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: skedia@rbsmail.rutgers.edu Financial Management W 6.40- 9.40 22:390:587:61, Fall 2007 New Brunswick, LCB-109

Financial Management This course is an introductory course in finance. After a brief introduction on financial markets and institutions, we will look at the decision criteria a firms uses to evaluate which projects to undertake, how it raises money from capital markets and how it decides on which financial instruments, i.e., debt or equity to use. We will examine in depth how firm’s make real investment decisions to maximize shareholder value. Textbook and Readings Required Text: Corporate Finance, by Ross, Westerfield, and Jaffe, 8th Edition. Supplemental material will be added in Lecture notes that will be available on Blackboard. Office Hours The usual office hours will be on Wednesday evening from 5.00 – 6.30 pm. My office is Levin 143. If you are not able to make it of office hours and have been attending class regularly please contact me and we will schedule another time. It is easiest to reach me by email. Grading: Your grade will be determined as follows: homework assignments (10%), mid-term examination (40%), and final examination (50%). Problem sets are meant to be individual work and to help you to practice and consolidate concepts before we move to new subjects. All problems set are to be handed to me on the appointed day or before. I will not accept problem set by email. If you are not able to make it to class that day, you can drop the problem set in my mail box anytime before the class. The midterm is scheduled for October 17th. I would encourage all students to ensure that they take the midterm at the appointed day. Topics and their approximate order: These topics do not correspond to class sessions for each week. Some topics might take longer than anticipated and some shorter, but by and large we will follow the order of these topics. Some modifications will develop as the course develops.

Classes 5th September 12th September 19th September 26th September 3rd October 10th October 17th October 24th October 31st October 7th November 14th November 21st November 28th November 5th December

Chapters 1,4 5 5,6 6 7 8, 9

Topics Introduction, Basics, Time Value of Money Bond Valuation Stock Valuation, Capital Budgeting Making Decisions Using NPV Discounted Cash Flow DCF, Real Options, Risk First Problem Set due and discussed Midterm

9, 10 11 15 16

Risk and Return Cost of Capital Capital Structure Limits to the use of Debt No Classes

17, 13

Valuation for levered firm, Market Efficiency, Summary, Overview 2nd Problem Set due and discussed

Introduction

Class of September 5th

**Prof. Simi Kedia Financial Management
**

Rutgers Business School

Information

Professor: Simi Kedia Phone: 973-353-1145 Email: skedia@business.rutgers.edu Office Hours: 5.00 – 6.15 Wednesday Levin 113

Textbook and Readings

Required Text: Corporate Finance by Ross, Westerfield and Jaffe, 8th Edition. Supplemental material will be added in Lecture notes that will be available on Blackboard.

Grading

Problem Sets

There are two problem sets Together they account for 10% of the grade

Exams

There are two exams Midterm: 40% Final: 50%

Exam attendance

I would really like you to take the exam at the appointed day and time If you have to miss

Need verifiable and acceptable reason Make up exam will be harder

The Course

This is the required course in Finance

We will spend most of the time mastering basic and core concepts We will not spend much time on the cutting edge of finance For those of you that have done this before – it may seem slow. For those of you that have not seen it before – it may seem fast Most of the course and the exams will be quantitative and number driven Please ask questions and stop me if you have questions.

What will we do?

The course is about giving you an understanding of how firms or corporations make their financial decisions Context

What is a firm or corporation? What is the role of finance in a firm? What is the environment in which firms make and implement financial decision?

Financial Markets, Instruments and Institutions

Corporations

Examples of corporations?

Microsoft Procter and Gamble General Electric

**What else do we see that is not a corporation?
**

Partnerships

Consulting firms: Mckenzie, Ernst and Young, e.tc

Sole Proprietor

Corner Deli, Dry Cleaning store

Characteristics of Corporations

Several Shareholder (owners)

Partnerships are owned by small group of partners Sole proprietors are owned by a individual

**Limited Liability Professional Management
**

Separation of ownership and control

Board of directors Legal Entity: Pay taxes, can be sued

Role of Finance

What Projects?

Applications in all areas

Marketing: Invest in advertising campaign? Operations: Invest in new machinery or use the old one at higher operating cost

Capital Budgeting Decision

**How to Finance the projects?
**

Financial markets, instruments Issue Equity or Debt Capital Structure Decision

Decision criteria

Maximize Firm Value

What is Debt?

When companies borrow money They promise to repay the money back after a fixed number of years --- maturity of debt They pay interest on the amount borrowed Adhere to some guidelines…Debt Covenants What if they cannot pay the money back?

What if they owe a million dollars but all the assets in the firm are worth only $100,000 Bankruptcy

Examples:

Verizon borrows 5 million dollars from Citi Bank for a new plant Pfizer issues 20 years bonds paying 5% 6 month treasury bills

What is Equity?

This is selling ownership Corporations can sell shares to raise money What happens if the firm is not doing well and your shares are not worth the purchase price?

NOTHING. The firm is not obliged to compensate you for the loss in your investment If the firm has some money, it has to pay the debt before

Financial Markets

Capital Markets

Long term financing: Debt and Equity

Debt: Public debt and Bank debt Equity

Money markets

Short term financing

Commercial paper Trade Credit

Financial Institutions

Mutual Funds

Raises money from investors (by selling its shares) and invests in the shares of firms

Pension Funds

Gets money from employees and invests in the shares of the firms

Banks

Get deposits and makes loans to firms In the US not allowed to invest in equity

Insurance Company

Gets money when consumers buy insurance policy

Financial Statements

This is how the firm communicates with the market and investors Summary of firm’s activity and performance They are prepared on a routine basis They have been standardized so that we can follow clearly what they do. What are the main financial statements of the firms

Balance Sheet Income Statement Cash flow Statement

Financial Statements

Balance Sheet

Snapshot of assets and liabilities at a point in time Prepared by firms at fiscal year end

Income Statement

Summary of firm’s activity over the year Total Revenues, total costs and net profits

**Cash Flow Statement
**

Shows the firm’s cash receipts and cash payments For e.g., a store can sell furniture for cash or for credit Important to see what the net cash flow vs. profits

Classes 5th September 12th September 19th September 26th September 3rd October 10th October 17th October 24th October 31st October 7th November 14th November 21st November 28th November 5th December

Chapters 1,4 5 5,6 6 7 8, 9

Topics Introduction, Basics, Time Value of Money Bond Valuation Stock Valuation, Capital Budgeting Making Decisions Using NPV Discounted Cash Flow DCF, Real Options, Risk First Problem Set due and discussed Midterm

9, 10 11 15 16

Risk and Return Cost of Capital Capital Structure Limits to the use of Debt No Classes

17, 13

Valuation for levered firm, Market Efficiency, Summary, Overview 2nd Problem Set due and discussed

Time Value of Money Chapter 4

**Future Value: One Year
**

What is the Value of $100 invested for 1-year if the interest rate is 9%? After 1-year you earn:

Interest = .09(100) = $9.00 Total value = $100 + $9.00 = $109 Total Value = $100 (1+.09) = $100(1.09)

This is also called Future Value (FV)

**Future Value: Two Years
**

What is the future value of $100 in 2 years if the interest rate is 9%. After 1-year we have $109.

Second year interest = .09(109) = $9.81 Future Value = $100 + $9 + $9.81 = 118.81 Future Value = $109 + 9.81 FV = $109*(1+.09) FV = $100 (1.09)2

**General Future Value Formula
**

In general the future value of $P invested today for n years is: FV = P(1+r)…(1+r) = P(1+r)n Terminology

FV = Future Value. PV = Present Value. The value of a cash flow right now. It is also P the principal r = the interest rate (sometimes i). Unless other wise stated it is annual interest N = time period (sometimes t). Unless specified, number of years.

Example

Ex: P = $1000, r = 8% How much will you have at the end of 10 years?

At the end of 10 years you have: FV = $1000(1+.08)10 = $2,158.925

**How much will you have in 5 years if r = 10%
**

FV = $1000(1+.10)5 = $1,610.51

**Ways to calculate Future Value
**

Ex: P = $1000, N = 10, r = 8%:

1.

**Regular calculator, use yx key.
**

FV = $1000(1+.08)10 = $2,158.925

2.

**FV tables – Future Value Interest Factor or FVIF - (Table A.3)
**

FVIF(8%,10) = 2.1589 FV = $1000*2.1589 = $2,158.90

**Future value interest factor of $1 per period at i% for n periods, FVIF(i,n).
**

Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 35 40 50 1% 1.010 1.020 1.030 1.041 1.051 1.062 1.072 1.083 1.094 1.105 1.116 1.127 1.138 1.149 1.161 1.173 1.184 1.196 1.208 1.220 1.282 1.348 1.417 1.489 1.645 2% 1.020 1.040 1.061 1.082 1.104 1.126 1.149 1.172 1.195 1.219 1.243 1.268 1.294 1.319 1.346 1.373 1.400 1.428 1.457 1.486 1.641 1.811 2.000 2.208 2.692 3% 1.030 1.061 1.093 1.126 1.159 1.194 1.230 1.267 1.305 1.344 1.384 1.426 1.469 1.513 1.558 1.605 1.653 1.702 1.754 1.806 2.094 2.427 2.814 3.262 4.384 4% 5% 6% 7% 1.040 1.050 1.060 1.070 1.082 1.103 1.124 1.145 1.125 1.158 1.191 1.225 1.170 1.216 1.262 1.311 1.217 1.276 1.338 1.403 1.265 1.340 1.419 1.501 1.316 1.407 1.504 1.606 1.369 1.477 1.594 1.718 1.423 1.551 1.689 1.838 1.480 1.629 1.791 1.967 1.539 1.710 1.898 2.105 1.601 1.796 2.012 2.252 1.665 1.886 2.133 2.410 1.732 1.980 2.261 2.579 1.801 2.079 2.397 2.759 1.873 2.183 2.540 2.952 1.948 2.292 2.693 3.159 2.026 2.407 2.854 3.380 2.107 2.527 3.026 3.617 2.191 2.653 3.207 3.870 2.666 3.386 4.292 5.427 3.243 4.322 5.743 7.612 3.946 5.516 7.686 10.677 4.801 7.040 10.286 14.974 7.107 11.467 18.420 29.457 8% 1.080 1.166 1.260 1.360 1.469 1.587 1.714 1.851 1.999 2.159 2.332 2.518 2.720 2.937 3.172 3.426 3.700 3.996 4.316 4.661 6.848 10.063 14.785 21.725 46.902 9% 10% 11% 12% 13% 14% 15% 1.090 1.100 1.110 1.120 1.130 1.140 1.150 1.188 1.210 1.232 1.254 1.277 1.300 1.323 1.295 1.331 1.368 1.405 1.443 1.482 1.521 1.412 1.464 1.518 1.574 1.630 1.689 1.749 1.539 1.611 1.685 1.762 1.842 1.925 2.011 1.677 1.772 1.870 1.974 2.082 2.195 2.313 1.828 1.949 2.076 2.211 2.353 2.502 2.660 1.993 2.144 2.305 2.476 2.658 2.853 3.059 2.172 2.358 2.558 2.773 3.004 3.252 3.518 2.367 2.594 2.839 3.106 3.395 3.707 4.046 2.580 2.853 3.152 3.479 3.836 4.226 4.652 2.813 3.138 3.498 3.896 4.335 4.818 5.350 3.066 3.452 3.883 4.363 4.898 5.492 6.153 3.342 3.797 4.310 4.887 5.535 6.261 7.076 3.642 4.177 4.785 5.474 6.254 7.138 8.137 3.970 4.595 5.311 6.130 7.067 8.137 9.358 4.328 5.054 5.895 6.866 7.986 9.276 10.761 4.717 5.560 6.544 7.690 9.024 10.575 12.375 5.142 6.116 7.263 8.613 10.197 12.056 14.232 5.604 6.727 8.062 9.646 11.523 13.743 16.367 8.623 10.835 13.585 17.000 21.231 26.462 32.919 13.268 17.449 22.892 29.960 39.116 50.950 66.212 20.414 28.102 38.575 52.800 72.069 98.100 133.176 31.409 45.259 65.001 93.051 132.782 188.884 267.864 74.358 117.391 184.565 289.002 450.736 700.233 1,083.657

Observation on FV

Which of the following are true FV factors are always greater the 1 Future value of a 1$ for 8% is higher at 3 years than at 5years. Future value 1$ for 5 years is higher at 10% than at 8%

**Simple vs. Compound Interest
**

Simple Interest:

Interest is paid just on original principle

Compound Interest

Interest is paid on principle plus past earned interest.

**Simple Interest Example
**

Interest is paid only on the principle. Ex. Invest $100 for 2 years with 10% simple interest.

Interest earned in year 1 = 100*.10 = $10 Interest earned in year 2 = 100*.10 = $10 Total payout (after 2 years) = $120

Compound Interest: FV = P(1+r)n

Compound Interest

What if the compounding interval is less than a year? For example: What is the FV of $100 invested for 2 years at 10% annual interest compounded semi-annually?

FV = $100(1+(.10/2))4 = $121.55 FV = $100(1+.05)4 = $121.55

Compound Interest II

In general: FV = $P(1+r/k)nk r = annual interest rate k = compounding intervals per year n = number of years

Compounding Interval

What is the future value if you invest $100 for 2-years at 10% and receive quarterly compounding?

K=4 FV =$100(1+.(10/4))8 = $121.84

What is the future value if you invest $100 for 2-years at 10% and receive monthly compounding?

K = 12 FV = $100(1+.(10/12))24 = $122.04

Example

Suppose I invest $100 for 1-year at 10% compounded semi-annually. How much do I have in one year?

FV = $100 (1.05)2=$110.25

**What is your total return for the year?
**

Return=(110.25-100)/100 = 10.25/100 = 10.25%

In this example the stated rate is 10%. The effective annual rate (EAR) is 10.25%

**Effective Annual Rate
**

Effective Annual Rate (EAR)

This is the effective yield you receive over a 1year period

**Stated Annual Rate
**

This is the rate stated as the annual rate.

**Why would these be different?
**

Compounding

**EAR with more compounding
**

Consider the same $100 investment at a 10% rate for one year. Compounded: Quarterly:

FV = 100 (1+.10/4)4 = 110.38 EAR = 10.38%

**Monthly: FV = 100(1+.10/12)12=110.47
**

EAR = 10.47%

**Daily: FV = 100(1+.10/365)365=110.52
**

EAR = 10.52%

**EAR with a 2-year problem
**

How do I calculate the EAR if I’m investing for 2-years? Consider Investing $150 for 2-years at 8% compounded quarterly. What is my EAR?

Answer

1.

Calculate the FV:

FV = $150(1+.02)8=175.75

2.

**Determine what interest rate (compounded annually) will give you FV = 175.75
**

FV = 150(1+EAR)2= 175.75 (1+EAR)2 = 175.75/150 = 1.1717 (1+EAR) = SQ Root(1.1717)=1.0825 EAR = .0825 = 8.25%

Present Value

Present Value (PV) is the value of future cash flows right now, today. We saw earlier that the future value of $P invested today for n years is: FV = P(1+r)…(1+r) = P(1+r)n So Present Value of FV is $P

**Present Value: Example
**

What is the PV of $1000 received 3 years from now if the interest rate is 8%?

If we have X dollars today and invest it for 3-years at 8%, what is the FV? FV = $X(1+.08)3 = $1000 $X = $1000/(1.08)3 = $793.83 So, PV of $1000 3-years from now at 8% interest is $793.83

Present Value

The present value of $F paid in n years is: PV = F/(1+r)n = F x [1/(1+r)n] F is the Future Value r is the interest rate n is the number of years

**Example: Present Value
**

What is the present value of $ 1213 received

In 9 years If interest rate is 7%?

Present Value is

PV = $1213/(1.07)9 = 659.79 Can use the Present Value Tables (A1) PVIF(7%,9) = 0.5439 PV = $1213 * 0.5439 = $659.7

**Present value interest factor of $1 per period at i% for n periods, PVIF(i,n).
**

Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 35 40 50 1% 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.896 0.887 0.879 0.870 0.861 0.853 0.844 0.836 0.828 0.820 0.780 0.742 0.706 0.672 0.608 2% 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.804 0.788 0.773 0.758 0.743 0.728 0.714 0.700 0.686 0.673 0.610 0.552 0.500 0.453 0.372 3% 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.722 0.701 0.681 0.661 0.642 0.623 0.605 0.587 0.570 0.554 0.478 0.412 0.355 0.307 0.228 4% 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.650 0.625 0.601 0.577 0.555 0.534 0.513 0.494 0.475 0.456 0.375 0.308 0.253 0.208 0.141 5% 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614 0.585 0.557 0.530 0.505 0.481 0.458 0.436 0.416 0.396 0.377 0.295 0.231 0.181 0.142 0.087 6% 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 0.527 0.497 0.469 0.442 0.417 0.394 0.371 0.350 0.331 0.312 0.233 0.174 0.130 0.097 0.054 7% 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.475 0.444 0.415 0.388 0.362 0.339 0.317 0.296 0.277 0.258 0.184 0.131 0.094 0.067 0.034 8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.429 0.397 0.368 0.340 0.315 0.292 0.270 0.250 0.232 0.215 0.146 0.099 0.068 0.046 0.021 9% 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.388 0.356 0.326 0.299 0.275 0.252 0.231 0.212 0.194 0.178 0.116 0.075 0.049 0.032 0.013 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 0.218 0.198 0.180 0.164 0.149 0.092 0.057 0.036 0.022 0.009 11% 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124 0.074 0.044 0.026 0.015 0.005 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104 0.059 0.033 0.019 0.011 0.003 13% 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087 0.047 0.026 0.014 0.008 0.002 14% 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073 0.038 0.020 0.010 0.005 0.001 15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 0.107 0.093 0.081 0.070 0.061 0.030 0.015 0.008 0.004 0.001

**Interest Rates and Time Changes
**

PV of $1000 3-years from now at 8% interest is $793.83 What is the PV of $1000 received in 3-years if the interest rate is 10%? Less than or greater than $793.83?

PV = $1000/(1.10)3 = 751.31 < $793.83

What is the PV of $1000 received in 5 years if the interest rate is 10%? Less than or greater than $793.83?

PV = $1000/(1.10)5 = $620.92 < $751.31

**Example: Comparing Cash Flows
**

You can receive either:

1. 2. 3.

$100 now $110 in 1-year $115 in 2 years. The discount rate is 8% Which option will you choose? Why?

**Converting to Present Value
**

To compare cash that come over different times, you need to change them to the same year. The most obvious is to convert them to year zero or now or present value

1. 2. 3.

PV = 100 PV = 110/1.08 = 101.85 PV = 115/(1.08)2 = 98.59 ⇒ Choose (b)

**Converting to Future Value
**

You can also convert to future value.

