In this chapter, students will be able to understand the methods for valuing domestic investments; can value a domestic investment using Free Cash Flow, NPV, WACC, Unlevered and Levered betas, Cost of Equity, Cost of Debt, Present Value of Growth perpetuities, and Exit Multiples. | Topic #6: Domestic Capital Budgeting: NPV, Free cash Flows, and Cost of Capital L. Gattis The Pennsylvania State University 0 Global Finance Capital Budgeting 0 Learning Objectives 1 Understand the methods for valuing domestic investments Can value a domestic investment using Free Cash Flow, NPV, WACC, Unlevered and Levered betas, Cost of Equity, Cost of Debt, Present Value of Growth perpetuities, and Exit Multiples Capital Budgeting 1 NPV and Discount Rate 2 Net 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 > 0 Interpretations: NPV is the value created by the project in excess of its initial investment If NPV = 0, the return on the project is exactly equal to the cost to finance the project Capital Budgeting 2 NPV and Discount Rate 3 Free Cash Flows (FCF) Includes initial investment and subsequent cash flows (not accounting profits) available to distribute to the securities holders of the organization FCFF (Free Cash Flows to the Firm) Cash flows available to distribute to both debt and equity holders CF before interest and dividend payments, but after taxes Non-cash “accounting costs” are added back (amortization and deprec.) capital expenditures are subtracted FCFF = EBIT*(1-Tc) + Deprec&Amort – CAPEX - ∆NWC Where: EBIT: Earnings Before Interest and Tax CAPEX: Capital Expenditures ΔNWC = change in net working capital (.) Capital Budgeting 3 Cost of Capital (K) 4 K (discount rate) Should reflect the risk of the project’s cash flows Total risk for undiversified investors (measured by std. dev.) Systemic risk for diversified investors (measured by beta) We will assume investors are diversified Should be consistent with free cash flows used debt and equity cashflows (FCFF) should be discounted at a rate that includes the both debt and equity risk Weighted Average Cost of Capital (WACC) is commonly used to discount FCFF . | Topic #6: Domestic Capital Budgeting: NPV, Free cash Flows, and Cost of Capital L. Gattis The Pennsylvania State University 0 Global Finance Capital Budgeting 0 Learning Objectives 1 Understand the methods for valuing domestic investments Can value a domestic investment using Free Cash Flow, NPV, WACC, Unlevered and Levered betas, Cost of Equity, Cost of Debt, Present Value of Growth perpetuities, and Exit Multiples Capital Budgeting 1 NPV and Discount Rate 2 Net 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 > 0 Interpretations: NPV is the value created by the project in excess of its initial investment If NPV = 0, the return on the project is exactly equal to the cost to finance the project Capital Budgeting 2 NPV and Discount Rate 3 Free Cash Flows (FCF) Includes initial investment and subsequent cash flows (not accounting profits) available to .
