1. Finance Lecture:
Project Valuation
Brad Simon

2. Lecture Overview
 Orientation
 What projects do we invest in?
 Estimating a Cost of Capital
 Hurdle Rate
 Weighted Average Cost of Capital
 Estimating Incremental Free Cash flows
 Time-weighted tools
 NPV
 IRR
 Others
 Summary
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3. Where we are in the course
 The first two modules focused on the building
blocks of finance which are common
throughout the field.
 Time Value of Money
 Bonds and Stocks
 Risk and Return (e.g. CAPM)
 Starting this week and for the remainder of the
course we will focus more on issues at the
firm-level.
 This week focuses on how managers select
the projects a firm should undertake.
 This is known as “Project Valuation” or
3 “Capital Budgeting.”

4. What Projects Do We Invest In?
 A firm can be thought of as a collection of
projects.
 We saw earlier in the course that the primary goal
of the firm is to maximize shareholder value.
 Selecting the right projects is the key to
maximizing shareholder value.
 Because of this managers need financial tools to
help them evaluate among prospective projects.
 We call this process, “Capital Budgeting,” as it
involves the long-term allocation of a firm’s capital
resources.
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5. What Projects Do We Invest In?
 In order to decide what to invest in we need three
things:
 A return threshold or hurdle rate
 The expected incremental cash flows related to the
project
 An analysis to stitch the above two items together
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6. Return Threshold (Hurdle Rate)
 We have discussed previously the costs of debt
and equity.
 Cost of debt:
 Interest rates,
 Yield to Maturity
 Yield to Call
 Cost of equity:
 The required return that equity holders need to be fairly
compensated
 This was estimated with the “CAPM”
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7. Return Threshold (Hurdle Rate)
 Moreover, we know that firms raise their capital
through some combination of these instruments.
(The details of how they choose such a
combination will be discussed in subsequent
modules.)
 A firm that employs Debt (D) and Equity (E), at
rates of rd and re, respectively, should be
investing in things that (at least) covers these
capital costs.
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8. Weighted Average Cost of Capital
(WACC)
 We can calculate a blended cost that weighs the
required returns of each source of capital by their
weights.
 We call this the Weighted Average Cost of Capital
(WACC)
 WACC = rd x Percentage of Debt + re x Percentage
of Equity
 This is often simply written as: rd x D + re x E
 Note, the cost of debt (rd) should be the after-tax cost of
debt, because interest on debt payments are deductable
from a firm’s net income.
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9. Weighted Average Cost of Capital
(WACC)
 Example of the WACC
 A company has debt of $200 million and equity of
$300 million. The after-tax cost of debt is 6% and
the cost of equity is 14%.
 %Debt = $200 million / ($200 million + $300 million) = 40%
 %Equity = 1 - %Debt = 60%
 WACC = rd x D + re x E
= 6% x 40% + 14% x 60%
= 2.4% + 8.4%
= 10.8%
 This means the company must invest in projects
that earn at least 10.8% annually, otherwise it is
9 destroying value.

10. Cash Flows
 The next item we need is an estimate of how
much cash our new project is expected to provide
over its life-time.
 The most common way to create an estimate of
the cash flow (the cash that will flow-in from our
project) is to create pro forma financial
statements (income statement, balance
sheet, etc.) based on what we think is going to
happen over the life of the project.
 Once created, we can manipulate the financial
statements to determine the cash that comes in
or goes out in a given period.
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11. Free Cash Flows
 The cash we are interested in estimating is the
cash that will be available to be used to pay our
financing (the debt and equity)
 This is termed the Free Cash Flow (FCF)
because we are free to use it to pay for the
financing of the project.
 FCF = Operating Cash Flow – Investment in
Operating Capital
 = (EBIT – Taxes + Depreciation) – (Investment in
Fixed Assets + Investment in Working Capital)
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12. Incremental Cash Flows
 Note, we are only interested in cash that relates
specifically to undertaking this new venture
(called the incremental cash flow).
 For example, if we have already invested in R&D for
the project we would not include that amount in our
analysis because it has no bearing on our decision
to move forward with the project – the money has
already been spent (it’s a “sunk” cost).
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13. Putting these items together
 Once we know:
 Our cost of capital (as represented by the WACC)
 Our estimate of the free cash flows related to the
project
 We can then use these in one of many
techniques to make an informed capital budgeting
decision.
 The most common such techniques are the Net
Present Value (NPV) and the Internal Rate of
Return (IRR).
 Fortunately, both of these relate directly to our
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Time-Value-of-Money calculations we worked with
earlier in the course.

14. Net Present Value
 Let’s say we have the following free cash flow
projection for a project:
 Year 0: -$100,000
 Year 1: $20,000
 Year 2: $25,000
 Year 3: $50,000
 Year 4: $75,000
 Additionally, let’s say the WACC for the company
is 9.0%.
 We can use the TVM analysis to calculate the
Present Value of each period and then add them
up to get a Net Present Value estimate.
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15. Net Present Value
Year Cash Flow PVIF PV
0 $ (100,000) $ (100,000)  Based on this
1 $ 20,000 0.917 $ 18,349 analysis the project
2 $ 25,000 0.842 $ 21,042
should generate
3 $ 50,000 0.772 $ 38,609
4 $ 75,000 0.708 $ 53,132
$31,132 of economic
NPV $ 31,132 value in present
value terms.
WACC 9.00%
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16. Net Present Value
 Positive NPV projects (i.e. where the value is greater than
zero) create economic value because they pay for their
capital costs.
 Negative NPV projects destroy value because capital
costs are not adequately covered.
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17. Internal Rate of Return
 While the NPV has an output in dollar terms
sometimes it is useful to have a rate (percentage)
output from our capital budgeting tool.
 The IRR analysis is most common for this.
 The IRR is defined to be the discount rate which
produces an NPV of 0.
 The next slide shows this for our prior example.
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18. Internal Rate of Return
Year Cash Flow PVIF PV  In this case the IRR is
0 $(100,000) $ (100,000) 19.63%.
1 $ 20,000 0.836 $ 16,718  We can then compare
2 $ 25,000 0.699 $ 17,467 the IRR to the required
3 $ 50,000 0.584 $ 29,201
hurdle rate (the
4 $ 75,000 0.488 $ 36,613
NPV $ -
WACC).
 When the IRR > WACC
IRR 19.63% the project is creating
value.
 When the IRR < WACC
the project is destroying
value.
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19. Other Capital Budgeting Tools
 While the NPV and IRR are the most important and
commonly used capital budgeting tools, they are not the
only ones.
 Other common tools include:
 Payback Period
 Discounted Payback Period
 Modified IRR
 Profitability Index
 Most frequently, financial analysts will use several of
these tools to make an informed view on how to
proceed with a project.
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20. Summary
 This lecture more formally began our exploration
into “Corporate Financial Management”
 The first step is to determine what projects a firm
should choose to undertake.
 Deciding what to invest in (capital budgeting)
involves:
 Calculating the company’s WACC or relevant cost
of capital.
 Estimating the incremental Free Cash Flows from
the project.
 Using our capital budgeting tools to analytically
determine value creation or value destruction:
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 NPV, IRR and other tools