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Staff Information
Instructor: Dr. Anson C. K. Au Yeung
Office: AC2 5112
Phone: 3442-2163
Email: anson.auyeung@cityu.edu.hk
Office Hours: By Appointment
Class Schedule
C01, CA1: Thursday 15:30 18:20, LT-15
C02, CA2: Friday 09:30 12:20, LT-15
C03, CA3: Tuesday 09:30 12:20, LT-4
(No class on Week 12, Week 12 is reserved for individual cases consultation)
Course Objectives
This course aims to provide students with a background in some fundamental concepts of
modern financial management. It also exposes students to some of the major financial
decision techniques used in the business world.
References
1. Course Package
2. Ross, Westerfield and Jordan, Corporate Finance Essentials (7th Edition), McGraw Hill
2011 [RWJ].
Assessment
1. Midterm (30%)
Week 11: 31 March 2012 (Saturday), 10:00 12:00
2. Individual Case Study (10%)
Week 13: 16 April 2011 (Monday), 17:00
3. Homework (10%)
4. Examination (50%)
Course Outline
Topic
1
2
3
4
5
6
7
8
9
10
Reference
Chapter 1
Chapter 2, 3
Chapter 4
Chapter 5
Chapter 8
Chapter 6, 7
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Table of Contents
1
1.1.1
1.1.2
1.1.3
1.2
1.2.1
Sole Proprietorship............................................................................................. 10
1.2.2
Partnership ......................................................................................................... 11
1.2.3
Corporation ........................................................................................................ 11
1.2.4
A Comparison .................................................................................................... 12
1.3
Introduction ................................................................................................................. 9
1.3.1
1.3.2
2.1.1
Assets ................................................................................................................. 17
2.1.2
Liabilities ........................................................................................................... 17
2.1.3
Equity ................................................................................................................. 18
2.1.4
2.1.5
Managerial Issues............................................................................................... 18
2.2
2.2.1
Revenues ............................................................................................................ 19
2.2.2
Expenses ............................................................................................................ 20
2.2.3
Depreciation ....................................................................................................... 20
2.2.4
Taxes .................................................................................................................. 20
2.3
2.3.1
2.3.2
2.4
2.4.1
2.4.2
2.4.3
2.4.4
2.4.5
2.4.6
2.4.7
2.5
2.5.1
2.5.2
2.5.3
2.5.4
3.1.1
3.2
3.2.1
3.2.2
3.3
3.3.1
3.3.2
3.4
3.5
3.6
4.1.1
4.1.2
4.2
Annuity ...................................................................................................................... 52
4.2.1
4.2.2
4.3
4.4
Perpetuity .................................................................................................................. 58
4.5
4.5.1
4.5.2
5
5.2
5.2.1
5.2.2
5.2.3
5.3
5.3.1
5.3.2
5.4
5.5
5.6
5.7
Comprehensive Problems.......................................................................................... 76
6.2
6.2.1
6.2.2
6.2.3
Consol ................................................................................................................ 83
6.3
6.4
6.5
6.6
6.6.1
6.6.2
6.6.3
6.7
Total Return............................................................................................................... 89
6.8
6.8.1
7
7.1.1
7.2
7.2.1
7.2.2
Depreciation ....................................................................................................... 99
7.2.3
7.2.4
7.3
7.4
7.4.1
7.4.2
7.5
8
Case Study Danforth & Donnalley Laundry Products Company ........................ 109
8.2
8.2.1
8.2.2
8.2.3
8.2.4
8.2.5
8.2.6
9.2
9.2.1
9.2.2
9.2.3
9.2.4
9.3
9.3.1
9.3.2
9.4
9.4.1
9.4.2
9.5
9.5.1
9.5.2
9.5.3
Diversification.................................................................................................. 127
9.5.4
9.5.5
9.5.6
9.6
10
10.1
10.2
10.4
10.5
10.6
10
1.2.2 Partnership
Partnership is a business formed by two or more individuals or entities.
In a general partnership,
All the partners share in gains or losses, and all have unlimited liability for all
partnership debts.
The partners share gains and losses as described in the partnership agreement.
In a limited partnership,
One or more general partners will run the business and have unlimited liability.
There will be one or more limited partners who do not actively participate in the
business.
A limited partners liability is limited to the amount that partner contributes to the
partnership.
The advantage:
It is based on relatively informal agreement and is easy and inexpensive to form.
The disadvantage:
The partnership terminates when a general partner wishes to sell out or dies.
Ownership by a general partner is not easily transferred since a new partnership must
be formed.
Although a limited partner can sell his interest without dissolving the partnership,
finding a partner may be difficult.
1.2.3 Corporation
Corporation is a business created as a distinct legal entity owned by one or more individuals
or entities. A corporation is a legal person separate and distinct from its owners, and it has
many of the rights, duties, and privileges of an actual person.
Corporations can borrow money and own property, can sue and be sued, and can enter into
contracts.
11
The advantage:
Stockholders in a corporation have limited liability.
The separation of ownership and management makes transferring of ownership a lot
easier.
Easier to raise capital.
The disadvantage:
There is agency problem as a result of the separation of ownership and management.
Double taxation.
1.2.4 A Comparison
Lets summarize some basic characteristics between partnership and corporation.
Partnership
Liquidity
Voting Rights
Taxation
Reinvestment and
Dividend Payout
Liability
Continuity
Subject to substantial
restrictions
General partner is in charge
Limited partners may have
some voting rights
Partners pay taxes on
distributions
All net cash flow is
distributed to partners
General partners have
unlimited liability
Limited partners enjoy
limited liability
Limited life
Corporation
Double taxation
Broad latitude
Limited liability
Perpetual life
12
13
Example 1.1
Suppose City Corporation is going to hire a salesman, and you decide to offer him an annual
wage of w. Your objective is to hire a hardworking salesman with a minimum wage. If the
salesman works hard, he can bring $270,000 revenue to the firm; otherwise, he can only bring
$70,000 revenue if he does not work hard.
The salesman utility can be described as U w, e w e . His reservation level of utility is
81,000. Once this salesman accepts the offer, he can put high (e = 25,000) or low (e = 0)
effort.
What is the minimum wage that you have to offer to this salesman for accepting the job?
Will the salesman act in the best interests (by working hard) of City Corporation?
How should you decide the wage if you want to hire a hardworking salesman?
From this example, the salesman (agent) takes an action that affects his utility as well as the
corporation (principal). The insight of this example is to show you the agent does not
necessarily choose the action in the interest of the principal.
It is therefore important that managers incentives are aligned with those of shareholders.
14
Price increases generated large cash flows in the industry. For example, the 1984 cash flows
of the ten largest oil companies were US$48.5 billion, 28% of the total cash flows of the top
200 firms in Duns Business Month survey.
The management did not pay out the excess resources to shareholders. Instead, the industry
continued to spend heavily on exploration and development (E&D) activity even though
average returns were below the cost of capital. Two studies indicate that oil industry E&D
expenditures have been too high since the late 1970s:
John McConnell and Chris Muscarella (1986) find that announcements of increases
in E&D expenditures by oil companies in the period 1975 1981 were associated
with systematic decreases in the announcing firms stock price.
B. Picchis study of returns on E&D expenditures for 30 large oil firms did not earn
even a 10% return on its pretax outlays in the period 1982 1984.
Oil industry managers also launched diversification programs to invest funds outside the
industry. For example:
Retailing: Marcor by Mobil.
Manufacturing: Reliance Electric by Exxon.
Office equipment: Vydec by Exxon.
