Chapter 3 Valuation

1. Chapter 3Valuation • Order Order Sale Cash • Placed Received Received • Accounts Collection • < Inventory > < Receivable > < Float > • Accounts Disbursement Time ==> • < Payable > < Float > • Invoice Payment Cash • Received Sent Paid

2. Objectives • Use cash flow timeline and discounting techniques to value future cash flows • Explain importance for using time value of money in short-term decisions • Apply the NPV technique to select value-enhancing proposals • Recognize difficulties in selecting appropriate discount rate

3. Two Financial Decision-Making Approaches • Financial statement approach • Valuation approach

4. Financial Statement Approach • Approach • compute incremental revenue and expense effects of proposal • calculate anticipated profit effect • Calculation steps • estimate unit sales and multiply by profit margin • estimate capital costs of additional required investments such as receivables, inventory, etc. • estimate additional bad-debt loss if new credit terms • calculate overall profit effect • Decision criteria • if anticipated profit is >=0, proposal would contribute profit • if anticipated profit is <0, proposal would not contribute profit

5. Valuation Approach • Approach • accounts for timing of cash flows • accounts for present values • results in making value enhancing decisions • Four steps • determine relevant cash flows • determine timing of cash flows • determine appropriate discount rate • discount cash flows • Decision criteria • if NPV >= 0 invest • if NPV < 0 do not invest

6. Economic Value Added • Incorporates elements from both financial statement approach and valuation approach • EVA = Operating profit - (Cost of capital)(Capital employed) • Advantage: provides better company-wide understanding of importance of improved working capital management • Caution: can be misused if user does not take a long-term view

7. NPV Calculations • Simple interest • 1PV = FV x ------------------- k (1 + (------) x n) 365 • Compound interest • 1 PV = FV x -------------- k (1+ -------)n 365

8. ........ Basic Valuation Model note: i = k/365 CFo CF1 CF2 CF3 CFn CF1 CF2 CF3 CFn NPV = CFo + ------------- + ------------- + ------------ + .... + ------------ (1 + i x 1) (1 + i x 2) (1 + i x3) (1 + i x n)

9. Valuation Using NPV • Solving DigiView’s financial dilemma

10. Choosing the Discount Rate • Three unique problems • funds are rarely raised specifically to fund short-term type projects • short-time horizon implies short-term not long-term rate • risk should be accounted for, but may be ambiguous. • One-shot projects • if net borrower, use short-term borrowing rate • if net investor, use short-term investment rate • Multi-year projects • maybe appropriate to use cost of capital • Formulation • kadj = krf + kavg + k

11. Summary • Short-term financial decisions can impact firm value by: • altering operating cash flows • changing the length of the cash conversion cycle • changing company risk posture • impacting net interest income • and by changing accuracy and timeliness of critical information. • Both financial statement approach and valuation offer insight in working-capital management decisions. • Choosing appropriate discount rate is an issue when trying to assess valuation impact.