DCF Theory Training Chess

Discounted Cash Flow / Net Present Value

October 2011

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DCF Thought

DCF is like Chess. The concept is relatively easy to understand. Becoming good at DCF / NPV analysis takes practice. To become a master takes dedication, time, and effort.

Today, we will focus on learning the fundamentals, and introduce you to some of the more advanced concepts. For those who wish to become a Grand Master, we have plenty of resources to guide you.

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Objective:Objective:

Provide an overview of DCF / NPVProvide an overview of DCF / NPV

Agenda:Agenda:Basic DCF Principles: Level 1, 2, 3NPV (Net Present Value)Various methods to evaluate projectsWatchouts / TipsQ&A

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DCF Level 1 = Castling

Castling

•A special move involving both the king and one rook. Its purpose is generally to protect the king and develop the rook. Castling on the kingside is sometimes called castling short and castling on the queenside is called castling long; the difference is based on whether the rook moves a short distance (two squares) or a long distance (three squares).

http://en.wikipedia.org/wiki/Castling

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DCF / Chess Thought: diagrams / pictures help drive home the thought.

Move Rook immediately next to the King on its opposite side:

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DCF:

Investment A Investment B

Cash is a scarce resource. Discounted Cash Flow Analysis provides a basis to compare different investment options.

Which investment is

better?

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DCF Level 1 Principles:

Discounted cash flow (DCF) analysis is a method of valuing a project (or a Company) using the concept of time value of money and risk:

• $1 today is worth more than $1 a year from today;

• Cash invested in a project is riskier than a US T-Bill, or some other ‘risk free’ investment.

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DCF Level 2 = En Passant

En passant

• ("in the act of passing"; derived from French) The rule that allows a pawn that has just advanced two squares to be captured by a pawn on the same rank and adjacent file. The pawn is therefore taken as if it had only moved one space. It is only possible to take en passant on the next move.

http://en.wikipedia.org/wiki/En_passant

http://en.wikipedia.org/wiki/French_language

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DCF Level 2 Thoughts:

• WACC

• Beta

• Market Risk Premium

• Risk Free Rate

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Fianchetto

•Refers to a bishop developed to the second square and the longest diagonal on the file of the adjacent knight (that is, b2 or g2 for white, b7 or g7 for black), or the process of developing a bishop to such a square. It usually occurs after moving the pawn on that file ahead one square (or perhaps two). The Italian word is actually a noun ("in fianchetto") and not a verb.

http://en.wikipedia.org/wiki/Fianchetto

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Fianchetto means “to flank”. It refers to a move where the bishop is placed on the longest diagonal it can attack.

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DCF Level 3 Thoughts:

• Monte Carlo Simulation

• Decision Tree + NPV

Name the Movie and the Character:

Test Your Knowledge

Movie: Searching for Bobby Fischer

Character: Josh Waitzkin

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DCF: Level 1

Money Cash

Discount Rate / Interest Rate / Equity Premium

Determining Cash Flows

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Cash Flow versus Earnings?

Why and when did the use of Cash Flows versus Earnings come into practice?

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Cash Flow versus Earnings?

Discounted cash flow was first formally articulated in 1938 after the market became wary of relying on reported income, or any measure of value besides cash.

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Why Cash Flows vs Accounting Earnings?

Accounting EarningsOne cannot spend earnings.

Shows revenues when products and services are sold or provided, not when they are paid for. Shows expenses associated with these revenues, not when expenses are paid.

Net income includes a number of non-cash adjustments to approximate economic activity as of (or over) a period of time.

Accounting adjustments do not necessarily reflect the company’s ability to pay its obligations or invest for future growth.

Cash FlowsCash flow reflects the company’s ability to generate funds in order to pay its obligations or invest for future growth

Various Cash Flow measures (i.e. - Free Cash Flow) adjusts accounting income to arrive at the funds available to pay stock and debt holders. For example, taking out Dividends provides one way to compare cash flows across Companies.

