Page 214 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 13: Integration of Working Capital and Capital Investment Process

seeks to maximize the value of the firm by investing in projects which yield a positive net Notes
present value when valued using an appropriate discount rate. These projects must also be
financed appropriately. If no such opportunities exist, maximizing shareholder value dictates
that management return excess cash to shareholders. Capital investment decisions thus comprise:
1. An investment decision,

2. A financing decision, and
3. A dividend decision.

13.1.1 Investment Decision

Management must allocate limited resources between competing opportunities (“projects”) in
a process known as capital budgeting. Making this capital allocation decision requires estimating
the value of each opportunity or project: A function of the size, timing and predictability of
future cash flows.
Project Valuation

In general, each project’s value is estimated using a Discounted Cash Flow (DCF) valuation, and
the opportunity with the highest value, as measured by the resultant Net Present Value (NPV)
is selected. This requires estimating the size and timing of all of the incremental cash flows
resulting from the project. These future cash flows are then discounted to determine their present
value. These present values are then summed, and this sum net of the initial investment outlay
is the NPV.

Did u know? What does Discounted Cash Flow - DCF Mean?
A valuation method used to estimate the attractiveness of an investment opportunity.
Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts
them (most often using the weighted average cost of capital) to arrive at a present value,
which is used to evaluate the potential for investment. If the value arrived at through DCF
analysis is higher than the current cost of the investment, the opportunity may be a good
one.
Calculated as:

CF CF CF
DCF = 1 + 2 + ...+ n n
1 ( + r) 1 1 ( + r) 2 1 ( + r)
CF = Cash Flow

r = discount rate (WACC)
The NPV is greatly affected by the discount rate. Thus identifying the proper discount rate – the
project “hurdle rate” – is critical to making the right decision. The hurdle rate is the minimum
acceptable return on an investment – i.e. the project appropriate discount rate. The hurdle rate
should reflect the riskiness of the investment, typically measured by volatility of cash flows,
and must take into account the financing mix. Managers use models such as the Capital Asset
Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT) to estimate a discount rate
appropriate for a particular project, and use the Weighted Average Cost of Capital (WACC) to
reflect the financing mix selected.

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