Mining: Kennecott by Sohio; Anaconda Minerals by Arco; Cyprus Mines by Amoco.
These acquisitions turned out to be among the least successful, partly because of bad luck and
partly because of a lack of managerial expertise outside the oil industry.
15
16
2.1.1 Assets
An asset is a resource controlled by the corporation as a result of past events and from which
future economic benefits are expected to flow to the corporation.
Assets can be classified into current and fixed.
Current asset has a life of less than a year, for example, inventory.
Fixed asset has a relatively long life, for example, land and building.
2.1.2 Liabilities
A liability is an obligation owed by the corporation to repay the claims in the future.
Liabilities can also be classified into current and long-term.
Current liability reflects the amount of money the firm owes and must pay within the
coming year, for example, accounts payable.
Long-term liability is debt due after one year from the date of the balance sheet.
17
2.1.3 Equity
Shareholders equity is the total equity interest that all shareholders have in a corporation. It
is the residual value remained to the shareholders after repaying all debts by selling its assets.
Equity can be separated into capital stock and retained earnings.
Capital stock is the owners initial investment in the firm.
Retained earnings represent the accumulated total of after-tax earnings and losses
from operations over the life of the firm that has been retained in the corporation.
2.1.4 The Accounting Identity
The most basic accounting identity is that the balance sheet must balance. That is,
Assets = Liabilities + Equity
Although this balance sheet identity is trivial, understanding the implication behind this
identity is important. You need to know how the changes in asset value in City Corporation
would have impact on your debtholders and equityholders. For example, during the financial
crisis, the asset value of the firm dropped much. The fall in the asset value must be
compensated by the drop in either the value of debt or equity, or both.
2.1.5 Managerial Issues
1. Net Working Capital
Net working capital is the difference between a firms current assets and its
current liabilities.
The level of working capital naturally expands and contracts with sales activities.
Too little working capital can put a firm in a bad position since the firm may be
unable to pay its bills or to take advantage of profitable opportunities.
Too much working capital reduces profitability since that capital has a carrying
cost.
2. Inventory
Having too many inventories can fill customer orders without delay and provides
a buffer against potential production stoppages.
The flip side of plentiful inventory is the risk of deterioration in the market value
of inventory itself.
18
3. Financial Leverage
Financial leverage refers to the use of debt in acquiring an asset. The more debt a
firm has, the greater is its degree of financial leverage.
Financial leverage creates an opportunity for a firm to gain a higher return on the
capital invested.
2.2.1 Revenues
An income statement starts with the firms revenues. According to the recognition principle,
revenue is recognized when the earnings process is virtually complete and the value of an
exchange of goods or services is known or can be reliably determined.
19
2.2.2 Expenses
Expenses shown on the income statement are based on the matching principle. The basic
idea is to first determine revenues and then match those revenues with the costs associated
with producing them.
As a result of the way revenues and expenses are reported, the figures reported in the
statements may not be at all representative of the actual cash inflows and outflows that
occurred during a particular period.
2.2.3 Depreciation
Depreciation is counted on the income statement as an expense, even though it involves no
cash outflows. Depreciation is a way of estimating the consumption of an asset over time.
For example, if a computer loses about a third of its value each year, the firm would not
expense the full value of the computer in the first year of its purchase, but deduct one-third
each year as an expense.
The depreciation deduction is simply an application of the matching principle in accounting.
2.2.4 Taxes
In making financial decisions, it is important to distinguish between average and marginal
tax rates.
Average tax rate is the total taxes paid divided by total taxable income.
Marginal tax rate is the amount of tax payable on the next dollar earned.
20
Example 2.1
The corporate tax rates in effect for 2007 are shown below.
Taxable Income
0 - 50,000
50,001 - 75,000
75,001 - 100,000
100,001 - 335,000
335,001 - 10,000,000
10,000,001 - 15,000,000
15,000,001 - 18,333,333
18,333,334 +
Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
If City Corporation is considering a project that will increase the firms taxable income by $1
million, what tax rate should you use in your analysis?
21
22
Example 2.2
Using the financial statements of U.S. Corporation, calculate the cash flow from assets, cash
flow to creditors, and cash flow to shareholders in 2008.
23
24
1,506
1,004
502
10
30
360
102
5
97
47
50
1
29
20
25
City Corporation
Balance Sheet as of 31 December, 2007 2008
($ in thousands)
2008
2007
Current assets:
Cash
Accounts receivable
Inventory
Total current assets
20
95
130
245
30
95
110
235
Fixed assets:
Land
Building and equipment
Total fixed assets
10
120
130
10
100
110
10
10
385
355
Current liabilities:
Accounts payable
Estimated income taxes payable
Total current liabilities
50
10
60
40
10
50
Fixed liabilities:
Mortgage bonds, 10%
50
50
TOTAL LIABILITIES
110
100
Shareholders equity:
Convertible preferred stock, 5%
Common stock (10,000 shares)
Retained earnings
Total shareholders equity
20
50
205
275
20
50
185
255
385
355
Other assets:
Goodwill
TOTAL ASSETS
26
Current Liabilities
245
4.1 times
60
The higher the ratio, the more protection the firm has against liquidity problems.
However, the ratio may be distorted by seasonal influences, slow-moving
inventories built up out of proportion to market opportunities, or abnormal
payment of accounts payable just prior to the balance sheet date.
Current Liabilities
245 130
The quick ratio in 2008
1.9 times
60
The quick ratio measures the ability of a firm to use its near-cash assets to
immediately extinguish its current liabilities.
3. Cash Ratio
Cash
Current Liabilities
20
0.3 times
60
Very short-term creditor might be interested in this ratio.
Total Assets
110
0.29
385
Total debt ratio indicates the proportion of a firms total assets financed by shortand long-term credit sources.
27
Another variation of this ratio is to measure the relative mix of funds provided by the owners
and the creditors.
2. Debt-equity Ratio
Total Liabilities
Shareholders' Equity
110
0.4
275
Interest
102
20.4 times
5
This ratio indicates the extent to which operating profits can decline without
impairing the firms ability to pay the interest on its long-term debt.
Interest
102 10
22.4 times
5
This ratio uses EBIT plus non-cash charges as the numerator. The modification
indicates the ability of the firm to cover its cash outflow for interest from its funds
from operations.
Inventory
1, 004
7.7 times
130
The inventory turnover ratio indicates how fast inventory items move through a
business.
28
Inventory Turnover
365
47 days
7.7
This ratio estimates the average length of time items spent in inventory.
3. Receivables Turnover
Sales
Accounts Receivable
1,506
15.9 times
95
Receivables Turnover
365
23 days
15.9
5. Asset Turnover
Sales
Total Assets
1,506
3.9 times
385
This ratio is an indicator of how efficiently management is using its investment in
total assets to generate sales.
High turnover rates suggest efficient asset management.
29
Sales
50
3.3%
1,506
Total Assets
50
13%
385
This ratio measures the return on total assets after recognition of taxes and
financing costs.
Total Equity
50
18%
275
The fact that ROE exceeds ROA reflects the firms use of financial leverage.
Shares Outstanding
50
$5 per share
10
This EPS figure is known as basic earnings per share.
30
Assume the price for the stock of City Corporation is $40, the PE ratio
40
8 times
5
PE ratio measures how much investors are willing to pay per dollar of current
earnings.
Higher PEs are often taken to mean that the firm has significant prospects for
future growth.
3. Price-Sales Ratio
Price Per Share
0.27 times
150.6
Price-Sales ratio can be used when the firm reported negative earnings for the
period.
