Corporate Finance

Dr Angie Andrikogiannopoulou
 Course Overview

Primer
1. Time Value of Money 2. Analysis of Financial Statements

Financing Decisions
Investment Decisions
1. Bond Valuation Company Valuation
1. Capital Budgeting
2. Equity Valuation 1. Forecast CFs
2. NPV/IRR/Payback
3. Capital Structure 2. Find discount rate
Capital Budgeting
 Forecasting Revenues and Costs
• Capital Budgeting is the process used to analyze alternate investments
and decide which ones to accept/reject.
• Incremental cash flows is the amount by which the firm’s CFs are
expected to change if the project is undertaken. First, determine the
incremental earnings of a project and then use incremental earnings to
forecast the incremental CFs of the project.

Incremental CFs =CFs with project – CFs w/o project

• Sunk costs are costs that have been or will be paid regardless of the
decision whether or not the project is undertaken (e.g. market research
study). These should not be taken into account!
The Blackberry z10 Project
Shortly after the release of the first iPhone in 2007, Verizon asked
Blackberry to create a touchscreen “iPhone killer.” Mr. Lazaridis, the co-
founder and former CEO of Blackberry opposed the launch plan for the
touchscreen z10 and argued strongly in favor of emphasizing keyboard
devices. But the current CEO, Mr. Heins, did not take his advice and
launched the z10, with disastrous results.

Read through the case study of Blackberry and answer the following
questions:
1. What are the key costs and benefits of the z10 project?
2. What is the value of this opportunity if the discount rate that
matches the risk of the cash flows from the z10 project is 10%?
3. Should Blackberry launch the z10?
Incremental Earnings

Incremental Income
With vs without the z10 Year 0 Year 1 Year 2 Year 3 Year 4
Units sold
Sale Price
Cost

Revenue
Erosion/Cannibalization
COGS
Depreciation
R&D
Selling, General & Admin
EBIT
Tax
(Incremental) Net Income
Working Capital Requirements

Year 0 Year 1 Year 2 Year 3 Year 4

Inventory Units
Inventory Cost
Accounts Receivable
NWC
Change NWC
Accounts Receivable/Payable Days

• We can express accounts receivable in terms of the number of days’ worth

of sales that it represents:
!""#$%&' ()")*+,-.)
!""#$%&' ()")*+,-.) /,0' =
!+)2,3) /,*.0 4,.)' ()+)%$)

• Suppose that Example,Inc. has total revenue of $100 million and accounts
receivable are $20 million. How many days does it take the company to
collect payments from its customers, on average?
• Suppose that accounts receivable of Global,Inc. are expected to remain
outstanding for 180 days. How large are the accounts receivable of the
company if total annual revenue is $100 million?
• Similarly,
!""#$%&' 9,0,-.)
!""#$%&' 9,0,-.) /,0' =
!+)2,3) /,*.0 :#'& #; 4,.)'
After-tax Salvage Value

In year 3, Blackberry will have:

• A cash inflow due to the money it receives from selling the machine.
• A cash outflow due to the taxes that it has to pay on any capital gains
realized from the sale.

Capital Gains = Sale Price – Book Value

Book Value = Initial Cost – Accumulated Depreciation

After-tax cash flow = Sale price – tax rate×Capital Gains

The after-tax salvage value should be added to the cash flows of

Blackberry in the year at which the sale took place. No depreciation after
year 3!
From Earnings to Free Cash Flows

Free Cash Flow = EBIT*(1-tax rate) + Depreciation –

CapEx – Change in NWC

Change in NWC = Change in Accounts Receivable +

Change in Inventories – Change in Accounts Payable
Free Cash Flows

Year 0 Year 1 Year 2 Year 3 Year 4

EBIT

Less: Taxes

Plus: Depreciation

Less: Change in NWC

Less: CapEx

Free Cash Flow

Net Present Value

• In order to evaluate the project we need to express cash flows in terms

of money today. Using the discount rate of 10%:

Year 0 Year 1 Year 2 Year 3 Year 4

FCF () (+ (- (. (/

(+ (- (. (/
$%& = () + + - + . +
1.1 1.1 1.1 1.1/
• You may use NPV function in Excel:
NPV(discount rate, CF1, CF2,…)
But be careful! It assumes that the first cash flow occurs at the end of
year 1.
Feasibility Study Estimates

There is usually a fair amount of uncertainty about future forecasts. You go

back to the feasibility study and find the following best- and worst-case
estimates:

Assumption Forecast Worst Case Best Case

First Year Sales 1.75 1.4 2
Production Cost 70 74 66
First Year Average Price 180 170 185
Cost of Capital 10% 15% 9%
Accounts Receivable 90 days 120 days 60 days
Sensitivity, Break-even and Scenario Analysis

• Sensitivity Analysis shows how the NPV varies with a change in one
of the assumptions, holding the other assumptions constant.

• Break-even Analysis
– The break-even level of a parameter (input) is the level that causes
the NPV of the investment to equal zero.

• Scenario Analysis considers the effect on the NPV of simultaneously

changing multiple assumptions.
Sensitivity Analysis

NPV SENSITIVITIES ($)

Base Case is $3.8M NPV
-40 -30 -20 -10 0 10 20 30

First Year Sales -28.07 20.05

Production Cost -9.23 9.23

First Year Average Price -18.07 9.03

Cost of capital -23.18 5.13

Accounts Receivable -4.054.05

Alternative Investment Decision Rules

• Do CFOs use the NPV rule?

