NPV calculation - why have you divided 2.5bn FCF by 10%? I understand this is TV calc. but why 10%?

Cutting Carbs - Divestiture in the Electrical Power Market
New answer on Mar 08, 2021
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Anonymous A asked on Mar 04, 2021

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Ian
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replied on Mar 04, 2021
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Hi there,

Absolutely fair question!

For this case (and most cases where you have to value future cash flows/costs), you need to use NPV. When using NPV, we must pick a discount rate.

The "case standard" for discount rate is 10% (this is just the default and what you should "propose"). This will be what we divide by unless the interviewer indicates otherwise.

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Clara
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replied on Mar 06, 2021
McKinsey | Awarded professor at Master in Management @ IE | MBA at MIT |+180 students coached | Integrated FIT Guide aut

Hello!

This is precisely the way we calculate NPV.

Conceptually, we are "bringing" the money from the future to the present, and we do so with an agreed disccount rate.

That is precisely the 10% :) That is somehting that they need to tell you.

Hope it helps!

Cheers,

Clara

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Anonymous B updated the answer on Mar 05, 2021

This case looks dodgy to me and it seems it misunderstands what Free Cash Flow Means. It assumes that the free cash flow generated by selling the coal plant is equal to the NPV of the operating costs. This is of course Malarkey.

The Free Cash Flow is the profit after tax, investments, etc. Selling the busines will LOWER the Free Cash Flow, not INCREASE it.The case states that the business has a 10-15% profit margin, so this should be the provit margin.

The true formula for the NPV should be

NPV = Deal value - divestment costs - (Revenue - operating costs)/10%, assuming a 10% discount rate and ignoring things like interest, tax, depreciation, etc.

Or phrased differently: Deal value and FCF should be opposite effects, not cumulative. Only if the offer you're getting is higher than the loss in FCF, you will have a positive NPV.

Very practically: If you were to make an NPV of $27B from selling the business only from cash flow, a buyer would not pay $8.5B for it, but demand a cash payment of $27B on top of taking the business.

The case should be corrected or withdrawn.

(edited)

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Anonymous C replied on Mar 05, 2021

Yeah, I've noticed that many of the cases here are not really well written. This case is particularly bad and should be deleted:

  • The case misunderstands FCF: FCF is profit after re-investments to maintain assets and after tax & interest. The case just takes operating costs instead
  • The case miscalculates NPV: ADDING FCF impact to sales price doesn't make sense. NPV can only be positive if FCF REDUCTION is lower than the sales price. So NPV = Sales price - NPV(FCF)
  • The case misundersands how M&A/PE works: Selling a company doesn't give you the sales price AND an FCF NPV. If the business generates NPV from a FCF perpetuity, you would have to PAY to get rid of it.
  • The case misunderstands the basics of electricity markets: Operating costs of a wind farm higher than that of a coal plant doesn't make any sense at all: Renewable Energy OPEX is virtually 0. This might only be explained if the case includes CAPEX in Operation costs, which also doesn't make any sense.
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Luca
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replied on Mar 08, 2021
BCG |NASA |20+ interviews with 100% success rate| 120+ students coached |GMAT expert 780/800 score

Hello there,

This is a fair question. 10% is the standard value used for the discount rate but you should be able to argument it a little bit.

I would suggest to read the following articles to understand what are the factors that can influence the discount rate value:
https://www.investopedia.com/terms/d/discountrate.asp

https://mrmr.cim.org/en/library/magazine-articles/factors-to-consider-when-determining-appropriate-discount-rate-for-project-npv/#:~:text=Discount%20rates%20are%20dependent%20on,capability%20of%20the%20project%27s%20owner.

Best,
Luca

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Ian gave the best answer

Ian

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