Transcript Document

Chapter 8
Valuation and Required Rates
of Return
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Objectives
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The Meaning of Worth or Value
The Present Value of All Future Dividends
Applying the Dividend Valuation Model to Project Valuation
Estimating ΔDIV0 and ΔDIVt
The Equity Approach to NPV
The Debt/Equity Approach to NPV
The Weighted Average Cost of Capital Approach to NPV
Using the WACC Approach: An Example
Estimating OCFt
Estimating I0
Estimating kA
Determining the Project’s NPV
Using the WACC Approach: Some Considerations
The Adjusted Present Value Approach to NPV Estimation
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
The basic formulation of owner’s value:
W0 = DIV0 + V0[DIVt]
Gives us:
NPV = ΔDIV0 + PV0[ΔDIVt]
n
NPV = ΔDIV0 + ∑ ΔDIVt
t=1 (1+kE)
ΔDIVt
= ΔR t - ΔE t - ΔINTt - ΔPRINt - ΔTAXt - N.DIVt
Where:
ΔR t
ΔE t
ΔINTt
ΔPRINt
ΔTAXt
N.DIV
= the change in the firm’s cash operating revenue at time t
as a result of undertaking the project
= the change in the firm’s cash operating expenses at time t
as a result of undertaking the project
= the change in the firm’s interest payments at time t to the
suppliers of any debt capital used to finance the project
= the change in the firm’s principal payments at time t to the
suppliers of any debt capital used to finance the project
= the change in the firm’s taxes at time t as a result of
undertaking the project
= any dividends payable at time t to new owners who
supplied additional equity capital to help finance the project
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
The Weighted Average Cost
of Capital Approach to NPV
NPV = PV0[OCFt] - I0
Where τΔINTt is accounted for in our required rate of
return.
The actual present value calculation would look like:
n
NPV = ∑
OCFt - I0
t=1 (1 + kA)
t
where kA is the after–tax weighted average cost of
capital and is calculated as:
kA = (1 - L)kE + LkD(1 - τ)
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC
Approach: An Example
Consider again the case of the Keystone
Restaurant which we examined earlier.
Assume that the managers of the Keystone
use a WACC approach in their calculation of
project NPV. In evaluating whether to
purchase the new grill, they need to
estimate the OCFt produced by the grill, the
appropriate kA, and the initial investment in the
grill, I0.
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Estimating OCFt
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The managers estimate that the life of the new grill will
be five years. Over that period, they expect that the
operation of the grill will increase cash revenues (ΔRt)
by $15,000 per year.
Likewise, they expect the cash expenses associated
with operating the grill (ΔEt) to be $7,000 per year.
They determine that $2,000 in depreciation (assuming
straight-line depreciation with a salvage value of zero
at the end of five years) can be taken on the grill each
year. The Keystone’s marginal tax rate, τ, is 40%.
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An example (cont’d)
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Financial approach:
t
(ΔRt - ΔEt)
(1 - τ) + (τΔDEPRt)
= OCFt
1 ($15,000 - $7,000) (1 - .4) + (.4)($2,000)
=$5,600
2 ($15,000 - $7,000) (1 - .4) + (.4)($2,000)
=$5,600
3 ($15,000 - $7,000) (1 - .4) + (.4)($2,000)
=$5,600
4 ($15,000 - $7,000) (1 - .4) + (.4)($2,000)
=$5,600
5 ($15,000 - $7,000) (1 - .4) + (.4)($2,000)
=$5,600
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An Example (cont’d)
Using Excel to calculate the OCFt for the financial approach would look like:
Cell
1
2
3
4
5
6
A
t
1
2
3
4
5
B
Δ Revenue
15000
15000
15000
15000
15000
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
C
Δ Expense
7000
7000
7000
7000
7000
D
(1-τ)
=1-0.4
=1-0.4
=1-0.4
=1-0.4
=1-0.4
E
(τ*Δ DEPRt)
=0.4*2000
=0.4*2000
=0.4*2000
=0.4*2000
=0.4*2000
F
OCFt
=(B2-C2)*D2+E2
=(B3-C3)*D3+E3
=(B4-C4)*D4+E4
=(B5-C5)*D5+E5
=(B6-C6)*D6+E6
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An Example (cont’d)
Accounting income statement approach to OCF:
Year 1
Year 2
Year 3
Year 4
Year 5
ΔRt
- ΔEt
- ΔDEPRt
$15,000
- 7,000
- 2,000
$15,000
- 7,000
- 2,000
$15,000
