FIN 673 Alernaive Valuaion Approaches Professor Rober B.H. Hauswald Kogod School of Business, AU Valuaion Beyond NPV Corporae Finance revolves around hree fundamenal quesions: wha long-erm invesmens should he firm make: he capial budgeing quesion he second regards he use of deb: he capial srucure quesion how o value he firm: pricing he capial srucure oday, revisi DCF echniques capial budgeing and exend NPV o a more useful paradigm: real opions APV, FE and WACC 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 2
A Refresher on DCF echniques Presen Value: adjusing cash flows for numeraor: denominaor: Ne Presen Value and is exensions NPV: brue force he WACC approach: he Flows-o-Equiy approach: Adjused Presen Value: 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 3 he Use of DCF Valuaion Diffusion Curve for DCF echniques 100% 90% 80% 70% Percen Adoping 60% 50% 40% 30% 20% 10% 0% 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 Callahan, C. and S. Haka, A Model and es of Inerfirm Innovaion Diffusion: he Case of Discouned Cash Flow echniques, mimeo, January 2002 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 4
Adjused Presen Value APV = NPV NPVF he value of a projec o he firm can be hough of as he value of he projec o an unlevered firm (NPV) plus he presen value of he financing side effecs (NPVF) here are five side effecs of financing: he ax Subsidy o Deb he Coss of Issuing New Securiies he Coss of Financial Disress Subsidies o Deb Financing Financial Risk Managemen gains or losses 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 5 APV Example: Pearson Consider a projec of he Pearson Company, he iming and size of he incremenal afer-ax cash flows for an all-equiy firm are: -$1,000 $125 $250 $375 $500 0 1 2 3 4 he unlevered cos of equiy is r 0 = 10%: NPV NPV 10% 10% = $1,000 = $56.50 $125 (1.10) $250 (1.10) $375 (1.10) $500 (1.10) he projec would be rejeced by an all-equiy firm: NPV < 0. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 6 2 3 4
Adding Deb: he ax Shield Now, imagine ha he firm finances he projec wih $600 of deb a r B = 8%. Pearson s ax rae is 40%, so hey have an ineres ax shield worh C Br B =.40 $600.08 = $19.20 each year. he ne presen value of he projec under leverage is: APV = NPV NPVF 4 $19.20 APV = $56.50 (1.08 = 1 ) APV = $ 56.50 63.59 = $7.09 So, Pearson should accep he projec wih deb. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 7 Deb NPV Noe ha here are wo ways o calculae he NPV of he loan. Previously, we calculaed he PV of he ineres ax shields. Now, le s calculae he acual NPV of he loan: NPV NPV loan loan 4 $600.08 (1.4) $600 = 600 (1.08) (1.08) $ 4 = 1 = $63.59 APV = NPV NPVF APV = $ 56.50 63.59 = $7.09 Which is he same answer as before. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 8
Flows o Equiy Approach Discoun he cash flow from he projec o he equiy holders of he levered firm a he cos of levered equiy capial, r S. here are hree seps in he FE Approach: Sep One: Calculae he levered cash flows Sep wo: Calculae r S. Sep hree: Valuaion of he levered cash flows a r S. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 9 Sep One: Levered Cash Flows Since he firm is using $600 of deb, he equiy holders only have o come up wih $400 of he iniial $1,000. hus, CF 0 = -$400 Each period, he equiy holders mus pay ineres expense. he afer-ax cos of he ineres is B r B (1- C ) = $600.08 (1-.40) = $28.80 CF 3 = $375-28.80 CF 4 = $500-28.80-600 CF 2 = $250-28.80 CF 1 = $125-28.80 -$400 $96.20 $221.20 $346.20 -$128.80 0 1 2 3 4 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 10
Sep wo: Calculae r S r S = r B ( 1 C )( r0 r S 0 B o calculae he deb o equiy raio, B/S, sar wih he deb o value raio. Noe ha he value of he projec is 4 $125 $250 $375 $500 19.20 PV = 2 3 4 (1.10) (1.10) (1.10) (1.10) (1.08) r S 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 11 ) = 1 PV = $ 943.50 63.59 = $1,007.09 B = $600 when V = $1,007.09 so S = $407.09. $600 =. 10 (1.40)(.10.08) = 11.77% $407.09 Sep hree: Pearson Valuaion Discoun he cash flows o equiy holders a r S = 11.77% -$400 $96.20 $221.20 $346.20 -$128.80 0 1 2 3 4 $96.20 $221.20 PV = 400 (1.1177) (1.1177) PV = $28.56 $346.20 (1.1177) $128.80 (1.1177) $ 2 3 4 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 12