Ca$$h is King

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Invest in projects that yield a return greater than the minimum acceptable hurdle rate

Return on projects should be measured based on:

• cash flows generated: Why cash flows and not earnings?

• the timing of these cash flows: cash flows that occur earlier value more than cash flows that occur later.

• incremental cash flows: use cash flows that are incremental related to the investment decision.

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Depreciation / Amortization / Capital

While depreciation reduces taxable income and taxes, it does not reduce cash flows.

It is a non-cash expense; therefore, it needs to be added back.

There is a cash flow benefit associated with depreciation – the tax benefit. In general, the tax benefit from depreciation can be written as:

Tax Benefit = Depreciation * Tax Rate

Capital expenditures (CAPEX) are not treated as accounting expenses, but they do cause cash outflows.

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Working Capital

Intuitively, money invested in inventory or in accounts receivable cannot be used elsewhere. Therefore, it represents a drain on cash flows.

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To get from accounting earnings to cash flows:

Free Cash Flow = Before Tax Profit (BTP) or EBIT

- Taxes

+ Add back Depreciation/Amortization

+/- Change in Working Capital

- Capital Expenditures

Ca$$h is King

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Relevant & Irrelevant Cash Flows

Flows that will be incurred as a direct result of the project (incremental cash flows)

Tax benefits (tax shield on depreciation)

Flows that do not change as a results of the project

Flows that have already occurred (sunk costs)

Flows that would be incurred regardless of the project activities (replace equipment)

Non-cash items (depreciation)

Irrelevant Cash FlowsRelevant Cash Flows

Net Present ValueTime Value of Money

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Basic Principles

Getting cash now is better than getting it later

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Time Value of Money

Providers of investment capital require a return of their principal and an amount of interest which is commensurate with the risk

and the length of time until their investment is returned

Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 TotalTotal

Car Loan from Bank

-30,000 -30,000

Principle Payment

10,000 10,000 10,000 30,000

Interest Payment

2,100 1,400 700 4,200

Total Payment

-30,000 12,100 11,400 10,700 4,200

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What is Net Present Value (NPV)

Net Present Value is

the value of future cash flows

in today’s dollars

Cash Flow Year 0

Total in today’s $

Cash Flow Year 1

Cash Flow Year 2

Cash Flow Year 3

Note: the number of years used in the analysis varies depending on the project type.

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Time Value Factor Calculation

PV Factor1

r t 1

r = discount rate*

t = Time (years)

FV Factor r t 1

If r = 9%, then the present value of $1

earned three years from now is $0.77

$1* / (1+0.09)^3

If r = 9%, then the value of $1 invested today will equal $1.30 three years

from now

$1* X (1+0.09)^3

NoteNote: Clorox uses its Weighted Average Cost of Capital (WACC) as its discount rate

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What is required for determining NPV?

Project YearProject Year 00 11 22 33

Cash Flows CF0 CF1 CF2 CF3

(Multiplied by)

Discount factor1 1/(1+r)^1 1/(1+r)^2 1/(1+r)^3

(Equals)

Discounted Cash FlowsDCF0 DCF1 DCF2 DCF3

Sum the discounted cash flows to get Sum the discounted cash flows to get

the Net Present Value of future cash flowsthe Net Present Value of future cash flows

1

2

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What is required for determining NPV?

Project YearProject Year 00 11 22 33 44 55 66 77

Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000

(Multiplied by)

Discount factor1

1/(1+r)^1

1/(1+r)^2

1/(1+r)^3

1/(1+r)^41/

(1+r)^51/

(1+r)^61/(1+r)^7

(Equals)

Discounted Cash Flows

DCF0 DCF1 DCF2 DCF3 DCF4 DCF5 DCF6 DCF7

1

2

The first step in calculating Net Present Value requires the determination of relevant,relevant, incrementalincremental cash flows

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Net Present Value Conclusion

If NPV is negative, reject the project; otherwise, further consideration is

required.

