Videoconference on NPV/IRR Exercises and Firm Valuation

September 26, 2023 Videoconference Call Narayanan Jayaraman Marc Wechsler Scheller College of Business

Agenda Apple Stock NPV Exercise NPV/IRR Student Exercise Firm Valuation Problems Cost of Capital Exercise NPV and Economic Profits Note: Lots of materials to cover tonight. So please ask questions in Chat

Apple Discussion What is the NPV of a share of Apple stock if purchased today (Sept 22, 2023)?

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Rainbow Products is considering the purchase of a paint-mixing machine to reduce labor costs. The savings are expected to result in additional cash flows to Rainbow of $5,000 per year. The machine costs $35,000 and is expected to last for 15 years. Rainbow has determined that the cost of capital for such an investment is 12%. [A] Compute the payback, net present value (NPV), and internal rate of return (IRR) for this machine. Should Rainbow purchase it? Assume that all cash flows (except the initial purchase) occur at the end of the year, and do not consider taxes. [B] For a $500 per year additional expenditure, Rainbow can get a “Good As New” service contract that essentially keeps the machine in new condition forever. Net of the cost of the service contract, the machine would then produce cash flows of $4,500 per year in perpetuity. Should Rainbow Products purchase the machine with the service contract? [C] Instead of the service contract, Rainbow engineers have devised a different option to preserve and actually enhance the capability of the machine over time. By reinvesting 20% of the annual cost savings back into new machine parts, the engineers can increase the cost savings at a 4% annual rate. For example, at the end of year one, 20% of the $5,000 cost savings ($1,000) is reinvested in the machine; the net cash flow is thus $4,000. Next year, the cash flow from cost savings grows by 4% to $5,200 gross, or $4,160 net, of the 20% reinvestment. As long as the 20% reinvestment continues, the cash flows continue to grow at 4% in perpetuity. What should Rainbow NPV/IRR Exercise Problem 1

NPV/IRR Exercise Problem 1

NPV = -35K + (4.5K/.12) = $2.5K NPV/IRR Exercise Problem 1

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Using Constant Growth Perpetuity NPV = -35000 + 4/.12-.04 NPV = $15,000 NPV/IRR Exercise Problem 1 35000 = 4K /

NPV/IRR Exercise Problem 1 Recap

Suppose you own a concession stand that sells hot dogs, peanuts, popcorn, and beer at a ballpark. You have three years left on the contract with the ballpark, and you do not expect it to be renewed. Long lines limit sales and profits. You have developed four different proposals to reduce the lines and increase profits. The first proposal is to renovate by adding another window. The second is to update the equipment at the existing windows. These two renovation projects are not mutually exclusive; you could take both projects. The third and fourth proposals involve abandoning the existing stand. The third proposal is to build a new stand. The fourth proposal is to rent a larger stand in the ballpark. This option would involve $1,000 in up-front investment for new signs and equipment installation; the incremental cash flows shown in later years are net of lease payments. You have decided that a 15% discount rate is appropriate for this type of investment. The incremental cash flows associated with each of the proposals are below. Using NPV what project would you choose? Using IRR? How do you explain the difference in the rankings? NPV/IRR Exercise Problem 2

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Using NPV what project would you choose? Using IRR? How do you explain the difference in the rankings? NPV/IRR Exercise Problem 2

Earnings to Cash Flow Models To calculate EBITDA is to start with operating profit (EBIT), and then add back depreciation and amortization. EBITDA is a more precise measure of corporate performance since it shows earnings before the influence of accounting and financial deductions. Two Paths to Free Cash Flow: From EBIT: FCF = (EBIT * (1-t)) + Depreciation – Capex – Change in WC cash outflow from capital expenditures cash flow from operations From EBITDA: FCF = ((EBITDA - Depreciation )* (1-t)) + Depreciation – Capex – Change in WC So let’s say you are told that a firms EBITDA is $300,000, depreciation is $75,000, the tax rate is 21%, capital expenditures are $55,000 and the change in Working Capital is $50,000. The FCF formula: FCF = (($300,000-$75,000)*(1-.21)) + $75,000 - $55,000 - $50,000 FCF = $147,750. Formula approximates the “indirect method” of developing a statement of cash flows

*loss carry forward. will be discussed on Thursday 2022 2023 2024 2025 2026 EBIT 4500 4600 4800 6010 8800 Capex 500 800 700 600 500 Change in WC 40 100 140 100 10 Deprec 50 80 100 120 150 Earnings to Cash Flow Model Example Consider the following Financial Projections for SKS Manufacturing, a muffler manufacturer and 2 nd tier supplier to the automotive industry Assume that SKS’s Cost of Capital is 10%, and T(tax rate) = 21%. What the the total NPV of SKS’s Free Cash Flow for the Projected Period of 2022 - 2026

