Objectives:

To review analytical techniques used to justify expansion decisions To compare and contrast the NPV and APV methods of analysis Nature of expansion decisions Expansion cash flows Valuation alternatives: NPV; APV Derivation of NPV model Derivation of APV model Capital structure issues

Topics:

Initial Capital investment

Additional Capital investment

For replacement and expansion

- $ FCF

FCFs are a function of value chain and industry economics

Expansion FCFs are incremental to the base case and are attributable to the project.

Because they include incremental revenues the full NPV equation is used to accept (accept if NPV>0)

If we are using the EBIT formulation for estimating FCF we have:

FCF= (EBIT)(1-T) + T(CCA) + NWC + Capex

The cash flow elements to be estimated are:

• net operating cash flows after tax (a.k.a. NOPAT, net operating profit after tax)(EBIT)(1-T) • the tax shield on Capital Cost TCCA • Incremental net working capital requirements NWC • incremental long-term assets Capex. At the end of the study period we also have estimates of cash inflow from sale of residual assets (RV), or the present value of FCFs which extend beyond the study period called continuing value (CV)

RSM 2301 Financial Management - Fall 2011

© Asher Drory All rights reserved

9- 3

Valuation Alternatives: NPV vs. APV Models

Net Present Value (NPV)

NPV

Expansion Decisions 9- 4

t t 0

FCFt (1 k )t

Where: k = WACC keu is unlevered equity return (i.e., the equity return of an equivalent unlevered firm) T is the corporate cash marginal tax rate Vd is the value of debt Note: NPV ≡ APV by definition

Adjusted Present Value (APV)

APV

t

FCFt TVd (1 keu )t t 0

The static NPV model discounts FCF by WACC

• The analyst...