Convert to the largest number of years. In this example it is two years

1. 2. 3.

FV = 100(1.08)2 = 116.64 FV = 110 (1.08)1 = 118.8 FV = 115 ⇒ Choose (b)

**Can you convert to any other year?
**

You can convert to any year you want and compare. The answer will be the same

Say convert to the end of year one

1. 2. 3.

FV = 100(1.08)1 = 108 FV = 110 = 110 FV = 115/(1.08)1 = 106.48 ⇒ Choose (b)

Example: PV of multiple CF

Suppose you are offered an investment that gives you $200 in 1-year, $400 in 2-years, and $600 in 3-years. The discount rate, r is 12%. What is this investment worth today?

Present Value

We can calculate the PV of each cash flow individually and then add them up. Year $200 $400 $600 PV of Cash Flow 200/1.12 = 178.57 400/(1.12)2= 318.88 600/(1.12)3=427.07 Total(PV)= $924.52

1 2 3

PV Additivity

Suppose you have a stream of cashflows for the next three years: Year 0 1 2 3 Cashflow C0 C1 C2 C3 PV = C0 + C1/(1+r) + C2/(1+r)2 + C3/(1+r)3

**FV of multiple cash flows
**

What if you will receive $100 in 1-year, 200 in 2-years, and $150 in 3-years. The interest rate is 10%. You are planning to buy a car in three years. How much will have from the above at the end of 3 years?

**FV of multiple cash flows
**

FV is additive too:

FV = $100(1.10)2 +$200(1.1)+150 FV = 121 + 220 + 150 = 491.00

Year Cashflow

0 C0

1 C1

2 C2

3 C3

FV = C0 (1+r)3 + C1(1+r)2 + C2(1+r) + C3

**Example2: Value of multiple CF
**

Suppose you are offered an investment that gives you $220 in 1-year, $440 in 2-years, and $500 in 3-years. The discount rate, r is 12%. What is the PV of these cash flows? What is the FV of these cash flows?

**Value of multiple cash flows
**

1 2 3 Year $220 $440 $500 PV of Cash Flow 220/(1+.12) = 196.42 440/(1.12)2= 350.75 500/(1.12)3= 355.89 Total(PV)= $903.08 FV of Cash Flow 220*(1.12)2 = 275.97 440*(1.12) = 492.8 500 = 500 Total(FV) = $1268.77

Year

1 2 3

$220 $440 $500

What is the PV of $1268.77?

**Annuities and Perpetuities
**

Next we turn to regular cash flow streams, Annuities and Perpetuities

Annuity

An annuity is a regular stream of payments for a specified period of time. For Example: An annuity of C dollars for T years will payout C dollars, beginning in one year, every year for the next T years.

Example: Annuity

Consider an annuity of $150 per year for 3 years. Year Cash Flow 1 $150 2 $150 3 $150 What is the PV of the annuity if the interest rate is 10%?

PV Annuity

We can just take the PV of the individual cash flows and then add them up. Year Cash flow PV 1 150 150/1.1 = 136.36 2 150 150/(1.1)2 = 123.97 3 150 150/(1.1)3 = 112.70 Total (PV annuity) = 373.03

PV Annuity

We can also calculate the PV of the annuity using the tables. The three PVIF at 10% are 0.9091, 0.8264, and 0.7513

PV = $150(.9091+.8264+.7513) PV = $150(2.4868) = 373.02

**We can also use the PVIFA table (A.3) and find PVIFA(10%,3) = 2.4869
**

PV = $150(2.4869)=373.04

**Present value interest factor of an (ordinary) annuity of $1 per period at i% for n periods, PVIFA(i,n).
**

Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 35 40 50 1% 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 10.368 11.255 12.134 13.004 13.865 14.718 15.562 16.398 17.226 18.046 22.023 25.808 29.409 32.835 39.196 2% 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 9.787 10.575 11.348 12.106 12.849 13.578 14.292 14.992 15.678 16.351 19.523 22.396 24.999 27.355 31.424 3% 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 9.253 9.954 10.635 11.296 11.938 12.561 13.166 13.754 14.324 14.877 17.413 19.600 21.487 23.115 25.730 4% 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 8.760 9.385 9.986 10.563 11.118 11.652 12.166 12.659 13.134 13.590 15.622 17.292 18.665 19.793 21.482 5% 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722 8.306 8.863 9.394 9.899 10.380 10.838 11.274 11.690 12.085 12.462 14.094 15.372 16.374 17.159 18.256 6% 0.943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 7.887 8.384 8.853 9.295 9.712 10.106 10.477 10.828 11.158 11.470 12.783 13.765 14.498 15.046 15.762 7% 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 7.499 7.943 8.358 8.745 9.108 9.447 9.763 10.059 10.336 10.594 11.654 12.409 12.948 13.332 13.801 8% 0.926 1.783 2.577 3.312 3.993 4.623 5.206 5.747 6.247 6.710 7.139 7.536 7.904 8.244 8.559 8.851 9.122 9.372 9.604 9.818 10.675 11.258 11.655 11.925 12.233 9% 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 6.805 7.161 7.487 7.786 8.061 8.313 8.544 8.756 8.950 9.129 9.823 10.274 10.567 10.757 10.962 10% 0.909 1.736 2.487 3.170 3.791 4.355 4.868 5.335 5.759 6.145 6.495 6.814 7.103 7.367 7.606 7.824 8.022 8.201 8.365 8.514 9.077 9.427 9.644 9.779 9.915 11% 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 7.379 7.549 7.702 7.839 7.963 8.422 8.694 8.855 8.951 9.042 12% 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 6.974 7.120 7.250 7.366 7.469 7.843 8.055 8.176 8.244 8.304 13% 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 6.604 6.729 6.840 6.938 7.025 7.330 7.496 7.586 7.634 7.675 14% 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 6.265 6.373 6.467 6.550 6.623 6.873 7.003 7.070 7.105 7.133 15% 0.870 1.626 2.283 2.855 3.352 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 5.954 6.047 6.128 6.198 6.259 6.464 6.566 6.617 6.642 6.661 16% 0.862 1.605 2.246 2.798 3.274 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 5.668 5.749 5.818 5.877 5.929 6.097 6.177 6.215 6.233 6.246 17% 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 5.405 5.475 5.534 5.584 5.628 5.766 5.829 5.858 5.871 5.880 18% 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 4.793 4.910 5.008 5.092 5.162 5.222 5.273 5.316 5.353 5.467 5.517 5.539 5.548 5.554 19% 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 4.938 4.990 5.033 5.070 5.101 5.195 5.235 5.251 5.258 5.262 20% 0.833 1.528 2.106 2.589 2.991 3.326 3.605 3.837 4.031 4.192 4.327 4.439 4.533 4.611 4.675 4.730 4.775 4.812 4.843 4.870 4.948 4.979 4.992 4.997 4.999

**PV of an Annuity/Formula
**

The PV of an annuity is: PV =

C C C C + + +...+ 2 3 T (1 + r) (1 + r) (1 + r) (1 + r)

r = discount rate C = cashflow T = years/periods

This simplifies to: PV =

1 ⎤ ⎡1 C⎢ − T⎥ ⎣ r r(1 + r) ⎦

Example: Annuity

Consider the same annuity of $150 per year for 3 years. However, you also get a payment today. Year Cash Flow 0 $150 1 $150 2 $150 3 $150 What is the PV of this set of cash flow if the interest rate is 10%?

PV Annuity

We know that from PVIFA table (A.3) that PVIFA(10%,3) = 2.4869

PV of year 1 to 3 payment = $150(2.4869)=373.04

PV of $ 150 today is $150 PV of cash flows is = 150 + 373.04 = 523.04

Note: PV of Annuity

The formula as well as the tables give you the value of a set of cash flows beginning one year from now, i.e., year 1. The annuity formula is applicable only if the cash flows are the same, i.e., C every year.

**Future Value: Annuity
**

Consider our 3-year, $150 per year annuity. What is the future value (at year 3) if the interest rate is 10%? Year Cash flow FV 1 150 150(1.1)2 = 181.50 2 150 150(1.1) = 165 3 150 150 = 150 Total FV = 496.50

**Calculating Future Value of Annuity
**

Use the Future Value Tables

150 x (1.210 + 1.1 + 1) = $ 496.50

**Use FVIFA (table A.4)
**

FVIFA(3,10%) = 3.31 Future Value = $150 x 3.31 = 496.50

**Future value interest factor of an ordinary annuity of $1 per period at i% for n periods, FVIFA(i,n).
**

Period 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 35 40 50 1% 1.000 2.010 3.030 4.060 5.101 6.152 7.214 8.286 9.369 10.462 11.567 12.683 13.809 14.947 16.097 17.258 18.430 19.615 20.811 22.019 28.243 34.785 41.660 48.886 64.463 2% 1.000 2.020 3.060 4.122 5.204 6.308 7.434 8.583 9.755 10.950 12.169 13.412 14.680 15.974 17.293 18.639 20.012 21.412 22.841 24.297 32.030 40.568 49.994 60.402 84.579 3% 1.000 2.030 3.091 4.184 5.309 6.468 7.662 8.892 10.159 11.464 12.808 14.192 15.618 17.086 18.599 20.157 21.762 23.414 25.117 26.870 36.459 47.575 60.462 75.401 112.80 4% 1.000 2.040 3.122 4.246 5.416 6.633 7.898 9.214 10.583 12.006 13.486 15.026 16.627 18.292 20.024 21.825 23.698 25.645 27.671 29.778 41.646 56.085 73.652 95.026 152.67 5% 1.000 2.050 3.153 4.310 5.526 6.802 8.142 9.549 11.027 12.578 14.207 15.917 17.713 19.599 21.579 23.657 25.840 28.132 30.539 33.066 47.727 66.439 90.320 120.80 209.35 6% 1.000 2.060 3.184 4.375 5.637 6.975 8.394 9.897 11.491 13.181 14.972 16.870 18.882 21.015 23.276 25.673 28.213 30.906 33.760 36.786 54.865 79.058 111.43 154.76 290.34 7% 1.000 2.070 3.215 4.440 5.751 7.153 8.654 10.260 11.978 13.816 15.784 17.888 20.141 22.550 25.129 27.888 30.840 33.999 37.379 40.995 63.249 94.461 138.24 199.64 406.53 8% 1.000 2.080 3.246 4.506 5.867 7.336 8.923 10.637 12.488 14.487 16.645 18.977 21.495 24.215 27.152 30.324 33.750 37.450 41.446 45.762 73.106 113.28 172.32 259.06 573.77 9% 1.000 2.090 3.278 4.573 5.985 7.523 9.200 11.028 13.021 15.193 17.560 20.141 22.953 26.019 29.361 33.003 36.974 41.301 46.018 51.160 84.701 136.31 215.71 337.88 815.08 10% 1.000 2.100 3.310 4.641 6.105 7.716 9.487 11.436 13.579 15.937 18.531 21.384 24.523 27.975 31.772 35.950 40.545 45.599 51.159 57.275 98.347 164.49 271.02 442.59 1,163.9 11% 1.000 2.110 3.342 4.710 6.228 7.913 9.783 11.859 14.164 16.722 19.561 22.713 26.212 30.095 34.405 39.190 44.501 50.396 56.939 64.203 114.41 199.02 341.59 581.83 1,668.8 12% 1.000 2.120 3.374 4.779 6.353 8.115 10.089 12.300 14.776 17.549 20.655 24.133 28.029 32.393 37.280 42.753 48.884 55.750 63.440 72.052 133.33 241.33 431.66 767.09 2,400.0 13% 1.000 2.130 3.407 4.850 6.480 8.323 10.405 12.757 15.416 18.420 21.814 25.650 29.985 34.883 40.417 46.672 53.739 61.725 70.749 80.947 155.62 293.20 546.68 1,013.7 3,459.5 14% 1.000 2.140 3.440 4.921 6.610 8.536 10.730 13.233 16.085 19.337 23.045 27.271 32.089 37.581 43.842 50.980 59.118 68.394 78.969 91.025 181.87 356.79 693.57 1,342.0 4,994.5 15% 1.000 2.150 3.473 4.993 6.742 8.754 11.067 13.727 16.786 20.304 24.349 29.002 34.352 40.505 47.580 55.717 65.075 75.836 88.212 102.44 212.79 434.75 881.17 1,779.1 7,217.7 16% 1.000 2.160 3.506 5.066 6.877 8.977 11.414 14.240 17.519 21.321 25.733 30.850 36.786 43.672 51.660 60.925 71.673 84.141 98.603 115.38 249.21 530.31 1,120.7 2,360.8 10,436 17% 1.000 2.170 3.539 5.141 7.014 9.207 11.772 14.773 18.285 22.393 27.200 32.824 39.404 47.103 56.110 66.649 78.979 93.406 110.28 130.03 292.10 647.44 1,426.5 3,134.5 15,090 18% 1.000 2.180 3.572 5.215 7.154 9.442 12.142 15.327 19.086 23.521 28.755 34.931 42.219 50.818 60.965 72.939 87.068 103.74 123.41 146.63 342.60 790.95 1,816.7 4,163.2 21,813 19% 1.000 2.190 3.606 5.291 7.297 9.683 12.523 15.902 19.923 24.709 30.404 37.180 45.244 54.841 66.261 79.850 96.022 115.27 138.17 165.42 402.04 966.71 2,314.2 5,529.8 31,515 20% 1.000 2.200 3.640 5.368 7.442 9.930 12.916 16.499 20.799 25.959 32.150 39.581 48.497 59.196 72.035 87.442 105.93 128.12 154.74 186.69 471.98 1,181.9 2,948.3 7,343.9 45,497

**Calculating Future Value of Annuity
**

Future Value is given by

⎡ (1 + r)T − 1⎤ C⎢ ⎥ r ⎢ ⎥ ⎦ ⎣

FV =

C = cash flow T = years/periods r = discount rate

**Annuity with different timing
**

What is the PV of annuity that pays $250 per year for 4 years where the first payment occurs 3-years from today? Year: 0 1 2 3 4 5 6 7 CF 0 0 0 250 250 250 250 0 Assume the interest rate is 8%

**Annuity with different timing (2)
**

Year: CF 0 0 1 2 3 4 5 6 7 0 0 250 250 250 250 0

⎡1 ⎤ 1 PV(a) = C ⎢ − T⎥ ⎢ r r(1 + r) ⎥ ⎣ ⎦ ⎡ PV(a) ⎤ PV(final) = ⎢ 2⎥ ⎢ (1 + r) ⎥ ⎣ ⎦

Timing

1.

First find the value of the annuity at year 2 (this is what the formula, or our tables give us)

PVIFA(8%,4) = 3.3121 PV (year 2) = $250(3.3121) = 828.03

2.

**Now this is a year 2 payment, just find the PV of this at year 0.
**

PV = 828.03/(1.08)2= 709.90

**Timing: Future Value
**

Year: 0 1 2 3 4 5 6 7 CF 0 0 0 250 250 250 250 0 Assume the interest rate is 8% What is the value of this annuity in year 7?

Future Value

We know the present value is $709.90 FV in year 7 = 709.9 (1.08)7=1216.6 or

Year 0 1 2 3 4 5 6 7 CF 0 0 0 250 250 250 250 0 FV(7) FV(7)

250(1.08^4) 250(1.08^3) 250(1.08^2) 250(1.08^1) Total FV

340.1222 314.928 291.6 270 0 0 1216.65

**Using the Formula
**

Value of 250 for six years at the end of 6 year

⎡ (1 + .08) 4 - 1⎤ FV(end of 6th year) = 250 ⎢ ⎥ .08 ⎦ ⎣

= 1126.53

Value of CF in 7th year = 1126.53 (1.08) = 1216.65

**Different Cash Flows
**

What is the PV of the following cash flows: Year: 0 1 2 3 CF 0 250 250 250 4 5 6 300 300 300

Assume the interest rate is 8%

**Different Cash Flows
**

PV at year 3 of first annuity =

$ 300 * PVIFA (8%,3) = 300 x 2.577 = 773.1 PV at year 0 = 773.1/(1.08)3 = 613.71

**PV at year 0 of second annuity
**

$ 250 x PVIFA(8%,3) = 250 x 2.577 = 644.25

Total PV of cash flows: 613.71 + 644.25 = 1258

End Example 1:

You have the following three options

1. 2. 3.

$ 132 in one year $ 139 in two years $ 150 in four years The interest rate is 7%

**Which option will you choose?
**

Convert to year 0 Convert to year 3

End Example 1

Converting to Year 0

PV = 132/(1.07)1 = 123.36 2. PV = 139/(1.07)2 = 121.4 3. FV = 150/(1.07)4 = 114.4 Choose (1)

1.

Converting to Year 3

1. 2. 3.

FV = 132(1.07)2 = 151.13 FV = 139(1.07)1 = 148.7 PV = 150/(1.07)1 = 140.19

**End Example 2: 3 year EAR
**

Consider Investing $100 for 3-years at 8%, with semi annual compounding. What is the EAR?

1.

Calculate the FV:

FV = $100(1+.04)6= 126.53

2.

**Determine what interest rate (compounded annually) will give you FV = 126.53
**

FV = 100(1+EAR)3= 126.53 (1+EAR)3 = 126.53/100 = 1.2653 (1+EAR) = 1.0816 EAR = .0816 = 8.16%

**Time Value of Money, Chapter 4 Bond Valuation, Chapter 5
**

Class of September 12th

Prof. Simi Kedia Financial Management Rutgers Business School

Annuity Formulas

PV of Annuity

1 ⎤ ⎡1 C⎢ − T⎥ ⎣ r r(1 + r) ⎦

FV of Annuity

⎡ (1 + r)T − 1⎤ ⎥ C⎢ r ⎥ ⎢ ⎦ ⎣

Example: Annuity

Suppose you win the lottery. It will pay you 1 million dollars, but in yearly payments of $50,000 a year for 20 years. Your first payment will be in 1 year. What is the present value of your prize if the interest rate is 8%?

Example: Annuity

The value of your prize is:

1 ⎡1 ⎤ PV = 50,000 ⎢.08 − .08(1+.08)20 ⎥ ⎣ ⎦

= $490,907.37

Or use the PVIFA table. PVIFA(20,8%)=9.8181 PV = 50,000(9.8181) = $490,905

What if your payments start immediately instead of in 1 year?

**Example: Annuity Cont.
**

What if your payments start immediately instead of in 1 year? The value of your prize is:

⎤ ⎡ 1 1 PV = 50,000 + 50,000⎢ − 19 ⎥ ⎢ .08 .08(1 + .08) ⎥ ⎦ ⎣

**From PVIFA table, PVIFA(19,8%)=9.6036
**

PV =50,000 + 50,000 (9.6036) = 50,000 + $480,180 = 530,180

Retirement Example

Suppose for your retirement

Save and Invest $3000 per year retire at 70 r = 10% n = 30 years (start saving at 40 years old)

How much money will you have when you retire?

