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Capital Budgeting and Stock Valuation Assignment
Word count: 2545
Business are faced with capital budgeting decisions daily. Many of these decisions will either enhance or detract from the competitive position of the firm. Firms must often decide between many mutually exclusive projects as capital is limited. Due to the limitation of capital, businesses engaged in the capital budgeting process to ensure that only the highest NPV projects are selected. Not only does the capital budget process allows companies to ensure they create value for shareholders, it also limits the downside of having a project significantly harm the company (Allen, 1960). This is critical in capital intensive industries such as airlines or railroads. Here capital budgeting is critical as they must invest large sums of money but are not assured of commensurate returns. By being conservative in their capital budgeting process, these capital-intensive firms can be adequately compensated for the risks that they take in the market. For example, railroads must decide if they would like to invest to expand theyre into markets. In order to arrive at an adequate decision, the finance team must determine the amount of profit this new market will generate relative to the cost of entering the market. They must also take into maintenance capex and its implications on future profitability. The same concepts apply to airlines as well. The current pandemic is shedding light on an unforeseen black swan event can have grave consequences for firms that may not have used the capital budgeting process conservatively. Particularly, with the airlines, purchases of aircraft cannot be undone once delivered to the company. As we are currently realizing, there is a large oversupply of seat capacity in the industry due to low demand. This is ultimately putting pricing pressure on the industry with extensive cost cuts, furloughs, layoffs and reduced airfares throughout. Capital Budgeting is simply the ability to profitable and rationally allocate capital. Here, an outlay of capital is justified only when the NPV is positive (Anderson, 1963). A negative NPV project indicates a destruction in value and should therefore not be undertaken. The IRR is the internal rate of return that creates an NPV of 0. The payback period indicates the amount of time needed to recover the initial cost of the investment. It is calculated as the cost of the investment divided by the annual cash flows. The profitability index rule is a decision-making exercise that helps evaluate whether to proceed with a project. The index itself is a calculation of the potential profit of the proposed project (Bouwman,1987). The rule is that a profitability index or ratio greater than 1 indicates that the project should proceed. A profitability index or ratio below 1 indicates that the project should be abandoned. NPV is superior return metric because it can be used when cashflows are uneven. It can also be used when determining mutually exclusive projects. As the discount rate increases, the NPV declines. Higher discount rates, as it relates to the sensitivity analysis increase the hurdle rate in which the project must clear in order to justify investment (Ahadiat,1990).
Table 1: NPV Calculation
Table 2: Sensitivity Analysis
Table 3: Relative Valuation (Source: Morningstar.com)
Facebook
Amazon
Apple
Netflix
Google
Average
Valuation
Price to Book
6.70
18.98
31.06
20.66
5.63
16.61
Price to Sales
10.11
4.57
7.62
9.19
7.12
7.72
Price...
Although each have very different and distinct business models, each of FAANG stocks are characterized as
technology. Due to this they have very similar characteristics...
…to Sales, the highest Price to Cash Flow, and the second higher Price to Earning. Essentially, the numerator of the ratio is too high, and
investors are assuming higher growth rates to justify the higher ratios. For the reasons mentioned above, there is serious concern as to companies ability to generate and maintain these higher growth rates in the future. If these dont materialize investor expectations must therefore decline and so too will the price (Pressman,1998).
Recommendations
In summary, I recommend that the firm maintain and even distribution of each of the FAANG stocks and sell Netflix. I believe the low interest rate environment, coupled with strong fundamentals, and market lending positions make the remaining 4 stocks viable investments in the portfolio. As it relates to Netflix, if the decision maker does not elect to sell the stock, I would recommend purchasing put options on the stock as a form of < style ='color:#000;text-decoration: underline!important;' id='custom' target='_blank' href='https://www.paperdue.com/topic/insurance-essays'>insurance if the stock declines.
References
1. Ahadiat, N. and R. I. Brueggemann. 1990. Evaluating an investment proposal.Journal of Accounting Education8(2): 299-310.
2. Allen, C. B. 1961. Evaluation of capital projects - An application of the investor's method.N.A.A. Bulletin(January): 45-54. (The cash rate of return or investor's method of calculating the return on investment).
3. Anderson, C. M. 1963. Motivation - The essential in budgeting.N.A.A. Bulletin(June): 46.
4. Bouwman, M. J., P. A. Frishoff and P. Frishoff. 1987. How do financial analysts make decisions? A process model of the investment screening decision.Accounting, Organizations and Society12(1): 1-29
5. Pressman, Steven. On Financial Frauds and Their Causes: Investor Overconfidence. American Journal of Economics and Sociology 57, no. 4 (October 1998): 40521. Available by subscription: http://www.jstor.org/stable/3487115 (accessed November 15, 2020)
6. Reinicke, C 2020, 'Nearly every FAANG stock hits a record high as the rally in mega-cap tech continues', Business Insider Australia, viewed 13 September 2020,https://www.businessinsider.com.au/facebook-apple-amazon-netflix-faang-stock-prices-record-high-rally-2020-7?r=US&IR=T.
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