NPV-WACC Valuaion for Pearson r WACC S = r S B S B r S B 1 B ( C o find he value of he projec, discoun he unlevered cash flows a he weighed average cos of capial. Suppose Pearson Inc. arge deb o equiy raio is 1.50 B 1.50 = 1. 5S = B r r S B 1.5S = = S B S 1.5S WACC = (0.40) (11.77%) (0.60) (8%) (1.40) = 7.58% 1.5 2.5 = 0.60 WACC 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 13 ) S = 1 0.60 = 0.40 S B From Cash Flows o NPV Cash flows are easy discoun raes are hard 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 14
NPV Valuaion for Pearson Using WACC o find he value of he projec, discoun he unlevered cash flows a he weighed average cos of capial NPV $125 $250 $375 = $ 1,000 2 3 (1.0758) (1.0758) (1.0758) $500 (1.0758) 4 NPV 7 = $6.68.58% 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 15 Capial Budgeing wih Esimaed Discoun Rae A scale-enhancing projec is one where he projec is similar o hose of he exising firm. In he real world, execuives would make he assumpion ha he business risk of he non-scaleenhancing projec would be abou equal o he business risk of firms already in he business. No exac formula exiss for his. Some execuives migh selec a discoun rae slighly higher on he assumpion ha he new projec is somewha riskier since i is a new enran. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 16
Bea and Leverage Recall ha an asse bea would be of he form: β Asse Cov( UCF, Marke) = σ 2 Marke Remember unlevering and relevering bea? asse beas? 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 17 Bea and Leverage: No Corporae axes In a world wihou corporae axes, and wih riskless corporae deb, i can be shown ha he relaionship beween he bea of he unlevered firm and he bea of levered equiy is: Equiy β Asse = β Equiy Asse In a world wihou corporae axes, and wih risky corporae deb, i can be shown ha he relaionship beween he bea of he unlevered firm and he bea of levered equiy is: Deb Equiy β Asse = βdeb β Asse Asse Equiy 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 18
Bea and Leverage: Corp. axes In a world wih corporae axes, and riskless deb, i can be shown ha he relaionship beween he bea of he unlevered firm and he bea of levered equiy is: Since Deb β Equiy = 1 (1 C ) β Unlevered firm Equiy Deb (1 ) Equiy mus be more han 1 for a 1 C levered firm, i follows ha β Equiy > β Unlevered firm If he bea of he deb is non-zero, hen: β = β (1 )(β β ) Equiy Unlevered firm C Unlevered firm Deb L 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 19 B S Comparing he APV, FE, and NPV-WACC Approaches All hree approaches aemp he same ask: valuaion in he presence of deb financing. Guidelines: Use WACC or FE if he firm s arge deb-o-value raio applies o he projec over he life of he projec. Use he APV if he projec s level of deb is known over he life of he projec. In he real world, he WACC is he mos widely used by far. However, APV is he mos useful concep 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 20
APV, FE, and NPV-WACC APV WACC FE Iniial Invesmen All All Equiy Porion Cash Flows UCF UCF LCF Discoun Raes r 0 r WACC r S PV of financing effecs Yes No No Which approach is bes? dynamic financial design Use APV when he level of deb is consan Use WACC and FE when he deb raio is consan 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 21 From NPV o APV Capial Budgeing he basic ne presen value equaion is CF V NPV = C (1 K) (1 K where: = 1 ) CF = expeced incremenal afer-ax cash flow in year, V = expeced afer ax cash flow in year, including reurn of ne working capial, C 0 = iniial invesmen a incepion, K = weighed average cos of capial. = economic life of he projec in years. 0 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 22
NPV and Operaing Cash Flows We can use CF = OCF (1 τ) τd o resae he NPV equaion as: NPV = CF V = 1 (1 K) (1 K) C 0 NPV = OCF (1 τ) τd V = 1 (1 K) (1 K) C 0 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 23 Incremenal Cash Flows For our purposes i is necessary o expand he NPV equaion: CF = ( R OC D I )(1 τ) D I (1 τ) R is incremenal revenue C is incremenal operaing cash flow D is incremenal depreciaion I is incremenal ineres expense τ is he marginal ax rae 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 24
NPV Adjused Presen Value = OCF (1 τ) V = 1 (1 K) (1 K) (1 K) C Can be convered o adjused presen value (APV) APV = OCF (1 τ) τd By appealing o Modigliani and Miller s resuls. τd = 1 (1 Ku ) (1 i) (1 i) (1 Ku ) τi V 0 C 0 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 25 Adjused Presen Value Model APV = OCF (1 τ) τd V = 1 (1 Ku ) (1 i) (1 i) (1 Ku ) τi C 0 he APV model is a value addiiviy approach o capial budgeing. Each cash flow ha is a source of value o he firm is considered individually. Noe ha wih he APV model, each cash flow is discouned a a rae ha is appropriae o he riskiness of he cash flow. 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 26