4. Market-to-Book Ratio (MB)
Market Value Per Share
40
1.45 times
27.5
Note that book value per share is total equity divided by the number of shares
outstanding.
A value less than 1 could mean that the firm has not been successful overall in
creating value for its shareholders.
31
Sales
Total Assets Total Assets
3.3% 3.9 13%
This formula indicates that the return on assets is closely related to the
profitability and turnover.
2. ROE (Du Pont Identity)
Profit Margin Asset Turnover Equity Multiplier = ROE
Net Income
Sales
Total Assets Net Income
Sales
Total Assets Total Equity Total Equity
3.3% 3.9 1.4 18%
Du Pont identity is a popular expression breaking ROE into three parts: operating
efficiency, asset use efficiency, and financial leverage.
2.4.7 Managerial Implications
So far, we have looked at the five major types of financial ratios. As a CFO, you would
probably ask How can we interpret all the ratios together?
A simple way to analyze the overall picture is to group the ratios into a matrix. For example:
Liquidity / Solvency
Liquid / Solvent
Illiquid / Insolvent
Liquid / Solvent
Illiquid / Insolvent
Profitability
High
High
Low
Low
Implications
32
33
Example 2.3
City Corporation had earnings of $10 million during the year just ended; a net worth of $100
million at the beginning of that year; and a permanent dividend payout policy of 50%.
Thus, City Corporation earned 10% on its beginning net worth, retained $5 million of
earnings. And the ending net worth will be $105 million.
If the 10% return on beginning equity is repeated during the next year, then the firms earning
will grow to $10.5 million.
This 5% earnings growth rate will be repeated annually as long as City Corporation continued
to earn 10% on each years beginning net worth and pay out 50% of its earnings in dividends.
2.5.2 Du Pont Decomposition
This growth rate is assumed to be sustainable because the firm is growing from internally
generated funds. We can associate the sustainable growth with fundamental factors using Du
Pont decomposition.
Recall that:
Net Income
ROE
Total Equity
Net Income
Sales
Total Assets
Sales
Total Assets Total Equity
EPS DPS
EPS
DPS
=1
EPS
=1 Dividend Payout Ratio
Retention Rate
Putting the two equations together and remembering that capital structure is held constant,
we can see the sustainable growth is affected by profitability, asset utilization, and earnings
retention.
g ROE b
Net Income
Sales
Total Assets DPS
Sales
Total Assets Total Equity EPS
34
Fundamental Factors
Profitability
Asset Utilization
Financial Leverage
Dividend Payout
ROE b
1 ROE b
35
36
37
You think the time that you get the money is important as well as how much you get.
Suppose you know where to invest your extra funds and you are smart enough to earn 10%
interest. Lets compare the two investments when the interest rate is 10%.
38
Investment 1
Beginning balance
Earnings on the balance at 10%
Inflow at the end of year
Ending balance
Year 1
0
0
20,000
20,000
Year 2
20,000
2,000
20,000
42,000
Year 3
42,000
4,200
20,000
66,200
Year 1
0
0
40,000
40,000
Year 2
40,000
4,000
9,000
53,000
Year 3
53,000
5,300
9,000
67,300
Investment 2
Beginning balance
Earnings on the balance at 10%
Inflow at the end of year
Ending balance
The results indicate that Investment 2 leaves you better off if you can earn 10% interest.
What happens if you can only earn 5% interest?
Investment 1
Beginning balance
Earnings on the balance at 5%
Inflow at the end of year
Ending balance
Year 1
0
0
20,000
20,000
Year 2
20,000
1,000
20,000
41,000
Year 3
41,000
2,050
20,000
63,050
Year 1
0
0
40,000
40,000
Year 2
40,000
2,000
9,000
51,000
Year 3
51,000
2,550
9,000
62,550
Investment 2
Beginning balance
Earnings on the balance at 5%
Inflow at the end of year
Ending balance
In this case, Investment 1 looks better.
This example shows that not only the amount of cash flows is important, but also the timing
of receipt. The more you can earn on the receipts, the better if you can get them earlier.
39
Beginning
Balance
50,000
55,000
5,500
60,500
60,500
6,050
66,550
Year
5,000
Ending
Balance
55,000
Interest
Formula
1
2
In general, the formula for future value when interest is compounded annually is:
Vt V0 1 r
40
Example 3.2
Given the interest rate is 10%, what would your $100 be worth after five years?
Without compounding, you can only earn a simple interest, that is, interest is only earned on
the principal. The simple interest is 100 10% 10 per year . Over the five year span of
investment, you accumulate $50 simple interest.
The difference $11.05 is the interest on interest from compounding.
Future values depend critically on the assumed interest rate, particularly for long-lived
investments.
41
We can study how $1 of investment grows at different rates and lengths of time.
Notice that the future value of $1 after 10 years is about $6.20 at a 20% return, but it is only
about $2.60 at 10%. Doubling the interest rate more than doubles the future value.
42
V0
Vt
1 r
The two simple examples serve to illustrate discounting and compounding are the inverse of
one another.
43
Cash Flow
Present
50,000
Year 1
Year 2
Year 3
66,550
Year 1
Year 2
Cash Flow
Year 3
66,550
50,000
3.3.1 Effects of Discounting
There are two important relationships between present value, interest rate and time:
For a given interest rate, the longer the time period, the lower the present value.
For a given time period, the higher the interest rate, the smaller the present value.
We can plot out the present value of $1 for different periods and rates.
44
Year 0
-50,000
Year 1
+20,000
Year 2
+20,000
Year 3
+20,000
20, 000
1.1
20, 000
1.12
20, 000
1.13
-262.96
45
Year 0
-50,000
Year 1
+40,000
Year 2
+9,000
Year 3
+9,000
40, 000
1.1
9, 000
1.12
9, 000
1.13
563.49
PV
FVt
1 r
FV t
r t 1
PV
Example 3.5
You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today.
What is the implied rate of interest?
46
In this example, we can apply the Rule of 72 to get an approximate of r. For reasonable
rates of return, the time it takes to double your money is given approximately by 72 / r.
47
PV
FVt
1 r
ln FVt ln PV
ln 1 r
In this example,
48
Excel Formula
= FV(rate, nper, pmt, pv)
= PV(rate, nper, pmt, fv)
= RATE(nper, pmt, pv, fv)
= NPER(rate, pmt, pv, fv)
49
50
If you use financial calculator, first, notice the cash flow pattern.
Year
0
1
2
3
4
5
6
Cash Flow
0
100
0
200
0
0
600
Noted that the F displayed in the calculator means the number of times a given cash flow
occurs in consecutive years. For example, at year 4, there are 2 consecutive years of having
zero cash flow.
1. Clear the Registers
2nd {CLR TVM}
2nd {CLR Work}
51
2. Input
CF
(CF0=) 0 ENTER
(C01=) 100 ENTER
(F01=) 1 ENTER
(C02=) 0 ENTER
(F02=) 1 ENTER
(C03=) 200 ENTER
(F03=) 1 ENTER
(C04=) 0 ENTER
(F04=) 2 ENTER
(C05=) 600 ENTER
(F05=) 1 ENTER
NPV
(I=) 10 ENTER
CPT
4.2 Annuity
Annuity formula is useful in discounted cash flow valuation. Annuity means the value of
cash flows is the same for a number of years.
To use the ordinary annuity formula, the following conditions should be satisfied:
The value of the cash flows in each period is the same.
The period or the interval for the cash flows remains unchanged.
The receipt / payment of the cash flows should occur at the end of each regular period.
