LN02_Titman_479536_Valuation_03_LN02.pptx

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1. Chapter 2 Forecasting and Valuing Cash Flows

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 vs. Project Free Cash Flow Forecasting Project Free Cash Flows Example: Lecion Electronics Corporation Valuing Investment Cash Flows Using NPV and IRR to Evaluate the Investment Mutually Exclusive Projects

3. Forecasting is tough: Even the experts have trouble Quotes from the Hall of Forecasting Shame will attest: “I think there is a world market for maybe five computers.” Thomas Watson, Chairman of IBM, 1943 “There is no reason anyone would want a computer in their home.” Ken Olson, president, chairman, and founder of Digital Equipment Corporation, 1977 “640K ought to be enough for anybody.” Bill Gates, 1981

4. Discounted Cash Flow Valuation (DCF) The idea behind DCF valuation 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.

5. The 3-Step DCF Process

6. 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?

7. 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

8. Incremental Cash Flow Example: Frito-Lay Frito-Lay evaluates the introduction of a new salty snack product, it has the highest potential cannibalization effect and the lowest incremental sales as compared to other new products 1 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 1 See 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).

9. 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.”

10. Equity vs. Project/Firm 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 Free cash flow (FCF): amount of cash produced (by a project or a firm) during a particular time that is available for distribution to both the firm’s creditors and equity holders Values the project or firm as a whole (both equity and debt claims)

11. Calculating FCF

12. Calculating FCF FCF = EBIT(1 - T) + DA -∆ONWC – CAPEX EBIT: Earnings before interest and taxes EBIT(1 - T): After-tax operating income or net operating profit after tax (NOPAT) T: Tax rate DA: Depreciation and amortization expense ∆ONWC: Change in operating net working capital CAPEX: Capital expenditures for property, plant, and equipment

13. FCF 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

14. FCF Definitions: CapEx To sustain productive capacity and provide for growth firms invest in long-lived assets or capital expenditures Net 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. 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 time 1 1 Net 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. To predict CAPEX using this relationship requires that we estimate the change in net PPE for 2010 and depreciation expense. Typically, the former involves relating changes in net PPE and predicted changes in project revenues.

15. FCF Definitions Changes in operating 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 1 Referred to as “change” rather than “increase” since the change can be both positive and negative.

16. Example: Estimating Project FCF for Proposed Warehouse Distribution Center

17. Example: Estimating Project FCF for Proposed Warehouse Distribution Center Table 2-5 ( cont.)

18. Example: Estimating Project FCF for Proposed Warehouse Distribution Center Table 2-5 ( cont.)

19. Example: Estimating Project FCF for Proposed Warehouse Distribution Center Table 2-5 ( cont.)

20. Example: Estimating Project FCF for Proposed Warehouse Distribution Center Table 2-5 ( cont.)

21. Project FCF and Value Drivers It is apparent that the firm’s cash flow forecasting problem involves developing estimates for each of these components of FCF for each year of the project’s anticipated life. These key components are “value drivers” because they determine the investment’s value.

22. 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

23. 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 :

24. Lecion: “The Numbers” Team estimates Lecion will maintain a market share of 20% of total industry sales of 42-inch LCDs in each quarter 1 Price forecast for the 42-inch LCDs reflects the use of a price decay function Estimating Cost of Goods Sold and Operating Expenses: 1 This is subject to a high level of uncertainty, and sensitivity analysis is recommended. 2 Decay function assumes that every time the cumulative market volume of LCDs produced and sold doubles, the price of an LCD drops by 20%.

25. Lecion: “The Numbers”

26. Lecion: “The Numbers” Positive cash flow by 2006; remains positive throughout project life

27. Lecion DCF Valuation Discounting the Cash Flows Opportunity cost of capital is 18% per year Calculate the discount factor for each year’s cash flow Sum the present values of the cash flows generated by the project Estimated value of the investment $303,253,010

28. Lecion: “The Numbers” If Lecion invests $200 million in the project, then the project will produce $103,253,010 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 commonly referred to as the net present value, or simply NPV.

29. 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: 20.24% per year Compare this IRR to the 18% cost of capital we used as our discount rate in calculating the NPV Lecion concludes that the investment should be viewed favorably

30. 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.

31. Summary The value of an investment project is determined by the cash flows it produces. In this chapter, we have discussed valuing investment opportunities using discounted cash flow (DCF) analysis that incorporates the three-step process:

32. Summary and Best Practices Investment opportunities can be evaluated using DCF analysis Forecasting is hard work and is subject to potentially very large errors 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