Corporate Finance

2013/9/25

Zan Yang
zanyang@tsinghua.edu.cn 08 - 62794059 Department of Construction Management

Todays contents

Valuation Principle Investment Decision

Time Value Terminology

Which one is more valuable?

Time value of money

Time Value Terminology

Time value of money is a basic concept of economics and finance. 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 current consumption 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

Time Value Terminology

Consider the time line below:

0 PV 1 2 3 ... FV t

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 and

the Future Value is represented by t.

The rate of interest is called r.

Time Value Terminology PV

Time Value Terminology PV

Perpetuities

Annuities

Example: Calculate the present value for the project which would last for 10 years have an income of 1,000,000 USD at 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 a required return on investment of 4%.

Example:
Return on investment: 4% +1,000,000 USD year 500,000 USD

-120,000 USD

Annuities -- Basic Formulas

Example: 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 least how much rate of return should your investment plan give?

Example: Jill wants to retire twenty years from now. She wants to save enough so that she can have a pension of 10,000 USD a year for ten years. How much she save each year, denoted S, during the first twenty years to achieve 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 the first date which the 10,000 USD pension is received at date 21.

Example:
Draw a timeline so that stream of cash flow can be conceptualize.

Example:

Investment NPV ruler

Example
Suppose you are at a BMW shareholder meeting. Three of the shareholders have very different ideas about what the firm should do Pension Fund Old lady: representative: Wants money now and therefore Wants money in 20 years. wants BMW to invest in luxury cars, Thinks there will be a which would yield a quick profit. serious oil crisis in that period. Recommends Little boys trust fund BMW to build small cars. representative: Wants money long way in the future. Wants Volvo to invest in building electronic cars.

Investment NPV ruler BMW should maximize NPV. It should accept any of the projects which have a positive NPV. The old lady cares about consumption now. she can borrow and use shares to repay the loan, or equivalently, she can sell them. Similarly, the little boy can deposit profits in the bank.

Example:
A project requires an initial fixed asset investment of $600,000, which will be depreciated straight-line to zero over the 6year life of the project. The pretax salvage value of the fixed assets at the end of the project is estimated to be $50,000. Projected sales volume for each year of the project is shown below. The sale price is $50 per unit for the first 3 years, and $45 per unit for years 4 through 6. Variable costs are $35 per unit, and fixed costs 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

Sales volume

10000

12500

15625

19531

24414

30518

Example:
Return on investment: 12% +$50/unit +$45/unit

$50,000

year

-$35/unit
-$50,000

-$600,000

Investment NPV ruler

How should you analyze a proposed 1 million USD investment?

Forecast the cash flows generated by the project Determine the appropriate opportunity cost of capital, which should reflect the time value and the risk involved in the project. Discount the future cash flows of the project with the determined discount rate. Calculate the Net Present Value by subtracting 1 million USD from the Present Value of future cash flows. Invest if NPV>0.

Investment NPV ruler How to determine the discount rate The discount rate is the opportunity cost of investing in the project rather than the capital markets Instead of investing in the project, the firm can distribute the cash as dividends and let the shareholders invest 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 of equivalent risk are compared.

Investment NPV ruler The payback ruler Decision rule: The initial outlay on any project should be recoverable within some specific. Example:
Project A
-2000 +2000

B
-2000 +1000

0
0 Payback period, years NPV at 10% 1 -182

+1000
+5000 2 +3492

Investment NPV ruler Problem with payback ruler 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

Internal Rate of Return (IRR) Decision rule: Accept project investment opportunities offering rates of return in excess of their opportunities cost of capital
Methodology: Find the discount rate which makes NPV=0

Accept the project if this rate exceeds the determined opportunity cost of capital The problem with the Payback rule are obvious. The problems with the IRR rule are less obvious.

Internal Rate of Return (IRR)

Cash Flows

-4000

+2000

+4000

Internal Rate of Return (IRR)

Project 0 1 2 IRR% NPV at 10% D -4000 +25000 -25000 25 and 400 -1934

Investment with inflation

It is important first to clarify the distinction between nominal and real. Nominal: The actual number of USD and the actual interest rates. Real: Taking into account of inflation such that the figures are, in some sense, what would have happened in the absence of inflation. In the context of capital budgeting, there are two ways of thinking about the same thing Either discount nominal cash flows at a nominal discount rate 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.

Investment with inflation

In Europe, US and Japan people deal in nominal terms since this is the form in which the data is presented. However, in high inflation counties such as Eastern Europe and many Latin American countries, until recently, it is often easier to work in real terms since you usually have much better feel for the numbers and pick up errors more quickly. For example, if inflation was 20% per year and the cheapest available new car now costs 10,000 USD, how much would it cost in five years time? Would it be 20,000 USD or 25,000 USD? It is difficult to tell. In fact it would be 25,000 USD. What about in ten years time? Would it be 50,000 USD or 60,000 USD?

Investment with inflation

Nominal Cash Flows -1000 +800 +700

Investment with inflation

Investment with inflation

Example Cash Flows Nominal =Real -1000 1 -1000 +800 1.4 +571.4 +867.3 +700

Investment with inflation

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 dividend plus the present value of the price expected to obtain in 1 year. 0 : Current price of share 1 : Price of stock in 1 year 1 : Expected Dividend per share during next year r: Expected return on securities in the same risk class (1 + 1 ) 0 = (1 + )

Stock Valuation
But what determines next years price 1 ?
(2 + 2 ) 1 = (1 + )

Substituting for 1 in the first equation

(1 ) (2 ) 2 0 = + + (1 + ) (1 + )2 (1 + )2

We can continue similarly. For H periods

0 = + (1 + ) (1 + )

Common stocks have nod ate at which they run out. They are unending.
0 = (1 + )

Stock Valuation The price of a share is equal to the PV of future dividend. How to determine ? Often assumed that dividend will grow at a constant rate g = (1 + )1

The constant growth formula

0 = 1 (1 + )1 1 = (1 + ) ( )

More information in Rosss Book Chapter 3 to 7