Having cash flows and present value factors,

the Net Present Value can be calculated


Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000

(Multiplied by)

Discount factor (10%)

1 .91 .83 .75 .68 .62 .56 .51

(Equals)


-3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566

Cumulative Cash Flows (NPV)

-3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728

DCF Level 2: What Rate Should We Use to Discount Cash Flows?

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Weighted Average Cost of Capital Definition

Weighted Average Cost of Capital (WACC) is the minimum rate of return that must be realized

in order to satisfy investors: both debt holders and shareholders.

Cost of Cost of EquityEquity

Cost of Cost of DebtDebt++>>

Project Project ReturnsReturns

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Calculating WACC

Key WACC concepts:

• Debt Cost

• Risk Free Rate

• Beta

• Equity Market Risk Premium

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Calculating WACC

Cost of Capital has two components:

Cost of equity (rk)

After tax Cost of debt (rd)

These are multiplied by the relative weight of their market values to arrive at an average cost:

WACC = rk * (E/(D+E)) + rd * (D/(D+E))

E = market value of equity

D = market value of debt

WACC = rk * (E/(D+E)) + rd * (D/(D+E))

DCF Level 2: Debt Cost

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“The AAA rating has made the U.S. Treasury bond one of the world’s safest investments — and has helped the nation borrow at extraordinarily cheap rates to finance its government operations, including two wars and an expensive social safety net for retirees.

Treasury bonds have also been a stalwart of stability amid the economic upheaval of the past few years. The nation has had a AAA rating for 70 years.

Analysts say that, over time, the downgrade could push up borrowing costs for the U.S. government, costing taxpayers tens of billions of dollars a year. It could also drive up interest rates for consumers and companies seeking mortgages, credit cards and business loans.” (Washington Post, August 5, 2011)

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DCF Level 2

Clorox: BBB+ rating

So what does that mean?

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• ‘AAA’ Extremely strong capacity to meet financial commitments.

• ‘A’ Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances

• ‘BBB’ Adequate capacity to meet financial commitments, but more subject to adverse economic conditions

• ‘BBB-’ Considered lowest investment grade by market participants

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Standard & Poors Ratings:

•‘BB+’ Considered highest speculative grade by market participants•‘B’ More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments•‘CCC’ Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments•‘CC’ Currently highly vulnerable•‘C’ A bankruptcy petition has been filed or similar action •‘D’ Payments default on financial commitments

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What factors do the Rating Agencies take into account in the Consumer Products arena?

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Market share, including its market position and the ability to sustain or increase share;

Strength, breadth, and diversity of brands in the product portfolio;

Degree of competition from private label and/or house-branded products within each product category and country market;

Product portfolio life cycle, i.e., the balance of well-established products and new product introductions;

Degree of operating efficiency, including size and economies of scale, which in turn may translate into greater purchasing power with suppliers;

Extent of geographic diversification; and

Management's track record of product innovation and brand building, including efficiency and effectiveness of marketing spend.

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Degree of concentration of manufacturing plants or operating lines and procurement, including high exposure to particular raw materials or suppliers (this may be a critical factor for smaller, or more narrowly focused companies);

Customer concentration, (this may be a critical factor for smaller, or more narrowly focused companies);

Reach and degree of penetration of distribution network, including costs of developing efficient distribution networks in faster-growing emerging markets;

Legal and regulatory environment, including taxation and restrictions on consumption and marketing of certain products; and History of managing product liability, reputational risks, and business interruptions.