Retirement Example

Using Formula FV =

⎡ (1 + .10)30 − 1⎤ 3000 ⎢ ⎥ = 493,482 .10 ⎢ ⎥ ⎣ ⎦

Using Table: FVIFA(10%,30) = 164.494 FV = 3000*(164.494) = 493,482

**Retirement Example Cont.
**

What if you start saving at 30 (so you have 40 years of saving)? FV=

⎡ (1 + .10) 40 − 1⎤ 3000 ⎢ ⎥ = 1,327,778 .10 ⎢ ⎥ ⎣ ⎦

FVIFA (10%,40 years) = 442.5926 FV = $3000(442.5926) = 1,327,778 See the power of compounding over many years?

**Retirement Example Cont.
**

How much do we save every year if I want to retire at age 70 with 1,000,000. Interest rate is 10% and I have 40 years to save.

⎡ (1 + .10) 40 − 1 ⎤ ⎥ = 1,000,000 X⎢ .10 ⎢ ⎥ ⎦ ⎣

Here FVIFA(10%,40) =442.59. So if I save $X per year: FV = $X(442.59) = 1,000,000 $X = 1,000,000/(442.59) $X = 2,259.43 per year

Determining n

Suppose I can save $2000 per year. How many years do I have to save at 16% to get $500,000?

⎡ (1 + .16) n − 1 ⎤ ⎥ = 500,000 2000 ⎢ .16 ⎢ ⎥ ⎦ ⎣

FV = $2000(FVIFA) = 500,000 FVIFA = 500,000/2000 = 250 at 16% FVIFA(n,16%) = 250, FVIFA(25,16%) = 249.2140 Need to save for 25 years

Perpetuity

A perpetuity of $A, is the payment of $A a year forever, beginning in one year. Time 0 Cashflow 0 1 A 2 A 3 A 4... A...

The PV of a perpetuity of $A, when the discount rate is r, is: PV = A/r

Perpetuity

Example: What is the PV of receiving $120 a year forever, beginning next year if the interest rate is 10%? PV = $120/.10 = $1,200 Example: What is the PV of receiving $120 a year forever, beginning today if the interest rate is 10%? PV = $120 + $120/.10 = 1,320

Example 1

To complete last year of business school and go through law school you will need $10,000 per year for 4 years, starting next year. Your rich uncle offers to put you through school. He will deposit in the bank that pays interest at 7%, compounded annually, a sum of money that is sufficient to provide the 4 payments. His deposit will be made today.

How large must the deposit be? How much will be in the bank immediately after you make the first withdrawal?

Example 1

Present value of the cost of going to school

⎡ 1 ⎤ 1 − PV(a) = 10,000⎢ = 33,872 4⎥ ⎢ .07 .07(1 + .07) ⎥ ⎣ ⎦

Year 1 Year 2 Year 3 Year 4 33872.11 26243.16 18080.18 9345.79 2371.05 1837.02 1265.61 654.21 10000.00 10000.00 10000.00 10000.00 26243.16 18080.18 9345.79 0.00

Beginning Bank Balance Interest earned Withdrawal Ending Bank Balance

Example 2

Ernie wants to save money for two objectives:

1.

2.

He would like to retire 30 years from today, with a annual retirement income of $300,000 for 20 years. The first $300,000 will be exactly 31 years from today. He would like to purchase a cabin in the mountains 10 years from today at an estimated cost of $350,000.

He can afford to save only $40,000 per year for the first 10 years. He expects to earn 7% per year from investments. Assuming he saves the same amount each year (for years 11-30), what must Ernie save annually from years 11 to 30 to meet his objectives?

Example 2

First figure out how much he needs at year 30, i.e., present value of retirement income

⎡ 1 ⎤ 1 − = 3,178,204 300,000⎢ 20 ⎥ ⎢ .07 .07(1.07) ⎥ ⎣ ⎦

The present value of the stream of his retirement benefits is $3,178,204 at year 30. Second: He need to save enough, such that the future value of all his savings in year 30 is worth $3,178,204

Example 2

FV of savings in year 30 is $3,178,204 Savings for the first 10 years: He saves 40,000 for the next 10 years. At the end of 10 years this is worth

⎡ (1 + .07)10 − 1 ⎤ 40,000 ⎢ ⎥ = 552,658 .07 ⎢ ⎥ ⎣ ⎦

He buys a house for $350,000 in year 10. This leave him with 552,658 – 350000 = 202658 in year 10 At the end of year 30, this is worth = 202,658(1.07)20 = $784,223

Example 2 cont.

How much should he save over years 11-30?

His savings over years 11-30 should be worth the following in year 30 3,178,204 - 784,223 = 2,393,981 Use the FVA formula

⎡ (1 + .07) 20 − 1 ⎤ 2,393,981 ⇒X= 2,393,981 = X ⎢ = 58,396 per year ⎥ 20 .07 ⎡ (1 + .07) − 1 ⎤ ⎢ ⎥ ⎣ ⎦ ⎢ ⎥ .07 ⎢ ⎥ ⎣ ⎦

Amortized Loans

Loans that are paid off in installments over time. For e.g. automobile loans, home mortgage loans, student loans Example: Consider a firm that borrows $1000

To be repaid in three equal payments at the end of each of the next three years Interest rate of 6%

**Amortized Loans: Example 3
**

⎡1 ⎤ 1 PV = C ⎢ − T⎥ ⎢ r r(1 + r) ⎥ ⎦ ⎣ ⎡ 1 ⎤ 1 $1,000 = C ⎢ − 3⎥ ⎢ 0.06 0.06(1 + 0.06) ⎥ ⎦ ⎣

1000 = C(2.673) C = 1000/2.673 = 374.11

Example 4

You need to borrow $23,000 to buy a truck. The current loan rate is 7.9% compounded monthly and you want to pay the loan off in equal monthly payments over 5 years. What is the size of your monthly payment?

Example 4

The monthly interest rate = 7.9%/12 = 0.66% Set the PV of a 60-month annuity equal to the $23,000 loan.

⎡ 1 ⎤ 1 − 23,000 = X ⎢ = X[49.4117] 60 ⎥ ⎢ .0066 .0066(1.0066) ⎥ ⎣ ⎦

X = 23,000/49.4117 = $465.48

Example 5

A rookie quarter back has the following three offers. The money is guaranteed in all three contracts. The interest rate is 10%. Which of the three contracts offers him the most money? All payments are in millions.

Year 1 Contract 1 Contract 2 Contract 3 3.00 2.00 7.00 Year 2 3.00 3.00 1.00 Year 3 3.00 4.00 1.00 Year 4 3.00 5.00 1.00

Example 5 cont.

The present value of the three contracts are

Year 1 Contract 1 Contract 2 Contract 3 3.00 2.00 7.00 Year 2 3.00 3.00 1.00 Year 3 3.00 4.00 1.00 Year 4 PV 3.00 9.51 m 5.00 10.72 m 1.00 8.62 m

Contract 2 offers him the most money

**Conclusion: Time Value of Money
**

What did we do:

Simple Interest vs. Compound Interest Compounding Interval and Effective Annual Rate (EAR) Present Value (PV) and Future Value (FV) Annuities: PV and FV Perpetuity Simple application to lotteries, retirement, amortization schedules

Valuing Bonds Chapter 5

Bonds

What is a Bond? A bond is just a promissory note. The bond issuer, or borrower agrees to pay the holder, or lender a specified amount of interest each year, as well as repaying the original principal.

Example of Bond

A 30-Year treasury bond with face value of $1000 and coupon of 7%.

Face Value or Par Value = $ 1000 Time to maturity = 30 Years Interest rate or coupon = 7%

Interest payments = 7% x 1000 = $ 70 every year

Issued by government

Bond Characteristics

Coupon interest rate:

Percentage of par that will be paid out annually in interest E.g., 9% coupon bond pays $90 annually

Maturity:

Length of time until bondholder receives principal Sometimes will be referred to as the year in which the principal is due. For e.g., maturity 2034

**Quotation of Coupon Bonds
**

The annual coupon payment is typically quoted as a percentage of the face value. The face value for US bonds is typically $1000 For example, what are the payments of a 15% coupon bond with a face value of $1000 that matures in 2 years with semi-annual coupon payments?

Annual Interest = 15% x 1000 = $ 150

Year 0 0

1/2 $75

1 $75

1 1/2 $75

2 $1000 + $75

Bond Characteristics

Security

Collateral – secured by financial securities Mortgage – secured by real property, normally land or buildings Debentures (sr.) – unsecured Subordinated (jr.) debentures

Fall behind secured debt and senior debentures in case of default.

Notes – unsecured debt with original maturity less than 10 years

Have to be paid before shareholders

**Cash Flows to Firm from Bonds
**

Ex: Bond with face value $1000 pays $I each year in interest. Let the price of the bond today be $P. What are the cash flows to the issuing firm? Year Cash Flow 0 1 2 3 … 15

+ $P - $I - $I - $I - $ (I+1000)

Note

The cash flows are negative when the firm needs to make a cash payment The cash flows are positive when the firm receives cash At maturity, in this case 15 years, the firm has to pay the par value back The price at which the bond sells need not be equal to the par value or face value.

**Cash Flows to Investors from Bonds
**

Ex: Bond with face value $1000 pays $I each year in interest. Let the price of the bond today be $P. What are the cash flows to the investor? Year Cash Flow 0 1 2 3 … 15

- $P + $I + $I + $I + $ (I+1000)

**Valuation of Coupon Bonds
**

The value of a coupon bond, or its price, is the present value of the bonds cash flows. If the bond has a face value of F (usually $1000), a coupon payment of C dollars, and matures in n periods, what is the value of the bond?

**Valuation of Coupon Bond
**

Year: CF 1 C 2 C 3 …………… C n F+C

C C C F+C PV = + + + ... + 2 3 (1 + r) (1 + r) (1 + r) (1 + r) n

⎡1 1 ⎤ ⎡ F ⎤ PV = C ⎢ − + n⎥ ⎢ n⎥ ⎢ r r(1 + r) ⎥ ⎢ (1 + r) ⎥ ⎦ ⎣ ⎦ ⎣

**What is the discount rate r?
**

The discount rate is

The current interest rate in the market It is not the coupon rate on the bond

Why not?

The bond could have been issued in the past when the interest rates were different

For e.g. firm Smarts issued bonds in 1999 at 9%. The market interest rate was 9%. Today the market interest rate is 5%.

Coupon rate = 9% Discount rate or r = 5%.

**Ex: Coupon Bond
**

Consider the following bond

25 years 10% annual coupon rate Face Value $1000 Interest rate, r = 10%

What is this bonds current price?

**Determine Cash flows
**

Annual coupon payments = 10%*1000 = 100 Year 1 100 2 100 3…… 100 25 1100

How can we value this cash flow?

Bond Value

Use the annuity formula

1 ⎤ ⎡1 PV of coupon = C ⎢ − r r(1 + r)T ⎥ ⎦ ⎣

r = discount rate C = cash flow T = periods

PV =

⎡ 1 ⎤ 1 1000 − 100 ⎢ + = 1000 25 ⎥ 25 ⎢ .10 .10(1 + .10) ⎥ (1.10) ⎣ ⎦

**Ex: Coupon Bond
**

Consider the following bond

25 years 10% annual coupon rate Face Value $1000 Interest rate, r = 8%

What is this bonds current price?

**Determine Cash flows
**

Annual coupon payments = 10%*1000 = 100 Year 1 100 2 100 3…… 100 25 1100

How can we value this cash flow?

Bond Value

Use the annuity formula

1 ⎤ ⎡1 PV of coupon = C ⎢ − r r(1 + r)T ⎥ ⎦ ⎣

r = discount rate C = cash flow T = periods

PV =

⎡ 1 ⎤ 1 1000 − 100 ⎢ + = 1213.48 25 ⎥ 25 ⎢ .08 .08(1 + .08) ⎥ (1.08) ⎣ ⎦

PVIFA(8%,25) = 10.6748, PVIF(8%,25)=0.1460 PV = 100*10.6748 + 1000*0.1460 = 1213.48

**Ex: Coupon Bond (2)
**

Consider the following bond

25 years 10% annual coupon rate Face Value $1000 Interest rate, r = 8% Semi-annual coupon payments

What is this bond’s current price?

**Determine Cash flows
**

Annual coupon payments = 10%*1000 = 100 Semi-annual coupon payments = 100/2 = $50 Year 0.5 1 1.5 2 2.5 3…… 25 50 50 50 50 50 50 1050 Convert to 6 month time periods Time 1 2 3 4 5 6 50 50 50 50 50 50 50 1050 How can we value this cash flow?

Bond Value

Use the annuity formula

1 ⎤ ⎡1 PV of coupon = C ⎢ − r r(1 + r)T ⎥ ⎦ ⎣

r = discount rate C = cash flow T = periods

1 ⎤ 1000 ⎡1 PV = 50 ⎢.04 − .04(1 + .04)50 ⎥ + (1.04)50 = 1214.82 ⎦ ⎣

PVIFA(4%,50) = 21.4822, PVIF(4%,50)=0.1407 PV = 50*21.4822+1000*0.1407 = 1214.81

**Ex: Coupon Bond (3)
**

Consider the following bond

25 years 10% annual coupon rate Face Value $1000 Interest rate, r = 12%

What is this bond’s current price?

Bond Value

Use the annuity formula

1 ⎤ ⎡1 PV of coupon = C ⎢ − r r(1 + r)T ⎥ ⎦ ⎣

r = discount rate C = cash flow T = periods

PV =

⎡ 1 ⎤ 1 1000 − 100 ⎢ + = 843.13 25 ⎥ 25 ⎢ .12 .12(1 + .12) ⎥ (1.12) ⎣ ⎦

Note

When coupon rate = 10% and r = 10%

Value of bond = 1000

**When coupon rate = 10% and r = 8%
**

Value of bond = 1213.48

**When coupon rate = 10% and r = 12%
**

Value of bond = 843.13

When the coupon = r, value of bond = par When the coupon < r, value of bond < par When the coupon > r, value of bond > par

Example

Your investment advisor suggests you buy bonds of firm Smarts. These have a face value of $ 1000, maturity of 3 years and a coupon of 10%. They are selling for $975.

What is the return I am earning? Like the EAR (effective annual return) problem

Example cont.

Let the return be y

975 = 100 100 1000 + 100 + + (1 + y) (1 + y) 2 (1 + y)3

Y = 11% This y is also called the yield to maturity in the context of bond valuations Should you buy the bonds? If the market interest rate r <= y, then buy the bonds

Yield to Maturity

The discount rate that makes the price of the bond equal the discounted cash flows it produces is call the Yield to Maturity(YTM) of the bond. The YTM tell you the annual return the bond holder is receiving over the life of the bond (assuming they buy the bond at the current price).

Calculating YTM

Consider a coupon bond, that pays annual coupons, C, for T years. If the current price of the bond is P, then the yield to maturity is the interest rate (YTM) such that the following equation holds: P = C/(1+YTM) + C/(1+YTM)2 + … + C/(1+YTM)T + FV/(1+YTM)T

**Example: Calculating YTM
**

Consider a bond that pays annual coupons of 8.5% on a face value of $1000 that matures in 3 year. If the current price of the bond is $981.10 then what is the YTM? $981.10 = 85/(1+YTM) + 85/(1+YTM)2 +1085/(1+YTM)3 ⇒ YTM = 9.25% When is it easy to calculate?

**Bond Types: Coupon Rates
**

Coupon Bond

Pays coupon (quoted as annual % of face value). Can be annual, semi-annul, or any regular interval Fixed or floating

**Zero Coupon bond
**

Pays no interest, sells below Face Value (discount bond)

**Valuation of Discount Bonds
**

Consider a discount bond (or zero coupon bond) with a face value of F dollars that matures in n years. Bond Cash flows: Year 0 1 2 3 …. n 0 0 0 0 F If the annual interest rate is r, then the present value of the bond’s CF is: PV = F/(1+r)n

**YTM of a discount bond
**

Consider the following discount bond:

Face Value = $1000 Matures in 10 years Current price = $422.41

**What is the YTM?
**

Can use calculator or PVIF table

**YTM of discount bond
**

Calculator: (solve the following) $422.41 = $1000/(1+YTM)10

$422.41(1+YTM)10 = $1000 (1+YTM)10 = $1000/$422.41 = 2.3674 (1+YTM) = (2.3674)1/10 = 1.09 ⇒ YTM = 9%

With Tables

$422.42 = $1000*PVIF(YTM,10) PVIF(YTM,10) = 422.42/1000 = 0.4224 PVIF(9%,10) = 0.4224 from table

**Interest Rates and Bond Prices:Example 1
**

Consider a 2-year with par value of $1000 and coupon rate of 5%, paid annually.

What are the cash flows for these bonds? What are the prices for these bonds, if the interest rate is 8%?

CF(2-year) Year 1 50 Year 2 1050

**PV(2-year) = 50/(1.08) + 1050/(1.08)2 = $946.50
**

As the interest rate is greater than coupon, price is less than par

**Bond Prices and Interest Rate
**

What happens if the interest rate increases from 8% to 9%? PV(2-year) = 50/(1.09) + 1050/(1.09)2 = $929.64 When interest rate was 8% price was 946.50 Interest rate increases and the bond price falls. Interest rates and bond prices are inversely related.

**Interest Rates and Bond Prices
**

When interest rates changes

The coupon payments do not change The face value or par value does not change The maturity does not change Only the discount rate changes

C C C F+C PV = + + + ... + 2 3 (1 + r) (1 + r) (1 + r) (1 + r) n

When Interest rate increases, discount rate increases PV falls, price of bond falls When Interest rate decreases, discount rate decreases PV increases, price of bond increases

**Interest Rates and Bond Prices
**

When interest rates increase, prices of all bonds fall

Let there be a 2 year bond and a 3 year bond. Should there be a difference between these two? 2-year: (929.64 - 946.50)/ 946.50 = -1.78% 3-year: (898.75 - 922.69)/ 922.69 = -2.59% The bond with the longer maturity is effected more by the change in interest rates.

**Interest Decrease and Value: Example 1
**

Suppose the interest rate decreases to 7%.

For the same two bonds, what is the value of the bonds?

**The percent changes in bond value are:
**

2-year: (963.84 - 946.50)/ 946.50 = 1.83% 3-year: (947.51 - 922.69)/ 922.69 = 2.69%

The bond with the longer maturity is effected more by the change in interest rates.

**Interest Rates and Bond Price: Example 2
**

Ex: Consider two bonds which both mature in 2 years. Bond A has a 5% coupon and Bond B has a 15% coupon. Each have a face value of $1000 and pay annual coupons. What are the bond prices if interest rate is 8.5%?

