methods of calculating selling price.

MBA619- NPV Analysis LECTURE

When making new a project investment decision, companies will usually perform a Net Present Value (NPV) analysis to assess whether or not to go forward with the project. NPV analysis was covered in your prerequisite courses. You may want to review your notes from previous classes, as an NPV analysis is a core component of your course project.

The simplest way to calculate a project NPV is with Excel. You begin by laying out all of your assumptions and resulting cash flows over the project life and use the NPV command to calculate the present value (Refer to the example file of an NPV Analysis in Excel in the Course Materials Folder).

Note: Your assumptions table is the core component of you analysis and all of your spreadsheet underlying equations must be based on your assumptions values. It represents an important value-added effort on your part in any analysis because your fellow managers will be able to follow exactly how, and on what basis you arrived at your conclusive figures. Further, your fellow managers will be able to conduct “what-if” analysis with your spreadsheet by simply changing assumption values.

review of NPV analysis

In an NPV analysis, the value of a project is expressed as the value today called Present Value (PV), of all future discounted free cash flows generated by the project operations over a specified period, (usually 5 to 10 years).

The free cash flows are discounted at the Weighted Average Cost of Capital (WACC) for the firm. When we subtract the initial cost of the project from the period total free cash flow, and factor in the WACC, we have its NPV. If the NPV is greater than zero, the project is considered a “go”; that is assuming the firm has considered all other risks and developed a mitigation strategy that senior management is comfortable with for those risks.

There are many approaches to NPV analysis, and it is not an exact science. There are often knows and unknowns that must be estimated. Some of these are the complete project startup costs, estimated product demand, product pricing and input costs, and external risks.

This analysis can be complex for a domestic project – forecasting cash flows and risk requires a great deal of skill and information. The complexity is compounded when we perform an NPV analysis on a project direct foreign investment (DFI). Not only are we trying to forecast cash flows in a foreign country, but we also have to deal with currency exchange rate risk. A small change in exchange rates can kill the project.

PV = future free cash flow discounted to today’s dollars at the firm’s WACC.

PV = (cash flow year 1)/(1+r) + (cash flow year 2)/(1+r)^2 + …

Where r = discount rate/WACC

You must do your “homework” to arrive at the best forecast for:

  1. Future Free Cash Flows

  2. Project Beta based on the risk of the business relative to market risk and interest rates

  3. Discount Rate/WACC

The projected free cash flow for a domestic project is based on sales, price, and product costs, all calculated in U.S. Dollars (USD). When you are forecasting free cash flow for a foreign investment project, and your firm reports its financials in the U.S., then you must convert the foreign currency NPV to USD.

Also covered in your prerequisite courses was calculation of the discount rate/WACC, which is a measure of how much return your firm demands from the project and is a function of how risky it is. Foreign projects are often riskier than domestic projects due to external economic factors, and will therefore have a higher discount rate.

New project beta:

New project beta = equity beta of the firm = βe.

· Benchmark – betas typically use the S&P500 market rate of return as a benchmark. The market itself has an underlying beta of 1.0. Individual firm/stock betas indicate how much they deviate from the market. A stock that swings more than the market has a beta value above 1.0. If a stock moves less than the market, the stock’s beta is less than 1.0. Therefore, a stock that exceeds the market by 20% follows the market in an overall decline or growth by a factor of 1.2, which means when the market declines/advances 3%, a stock with a beta of 1.2 will declines/advance 3*1.2/3.6%.

· Beta is a volatility/risk metric. In the same way a stock’s beta shows its relation to market shifts, it also is used as an indicator for required/expected returns on investment (ROI), and WACC/Discount Rate calculation for a firm’s new projects.

WACC/Discount Rate calculation:

The expected return on equity is a firm’s cost of equity, or in the case of a “new project”, the new project WACC rate.

· WACC can be calculated using the Capital Asset Pricing Model (CAPM), where the expected return on equity/WACC is a function of a firm’s equity beta (βe/ “new project beta”).

· CAPM model: Ke = Rf + ((βe)*(Rm – Rf))

· r or Ke = firm’s cost of equity/the expected return/WACC/discount rate

· Rf = risk free rate of return (e.g. U.S. Treasury Bonds RR)

· Rm = return on the market portfolio/S&P500 RR or market rate of return

· βe = firm’s equity beta/new project beta, or risk of this project/company relative to a market such as the S&P500

Calculating Selling Price

There are several methods of calculating selling price. Two common methods are “Markup on Cost” and “Markup on Selling Price”.

Markup on Cost:

The Markup on Cost approach is meant for a scenario where products are manufactured and sold in the same country. Markup on cost can be calculated by adding a pre-set (often industry standard) profit margin, or percentage to the cost of the merchandise, or by using a multiplier factor.

Arriving at a company specific profit margin is often accomplished by calculating the Contribution Margin (CM), which was covered in your prerequisite accounting course. Here is a review of the CM method (Refer to the example NPV Analysis Excel file in the Course Materials Folder).

CM=Unit Sell Price-Unit Total Variable Cost (TVC)

Year-1 Ratio

Unit sell 3.60 100.00%

Unit TVC 2.00 55.56%

Unit CM 1.60 44.44%

This establishes the CM ratio that we want to achieve year-over-year of 44.44%. Now to factor this CM rate into our forecasted selling price, we also calculate the CM to TVC ratio, which becomes our “cost markup” factor, in this case 80%.

Unit CM:TVC ratio = 1.60/2.00 = .8 or 80.00%

Thus, our forecasted selling price for years 2 – 10 will be calculated as a multiple of TCV. Of course, we will need to adjust TVC for the forecasted inflation rate beforehand. Therefore, the TVC adjusted for inflation rate is then used as follows to arrive at out markup factor.

We apply the CM:TVC ratio by multiplying TVC by 1+80%, or 1.8. Unit Sell Price = TVC1.8 = 2.001.8 = 3.60 verifies the validity of our CM:TVC ratio approach. Now we can use the CM equation above to include a row in our spreadsheet analysis that confirms our marked up selling price is achieving a 44.44% contribution/profit margin.

Markup on Selling Price:

Markup on Selling Price is used in the case of producing a product in country A, and selling it into country B; we must deal with the added complexity of adjusting our selling price for country B inflation as well. In this scenario, we would use a method in which the selling price is marked up by the inflation rate of country B; a multiplying factor arrived at by 1+% Inflation.