1

Valuation Methods & Capital

Budgeting
Payback/Discounted Payback
IRR
MIRR
Benefit Cost Ratio (BCR)
NPV (DCF)
FCF: Free cash flow
FTE: Flow to equity
APV: Adjusted present value
2
Payback Rule
Payback period: The amount of time it
takes to recover the original cost.

Payback rule: If the calculated payback
period is less than or equal to some pre-
specified payback period, then accept the
project. Otherwise reject it.
3
The Payback Rule
Time
$200 $420 $855
$-600
0
1 3
4
2
$645
Payback period=2+((600-420)/225)=2.8 years
Accept because payback < 3 years
4
Advantages and Disadvantages of
the Payback Rule
Advantages
Easy
Biased toward liquidity
Quick evaluation
Adjusts long term cash flow uncertainty (by ignoring them)
Disadvantages
Ignores TVM
Ignores cash flow beyond payback period
Biased against long term projects
Popular among many large companies
Commonly used when the:
capital investment is small
merits of the project are obvious so more formal analysis is unnecessary
5
The Discounted Payback Rule
Time
$-600
0
1 3
4
2
The project never pays back so reject.
What is the NPV?
67 . 166
) 2 . 0 1 (
200
1
+
93 . 550
) 2 . 0 1 (
210
4
+
44 . 319
) 2 . 0 1 (
220
2
+
65 . 449
) 2 . 0 1 (
225
3
+
Accumulated discounted cash flows
6
Discounted Payback Rule?
Things to Consider
Involves discounting
How do you choose r?
How do you choose the cut-off period?
Advantages
If project ever pays back then NPV>0
Biased toward liquidity
Easy
Disadvantages
May reject NPV>0 projects
Cut-off period is arbitrary
Biased against long term projects
Bottom Line: Why not just use NPV?
7
Benefit-Cost Ratio (BCR)
Outflows Cash of Value esent
Inflows Cash of Value esent
BCR
Pr
Pr
=
Rato of discounted inflows to outflows.

Rule: Accept project if BCR greater than 1.

Use caution if using to compare mutually exclusive
projects.
Similar BCRs can have radically different NPVs.
8
Internal Rate of Return (IRR) Rule
IRR is that r that makes the NPV=0
T
0 = t
t
t
r) + (1
CF
= NPV

9
IRR Rule
Accept the project if the IRR is greater than
the required rate of return. Otherwise, reject
the project.

Comparison of NPV and IRR
If cash flows are conventional and project is
independent, then NPV and IRR lead to same accept
and reject decisions.

10
IRR Rule and Unconventional
Cash Flows
Unconventional cash flows: A negative cash
flow after a positive one.

Strip Mining Project
Year Cash Flows
0 -60
1 155
2 -100
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Problems with the IRR Rule
Unconventional cash flows lead to multiple IRRs
25% and 33.33%
-1.74
-0.31
-0.28
0
0
0.06
-2
-1.8
-1.6
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
0.2
0 10 20 30 40 50
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Mutually Exclusive
Taking one project means another is not taken
The highest IRR may not have the highest NPV

To evaluate we need to find the crossover rate
Take the differences between the two projects cash
flows and compute the IRR for those incremental
flows
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Mutually Exclusive Cash Flows
Period Proj. A Proj. B Incremental
(A - B)
0 -500 -400 -100
1 325 325 0
2 325 200 125
IRR 19.43 22.17 11.8
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NPV Profiles of Mutually
Exclusive Projects
Crossover Rate = 11.8
IRR
A
=19.43
IRR
B
=22.17
($50.00)
($30.00)
($10.00)
$10.00
$30.00
$50.00
$70.00
$90.00
$110.00
$130.00
$150.00
0 5 10 15 20 25
Project A Project B
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Reinvestment Rate Assumption
During the life of a project, what are the
investment assumptions of the intermediate
cash flows?
Implicitly the PV oriented methods assume
that the cash flows can be reinvested at r.
Is this reasonable?
NPV
IRR
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Modified IRR (MIRR)
Solves the
reinvestment rate
problem
Example: A projects
cash flows are -400,
325 and 200.
Appropriate r is 12%
Accept the project
because 18.74%>12%
Note: The IRR on
this project is 22.16%

400
) 12 . 1 (
400
) (
0
) 1 (
) (
0
0
= =
<
+
=

=
outf lows PV
C if
r
C
outf lows PV
t
T
t
t
t
564 ) 12 . 0 1 ( 200 ) 12 . 0 1 ( 325 ) (inf
0 ) 1 ( ) (inf
2 2 1 2
0
= + + + =
> + =

=

lows FV
C if r C lows FV
t
T
t
t T
t
1874 . 0 1
400
564
1
) 1 (
2 / 1
/ 1
=
(

=
+
=
MIRR
PV
FV
MIRR
MIRR
FV
PV
T
T
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Summary of IRR/MIRR
Advantages: Easy to understand
Conventional Cash Flows and Independent Projects:
Same Decisions as NPV Rule
Required Rate of Return Benchmark
Often same discount rate in NPV
MIRR has more realistic reinvestment rate (use instead of IRR if possible)
Disadvantages:
Unconventional cash flows may result multiple answers
If projects are mutually exclusive may lead to incorrect decisions
Not always easy to calculate
Difficult to interpret (particularly if the project has multiple rs)
IRR may have unrealistic reinvestment rate
Very Popular: People like to talk in terms of returns
Survey of 100 largest Fortune 500 Ind.
99% use IRR Rule
85% use NPV Rule
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NPV(DCF) Valuation Methods
FCF: All relevant cash flows excluding financing costs
discounted by the whole firm r (typically estimated
with WACC(adjusted for taxes))
FTE: FCF minus payments to other finance sources
(typically debt holders) discounted by r
e
APV: All relevant cash flow components separately
discounted by the appropriate rs