Example Continued

Bond Payments Bond A CF(5%) Bond B CF(15%) Year 1 50 150 Year 2 1050 1150

If interest rate is 8.5%, value of the bonds are: A = 50/(1.085) + 1050/(1.085)2 = $938.01 B = 150/(1.085) + 1150/(1.085)2 = $1115.12

**Increase in Interest Rates: Example 2
**

Suppose the interest rate increases to 9%, now the bond values are:

A = 50/(1.09) + 1050/(1.09)2 = $929.64 B = 150/(1.09) + 1150/(1.09)2 = $1105.55

**Percent changes in price:
**

A = (929.64 - 938.01)/938.01 = -0.89% B = (1105.55 - 1115.12)/1115.12 = -0.86%

The bond with the lower coupon is effected more by the change in interest rates.

**Determination of interest rates
**

Bond prices are readily available. Bond payments are fixed based on the bond contracts. From this data we can determine the current interest rate.

**One Year Interest Rate
**

Suppose we have the following One-year zero coupon government bond:

Face Value = $1000 Current Price = $966.18

What is the current one year interest rate?

**One Year Interest Rate
**

The current one year interest rate:

$966.18 = $1000/(1+r1) ⇒ (1+r1) = $1000/966.18 (1+r1) = 1.035 or r1 = 3.5%

**Two Year Interest Rate
**

Suppose we have the following Two-year zero coupon government bond:

Face Value = $1000 Current Price = $924.56

What is the current two year interest rate?

**Two Year Interest Rate
**

The current two year interest rate:

$924.56 = $1000/(1+r2)2 ⇒ (1+r2)2 = $1000/924.56 (1+r2)2 = 1.0816 ⇒(1+ r2) = (1.04) r2 = 4%

Summary

One year interest rate is 3.5% Two year interest rate (annual): 4% How can this be?

Term Structure

The relation between short and long term interest rates is known as term structure of interest rates. It is also called the yield curve. When long term interest rates are higher than short term rates, then the term structure is upward sloping. This is usually the case. When the long term interest rates are lower than short term rates, the term structure is downward sloping.

Term Structure

In the above case, one year rate is 3.5% and the 2 year rate is 4%. The term structure is upward sloping What determines the term structure

Time value of money Inflation premium Interest rate risk premium

Term Structure

Time Value of money: Real Rate

Determines the overall level, not shape of term structure

Inflation Premium

Compensation for Inflation

**Interest Rate Risk Premium
**

Longer term bonds have greater risk from changes in interest rate Investors want a higher interest rate to take this risk

**Price of a 2-year Coupon Bond
**

Given the above term structure of interest rates (r1 = 3.5%, r2=4%) what is the current price of the following 2-year bond:

Face Value $1000 Coupons of 10% paid annually PV = 100/(1.035) + 1100/(1.04)2 = $1,113.63

What is the YTM of this bond?

**Yield to Maturity vs. Term Structure
**

What is the YTM of the above 2-year coupon bond? $1,113.63 = 100/(1+YTM) + 1100/(1+YTM)2 ⇒ YTM = 3.98% YTM is between the 1-year and 2-year interest rates.

**Bond Valuation, Chapter 5
**

Class of September 19th

Prof. Simi Kedia Financial Management Rutgers Business School

**Valuation of Coupon Bond
**

Year: CF 1 C 2 C 3 …………… C n F+C

C C C F+C PV = + + + ... + 2 3 (1 + r) (1 + r) (1 + r) (1 + r) n

⎡1 1 ⎤ ⎡ F ⎤ PV = C ⎢ − + n⎥ ⎢ n⎥ ⎢ r r(1 + r) ⎥ ⎢ (1 + r) ⎥ ⎣ ⎦ ⎣ ⎦

**Yield To Maturity (YTM)
**

The discount rate that makes the price of the bond equal the discounted cash flows it produces is call the Yield to Maturity(YTM) of the bond. Consider a coupon bond, that pays annual coupons, C, for T years. If the current price of the bond is P, then the yield to maturity is the interest rate (YTM) such that the following equation holds: P = C/(1+YTM) + C/(1+YTM)2 + … + C/(1+YTM)T + FV/(1+YTM)T

Term Structure

The relation between short and long term interest rates is known as term structure of interest rates. It is also called the yield curve. When long term interest rates are higher than short term rates, then the term structure is upward sloping. This is usually the case. When the long term interest rates are lower than short term rates, the term structure is downward sloping.

**Price of a 2-year Coupon Bond
**

Given the above term structure of interest rates (r1 = 3.5%, r2=4%) what is the current price of the following 2-year bond:

Face Value $1000 Coupons of 10% paid annually PV = 100/(1.035) + 1100/(1.04)2 = $1,113.63

What is the YTM of this bond?

**Yield to Maturity vs. Term Structure
**

What is the YTM of the above 2-year coupon bond? $1,113.63 = 100/(1+YTM) + 1100/(1+YTM)2 ⇒ YTM = 3.98% YTM is between the 1-year and 2-year interest rates.

Example

Consider a 2-year bond with FV=$1000 and a coupon of 25% paid annually.

What is the price of this bond? What is the YTM of this bond? The one year interest rate is 3.5% and the two year interest rate is 4%.

Example

What is price and YTM of a 2-year bond with FV=$1000 and a coupon of 25% paid annually? Price = $250/(1.035) + 1250/(1.04)2 = 1397.24 YTM: $1397.24 = 250/(1+YTM) + 1250/(1+YTM)2 ⇒ YTM = 3.95%

**Another Term Structure Problem
**

Suppose we have the following two bonds:

1.

2.

FV = $1000, maturity in 1-year, 5% annual coupons, current price = $972.22 FV = $1000, maturity in 2-years 15% annual coupons, current price = $1089.30

Given this information, what is the value of a 2-year annuity with a payment of $100?

**Term Structure Example
**

The first year interest rate

972.22 = 1050/(1+r) Interest rate r1 = (1050/972.22) - 1 = 8%

**The second year interest rate
**

1089.3 = 150/(1+.08) + 1150/(1+r)2 (1+r)2 = 1150/950.41=1.21 Interest rate r2 = 10%

**Term Structure Example
**

What is the value of a 2-year annuity with a payment of $100?

PV of annuity = 100/(1.08) + 100/(1.1)2 =92.59 + 82.65 = 175.24

**Bond Price Movements
**

Interest Rates changes

Interest rate increases – bond prices drop Interest rate decreases – bond prices increase

**Does the price of the Bond change if there are no interest rate changes? Bond A:
**

Coupon: 8%, semi-annual YTM: 6% 13 years to maturity What is the price today? In one year? In 8 years?

**Bond Price Changes
**

Price today =

⎛ 1 1 40⎜ − ⎜ 0.03 0.03(1.03) 26 ⎝ ⎞ 1000 ⎟+ ⎟ (1.03) 26 = 1178.77 ⎠

Price one year later =

⎛ 1 ⎞ 1000 1 − 40⎜ ⎜ 0.03 0.03(1.03) 24 ⎟ + (1.03) 24 = 1169.36 ⎟ ⎝ ⎠

Price five years later =

⎛ 1 ⎞ 1000 1 − 40⎜ ⎜ 0.03 0.03(1.03)10 ⎟ + (1.03)10 = 1085.30 ⎟ ⎝ ⎠

**Bond Price Movements
**

1200

Bond Price

1150

1100

Bond Prices

1050

1000

950

900 0 1 3 8 12 13

Years From Today

**Bond Price Movements
**

Bond B:

Coupon: 6%, semi-annual YTM: 8% 13 years to maturity What is the price today? In one year? In 5 years?

**Bond Price Changes
**

Price today =

⎛ 1 ⎞ 1000 1 − 30⎜ ⎜ 0.04 0.04(1.04) 26 ⎟ + (1.04) 26 = 840.17 ⎟ ⎝ ⎠

Price one year later =

⎛ 1 ⎞ 1000 1 ⎜ ⎟+ − = 847.53 30⎜ 24 ⎟ 0.04 0.04(1.04) ⎠ (1.04) 24 ⎝

Price five years later =

⎛ 1 ⎞ 1000 1 ⎜ ⎟+ − = 918.89 30⎜ 10 ⎟ 0.04 0.04(1.04) ⎠ (1.04)10 ⎝

**Bond Price Movements
**

1400

1200

1000

Bond Prices

800

600

400

200

Price - Bond A Price Bond B

0 0 1 3 8 12 13

Years from Today

**Inflation: Real vs. Nominal Interest
**

Nominal Interest Rate: Actual stated interest rate. Real Interest Rate: Interest earned adjusted for inflation (i.e., adjusted for change in purchasing power of money)

**Example: Real vs. Nominal
**

Suppose I have $100 today. I like baseball and can buy Baseball Weekly (BW) magazine for $1 each. Today I can buy $100 BW Suppose I invest my $100 for 1-year. The one-year nominal interest rate = 8%, and inflation is 3%. How many BW can I buy in one year?

**Example: Real vs. Nominal
**

In one year my $100 grows to:

$100*(1.08) = $108.00 BW now costs $1(1.03) = $1.03 I can $108/(1.03) = 104.85 BW

Real Return:

rr = (104.85-100)/100=4.85%

Nominal Return

rN = (108-100)/100 = 8%

**Determining the real rate
**

General Formula: (1+rr)=(1+rn)/(1+i) Where: rr = real interest rate rN = nominal interest rate i = inflation rate Quick estimate: rr ≈ rN - i

Here rr ≈ 8% - 3% ≈ 5% vs. 4.85 actual rr

**What rate should you use?
**

Be consistent:

Discount nominal cash flows with the nominal rate. Discount real cash flows with the real rate. Note: we almost always will be working with nominal numbers. However, there are cases where real cash flows are easier to use.

Rates

Suppose the nominal interest rate is 6%. The inflation rate is 2% What is the real rate? (1+rr) = (1.06)/(1.02) = 1.0392 rr = 3.92%

Note: Estimate rr = 6%-2% = 4%

**Example: Real and Nominal
**

Consider the following Cash Flows: Year Cash Flow (Nominal) 0 0 1 100 2 150 3 250 4 200 What is the PV of these cash flows if the interest rate is 6%?

**What is the PV? (nominal)
**

Discount the nominal cash flows by the nominal interest rate: Year Cash Flow Present Value 0 0 0 1 100 = 100/1.06 = 94.34 2 150 = 150/(1.06)2 = 133.50 3 250 = 250/(1.06)3 = 209.90 4 200 = 200/(1.06)4 = 158.42 Total PV = 596.16 How will you convert these cash flows to real cash flows?

Example Cont.

The real cash flows: Year Cash Flow Real Cash Flow 0 0 0 1 100 = 100/(1.02) = 98.04 2 150 = 150/(1.02)2 = 144.18 3 250 = 250/(1.02)3 = 235.58 4 200 = 200/(1.02)4 = 184.77 What is the present value of these real cash flows?

**What is the PV (real)?
**

Discount the real cash flows at the real interest rate. Year Real Cash Flow Present Value

0 1 2 3 4 0 0 98.04 = 98.04/1.0392 = 94.34 144.18 = 144.18/(1.0392)2 = 133.51 235.58 = 235.58/(1.0392)3 = 209.91 184.77 = 184.77/(1.0392)4 = 158.43 Total PV = 596.19

Default Risk

Bonds are issued by

Governments Corporations

Most governments bonds are considered riskless. Governments do not default, they print more money But firms could run into trouble be unable to pay the interest and/or face value Lenders demand a premium (higher interest rate) from firms in comparison to governments. This is the default premium

**Bond Types: Rating
**

Ratings attempt to convey two factors

The likelihood of default Amount of recovery if default occurs

**Investment Grade (AAA – BBB) Junk (BB and below)
**

Historically Junk bond were “fallen Angles” More recently firms issue junk bonds (since the mid 80s)

**Issued by independent firms
**

Moody’s and S&P, measure of default risk

Bond Valuation

Bond Terminology Bond Valuation: What is the price of the bond? YTM Effect of interest rates on bond prices Term Structure of Interest Rates Real vs. Nominal

Cash flows and interest rates

Valuing Stocks

Prof. Simi Kedia Introduction to Financial Management Rutgers Business School

Key Concepts

Preferred Sock Common Stock Stock Characteristics (features) Stock Valuation

Dividend Growth Model

Types of Stock

Two basic types of stock

Common Stock Preferred Stock

**One firm can have many different issues of each type of stock
**

Class A common stock Class B common stock

Preferred Stock

Preferred stock has features of debt and equity.

Like equity:

No maturity date Company does not “have” to pay dividend Dividend not tax deductible

Like Debt

Dividends are fixed

**Preferred Stock Features
**

Claims on Assets

Between bond holders and common stock holders. Preferred dividend must be paid before common stock dividends

**Cumulative Dividends are common Convertibility
**

Many issues are convertible to common stock

Adjustable rate

sometimes the dividend is linked to current interest rates

Does not have voting rights

**Preferred Stock Valuation
**

Discount the cash flows What are the cash flows for preferred stock?

Periodic fixed payment that never matures

How do we calculate the value of preferred stock?

**Preferred Stock Valuation
**

Discount the cash flows What are the cash flows for preferred stock?

Periodic fixed payment that never matures Perpetuity value = C/r

**Let D = dividend per year and rps = required rate of return for the preferred stock
**

Stock Value = D/rps

Example

Consider a company’s preferred stock with a dividend of $5 per year (beginning is one year). If the required rate of return is 8% what is the value of the preferred stock? Value = $5/0.08 = $62.50

**Determining the required return
**

Often times we know the current price of preferred stock and the dividend, but do not know the required rate of return. In this case we can solve for the expected rate of return. What is the expected rate of return if a preferred stock sells for $50 and pays a $5 dividend per year.

**Value = Div/rps
**

⇒ $50 = $5/rps ⇒ $50rps = $5 rps = $5/$50 = .10 or 10%

**Features of Common Stock
**

Claim on Assets (after bondholders and preferred stock holders) Voting Rights Elect board of directors, vote on changes in charter. Proxy voting, Classes of stock (different voting rights) . Other Rights

Share proportionally in declared dividends Share proportionally in remaining assets during liquidation Preemptive right – first shot at new stock issue to maintain proportional ownership if desired

Dividend Characteristics

Dividends are not a liability of the firm until a dividend has been declared by the Board Consequently, a firm cannot go bankrupt for not declaring dividends Dividends and Taxes

Dividend payments are not considered a business expense, therefore, they are not tax deductible Dividends received by individuals are taxed as ordinary income

Stock Valuation

Stocks are valued by determining the present value of the cashflows produced. What are the Cashflows? What discount rate should be used?

**1-Year Stock Return
**

If you purchase stock for 1 year and then sell it you receive all dividends the stock pays during the year plus the stock price at the end of one year. Assume all dividends are paid at the end of the year. The present value of owning a share of stock is: PV = Div1/(1+r) + P1/(1+r) = P0

Example: GM

Suppose I think GM will sell for $37.50 oneyear from now. I also know that GM will pay $2.00 Div one year from now. I require a 10% return. What should the price of GM be today? Price (GM) = 2.00/(1.1) + 37.50/1.1 Price (GM) = $35.91

**Stock Valuation Problems
**

This method of stock valuation has several shortfalls.

(1) We have to assume a holding period (2) We have to assume a price at the end of the holding period (3) Different holding periods can give different current valuations

What is P1?

If someone buys the stock 1 year from now, their 1 year return will be Div2 plus price at year 2. P1= Div2/(1+r) + P2/(1+r) Substitute this equation in for P1 yields: P0 = Div1/(1+r) + Div2/(1+r)2 + P2/(1+r)2

**Dividend Discount Model
**

If we continue the above substitution pattern (next substitute for P2, then P3, and so on) the resulting current price can be expressed as follows:

P0 = Div1/(1+r) + Div2/(1+r)2 + Div3/(1+r)3+…

The current price is just the present value of the expected dividend payments.

**Constant Dividend Stock
**

Consider a stock with a constant dividend. If we expect the dividend to remain constant indefinitely, then the current value of the stock is:

P0 = Div/(1+r) + Div/(1+r)2 + Div/(1+r)3+… = Div/r This is just a perpetuity of Dividends.

**Constant Growth Dividend Stock
**

Consider a stock where the dividend is expected to grow at a constant rate, g. The dividends are: Year 1 Div1 2 Div1(1+g) 3 4... Div1(1+g)2 Div1(1+g)3...

This is a growing perpetuity. The present value is: P0 = Div1/(r-g)

Example

Suppose GM is expected to pay a dividend of $2.08 at the end of the year. You expect the dividend to grow at a 4% rate forever. The required rate of return on GM stock is 10%. What is the price today? Price (GM) = 2.08/(0.10-.04) Price (GM) = 2.08/0.06 = $34.67

**Change in growth rate
**

What if new news comes out today.

The 0% financing has hurt current and future profits. New Growth rate is expected to be 3% What is the new Price?

Price(GM) = 2.08/(.10-.03) = $29.71 %Price Drop = (34.67-29.71)/34.67 = 14% Big Price change from small change in growth rate.

Example

GM paid a dividend of $2.08 today. You expect the dividend to grow at a 4% rate forever. The required rate of return on GM stock is 10%. What is the price today? Price (GM) = 2.08(1.04)/(0.10-.04) Price (GM) = 2.16/0.06 = $36.05

**Determining Expected Return
**

If we know the current price, dividend, and growth rate we can calculate the expected return of the stock. Price = D1/(rcs-g) ⇒ P(rcs-g) = D1 ⇒ rcs-g = D1/P ⇒ rcs = (D1/P) + g

**Example: Expected Return
**

General Electric closed at $22.70 and expected to pay a dividend of $0.76. Suppose the growth rate, g = 6%. What is the expected return on GE stock? 22.7 = 0.76/(r-0.6) rcs = 0.76/22.70 + .06 = 0.0934 or 9.34%

**Differential Growth Stock
**

Consider a stock whose dividend is expected to grow at a rate gh for the next T years, and then grow at the rate gl from year T into perpetuity. How would you value this stock?

**Differential Growth Stock
**

How would you value this stock?

First, value the next T years cash flows. Second, value the remaining years as a growing perpetuity.

**Example: Differential Growth
**

Consider the following stock

Expected to pay a dividend of $0.45 in one year. The dividend is expected to grow at a rate of 20% for following 4 years. Following this rapid growth period the dividend is expected to grow at 15% into perpetuity. The discount rate for this stock is 22%

Dividend Payments

Year Growth Dividend 1 0.45 2 0.20 0.54 = .45(1+.20) 3 0.20 0.648 = .54(1+.20) 4 0.20 0.7776 = .648(1+.20) 5 0.20 0.9331 = .7776(1+.20) 6 0.15 1.073 = .9331(1+.15) 7 0.15 1.234 = .9331(1+.15)2 all additional years at 15%

**Value of Growing Annuity
**

The value of the first five years of dividends with a discount rate of 22%.