4.2.1 Present Value of an Annuity
1
1
Present Value of an Annuity C 1
r 1 r t
52
Example 4.3
A project is expected to have an economic life of five years. The value of this projects net
cash inflows is estimated to be $2,000 for each year and this is to be received at the end of
each year. The appropriate discount rate is 15% per annum. What is the present value of this
projects cash inflows?
Using our old discounting approach,
To find annuity present value with financial calculators, we need to use the PMT key.
1. Clear the Registers
2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs
2,000 PMT
5N
15 I/Y
3. Compute and Return the Outputs
CPT PV
You will also get PV = - 6,704.31.
53
Example 4.4
A projects annual net cash inflows, to be received at the end of each year, are estimated as
follows. For the first nine years the project does not generate any cash inflow. For the next
eleven years, that is, from the tenth to the twentieth years inclusive, it generates $60 per year.
The discount rate is 10% per annum. What is the present value of this project?
The timeline of the projects cash flow:
There is another way to view this example. We know the annuity cash flows only start at
year 10. Therefore, we can first figure out the present value of this annuity at year 9 and then
discount the whole sum back to year 0.
Example 4.5
You are 20 years old now and want to retire as a millionaire by the time you turn 70. How
much will you have to save at the end of each year if you can earn 5% compounded annually?
54
Example 4.6
Suppose you want to borrow $20,000 for new car. You can borrow at 8% per year,
compounded monthly (8/12 = 0.67% per month). If you take a 4-year loan, what is your
monthly payment?
Example 4.7
Suppose you borrow $10,000 from your friend. You agree to pay $207.58 per month for 60
months. What is the monthly interest rate?
Using financial calculator,
1. Clear the Registers
2nd {CLR TVM}
2nd {CLR Work}
2. Enter the Inputs
- 207.58 PMT
60 N
10,000 PV
3. Compute and Return the Outputs
CPT I/Y
You will also get I/Y = 0.7499.
55
Without a financial calculator, then you have to go through the trial and error process.
Choose an interest rate and compute the PV of the payments based on this rate.
Compare the computed PV with the actual loan amount.
If the computed PV > loan amount, then the interest rate is too low.
If the computed PV < loan amount, then the interest rate is too high.
Adjust the rate and repeat the process until the computed PV and the loan amount are
equal.
4.2.2 Future Value of an Annuity
We already know the formula of present value of annuity. To get the future value of an
annuity, we can simply multiply that present value by 1 r .
t
1 r
Future Value of an Annuity C
Example 4.8
Suppose you begin saving for your retirement by depositing $2,000 per year in MPF. If the
interest rate is 7.5%, how much will you have in 40 years?
56
We can verify the answer by finding the present value of each cash flow.
57
4.4 Perpetuity
Perpetuity is a special case of an annuity in which the number of equal cash flows is infinite.
The formula for the present value of a perpetuity is:
Present Value of a Perpetuity
C
r
Example 4.10
In the early 1900's the Canadian Government issued $100 par value 2% Consol bonds. The
holder of these bonds is entitled to receive a coupon (or interest) payment of $2 per year
forever. If the current appropriate discount rate is 5% p.a. and the next coupon is due one
year from now, how much is one of the Consols worth?
Obviously, option 2 is better as you can enjoy the interest on interest. As the example
illustrates, 10% compounded semiannually is actually equivalent to 10.25% per year.
58
Quoted Rate
EAR 1
1
m
Where m is the number of times the interest is compounded during the year.
Example 4.11
Suppose a bank offers a nominal interest rate of 5% on your time deposit. Compare the
different EARs with various times the interest is compounded each year.
Compounding
Formula
Annually
0.05
r 1
1
1
Semiannually
0.05
r 1
1
2
Quarterly
0.05
r 1
1
4
Monthly
0.05
r 1
1
12
Weekly
0.05
r 1
1
52
Daily
0.05
r 1
365
Hourly
0.05
r 1
8760
Continuously
r e0.05 1
5.0000%
5.0625%
5.0945%
12
5.1162%
52
5.1246%
365
5.1267%
8760
5.1271%
5.1271%
59
Example 4.12
You are looking at two savings accounts. HSBC pays you 5.25%, with daily compounding.
BOC pays 5.3% with semiannual compounding. Which account should you use?
HSBC:
BOC:
For (2):
Remember, APR is only an annual rate that is quoted by law. In order to figure out the
actual rate, you need to compute the EAR.
60
APR
EAR 1
1
m
APR m 1 EAR m 1
Example 4.14
Suppose you want to earn an effective rate of 12% and you are looking at an account that
compounds on a monthly basis. What APR must this account pay?
61
Project
A
Investment
Revenue
Expenses
Year 0
-10,000
Cash Flow
Year 1
Year 2
Year 3
21,000
11,000
Investment
Revenue
Expenses
-10,000
Investment
Revenue
Expenses
-10,000
Investment
Revenue
Expenses
-10,000
15,000
5,833
17,000
7,833
10,000
5,555
11,000
4,889
30,000
15,555
30,000
15,555
10,000
5,555
5,000
2,222
All the projects capital investment will be depreciated to zero on a straight-line basis. The
marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.
What is your advice to the management?
In this case, City Corporation processes four possible investments. Some are valuable and
some are not. Of course, our important goal is to identify which are which. We will try to
present several investment criteria commonly used in practice and introduce the techniques
used to analyze investment decisions.
62
NPV
t 1
Ct
1 r
I0
Whether an investment is worth undertaking, we have to see if it creates value for its owner.
A positive NPV says the investment is worth more than it costs, and therefore creates value.
A negative NPV suggests once the investment is implemented, it will destroy value.
Based on the simple logic, in determining whether to accept or reject a particular investment,
the NPV decision rule is:
Accept an investment if its NPV > 0.
Reject an investment if its NPV < 0.
Example 5.1
Consider the following investment proposal:
Cash Flow
Year 0
-100
Year 1
11
Year 2
11
Year 3
11
11
Year 25
11
63
Cash Flow
Year 2010
-100
Year 2011
Year 2012
50
Year 2013
30
80
We understand this is a good investment project since the NPV is greater than zero. But what
does this 30.35 really mean?
The 30.35 is exactly the additional amount of money you can spend today if you take the
project. Suppose you can borrow and lend at 10%, then you can do the following strategy:
Spend 30.35 today and borrow the money from the bank.
Repay the loan by using the project cash flows.
Let us illustrate the strategy with the following table.
Year 2010
-100.00
+130.35
0.00
-130.35
30.35
Year 2011
+50.00
-50.00
13.04
-93.39
0.00
Year 2012
+30.00
-30.00
9.34
-72.73
0.00
Year 2013
+80.00
-80.00
7.27
0.00
0.00
A positive NPV means you can earn extra cash flow for your consumption. In the example
here, 30.35 is your riskless profit since your project cash flow can completely repay your loan
in future. Hence, if you undertake this project, you will be better off.
64
Year
Cash Flow
Year
Cash Flow
0
-3,000
0
-2,000
1
1,000
Machine A
2
1,000
3
1,000
4
1,000
1
700
Machine B
2
700
3
700
4
700
The discount rate is 10%. What are the NPVs of the two machines?
Purchasing both machines will bring positive NPV to the firm. When there is no constraint,
City Corporation should purchase both machines. However, if the purchasing decisions are
mutually exclusive (either purchasing Machine A or B), then the decision is to choose the
highest NPV. Machine B is thus the preferred alternative.
65
Year
Cash Flow
0
-1,000
1
350
Machine C
2
350
Year
Cash Flow
0
-1,000
1
750
Machine D
2
500
3
350
4
350
The discount rate is 10%. What are the NPVs of the two machines?