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Complex Cash Flows – Terminal Values and Perpetuities Three key variables: FCF = Most Recent Free Cash Flow g = growth rate r = discount rate (cost of capital) Scenario 1. Growth rate = 0. What is the NPV of Constant Cash Flow to Perpetuity Formula. The NPV of a constant free cash flow to perpetuity = FCF/r Example. What is the NPV of $500/year to perpetuity, if the discount rate is 11% Answer: $500/.11 = $4545.46 Scenario 2. Growth rate = g (non-zero but CONSTANT). What is the NPV of a FCF that grows at a constant rate to perpetuity Formula. The NPV of a Constant Growth free cash flow = (FCF (1+g))/(r-g) Example. What is the NPV of $500/year that grows at an annual rate of 3%/year to perpetuity, if the discount rate is 11% ANSWER: ($500 * (1 + .03))/(.11 - .03) = $6437.50

Complex Cash Flows – Terminal Values and Perpetuities Example Lets say that the CEO of SKS wants to determine the fair value of SKS using NPV. Years earlier the CEO learned from Dr. Jayaraman that the fair value of a firm can be determined by calculating the NPV of all future free cash flows. An earlier projection of the NPV of the firms FCF for the 5 years ending 2026 projected a NPV of $14,345 . But what about all the future free cash flows after 2026? Checking with his CFO, the CEO learned that if the FCF of a firm grew at a constant rate, a TERMINAL for the firm could be estimated using the CONSTANT growth perpetuity method. The TERMINAL Value would be the value of all of the future FCFs of the firm at that time the perpetuity is determined. Based on this information the CEO decided to make the following assumptions to calculate the firm’s TERMINAL value: At the end of 2026 the future EBIT of SKS would grow at a 2.5% annual rate to perpetuity; that over the perpetuity, capital expenditures would equal depreciation charges, and that the change in working capital would be zero. Cost of Capital would remain 11% and the tax rate would remain 21% FCF for TV = ($8800* (1-.21))*(1 + .025) – 0 – 0 = = $7125.8 Capex – deprec = 0 Change WC = 0 SKS TV = $7125.8/(.11-.025) TV = $83,833 Which is the value at 2026 PV of TV = $83,833/(1+.11)^5 PV TV = $49,753 NPV of SKS = $14,345 + $49,753 = $64,098

Schultz Industries Problem Schultz Industries is considering the purchase of Arras Manufacturing. Arras is currently a supplier for Schultz, and the acquisition would allow Schultz to better control its material supply. The current cash flow from assets for Arras is $6.8 million. The cash flows are expected to grow at 8 percent for the next five years before leveling off to 4 percent for the indefinite future. The cost of capital for Schultz and Arras is 12 percent and 10 percent, respectively. Arras currently has 2.5 million shares of stock outstanding and $30 million in debt outstanding. What is the maximum price per share Schultz should pay for Arras? TV = (9.9914*(1+.04))/r-g2 = TV/(1+r)^5

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Happy Times, Inc. wants to expand its party stores into the Southeast. In order to establish an immediate presence in the area, the company is considering the purchase of the privately held Joe’s Party Supply. Happy Times currently has debt outstanding with a market value of $115 million and a YTM of 6 percent. The company’s market capitalization is $360 million, and the required return on equity is 11 percent. Joe’s currently has debt outstanding with a market value of $45 million. The EBIT for Joe’s next year is projected to be $17.3 million. EBIT is expected to grow at 10 percent per year for the next five years before slowing to 3 percent in perpetuity. The CHANGE in net working capital , total capital spending, and depreciation as a percentage of EBIT are expected to be 9 percent, 15 percent, and 8 percent, respectively. Joe’s has 1.95 million shares outstanding and the tax rate for both companies is 21 percent. Based on these estimates, what is the maximum share price that Happy Times should be willing to pay for Joe’s? Debt X B = $115,000,000/($115,000,000 + 360,000,000) = .2421, or 24.21% Equity X S = $360,000,000/($115,000,000 + 360,000,000) = .7579, or 75.79% The R WACC for Happy Times is: R WACC = .2421(.06)(1 – .21) + .7579(.11) R WACC = .0948, or 9.48% to TV calculation NOTE THAT IN THIS PROBLEM JOE’S COST OF CAPITAL IS NOT PROVIDED. SINCE JOE’S COST OF CAPITAL IS UNKNOWN, WE USE HAPPY TIMES COST OF CAPITAL Happy Times Problem

Terminal Value Calculation market value of debt TV5 = $211,479,718 s = $211,479,718 – 45,000,000 s = $166,479,718 Share price = $166,479,718/1,950,000 Share price = $85.37 Happy Times Problem