PV = 0.45/(1.22) + 0.54/(1.22)2 + 0.648/(1.22)3 +0.7776/(1.22)4 + 0.9331/(1.22)5

= 1.7848

**Value of Growing Perpetuity
**

The dividend payments for year 6 on can be valued as a growing perpetuity. The year 6 dividend is 1.073 and the growth rate is 15% forever (same discount rate of 22%). The year 5 value of this perpetuity is: PV(at year 5) = 1.073/(.22-.15) = $15.3286 This is a year 5 value, so the year 0 value is: PV = $15.3286/(1+.22)5 = $5.6716

Determining Value

Year: CF 0 0 1 2 3 4 D1 D2 D3 D4

PV(a) =

5 6 7 D5 D6 D7

D6 1.073 = = $15.3 r - g 0.22 - 0.15

⎡ PV(a) ⎤ 15.3 PV(final) = ⎢ = = $5.67 5⎥ 5 ⎢ (1 + r) ⎥ (1 + .22) ⎣ ⎦

**Present Value of Stock
**

The time 0 stock price should be the sum of the annuity value (of dividends 1 - 5) and the perpetuity value from year 6 on. P0 = 1.7848 + 5.6716 = $7.4564

Determining g

Dividends

seldom constant If growing: the price of the stock is very sensitive to the assumption regarding growth rate g

How do we determine g? Can use historical dividends to determine g

Example: Determining g

The following are the historical dividends paid by Coke. What is the growth rate of dividends?

2000 2001 2002 2003 2004

Dividends 1.98 2.04 2.1 2.17 2.24

Example

2000 2001 2002 2003 2004 Dividends 1.98 2.04 2.1 2.17 2.24 Annual Growth Rates (2.04 - 1.98) / 1.98 (2.1 - 2/4)/ 2.04 (2.17 - 2.1)/ 2.1 (2.24 - 2.17)/2.17 0.030 0.029 0.033 0.032 0.031

Average growth rate of dividends

**What are the problems with this approach?
**

Future growth rates are not likely to be the same as past. Young companies grow at a rapid pace yearly on in their life and then growth rates drop Very difficult to predict future growth rates

Other Approaches

What happens when the firm does not pay any dividends? The P/E Approach

The is the price to earning ratio It is quite simple Essentially, price is a multiple of some important attribute For e.g., the retail price of the book for our course is $140. Your friend bought a used copy for $70, i.e., at half the price You want to buy a used copy for Marketing Management. The retail price of the book is $90. What price would you be willing to pay for the used copy?

Multiple Approach

Need to also keep in mind

Is it the same edition? How many people have owned the book before? Is it in good condition

Are there markings Dog ears

**Similarly, firms could be priced as a multiple of earnings.
**

Coke annual earnings per share were $8. It is trading at a P/E ratio of 12. The share price is ? If Pepsi had earnings of $6 a share, what would its share price be?

P/E Ratios

Earnings of Kawasaki motorcycles is $ 5 a share. What is its price?

Before you use the P/E ratio need to be comfortable that stocks are similar Difficult to translate it across industries Difficult to translate it across firms with different risks

What is an example of a market where multiples are used commonly?

Other Approaches

The fundamental approach is Discounted Cash Flow What does a firm do with its earnings

Pays it out as dividends Or keeps it in the firm and invests it in other projects These other projects generate their own profits

If the firm does not pay out any cash, it can be valued by asking how much cash it will generate

This is the true value. As a shareholder you can get it by receiving dividends or increase in stock price from the new projects undertaken Next module, we will spend time on how to estimate the firms cash flows. Once we have the cash flows, these can be discounted to get the value of the firm.

Net Prevent Value Sept 26th

Prof. Simi Kedia Financial Management Rutgers Business School

1

Concepts/Introduction

Capital Budgeting (CB) Criteria

How Firms decide what to do? How much value do these activities generate? NPV Payback Discounted Payback Internal Rate of Return Profitability Index

2

Value Projects

Determine the Cash Flows Calculate the Present Value Decision Criteria: Should we do this project or not?

3

**Example: Project Begin
**

You are looking at a new project, Project Begin. The details of the project are as follows

The Project requires investment in plant and machinery of $ 165,000 now The project will generate cash flows of $63,120 at the end of one year. It will generate cash flows of $70,800 in the second year and cash flow of $ 91,080 in the third year. The required return on the project of this risk is 12%.

Question:

Should you undertake this project? How much will you gain from it?

4

**Project Begin: PV of Cash Inflows
**

The Cash inflows from Project Begin The cash inflows are:

Year 1: Year 2: Year 3: CF = 63,120; CF = 70,800; CF = 91,080;

**Your required return for assets of this risk is 12%. PV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 PV = 177,627.42
**

5

**Should we do the Project?
**

Present Value of cash inflows $ 177,627.42

Cost of doing the project: $ 165,000 Net Present Value or NPV = $12,627.42 Do the Project if NPV>0

6

**Project Begin: PV of Cash Flows
**

Alternatively, we could look at all cash flows from Project Begin. These are

Year 0: Year 1: Year 2: Year 3: CF = -165,000 CF = 63,120; CF = 70,800; CF = 91,080;

**Net Present Value or NPV is: 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = $12,627.42
**

7

**Net Present Value (NPV)
**

The difference between the market value (or present value) of a project and its cost If the NPV is positive, accept the project

A positive NPV: project adds value to the firm and will increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

8

Payback Period

How long does it take to get the initial cost back in a nominal sense? Computation

Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered

**Decision Rule – Accept if the payback period is less than some preset limit
**

9

**Example: Project Begin
**

Let us look at Project Begin again

The Project requires investment in plant and machinery of $ 165,000 now The project will generate cash flows of $63,120 at the end of one year. It will generate cash flows of $70,800 in the second year and cash flow of $ 91,080 in the third year. The required return on the project of this risk is 12%.

Question:

What is the payback period? If the criteria is to accept projects with payback period of two years, should we accept the project?

10

**Payback Period for Project Begin
**

Assume we will accept the project if it pays back within two years.

Year 1: 165,000 – 63,120 = $101,880 still to recover Year 2: 101,880 – 70,800 = $31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 Project pays back in year 3

**We reject the project.
**

11

**Problems with Payback Criteria
**

Year 0 1 2 3 Cashflow A $-1000 $ 900 $0 $ 300 Cashflow B $-1000 $ 300 $0 $ 900

Payback = 3 years for both A and B Are the projects worth the same?

12

**Problems with Payback Criteria
**

Year 0 1 2 3 Cashflow A $-1000 $ 900 $0 $ 300 Cashflow B $-1000 $ 300 $0 $ 900

**Payback = 3 years for both A and B At a discount rate of 10%
**

NPV(A) = $43.58 NPV(B) = $ - 51.09

13

**Advantages and Disadvantages of Payback
**

Advantages

Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity

Disadvantages

Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against long-term projects, such as research and development, and new projects

14

**Discounted Payback Period
**

Compute the present value of each cash flow and then determine how long it takes to payback on a discounted basis Compare to a specified required period Decision Rule - Accept the project if it pays back on a discounted basis within the specified time

15

**Example: Project Begin
**

Let us look at Project Begin again

The Project requires investment in plant and machinery of $ 165,000 now The project will generate cash flows of $63,120 at the end of one year. It will generate cash flows of $70,800 in the second year and cash flow of $ 91,080 in the third year. The required return on the project of this risk is 12%.

Question:

What is the discounted payback period? If the criteria is to accept projects with payback period of two years, should we accept the project?

16

**Discounted Payback for the Project Begin
**

Assume we will accept the project if it pays back on a discounted basis in 2 years. Compute the PV for each cash flow and determine the payback period using discounted cash flows Year PV of CF Amount to Recover Year 1: 63,120/1.121 = 56,357 165,000 – 56,357 = 108,643 Year 2: 70,800/1.122 = 56441 108,643 – 56,441 = 52,202 Year 3: 91,080/1.123 = 64829 52,202 – 64,829 = -12,627

**Project pays back in year 3 We reject the project
**

17

**Advantages and Disadvantages of Discounted Payback
**

Advantages

Includes time value of money Easy to understand Does not accept negative estimated NPV investments Biased towards liquidity

Disadvantages

May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products

18

**Internal Rate of Return
**

This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

19

**IRR – Definition and Decision Rule
**

Definition: IRR is the return that makes the NPV = 0 IRR solves the following equation:

C C Cn 2 1 NPV = C + + n =0 2 + ...+ 0 (1 + IRR ) (1 + IRR ) (1 + IRR )

**Decision Rule: Accept the project if the IRR is greater than the required return
**

20

**Example: Project Begin
**

Let us look at Project Begin again

The Project requires investment in plant and machinery of $ 165,000 now The project will generate cash flows of $63,120 at the end of one year. It will generate cash flows of $70,800 in the second year and cash flow of $ 91,080 in the third year. The required return on the project of this risk is 12%.

Question:

What is the IRR? Should we accept the project?

21

**Example: Computing IRR
**

Continuing our example, IRR is obtained by solving.

**NPV = 0 = -165,000 + 63,120 + 70,800 + 91,080 (1+ IRR ) (1+ IRR )2 (1+ IRR )3
**

Look at following table: r 0 10 12 16 16.132 17 NPV(project) $60,000 $19,324 $12,627 $381 $0.7 -$2,463

22

**Decision Criteria with IRR
**

The estimated IRR = 16.132% As the required rate of return is 12%, and IRR = 16.132% > 12% Accept the Project

23

Advantages of IRR

Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesn’t know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task Takes into account the time value of money

24

Summary of Criteria

For the example

NPV method: We accept the project By IRR method: We accept the project By payback method (2 years): We reject project By discounted payback method (2 years): We reject the project

If conflict: Always use NPV rule

25

Example

Firm Dark Ages has the following project: Year Cash Flow 0 -1500 1 300 2 800 3 600 4 500 Dark Ages uses a payback period of 3 years as its criteria.

a) What is the payback period (in years)? b) Will they accept of reject this project?

26

Payback Period

Year Cash Flow Amount Left 0 -1500 1 300 1200 2 800 400 3 600 -200 4 500 Payback period is 3 years Accept the project If discount rate is 15%, What is the discounted payback period? Should you accept the project?

27

**Discounted Payback Period
**

Year 0 1 2 3 4 Cash PV of Cash Amount Left Flows Flows to Recover -1500 -1500 300 260.87 1239.13 800 604.91 634.22 600 394.51 239.71 500 285.88 -46.17

**Discounted Payback period is 4 years Reject the project Is this a good or bad project?
**

28

NPV

Year 0 1 2 3 4 NPV Cash PV of Cash Flows Flows -1500 -1500 300 260.87 800 604.91 600 394.51 500 285.88 46.17

**The NPV is positive Accept the project
**

29

NPV Vs. IRR

NPV and IRR will generally give us the same decision Exceptions

Non-conventional cash flows – cash flow signs change more than once Mutually exclusive projects – When only one of two or more projects can be chosen

30

**Mutually Exclusive Projects
**

Two or more projects that cannot be pursued simultaneously If you can choose only one project:

The NPV rule:

Choose the project with the highest positive NPV

**The natural IRR rule
**

Accept the project with the highest IRR.

31

Example

Consider the following two projects

Year 0 1 2 3 4 Project S Project L -1000 -1000 500 100 400 300 300 400 100 600

**If the discount rate is 5% should we do project S? Project L?
**

32

Example Cont..

Year 0 1 2 3 4 NPV Discounted Cash Project S Flows at 10% -1000 -1000 500 476.19 400 362.81 300 259.15 100 82.27 180.42

**As NPV = 180>0, Accept the project
**

33

Example Cont..

Year 0 1 2 3 4 NPV Discounted Cash Project L Flows at 10% -1000 -1000 100 95.24 300 272.11 400 345.54 600 493.62 206.50

As NPV = 206.5>0, Accept the project What are the IRR of the two projects?

34

Example: IRR

What are the IRR of the two projects? For Project S

0 = -1000 + 500 + 400 + 300 +...+ 100 = 0 (1+ IRR ) (1+ IRR )2 (1+ IRR )3 (1+ IRR )4

IRR for project S is 14.5%

**The IRR for project L is 0 = -1000 + 100 + 300 + 400 +...+ 600 = 0 (1+ IRR ) (1+ IRR )2 (1+ IRR )3 (1+ IRR )4
**

The IRR for Project L is 11.8%

35

NPV Profiles

Cost of Capital 0 5 10 15

NPV of Project S 300 180.42 78.8 -8.33

NPV of Project L 400 206.5 49.18 -80.14

36

**Net Present Value Profiles
**

500

400

300

200

NPV

**NPV of Project S NPV of Project L
**

100

IRR (S) = 14.5%

0 0 5 10 15

-100

**Cross Over Rate = 7.2%
**

-200

IRR(L)

= 11.8%

Cost of Capital

37

Project S and L

If you can choose only Project S or Project L which one will you choose? NPV Rule

If the cost of capital is less than 7.2% (the cross over rate): Choose Project L If the cost of capital is greater than 7.2%: Choose Project S Why? Project S cash flows come sooner. It is better if the discount rate is high

38

**Mutually Exclusive Projects: Another Example
**

Consider projects A and B with r =15% Year Cash Flow(A) Cash Flow (B) 0 -$1,000 -$10,000 1 $1,500 $12,500 IRR NPV 50% $304 25% $870

NPV rule: Chose Project B IRR rule: Choose Project A A has higher IRR, but B will make the firm richer

39

**Mutually Exclusive Projects
**

Two basic conditions can cause the answers from NPV and IRR to conflict with mutually exclusive projects

When timing differences exist (first example) When scale differences exist (second example) Always use the NPV method when there is a conflict

40

Evaluating Incremental CF

One way around this problem is by evaluating the incremental cash flows.

Start with the highest IRR project (Project A). Decide whether you want to undertake it. If yes, then ask if taking the incremental investment required for B is a good idea Incremental investment is the difference in the investment of Project A and Project B B is equivalent to A + (B-A) = B

41

Ex: Continued

Consider projects A and B with r =15%

Yr CF(A) 0 -$1,000 1 $1,500 CF(B) CF(B-A) Incremental project -$10,000 -$9,000 $12,500 $11,000

IRR

50%

25%

22%

IRR for incremental Project = 22% > 15% so we should take the incremental project, i.e, take Project B 42 Notice: could just use NPV to begin with

**Second Problem with IRR
**

IRR and NPV give different results if there are unconventional cash flows i.e., multiple sign changes If the cash flows are not all negative followed by all positive there are two possibilities:

There are multiple IRRs There is no IRR in relevant range (I.e..., positive real numbers)

43

**Example: Multiple Sign Changes
**

Consider the following project Year Cash Flow 0 -$4,000 1 $25,000 2 -$25,000 IRR 25% and 400% NPV at 10% = -1934

44

Discount Rates vs. PV

3000 2000 1000 0 PV -1000 0 -2000 -3000 -4000 -5000 Discount Rate 10 25 100 200 300 400

45

Example: No IRR

Consider the following project Year Cash Flow 0 $1,000 1 -$3,000 2 $2,500 IRR none NPV at 10% = 339

46

600 500 400 PV 300 200 100 0 0 10 20 30 40 50 100 Discount Rate

47

**Conflicts Between NPV and IRR
**

IRR is unreliable in the following situations

Non-conventional cash flows

Two or more IRR No IRR

**Mutually exclusive projects
**

May make you choose the wrong project

NPV measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV

48

**The Verdict on IRR
**

IRR can be useful. However, only useful when it is equivalent to the NPV rule. With information we need to compute IRR we can compute NPV. NPV gives us what we want: the addition to firm value of the project. Should use NPV or incremental IRR.

49

**Mutually Exclusive Projects
**

Interesting Issues that arise when we have to choose between projects

Capital Rationing: When capital in limited

Profitability Index

Choosing between projects with different durations Investment Timing: When to undertake the project

50

Profitability Index (PI)

PI = Net Present Value (NPV) Initial Investment Measures the benefit per unit cost, based on the time value of money Notice that:

(NPV)/(Inv) > 0 when NPV > 0

**Decision Rule: Take projects with profitability index greater than 0.
**

51

Example

Suppose you can choose between two mutually exclusive projects. Project Year 0 Year 1 Year 2 1 -100 200 150 2 -500 350 1000 Assume that r = 10%

52

Example Continued

We can calculate the PI for each project. Project 1: NPV= -100 + 200/1.1 + 150/1.12 = $205.79 Initial Investment = 100 PI = 205.79/100 = 2.06 Project 2: NPV = -500 + 350/1.1 + 1000/1.12 = 644.63 Initial Investment = 500 PI = 644.63/500 = 1.29

53

Example Continued

Decision Criteria: Accept Project with the highest Profitability Index, i.e., accept project 1 Wrong: The above decision criteria does not take into account the scale of the project (like IRR)

Ex: A project with a cost benefit-ratio of 0.5 and initial investment of $100,000,000 is better than a project with a costbenefit ration of 1 and an initial investment of $100.

**This problem can be solved like the IRR problem
**

Use NPV Or calculate the PI of incremental project

54

Example Continued

Project 1 2 IP (2-1) Year 0 -100 -500 -400 Year 1 200 350 150 Year 2 150 1000 850 PI 2.06 1.29 1.10

If profitability index of incremental project is greater than zero, then take project #2.

55

Capital Rationing

Profitability index is useful when capital is limited. This may happen when Manager of division given a limited capital budget. For e.g., consider the following

Project Capital NPV A 100 200 B 100 100 C 200 100 Which projects should you choose if you have only $200 to invest?

56

Capital Rationing (2)

Project A B C Choices are Capital 100 100 200 NPV 200 100 100 PI 2 1 0.5 Rank(PI) 1 2 3

1) Project C: NPV = $ 100 2) Project A and B: NPV = $ 200 + $ 100 = $ 300

**Use Profitability Index
**

Rank projects By Profitability Index Take projects with highest PI until capital is used up or PI < 0.

57

**Ex. Capital Rationing
**

Pjct Cost A B C D E F NPV

200,000 100,000 500,000 120,000 400,000 300,000 200,000 75,000 100,000 30,000 100,000 40,000 Capital Budget 1Million.

58

**Ex. Capital Rationing
**

Pjct Cost NPV A 200,000 100,000 B 500,000 120,000 C 400,000 300,000 D 200,000 75,000 E 100,000 30,000 F 100,000 40,000 Capital Budget 1Million.

Take C,A,F,D, and E.