Note:
r
e
(e=equity) is the same as r
S
(S=stock)
r
d
(d=debt) is the same as r
B
(B=bond)
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Compare Methods
FCF
Very strict assumptions of constant proportion capital structure (from
WACC)
Can adjust r if risk or capital structure is different from existing firm
Tax debt shield must be t
c
D (for WACC(adjusted))
FTE
Probability of payments to other finance sources, i.e. debt holders
Option to default usually not considered so FTE value is usually low
Difficult to extrapolate entire firm value
APV
Flexible and works well for changing capital structure
Usually will need an estimate of unlevered r
Potential for estimation error depending on NPV of financing
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Incremental cash flows: Only the incremental portion
of any flow is relevant

Otherwise known as the Stand-Alone Principle
Project = "Mini-firm"
Allows us to evaluate the investment project
separately from other activities of the firm
Allows us to make optimal decisions with a
relatively simple process

Relevant Cash Flows
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Relevant Cash Flows?
Sunk Costs
No
Opportunity Costs
Yes
Side Effects (Erosion)
Yes
Net Working Capital
Yes
Value of cash flow volatility change
Yes
Financing Costs
No (there are some methods where this is relevant)
Allocated Overhead Costs
No
All Cash Flows should be after-tax cash flows
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How do we make reasonable cash flow estimates?
Estimate them from scratch
Pro forma financial statements
Probably the best current estimate of future flows.
Make sure you adjust the financial statements for the difference
between accounting flows and finance flows.
Finance flows are based on the principle of opportunity
costs and the timing of the flows is based on when the
money is actually paid/received
Accounting flows (as presented in financial statements) are
based on historical costs and the timing of the flows is
usually based on accrual (not cash) accounting
Use statements to get the basic project cash flow
Need an after tax terminal value
Assume the project goes on forever and use a perpetuity
Assume the project ends and the balance sheet is zeroed out
(everything is sold and settled)
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Two Approaches
Item by item Discounting: Separately forecast relevant flows then
discount them
Very flexible: Can use different discount rates for each flow

Whole Project Discounting: determine projects relevant cash
flows, sum them in each year then discount the yearly sum
FCF=OCF + Net Capital Spending - Changes in NWC
Operating Cash Flows (OCF): EBIT+Depreciation+Other
Non-Cash Expenses-Taxes
Net Capital Spending
Project specific assets, initial costs
After tax salvage value (if project ends)
Changes in NWC
NWC=CA-CL
Changes in NWC = NWC(t)-NWC(t-1)
Recover all NWC at the end of the project (if project ends)
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Alternate Ways to Compute OCF
GOAL: Make sure that all relevant cash inflows
and outflows are included (Holden shows several
of these methods)
Bottom Up: OCF=Net Income + Non-cash
deductions
CAUTION: This method only works if there are no
financing costs already taken out of net income!
Top Down: OCF=Sales - Costs - Taxes
Subtract all deductions except non-cash items
Tax Shield: OCF=(Sales-Costs) x (1-t
c
) + (non-
cash deductions x t
c
)
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Scenario Analysis
WHAT IF?
Estimate NPV with various assumptions
Statistical distribution
Best case, worst cast, most likely case

Sensitivity analysis: Change in NPV due to
one or a few items
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Capital Rationing
NPV>0 then accept, is based on unlimited capital

NPV is still the best criteria but we need to ration
Profitability Index is NPV per investment dollar
Order the projects by PI
Choose projects until PI<0 or you run out of money
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You have $500,000 to spend
Project B, $200,000
Project D, $250,000
Project C, $50,000 (partial investment)

What if you cant do partial investments?
Project Investment NPV PI
A 500,000 80,000 16%
B 200,000 45,000 22.5%
C 300,000 55,000 18.3%
D 250,000 50,000 20%
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Evaluating projects
with different economic lives
Assumptions
Different lives
The project can go on forever

Equivalent Annual Cash (EAC) flows


(

+
=
t
r r
EAC
PV
) 1 (
1
1
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EAC Example
Assume you need to
choose between two
production processes
Original process:
NPV=4,402,679, 8 year
life
Alternative:
NPV=3,200,000, 4 year
life
Which process is better?
272 , 886
) 12 . 0 1 (
1
1
12 . 0
679 , 402 , 4
8
=
(

+
=
(

EAC

EAC
r) + (1
1
- 1
r
EAC
= PV
t
550 , 053 , 1
12 . 0 12 . 0
000 , 200 , 3
4
=
(

EAC

) + (1
1
- 1
EAC
=
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Biases
Systematic deviation from the actual value

31
Cognitive Bias
When conscious beliefs do not reflect the
information
Easy to recall/available information is used
Adjustment and anchoring
Representative
32
Motivational Bias
Statements do not reflect beliefs
Dishonesty
Greed
Asymmetric Reward
Brown-nosing
Fear
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Managing Bias
Recognize it!
Keep going back to the economics
Sensitivity analysis
Information management
Check and recheck assumptions