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US:

We have lowered our long-term sovereign credit rating on the United States of America to 'AA+' from 'AAA‘

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Standard & Poors Ratings:

• United States AA+

• Canada AAA

• Hong Kong AAA

• New Zealand AA+

• China AA-

• Italy A

• Bahamas BBB+

• Greece CC

http://en.wikipedia.org/wiki/United_States

http://en.wikipedia.org/wiki/Canada

http://en.wikipedia.org/wiki/Hong_Kong

http://en.wikipedia.org/wiki/New_Zealand

http://en.wikipedia.org/wiki/China

http://en.wikipedia.org/wiki/Italy

http://en.wikipedia.org/wiki/The_Bahamas

http://en.wikipedia.org/wiki/Greece

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Cost of Debt

Clorox’s cost of debt includes short term notes and long term debt

After tax cost of debt is 5.00% * (1-38%) = 3.1%

Pretax rate Balance ($MM)

US Commercial Paper 4.78% $487

Debt 2-3 years 5.21% $500

Debt 4-5 years 4.26% $575

Debt 5-10 years 5.42% $1,029

Total 5.00% $2,590

DCF Level 2: Equity Cost

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CAPM Formula:

Cost of equity = Risk free rate + Beta * Market risk premium

• Risk free rate is equal to the return on long term government securities; e.g. 30 year treasury bond yield.

• Beta is a measure of risk defined by the correlation between Clorox’s stock price movement and the stock market in total.

• Equity market risk premium is the premium investors require for purchasing stock vs. debt instruments.

Cost of Equity - CAPM

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Cost of Equity Assumptions

• Risk Free RateRisk Free Rate: 5.5%

• BetaBeta: in the range of 0.65 to 0.85 range for cost of capital calculations, in line with industry averages. Average = 0.75.

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•Market risk premium = expected market return - risk-free rate.

•Determine the "risk-free" rate of return. Treasuries are considered to be risk free as they are backed by the "full faith and credit" of the U.S. government. For this reason, we can use them as a proxy for the risk-free rate.

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•Determine the expected return of the market. According to Ibbotson Associates, the S&P has returned an average of 10.3 percent a year, compounded, since 1926 (CNN, 2008). This is a good proxy for expected return of the market.

•The market risk premium equals the average expected return from the market minus the risk free rate. The risk premium = 6.5 percent.

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• Market risk premiumMarket risk premium: ranges from 5.5% to 7.5% for cost of capital calculations: call it +6.5%


10.5% = 5.5% 0.75 + 6.5% *


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Equity Risk Profile Concept

No risk investment Government T-Bill

Inflation risk Government Bond

Equity market risk (Beta = 1.0)

S&P 500

Clorox

Risk Type Example

Company specific risk (Beta = .75)

Yield Curve

Cost of Equity

4.0

1.5

6.5

-1.5

% Rate

4.0

5.5

12.0

10.5

% Rate Cumulative

DCF Level 2: Bringing WACC together

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Capital Structure

Market value of debt = $3 Billion

Total shares outstanding = 153MM

Stock price = $65

Market value of equity = $9 B

EquityEquityDebtDebt

Total capital = $12 billion

Debt : Total Capital Ratio = 22%

Total CapitalTotal Capital

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Bringing it all together: WACC

Cost of Equity of 10.5%

Total Capital ratio equal to 78% Equity / 22% Debt

After Tax Cost of Debt of 3.1%

8.8%=10.5% 3.1% + 22% *78% *

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Quick Quiz: What if…..

WACC goes:

Interest Rates go up

Total Debt Goes up

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Quick Quiz: What if…..

WACC goes:

Interest Rates go up Up

Total Debt Goes up Down

How do various firms evaluate Projects,

Or

“What are various opening moves used by the Grand Masters?”

1. Sicilian Defense

2. Caro-Kann Defense

3. Italian Game

4. Ruy Lopez

5. Queen’s Gambit

6. Co-Lo Gambit

7. Indian Defense

8. English Opening

Chess Openings

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What Firms actually used as primary decision rule

MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse Est. % Firms using Est. % Firms using as primary ruleas primary rule

Net Present Value

$

The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows)

Values greater than $0 indicate the amount of value added to the company.

20%

Internal Rate of Return

%The relative return a project generates over time compared to its cost

Should be equal to or greater than hurdles to ensure adequate returns

50%

Payback

Period (using discounted cash flows)

Years

The amount of time it takes for a project to pay for itself given the cost of financing.