66
The decision rule is to choose the one with highest equivalent annuity. In our example,
Surprisingly, although Machine D has a lower NPV than Machine C, the firm should select
Machine D as it has a higher equivalent annuity.
0
t 1
Ct
1 IRR
I0
In determining whether to accept or reject an investment, the IRR decision rule is:
Accept an investment if IRR > required return.
Reject an investment if IRR < required return.
The logic of IRR reverses the one of the NPV. When computing NPV, we calculate the NPV
for a given discount rate on an investment, and accept an investment whenever the NPV is
positive. If we use IRR rule, we calculate the discount rate that makes the NPV equal to zero.
The two methods are related.
67
Example 5.5
Consider the following investment project:
CF
(CF0=) -200 ENTER
(C01=) 50 ENTER
(F01=) 1 ENTER
(C02=) 100 ENTER
(F02=) 1 ENTER
(C03=) 150 ENTER
(F03=) 1 ENTER
IRR CPT
68
If we graph NPV versus the discount rate, we can see the IRR is actually the x-intercept.
$120.00
$100.00
$80.00
$60.00
$40.00
NPV $20.00
$0.00
-$20.00 0%
10%
20%
30%
40%
50%
-$40.00
-$60.00
-$80.00
IRR
We can see that the NPV of the project decreases as we increase the discount rate. The line
cuts the x-axis at the IRR of 19.44%. For all discount rate above 19.44%, the NPV of the
project is negative; for all discount rate below the IRR, the NPV of the project is positive.
Lets say if the required rate of return is 10%, then based on both decision rules (NPV &
IRR), they all come to the same conclusion the project should be accepted.
5.3.1 Nonconventional Cash Flows
One problem with the IRR comes about when the cash flows are not conventional.
Example 5.6
Consider the following investment project:
69
From the graph, there are two IRRs for this project. The curve crosses the x-axis at 0% and
100%.
70
60
50
40
30
NPV
20
10
0
-10
0%
-20
20%
40%
60%
80%
100%
120%
IRR
The idea is that when cash flows change signs more than once, there will be more than one
IRR. In this situation, you will have to use your judgment to decide which IRR should be
used.
5.3.2 Mutually Exclusive Investments
Another problem with IRR comes about when we are trying to compare two or more
mutually exclusive investments.
Example 5.7
City Corporation has two mutually exclusive projects, A and B. The cash flows of the two
projects are as follow:
Year 0
Project A
Project B
Year 1
-500
-400
Year 2
325
325
325
200
If the required return for both projects is 10%, which project should the firm accept?
70
In this example, NPV(A) > NPV(B) but IRR(B) > IRR(A). Based on NPV rule, we should
choose Project A. However, if we rely on IRR rule, the rule suggests us to choose Project B.
The two rules give conflicting conclusions.
The conflict between the NPV and IRR for mutually exclusive investments can be illustrated
by plotting their profiles.
190.00
140.00
90.00
Project A
NPV
Project B
40.00
(10.00) 0%
5%
10%
15%
20%
25%
30%
35%
(60.00)
71
The crossover point of the two curves can be found by setting NPV(A) = NPV(B).
Crossover point:
Below the crossover point, both NPV and IRR share the same decision investing in Project
B is more preferred. Notice that when the discount rate is less than 11.8%, the NPV for
Project A is higher even though Project Bs IRR is higher.
Remarks:
Whenever there is a conflict between NPV and IRR, you should always use NPV.
IRR is unreliable in the situations of nonconventional cash flows and mutually
exclusive projects.
72
Example 5.8
City Corporation is considering purchasing either one machine (mutually exclusive
investment). The firms required rate of return is 10%.
Year
Cash Flow
0
-1,000
1
200
Machine E
2
800
Year
Cash Flow
0
-1,000
1
600
Machine F
2
300
3
25
3
1,000
If City Corporation requires a payback period of three years or less, which machine would
you purchase?
The payback period:
Machine E: 2 years.
Machine F: 3 years.
The payback rule dictates that Machine E should be accepted. However, if we calculate the
NPV of the two machines, we get:
Based on NPV rule, purchasing Machine E is actually not a good investment choice. This
example shows that there are problems with the payback method:
1. It ignores the time value of money.
A remedy for this problem is to use the discounted payback period.
2. It ignores the cash flows after the payback period.
3. The standard for payback period is arbitrary.
73
Although the AAR seems very impressive, there are some drawbacks about this measure.
1. It is not a true rate of return and it also ignores the time value of money.
2. It uses an arbitrary cutoff rate.
3. It is based on accounting net income and book values, not cash flows and market values.
74
PV
I0
Cost
1,000
4,000
6,000
2,000
5,000
PV
1,600
6,000
8,400
2,700
5,500
NPV
600
2,000
2,400
700
500
PI
1.60
1.50
1.40
1.35
1.10
In the meeting, you know from the budget that $12,000 will be available to invest in the
coming year. Which projects will you select?
By investing all projects, it will cost the firm $18,000. Since the firm only has $12,000
capital, it is not feasible to invest all projects even though all projects have positive NPV. In
this situation, you can rank the projects PI from highest to lowest and then select from the
top of the list until the capital budget is exhausted.
Based on the PI rule, you will select Project A, B and C as the three projects will give you
highest PI.
75
However, the PI will lead you to the wrong conclusion. If you calculate the aggregate NPV
of various combinations, you have:
In this example, the best alternative is Project B, C and D with an aggregate NPV of $5,100.
Project
A
Investment
Revenue
Expenses
Year 0
-10,000
Cash Flow
Year 1
Year 2
Year 3
21,000
11,000
Investment
Revenue
Expenses
-10,000
Investment
Revenue
Expenses
-10,000
Investment
Revenue
Expenses
-10,000
15,000
5,833
17,000
7,833
10,000
5,555
11,000
4,889
30,000
15,555
30,000
15,555
10,000
5,555
5,000
2,222
All the projects capital investment will be depreciated to zero on a straight-line basis. The
marginal corporate tax rate is 40%. None of the projects will have any salvage value at the
end of their lives.
76
77
78
79
Consider a zero coupon bond that pays a face value of F in T years. The value of this zero
coupon bond is the present value of the face amount.
1 r
Example 6.2
A zero coupon bond that matures in 20 years has a par value of $1,000. If the required return
is 4.3%, what is the value of the zero?
$C
$C
$C+$F
80
C
C
1 r 1 r 2
1
1
C
2
1 r 1 r
1
1
C 1
T
r 1 r
1 r
T 1
1 r
CF
1 r
1
F
T
1 r
1
F
T
1 r
Example 6.3
A 30-year bond with an 8% (4% per 6 months) coupon rate and a par value of $1,000 has the
following cash flows:
Semiannual coupon = $1,0004% = $40
Par value at maturity = $1,000
Therefore, there are 60 semiannual cash flows of $40 and a $1,000 cash flow 60 six-month
periods from now.
$40
$40
$40
$40+$1,000
60
81
Suppose the discount rate is 8% annually or 4% per 6-month, the price of the bond is:
What if the discount rate rises to 10% annually, then the bond price will fall by $189.29 to
$810.71.
The central feature of fixed income securities is that there is an inverse relation between bond
price and discount rate.
82
4%
1,695.22
6%
1,276.76
8%
1,000.00
10%
810.71
12%
676.77
Note:
When the coupon rate equals the discount rate, the price equals the par value.
When the coupon rate is less than the discount rate, the price is less than the par
value.
When the coupon rate is greater than the discount rate, the price is greater than the
par value.
