Chapter 1

Overview of
Valuation
 Chapter Outline

• Introduction to Valuation
• Major Investment Decisions
– Project Valuation
– Enterprise (Business) Valuation
• Dealing with Complexity
– Investment Evaluation Process
• Case Study: CP3 Pharmaceuticals
Laboratories Inc.

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 Example of valuation in the real
world: Starbucks (SBUX)

2006 SBUX acquisition of Seattle’s Best Coffee

Internal Analysts Determine the Intrinsic

Value of Seattle’s Best Coffee

SBUX management determines whether the

company’s shares are over- or under-valued
(for decision to use cash or stock)

Wall Street security analysts to perform

valuation to determine “Buy-Sell or Hold”
rating and to evaluate potential synergies

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 Major Investment Decisions
We will discuss how firms evaluate investments and grow and expand through:

• Project valuation: firms acquire productive

capacity by assembling necessary assets.
• Enterprise valuation: acquisitions of entire
businesses - acquiring the productive assets
of an existing firm
– Common valuation tools and underlying
principles can be used for both types of analysis.

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 Project & Enterprise Valuation
We will discuss how firms evaluate investments and grow and expand through:

– Project Valuation – Enterprise Valuation

• Rio Tinto joint venture • Kraft Foods Inc. acquisition of
agreement with CODELCO Cadbury plc
for copper exploration in
Chile • Walt Disney Co’s acquisitions
• Microsoft and HP 3-year of Marvel and Pixar
$250 million investment into • Coca-Cola Co. and PepsiCo’s
cloud computing respective deals to acquire
• Coca-Cola’s bottling and bottler operations
distribution joint-ventures in • As of July 2010, Google has
China
acquired 76 companies
• Fashion retailer Zara’s including Doubleclick and
(parent company Inditex) 77 YouTube
market entries across the
world including the most
recent into India.

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 Valuation: Tool for Value
Creation
• The objective of a firm is to create wealth by
initiating and managing investments that generate
future cash flows that are worth more than the
amount invested.
– Management’s goal is to avoid decision errors based on
flawed or incomplete analysis
– Valuation provides tools for the evaluation of new
investment opportunities
• From capital budgeting to mergers & acquisitions, valuation is
more than discounting cash flows
• Effective valuation analysis involves a disciplined 3-phase
investment evaluation process

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 Investments that Create Value

• Invest $100 million today in a project that generates a stream

of cash flows valued at $150 million.
• Investment generates an incremental $50 million in wealth
for its shareholders.
• The project has a net present value (NPV) of $50 million.1

1
You will recall that NPV is equal to the difference between the value of expected future cash flows derived from an investment
and the cost of making the investment.

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 Investments that Destroy Value

• DaimlerChrysler formed by the $36 billion acquisition of

Chrysler by Germany's Daimler-Benz in 1998
– Net cash outflows, restructuring payments, Chrysler “bleeding
cash and unlikely to become profitable under the best-case
scenario until 2009”
• 2007 Cerberus Capital Management acquisition of 80% of
Chrysler for $7.4 billion
– According to one analyst, "Daimler is basically paying Cerberus
to get rid of it.“
– More trouble in July 2007 with the debt capital market crunch
• Trouble in syndication - J.P. Morgan Chase, Bear Stearns and Morgan
Stanley asked Cerberus and DaimlerChrysler AG, to pay higher
interest rates and change the covenants.

Source: Cerberus 'rescues' Daimler” www.thedeal.com May-15-2007 and “Debt world trauma: Tricky talks” Jul-30-2007; by Lisa
Gewirtz-Ward

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 Investments that Destroy Value

• Over half of all large investment projects fail

to achieve their hoped-for results.1
• Potential causes:
– Managers “go with their gut”
– Investments in risky projects
– Uncertain future events
– Incomplete information

Nadim F. Matta and Ronald N. Ashkenas, 2003, Why good projects fail anyway, Harvard Business Review (September), 109–114.
1

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 Project Valuation – Stages of
Investment
• The Caspian Sea oil
field development
project illustrates
the complexities of
investment
decisions and the
stages of
investment.

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 Project Valuation – Issues to Consider

• In any situation in which a company must value a major new

investment, five key issues arise:

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 Enterprise Valuation –
CSCO/Linksys
• Does the story make sense?
– Purchase made in 2003
– “Fueled by consumer broadband adoption, the home networking space
has experienced mass market acceptance. Linksys has captured a strong
position in this growing market by developing an extensive, easy-to-use
product line for the home and small office.”
– One of many acquisitions made specifically to broaden their portfolio of
networking solutions into high-growth markets, in this case the home
market for wireless networking and low-cost SOHO switches and hubs.

