Project Valuation for Managers


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1 Project Valuation for Managers An Essential Skill Corporate Finance By Cameron Hall
2 Key Messages The job of managers is to create value. Value in a firm comes from two sources: current operations and new projects. To create value, we must know which projects to accept and which to reject. While many people know the three steps of project valuation (work out cash flows, work out discount rate, calculate present value), few understand the conceptual foundations (present value, opportunity cost of capital, risk, CAPM & WACC). It is essential to understand these foundations to correctly value projects beyond the most basic. Net present value leads to the best investment decisions, but care must be taken in complex situations where there are multiple projects and capital rationing. Contents: A Five Part Paper 1. Why Project Valuation is Important 2. Conceptual Foundations of Project Valuation 3. An Example of a Project Valuation using NPV 4. Alternatives to NPV: IRR, PP & PI 5. Complexities & Subtleties to Watch for 1. Why Project Valuation is Important The job of managers, executives and the consultants that help them is to create value for a given firm. Value in a firm is derived from current operations and the present value of growth opportunities (PVGO). PVGO is a fancy way of saying the value of all projects, initiatives, or investments which will provide future benefit. Ultimately all projects become part of current operations when they go live. Therefore it is critical that we know which projects to accept or reject based on their contribution to the value of the firm. 2. Conceptual Foundations of Project Valuation Project valuation can be explained in simple terms which many of us know. However, we have decided to try and relate to you some of the important conceptual foundations of project valuation. There are six key concepts. These six concepts are: Concept 1. Present value. Concept 2. Opportunity cost of capital. Concept 3. Risk. Concept 4. Capital Asset Pricing Model (CAPM). Concept 5. Weighted Average Cost of Capital (WACC). Concept 6. Bringing it all together  the three steps.
3 Concept 1. Present value. Present value is the first valuation concept. It works like this: A project is a series of cash flows In an abstract sense, all projects are nothing more than a series of cash outflows (investment) and cash inflows (returns). Cash flows are the only thing relevant to investors These cash flows are the only thing relevant to investors because they are real. They are not an abstraction like accounting earnings  they are real dollars in the bank. The key is to value those cash flows The task of project valuation is to be able to look at that series of cash flows over time and to be to evaluate them relative to either a different series of cash flows or a pre determined benchmark for investment performance. The difficulty is that cash flows are two dimensional The difficulty here is that cash flows are two dimensional. They have a magnitude (how much) and a timing (when) which makes them difficult to compare. The present value concept makes them one dimensional This is where one of the pillars of finance comes in: present value. The concept of present value is simple. It says that a dollar received now is worth more than a dollar received in the future because the dollar now can earn a return in the interim. This return is known as the opportunity cost of capital. Adjusting these future cash flows to take into account opportunity cost of capital is the essence of present value. Concept 2. Opportunity cost of capital. Opportunity cost of capital is best understood in terms of a simple example: Someone says to you that you can have either $1 now or $1 in a year s time. You take the dollar now because you know that if you put it in a savings account at 9% p.a. you will have $1.09 on a year s time. What you have done here is recognise that there is an opportunity cost of capital, in this case 9% per annum. That s just intuitive. Slightly less intuitive, but conceptually the same is to say that the $1 in the future is only worth 92c today. Why? Because if you invest 92c at 9% p.a. for a year you will have $1. The 92c is the present value of the distant dollar.
4 Concept 3. Risk Risk in investment is the uncertainty of future returns. Investors don t like uncertainty. Or more correctly, they like certainty more than uncertainty. For example, the two stocks below have an average return of 10%. However, stock B is less risky because it has a smaller standard deviation of returns and will therefore be worth more in the eyes of investors. This conceptual link between risk & return is born out by 70 years of data from the NYSE. This data provides us with two useful reference points:  The lowest risk investment  US Tbills (known as the risk free rate) and return on the entire stock market known as the equity market return.
