process


Defining Investment Cash Flows

• What cash flows are relevant to the valuation of a project or investment?

• Are the cash flow forecasts either conservative or optimistic?

• What is the difference between equity and project cash flows?


Relevant Cash Flows

• Relevant cash flows are often referred to as incremental cash flows– Cash flows directly generated by the investment– Indirect effects that the investment may have on a

firm’s other lines of business• Incremental Cash Flows

– Projected revenues and costs of the new product– Potential cannibalization of other existing products

• Sunk costs are not incremental cash flows and should be ignored


Incremental Cash Flow Example: Frito-Lay

• Frito-Lay evaluates the introduction of a new lime-flavored Doritos® brand Tortilla Chips, it has the highest potential cannibalization effect and the lowest incremental sales as compared to other new products1

– Lime Doritos®: Highest risk of cannibalization• Low incremental sales, most sales a result of reductions in existing

product sales– Baked Chip: Medium risk of cannibalization

• Higher percentage of the revenue considered as true incremental sales due to potential for additional store shelf space

– Natural Line: Lowest risk of cannibalization• Highest percentage of incremental sales because it provides the

opportunity to enter new channels and/or develop new shelf space

1See Practitioner Insight for a look at Frito-Lay’s three-step incremental cash flow; in this example, potential cannibalization refers to the new-lime-flavored Doritos negatively impacting or source sales from, other existing products (such as DORITOS NACHO CHEESE® Flavored Tortilla Chips or DORITOS COOL RANCH® Flavored Tortilla Chips).


Conservative and Optimistic Cash Flows

– Biases exist because of managerial incentives and overconfidence

• Conservatism in Forecast: May result if a cash flow forecast will serve as future targets that will influence future bonuses

• Optimism in Forecast: May result if manager gets a bonus for identifying a promising investment opportunity that the firm initiates

– “Hoped-for” vs. “expected” cash flows

• “If all goes as planned, these are the cash flows that we expect to achieve.”


Equity vs. Project Free Cash Flow

• Investment cash flow is the sum of the cash inflows and outflows from the project

• Equity free cash flow (EFCF): cash flow available for distribution to the firm’s common shareholders– Values the equity claim in the project– Includes cash dividends and share repurchases

• Project free cash flow (PFCF): cash flows available for distribution to both the firm’s creditors and equity holders– Values the project as a whole (both equity and debt claims)


Equity free cash flow (EFCF)

EFCFUnlevered Firm = EBIT(1 - T) + DA -WC –CAPEX

EBIT: Earnings before interest and taxesEBIT(1 - T): After-tax operating income or net operating

profit after tax (NOPAT)T: Tax rateDA: Depreciation and amortization expenseWC: Change in net working capitalCAPEX: Capital expenditures for property, plant, and

equipment


Calculating EFCF from Income Statement


EFCF Definitions

• Depreciation and amortization expense (DA) – Does not represent an actual cash payment– Arises out of the matching principle of accrual

accounting, matches expenditures made for long-lived assets (plant, machinery and equipment) against the revenues they help generate

– The actual expenditure of cash may have taken place many years earlier when the assets were acquired


EFCF Definitions

• Capital expenditures (CAPEX)– To sustain productive capacity and provide for growth

firms invest in long-lived assets• Maintenance CAPEX: Assets physically wear out and need

replacement• Growth CAPEX: To achieve growth in future cash flows firms

require added capacity through investments in new PPE and acquisitions of businesses

– CAPEX can be calculated by analyzing how net PPE on the balance sheet changes over time1

1Net property, plant, and equipment is equal to the difference in the accumulated cost of all property, plant, and equipment (gross PPE) less the accumulated depreciation for those assets.


EFCF Definitions

• Changes in net working capital (WC)1

– Investments in current assets used in a firm’s operations are partially financed by increases in current liabilities

– The end result is an outlay for working capital equal to the change in operating net working capital

1Referred to as “change” rather than “increase” since the change can be both positive and negative.


2.2 Example—equity free cash flow (EFCF) for an all-equity-financed project


Example—equity free cash flow (EFCF) for an all-equity-financed project


Equity free cash flow (EFCF) adjusted for use of debt financing

EFCF = (EBIT-I)(1 - T) + DA - CAPEX - WC – P + NP

• (EBIT – I)(1 - T): Net income after taxes• P: Principal payments on the firm’s outstanding debt• NP: Net proceeds from the issuance of new debt

– When a firm uses debt the two cash flow consequences are net proceeds (inflow) and cash outlays for principal and interest payments. Since interest expense is tax deductible, it reduces the taxes the firm has to pay.


