FINANCIAL MANAGEMENT

Valuing Projects and Firms

Final Exam (03/04/15)
Preparation Key elements

IESEG FINANCIAL MANAGEMENT S2-2014/2015

COURSE PRESENTATION - AIMS

To get an overview on investment decisions in
a company
To understand the companys investment
decision (NPV, IRR, Payback Investment Rules)

To understand the fundamentals of capital

budgeting
IESEG FINANCIAL MANAGEMENT S2-2014/2015

COURSE PRESENTATION - AIMS

To understand the fundamentals of stock
valuation
To link financial management decisions with
the companys global strategy

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Chapter 3
Financial Decision
Making and the Law
of One Price

Using Market Prices to Determine Cash

Values General Principle
Whenever a good trades in a competitive
market by which we mean a market in which it
can be bought and sold at the same price that
price determines the cash value of the good. As
long as a competitive market exists, the value of
the good will not depend on the views or
preferences of the decision maker
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The Interest Rate: An Exchange Rate

Across Time
Present Versus Future Value

When we express the value in terms of dollars

today, we call it the present value (PV) of the
investment.
If we express it in terms of dollars in the future,
we call it the future value of the investment.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Present Value
and the NPV Decision Rule
The net present value (NPV) of a project or
investment is the difference between the
present value of its benefits and the present
value of its costs.
Net Present Value
NPV PV (Benefits) PV (Costs)
NPV PV (All project cash flows)

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The NPV Decision Rule

When making an investment decision, take the
alternative with the highest NPV.
Choosing this alternative is equivalent to
receiving its NPV in cash today.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The NPV Decision Rule

Accepting or Rejecting a Project

Accept those projects with positive NPV

because accepting them is equivalent to
receiving their NPV in cash today.
Reject those projects with negative NPV
because accepting them would reduce the
wealth of investors.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Choosing Among Alternatives

We can also use the NPV decision rule to choose
among projects. To do so, we must compute the
NPV of each alternative, and then select the one
with the highest NPV. This alternative is the one
which will lead to the largest increase in the
value of the firm.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

NPV and Cash Needs

Regardless of our preferences for cash today
versus cash in the future, we should always
maximize NPV first. We can then borrow or lend
to shift cash flows through time and find our
most preferred pattern of cash flows.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Arbitrage and the Law of

One Price
Law of One Price
If equivalent investment opportunities trade
simultaneously in different competitive markets,
then they must trade for the same price in both
markets.
=> Any competitive price can be used to determine a cash
value, without checking the price in all possible markets
IESEG FINANCIAL MANAGEMENT S2-2014/2015

The NPV of Trading Securities and Firm Decision Making

Separation Principle
We can evaluate the NPV of an investment decision
separately from the decision the firm makes
regarding how to finance the investment or any
other security transactions the firm is considering.

=> We can separate the firms investment decision

from its financing choice
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Chapter 4
The Time Value
of Money

The Timeline
A timeline is a linear representation of the
timing of potential cash flows.

It can be used to represent a series of cash

flows lasting several periods (= stream of cash
flows).
Drawing a timeline of the cash flows will help
you visualize the financial problem.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Timeline
Differentiate between two types of cash flows
Inflows are positive cash flows.
Outflows are negative cash flows, which are
indicated with a (minus) sign.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Timeline

Assume that you are lending $10,000 today and that the loan will be
repaid in two annual $6,000 payments.

The first cash flow at date 0 (today) is represented as a negative sum

because it is an outflow (vs the 2 inflows of + $6000)

Timelines can represent cash flows that take place at the end of any time
period a month, a week, a day, etc.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Three Rules of Time Travel

Financial decisions often require combining
cash flows or comparing values. Three rules
govern these processes.
The Three Rules of Time Travel

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Valuing a Stream of Cash Flows

Most investment opportunities have multiple
cash flows that occur at different point in time
Based on the first rule of time travel we can
derive a general formula for valuing a stream
of cash flows:
If we want to find the present value of a stream
of cash flows, we simply add up the present
values of each.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Internal Rate of Return

In some situations, you know the present value
and cash flows of an investment opportunity but
you do not know the internal rate of return
(IRR), the interest rate that sets the net present
value of the cash flows equal to zero.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Chapter 7
Investment
Decision Rules

NPV and Stand-Alone Projects

The NPV Decision Rule (reminder)
When making an investment decision, take the
alternative with the highest NPV.
Choosing this alternative is equivalent to receiving
its NPV in cash today.

=> Compare the projects NPV to zero and accept

the project if its NPV is positive
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Alternative Rules Versus the NPV Rule

Sometimes alternative investment rules may
give the same answer as the NPV rule, but at
other times they may disagree.
When the rules conflict, the NPV decision rule
should be followed => in these cases, the
alternative rules lead to bad decisions that
reduce wealth

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Internal Rate of Return Rule

Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the cost
of capital. Turn down any investment whose IRR is
less than the cost of capital.

Project cost of capital : return on other

alternatives in the market with equivalent risk
and maturity

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Internal Rate of Return Rule

The IRR Investment Rule will give the same answer as the NPV rule
in many, but not all, situations.
In general, the IRR rule works for a stand-alone project if all of the
projects negative cash flows precede its positive cash flows.

In other cases, the IRR rule may disagree with the NPV rule and
thus be incorrect.
Situations where the IRR rule and NPV rule may be in conflict:
Delayed Investments
Nonexistent IRR
Multiple IRRs

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Payback Rule

The payback period is amount of time it takes to recover or pay
back the initial investment. If the payback period is less than a prespecified length of time, you accept the project. Otherwise, you
reject the project.
The payback rule is used by many companies because of its
simplicity.
Pitfalls:
Ignores the projects cost of capital and time value of money.