5 Concept 4. Capital Asset Pricing Model (CAPM) Now we know what risk is. The real question is how do we price it. This introduces one of the most powerful tools in corporate finance the Capital Asset Pricing Model (CAPM) The CAPM formula: What the CAPM allows us to do is to work out what the required return for a stock is given its risk. From the previous page we know that if we had an investment portfolio which was 100% US T Bills, that our return would be 0.4% p.a. And, if we had an investment portfolio which consisted of the entire equity market its return would be 8.8% p.a. Those two points are defined as having risk measured by a factor called beta of 0 and 1 respectively The required return for a stock which has risk somewhere between 0 and 1 is defined by a line between rf and rm known as the security market line of the CAPM.
6 Concept 5. Weighted Average Cost of Capital (WACC) The final concept is the WACC. Any project is financed by a blend of debt and equity reflecting the capital structure of the firm. We now know the required return on equity from the CAPM and can therefore work out the WACC which takes into account debt. Concept 6. Bringing it all together  the three steps This leads us to the three steps in project valuation
7 3. An Example of Project Valuation A simple example can bring this all together. The investment You buy a widget machine for $10,000. The machine has a useful life of five years, after which it will have zero salvage value. It will take one year to install the machine. Operational costs will be $1,000 per year. The return The expected revenues in years 2, 3, 4 & 5 will be $1,000, $4,000, $6,000 & $5,000. This reflects the slow takeup of the widget product, the peaking of demand & drop in price as competition hits. Taxation The corporate taxation rate is 40%. It is assumed that any losses can be applied to other profits in the business. Now we outline the steps you take to assess the project.
8 Step 1. Work out the incremental after tax cash flows The first thing to do is describe the pre tax cash flows. In this case they are an investment of $14,000 and a return of $16,000. Then we must calculate the tax to be paid on the incremental profit of this project. Remember that tax is calculated on accounting earnings not cash flow. This gives us the after tax cash flow.
9 Step 2. Calculate the opportunity cost of capital The opportunity cost of capital is the weighted average of the required return on equity and the required return on debt. Step 3. Calculate the present value The discount rate can be applied to after tax cash flows to return the Present Value (PV). This is also referred to as the Net Present Value (NPV) to reflect the initial investment. This shows that the project would destroy $1,076 of shareholder value.
10 4. Alternatives to NPV: IRR, PP & PI The three most common alternatives to NPV are IRR, PP & PI. NPV leads to the best outcomes because: IRR has some funny quirks. o For a project offering positive cash flows followed by negative cash flows, NPV rises as the discount rate is increased. Except if IRR is less than opportunity cost of capital. o If there is more than one change in the sign of the cash flows, the project may have several IRR s o May give the wrong ranking of mutually exclusive projects that differ in economic life or in scale of required investment. o Comparing IRR with the opportunity cost of capital (OCC) is difficult where there may be different OCC s for different maturities. Profitability index is a relative not absolute measure. Payback period ignores the time value of money. Only NPV shows absolute value of shareholder wealth created.
11 5. Complexities & subtleties Which costs to include? If you only remember one thing from today, remember this. Only incremental after tax cash flows matter. How to deal with multiple projects. There are two complicating factors when multiple projects are being considered 1. Capital rationing vs unlimited capital Finance theory says that capital markets will fund all positive NPV projects. Unfortunately, in the real world capital within operating units is sometimes rationed. This is a control response not an economic response. We do however have to be able to deal with it. 2. Independent vs mutually exclusive projects Mutually exclusive projects are those which are either or. For example, if a bank has two proposals to install accounting systems they can only take one  the one with the highest NPV.
12 Various landmines to be aware of Project vs Firm risk Only use the WACC as your discount rate if the project is the same risk as the firm. If it is different, use the asset betas of firms in the same industry as the project not the rate of the firm. Consistent interest rates If the project is five years you need to use the return on debt of the same period. This does not apply to the risk free rate. Don t mix investment & financing Don t include interest charges as reductions in cash flows. This is done implicitly in the WACC which reduces cash flows by a capital charge in each period. Consistent investment horizon You can t compare a 3 year & 5 year project which are mutually exclusive because after 3 years the investment needs to be made again. The best way to handle this is annualised cost which turns the NPV of each project into an annuity. Use Excel Excel does the NPV & other calculations. Optimiser can be used for capital rationing. Capital is unlimited but managers are not Yes, all projects can be funded by the capital markets, but can they be managed?
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