lecture 2_701609961
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Transcript of lecture 2_701609961
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Corporate Finance
2013/9/25
08 - 62794059
Department of Construction
Management
mailto:[email protected]:[email protected] -
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Todays contents
Valuation PrincipleInvestment Decision
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Time Value Terminology
Which one is more valuable? Time value of money
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Time Value Terminology
Time value of money is a basic concept of economics andfinance .
Value of money is changing on different points of the timeline: Inflation Real productivity of capital
Current money Use for consumption immediately and gain utility Spend on investment and gain more money in the future
Saving equals to give up the opportunity cost of the currentconsumption
Including return of risk investment and compensation for risk Riskless return + Risk premium As uncertainty is full in the future, risk would lower the value
of money in the future
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Consider the time line below:
PV is the Present Value , that is, the value today.
FV is the Future Value , or the value at a future date.
The number of time periods between the Present Value andthe Future Value is represented by t.
The rate of interest is called r.
. . . 0 1 2 3 t
PV FV
Time Value Terminology
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Time Value Terminology PV
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Perpetuities
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Calculate the present value for the project which would last for 10 years have an income of 1,000,000 USDat the end of each year, an expenditure of 120,000 USD for
management each year. Assume the pretax salvage value of the fixed assets at
the end of the project is around 500,000. The project has arequired return on investment of 4%.
Example:
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Example:
+1,000,000 USD
-120,000 USD
500,000 USDReturn on investment: 4%
year
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Annuities -- Basic Formulas
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Say you have 5,000 USD can be used for investment now.In order to save at least 50,000 USD 12 years later, at leasthow much rate of return should your investment plan give?
Example:
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Example:
Jill wants to retire twenty years from now. She wants to save enough so that she can have a pension of10,000 USD a year for ten years. How much she save
each year, denoted S, during the first twenty years toachieve her goal if the interest rate is 5%? Assume that all cash flows occur at the end of the
year so that it is possible to use the standard formula.
Thus the first date at which S is saved at date 1 and thefirst date which the 10,000 USD pension is received atdate 21.
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Draw a timeline so that stream of cash flow can be conceptualize.
Example:
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Example:
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Investment NPV ruler
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Investment NPV ruler
BMW should maximize NPV. It should accept anyof the projects which have a positive NPV. Theold lady cares about consumption now. she can
borrow and use shares to repay the loan, orequivalently, she can sell them. Similarly, the littleboy can deposit profits in the bank.
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Example:
A project requires an initial fixed asset investment of$600,000, which will be depreciated straight-line to zero over the 6-year life of the project. The pretax salvage value of the fixed assets atthe end of the project is estimated to be $50,000.
Projected sales volume for each year of the project is shownbelow. The sale price is $50 per unit for the first 3 years, and $45 perunit for years 4 through 6. Variable costs are $35 per unit, and fixedcosts are $50,000 per year. The firm has a required return on
investment of 12%. What is the NPV of the project?
Year 1 2 3 4 5 6
Salesvolume
10000 12500 15625 19531 24414 30518
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Investment NPV ruler
How should you analyze a proposed 1 million USDinvestment?
Forecast the cash flows generated by the projectDetermine the appropriate opportunity cost of capital, whichshould reflect the time value and the risk involved in the project.Discount the future cash flows of the project with the determineddiscount rate.Calculate the Net Present Value by subtracting 1 million USDfrom the Present Value of future cash flows.Invest if NPV>0.
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Investment NPV ruler How to determine the discount rate
The discount rate is the opportunity cost of investing inthe project rather than the capital markets
Instead of investing in the project, the firm can
distribute the cash as dividends and let the shareholdersinvest it in the financial markets The opportunity cost of taking the project is the return
the shareholders could have earned had they invested the
funds on their own Which Financial Assets should we compare with?
The opportunity cost only makes sense if assets ofequivalent risk are compared.
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Decision rule: The initial outlay on any projectshould be recoverable within some specific.
Example:
Project A B
-2000 -2000
+2000 +1000
0 +10000 +5000
Payback period, years 1 2
NPV at 10% -182 +3492
Investment NPV ruler The payback ruler
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It gives equal weight to all cash flows before the payback date
No weight to all subsequent flows
Arbitrary cutoff date
Result Accept too many short lived projects Reject too many long lived projects
Investment NPV ruler Problem with payback ruler
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Internal Rate of Return (IRR)
Decision rule: Accept project investmentopportunities offering rates of return in excess of theiropportunities cost of capital
Methodology: Find the discount rate which makes NPV=0
Accept the project if this rate exceeds the determinedopportunity cost of capital
The problem with the Payback rule are obvious. The problemswith the IRR rule are less obvious.
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Internal Rate of Return (IRR)
Cash Flows
-4000 +2000 +4000
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Internal Rate of Return (IRR)
Project D
0 -4000 +25000
2 -25000IRR% 25 and 400
NPV at 10% -1934
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Investment with inflation
It is important first to clarify the distinction between nominaland real.
Nominal: The actual number of USD and the actual interestrates.
Real: Taking into account of inflation such that the figures are,in some sense, what would have happened in the absence ofinflation.
In the context of capital budgeting, there are two ways ofthinking about the same thing
Either discount nominal cash flows at a nominal discountrate
Or discount real cash flows at a real discount rate Provided you do this, it does not matter whether you work in
real or nominal terms.
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Investment with inflation
Nominal Cash Flows
-1000 +800 +700
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Investment with inflation
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Investment with inflation
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Stock Valuation
The cash payoffs to stocks come in two forms Cash Dividends Capital Gains or Losses
The price today is determined by the present value of the dividendplus the present value of the price expected to obtain in 1 year.
0: Current price of share : Price of stock in 1 year
: Expected Dividend per share during next year r: Expected return on securities in the same risk class
0 = ( + )(1+ )
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More information in Rosss Book Chapter 3 to 7