• Researchers sent questionnaires to CFOs of large US listed firms
asking them to complete the sentence:
“To value an investment, I would always use …”
NPV 75%
IRR 76%
Payback 53%
Discounted payback 28%
The Internal Rate of Return (IRR) Rule
• The !"" is the discount rate that makes the #$% = 0.

(+ (- (/
#$% = () + + -
+ ⋯+ /
=0
1 + !"" 1 + !"" 1 + !""

• The !"" can be found by plotting the #$% as a function of the

discount rate 0. Alternatively, it can be computed by trial and error
or by using the !"" function in Excel
122(456 , 458 , … )

• IRR rule: Accept projects with 0 < !"".

The Internal Rate of Return (IRR) Rule

80 Blackberry z10
60

40
NPV($ millions)

20
IRR=10.76%
0
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% 32% 34%
-20

-40

-60

-80

-100
Discount Rate
The Internal Rate of Return (IRR) Rule

Reasoning: If the opportunity cost of capital is lower (higher) than

the IRR, the project has positive (negative) NPV when discounted at
the opportunity cost of capital.

The IRR rule will give you the same answer with the NPV rule
whenever the NPV of a project is a declining function of the discount
rate.

Situations where the IRR rule and NPV rule may be in conflict:
1. Delayed Investments
2. Nonexistent IRR
3. Multiple IRRs
Pitfalls of using the IRR – Delayed Investments

Assume you have just retired as the CEO of a successful company. A

major publisher has offered you a book deal. The publisher will pay
you $1 million upfront if you agree to write a book about your
experiences. You estimate that it will take three years to write the
book. The time you spend writing will cause you to give up speaking
engagements amounting to $500,000 per year. You estimate your
opportunity cost to be 10%.

1. Should you accept the deal according to the IRR rule?

2. Should you accept the deal according to the NPV rule?
Pitfalls of using the IRR – Delayed Investments
• Calculate the IRR of the project
: 9 < =

9:::::: −;::::: −;::::: −;:::::

500000 500000 500000

!"# = 1000000 − − −
1+* 1+* + 1+* ,

Setting !"# = 0 and solving for *, we find that -.. = 23.38%, i.e., larger
than the cost of capital (10%). The IRR rule says you should accept the deal.

• Calculate the NPV

500000 500000 500000
!"# = 1000000 − − + − , = −$ 243,426
1.1 1.1 1.1
Since !"# < 0, the NPV rule indicates you should reject the deal.
NPV as a function of discount rate

When the benefits of an investment occur before the costs, the NPV is an
increasing function of the discount rate.
Pitfalls of using the IRR – Multiple IRRs

Suppose you inform the publisher that he needs to sweeten the deal before
you will accept it. The publisher offers $550,000 in advance and $1,000,000
in four years when the book is published.
– Should you accept or reject the new offer?
Pitfalls of using the IRR – Multiple IRRs

The cash flows would now look like:

The NPV is calculated as:

500000 500000 500000 1000000
!"# = 550000 − − − +
1+* 1+* + 1+* , 1+* -

By setting the !"# = 0 and solving for *, we find the .//.

In this case, there are two .//s: 7.164% and 33.673%.
Because there is more than one .//, the .// rule cannot be applied.
NPV as a function of discount rate
 Pitfalls of using the IRR – Nonexistent IRR

Finally, you are able to get the publisher to increase his advance payment
to $750,000, in addition to the $1 million when the book is published in
four years. With these cash flows, no IRR exists; the NPV is positive for
all values of the discount rate. Thus the IRR rule cannot be used.
The Payback Rule
• Payback period
– length of time until the accumulated cash flows equal or
exceed the original investment
• Payback rule: Quicker is Better
– accept if payback is less than some pre-specified number
of years
! " # $ %

−', !!! ", )!! #, !!! #, )!! #, )!!

What is the payback period?

The Payback Rule - Example

Consider the following 3 projects. The discount rate is 10%.

Project $%& $%' $%( $%) Payback NPV

period
A −2000 500 500 5000

B −2000 500 1800 0

C −2000 1800 500 0

The Payback Rule - Example

Consider the following 3 projects. The discount rate is 10%.

Project $%& $%' $%( $%) Payback NPV

period
A −2000 500 500 5000 3 +2624

B −2000 500 1800 0 2 −58

C −2000 1800 500 0 2 +50

• NPV rule tells us to accept projects A and C and reject project B.

• What if the firm uses the payback rule with a cutoff period of 2 years?
The Payback Rule Evaluated

• Advantages
– simple to use
– it is a crude measure of liquidity

• Drawbacks
– how to determine cut-off? it’s arbitrary!
– bias against long-term projects
– ignores time value of money

Payback used on its own is inconsistent with maximization of

shareholder value
The Discounted Payback Rule

In practice, we should at least try to account for the time

value of money.
! " # $ %

−', !!! ", )!! #, !!! #, )!! #, )!!

• Suppose * = 10%
• 012 = 602.35
• Discounted Payback = ?
The Discounted Payback Rule Evaluated

• Useful adjustment to Payback, with similar information about

liquidity

• Beware of the pitfalls

– arbitrary cut-off date
– bias against long-term projects

• Use it qualitatively, and jointly with NPV as a secondary method.