Should be less than or equal to hurdles to ensure timely returns

20%

Clorox uses some common approaches to

evaluate individual value enhancing opportunities

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How does Clorox evaluate opportunities?

MetricMetric MeasureMeasure Practical DefinitionPractical Definition UseUse

Net Present Value $

The value of future cash inflows and outflows in today’s dollars (ie. Discounted Cash Flows)

Values greater than $0 indicate the amount of value added to the company.


%The relative return a project generates over time compared to its cost

Should be equal to or greater than hurdles to ensure adequate returns

Payback Period (using discounted cash flows)

YearsThe amount of time it takes for a project to pay for itself given the cost of financing.

Should be less than or equal to hurdles to ensure timely returns

Clorox uses some common approaches to

evaluate individual value enhancing opportunities

Payback Period

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What is the payback period?

Payback period is the number of years required to recover a project’s cost.

It is also the answer to how long does it take to get the business’ money back?


Cash Flows -3,000 -11,100 3,000 3,700 5,400 5,700 4,900 5,000

(Multiplied by)

Discount factor (10%)

1 .91 .83 .75 .68 .62 .56 .51

(Equals)


-3,000 -10,091 2,479 2,780 3,688 3,539 2,766 2,566

Cumulative Cash Flows (NPV)

-3,000 -13,091 -10,612 -7,832 -4,132 -604 2,162 4,728

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Internal Rate of Return (IRR) is the discount rate at which NPV is

$0.

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Recap

Project evaluation is done to help ensure that investors’ goals are being considered in go / no-go decisions

NPV (DCF), IRR, and Payback period are measures used by Clorox to estimate a project’s ability to add value

Only incremental cash flows are considered in the analysis

WACC is used as the discount rate to calculate the present value

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Fundamentals – Decision Rules Revisited

General Clorox Decision Rules

NPVNPV – If NPV is negative, reject the project; otherwise, further consideration is required.

IRRIRR – If IRR is less than the cost of capital, reject the project; otherwise, further consideration is required.

PaybackPayback – Generally, the shorter the payback period the less risky the project.

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The cash flow analysis should be from 3 to 10 years depending on the project gear:

Rapid Response: 3 year

Core Growth: 5 year

Game Changer: 10 year

Perpetuity Cash Flow/NPV:

Primarily calculated for Acquisitions where value is realized over a longer period of time

Not recommended for new products since sustainability of product is hard to predict past 10 years

Clorox Guidelines

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Case Study Results Comparison

ResultResult Decision Decision RuleRule

RecommendatiRecommendationon

Net Present Value $4,728 >$0

Internal Rate of Return 26% >10%

Payback Period 6 years <4 years

Shortcomings

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Shortcomings / Watchouts“Discounted Cash Flow models are powerful,

but they do have shortcomings. DCF is a mechanical valuation tool, which makes it subject to the axiom “garbage in, garbage out”. Small changes in inputs can result in large change in the value.”

- Wikipedia 8/31/2011

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Shortcomings / Watchouts“Real Estate: straight line assumptions about

income increasing over ten years are generally based upon historic increases in market rent but never factors in the cyclical nature of many real estate markets. Most loans are made during boom real estate markets and these markets usually lasts less than ten years.”

- Wikipedia 8/31/2011

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DCF: Level 3Monte Carlo simulators

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Net Present Value: in reality, is a range of outcomes….

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Furthermore, the range of NPV’s associated with different projects is different depending on factors such as whether it’s a new category or an existing category….

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Tips

Retrospective analysis: Retrospective analysis: looks at the financial impacts after the project has been implemented

• It can be used to confirm benefits realization

• To identify opportunities to improve estimates for future analyses

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Tips Vision

Simplified / StandardizedComplex Project

Project Criteria:

Select Customization

Rapid Response

Core Growth

Game Changer+

Model Type:HVR-simplified model Monte Carlo

Questions ????