PI RANK(PI) 0.50 2 0.24 6 0.75 1 0.38 4 0.30 5 0.40 3

59

**Advantages and Disadvantages of Profitability Index
**

Advantages

Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited

Disadvantages

May lead to incorrect decisions in comparisons of mutually exclusive investments. Does not account for the scale of the project

60

**Choosing Between Projects of Different Durations
**

Many times a firm is faced with a choice between two projects with different lives: For example, a firm needs to choose between two machines.

One is more expensive, but lasts longer One is cheaper, but less durable

**We need a framework to compare the merits of the two different investments
**

61

**Ex. Projects with different durations
**

Consider the choice between the following machines: Initial Cost Annual Operating Cost Life A:15M 2M 2 years B:20M 1M 3 years Revenue generated per year is the same. r = 5%

62

Take PV of Costs

As the revenues from both machines are the same, choosing projects with maximum NPV is the same as choosing projects with lowest Present value of Cost PV of costs for the two projects are A: 15 + 2/(1.05) + 2/(1.05)2 = 18.72 M B: 20 + 1/(1.05) + 1/(1.05)2 + 1/(1.05)3 = 22.72 M

63

Example: continued

Project A has lower PV of costs Should we choose Project A? But Project B lasts longer? How do we take this into account? Two techniques: 1: Compare over a common duration (Replacement Cost) 2: Compare Equivalent Annual Cost

64

Common Duration

Suppose firm needs to produce this product for 6 years. Machine A needs to be purchased 3 times

Yr 0 1 2 3 4 5 6 1st Time 15M 2M 2M 2nd Time 3rd Time Total Costs 15M 2M 17M 2M 17M 2M 2M

65

15M 2M 2M

15M 2M 2M

Common Duration

Machine B needs to be purchased 2 times. Total Costs for both machines are

Yr 0 1 2 3 4 5 6 Cost of A 15M 2M 17M 2M 17M 2M 2M Cost of B 20M 1M 1M 21M 1M 1M 1M

PV cost A = 51.10M PV cost B = 42.35M Buy B

66

**Equivalent Annual Cost (EAC)
**

We could also estimate the equivalent annual cost. This is equivalent to a rental rate which would allow a firm renting the machine to break even. The annualized costs for each machine are such that the present value of these costs equals the present value of the actual costs of the machines.

67

Computing EAC

Machine A:

Year 0 1 2 PV Annual Cost 15M 2.00M 2.00M 18.72M EAC 0.00M XM XM 18.72M

X is the 2-year annuity payment that has a PV of 18.72 at the 5% cost of capital.

**Firm is indifferent between buying A or renting A for $X M per year.
**

68

Computing EAC

EAC is determined by: EAC = (PV of Costs)/(Annuity Factor,r,n)

n = life of machine, r = discount factor

PV

EAC =

⎡1 ⎤ 1 ⎢ − ⎥ n⎥ ⎢ r r(1 + r) ⎦ ⎣

**Here: PV = 18.72M r = .05 n = 2 years (life of the machine) EAC for Machine A = 10.07M
**

69

EAC continued

Buying machine A 3 times over the 6 years is equivalent to paying out 10.07M per year. Notice that:

PV of a 6 year annuity of 10.07M is 51.10M. This is the same as the PV of buying machine A 3 times over 6 years.

70

**EAC for Machine B
**

Machine B:

EAC = 22.72 / (Annuity Factor, 5%, 3 years) = 8.34M

Machine B has lower EAC and should be purchased over machine A.

71

**Projects with different duration
**

1.

**Compare over a common duration (Replacement Cost)
**

Choose the project with the higher NPV over the common duration. If revenues are same, this is similar to choosing project with lower PV of costs over the common durations

2.

**Compare Equivalent Annual Cost
**

Choose project with lower equivalent annual cost

72

**Example: Different Duration
**

Firm is considering two project C and F with the following costs and Cash flows

Project C 0 1 2 3 4 5 6 -40,000 8000 14,000 13,000 12,000 11,000 10,000 Project F -20,000 7,000 13,000 12,000

**Project C: NPV (at 11.5%) = 7,165, IRR = 17.5% Project F: NPV (at 11.5%) = 5,391, IRR = 25.2%
**

73

Example

Though NPV for project C is higher, the analysis is incomplete due to different duration Method 1: Same Duration Analysis

Project F will have to be done twice. The NPV of the project the second time is also 5391 but in year 3. Total NPV 5391 + 5391/(1.115)3 = 9280 The NPV of project C = 7165 Choose Project F.

74

Different Duration

Our methods of comparing projects with different durations are valid only if

The firm actually intends to operate the project for the extended time period. If there is inflation, then cost of replacing the machinery may be different If replacements incorporate new technology then how do we incorporate these It is not easy to estimate the lives of projects anyway. Is there a big difference between projects with lives of 8 years or 10 years?

75

**Economic life vs. Physical Life
**

Projects are normally evaluated with the assumption that they will run for their full physical life

This need not be true

**Salvage value is the value the firm will get if it terminates the project at that time
**

Usually the sale of the physical plant and equipment

76

Example

Consider the firm with the following cash flows and salvage values. The discount rate is 10%

Year 0 1 2 3 Cash Flows -4,800 2000 2000 1750 Salvage Value 4800 3000 1650 0

**How long should you run the project?
**

77

Example cont.

If you run the project for three years

NPV = -4,800 + 2000/(1.1)1 + 2000/(1.1)2 + 1750/(1.1)3 = -$14.12 If you run the project for two years then NPV = -4,800 + 2000/(1.1)1 + 2000/(1.1)2 + 1650/(1.1)2 = $34.71 If you run the project for one years then NPV = -4,800 + 2000/(1.1)1 + 3000/(1.1)1 = -$254.55

78

Example cont.

The project should be run for two years 2 years is the economic life of the project, as opposed to the physical or engineering life which is 3 years.

79

Investment Timing

You are considering buying a cell phone.It has a life of 2 years. The discount rate is 10% .Other details are as follows: Year Price PV of gains 0 50 100 1 45 100 2 33 100 3 30 100 Should you buy it today, next year, or even later?

80

Investment Timing

Year Price PV (gains) NPV (Purchase) 100 100 100 100 50 55 67 70 NPV (today) 50 = 50 55/(1.1)1 = 50 67/(1.1)2 = 55 70/(1.1)3 = 53

0 1 2 3

50 45 33 30

**Buy the phone in year 2
**

81

**Conclusion for NPV
**

NPV tells us what we want to know

Whether the project should be done or not How much will be gain by doing the project

**Other criteria can be useful:
**

Payback, Discounted Payback: Emphasis on Liquidity Profitability Index: Helps when capital rationing IRR: Intuitive Must know the possible pitfalls of these methods.

**If conflict , always use NPV rule.
**

82

Discounted Cash Flows Oct 3rd

Prof. Simi Kedia Financial Management Rutgers Business School

1

Announcements

The problem set is due on Oct 10th. We will discuss it on Oct 10th. If there are any other questions we will also discuss that on Oct 10th The Midterm is on Oct 17th.

It will be mostly multiple choice problems There will be no class after the exam

2

Introduction To DCF

We have learnt

The mechanics of calculating present values The different criteria used to decide whether to do projects or not

**Now we will study
**

How to estimate Cash flows What to include and what to exclude Determine Cash Flows from accounting numbers Use the above cash flows to value a whole firm

3

**Cash Flows from Financial Statements
**

We have been given cash flows till now Now we will study how to come up with cash flows from the financial statements of firms We need cash flows not profits

Why?

4

**Our Typical Problem
**

Firm buys machine A. The cash flows from the machine are:

Year 0 1 2 3 Cash Flows -30M +16M +16M + 16M

**Let us understand how we will put this transaction on our books….account for it.
**

What is Depreciation?

5

Depreciation

Initial Value = $ 30,000 Life of the equipment = 3 years Straight Line Depreciation = $30,000/3 = 10,000 Year 1 30k 10k 20k Year 2 20k 10k 10k Year 3 10k 10k 0k

Begin value Depreciation End value

6

Depreciation

This is a non cash expense

It is there for accounting. The corresponding cash expense was undertaken at the beginning of the project Other non cash expenses are amortization.

**As it is not a cash outflow, and accounting profits deduct this we have to
**

Add this back to get cash flows

7

Example

A firm spends $30,000 in cash to purchase a machine today that it plans to depreciate on a straight line basis over three years. With this machine, the firm can produce 10,000 units that cost $1 to make and sell for $3. Taxes are 40%

What is the income statement? What are the cash flows from this project?

8

**Example: Income Statement
**

Sales less: COGS Gross Profits Less: Depreciation EBIT Less: Taxes (40%) Net Income 30,000 10,000 20,000 10,000 10,000 4,000 6,000

**How much cash does this project generate every year?
**

Net Income + Depreciation: $6,000 + $10,000 = $16,000

9

**Could we do the following?
**

Sales less: COGS Gross Profits Less: Depreciation EBIT Less: Taxes (40%) Net Income 30,000 10,000 20,000 20,000 8,000 12,000

**What is the problem with this?
**

10

**Depreciation Tax Shield
**

Depreciation is deductible to calculate taxes payable

With deprecation: Taxes were 4000 If we do not deduct depreciation: Taxes are 8000 The 4,000 is the difference we see

If we ignore depreciation in calculating net income, then need to add the above benefit on the side Depreciation tax shield = DT

D = depreciation expense T = marginal tax rate 10,000*.4 = 4000 every year Cash flows are: 12000 + 4000 = 16,000

11

**Example: Income Statement
**

Sales less: COGS Gross Profits Less: Taxes (40%) After Tax Income (1) Depreciation Depreciation Tax Shield (Dxt) (2) Total Cash Flow ( 1 + 2 ) 30,000 10,000 20,000 8,000 12,000 10,000 4000 16,000

12

Cash Flow

Cash Flows from the project

Year 0 Cash Flow from Operations Cash Flow from Investment Total Cash Flows from Projec -30,000 -30,000 Year 1 Year 2 Year 3 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000

13

Computing Depreciation

Straight-line depreciation

D = Initial cost / number of years Very few assets are depreciated straight-line for tax purposes

**MACRS (Modified Accelerated Cost Recovery System)
**

Need to know which asset class is appropriate for tax purposes Multiply percentage given in table by the initial cost Depreciate to zero

14

Example: Depreciation

You purchase equipment for $110,000. Other information

The company’s marginal tax rate is 40%. Life is six years What is the depreciation expense each year

With straight line depreciation With MACRS?

**What is the book value of the asset at the end of six years?
**

15

Example: Depreciation

You purchase equipment for $110,000. Other information

The company’s marginal tax rate is 40%. Life is six years What is the depreciation expense each year

With straight line depreciation With MACRS?

What is the book value of the asset at the end of six years?

**With straight-line depreciation
**

Annual Depreciation = 110,000 / 6 = 18,333.33 Book Value in year 6 = 110,000 – 6(18,333.33) = 0

16

MACRS

Was put forth by the Tax Reform Act of 1986 This sets out annual depreciation deductions for various classes of assets

Automobiles for business are in the three-year class Computer equipment is part of the five year class Most manufacturing equipment is in the seven year class

17

**Example: Three-year MACRS
**

Year 1 2 3 4 MACRS percent .3333 .4444 .1482 .0741 Dep. .3333(110,000) = 36,663 .4444(110,000) = 48,884 .1482(110,000) = 16,302 .0741(110,000) = 8,151

18

BV in year 6 = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = 0

**Example: 7-Year MACRS
**

Year 1 2 3 4 5 6 7 8 MACRS Percent 0.1429 0.2449 0.1749 0.1249 0.0893 0.0893 0.0893 0.0445 Dep.

**What is the book value at the end of six years
**

19

**Example: 7-Year MACRS
**

Year 1 2 3 4 5 6 MACRS Percent .1429 .2449 .1749 .1249 .0893 .0893 Dep. .1429(110,000) = 15,719 .2449(110,000) = 26,939 .1749(110,000) = 19,239 .1249(110,000) = 13,739 .0893(110,000) = 9,823 .0893(110,000) = 9,823

20

BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718

Salvage Value

This is the value the asset can be sold for at the end of the project. There are two effects The amount of depreciation

Straight-line depreciation

D = (Initial cost – salvage) / number of years

MACRS: It does not effect the depreciation

If the salvage value is different from the book value of the asset, then there is a tax effect

21

**Salvage Value and Tax Effect
**

This is cash inflow, it should be included in cash flows However, the gains on selling the machine are taxed by the government. These taxes paid are a cash outflow. We have to subtract the taxes from cash flows.

Gain from selling the machine = Value at which the machine is sold – book value of machine Book value = initial cost – accumulated depreciation Taxes on the profits: T(salvage – book value).

**After-tax impact on cash flow = salvage – T(salvage – book value)
**

22

Continuing Example

You purchase equipment for $110,000. Other information

The company’s marginal tax rate is 40%. Life is six years Salvage Value at the end of six years is $ 17,000 With both depreciation methods (3yr and 7 yr MACRS)

What is the annual depreciation expense? What is the after tax salvage value?

23

**Example: Straight-line Depreciation
**

With straight-line depreciation

Annual Depreciation = (110,000 – 17,000) / 6 = 15,500 Book Value in year 6 = 110,000 – 6(15,500) = 17,000 Salvage value = 17,000 Profit/ Loss on selling the machine = 0 After-tax salvage = 17,000 - .4(17,000 – 17,000) = 17,000

24

**Example: Three-year MACRS
**

Year 1 2 3 4 MACRS percent .3333 .4444 .1482 .0741 Dep. .3333(110,000) = 36,663 .4444(110,000) = 48,884 .1482(110,000) = 16,302 .0741(110,000) = 8,151

25

BV in year 6 = 110,000 – 36,663 – 48,884 – 16,302 – 8,151 = 0 After-tax salvage = 17,000 .4(17,000 – 0) = $10,200

**Example: 7-Year MACRS
**

Year 1 2 3 4 5 6 MACRS Percent .1429 .2449 .1749 .1249 .0893 .0893 Dep. .1429(110,000) = 15,719 .2449(110,000) = 26,939 .1749(110,000) = 19,239 .1249(110,000) = 13,739 .0893(110,000) = 9,823 .0893(110,000) = 9,823

BV in year 6 = 110,000 – 15,719 – 26,939 – 19,239 – 13,739 – 9,823 – 9,823 = 14,718 After-tax salvage = 17,000 .4(17,000 – 14,718) = 16,087.20

26

**Net Working Capital
**

Net working Capital = A/c Receivables + Inventory – A/c Payables

Accounts Receivables: Having receivables means that the company has made the sale but has yet to collect the money from the purchaser. Accounts Payables: Money that is owed to suppliers. The company has got its raw materials but not paid for them yet Inventory: The value of the goods not sold yet

27

More on NWC

Why do we have to consider changes in NWC separately?

GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales although we haven’t collected cash yet

28

Working Capital

The difference in timing between accounts receivable and payable plus inventory costs is accounted for in changes of Working Capital. This working capital can be absorbed as a cash inflow when the project is concluded.

29

**More on Working Capital
**

Net working Capital = A/c Receivables + Inventory – A/c payables Year 0 Sales Cost NI A/C Receivable A/c Payable Inventory NWC ∆NWC -2.5M Year 1 10M 8M 2M 800k 300k 2M 2.5M -0.7M Year 2 12M 9M 3M 1.2M 500k 2.5M 3.2M +3.2M Year 3 8M 7M 1M 0 0 0 0

30

**Why does WC change over time?
**

What would cause working capital to increase?

If inventories are increasing If accounts receivable are increases If accounts payable are decreasing

**What would cause working capital to decrease?
**

If inventories are decreasing If accounts receivable are decreasing If accounts payable are increasing

31

**Pro Forma Statements and Cash Flows
**

Cash inflows or outflows can come from

From operations: If you are a manufacturing firm, this is the cash from selling the machinery produced From the investments required to run the business

Cash flow from assets: For e.g. buying machinery and equipment Investment in Working Capital: This is the cash buffer you need to run the business

32

**Relevant Cash Flows
**

The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

33

**Asking the Right Question
**

You should always ask yourself “Will this cash flow occur ONLY if we accept the project?”

If the answer is “yes”, it should be included in the analysis because it is incremental If the answer is “no”, it should not be included in the analysis because it will occur anyway If the answer is “part of it”, then we should include the part that occurs because of the project

34

Sunk Costs

These are costs that have been incurred. For e.g., Smart Inc is considering launching a new line of fashion clothing. It paid $30,000 to Greatads Inc. to study the success of this fashion line. In deciding whether to launch this line, should Smart Inc include the payment to Greatads Inc?

35

Opportunity Costs

These are not out-of-pocket expenses. This requires us to give up a benefit. An advantage Smart Inc has in launching its new fashion line is a fortunate real estate deal. 10 years back it bought office space in the garment district in mid town Manhattan for 1M dollar. Now it is worth 10M dollar. As office costs will only be 1M the project is likely to be positive NPV Do you agree with Smart Inc.?

36

Side Effects

These are effects on other areas of the firm. The new fashion line with be integrated with the existing accessories which Smart Inc sells. Smart Inc. expects the sales of its accessories to increase by 25% with the launch of its new line. This is another advantage associated with the new line of clothing. Do you agree with Smart Inc.?

37

**Summary: Relevant Cash Flows
**

Sunk costs

Costs already incurred

**Do not included Opportunity costs
**

Cost of lost options.

**Included Side effects
**

Positive side effects – benefits to other projects Negative side effects – costs to other projects

Included

38

**Example of Relevant Cash Flows
**

Which of these cash flows should be included

1.

2.

3.

A reduction in the sale of companies other products caused by the investment An expense on equipment that will be made only if the project is undertaken Cost of research and development undertaken in the past three years to develop the product. You are considering whether to manufacture the product or not

39

**Example of Relevant CF cont.
**

Which of these cash flows should be included

Annual depreciation expense from the investment in the project Some of the people working on the project will be from other departments in the firm. The salary and medical costs associated with these people.

