CLASS NOTES

WEEK II

READING ASSIGNMENT
BMA 2 part II

Alex Kane 1 IPCOR421 Finance
 PV and NPV
• Suppose a firm can invest in a project that costs
C(0)= –$90 (negative for outflow) and yields
C(1)=$100 next year (nothing after), and the DF
is 0.95
• The PV of the project is DF*C(1)=0.95*100=$95
• We define the net present value of the project
(NPV) by:
NPV = C(0)+PV=C(0)+C(1)/(1+r)= –90+95 = $5
• NPV measures the increase in the value of the
corporation (hence, shareholders’ wealth) from
this activity
Alex Kane 2 IPCOR421  Finance
 Risk and PV (I)
• The future CF from a project is never certain
• We observe: riskier financial assets sell for less
• Conclusion
1. a risky (future) dollar is worth less than a safe one
2. humans are risk averse
3. speculation = take risk for a sufficient reward
4. gambling = paying for taking risk. In the small it is taken as
entertainment; when compulsive it is a disease
• To put a value on a risky CF we
1. project the probability distribution of the future cash flow,
and compute the expected value
2. discount the expected cash flow by a higher rate (use a
smaller DF) -- commensurate with the assessed degree of
risk (from the probability distribution above)
Alex Kane 3 IPCOR421  Finance
 Risk, PV and NPV
• Suppose the CF of the previous project is
uncertain and estimated by scenario analysis
• Event: (i=1) Slump (i=2) Normal (i=3) boom
Probability: 0.2 0.5 0.3
C(1): 45 110 120
• E[C(1)] = ΣPr(i)*CF(i) = sumproduct(Pr,CF)
= 0.2*45+0.5*110+0.3*120 = $100
• We must determine the DF, or equivalently, the
hurdle rate for the risky project?
Alex Kane 4 IPCOR421  Finance
 Required rates of return on risky projects
• Just as we obtain the required rate on safe assets
from observed prices of U.S. bonds, we look for
required rates on risky assets from prices of risky
assets in financial markets
• Suppose we observe: price of a stock (S), with a
probability distribution of CF identical to our
project, and S= $91. We determine the required
1-year rate of return for such risk from:
1+r =E[C(1)]/C(0)=100/91=1.0989 (r=9.89%); DF=.91

Alex Kane 5 IPCOR421  Finance
 The required risky rate
• Admittedly, finding a stock with probability
distribution identical to a given project is
difficult. We take on this issue later
• However, observation of a huge number of assets
over many years assures us that
– a statistical relationship (that can be estimated) exists
between risk and expected returns
– investors are, in the aggregate, quite consistent in
pricing risky assets (and quite risk averse)
• Hence, the relatively high required rate for this
risky project (9.89%) is no accident
Alex Kane 6 IPCOR421  Finance
 The NPV and expected return
• With a required rate of 9.89%, the NPV of our
project is
1. Using hurdle rate: –90+100/1.0989= –90+91= $1
2. Using the DF: –90 +.91*100 = $1
• We can compute the expected return on our
project (not the same as the required rate!) by:
E(r) = expected return = expected profit/investment
= (100–90)/90=0.1111 (11.11%)
• Notice: the expected return (11.11%) is greater
than the cost of capital (9.89%), indicating the
project has a positive NPV, as we already know
Alex Kane 7 IPCOR421  Finance
 Real-life analysis
• Using only three scenarios is quite crude. In
practice, more scenarios are used, and often a
continuous probability distribution (e.g. normal) is
projected, yielding the expected return
• In real life, it’s not likely to find one stock that
matches a project. In practice, a portfolio of
financial assets (not just stocks) is compiled to
match a project. The expected rate of return of the
portfolio is then taken as the required rate for the
project
Alex Kane 8 IPCOR421  Finance
 Foundation of NPV
• The NPV of a project comes from
1. the project: expected cash flows and risk assessment
2. market: the required rate for the assessed risk
• The expected rate of return which depends
ONLY on project data -- cannot, alone, be used
for decision making (need a benchmark)
• One role of financial markets in corporate
management is to supply data on prices of
projects already in place. These imply
benchmarks for new projects (DF, required
rate)
Alex Kane 9 IPCOR421  Finance
 Project background (how Fig.2.1is made)
• A venture capital fund (VC) has only one project on the
docket. The fund has $5 million to invest
• The project’s nature is such that it will take only one
year for cheap imitations to end the life of the project
• For the one year of profitable operations, the VC must
choose the scale of production
• A larger scale means
– build larger capacity
– sell more units, but at a lower price
• Given the risk, the required rate for this projects is 10%
• Total unit cost is $3 at any capacity (no returns to scale)
• Must decide the optimal scale
Alex Kane 10 IPCOR421  Finance
 Project data (except for unit price and
profit margin, all quantities in millions)
Investment Units Price Margin Cash flow NPV Return(h*)
5 12.5 3.38 0.38 4.75 –0.68 –5%
4.5 11.25 3.4 0.40 4.5 –0.41 0
4 10 3.42 0.42 4.2 –0.18 5
3.5 8.75 3.44 0.44 3.85 0 10
3 7.5 3.46 0.46 3.45 0.14 15
2.5 6.25 3.48 0.48 3 0.23 20
2 5 3.50 0.50 2.5 0.27 25
1.5 3.75 3.52 0.52 1.95 0.27 30
1 2.5 3.54 0.54 1.35 0.23 35
0.5 1.25 3.56 0.56 0.7 0.14 40
Alex Kane 11 IPCOR421  Finance
 Choice of scale
• The optimal scale is 3.75 million units (investment=$1.5)
• This scale maximizes NPV
• Why can the rate of return be misleading?
– because it is an average, not incremental
– each increase in scale is a project unto itself
– The excel file computes the incremental return from increased
scale
– It shows the incremental return on increasing scale from 1.5 to
2 mil units is 10%, which is why the NPV does not change
• NPV is the one and only correct measure of project value