Ignores cash flows after the payback period.

Relies on an ad hoc decision criterion.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Choosing Between Projects

Mutually Exclusive Projects :

When you must choose only one project

among several possible projects, the choice is
mutually exclusive.
NPV Rule
Select the project with the highest NPV.
It leads to the greatest increase in wealth

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Choosing Between Projects

Mutually Exclusive Projects :
IRR Rule :
Selecting the project with the highest IRR
But, it may lead to mistakes :
When projects differ in scales of investment

When projects differ in the timing of their cash flows

When projects differ in their riskiness

=> Then their IRRs cannot be meaningfhully compared

IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Incremental IRR Rule

Incremental IRR Investment Rule
Apply the IRR rule to the difference between the
cash flows of the two mutually exclusive
alternatives (the increment to the cash flows of
one investment over the other)
The incremental IRR tells the discount rate at
which it becomes profitable to switch from one
project to the other => we dont compare the
projects directly, we evaluate the decision to
switch from one to the other using the IRR rule
IESEG FINANCIAL MANAGEMENT S2-2014/2015

The Incremental IRR Rule

Shortcomings of the Incremental IRR Rule (same
as for IRR Rule) :
The incremental IRR may not exist.
Multiple incremental IRRs could exist.

The fact that the IRR exceeds the cost of capital for
both projects does not imply that either project has a
positive NPV.
When individual projects have different costs of
capital, it is not obvious which cost of capital the
incremental IRR should be compared to.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Project Selection
with Resource Constraints
Evaluation of Projects with Different Resource
Constraints
The profitability index can be used to identify the
optimal combination of projects to undertake.
Profitability Index

Value Created
NPV

Resource Consumed
Resource Consumed

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Shortcomings of the Profitability Index

In some situations the profitability Index does
not give an accurate answer.
Two Conditions of the Profitability Index :
The set of projects taken following the
profitability index ranking completely exhausts the
available ressource
There is only a single relevant ressource constraint
=> With multiple resource constraints, the
profitability index can break down completely.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Chapter 8
Fundamentals of
Capital Budgeting

Forecasting Earnings
Capital Budget
Lists the investments that a company plans
to undertake

Capital Budgeting
Process used to analyze alternate investments and
decide which ones to accept

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Forecasting Earnings
Incremental Earnings
The amount by which the firms earnings are
expected to change as a result of the investment
decision

Earnings are not actual cash flow. However, as

a practical matter, to derive the forecasted
cash flow of a project, financial managers
often begin by forecasting earnings.
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Interest Expense
In capital budgeting decisions, interest
expense is typically not included. The rationale
is that the project should be judged on its
own, not on how it will be financed.

For this reason, we refer to the net income we

compute as the unlevered net income

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Taxes
Marginal Corporate Tax Rate
The tax rate on the marginal or incremental dollar of
pre-tax income. Note: A negative tax is equal to a
tax credit.
Income Tax EBIT c

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Unlevered Net Income

Unlevered Net Income Calculation
Unlevered Net Income EBIT (1 c )
(Revenues Costs Depreciation) (1 c )

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Incremental Earnings Forecast

Spreadsheet Incremental Earnings Forecast

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Sunk Costs and Incremental Earnings

Sunk costs are costs that have been or will be paid regardless of the
decision whether or not the investment is undertaken.

Sunk costs should not be included in the incremental earnings

analysis.
Typically overhead costs are fixed and not incremental to the
project and should not be included in the calculation of incremental
earnings (except the additional overhead expenses that arise
because of the decision to take the project).
Past Research and Development Expenditures :Money that has
already been spent on R&D is a sunk cost and therefore irrelevant.
The decision to continue or abandon a project should be based only
on the incremental costs and benefits of the product going forward.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Determining Free Cash Flow and NPV

Earnings are an accounting measure of the
firms performance.
To evaluate a capital budgeting decision, we
must determine its consequences for the
firms available cash.
The incremental effect of a project on a firms
available cash is its free cash flow.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Calculating the Free Cash Flow

from Earnings
Net Working Capital (NWC)
Net Working Capital Current Assets Current Liabilities
Cash Inventory Receivables Payables

Most projects will require an investment in net

working capital.
Trade credit is the difference between receivables
and payables.

The increase in net working capital is defined as:

NWCt NWCt NWCt 1
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Calculating the Free Cash Flow

from Earnings
Spreadsheet Calculation of Free Cash

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Calculating Free Cash Flow Directly

Free Cash Flow
Unlevered Net Income

Free Cash Flow (Revenues Costs Depreciation) (1 c )

Depreciation CapEx NWC

Free Cash Flow (Revenues Costs) (1 c ) CapEx NWC

c Depreciation

The term c Depreciation is called the depreciation tax

shield (tax savings resulting from the ability to deduct
depreciation => depreciation expenses have a positive
impact on the free cash flow)
IESEG FINANCIAL MANAGEMENT S2-2014/2015

Calculating the NPV

FCFt
PV (FCFt )
FCFt
t
(1 r )

1
(1 r )t
t year discount factor

Spreadsheet Computing NPV

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Analyzing the Project

Break-Even Analysis
The break-even level of an input is the level
that causes the NPV of the investment to
equal zero.
In a break-even analysis, for each parameter,
we calculate the value at which the NPV is
zero.

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Sensitivity Analysis
Sensitivity Analysis shows how the NPV varies
with a change in one of the assumptions,
holding the other assumptions constant.
Which aspects of the project are more critical
when managing the project

IESEG FINANCIAL MANAGEMENT S2-2014/2015

Chapter 9
Valuing Stocks