Annuity NPV  comparing projects with different lives

PV of ¿  not sufficient for comparison when different

[ ]
X = amount of Equivalent
annuity
Payment 1 1 1 EA
beginning PV ( X ,n ,r ) =X × ¿] Annuity ∗ 1− discount rates (r) – Perpetuity
next
r = Interest rate/yield
n = time
r r (1+ r )n r
period:
PV of a
g = growth rate 1 Cost of Equity (r E) -> return to shareholders
growing
r>g
PV ( X , g , n , r )= X × ¿
r −g
( 1+r )
annuity at g Dividend Discount Constant long-term growth:
¿ 1+ P 1
Model (DDM) Price=P 0= ¿1 ¿2
Perpetuity E + P 0= +…
X 1+r E (1+ r E )2
PV of perpetuity beginning next period: PV = ¿1
r ¿ 1+ P 1 ¿1 P 1−Pℜ=
0 +g
X r E= −1= + P0
PV of a growing perpetuity at g PV = P0 P0 P0
r−g Div Yield
Capital Gain
Cash-Flow Total Payout
Model
P 0=Total Payout / ( ℜ−g ) / Number of Shares
EBIT(1-τ c) EBIT ( 1−τ c )=(Sales−COGS−SGA −Depreciation)∗(1−τ c)
τ c =Net income / EBT Capital Asset  Establishes relationship between price of a security and its risk
Operating CF EBIT(1-τ c) + Depreciation Pricing Model  CAPM used to determine the cost of capital (r): minimum
(CAPM) return required by investors for a certain level of risk
FCFF FCFF=EBIT ( 1−τ c ) + Depreciation−CapEx−Changes∈WC  Assumes investors are well diversified, thus risk premium
potential is proportional to a measure of market risk (Beta)
FCFF (incl.
liquidation value) FCFF (+liq )=FCFF +liquidation value−Tc∗(liquidation value−BV ¿assets) Expected return on stock = Risk-free rate + Beta of stock *
Market risk premium
FCFF
FCFF discounted FCFF (disc .)= r =cost of capital r E=r f + β i∗[ E ( r M ) −r f ]
t
(1+r )
FCFF ( disc . cumul . t 0 ) =FCFF disc . at t 0 Cost of Debt (r D) -> return to creditors

FCFF disc. FCFF ( disc . cumul . )=disc . cumul . at t−1+cumul . FCFF at currentYield
t to Maturity
(YTM)
 Single discount rate that equates the PV of the bond’s remaining
CF to its current price

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cumulative *The FCFF disc. cumul. from the last year is equal to the NPV (and
also equal to all the sum of FCFF discounted, as the NPV formula ( Couponrate∗par value )∗1 1 par value
Price= 1− +
suggests) y ( 1+ y ) n
(1+ y)
n

CF based Criteria  Find y

Payback Period FCFF d . c .(Year

yearofof change)
change = last r D= y− p∗L=YTM −Prob ( default )∗expected loss rate
(PP) PP=t at year of change + neg.
FCFF d ( year o . c .+1) Binomial Model
FCFF FCFF (t 0) FCFF (t 1) FCFF (t 2) Call: right to buy at strike price
NPV NPV =Σ = + + +… Put: right to sell
(1+r )t (1+ r )0 (1+r )1 (1+r )2
Profitability Index
PI =NPV /CapEx
1. Given, dt, volatility and Rf
(PI)
Cash Flow: -/+/- do not compute; if NPV positive IRR higher than cost
 u=e σ √ dt
IRR
of capital (r)  d=1/u
“The IRR is the rate the equals NPV to 0. So if NPV>0 then IRR>cost ( Rf∗dt )
of capital.” e −d
 pu = (contin.)
u−d
 1+ R f −d E E
 pu = (discrete)  rU = pre-tax WACC = rA ; rU = r E+ r or
u−d E+ D E+ D D
 pd =1− pu 1 D/ E
r + r
2. Build tree for underlying asset 1+ D/ E E 1+ D/ E D
3. Compute payoffs at maturity T (S at T-K is S0) WACC with Corporate Taxes
 Call=Max ¿ ) E E E
rU = r E+ r D− r τ reduction due to interest tax shield
 Put =Max ¿ ) -> negative = 0 (will not be executed) E+ D E+ D E+ D D c
4. Discount back payoffs at maturity + repeat until you get value at t=0 (ITS)
u d
p u∗C + ( 1− pu )∗C PV of the Interest Tax Shield
 (continuous)
(¿ Rf ∗dt )
e ¿ Regular Case
Annual ITS = τ c (Corporate tax rate) * (Interest
u d
p u∗C + ( 1− pu )∗C Payment)
 (discrete)
Special Case #1: Firm borrows τ c (R D D)
(1+ R f )
t
debt D and keeps level of D
PV ( ITS )= =τ c D -> debt
5. Calculate expected payoff permanently
RD
is perpetuity
 current value of call option=( C 1∗pu ) +(C2∗p d )/(R f +1)
1
 current value of put option= ( P1∗pu ) +(P2∗pd )/( Rf +1) Special Case #2: Interest PV ( ITS )=annualinterest × tax rate × ¿
payments are known r
Black-Scholes Model )
 Assumes that rate of return of underlying asset follows random walk
E D
( )
Call0=N d1 ∗S0−N d 2 ∗PVN(d) ( )
( K )= cumulative S = current share ( 1 ) Pre−Tax wacc= r E+ r
normal distribution price E +D E+ D D
S0 K = exercise price  = volatility (st.d.
ln ⁡( ) t = time to maturity in of r)
PV ( K ) σ √ t years *d2: use positive U FCF
d 1= + value, then 1-value V =
σ√t 2 from table Special Case #3: Target D/E Pre tax wacc−growth rate of FCF / perpetuity
d 2=d 1−σ √ t * Ratio
(2) r wacc =
E
r E+
D
r (1−τ c ) ;
PV ( K )=K∗e
(−R ∗dt) f E +D E+ D D
L FCF
Put-Call Parity V =
r wacc −growt h rate of FCF
Put =Call−S0 + PV (K ) // Call +PV(K)=Put +S
(3) PV ( ITS ) =V L −V U
Modigliani-Miller Model
MM I Valuation with Corporate Taxes (Tc) I Constant D/E Ratio
Value of levered Firm = Value WACC (1) Determine FCFs and rwacc :
of unlevered Firm (zero debt) rE = Cost of levered Method E D
MM II
V =V
L U Equity r wacc = r E+ r ( 1−τ c )
D rU = Cost of unlevered E +D E+ D D
With r E=r U + (r −r )
L U E U D Equity
L FCF 1 FCF 2 FCF 3
τ c :V =V + PV (ITS ) E = Market value of (2) Compute V0L : V 0= + + +…
Equity 1+r wacc (1+r wacc) (1+r wacc )3
2
FCF D = Market Value of Debt
V U= ! FCF0+V0L = NPV of project
rU APV Method (1) Determine unlevered value of firm:
(adjusted PV)
 Compute N(d1) and N(d2) Table Normal: N(d1) = .5793; N(d2) = .3300
Calculate Call-Option-Price
0.5793 ×5.75−0.3300 ×6.23=1.275
U FCF 1 FCF 2 FCF 3 What is the value of a put option?
(2) Compute VU :V = + + +… Build tree and calculate up and K - Maturity Value 1, K – Maturity Value 2 … (If negative
1+ r U (1+ r U ) (1+r U )3
2
down values at maturity = 0)
(3) Estimate annual interest payments: t=r D × D t −1 Calculate values from period
before through formula
u
p u∗C + ( 1− pu )∗C
d