DCF Mehods are Problemaic Modern approach: APV - muli-sep procedure economics: assume ha whole projec is financed by equiy o yield NPV wihou any adjusmens finance: deduc he cos of financing - advanage? Bu: unable o capure he value operaional and managerial flexibiliy fuure opporuniies creaed hrough iniial invesmens Paricularly imporan in sraegic decision making M&A, VC invesmens: opions on fuure cash flows 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 27 Choice and Flexibiliy NPV, APV ake all fuure decisions for graned abiliy of projec managers o make decisions over ime in response as uncerainy is resolved Opion o wai and sar invesing a he mos appropriae ime Opion o reconsider (hal, slow down) consrucion on he projec Opion o increase or decrease producion, close down emporarily, or abandon he projec 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 28
Wai and See: an Illusraion Suppose ha he NPV of a projec > 0 oday by invesing oday, realize a projec wih an expeced posiive value bu wha if P (price of oupu) decreases in fuure? If insead you delay invesing in he projec: inves laer if P increases (even more profiable) don inves hough if P decreases in deciding o delay, consider los revenues NPV (APV) undersaes value! 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 29 Example: Feasibiliy Sudies a (financial) opion is he righ, no obligaion, o ransac a a fuure dae a a price fixed oday Feasibiliy sudy: essenially a call opion pay up fron: opion premium (cos of sudy) once he sudy is complee: resoluion of uncerainy decide o inves addiional capial in order o obain he presen value of he projec : exercise price compound opion (posponemen): opion on an opion - business sraegies are compound opions!! 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 30
Opions o Inves: Call Opion Some opporuniies mus be seized immediaely Considerable uncerainy, waiing is feasible usually opimal o delay invesmen in a projec flexibiliy is valuable: opions are expensive! Sources of uncerainy: new economy: R&D risk - Viagra example inpu/oupu prices; revenues, profis, axes echnical uncerainy, poliical risk ineres rae, exchange rae flucuaions 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 31 Pos-Compleion Opions Producion, oupu rae may be alered as inpu or oupu price changes: maximize profis expand or conrac he capaciy of he faciliy. emporary shu down or abandonmen opions pu opion: righ o sell for a paricular price (salvage value) on or before a specified fuure dae miigaes some of he downside risk of a projec, in paricular if here is some salvage value ofen ignored in sandard NPV calculaions, hus downward biasing projec valuaion 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 32
When o Use Real Opions? Invesmen irreversibiliy: marke commimen Resoluion of uncerainy: learning by doing posponemen: iming opions compound opions: on marke, pre-empion Naural resource exracion projecs ineracion of risks and opions: poliical risk (expropriaion, converibiliy) as graning opions Problem wih APV: undervaluaion curse or blessing in disguise? 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 33 Capial Budgeing echniques How freqenly does your firm use he following echniques when deciding which projec or acquisiion o pursue? Source: Graham Harvey JFE 2001 n =392 IRR NPV Hurdle rae Payback Evaluaion echnique Sensiiviy analysis P/E muliple Discouned payback Real opions Book rae of reurn Simulaion analysis Profiabiliy index APV 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% % always or almos always 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 34
Summary and Conclusions DCF valuaion echniques Use he NPV-WACC or FE if he firm's arge deb o value raio applies o he projec over is life. he APV mehod is used if he level of deb is known over he projec s life. he bea of he equiy of he firm is posiively relaed o he leverage of he firm. only provide a parial picure of value canno capure he value of flexibiliy paricularly imporan in he conex of capial ransacions 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 35 APV, FE and WACC 1. he APV formula can be wrien as: APV UCF (1 r ) = = 1 0 Addiional Iniial effecs of invesmen deb 2. he FE formula can be wrien as: APV FE = LCF Iniial Amoun = 1 (1 r ) invesmen borrowed S 3. he WACC formula can be wrien as NPV = WACC = 1 UCF (1 r WACC Iniial invesmen 1/13/2011 Adjused Presen Value - Rober B.H. Hauswald 36 )