Tài chính doanh nghiệp - Finance 407: Multinational financial management - Topic 14: Domestic capital budgeting: npv, free cash flows, and cost of capital

Topic #14: Domestic Capital Budgeting: NPV, Free cash Flows, and Cost of CapitalL. GattisThe Pennsylvania State University0Finance 407: Multinational Financial ManagementReview Poll: Real Appreciation1Suppose the Chilean peso exchange rate increases from P450/$ to P475/$. Over that same time period inflation in the U.S. was 2% and inflation in Chile was 7.6%. What was the real appreciation of the peso?A. -15% B. -5% C. 0% D. +5% E. +15%Learning Objectives2Students understand and can recallThe methods for valuing domestic investments and managing country riskStudents can computeNPVWACCUnlevered and levered betaCost of equityPresent value of Growth perpetuitiesPresent value of exit multiplesNPV and Discount Rate3Net Present Value (NPV)discounted present value of an investment’s free cash flows discounted at a rate, K, which is called the “cost of capital”Rule: accept all investments where NPV > 0Interpretations:NPV is the value created by the project in excess of its initial investmentIf NPV = 0, the return on the project is exactly equal to the cost to finance the projectNPV and Discount Rate4Free Cash Flows (FCF)Includes initial investment and subsequent cash flows (not accounting profits) available to distribute to the securities holders of the organizationFCFF (Free Cash Flows to the Firm)Cash flows available to distribute to both debt and equity holdersbefore interest and dividend payments, but after taxesNon-cash “accounting costs” are added back (amortization and deprec.)capital expenditures are subtractedFCFF = EBIT*(1-Tc) + Deprec&Amort – CAPEX - ∆NWC Where: EBIT: Earnings Before Interest and TaxCAPEX: Capital ExpendituresΔNWC = change in noncash net working capital (C.A.-C.L.)Cost of Capital (K)5K (discount rate)Should reflect the risk of the project’s cash flowsSystemic risk for diversified investors (measured by beta)Total risk for undiversified investors (measured by std. dev.)We will assume investors are diversifiedShould be consistent with free cash flows useddebt and equity cashflows (FCFF) should be discounted at a rate that includes the both debt and equityWeighted Average Cost of Capital (WACC) is commonly used to discount FCFFWACCWeighted Average Cost of Capital (WACC): a firm’s weighted average cost of debt and equity. Where E and D are the market values of the firm’s equity and debt instruments; t is the firm’s tax rate Use target E/D values if new investment with differ than existing valueE.g.: 0.6 D/E ratio is a D/(E+D) ratio of .6/(1+.6)= .6/1.6Cost of Equity (Ke): required rate of return for equity holders CAPM is commonly used to compute: K=Rf+Beta(Rm-Rf)Cost of Debt (Kd): required rate of return for debt holders (bond)Sources: (1) Yield on firm’s debt or interest rate on incremental bank financing, (2) Yield Spread Based on Company Credit Rating or Coverage Ratios66Estimating Ke (Using CAPM)Cost of EquitySince future required equity returns are not readily observable, CAPM is used to estimate the required return Ke= Rf+Be(Rm-Rf)Applying CAPM in the real worldRf: yield on Treasury bills or bondsRm-Rf: (a.k.a., market risk premium) historical return on the S&P500 in excess of the yield on Treasury bills or bondsReasonable Range: 4-8%Equity Beta (Be)Regression coefficient when regress the excess returns on the individual stock to that of the S&P500Or use this formula778Estimating EBAY’s Stock BetaCAPM: Ri=Rf+B(Rm-Rf)Solving for Beta: Bi = (Ri-Rf) / (Rm-Rf) = Stock i’s Excess Return / Mkt Excess ReturnRebay=4.57+2.03*RSP500Beta=2.038Methods to Estimate KdBond Yields: use the average YTM of the firm’s bonds or average interest rate on its bank loansActual Interest Expense: the ratio of the income statement’s interest expense and the balance sheets debt.Credit (Default) Spread: Find average credit (default) spread for similar firms Example for BBB Industrial Company 10-year Treasury yield is 3% 10-year, BBB, Industrial, corporate bonds have an average Treasury spread of 1.5% The cost of debt = 3% + 1.5% = 4.5% If credit ratings are not available, use the yield on firms with similar coverage and liquidity ratios99NPV and WACC10Apple has already completed R&D and market analysis of the mini ipad to compete with other small tablets. The investment would cost $500M today. Apple estimates that the investment would last three years and would return an annual EBIT of $400M, Depreciation of $80M, CAPEX of $75M, and