Capital Budgeting and Financial Planning

1. Capital Budgeting and Financial Planning Course Instructor: M.Jibran Sheikh Contact info: jibransheikh@comsats.edu.pk

2. Valuation Using Free Cash Flow Technique

3. Capital Budgeting Decisions are based on cash flows, not accounting income. The relevant cash flows to consider as part of the capital budgeting process are incremental cash flows, the changes in cash flows that will occur if the project is undertaken. In determining the relevant cash flows remember the following: • Sunk costs are costs that cannot be avoided, even if the project is not undertaken.

4. Since these costs are not affected by the accept/reject decision, they should not be included in the analysis. An example of a sunk cost is a consulting fee paid to a marketing research firm to estimate demand for a new product prior to a decision on the project.

5. Externalities • Externalities (Side Effects) are the effects the acceptance of a project may have on other cash flows of the firm. • The primary one is a negative externality called cannibalization (Erosion), which occurs when a new project takes sales from an existing product. • When considering externalities, the full implication of the new project (loss in sales of existing products) should be taken into account.

6. An example of cannibalization is when a soft drink company introduces a diet version of an existing beverage. The analyst should subtract the lost sales of the existing beverage from the expected new sales of the diet version when estimated incremental project cash flows. A positive externality exists when doing the project would have a positive effect on sales of a firm's other product lines.

7. Opportunity costs Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken. Opportunity costs should be included in project costs. For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project since it could be sold if not used

8. Cash flows are analyzed on an after-tax basis. The impact of taxes must be considered when analyzing all capital budgeting projects. Firm value is based on cash flows they get to keep, not those they send to the government. • Financing costs are reflected in the project's required rate of return. Do not consider financing costs specific to the project when estimating incremental cash flows. • The discount rate used in the capital budgeting analysis takes account of the firm's cost of capital. • Only projects that are expected to return more than the cost of the capital needed to fund them will increase the value of the firm.

9. Review Problem • Opportunity costs are cash flows that a firm will lose by undertaking the project under analysis. • These are cash flows generated by an asset the firm already owns that would be forgone if the project under consideration is undertaken. • Opportunity costs should be included in project costs. • For example, when building a plant, even if the firm already owns the land, the cost of the land should be charged to the project since it could be sold if not used.

10. Review Problem • Test your understanding of these points by answering the following review problem. • Which of the following cash flows should be treated as incremental cash flows when computing the NPV of an investment? • The reduction in sales of the company's other products • The expenditure on plant and equipment • The cost of research and development undertaken in connection with the project during the past three years • The annual depreciation expense • Dividend payments • The resale value of plant and equipment at the end of the project's life • Salary and medical costs for production employees on leave

11. Free Cash Flows • Dividends are the cash flows actually paid to stockholders • Free cash flows are the cash flows available for distribution. • Applied to dividends, the DCF model is the discounted dividend approach or dividend discount model (DDM). This lecture extends DCF analysis to value a firm and the firm’s equity securities by valuing its free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).

12. . Many large companies such as Cisco, Dell, Google, and Microsoft do not pay dividends. These companies often engage in stock buybacks in order to increase demand for the stock and drive up prices. This practice also makes earnings per share figures more attractive because there are then fewer shares amongst which to divide the earnings. Other reputable Companies Which Refuse To Pay Dividends are AMZN, AMGN, AAPL, BBBY, BRK-A, CBB, DELL, DG, DLTR, EBAY, ERTS, EMC, ESRX, FLEX, GOOG, JACK, NDAQ, SYMC, UAL, URBN, WDC, YHOO, ZBRA, CSCO, VMW, MHS.

13. Free Cash Flows • Analysts like to use free cash flow valuation models (FCFF or FCFE) whenever one or more of the following conditions are present: • the firm is not dividend paying, • the firm is dividend paying but dividends differ significantly from the firm’s capacity to pay dividends, • free cash flows align with profitability within a reasonable forecast period with which the analyst is comfortable, or • the investor takes a control perspective.

14. Intro to Free Cash Flows • Common equity can be valued by either • directly using FCFE or • indirectly by first computing the value of the firm using a FCFF model and subtracting the value of non-common stock capital (usually debt and preferred stock) to arrive at the value of equity.

15. Defining Free Cash Flow • Free cash flow to equity (FCFE) is the cash flow available to the firm’s common equity holders after all operating expenses, interest and principal payments have been paid, and necessary investments in working and fixed capital have been made. • FCFE is the cash flow from operations minus capital expenditures minus payments to (and plus receipts from) debtholders.