• What are the risks entailed in the investment?

– Tech risks are sometimes obvious: new wireless technologies could render
current product line obsolete.
– Partially mitigated by the fact that Linksys is the industry leader.
– Can Cisco maintain Linksys’s competitive edge while operating them as a
division of a large firm?

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 Enterprise Valuation –
CSCO/Linksys
• How will the investment be financed?
– CSCO issues stock with an aggregate value of $500 million to acquire the
Linksys business and to assume all outstanding employee stock options.

• How does the investment affect near-term earnings?

– “Exclusive of acquisition charges, Cisco anticipates this transaction will
add approximately $0.01 to its FY2004 pro forma EPS. The transaction will
be accretive to both GAAP and pro-forma earnings thereafter.”

• Inherent flexibilities in the investment?

– Staging? (Probably not in this single investment; but this can be viewed as
a stage in a broader acquisition strategy.)
– Follow-on investments? (opens a door to the SOHO market)
– Distribution, marketing synergies?

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 Enterprise Valuation

• Acquisitions usually involve similar issues

• Recent suggested acquisitions for consideration:

– Oracle’s acquisition of Sun Microsystems ($7.4 Billion)
– Disney’s acquisition of Marvel ($4 Billion)
– Pfizer’s acquisition of Wyeth ($68 Billion)
– InBev’s acquisition of SABMiller (over $100 Billion)

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 Dealing with Complexity –
Process & Discipline

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 CP3 Pharmaceuticals
Laboratories
• Investing in a New Materials-Handling System
– Figure 1-5 in the text is an abbreviated version of a firm’s
typical investment evaluation report. The report provides a
thorough analysis of the project. It begins with a list of the
various reasons why the group believes the project is likely
to be successful. It includes:
• Summary measures of project value: NPV, IRR, Payback
• Cost and cash flow projections as support to the summary
analysis

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 CP3 Executive Summary

• CP3 Austin, TX plant is requesting $547,000 to

purchase and install a new scrap materials-
handling system for its medical-packaging
operations to:
– Reduce waste in the firm’s packaging operations,
$300,000 savings per year
– Reduce head count from the test area, $35,000 savings
per year
– Recycle plastic materials that historically were part of
waste, $8,800 savings per year.
– Earn a 20% rate of return on invested capital.

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 CP3 Proposal, Justification, Risks
& Timeline

• Proposal: CP3’s medical-packaging unit expected production:

400 million vials of over-the-counter drugs this year.
• Justification: Packaging of these vials will generate 1.5 million
pounds of scrap plastics; 1/3 recycled, remainder becomes
scrap.
– Existing system: disposal cost for 1 million pounds of scrap
plastic: $8,800 per year
– New system: ground-up scrap can be sold for $300,000 per year
while eliminating the scrap disposal cost of $8,800 per year.
• Risks: stoppages
• Timeline: 3 months to get the new system up and running.
– Installation must coincide with existing production shifts

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 CP3 Financial Analysis

• These estimates span a period of 5 years ending in 2020.1

(Detailed estimates are found in Problem 2-6 at the end of Chapter 2.

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 Summing Up

• Process can be:

– Very costly and time-consuming
– Subject to biased estimates of project value such
as conflicts of interest and incentive problems
– Affected by problems arising out of differences in
the information available to project champions
and the internal review or control group (the
strategic planning committee)

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 Looking Forward

• Finance academics sometimes strip away

complexities to focus on what determines
value; sometimes creating a disconnect
between what should be done in theory and
what is done in practice.
• The study of valuation in this class will
integrate the analysis of individual projects
and entire enterprises along two
dimensions. Both build upon the same
theoretical base.

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 Looking Forward

• Valuation Topic Outline

– Chapters 6: forecasting using financial
statement analysis
– FSA using ratios (outside of text)
– Chapters 2-3: valuing cash flows and performing
risk analysis
– Chapters 4-5: firm and project costs of capital
– Recapitalization (outside of text)
– Chapters 8-10: valuation of the business
enterprise

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 Summary

• Valuation is more than about discounting cash flows

and determining NPV. Evaluating investments and
acquisitions has come a long way.
• Firms must consider:
– Cash flow estimation
– Risk assessment
– Financing opportunities
– The effects on earnings
– Staged investments
– “Follow-on” investments

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