40

Another Example

Golfco is considering the following project

Introducing a brightly colored ball They spend $250k to investigate the potential of selling these balls If they decide to manufacture and sell this ball, they will require an investment of $100K in equipment to manufacture a new line of balls. The cash flow from selling the machine at the end of year 5 is $ 21.76 They plan to use a building owned by the firm which is currently vacant. The building is valued at $150K and expected to keep its value in five years The tax rate = 34%, required rate of return = 10% Years of project = 5 Years

41

Income Statement

Year 0 Revenue Costs Depreciation EBIT Taxes @ 34% Net inocme NWC

Year 1 Year 2 Year 3 Year 4 Year 5 100 163.2 249.72 212.2 129.9 50 88 145.2 133.1 87.84 20 32 19.2 11.52 11.52 30 43.2 85.32 67.58 30.54 10.2 14.688 29.0088 22.9772 10.3836 19.8 28.512 56.3112 44.6028 20.1564 10 10 16.32 24.97 21.22

42

Salvage Value

Accumulated Depreciation: 20 + 32 + 19.2 + 11.52 + 11.52 = 94.24 Book Value at the end of five years

100 – 94.24 = 5.76

**Gain from selling the machine: 21.76 – 5.76 = 16 Taxes from selling it = 0.34 x 16 = 5.44 After Tax cash flow
**

21.76 – 5.44 = 16.32

43

Cash Flows

EBIT Taxes @ 34% Depreciation Operting CF (1) NWC Change in NWC (2) Equipment (3) Building (4) Test Marketing CF ( 1+2+3+4) 30.00 10.20 20.00 39.80 10 0.00 43.20 14.69 32.00 60.51 10.00 -6.32 85.32 29.01 19.20 75.51 16.32 -8.65 67.58 22.98 11.52 56.12 24.97 3.75 30.54 10.38 11.52 31.68 21.22 21.22 16.32 150.00 39.80 54.19 66.86 59.87 219.22

-10 -100 -150 -260

44

NPV

NPV at 10% = $ 51k Golfco should accept the project Note:

Did not include test marketing costs. This is sunk costs Included the building cost: This is the opportunity cost Used Cash flows not accounting earnings / net income

45

What if?

What if the firm is not able to sell the number of Balls it plans to? What if there is a lot of competition and the firm has to reduce its price to sell? What if the are costs are higher than anticipated? Before accepting the project it is a good idea to get a sense of how bad or good things might be?

46

Scenario Analysis

One way to handle this is to construct the pessimistic and optimistic case Consider the following example. After analyzing the various possibilities you come up with the following

Sales Price Variable. Cost Fixed Cost Base Case 6,000 $80 $60 $50,000 Pessimistic 5,500 $75 $62 $55,000 Optimistic 6,500 $85 $58 $45,000

47

Scenario Analysis

Base Case Net Income Cash Flow NPV IRR $19,800 $59,800 $15,567 15.1% Pessimistic -15,510 24,490 -111,719 -14.4% Optimistic 59,730 99,730 159,504 40.9%

This can help us get a sense of what kind of disasters can happen It does not give us a “rule” for whether to take the project or not

48

Sensitivity Analysis

There can be a problems in forecasting

Units sold Future Price at which the units are sold The variable costs The fixed costs

Sensitivity analysis helps to figure out which errors are likely to have the biggest impact on the decision The firm can then spend more resources to examine in detail this “sensitive” variable

49

Sensitivity Analysis

We keep all the variables, except one fixed. We calculate NPV for different values of the one variable which is not fixed With this we get a sense of how much this variable will effect the NPV

50

Sensitivity Analysis

Let us consider how sensitive our analysis is to the number of units sold

Units Sold Cash Flow NPV 5000 46,000 -32,017 5400 51,880 -12,298 6000 59,800 15,566 6600 67,720 44,115 7000 73,000 63,149

51

Sensitivity Analysis

80,000

60,000

40,000

NPV

20,000

NPV

0 5000 5400 6000 6600 7000

-20,000

-40,000

Units Sold

52

Sensitivity Analysis

Unit Costs 70 66 60 54 50 Cash Flow NPV 20,200 -127,184 36,040 -70,084 59,800 15,566 83,560 101,215 99,400 158,315

53

Sensitivity Analysis

Decrease in units sold by 10% (to 5400) reduce NPV by 16.6% Increase in unit costs by 10% (to $66) reduces NPV by more than 500%. NPV falls from $15,566 to -$70,084.

54

**Example: Replacement Problem
**

Original Machine

Initial cost = 100,000 Annual depreciation = 9000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000 Salvage in 5 years = 10,000

New Machine

Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation

Required return = 10% Tax rate = 40%

55

Discounted Cash Flows Oct 10th

Prof. Simi Kedia Financial Management Rutgers Business School

1

**DCF: Discounted Cash Flows
**

Three sources of cash flows

Operating cash flows

Depreciation: Add Depreciation to Net income Straight line MACRS: 3 year, 5 year or 7 year schedule

Capital Expenditures

Upfront Expense Salvage Value: SV – Tax Rate (SV – BV)

**New Working Capital
**

Change in NWC

Add all three sources to get total cash flows Remember to exclude cash flows that were not relevant – for e.g. sunk costs

2

Example: Operating CF

ABC Inc. has the gross profits of $4000, $5000 and $6000 for the three years of the project. Its annual depreciation is $ 5000 and tax rate is 40%. What are the operating cash flows for the three years?

3

Example: Operating CF

1 4000 5000 -1000 -400 -600 4400 2 5000 5000 0 0 0 5000 3 6000 5000 1000 400 600 5600

Gross Profits Depreciation (1) Earnings Before Interest and Taxes (EBIT) Taxes Net Income (2) Operating Cash Flows (1+2)

4

**Example: Salvage Value
**

Continuing with the previous example ABC Inc can sell its plant at the end of three years for $3000. It had bought the plant for $20,000. What are the cash flows from selling the plant?

5

**Example: Salvage Value
**

Accumulated Depreciation: $5000 + $5000 + $5000 = $ 15,000 Book Value of plant at time of selling = $20,000 - $ 15,000 = $ 5000 Profit/Loss on selling is = 3000 – 5000 = 2000 Cash Flows = 3000 - 40%(-2000) = $3800

6

**Example: Replacement Problem
**

Original Machine

Initial cost = 100,000 Annual depreciation = 9000 Purchased 5 years ago Book Value = 55,000 Salvage today = 65,000 Salvage in 5 years = 10,000

New Machine

Initial cost = 150,000 5-year life Salvage in 5 years = 0 Cost savings = 50,000 per year 3-year MACRS depreciation

Required return = 10% Tax rate = 40%

7

Example

We have two options

Option 1: Buy the new machine and sell the old Option 2: Keep the old machine

**Two ways to tackle the problem
**

Find the NPV of Option 1 and of Option 2 and choose the one which is higher We will ask ourselves, what is different between situation 1 and 2 i.e., what is incremental. Then evaluate those cash flows

8

**Buy the New and Sell the Old
**

Capital Expenditure

Cost of new machine = 150,000

After-tax salvage on old machine = 65,000 - .4(65,000 – 55,000) = 61,000 Net capital spending = 150,000 – 61,000 = 89,000

Year 5: No Salvage value

**Operating Cash Flows
**

Savings of 50,000 every year Depreciation

9

**Cash Flows of Option 1
**

Capital Expenditure Salvage Value Cost Saving MACRS Depreciation EBIT Taxes Net Income Operating Cash Flows Total CF PV at 10% NPV 0 -150000 61000 1 2 3 4 5

50000 0.3333 49995 5 2 3 49998

50000 0.4444 66660 -16660 -6664 -9996 56664

50000 0.1482 22230 27770 11108 16662 38892

50000 0.0741 11115 38885 15554 23331 34446

50000

50000 20000 30000 30000

-89000 49998 56664 38892 34446 30000 -89000 45452.73 46829.75 29220.14 23527.08 18627.64 74657.34

10

**Option 2: Keep the Old
**

Capital Expenditure

Year 0: No expense Year 5: After-tax salvage on old machine =10,000 - .4(10,000 – 10,000) = 10,000

**Operating Cash flows
**

No Cost Savings Depreciation of 9000 every year

11

**Cash Flows for Option 2
**

0 Capital Spending Salvage Value Cost Saving Dep EBIT Taxes Net Income Operating Cash Flows Total Cash Flows PV at 10% NPV 0 9000 -9000 -3600 -5400 0 9000 -9000 -3600 -5400 0 9000 -9000 -3600 -5400 0 9000 -9000 -3600 -5400 1 2 3 4 5 10000 0 9000 -9000 -3600 -5400 3600 13600 8444.53

3600 3600 3600 3600 3600 3600 3600 3600 3272.727 2975.207 2704.733 2458.848 19856.05

12

**Incremental Cash Flows
**

To get to incremental cash flows we will compare two situations

Situation 1: Buy the new machine and sell the old Situation 2: Keep the old machine

We will ask ourselves, what is different between situation 1 and 2 i.e., what is incremental Then we will evaluate those cash flows

13

**Operating Cash Flows
**

Things that are different between Situation1 and Situation2

Cost saving of 50,000 in situation 1 relative to situation 2 Depreciation

Situation 1: 3 year MACRS (33.33%, 44.44%, 14.82%, 7.41%) Situation 2: annual deprecation of 9000

Capital Expenditure and Salvage Value

14

**Operating Cash Flows
**

1 0.3333 49,995 9,000 40,995 50000 9,005 3602 5,403 46,398 2 0.4444 66,660 9,000 57,660 50000 -7,660 -3064 -4,596 53,064 3 0.1482 22,230 9,000 13,230 50000 36,770 14708 22,062 35,292 4 0.0741 11,115 9,000 2,115 50000 47,885 19154 28,731 30,846 5 0 9,000 -9,000 50000 59,000 23600 35,400 26,400

Dep: Situation 1 Dep: Situation 2 Incremental Deprecation (a) Cost Savings EBIT Less Taxes at 40% Net Income (b) Operating Cash Flows

15

**Incremental Net Capital Spending
**

Situation 1: Buy new and sell old

Year 0

Cost of new machine = 150,000 After-tax salvage on old machine = 65,000 - .4(65,000 – 55,000) = 61,000 Net capital spending = 150,000 – 61,000 = 89,000

Year 5: No Salvage value

**Situation 2: Keep the old machine
**

Year 0: No expense Year 5: After-tax salvage on old machine = 10,000 - .4(10,000 – 10,000) = 10,000

**Incremental Net Capital Spending
**

Year 0: -89,000 Year 5: 0 – 10,000 = -10,000

16

Cash Flow From Assets

Year OCF NCS ∆ In NWC CFFA

0

1

46,398

2

53,064

3

35,292

4

30,846

5

26,400

-89,000

-10,000

0

0

-89,000

46,398

53,064

35,292

30,846

16,400

17

**Analyzing the Cash Flows
**

Now that we have the cash flows, we can compute the NPV

Compute NPV (at 10%) = 54801.10

Should the company replace the equipment?

18

**Lemon Juice Project
**

Equipment costs 240,000. Depreciation is 3 years MACRS with 33%, 45%, 15% and 7% Salvage value is $25,000 at end of life of 4 years. Average inventory is $25,000 and accounts payable is $ 5,000. Unit sales are 100,000 cans per year at $2 a can. Cash operating costs are expected to be 60% of dollar sales. Tax rate is 40% Cost of capital is 10%

19

**Operating Cash Flows
**

1 200,000 120000 80,000 79200 800 320 480 79,680 2 200,000 120000 80,000 108000 -28,000 -11200 -16,800 91,200 3 200,000 120000 80,000 36000 44,000 17600 26,400 62,400 4 200,000 120000 80,000 16800 63,200 25280 37,920 54,720

Revenue (100,000 x 2) Cost of Goods Sold Gross Profit Depreciation EBIT Taxes at 40% Net Income Operating Cash Flows

20

Other Cash Flows

Fixed Assets Salvage Value Book Value Taxes on Gain Cash flow from Sale Total Cash Flow Net Working Capital Changes in NWC

-240000 25000 0 10000 15000 15000 20,000 -20,000 20,000 20,000 20,000 20000

-240000

21

NPV Analysis

0 Operating Cash Flows Fixed Assets Cash from Salvage Value Changes in NWC Total Cash Flow NPV 1 79,680 -240000 -20,000 -260,000 -4030 79,680 91,200 62,400 15000 20000 89,720 2 91,200 3 62,400 4 54,720

22

Risk and Return Oct 24th

Prof. Simi Kedia Financial Management Rutgers Business School

Dollar Returns

Total dollar return = income from investment + capital gain (loss) due to change in price Example:

You bought a bond for $950 1 year ago. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return? What is your percentage return?

Dollar Returns

Total dollar return = income from investment + capital gain (loss) due to change in price Example:

You bought a bond for $950 1 year ago. You have received two coupons of $30 each. You can sell the bond for $975 today. What is your total dollar return?

Income = 30 + 30 = 60 Capital gain = 975 – 950 = 25 Total dollar return = 60 + 25 = $85

Percentage Returns

It is generally more intuitive to think in terms of percentages than dollar returns In last example:

Percentage return = ($Return)/Price Paid Percentage return = 85/950 = .0895 = 8.95%

**Example – Calculating Returns
**

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?
**

Percentage return = $6.25/$35 = .1786 or 17.86%

**Percentage Return for Stocks
**

Dividend yield = dividend / price paid Capital gains yield = (selling price – price paid) / price paid Total percentage return = dividend yield + capital gains yield In above example:

Dividend yield = 1.25 / 35 = 3.57% Capital gains yield = (40 – 35) / 35 = 14.29% Total percentage return = 3.57 + 14.29 = 17.86%

Figure 12.4

**Average Returns (1925-2000)
**

Investment Large stocks Small Stocks Long-term Corporate Bonds Long-term Government Bonds U.S. Treasury Bills Inflation Average Return 13.0% 17.3% 6.0% 5.7% 3.9% 3.2%

Risk Premiums

The “extra” return earned for taking on risk Treasury bills are considered to be risk-free The risk premium is the return over and above the risk-free rate

**Historical Risk Premiums
**

Large stocks: 13.0 – 3.9 = 9.1% Small stocks: 17.3 – 3.9 = 13.4% Long-term corporate bonds: 6.0 – 3.9 = 2.1% Long-term government bonds: 5.7 – 3.9 = 1.8%

**Risk, Return and Financial Markets
**

Lesson from capital market history

There is a reward for bearing risk The greater the risk the greater the required return This is called the risk-return trade-off

How do we measure Risk? What is the price of Risk?

Frequency distribution, Large-Stocks

**Variance and Standard Deviation
**

Variance and standard deviation measure the volatility of asset returns The greater the volatility the greater the uncertainty Historical variance = sum of squared deviations from the mean / (number of observations – 1) Standard deviation = square root of the variance

Example

Consider a stock with the following returns for four years Year Return 1 0.15 2 0.09 3 0.06 4 0.12

Average Returns = 0.15 + 0.09 + 0.06 + 0.12 = 0.105 4

**Example – Variance and Standard Deviation
**

Year 1 2 3 4 Totals Actual Return .15 .09 .06 .12 .42 Average Return .105 .105 .105 .105 Deviation from the Mean .045 -.015 -.045 .015 .00 Squared Deviation .002025 .000225 .002025 .000225 .0045

Variance = .0045 / (4-1) = .0015

Standard Deviation = .03873

Figures

Comments

Another Lesson from History

On average you are rewarded handsomely for bearing risk. However, in any one year there is a significant chance of loss in value

**Do we have a measure or Risk?
**

Use Standard deviation to measure risk Higher the standard deviation the greater is the risk

Portfolios

A portfolio is a collection of assets The risk-return trade-off for a portfolio is measured by the portfolio expected return and standard deviation, just as with individual assets

Portfolio Weights

Investors hold more than one stock. Consider a portfolio of 2 stocks. $50 in stock A and $150 in stock B Portfolio weight:

wA = $50/($200) = .25 wB = $150/($200) = .75

Note: weights need to sum to 1.

**Expected Return of Portfolio
**

The expected return on a portfolio is just the weighted average of the returns of each stock in the portfolio: E[r] = w1 µ1 + w2 µ2 wi = portfolio weight of asset i µi = expected return of asset i

**Ex: Portfolio Expected Return
**

You have $3000 to invest today. You decide to buy $2000 of stock A, $500 of stock B, and $500 of stock C.

If E[rA] = 10%, E[rB] = 6%, E[rC] = 12% What is the expected return of your portfolio?

Expected Return

First determine the portfolio weights. wA = 2000/3000 = 2/3 wB = 500/3000 = 1/6 wC = 500/3000 = 1/6

E[rPortfolio] = (2/3)(.10)+(1/6)(.06)+(1/6)(.12) = .0967 or 9.67%

**Example: Umbrella Maker
**

Consider an umbrella maker, if it could either rain or shine State Prob. Umbrella Maker Rain .50 70% Shine .50 -20%

Expected Return = .5(70%) + .5(*-20%) = 25%

**Variance and Standard deviation
**

Variance = Expected squared deviation from the mean Standard deviation = SQRT(Var.)

Prob. Return 0.5 0.5 .70 -.20 Deviation Prob.X Squared Deviation from mean = 0.1013 .70-.25 = .45 .5 (.45)2 = 0.1013 -.20-.25 = -.45 .5(-.45)2 Sum = 0.2025

Var. = .2025 Standard Deviation (STD) = (.2025)1/2 =0.45 or 45%

**Example: Ice Cream Maker
**

Consider an ice cream maker, if it could either rain or shine State Prob. Ice Cream Maker Rain .50 -10% Shine .50 50%

Expected Return = .5(-10%) + .5(*50%) = 20%

**Variance and Standard deviation
**

Variance = Expected squared deviation from the mean Standard deviation = SQRT(Var.)

Prob. Return 0.5 0.5 -.10 .50 Deviation Prob.X Squared Deviation from mean -.10-.20 = .30 .5(-.30)2 = 0.045 .50-.20 = .30 .5 (.30)2 = 0.045 Sum = 0.09

Var. = .09 Standard Deviation (STD) = (.09)1/2 =0.30 or 30%

Example: Portfolio

If you own both the umbrella and ice cream maker (50% of money in each) State Prob. Umbrella Ice Cream Portfolio Rain .5 70% -10% 30% Shine .5 -20% 50% 15%

Expected Return (rain) = .5(30%) + .5(15%) = 22.5%

**Standard deviation of Portfolio
**

Variance = Expected squared deviation from the mean Standard deviation = SQRT(Var.)

Prob. Return 0.5 0.5 .30 .15 Deviation Prob.X Squared Deviation from mean .30-.225 = .075 .5(.075)2 = 0.0028 .15-.225 = -.075 .5 (-.075)2 = 0.0028 Sum = 0.0056

Var. = .0056 Standard Deviation (STD) = (.0056)1/2 =0.075 or 7.5%

Summary

Return 25% 20% 22.5% Standard Dev 45% 30% 7.5%

Umbrella Ice Cream Portfolio

So what happened?

Portfolio Variance

Portfolio variance is given by

2 2 2 2 VAR p = wa σ a + wb σ b + 2wa wbσ a ,b

Where wa , wb

2 2 σa ,σb

are the portfolio weights are the variance of stock A and B is the covariance between stock A and B

σ a,b

Covariance

The variance of the portfolio depends on

The variance of individual stocks The covariance between the two stocks

**If the covariance is negative
**

Then it reduces the variance of the portfolio.