6.2.3 Consol
Not all bonds have a final maturity. Consol is a bond that never stop paying a coupon, has no
final maturity date. Thus, a consol is a perpetuity.
Example 6.4
What is the price of a consol with a yearly interest of $50 if the interest rate is 10%?
P
t 1
Ct
1 YTM
1 YTM
83
Example 6.5
Consider a 30-year bond with $1,000 face value has an 8% coupon. Suppose the bond sells
for $1,276.76, the YTM:
60
1276.76
t 1
40
1 YTM
1000
1 YTM
60
84
Lets assume you buy a stock and hold it for one year. The price you are willing to pay for
the stock today is equal to the present value of the cash flows you will receive for holding a
year:
Div1
P
P0
1
1 r 1 r
P1 can be determined by the dividend you will receive and the sale price at year 2:
P1
Div2
P
2
1 r 1 r
P
Div2
2
Div1 1 r 1 r
P0
1 r
1 r
Div1
Div2
P2
2
1 r 1 r 1 r 2
If you repeat this logic, the stock price for today eventually becomes:
Div3
Div1
Div2
P0
2
1 r 1 r 1 r 3
t 1
Divt
1 r
Thus, the value of a firms common stock to the investor is equal to the present value of all of
the expected future dividends. The method that we have applied to value common stocks is
called dividend discount model.
85
2
1 r 1 r 1 r 3
Div
r
Div0 1 g 1 g
Div0 1 g
Divt Div0 1 g
Thus, the value of a stock under this constant growth dividend is:
Div3
Div1
Div2
P0
2
1 r 1 r 1 r 3
2
3
1 r
1 r
1 r
2
86
2
3
1 r
1 r
1 r
2
1 g 1 g 2 1 g 3
Div0
1 r 1 r 1 r
1 g 1 g 2 1 g 3
1 r
P
Div
0 1
0
1
g
1
r
1
r
1
1
Div0
1 g
1
1 r
Div0 1 g
P0
rg
Div1
rg
The price of the stock P0 is higher when:
Example 6.6
Suppose City Corporation just paid a dividend of $0.50. It is expected to increase its
dividend by 2% per year. If the market requires a return of 15%, how much should the stock
be selling for?
87
Example 6.7
The next dividend for City Corporation will be $4 per share and it is expected to grow at 6%
per year. The required return is 16%.
What is the current price?
What is the implied return given the change in price during the four year period?
This example illustrates that the constant growth model makes the implicit assumption that
the stock price will grow at the same constant rate as the dividend. In this model, both stock
price and dividends grow at g.
88
Div1
, the model implies:
rg
Div1
g
P0
This expression tells us that the total return has two components. The first part
Div1
is
P0
called the dividend yield, and the second part of the return is the capital gain.
89
Example 6.9
Suppose a share of City Corporation is selling for $10.50. It just paid a $1 dividend and
dividends are expected to grow at 5% per year. What is the required return?
90
Example 6.10
Suppose No-Growth Inc. has exactly the same asset that generates an expected $5 EPS
each year. This company pays out all its earnings as dividend, what is its stock price?
Since this company pays out all its earnings as dividend,
The difference between the stock price with growth and the stock price without growth is
called the present value of growth opportunities (PVGO).
The stock is like perpetuity if PVGO is 0. $40 is the present value of perpetuity with $5 each
year. It is also called capitalized earnings, or value of assets in place.
The two examples illustrate that stock price has two components:
Present value of earnings under a no-growth policy.
Present value of growth opportunities.
91
Example 6.11
City Corporation currently has assets in place that generates x of EBIT in perpetuity. At
time t, there is an investment opportunity I t that gives a return of r * in perpetuity.
Let:
x EBIT of current activities (perpetuity)
I t Investment at time t
r * Return on investment
r Discount rate
The cash flows of City Corporation will be:
92
Once again, this example shows that the stock price equals the present value of assets in place
plus the net present value of growth opportunities.
93
x
1
can increase the value of the firm as P0
r 1 r t
r * r x
It .
r r
However, the stock price will be decreased when firms undertake a negative NPV investment
( r * r ). It is always bad to have negative NPV investment since it will destroy the value of
the firm. It is better not to undertake the investment as P0
x
1 r * r x
It .
r 1 r t r r
94
NPV
t 1
Ct
1 r
I0
In order to compute the NPV of an investment project, the general capital budgeting
procedures involve:
1. Analyze the project cash flows.
2. Estimate the appropriate discount rate.
3. Consider other strategic options if any.
We are going to start bringing all these steps together.
95
96
Example 7.2
Two years ago, City Corporation hired a consultancy firm to do a marketing study in online
shopping at a cost of $20,000. And now it is planning to develop an online ordering site for
its latest product. Should the cost be included in the projects cash flows?
200,000
125,000
75,000
12,000
30,000
33,000
11,220
21,780
97
All the three approaches give you the same OCF. The best one to use is whichever happens
to be the most convenient for the problem at hand.
98
7.2.2 Depreciation
We have two approaches to calculate depreciation.
1. Straight-line
Depreciation Initial Cost Salvage No of Years
Example 7.3
You purchase equipment for $100,000 and it costs $10,000 to have it delivered and installed.
Based on past information, you believe that you can sell the equipment for $17,000 when you
are done with it in 6 years. What is the depreciation suppose the appropriate schedule is
straight-line?
3-year
5-year
7-year
Year
1
2
3
4
5
6
7
8
9
10
11
3-year
0.333
0.445
0.148
0.074
MACRS Table
5-year
0.200
0.320
0.192
0.115
0.115
0.058
7-year
0.143
0.245
0.175
0.125
0.089
0.089
0.089
0.045
10-year
0.100
0.180
0.144
0.115
0.092
0.074
0.066
0.066
0.065
0.065
0.033
99
Example 7.4
You purchase a car costing $12,000. What is the depreciation schedule if you apply MACRS?
Autos are classified as 5-year property. The depreciation each year is:
Year
1
2
3
4
5
6
MACRS Percentage
0.200
0.320
0.192
0.115
0.115
0.058
Depreciation
Notice that the MACRS percentages sum up to 100%. As a result, you write off $12,000 of
the cost of the asset.
7.2.3 After Tax Salvage
If the salvage value is different from the book value of the asset, then there is a tax effect.
The definition:
Book Value = Initial Cost Accumulated Depreciation
After Tax Salvage = Salvage T (Salvage Book Value)
Example 7.5
Suppose you want to sell your car after five years. The sale price is $3,000 at year 5 and the
tax rate is 34%. What is the after tax salvage?
Year
1
2
3
4
5
6
Depreciation
2,400
3,840
2,304
1,380
1,380
696
100
Example 7.6
Consider a replacement problem. City Corporation has an old machine purchased 5 years
ago. The initial cost of this old machine is $100,000. The annual depreciation is $9,000.
The salvage today is $65,000. If the machine is used for another 5 years, the salvage in 5
years will be $10,000.
If City Corporation decides to replace the old machine, the new machine will cost $150,000
and is last for 5 years. Depreciation follows 3-year MACRS. Salvage in 5 years will be zero.
This new machine helps saving $50,000 cost per year. The required return is 10% and the tax
rate is 40%.
Should City Corporation replace the machine?
Remember that we are interested in incremental cash flows. If we buy the new machine, then
we will sell the old machine.
First, we have to look at the cash flow consequences of selling the old machine today instead
of in 5 years. Then, figure out the OCF.