- 7,000
- 2,000
$15,000
- 7,000
- 2,000
$15,000
- 7,000
- 2,000
ΔTAXABLE
INCOMEt
- Δ TAXt(@40%)
6,000
- 2,400
6,000
- 2,400
6,000
- 2,400
6,000
- 2,400
6,000
- 2,400
ΔNIt
+ ΔDEPRt
3,600
2,000
3,600
2,000
3,600
2,000
3,600
2,000
3,600
2,000
OCFt
$5,600
$5,600
$5,600
$5,600
$5,600
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An Example (cont’d)
Using Excel to calculate the OCFt for the accounting approach would look like:
Cell
1
2
3
4
5
6
7
8
9
A
Δ Revenue
Δ Expense
Δ DEPRt
Δ Taxable Income
Δ Tax (@40%)
Δ Net Income
Δ DEPRt
OCFt
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
B
Year 1
15000
7000
2000
=B2-B3-B4
=B5*0.4
=B5-B6
2000
=B7+B8
C
Year 2
15000
7000
2000
=C2-C3-C4
=C5*0.4
=C5-C6
2000
=C7+C8
D
Year 3
15000
7000
2000
=D2-D3-D4
=D5*0.4
=D5-D6
2000
=D7+D8
E
Year 4
15000
7000
2000
=E2-E3-E4
=E5*0.4
=E5-E6
2000
=E7+E8
F
Year 5
15000
7000
2000
=F2-F3-F4
=F5*0.4
=F5-F6
2000
=F7+F8
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Example: suppose that the Keystone Restaurant is
considering investing in a new grill that will cost $10,000.
Sixty percent of the cost will be financed from the
restaurant’s earnings (ΔRE0) and the rest by borrowing at
a rate (kD) of 10%. Assume that the owner’s required rate
of return (kE) on a project with a risk level equal to the
new grill’s risk level is 16%. What will be the kDE of this project?
kDE = (1 - L)kE + LkD
= (1 – (4,000/10,000))(.16) + (4,000/10,000) (.10)
= (.6)(.16) + (.4) (.10)
= .136 or 13.6%
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An Example (cont’d)
 Estimating I0. Estimating the total initial (time 0) investment, I0,
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is straightforward in this case. It is just the total purchase price
of the grill (including installation)—that is, $10,000.
Estimating kA. Earlier, we estimated the before-tax weighted
average cost of capital for the grill (kDE) to be 13.6%. When
using the WACC approach, however, we need to estimate kA,
the after-tax weighted average cost of capital.
kA
= (1 - L)kE + LkD (1 - τ)
= (1 – (4,000/10,000)) (.16) + (4,000/10,000)(.10) (1 - .4)
= (.6)(.16) + (.4) (.10)(.6)
= .12 or 12%
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
An Example (cont’d)
Determining the Project’s NPV
n=5
NPV =  OCFt
- I0
(1 + kA)t
t=1
Solving for NPV:
NPV =
$5,600[PVAn=5,k=12] - $10,000
= $5,600[3.6048] - $10,000
= $10,186.88
Solving using Excel: =NPV(0.12,5600,5600,5600,5600,5600)-10000
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Using the WACC Approach:
Some Considerations
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The leverage ratio, L, should be based on the market
values of the debt and equity used to finance the project.
The kA used for a project should reflect the risk of the
project, which will not necessarily be the same as the
risk of the firm undertaking the project.
The WACC approach to NPV implicitly assumes that the
leverage ratio will be held constant over the life of the
project.
When the firm uses several kinds of debt in its financing:
kD = WEkE +WD1kD1(1 - τ) + WD2kD2(1 - τ) + WD3kD3(1 - τ)
where WE + WD1 + WD2 + WD3 = 1.0
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458
Summary
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Beginning with our fundamental description of owner’s value, W0
= DIV0 + V0[DIVt], we showed how owner’s value is affected
when the firm undertakes a new project or investment and have
defined net present value (NPV) as the resulting change in
owner’s value.
Starting with the most basic expression of NPV, the retained
earnings approach, we developed or presented four other
approaches to calculating NPV: the equity, debt/equity, WACC,
and APV approaches.
The two approaches with the greatest operational application in
the hospitality industry are the WACC approach, which assumes
that the firm maintains a constant proportion of debt in its
financing, and the APV approach, which requires that the project
evaluator know exactly how much debt the project will use and
exactly what the debt repayment schedule will be.
Andrew, Damitio, Schmidgall
Financial Management for the Hospitality Industry
©2007 Pearson Education, Inc.
Upper Saddle River, NJ 07458