incremental Working Capital of $50M. The corporate tax rate is 40%. Treasury yields are 3% and the yield spread for AAPL debt is 2%. Apples equity beta is 1.3 and the market risk premium is assumed to be 5%. Apple plans to finance the project using the their existing capital structure of 90% equity and 10% debt.What is the NPV of the investment (include today’s investment and 3 years of free cash flows?A. -$5M B. $8M C. $42M D. $65M E. None of the above11WACC and Capital Structure12If the investment has different capital structure (leverage) than the existing firm’s operations, the Ke, Kd, and WACC can be estimated1. Ke: De-lever the firm’s beta using the firm’s current D/E2. Then re-lever the beta using the investment’s D/E and tax rate3. Then compute Ke using CAPMWACC and Capital Structure13If the investment has different capital structure (leverage) than the existing firm’s operations, the Ke, Kd, and WACC can be estimatedKd: Find a credit spread appropriate for the investments business risk and leverageAdd investment credit spread to risk-free rate of same maturityThen compute the WACC using the investment’s Ke, Kd, t, and D/EWACC and Capital Structure14Apple has already completed R&D and market analysis of the mini ipad to compete with other small tablets. The investment would cost $500M today. Apple estimates that the investment would last three years and would return an annual EBIT of $400M, Depreciation of $80M, CAPEX of $75M, and incremental Working Capital of $50M. The corporate tax rate is 40%. Treasury yields are 3% and yield spreads for AAPL are 2%. Apples equity beta is 1.3 and the market risk premium is assumed to be 5%. Apple plans to finance the project using the their existing capital structure of 90% equity and 10% debt.What is the NPV of the investment (include today’s investment and 3 years of free cash flows?WACC =.9*(.03+1.3*.05)+.1*(.03+.02)*(1-.4)=.0885FCFF=400*(1-.4)+80-75-50=$195MNPV=-500+195/1.0885+195/1.0885^2+195/1.0885^3=-$5MIf the investment is financed with more debt, the beta will increase due to fixed interest expenses, cost of debt may increase as coverage ratios fall, and the WACC will increase its weight towards debt.WACC and Capital Structure15What is the NPV of the investment (include today’s investment and 3 years of free cash flows?WACC =.9*(.03+1.3*.05)+.1*(.03+.02)*(1-.4)=.0885FCFF=400*(1-.4)+80-75-50=$195MNPV=-500+195/1.0885+195/1.0885^2+195/1.0885^3=-$5MWhat is the NPV of the investment if the new investment is financed 35% debt and 65% equity and the new credit spread is 2.5% (which is an additional .5% credit (default) spread due to higher debt levels). Bu=1.3/(1+(.1/.9)*(1-.4))=1.22 (no debt, lower beta)BL=1.22*(1+(.35/.65)*(1-.4)=1.61 (higher debt, higher beta)WACC =.65*(.03+1.61*.05)+.35*(.03+.02+.005)*(1-.4)=.0834NPV=-500+195/1.0834+195/1.0834^2+195/1.0834^3=-$.5MHow can higher debt levels create value? Should they issue more debt and create more value?WACC and Business Risk16Using the firm’s existing WACC is not appropriate if the investment has different business risk than the existing firm’s operations. Why: the firm’s current securities holder’s demand a return consistent with firm’s current operationsDifferent business risk may arise fromNew productsNew industryNew productionNew location --- global Example: Proxy Beta17Apple is considering an investment in cable television which has different business risk than Apple’s existing business. The cable industry has an average beta of 1.05 with a D/E of 0.3 and tax rate of 35%. Apple has a D/E of .1/.9 and tax rate of 40%. De-lever the cable industry beta and re-lever for Apple’s D/E. What is AAPL’s cost of equity for an investment in the cable industry? (assuming rf=3%, rm=8%)A. 6.5% B. 7% C. 8% D. 8.5% E. 9%Exit Multiples and Growth Perpetuities18Valuing an ongoing enterprise requires assumptions about long-term cash flows. Two common methods:Growth PerpetuityExit MultipleWhere g∞<KWhere M = Exit MultipleGrowth Perpetuity Example19Facebook is evaluating an investment in a new venture. The investment costs $900M today and is expected to return FCFs of $100M next year. FCF growth in years 2 and 3 is 15% and then grow at 3% forever. What is the NPV of the project if the WACC is 12%? =-900+100/1.12^1+100*1.15/1.12^2+100*1.15^2/1.12^3+(100*1.15^2*1.03/(0.12-0.03))/(1.12^3)=452Exit Multiple Example20Facebook is evaluating an investment in a new venture. The investment costs $900M today and is expected to return FCFs of $100M next year. FCF growth in years 2 and 3 is 15%, and 