Cost Saving
Year 1
50,000
Year 2
50,000
Year 3
50,000
Year 4
50,000
Year 5
50,000
Depreciation
- New
- Old
Incremental
49,950
9,000
40,950
66,750
9,000
57,750
22,200
9,000
13,200
11,100
9,000
2,100
0
9,000
-9,000
9,050
3,620
5,430
-7,750
-3,100
-4,650
36,800
14,720
22,080
47,900
19,160
28,740
59,000
23,600
35,400
46,380
53,100
35,280
30,840
26,400
EBIT
Tax
NI
OCF
= NI + Dep
Year 0
-150,000
61,000
Year 5
-10,000
-89,000
-10,000
101
Year 0
OCF
NCS
NWC
-89,000
0
-89,000
Year 1
46,380
Year 2
53,100
Year 3
35,280
Year 4
30,840
46,380
53,100
35,280
30,840
Year 5
26,400
-10,000
0
16,400
Finally, we can compute the NPV and IRR based on the cash flows we have.
NPV = 54,801
IRR = 36.27%
7.2.4 Changes in Net Working Capital
Recall that net working capital (NWC) is the difference between current assets and current
liabilities.
Changes in NWC NWCt NWCt 1
102
The zither industry will have a rapid expansion in the next four years. With the brand name
recognition that City Corporation brings to bear, we feel that the company will be able to sell
3,200, 4,300, 3,900 and 2,800 units each year for the next four years respectively. Again,
capitalizing on the name recognition of City Corporation, we feel that a premium price of
$780 can be charged for each zither. Because zithers appear to be a fad, we feel at the end of
the four-year period, sales should be discontinued.
City Corporation believes that fixed costs for the project will be $425,000 per year, and
variable costs are 15% of sales. The equipment necessary for production will cost $4.2
million and will be depreciated according to a three-year MACRS schedule below. At the
end of the project, the equipment can be scrapped for $400,000. Net working capital of
$125,000 will be required immediately. City Corporation has a 38% tax rate, and the
required return on the project is 13%. What is the NPV of the project? Assume the firm has
other profitable projects.
Exhibit 7.1
MACRS Schedule
Year
3-year
1
33.33%
2
44.45%
3
14.81%
4
7.41%
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104
Unit sales
Price per unit
Variable costs per unit
Fixed costs per unit
Base Case
6,000
80
60
50,000
Lower Bound
5,500
75
58
45,000
Upper Bound
6,500
85
62
55,000
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Unit sales
Price per unit
Variable costs per unit
Fixed costs per unit
Base Case
6,000
80
60
50,000
Worst Case
Best Case
We can apply the tax shield approach to compute the operating cash flows for each scenario.
Once we have the OCF, we can calculate the NPV. Noted that the five-year annuity factor is
1
1
1
3.6048 .
5
0.12 1.12
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In summary,
Scenario
Base Case
Worst Case
Best Case
Cash Flow
59,800
24,490
99,730
NPV
15,567
-111,718
159,506
IRR
15.1%
-14.4%
40.9%
Unit sales
Price per unit
Variable costs per unit
Fixed costs per unit
Scenario
Base Case
Worst Case
Best Case
Base Case
6,000
80
60
50,000
Cash Flow
59,800
53,200
66,400
Worst Case
5,500
80
60
50,000
NPV
15,567
-8,225
39,359
Best Case
6,500
80
60
50,000
IRR
15.1%
10.3%
19.7%
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Graphical illustration:
50000
40000
30000
20000
NPV
10000
0
5,400
-10000
-20000
5,600
5,800
6,000
6,200
6,400
6,600
Unit Sales
The drawback of scenario and sensitivity analysis is that both methods are useful for pointing
out where forecasting errors will do the most damage, but they do not tell us what to do about
possible errors.
A final thought:
At some point, you have to make a decision.
If the majority of your scenarios have positive NPVs, then you can feel reasonably
comfortable about accepting the project.
If you have a crucial variable that leads to a negative NPV with a small change in the
estimates, then you may want to forgo the project.
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109
Donnalley not to consider cash flows occurring more than 15 years into the future, as
estimates that far ahead "tend to become little more than blind guesses."
Rainey cautioned against taking the annual cash flows (as shown in Exhibit 7.2) at face value
because portions of these cash flows actually are a result of sales that had been diverted from
Lift-Off and Wave. For this reason, Rainey also produced the annual cash flows that had
been adjusted to include only those cash flows incremental to the company as a whole (as
shown in Exhibit 7.3).
At this point, discussion opened between Donnalley and McDonald, and it was concluded
that the opportunity cost on funds is 10%. Gasper then questioned the fact that no costs were
included in the proposed cash budget for plant facilities, which would be needed to produce
the new product.
Exhibit 7.2
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast
(Including flows resulting from sales diverted from the existing product lines)
Year
1
2
3
4
5
6
7
8
Cash Flows
280,000
280,000
280,000
280,000
280,000
350,000
350,000
350,000
Year
9
10
11
12
13
14
15
Cash Flows
350,000
350,000
250,000
250,000
250,000
250,000
250,000
Exhibit 7.3
D&D Laundry Products Company Annual Cash Flows from the Acceptance of Blast
(Not including those flows resulting from sales diverted from the existing product lines)
Year
1
2
3
4
5
6
7
8
Cash Flows
250,000
250,000
250,000
250,000
250,000
315,000
315,000
315,000
Year
9
10
11
12
13
14
15
Cash Flows
315,000
315,000
225,000
225,000
225,000
225,000
225,000
Rainey replied that, at the present time, Lift-Offs production facilities were being used at
only 55% of capacity, and because these facilities were suitable for use in the production of
Blast, no new plant facilities other than the specialized equipment and packaging facilities
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previously mentioned need be acquired for the production of the new product line. It was
estimated that full production of Blast would require only 10% of the plant capacity.
McDonald then asked if there had been any consideration of increased working capital needs
to operate the investment project. Rainey answered that there had and that this project would
require $200,000 of additional working capital; however, as this money would never leave
the firm and always would be in liquid form, it was not considered an outflow and hence was
not included in the calculations.
Donnalley argued that this project should be charged something for its use of the current
excess plant facilities. His reasoning was that, if an outside firm tried to rent this space from
D&D, it would be charged somewhere in the neighborhood of $2 million, and since this
project would compete with the current projects, it should be treated as an outside project and
charged as such; however, he went on to acknowledge that D&D has a strict policy that
forbids the renting or leasing out of any of its production facilities. If they didnt charge for
facilities, he concluded, the firm might end up accepting projects that under normal
circumstances would be rejected.
From here, the discussion continued, centering on the questions of what to do about the "lost
contribution from other projects," the test marketing costs, and the working capital.
1. If you were put in the place of Steve Gasper, would you argue for the cost from market
testing to be included as a cash outflow?
2. What would your opinion be as to how to deal with the question of working capital?
3. Would you suggest that the product be charged for the use of excess production facilities
and building?
4. Would you suggest that the cash flows resulting from erosion of sales from current
laundry detergent products be included as a cash inflow? If there were a chance of
competition introducing a similar product if you do not introduce Blast, would this affect
your answer?
5. What are the NPV, IRR, and PI of this project, including cash flows resulting from lost
sales from existing product lines? What are the NPV, IRR, and PI of this project
excluding these flows? Under the assumption that there is a good chance that competition
will introduce a similar product if you do not, would you accept or reject this project?
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112
113
114
But why the financing activity has a zero NPV? Before we look at the answer of this
question, let us think about the implications behind the zero NPV.
A zero NPV in financing means the equity issued by the firm is fairly priced. In the example
above, the 40% ownership is worth $2. As a new investor, you are willing to pay for $2 or
less in exchange for the 40% ownership. However, the firm is only willing to sell you its
shares at $2 or more.
