Lecture One
Overview of Valuation
Professor Paul Howe
Lecture Outline
• Introduction to Valuation
• Major Investment Decisions
– Project Valuation
– Enterprise (Business) Valuation
• Dealing with Complexity
– Investment Evaluation Process
• Case Study: CP3 Pharmaceuticals
Laboratories Inc. and Facebook
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Example of valuation in the real
world: Starbucks (SBUX)
2006 SBUX acquisition of Seattle’s Best Coffee
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Major Investment Decisions
We will discuss how firms evaluate investments and grow and expand through:
• Project valuation: firms acquire productive
capacity by assembling necessary assets.
• Enterprise valuation: acquisitions of entire
businesses - acquiring the productive
assets of an existing firm
– Common valuation tools and underlying
principles can be used for both types of
analysis.
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Project & Enterprise Valuation
We will discuss how firms evaluate investments and grow and expand through:
– Project Valuation – Enterprise Valuation
• Rio Tinto joint venture • Kraft Foods Inc. acquisition
agreement with CODELCO of Cadbury plc
for copper exploration in
Chile • Walt Disney Co’s
• Microsoft and HP 3-year acquisitions of Marvel and
$250 million investment into Pixar
cloud computing
• Coca-Cola Co. and PepsiCo’s
• Coca-Cola’s bottling and respective deals to acquire
distribution joint-ventures in bottler operations
China
• As of July 2010, Google has
• Fashion retailer Zara’s
(parent company Inditex) acquired 76 companies
77 market entries across including Doubleclick and
the world including the most YouTube
recent into India.
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Valuation: Tool for Value Creation
• The objective of a firm is to create wealth by
initiating and managing investments that
generate future cash flows that are worth more
than the amount invested.
– Management’s goal is to avoid decision errors based on
flawed or incomplete analysis
– Valuation provides tools for the evaluation of new
investment opportunities
• From capital budgeting to mergers & acquisitions, valuation
is more than discounting cash flows
• Effective valuation analysis involves a disciplined 3-phase
investment evaluation process
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Investments that Create Value
• Invest $100 million today in a project that generates a
stream of cash flows valued at $150 million.
• Investment generates an incremental $50 million in wealth
for its shareholders.
• The project has a net present value (NPV) of $50 million.1
1
You will recall that NPV is equal to the difference between the value of expected future cash flows derived from an investment
and the cost of making the investment.
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Investments that Destroy Value
• DaimlerChrysler formed by the $36 billion acquisition of
Chrysler by Germany's Daimler-Benz in 1998
– Net cash outflows, restructuring payments, Chrysler “bleeding
cash and unlikely to become profitable under the best-case
scenario until 2009”
• 2007 Cerberus Capital Management acquisition of 80% of
Chrysler for $7.4 billion
– According to one analyst, "Daimler is basically paying Cerberus
to get rid of it.“
– More trouble in July 2007 with the debt capital market crunch
• Trouble in syndication - J.P. Morgan Chase, Bear Stearns and
Morgan Stanley asked Cerberus and DaimlerChrysler AG, to pay
higher interest rates and change the convents.
Source: Cerberus 'rescues' Daimler” www.thedeal.com May-15-2007 and “Debt world trauma: Tricky talks” Jul-30-2007; by Lisa
Gewirtz-Ward
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Investments that Destroy Value
• Over half of all large investment projects
fail to achieve their hoped-for results.1
• Potential causes:
– Managers “go with their gut”
– Investments in risky projects
– Uncertain future events
– Incomplete information
1
Nadim F. Matta and Ronald N. Ashkenas, 2003, Why good projects fail anyway, Harvard Business Review (September), 109–114.
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Project Valuation – Stages of Investment
• The Caspian Sea oil
field development
project illustrates
the complexities of
investment
decisions and the
stages of
investment.
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Project Valuation – Issues to Consider
• In any situation in which a company must value a major new
investment, five key issues arise:
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Enterprise Valuation
• Acquisitions involve similar issues, i.e Cisco’s acquisition of Linksys.
– Review the example provided in the Lecture on Cisco/Linksys (pages 8-9).
• Practice Assignment: Research a recent acquisition and consider the
framework of issues identified in the earlier examples.
– Issue 1: Does the “story” make sense?
– Issue 2: What are the sources of risk and can they be managed?
– Issue 3: How can the investment be financed?
– Issue 4: What is the short-term effect of the investment’s acceptance on the firm’s
reported earnings?
– Issue 5: Dies the investment have inherent flexibilities that allow the firm to
modify it in response to changing circumstances?
• Recent suggested acquisitions for consideration:
– Oracle’s acquisition of Sun Microsystems ($7.4 Billion)
– Disney’s acquisition of Marvel ($4 Billion)
– Pfizer’s acquisition of Wyeth ($68 Billion)
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Dealing with Complexity – Process &
Discipline
The three-phase investment evaluation process:
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CP3 Pharmaceuticals Laboratories
• Investing in a New Materials-Handling System
– Figure 1-5 in the text is an abbreviated version of a
firm’s typical investment evaluation report. The report
provides a thorough analysis of the project. It begins
with a list of the various reasons why the group believes
the project is likely to be successful. It includes:
• Summary measures of project value: NPV, IRR, Payback
• Cost and cash flow projections as support to the summary
analysis
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CP3 Executive Summary
• CP3 Austin, TX plant is requesting $547,000 to
purchase and install a new scrap materials-
handling system for its medical-packaging
operations to:
– Reduce waste in the firm’s packaging operations,
$300,000 savings per year
– Reduce head count from the test area, $35,000 savings
per year
– Recycle plastic materials that historically were part of
waste, $8,800 savings per year.
– Earn a 20% rate of return on invested capital.
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CP3 Proposal, Justification, Risks &
Timeline
• Proposal: CP3’s medical-packaging unit expected
production: 400 million vials of over-the-counter drugs this
year.
• Justification: Packaging of these vials will generate 1.5
million pounds of scrap plastics; 1/3 recycled, remainder
becomes scrap.
– Existing system: disposal cost for 1 million pounds of scrap
plastic: $8,800 per year
– New system: ground-up scrap can be sold for $300,000 per
year while eliminating the scrap disposal cost of $8,800 per
year.
• Risks: stoppages
• Timeline: 3 months to get the new system up and running.
– Installation must coincide with existing production shifts
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CP3 Financial Analysis
• These estimates span a period of 5 years ending in 2010.1
(Detailed estimates are found in Problem 2-6 at the end of Lecture 2.
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Summing Up
• Process can be:
– Very costly and time-consuming
– Subject to biased estimates of project value
such as conflicts of interest and incentive
problems
– Affected by problems arising out of differences
in the information available to project
champions and the internal review or control
group (the strategic planning committee)
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Looking Forward
• Finance academics sometimes strip away
complexities to focus on what determines
value; sometimes creating a disconnect
between what should be done in theory
and what is done in practice.
• Our study of valuation integrates the
analysis of individual projects and entire
enterprises along two dimensions. Both
build upon the same theoretical base.
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Looking Forward
• Topic Outline – Structure of Text
– Lectures 2-3: valuation for project valuation
– Lectures 4-5: cost of capital
– Lectures 6-7: review and analysis of essential
accounting issues and financial statement
analysis
– Lectures 8-10: valuation of the business
enterprise
– Lectures 11-13: investment valuation of
derivative securities (options)
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Summary
• Valuation is more than about discounting cash flows
and determining NPV. Evaluating investments and
acquisitions has come along way.
• Firms must consider:
– Cash flow estimation
– Risk assessment
– Financing opportunities
– The effects on earnings
– Staged investments
– “Follow-on” investments
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