CORPORATE VALUATION
Separation of Financing from Investment
The Separation Theorem allows for the evaluation of an investment without regard to how it is financed as long as the required rate of return reflects the financing via the use of the Average Cost of Capital.
Assume the following:
Cost of Debt = 10%
Tax Rate = 40%
Aftertax Cost of Debt = 6%
Cost of Equity = 14%
Percent Debt Financing = 50%
Percent Equity Financing = 50%
Average Cost of Capital = Cost of Debt * (Percent Debt Financing) +
Cost of Equity * (Percent Equity Financing)
= 10% * (1-.4) * (.5) + 14% * (.5)
= 6% * (.5) + 14% * (.5)
= 10%
A) Project Cash Flows
Year 0 Year 1 Year 2 Year 3
Investment Cost (4,000)
Revenues 3,000 3,000 4,792
Costs (800) (800) (1,000)
Taxable Inc. 2,200 2,200 3,792
Taxes (40%) (880) (880) (1,517)
Net Cash Flows (4,000) 1,320 1,320 2,275
NPV @ 10% = 0
A NPV of zero indicates that both lenders and stockholders are earning their respective required rates of return as well as getting their investment back (with no surplus). Consider the financing explicitly with the payment of interest and a repayment of principal as follows:
B) Equity Cash Flows
Year 0 Year 1 Year 2 Year 3
Investment Cost (4,000)
Revenues 3,000 3,000 4,792
Costs (800) (800) (1,000)
Operating Inc. 2,200 2,200 3,792
Interest Expense (200) (154) (103)
Taxable Income 2,000 2,046 3,689
Taxes (40%) (800) (818) (1,475)
Net Income 1,200 1,228 2,213
Debt Payment 2,000 (460) (506) (1,034)
Equity Cash Flow (2,000) 740 722 1,179
IRR = 14%
Return of Principal Calculations:
Year 1 Cash Flow 2,200
Interest on Debt (200) (10% * 2,000)
Shareholder Rate of Return (280) (14% * 2,000)
Taxes (800)
Return of Principal 920
Return of Principal to Lenders = 460 (50%)
Return of Principal to Stockholders = 460 (50%)
Beg. Debt Balance Yr. 1: 2,000 Beg. Equity Balance Yr. 1 2,000
Debt Repayment (460) Equity Repayment (460)
Ending Debt Balance Yr. 1: 1,540 End. Equity Balance Yr. 1 1,540
Year 2 Cash Flow 2,200
Interest on Debt (154) (10% * 1,540)
Shareholder Rate of Return (216) (14% * 1,540)
Taxes (818)
Return of Principal 1,012
Return of Principal to Lenders = 506 (50%)
Return of Principal to Stockholders = 506 (50%)
Beg. Debt Balance Yr. 2: 1,540 Beg. Equity Balance Yr. 2 1,540
Debt Repayment (506) Equity Repayment (506)
Ending Debt Balance Yr. 2 1,034 End. Equity Balance Yr. 2 1,034
Year 3 Cash Flow 3,792
Interest on Debt (103) (10% * 1,034)
Shareholder Rate of Return (145) (14% * 1,034)
Taxes (1,475)
Return of Principal 2,068
Return of Principal to Lenders = 1,034 (50%)
Return of Principal to Stockholders = 1,034 (50%)
Beg. Debt Balance Yr. 3: 1,034 Beg. Equity Balance Yr. 3 1,034
Debt Repayment (1,034) Equity Repayment (1,034)
Ending Debt Balance Yr. 3: 0 End. Equity Balance Yr. 3 0
Cash Flows To Lenders Year 0 Year 1 Year 2 Year 3
Loan (2,000)
Interest 200 154 103
Principal 460 506 1,034
Net Cash Flows (2,000) 660 660 1,138
IRR = 10%
Cash Flows To Stockholders Year 0 Year 1 Year 2 Year 3
Investment (2,000)
Dividends 280 216 145
Principal 460 506 1,034
Net Cash Flow (2,000) 740 722 1,179
IRR = 14%
Since the result is the same whether utilizing Project Cash Flows and the average cost of capital, or Equity Cash Flows and the cost of equity, the investment decision can be made at the divisional level and the financing decision can be made at the corporate level.
Project Valuation
Capital budgeting, as in the previous example, usually assumes that a project “ends” after a number of years. In general, however, investments are made with the expectation that, if successful, the activities will continue indefinitely. The best way to evaluate any sort of investment is to create two scenarios: a base-case which projects the cash flows if a company just continues business as usual, and an expansion (or NewCo, etc.) scenario which reflects the anticipated cash flows should a project be undertaken. The relevant cash flows are just the difference between the two scenarios. Rather than shutting the project down at the end of the planning horizon, however, the free cash flow can be capitalized using the WACC.
As an example, consider the following company which is considering opening an office in another city to expand its territory. For simplicity, we’ll use the percentage-of-sales method for forecasting the balance sheet.
Base-case:
Income Statements
Balance Sheets
Statement of Cash Flows
Of course, the actual financing may vary either by borrowing more money to finance the asset expansion or by paying down the debt due to a debt schedule for the loans. It really doesn’t matter with respect to the valuation since we are assuming that either (1) the actual long-term financing target is reflected in the WACC or (2) the average cost of capital is independent of capital structure. In any event, the cash flows we will be analyzing will not include any financing cash flows since the financing is reflected in the WACC.
Now consider the expansion case where we anticipate the following:
· Sales will increase by $200,000 in Year 1 over current projections and then grow at 4% annually.
· Salaries will increase by $40,000 in Year 1 over current projections and then grow at 2% per year.
· Utilities will increase by $5,000 over current projections and grow by 2% per year.
· $150,000 of additional Fixed Assets will be required
· Additional L-T debt of $75,000 will be required to cover much of the asset expansion
Expansion:
Income Statements
Balance Sheets
Statements of CF
The incremental cash flows can be calculated by simply subtracting the cash flows in the Base-Case from the cash flows in the Expansion Case. Note that the financing cash flows have been ignored with the exception that a line has been included to add back the after-tax additional interest expense that occurred in the Expansion case due to the additional loan of $75,000.
Incremental Cash Flows
The Free Cash Flows (FCF) are readily available from these figures. It is customary to accelerate the outflows, in this case the investment in Fixed Assets and Working Capital, to the beginning of each year. Thus, we’ll have to add in an adjustment for the now-missing 3rd year. We also need to calculate a Terminal (or Residual) Value to capture the cash flows beyond our three-year planning horizon.
Free Cash Flows and Valuation
NPV @ 10% = $(1,574)
Since the NPV is negative, the expansion is not desirable. Of course, it is very close to be acceptable. One could argue that there are strategic reasons for going ahead with the expansion. That, however, assumes that there are benefits that have not been captured in the cash flow projections.