Thank You

Appendix

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Appendix - Comparison of Internal & External WACC Estimates

MorganStanley

Historical FY04 Current Jan 03 Apr-04 Apr-05 Jan-04 Apr-05 Apr-05 Apr-05Risk Free Rate (1) 6.0% 6.0% 5.5% 4.9% 5.3% 4.7% 4.1% 4.5% 4.3% 4.5%

Clorox Beta (2) 0.95 0.75 0.75 0.69 0.75 0.75 0.72 0.62 0.64 0.9

Market Premium 5.0% 6.5% 6.5% 6.5% 6.5% 6.5% 6.0% 6.0% 4.0% 4.5%

Cost of Equity 10.8% 10.9% 10.4% 9.4% 10.2% 9.6% 8.4% 8.2% 6.9% 8.5%

After Tax Cost of Debt 4.0% 2.1% 2.8% 3.0% 3.1% 3.1% 3.0% 3.3% 3.4% 2.9%

Debt/ Total Capital 10% 10% 25% 11% 10% 21% 10% 21% 20% 21%

Cost of Capital 10.1% 10.0% 8.5% 8.7% 9.4% 8.2% 7.9% 7.2% 6.2% 7.3%

Notes:

(1) Clorox & Citigroup use forecasted 30 year treasuries while the other bamks use current 10 year treasuries

(2) JP Morgan uses a judgement beta of 0.9. JP Morgan also calculated WACC using a market derived capital pricing model (MCPM) to calculate cost of equity. Using this methodology, JP Morgan calculated WACC to be 7.3-7.9%

JP MorganClorox Citigroup Goldman

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Appendix - WACC Estimates Summary

5.5% 6.5% 7.5% 5.5% 6.5% 7.5%

Risk Free Rate = 4.5%

Beta = 0.65 8.1% 8.7% 9.4% 7.0% 7.5% 8.0% Beta = 0.75 8.6% 9.4% 10.1% 7.4% 8.0% 8.6% Beta = 0.85 9.2% 10.0% 10.9% 7.8% 8.5% 9.2%


Beta = 0.65 9.1% 9.7% 10.4% 7.8% 8.3% 8.8% Beta = 0.75 9.6% 10.4% 11.1% 8.2% 8.8% 9.4% Beta = 0.85 10.2% 11.0% 11.9% 8.6% 9.3% 9.9%


Beta = 0.65 10.1% 10.7% 11.4% 8.5% 9.0% 9.5% Beta = 0.75 10.6% 11.4% 12.1% 9.0% 9.5% 10.1% Beta = 0.85 11.2% 12.0% 12.9% 9.4% 10.1% 10.7%

Equity Market Risk Premium Equity Market Risk Premium

Cost of Equity WACC

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Appendix – Continuous Compounding

Continuous Compounding Factor: A method of discounting which recognizes ongoing

cash flows as they occur not at the end of the period

Discount Rate = .09 = 1.044

ln (1 + Disc Rate) ln(1+.09)

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Perpetuity Cash Flow/NPV

Primarily calculated for Acquisitions where value is realized over a longer period of time

Not recommended for new products since sustainability of product is hard to predict past 10 years

Calculation: PV of Perpetuity = CFn+1 /(WACC-g); where G is the constant growth rate

Useful when valuing equity, where CFn+1 is replaced with Dividends estimate for next year

Appendix – Perpetuity

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Quick Question: Budget Constraints

Project Project Net Net FlowsFlows

Year 0Year 0 Year 1Year 1 Year 2Year 2 Year 3Year 3 Year 4Year 4 Year 5Year 5 TotalTotal

New packaging in US

-30 -20 80 -40 -30 100 60

Product expansion in Asia

-125 25 35 50 55 60 100

Outsourcing production

-500 -250 150 150 150 150 150

Acquisition in Latin America

-250 -50 50 100 125 125 100

How would a manager provide a recommendation if there were only enough budget to fund two of the four projects below?

DCF Theory Training Chess

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