Alex Kane 12 IPCOR421  Finance
 The transformation curve of the
Project (subtext for Fig.2.1 in text)
Notes
slope of tangent equals 1+h  
(the incremental rate h<h*)
Operating income from investment

(1) h is the rate of return on 
the incremental project. (2) 
notice the difference between 
the incremental (marginal) h 
project Income =   and average h*. (3) The 
I(1+h*) curve shows a decreasing 
incremental rate, h. (4) The 
incremental rate may even 
turn negative.
slope=1+h* 
h*=average h
Resources and 
Invested in  Invested in  Investments
financial markets project
R=5
Alex Kane 13 IPCOR421  Finance
 How the market rate is determined
• Suppose at any one time we take all the projects of the
same risk characteristics and order them from high to
low expected rate of return
• We can now measure the rate of return against the
amount of investment in the economy (at that level of
risk)
• Supply of capital determines the aggregate level of
investment
• As in the market for goods/services, projects of other
level of risk compete with these projects, so supply is
affected by the quality of projects of other risk classes
Alex Kane 14 IPCOR421  Finance
 Marginal efficiency of capital and the
market rate
Rate of return marginal efficiency 
of capital
supply of capital average rate of return 
in the economy

required 
rate

aggregate investment Investment
Alex Kane 15 IPCOR421  Finance
 Expected annual increase in wealth
• Note that accepted projects (in all risk classes)
earn a rate of return greater than the cost of
capital, that is, generate positive NPV
• The aggregate NPV of the projects is the
expected increase in wealth of the economy
• These numbers are all forward looking, hence we
are talking about EXPECTED increase in wealth
• How can we actually see this? The total market
value of the business sector will increase by NPV
Alex Kane 16 IPCOR421  Finance
 Actual increase/decrease in wealth
• In the 1990s, forecasts of demand for high-tech
products, particularly broad-band capacity, was
very high. Aggregate NPV of projects was high
• Huge capacity was built and the NPV reflected in
NASDAQ = 5000
• In 2000, realization set in that forecasts will not be
realized. Many projects were terminated (value
fell to zero) revised NPV of others fell sharply
• Revision in forecasts caused assets prices to fall,
NASDAQ fell to about 1200!!
Alex Kane 17 IPCOR421  Finance
 Maximizing profit
• You hear a lot about ‘profit maximizing’ in
economics courses and on the street
• Really it means maximizing NPV. Otherwise
– profit of which year?
– using which accounting convention?

Alex Kane 18 IPCOR421  Finance