Value Creation

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Valuation
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3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
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3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
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DCF Valuation

• Spreadsheet Approach

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Economic Valuation
k
...
C
C
C
1
n
2



PV

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(
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(
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(
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1
2
n
1

k
1

k
1
k

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Capital Projects AsCash Flow Tradeoffs
Capital Recovery
Net Benefits
TIME
Additional Outlay
Initial Outlay
Match initial investment with the combined PV of
all future cash flows
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Capital Project Valuation

Annual cash flow
20
20
20
20
20
20
20
k
1
2
3
4
5
6
10
Investment 100 NPV 13
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Discounting Example

• Cash Discount P.V. Cumul.
• Yr Flow Factor Cash Flow P.V.
• 1 20 .9091 18.18 18.18
• 2 20 .8264 16.53 34.71
• 3 20 .7513 15.03 49.74
• 10 20 .3855 7.71
  113.00
• Discount Factor 1/(1.10)n

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Corporate Value

• infinity
• Value Cash Flowt
• t0 (1 Cost of Capital)t

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Free cash flow is the basis of value!
Investors watch this pattern
Trend
Time
.which is cash in and cash out
Free cash flow NOPAT adjusted for depreciation
and other accounting elements Less net investment
in working capital, fixed assets, capitalized
RD, etc.
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PLEASE DO NOT DISTURB
Working on A big project !!!
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STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION
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STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION
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STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION
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STRATEGY, PERFORMANCE MEASUREMENT, COMPENSATION
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Portal.com Example
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Portal.com2001 Valuation Cash Flows
Customers 12,000 Revenue
Working Capital Cash
150 Receivables 1,100 Inventory
1,100 Payables -1,010
-------- 1,340
Cash Expense COGS 3,500 SGA 3,000
------- 6,500
Investment 2,000
Taxes 2,100
Available to Shareholders and Debt Suppliers 60
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Company Valuation
7,044

Terminal Value
Annual cash flow
845
545
327
170
60
k
1
2
3
4
5
0
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Free Cash Flow Valuation
0
5,245
2,000
5,245
3,245
Marketable Securities Non-operating Cash Flows
Market Value of Entity
Market Value of Debt and other Liabilities
Value of Operating Cash Flows
Market Value of Equity
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Adjusted Present Value (APV)
Value of financing side effects
Interest tax shields
Costs of financial distress
Base-case value
Value of the project as if it were financed with
equity
APV

Subsidies
APV
Hedges
Issue costs
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DCF Valuation

• Formula Approaches

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Company Valuation Free Cash Flow
Formulas             NOPAT0
initial after-tax earnings before interest and
taxes (EBIT) b rate of investment
per period divided by NOPAT g
growth in free cash flows. The subscripts s and
c refer to the supernormal
growth rate and the constant growth rate.
n number of periods of supernormal
growth k the companys weighted
average cost of capital WACC
No growth   NOPAT0 V
------------------ k
Constant growth    NOPAT0(1 - b)(1
g) V --------------------------------
k - g
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Company Valuation Free Cash Flow
Formulas         NOPAT0 initial
after-tax earnings before interest and taxes
(EBIT) b rate of investment per
period divided by NOPAT g growth
in free cash flows. The subscripts s and c refer
to the supernormal growth
rate and the constant growth rate. n
number of periods of supernormal growth
k the companys weighted average cost of
capital WACC
Temporary supernormal growth, then no growth  
n (1
g)t NOPAT0(1 g)n1 V
NOPAT0 (1 - b) ? -----------------
---------------------------
t1 (1 k)t
k (1 k)n
Temporary supernormal growth, then constant
growth  
n (1 gs)t NOPAT0 (1 - bs)
(1 gs)n1 V NOPAT0 (1 - b) ?
----------------- --------------------- x
-------------
t1 (1 k)t
k - g (1 k)n
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DCF Approaches to Estimate Continuing Value
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Valuation Framework

• NOPAT R - K
• V ------------- ------------
  I T
• K K
• WHERE NOPAT NET OPERATING PROFITS AFTER TAX
• K COST OF CAPITAL
• R RETURN ON
  CAPITAL
• I ANNUAL
  INCREMENTAL INVESTMENT
• T NO. OF YEARS
  THAT I CAN BE INVESTED
• AT R gt K
• V AS IS VALUE VALUE GROWTH OPPORTUNITIES

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3 Factors in Value Creation

• ROI gt WACC
• Amount of Investment
• Interval of Competitive Advantage
• Note
• Forward-looking
• Expected cash flows

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Value Creation - Another View

• Value Created (Return On Investment
• - Cost of Capital)
• X Capital employed
• Dependent Upon
• Cost of Capital Spread
• Duration of Spread
• Amount of Capital Employed

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Economic Profit (EP)

• (R - K) x capital
• NOPAT - K x capital
• Operating profits - a capital charge
• EP ties directly to NPV
• NPV market value - capital
• NPV the present value of projected EP
• Market value Capital PV of projected EP

K WACC R NOPAT / Capital
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Economic Profit

• Discounted Cash Flow Approach
• Yr. 0 Yr. 1 Yr. 2
• NOPAT 250 250...
• P.V. Perpetuity 2,500
• Investment (1,000)
• NPV _at_ 10 1,500

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Economic Profit

• Discounted EP Approach
• Yr. 0 Yr. 1 Yr. 2
• Nopat 250 250...
• Investment 1,000
• Capital Charge
  100 100...
• EP 150 150...
• NPV _at_ 10 1,500

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NPV and the Regulatory Process

• Remember
• NPV Cash Inflow - Cash Outflow
• where Cash Inflow Revenues - Costs
• But in a regulated environment,
• Revenues Costs Return x Investment
• Therefore, the NPV is always zero

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NPV and the Regulatory Process
n
NPV
t1
but R C KI
n
(C KI - C)t

- I
(1 K)t
t1
n
(KI)t

0
- I

(1 K)t
t1
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3 Valuation Frameworks
Discounted Cash Flow (DCF)
Comparables
Option Value
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Comparables An Example