(4) Compute PV (ITS): (continuous)

(¿ Rf ∗dt )
ITS1 ITS 2 ITS 3 e ¿
PV ( ITS )= + + +… u
p u∗C + ( 1− pu )∗C
d
1+r U (1+r U ) (1+r U )3
2
(discrete)
(5) Determine VL: L U
V =V + PV ( ITS ) (1+ R f )t
Do it until reach today’ value
FTE Method (1) Calculate FCFE = FCF - (1-τ c) x Interest Payments
t t t + Net
(Flow-to-
Equity) Borrowingt // FCFEt= Net Incomet + Depreciationt - CapExt – Compute the up and down factors (u, d) of the binomial model implied in this
Increase in NWCt+ Net Borrowingt [with Net Borrowing at t = tree
*rE = Equity Dt – Dt-1] and provide an estimate of the annual volatility
cost of D Compute u and d
boom up value down value
capital (2) Compute FCFE and rE (r E=r U + (r −r )) u= d=
E U D S S
(3) Determine NPV(FCFE) at rE*:
FCFE1 FCFE 2
Use formula
u=e √dt
NPV ( FCFE )=FCFE0 + + +…
Find 
ln ⁡(u)
1+ r E (1+r E)2 ln(u) =  √ dt  ¿
√ dt
Apply the Flow-to-Equity (FTE) method to assess the quality of the project
Compute data and calculate
rwacc
Create a table
FCF 1 FCF 2 FCF 3
1. FCF; 2. PV ( + + ¿; 3.
1+ r wacc ( 1+r wacc ) ( 1+r wacc )3
2

Debt; 4. Cost of Debt; 5. Net Cost of Debt (Debt(1-τ )); 6. Net

c
Borrowing (Dt y1 – Dt y2 …); 7. FCFE; 8. NPV

Compare Two Products with different life (given data: Life, Cost of Capital, NPV)
Say which project to invest if one Choose the project with higher NPV
EXAMPLES shot
Calculate Equivalent Annuity of
both projects NPV

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What is the value (BS) of a call option? [=40%, S=5.75, YTM=30months/2.5 years,
Rf=2% (cont.), K=6.55] 1 1
Calculate PV(K) −0.02× 2.5 ∗ 1−
PV (6.55 )=6.55 × e =6.23 r (1+ r )n
Calculate d1 and d2
5.75 Choose the project with higher “In case of repetition, I would choose project X”
ln ⁡( ) Eq. Ann
6.23 0.4 √ 2.5 ; Should the company invest in this project (Given Balance Sheet, Cost of Cap.,
d 1= + =0.189 Expected Cash Flows, Risk Free Rate and Exp. Market Premium)
0.4 √ 2.5 2 Compute data and calculate
1 D/ E
d 2=0.189−0.4 √ 2.5=−0.443 rwacc
r E+ r Don’t forget: (D – Cash)/E
1+ D/ E 1+ D/ E D
Continue using Wacc Method