3% in year 4. What is the NPV of the project if the WACC is 12% and the FCF exit multiple is 10? =-900+100/1.12^1+100*1.15/1.12^2+100*1.15^2/1.12^3+(10*100*1.15^2*1.03)/1.12^4=241Exit Multiple and Perpetual g21In the last example, the cost of capital was 12% and the FCF exit multiple was 10. Suppose Facebook used a growth perpetuity instead of an exit multiple to value the investment. What is the equivalent perpetual growth assumptions that would give the same valuation in year 5? K=12%, M=10CF * (1/(.12-g)) = 10 * CFg = 2% Capital Budgeting in the Real World22Cash Flow EstimationIts really hard to forecast past a few yearsManager’s often confuse expected cash flows (probability weighted) and most likely cash flowsLong-term g should not exceed long-term Treasury yields (which is an estimate of long term growth of the economy)Net CAPEX (Capex – Depreciation) should be consistent with growth assumptions. (e.g., positive for growth firms)People lie – especially employees seeking funding that benefits their careerIdiosyncratic risk matters to managersSome companies use a rule of thumb for the cost of capitalE.g. High/Med/Low Risk --- 16%/ 12% / 10%Capital is rationed – cannot accept all positive NPV projectsMost dos! Some projects will be done despite the NPV due to option value, to reward managers, divisional politics, and executive manager pet projectsiClicker: Class EvaluationHow would you rate today’s class? Highest Lowest23Assigned Problems241. The YTM on JNJ’s bond is 6.55% and its stock beta is 0.72. Long-term Treasury yields are 4.5% and it is believed that stocks will outperformed bonds by 4% over the long term. JNJ’s tax rate is 31% and its debt-to-equity ratio is 0.4. What is JNJ’s WACC?D/E=.4/1; D/(D+E)=.4/1.4; E/(D+E)=1/1.4WACC =(.045+.72*.04)(1/1.4)+.0655*(.4/1.4)*.69=6.56%2. Google is considering a project that will generate annual revenues of $400M, expenses of $210M, and net CAPEX (CAPEX – Depr.) of $100M starting in one year and ending in year five. The project discount rate is 10%. The project will also require a payment today of $300M. What is the NPV? FCF=400-210-100=90 NPV=-300+90/1.1+90/1.1^2+90/1.1^3+90/1.1^4+90/1.1^5=41.7Amazon is evaluating an investment in a publishing company. The target company FCFs are expected to be $40M next year and grow at 20% for two years, then grow at 9% in year 4 and then 3% forever. The WACC for the investment is 10%. What is the most Amazon should pay for this investment? (Hint: compute the PV of future FCFs without an initial investment)=40/1.1+40*1.2/1.1^2+40*1.2^2/1.1^3+40*1.2^2*1.09/1.1^4+(40*1.2^2*1.09*1.03)/(.1-.03)/1.1^4= $793MCareStream, Inc., is considering an investment in a new plant in Rochester, NY. The plant would cost $300M today and cost another $350M in one year. FCF’s in year 2 are expected to be $150M and grow at 5% for three more years . In year five, CareStream estimates that the plant is valued at 6 times FCF. What is the NPV of the investment assuming a discount rate of 8%.=-300-350/1.08+150/1.08^2+150*1.05/1.08^3+150*1.05^2/1.08^4+6*150*1.05^3/1.08^5=$460Assigned Problems25Under Armour (UA), a clothing manufacturer based in Baltimore, is considering an new venture in retail outlet company stores. The initial outlet investment would cost $300M today. The first year’s FCF estimate is EBIT of $10M, depreciation of $5M, incremental working capital of $1M, CAPEX of $3M, and its composite tax rate is 39%. FCFs are expected to grow at 15%, 10%, and 5% for the following 3 years (years 2-4), respectively. Then cash flows will assumed to grow at 2.5% forever (year 5+). UA uses a WACC of 8% for clothing manufacturing. UA has decided that operating outlets have significantly different business risks than manufacturing. Other outlet operators (proxies) have an average beta of 0.80, a debt to equity ratio of .55, and a tax rate of 40%. UA’s outlets plan to have a debt to equity ratio of 0.35. The UA outlet centers expect to have a pre-tax debt yield of 5.5%. The risk free rate is 2.5% and the market risk premium is expected to be 5%. What is the NPV UA’s investment in this new area? (Hint: re-lever the proxy beta and compute UA’s outlet WACC.Unlevered Proxy Beta=0.8/(1+0.55*(1-0.4))=.6015Levered UA Outlet Beta =.6015*(1+.35*(1-.39))=.7299Levered UA Outlet Cost of Equity =.025+.7299*.05=.0615UA Outlet WACC=(1/1.35)*.0615+(.35/1.35)*.055*(1-.39)=.0543FCF(1)=10*(1-.39)+5-1-3=$7.1NPV=-300+7.1/1.0543+7.1*1.15/1.0543^2+7.1*1.15*1.1/1.0543^3+7.1*1.15*1.1*1.05/1.0543^4+(7.1*1.15*1.1*1.05*1.025/(.0543-.025))/1.0543^4=-$3.6M