If there is trade between the firm and the new investor, we know the shares will be eventually
settled at $2 and both party can only make a zero NPV deal at the end.
Now, the key question becomes Are securities fairly priced?
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Example 8.2
Reaction of stock price to new information in efficient and inefficient markets:
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117
118
9.2 Returns
9.2.1 Dollar Returns
Total Dollar Return = Income from Investment + Capital Gain (Loss)
Example 9.1
You bought a bond for $950 one year ago. You have received two coupons of $30 each.
You can sell the bond for $975 today. What is your total dollar return?
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Divt Pt Pt 1
Pt 1
Divt Pt Pt 1
Pt 1
Pt 1
Example 9.2
You bought a stock for $35 and you received dividends of $1.25. The stock is now selling
for $40. What is your dollar return?
Dollar return = 1.25 + (40 35) = $6.25
What is your percentage return?
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121
Investment
Large Stocks
Small Stocks
Long-term Corporate Bonds
Long-term Government Bonds
U.S. Treasury Bills
Inflation
Average Return
12.3%
17.4%
6.2%
5.8%
3.8%
3.1%
Note that the geometric return will be less than the arithmetic return unless all the returns are
equal.
The arithmetic return is optimistic for long horizons.
The geometric return is pessimistic for short horizons.
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9.3 Risks
9.3.1 Risk Premiums
Risk premium is the extra return earned for taking on risk. We usually consider treasury
bills to be risk-free.
The risk premium is the return over and above the risk-free rate.
Investment
Large Stocks
Small Stocks
Long-term Corporate Bonds
Long-term Government Bonds
U.S. Treasury Bills
Average Return
12.3%
17.4%
6.2%
5.8%
3.8%
Risk Premium
12.3 3.8 = 8.5%
17.4 3.8 = 13.6%
6.2 3.8 = 2.4%
5.8 3.8 = 2.0%
3.8 3.8 = 0%
Var
1 T
2
ri r
T 1 i 1
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Example 9.4
A stock has a return of 15% in Year 1, 9% in Year 2, 6% in Year 3 and 12% in Year 4. What
are the variance and standard deviation of this stock?
The mean return:
Year
1
2
3
4
Total
The variance:
9.4 Expectation
In reality, the stock price in future is an unknown. We now begin to discuss how to analyze
returns and variances when the information we have concerns future possible returns and
their probabilities.
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E r pi ri
i 1
Example 9.5
Suppose you have predicted the following returns for Stocks C & T in three possible states of
nature. What are the expected returns?
State
Probability
0.3
0.5
0.2
Boom
Normal
Recession
Stock C
0.15
0.10
0.02
Stock T
0.25
0.20
0.01
2 pi ri r
i 1
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Example 9.6
Consider the previous example. What are the variance and standard deviation for each stock?
E rp wi E ri
N
i 1
Example 9.7
Suppose you have $15,000 to invest and you have purchased stocks in the following amounts.
Stock
A
B
C
D
Amount
2,000
3,000
4,000
6,000
Return
19.65%
8.96%
9.67%
8.13%
126
n n
127
128
Standard Deviation
20%
30%
Beta
1.25
0.95
129
Consider 3 stocks: T-bills, S&P500 and Apple Inc. The followings are the information:
T-bills
S&P500 (Market Portfolio)
Apple Inc. (Stock A)
Expected Return
5%
10%
15%
Beta
0
1
2
We can plot out there is a linear relationship between beta and expected return. The slope of
the line is the reward-to-risk ratio.
Slope
E rm rf
10 5
1
5
130
Suppose Stock S has a beta of 1 and an expected return of 12%. Knowing that Stock S has
the same beta risk as the S&P500, we should expect both stocks should give us the same
expected return. In this case, as the expected return of Stock S is greater than S&P500 (12%
> 10%), every investors in the market will want to buy Stock S instead of S&P500.
This will drive up the price of Stock S and push down its expected return until the reward-torisk ratio reaches 5.
Therefore in equilibrium, all stocks and portfolios must have the same reward-to-risk ratio,
and they all must equal the reward-to-risk ratio for the market.
E rA rf
E rm rf
Since the market beta is equal to 1, we can rearrange the above equation and get the
important formula:
E rA rf
E rA rf
E rm rf
E rm rf
1
E rA rf A E rm rf
This important formula is known as the Capital Asset Pricing Model (CAPM).
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Example 9.9
Consider the betas for each of the assets given below. If the risk-free rate is 3.15% and the
market risk premium is 9.5%, what is the expected return for each stock?
Stock
A
B
C
D
Weight
0.133
0.200
0.267
0.400
Beta
4.03
0.84
1.05
0.59
If we form a portfolio according to the weight, what will be the portfolio beta?
The portfolio beta is the weighted sum of each individual stocks beta.
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E
D
Re Rd 1 Tc
V
V
where :
Re Cost of Equity
Rd Cost of Debt
E Market Value of Equity
D Market Value of Debt
V DE
133
When we apply the dividend growth model approach, the two inputs: dividends and price are
observable. What we have to estimate is the growth rate. One method for estimating the
growth rate is to use the historical average.
134
Example 10.2
Suppose the dividend history of City Corporation is as follows:
Dividend
2005
1.23
2006
1.30
2007
1.36
2008
1.43
2009
1.50
Dividend
% Change
2005
2006
2007
2008
2009
1.23
1.30
5.7%
1.36
4.6%
1.43
5.1%
1.50
4.9%
Re rf e E rm rf
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Example 10.3
Suppose City Corporation has an equity beta of 0.58, and the current risk-free rate is 6.1%. If
the expected market risk premium is 8.6%, what is the cost of equity capital?
The advantages:
Explicitly adjusts for systematic risk.
Applicable to all companies, as long as we can estimate beta.
The disadvantages:
Have to estimate the expected market risk premium, which does vary over time.
Have to estimate beta, which also varies over time.
We are using the past to predict the future, which is not always reliable.
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Rp
D
P0
Example 10.5
City Corporation has preferred stock that has an annual dividend of $3. If the current price is
$25, what is the cost of preferred stock?
137
E
D
Re Rd 1 Tc
V
V
E
P
D
Re Rp Rd 1 Tc
V
V
V
where :
Re Cost of Equity
R p Cost of Preferred Stock
Rd Cost of Debt
E Market Value of Equity
P Market Value of Preferred Stock
D Market Value of Debt
V DEP
Dividends are not tax deductible, so there is no tax impact on the cost of equity.
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Common Stock:
Preferred Stock:
Market:
The tax rate is 34%. The project requires $825,000 in initial net working capital investment
to get operational.
1. Calculate the projects time 0 cash flow taking into account all side effects.
2. The new RDS project is somewhat riskier than a typical project for City Corporation,
primarily because the plant is being located overseas. Management has told you to use an
adjustment factor of +2 percent to account for this increased riskiness. Calculate the
appropriate discount rate to use when evaluating the project.
3. The manufacturing plant has an eight-year tax life, and uses straight-line depreciation. At
the end of the project (the end of year 5), the plant can be scrapped for $1.25 million.
What is the after tax salvage value of this manufacturing plant?
4. The company will incur $2,100,000 in annual fixed costs. The plan is to manufacture
11,000 RDS per year and sell them at $10,000 per machine; the variable costs are $9,300
per RDS. What is the annual operating cash flow from this project?
5. Finally, CEO wants you to throw all your calculations and all you assumptions. He wants
to know what are the IRR and NPV of the project.
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140
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