Happy Times Problem, Part B To calculate the terminal value using the EV/EBITDA multiple need to calculate the Year 5 EBITDA, which is EBIT plus depreciation, or: EBITDA = $25,328,930 + 2,026,314 EBITDA = $27,355,244 We can now calculate the terminal value of the company using the Year 5 EBITDA, which will be: TV 5 = $27,355,244*(9). Or TV 5 = $246,197,200 Note, this is the terminal value in Year 5 since we used the Year 5 EBITDA. We need to calculate the present value of the cash flows for the first 5 years, plus the present value of the Year 5 terminal value. So, the value of the company today is: V 0 = $10,899,000/1.0948 + $11,988,900/1.0948 2 + $13,187,790/1.0948 3 + $14,506,569/1.0948 4 + ($15,957,226+ 246,197,200)/1.0948 5 V 0 = $206,785,486 The market value of the equity is the market value of the company minus the market value of the debt, or: S = $206,785,486 – 45,000,000 S = $161,785,486 To find the maximum offer price, we divide the market value of equity by the shares outstanding, or: Share price = $161,785,486/1,950,000 Share price = $82.97 After examining your analysis, the CFO of Happy Times is uncomfortable using the perpetual growth rate in cash flows. Instead, she feels that the terminal value should be estimated using the EV/EBITDA multiple. If the appropriate EV/EBITDA multiple is 9, what is your new estimate of the maximum share price for the purchase?

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Cost of Capital Cost of Debt = Treasury Bond Rate + Default Premium Cost of Equity = Treasury Bond Rate + (Market Risk Premium * Beta) Note that the Equity Amount is the Market Value of Equity = = Illustrated Example Data T-Bond Rate 4.3%* Default Premium 120 Basis Points Market Risk Premium. 6.25% Beta .89 Debt 15B Market Cap 15B *As of Sept 24 2023 Less 21% tax Debt 50% Equity 50% 10 Year T-Bond (4.3%) Default Premium (120 basis points) Cost of Debt (5.5%) After Tax Cost of Debt (4.345%) Cost of Equity (9.8625%) 10 Year T-Bond (4.3%) Beta (.89) Market Risk Premium ( 6.25% ) Weighted Cost of Debt (2.1725%) Weighted Cost of Equity (4.93125%) + = Weighted Cost of Capital (7.10375%) Capital Structure x x

Cost of Debt = 4.3 + 1.11 = 5.41% Cost of Equity = 4.3 + (6.25 * .97) = 10.3625% Mkt Cap + Debt = $53.565B + $16.94B = $70.465B WACC = .0471 * (1-.21) * (16.94/70.465) PLUS .0979* (53.565/70.465) = 8.34% MVA = (Price/Share – BV of Equity/share)*#shares o/s MVA = ($97.04 – $14.13) *551.99 million MVA = $45,765.49 million or 45.765 billion Consider the following profile information regarding 3M. For the purposes of this problem the 10 Year Treasury rate is 4.3% and the Market Risk Premium is 6.25%. Assume a 21% tax rate. Assume 3Ms Default Risk Premium = A1= 111 basis points 3M Cost of Capital Exercise 3M as of Sept 22, 2023 4:00pm

The Net Present Value (NPV) can also be calculated by discounting a project’s economic profits (EVA) over its life. EVA 1 EVA 2 EVA T NPV = --------- + --------- + …….. + ---------- 1 + r 1 + r) 2 (1 + r) T Net Present Value and Economic Profits

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Discounting an Investment’s Annual EVA Stream Is Equivalent to Calculating the Investment’s NPV Net Present Value and Economic Profits

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Discounting an Investment’s Annual EVA Stream Is Equivalent to Calculating the Investment’s NPV Net Present Value and Economic Profits Net Present Value and Economic Profits

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

EBIT = Earnings before interest and taxes (operating profit before tax); Invested capital = Cash + Working capital requirement + Net fixed assets; WACC = [% Debt][After tax cost of debt] + [% Equity][Cost of equity]. Operating margin = EBIT Sales Capital turnover = Sales Invested Capital Tax effect = (1 - Tax rate) After tax cost of debt Estimated cost of equity Economic, political and social environments Market structure Competitive advantages and core competencies EBIT Investment Cap. (pretax ROIC) Expected after tax ROIC Weighted avg. cost of capital WACC Percent of equity financing Percent of debt financing Sustainability of growth Return spread (ROIC - WACC) MARKET VALUE ADDED (MVA) If the present value of the future stream of expected return spreads is positive, MVA is positive and the higher the growth, the more value created. If the present value of the future stream of expected return spreads is negative and the higher the growth, the more value destroyed. Finance Module Wrap-Up

Your preview ends here

Eager to read complete document? Join bartleby learn and gain access to the full version

Access to all documents
Unlimited textbook solutions
24/7 expert homework help

Sept 26 2023 Video Conference Call (Finance 3)-2-1

Related Documents