16. Valuing FCFE • The value of equity can also be found by discounting FCFE at the required rate of return on equity (r): • Since FCFE is the cash flow remaining for equity holders after all other claims have been satisfied, discounting FCFE by r (the required rate of return on equity) gives the value of the firm’s equity. • Dividing the total value of equity by the number of outstanding shares gives the value per share.

17. Single-stage, constant-growth FCFE valuation model • FCFE in any period will be equal to FCFE in the preceding period times (1 + g): • FCFEt = FCFEt–1 (1 + g). • The value of equity if FCFE is growing at a constant rate is • The discount rate is r, the required return on equity. The growth rate of FCFF and the growth rate of FCFE are frequently not equivalent.

18. Computing FCFF from Net Income • This equation can be written more compactly as FCFF = NI + Depreciation + Int(1 – Tax rate) – Inv(FC) – Inv(WC) • Or • FCFF = EBIT(1-tax rate) + depreciation – Cap. Expend. – change in working capital – change in other assets

19. Finding FCFE from NI or CFO • Subtracting after-tax interest and adding back net borrowing from the FCFF equations gives us the FCFE from NI or CFO: FCFE = NI + NCE – Inv(FC) – Inv(WC) + Net borrowing FCFE = CFO – Inv(FC) + Net borrowing

20. Forecasting free cash flows

21. Forecasting free cash flows • Computing FCFF and FCFE based upon historical accounting data is straightforward. Often times, this data is then used directly in a single-stage DCF valuation model. • On other occasions, the analyst desires to forecast future FCFF or FCFE directly. In this case, the analyst must forecast the individual components of free cash flow. This section extends our previous presentation on computing FCFF and FCFE to the more complex task of forecasting FCFF and FCFE. We present FCFF and FCFE valuation models in the next section.

22. Forecasting free cash flows • Given that we have a variety of ways in which to derive free cash flow on a historical basis, it should come as no surprise that there are several methods of forecasting free cash flow. • One approach is to compute historical free cash flow and apply some constant growth rate. This approach would be appropriate if free cash flow for the firm tended to grow at a constant rate and if historical relationships between free cash flow and fundamental factors were expected to be maintained.

23. Forecasting FCFE • If the firm finances a fixed percentage of its capital spending and investments in working capital with debt, the calculation of FCFE is simplified. Let DR be the debt ratio, debt as a percentage of assets. In this case, FCFE can be written as • FCFE = NI – (1 – DR)(Capital Spending – Depreciation) – (1 – DR)Inv(WC) • When building FCFE valuation models, the logic, that debt financing is used to finance a constant fraction of investments, is very useful. This equation is pretty common.

24. Preferred stock in the capital structure • When we are calculating FCFE starting with Net income available to common, if Preferred dividends were already subtracted when arriving at Net income available to common, no further adjustment for Preferred dividends is required. However, issuing (redeeming) preferred stock increases (decreases) the cash flow available to common stockholders, so this term would be added in. • In many respects, the existence of preferred stock in the capital structure has many of the same effects as the existence of debt, except that preferred stock dividends paid are not tax deductible unlike interest payments on debt.

25. Nonoperating assets and firm value • When calculating FCFF or FCFE, investments in working capital do not include any investments in cash and marketable securities. The value of cash and marketable securities should be added to the value of the firm’s operating assets to find the total firm value. • Some companies have substantial non-current investments in stocks and bonds that are not operating subsidiaries but financial investments. These should be reflected at their current market value. Based on accounting conventions, those securities reported at book values should be revalued to market values.

26. Nonoperating assets and firm value • Finally, many corporations have overfunded or underfunded pension plans. The excess pension fund assets should be added to the value of the firm’s operating assets. Likewise, an underfunded pension plan should result in an appropriate subtraction from the value of operating assets.

27. FCFF vs. Accounting Cash Flows Income Statement, Hudson’s Bay ($millions, FYE Jan 1999) Sales $7,075 Cost of Goods Sold $6,719 EBITDA $ 356 Depreciation $ 169 EBIT $ 187 Interest Expense $ 97 Income Taxes $ 50 Net Income $ 40 Dividends $ 53 Cash Flow Statement, Hudson’s Bay, ($millions, FYE Jan 1999) Cash flow from operations Net Income $ 40 Non-cash expenses $ 169 Changes in WC ($116) Cash provided (used) by investments Additions to P,P & E ($719) Cash provided (used) by financing Additions (reductions) to debt $ 259 Additions (reductions) to equity $ 356 Dividends ($ 53) Overall Net Cash Flows ($ 64) Hudson’s Bay FCFF = 187 * (1- 0.44) + 169 - 719 - 116 = ($ 561)