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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