Calculating EFCF for Leveraged Project Using the Income Statement


Financial Leverage and the Volatility of EFCFs

• Borrowing to finance an investment results in financial leverage– Borrowing costs are generally fixed and as the firm’s

profits rise and fall, the borrowing costs do not change (risk of uncertain cash flows must be absorbed by the equity holders)

– Shareholders’ cash flows become more volatile– Because of the higher risk, shareholders require higher

rates of return to entice them to invest in levered projects


Equity free cash flow (EFCF) adjusted for use of debt financing


Calculating PFCF


Lecion Example

• Lecion Electronics Corporation manufactures flat panel LCD computer monitors

• Considering $1.75 billion investment in a new fabrication plant in South Korea– For production of 42-inch LCDs over the next 20 quarters (5

years) using the firm’s proprietary technology– The investment would position Lecion as a major supplier of

large-screen LCDs for sale in the home-entertainment market

• Internal marketing group believes firm can capture an estimated 20% market share once the plant is in full production


Lecion: “The Numbers”

• All of the plant’s revenues are incremental and relevant to our analysis.

• Defining the key cash flow drivers– The new plant will produce a single product (42-inch LCD panels)– Revenues for any given period are equal to the product of the volume of

units sold by the firm times the market price received for each unit sold– Lecion’s revenues for period t:


Lecion: “The Numbers”

• Team estimates Lecion will maintain a market share of 20% of total industry sales of 42-inch LCDs in each quarter1

• Price forecast for the 42-inch LCDs reflects the use of a price decay function2

– Price starting at $9,995 (Q1 2004) dropping to $4,094 by the end of the 20-quarter forecast period (Q4 2008)

• Estimating Cost of Goods Sold and Operating Expenses:

1This is subject to a high level of uncertainty, and sensitivity analysis is recommended (discussed in Chapter 3)2Decay function assumes a rate of price decay of 15%; every time the cumulative market volume of LCDs produced and sold doubles, the price of an LCD drops by 15%.


Lecion PFCF Forecast

Positive cash flow by end of Q3 2004; remains positive throughout project life


Lecion DCF Valuation

• Discounting the Cash Flows– Opportunity cost of capital is 21.55% per year,

or 5% per quarter– Sum the present values of the cash flows

generated by the project in each quarter of the project’s operations (Qtr 1- 20)

• Estimated DCF value of the investment $2,113,170,300


Lecion DCF Valuation

• If Lecion invests $1.75 billion in the project, the project will produce $363,170,300 more, in present value terms, than it costs

• This difference in the present value of the project’s expected future cash flows and the initial cost of making the investment is the net present value (NPV)


Lecion: Analyze NPV and IRR

• Another indicator of anticipated wealth created by an investment is the internal rate of return (IRR)– Compound rate of return earned on the investment

• Lecion project IRR: 6.55% per quarter; 28.91% per year (annualized)– Compare this IRR to the 21.55% cost of capital we

used as our discount rate in calculating the NPV

• Lecion concludes that the investment should be viewed favorably


Mutually Exclusive Projects

• Often the analysis will entail consideration of multiple alternatives or competing projects, where the firm must select only one

• Mutually exclusive investments: the selection of one alternative precludes investment in the others


DCF Valuation: Best Practices

• Investment opportunities can be evaluated using DCF analysis

• Incorporate the three-step process to minimize impact of estimation errors and the subjectivity of forecasting

• Important to identify and forecast incremental revenues and costs

• Maintain flexibility in the implementation of an investment to allow for modification or response to unforeseen future events


Additional Equations

2.1


Table 2-2 Estimating Equity Free Cash Flows (EFCFs) for a Levered Project


Table 2-2 Estimating Equity Free Cash Flows (EFCFs) for a Levered Project (cont.)


Table 2-2 Estimating Equity Free Cash Flows (EFCFs) for a Levered Project (cont. 2)


Table 2-2 Estimating Equity Free Cash Flows (EFCFs) for a Levered Project (cont. 3)

© 2008 pearson addison wesley. all rights reserved chapter two project analysis using discounted...

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