**Weighted average of STD
**

If we used the weighted average of the standard deviation: (DON’T DO THIS)

Negative Covariance

Umbrella Maker

Ice Cream Maker

Positive Covariance

**The Principle of Diversification
**

Portfolio diversification is the investment in several different asset classes or sectors Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion

Diversification and Risk

Diversification and Risk

Unsystematic Risk

The risk that can be eliminated by combining assets into a portfolio. It is also called unique, asset-specific risk or idiosyncratic risk Risk factors that affect a limited number of assets. Includes such things as labor strikes, part shortages, etc.

Systematic Risk

The risk that cannot be eliminated Also known as non-diversifiable risk or market risk Risk factors that affect a large number of assets . Includes such things as changes in GDP, inflation, interest rates, etc.

Total Risk

Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk

**Systematic Risk Principle
**

There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away The measure of risk for any stock is the level of systematic risk it bears

**Measuring Systematic Risk
**

How do we measure systematic risk? We use the sensitivity of a stock’s return to macroeconomic events, i.e., the sensitivity of the stock return to the fluctuations in the returns of the market portfolio. The market portfolio should contain all the assets in the economy:

Stock, Bonds, Foreign securities, Real Estate In reality, most people use stock portfolio (S&P 500 index)

The measure of sensitivity is called the Beta of a stock.

Beta

What does beta tell us?

A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market

Stocks with Beta greater than one are risky. They will earn a higher return.

Example of Betas

Firm Exxon IBM General Motors Harley Davidson AOL – Time Warner Beta .75 .95 1.05 1.20 1.75

**Total versus Systematic Risk
**

Consider the following information:

Security C Security K Standard Deviation 20% 30% Beta 1.25 0.95

Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return?

**Example: Portfolio Betas
**

Consider this example with the following four securities

Security DCLK KO INTC KEI Weight 0.133 0.2 0.167 0.5 Beta 3.69 0.64 1.64 1.79

**What is the portfolio beta?
**

.133(3.69) + .2(.64) + .167(1.64) + .5(1.79) = 1.78

Example

You put $300 in the equity of firm A. The expected return for firm A is 12% and its beta is 1.1. The remaining money of $ 500 you invest in security B. B has expected return of 15% and a beta of 1.4. What is the portfolio’s expected return? What is the portfolio’s beta?

Example

Total investment = 300 + 500 = 800

Wa = 300/ 800 = 0.375 Wb = 500/ 800 = 0.625

Expected return = 0.375x12% + 0.625 x 15% = 13.875% Beta of portfolio = .375 x 1.1 + 0.625 x 1.4 = 1.2875

Next…

Measure of Risk we will use

Beta

**What is the Price of Risk?
**

Risk premium = expected return – risk-free rate Higher risk implies higher return. So higher the beta, the greater should be the risk premium. Relation between beta and returns formalized by Capital Asset Pricing Model

**The Capital Asset Pricing Model (CAPM)
**

The capital asset pricing model defines the relationship between risk and return E(RA) = Rf + βA(E(RM) – Rf) If we know an asset’s systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets

**Factors Affecting Expected Return
**

Pure time value of money – measured by the risk-free rate Reward for bearing systematic risk – measured by the market risk premium Amount of systematic risk – measured by beta

Example - CAPM

Consider the betas for each of the assets given earlier. If the risk-free rate is 4.5% and the market risk premium is 8.5%, what is the expected return for each?

Security DCLK KO INTC KEI

Beta 3.69 .64 1.64 1.79

Expected Return 4.5 + 3.69(8.5) = 35.865% 4.5 + .64(8.5) = 9.940% 4.5 + 1.64(8.5) = 18.440% 4.5 + 1.79(8.5) = 19.715%

**The Capital Asset Pricing Model (CAPM)
**

The capital asset pricing model defines the relationship between risk and return E(RA) = Rf + βA(E(RM) – Rf) βA is the beta and captures risk E(RM) – Rf is the market risk premium and captures the price of risk Rf is the risk free rate today E(RA) is the expected rate or return for A

**Inputs to the CAPM
**

Risk Free Rate: Most people will use the short term treasury bill rate Market Risk Premium;

Historical average return earned by the market portfolio over the risk free rate Problem is that using the past to predict the future Is sensitive to how long back the data goes

For e.g. in the depression of 1927 included or not?

**This number is manipulated a lot
**

In 2000, prestigious analysts used market risk premiums from 2% to 8%

Beta

Beta can be estimated from past return data

Use regression analysis to see how much the equity returns change when the market changes These are also a function of how long back you go to get returns As beta could change over time

This suggests you take a shorter time period of say 3 years This introduces noise in the estimation

Betas can be obtained from several sources: Bloomberg, Value Line

**Advantages and Disadvantages of CAPM
**

Advantages

Explicitly adjusts for systematic risk Applicable to all companies, as long as we can compute beta

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 relying on the past to predict the future, which is not always reliable

**Does the CAPM work?
**

Do stock returns essentially fit in with CAPM in real life? Several studies over the years have tried to test this:

There is broad support for CAPM. Risk is based on covariance rather than variance There is little reward for unsystematic risk

**Does the CAPM work?
**

However,

The Security market line appears to be too flat. Characteristics other than the beta appear to explain stock returns

Small companies have higher returns than large companies (called the size effect) Stock with high ratio of book-to-market have higher returns than those with low book-to-market. Stock Returns are higher in January (January effect) Stock that have higher returns in the past continue to do well (momentum effect)

**The CAPM Approach
**

The CAPM gives us

Expected Return on the Stock This is the same as the required rate of return This is the same as the cost of equity capital to the firm We can use the CAPM to get required returns on Bonds or any physical asset

Example – CAPM

Consider the following firm

Equity beta = 1.02 Current risk-free rate = 1.8% Expected market risk premium = 9.1% What is your cost of equity capital? RE = 1.8 + 1.02(9.1) = 11.08%

**Expected versus Unexpected Returns
**

CAPM gives you the Expected Returns

These are returns which you expect to earn when you buy This is not the realized returns Realized Returns are what you actually make

**Realized Return = expected return (CAPM) + unexpected return Unexpected Returns:
**

At any point in time, the unexpected return can be either positive or negative Over time, the average of the unexpected component is zero

**Expected versus Unexpected Returns
**

Can Expected Returns be negative?

Can Realized Returns be negative? When you buy a stock do you know its expected return? Realized Return?

Example 1

Stock ABC has a beta of 1.1 and an expected return of 15%. The risk-free asset has an return of 5%. What is the expected return on a portfolio that is equally invested in stock ABC and the risk free asset? What is the portfolio’s beta?

Example 1

Equally Invested:

50% in stock ABC 50% in the risk free asset

Returns

Expected Return for ABC is 15% Expected Return for risk free asset is 5%

E[rp] = .5(15%) + .5(5%) = 10% Beta of portfolio = 0.5(1.1) + 0.5(0) = 0.55

Example 2

Stock ABC has a beta of 1.1 and an expected return of 15%. The risk-free asset has an return of 5%. If a portfolio of stock ABC and the risk free asset has a beta of 0.6, what are the portfolio weights? 0.6 = x(1.1) + (1-x)(0) X = 0.6/1.1 = 0.5455 Stock ABC accounts for 54.55% of the portfolio and the riskfree asset accounts for 45.45%

Example 3

Stock ABC has a beta of 1.1 and an expected return of 15%. The risk-free asset has an return of 5%. What is the market risk premium? Information for ABC stock: Beta of 1.1 Expected return of 15% Using the CAPM 15% = 5% + 1.1(market risk premium) Market risk premium = 10%/1.1 = 9.09%

Example 4

Stock ABC has a beta of 1.1 and an expected return of 15%. The risk-free asset has an return of 5%. The market risk premium is 9.09% If a portfolio of stock ABC and the risk free asset has an expected return of 9%, what is the portfolio’s beta? Using the CAPM 9% = 5% + Beta(9.09) Beta = 0.44

Example 5

Stock ABC has a beta of 1.1 and an expected return of 15%. The risk-free asset has an return of 5%. If a portfolio of stock ABC and the risk free asset has a beta of 2.20, what are the portfolio weights? How do you interpret the weights for the two assets in this case? 2.2 = x(1.1) + (1-x)(0) x = 2.2/1.1 = 2 (1-x) = 1-2 = -1 The portfolio weight of –1 means that you sell short or in this case you borrow.

Risk and Return Oct 31st

Prof. Simi Kedia Financial Management Rutgers Business School

**The Capital Asset Pricing Model (CAPM)
**

The capital asset pricing model defines the relationship between risk and return E(RA) = Rf + βA(E(RM) – Rf) βA is the beta and captures risk E(RM) – Rf is the market risk premium and captures the price of risk Rf is the risk free rate today E(RA) is the expected rate or return for A

Cost of Capital

However, the firm can issue several different kinds of securities

Equity Debt Preferred Stock

What is the total required rate of return or the cost of capital for the firm?

Cost of Equity

The cost of equity is the return required by equity investors given the risk of the cash flows from equity There are two major methods for determining the cost of equity

Capital Asset Pricing Model (CAPM) Dividend growth model

**The Dividend Growth Model Approach
**

Start with the dividend growth model formula and rearrange to solve for RE

P R = = D R D P

E 1 0 1

0

− +

g g

E

**Dividend Growth Model Example
**

Consider the following example

Expected dividend next year: $1.50 Growth rate of dividends: 5.1% The current stock price is $25 What is the cost of equity?

1 .50 RE = + .051 = .111 25

**Estimating the Dividend Growth Rate
**

One method for estimating the growth rate is to use the historical average

Year 1995 1996 1997 1998 1999 Dividend Percent Change 1.23 1.30 (1.30 – 1.23) / 1.23 = 5.7% 1.36 (1.36 – 1.30) / 1.30 = 4.6% 1.43 (1.43 – 1.36) / 1.36 = 5.1% 1.50

(1.50 – 1.43) / 1.43 = 4.9%

Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%

**Advantages and Disadvantages of Dividend Growth Model
**

Advantage – easy to understand and use Disadvantages

Only applicable to companies currently paying dividends Not applicable if dividends aren’t growing at a reasonably constant rate Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% Assumes that the market has considered risk and has already come up with a current stock price

**Another Example – Cost of Equity
**

Consider the firm

Beta = 1.5 Market risk premium = 9% Current risk-free rate is 6% Expected dividend growth rate = 6% Dividend yesterday = $2 Current Stock price = $15.65 What is our cost of equity?

Using CAPM Approach? Using the Dividend Growth Model?

**Another Example – Cost of Equity
**

Using CAPM RE = 6% + 1.5(9%) = 19.5% Using Dividend Growth Model RE = [2(1.06) / 15.65] + .06 = 19.55% As the two estimates are close, it should give you confidence in your estimate

Cost of Debt

The cost of debt is the required return on our company’s debt We usually focus on the cost of long-term debt or bonds Required return on long-term debt

Compensates the investor for risk We can use the CAPM to get the expected return for debt When debt is very risky, it makes sense to calculate the beta for debt However, when debt is not very risky, it can be estimated by computing the yield-to-maturity on the existing debt The cost of debt is NOT the coupon rate

**Example: Cost of Debt
**

Consider the following zero coupon bond:

Maturity: 10 years Current price: $385.54 Face Value: $1000 bond What is the cost of debt? Price = $1000/(1+YTM)10 = $385.54 YTM = (1000/385.54)1/10 - 1= 0.10 or 10%

**Cost of Debt, Preferred Stock
**

Generally, firms issue coupon bonds. Can use the YTM on existing bonds to get the required return on bonds Firms also issue preferred stock

Preferred generally pays a constant dividend every period Dividends are expected to be paid every period forever Preferred stock is a perpetuity, so we take the perpetuity formula, rearrange and solve for the required return or RP RP = D / P0

**Example: Cost of Preferred Stock
**

Your company has preferred stock that has an annual dividend of $3. If the current price is $25, what is the cost of preferred stock? RP = 3 / 25 = 12%

Example

Firm A has an equity beta of 1.5. The risk free rate is 3% and the market risk premium is 7%. What is the expected return on Firm A equity? E[r] = 3% + 1.5(7) = 13.5%

Example

Company A has preferred stock that has an annual dividend of $5. If the current price is $50, what is the cost of preferred stock? RP = 5 / 50 = 10%

Example

Consider the following zero coupon bond:

Maturity: 5 years Current price: $585 Face Value: $1000 bond What is the cost of debt? Price = $1000/(1+YTM)5 = $585 YTM = (1000/585)1/5 – 1 = 0.113 or 11.3%

**The Average Cost of Capital
**

We can use the individual costs of capital that we have computed to get our “average” cost of capital for the firm. This “average” is the required return on our assets, based on the market’s perception of the risk of those assets The weights are determined by how much of each type of financing that we use

**Capital Structure Weights
**

Notation

E = market value of equity = # outstanding shares times price per share D = market value of debt = # outstanding bonds times bond price V = market value of the firm = D + E

Weights

wE = E/V = percent financed with equity wD = D/V = percent financed with debt

**Example: Capital Structure Weights
**

Suppose you have a market value of equity equal to $500 million and a market value of debt = $475 million.

What are the capital structure weights?

V = 500 million + 475 million = 975 million wE = E/D = 500 / 975 = .5128 = 51.28% wD = D/V = 475 / 975 = .4872 = 48.72%

**Average Cost of Capital
**

Now we can combine all the components ACC = wERE + wDRD

wE and wD : market weights of debt and equity RE is the cost of equity RDcost of debt

This would be the cost of capital for the firm. It is the required rate of return we need to discount the cash flows of the firm

**Example: Cost of Capital
**

In1998, Pinnacle’s stock accounted for 80% of firm value and debt accounted for 20% of firm value.

Beta of equity = 1.5 Market Risk Premium = 7% Risk free rate = 4% Cost of debt = 5%

What is the firm’s average cost of capital?

**Example: Cost of Capital
**

Cost of equity = 4% + 1.5(7%) = 14.5% Firm Cost of Capital is

= .2 (5%) + .8 (14.5%) = 12.6%

This is only in a world with no taxes

**Taxes and Cost of Debt
**

There is an asymmetry between debt and equity

Payments to Debt holders, i.e., interest is tax deductible Payments to Equity holders, i.e., dividends are not tax deductible This implies that the cost of debt is effectively lower than the required rate we calculated

**Tax Benefit of Debt
**

Equity

Dividend Payments Interest Payments EBIT Interest Earnings Before Taxes Taxes Paid @ 40% Net Income Dividends to Shareholder Retained Earnings Tax Savings Tax Savings Cost of Debt 50 50 100 100 40 60 50 10 100 50 50 20 30

Debt

30 20 Tax rate x Interest Payments (1-tax rate) x Interest Payments

**Weighted Average Cost of Capital (WACC)
**

Due to this tax benefit, the effective cost of debt is actually

After-tax cost of debt = RD(1-TC) Where RD = required return on debt TC is the corporate tax rate

In a world of taxes, the cost of capital for the firms is WACC = wERE + wDRD(1-TC) This is the required rate of return we need to discount the cash flows of the firm

WACC Example

Firm A required return on equity is 15%. The cost of debt is 8%. Firm A has 20% debt and 80% equity. The tax rate is 40%. What is the firm’s WACC? WACC = .8x15% + (1-.4)x0.2x8% = 12.96%

**Extended Example – WACC - I
**

Equity Information

50 million shares $80 per share Beta = 1.15 Market risk premium = 9% Risk-free rate = 5%

Debt Information

$1 billion in outstanding zero coupon debt (face value) Current quote = 338.00 per 1000 face value 15 years to maturity

Tax rate = 40%

**WACC Example Cont…
**

What is the cost of equity?

RE = 5 + 1.15(9) = 15.35%

**What is the cost of debt?
**

Price = 1000/(1+RD)15 = 338.00 RD = (1000/338)1/15 –1 = 7.5%

**What is the after-tax cost of debt?
**

RD(1-TC) = 7.5(1-.4) = 4.5%

**WACC Example Cont..
**

What are the capital structure weights?

E = 50 million x 80 = 4 billion D = 1 billion x (.338) = 0.338 billion V = 4 + 0.338 = 4.338 billion wE = E/V = 4 / 4.338 = 0.9221 wD = D/V = .338 / 4.338 = 0.0779

**What is the WACC?
**

WACC = .9221(15.35%) + .0779(4.5%) = 14.50%

WACC: Example 2

Sales ($ millions) Net income ($ millions) Earnings per share ($) Dividends per share ($) Dividend yield (c) Common stock - high (c) Common stock - low (c) Common stock - close (c) Closing P/E Total capitalization(Book values) Debt Preferred stock Common stock Number of shares (million) Financial Data for Dixon 2001 2002 $4.0 0.71 $1.42 $0.35 2.9% 13 7.50 12 8.5 2.60 0.49 0.00 2.11 0.50 $4.3 0.79 $1.58 $0.40 3.5% 14.25 9 11.50 7.3 3.20 0.48 0.00 2.72 0.50

WACC: Example 2

Further information for Dixon is

Market Risk Premium = 7% Risk Free rate = 4% Beta: 1.2 Cost of debt of 6% Tax rate of 35% What is the Dixon’s WACC?

Market Weights

Total capitalization(Book values) Debt (1) Preferred stock Common stock Number of shares (million) Market value of equity ($ million) (2) Common stock - close Market Value of Firm (1+ 2) E/V D/V Average E/V D/V Financial Data for Dixon 2001 2002 2.60 0.49 0.00 2.11 0.50 6.00 12 6.49 0.924 0.076 0.923 0.077 3.20 0.48 0.00 2.72 0.50 5.75 11.50 6.23 0.923 0.077

WACC: Dixon

Cost of equity = 4% + 1.2(7) = 12.4%

WACC = wERE + wDRD(1-TC) = 0.923 x 12.4% + 0.077 x 6% x (1-.35) = 11.75%

**More than two sources of Capital
**

Reactive Industries has the following capital structure

Security Market Value Required Return 6% 8% 12% Debt $ 20 million Preferred Stock $ 10 million Common Stock $ 50 million Corporate tax rate is 35% What is the firm’s WACC?

**More than two sources of Capital
**

Market Value of Firm: 20+10+ 50 = $ 80 million

E/V D/V P/V

E V

= 50/80 = = 20/80 = = 10/80 =

D V

62.5% 25% 12.5%

P V

WACC

=

R

e

+

R

d

(1 − T ) +

R

p

=0.625(12%) + 0.25(6%)(1-0.35) + 0.125(8%) = 9.475%

**Appropriate Cost of Capital
**

The cost of capital used to discount cash flows from the project

Should capture the risk of those cash flows

The risk of cash flows are captured by the beta of the project Usually, beta of firms in a similar activity are similar. If the fraction of debt and equity are the same, then firms in the same industry have similar risk, similar beta, and the resulting cost of capital For e.g. Gold mining is riskier than manufacturing cheese. Gold mining firms will have higher expected returns on average than cheese manufacturers.

**Appropriate Cost of Capital
**

Honda, the Japanese automaker is considering manufacturing a new line of mini cars. Honda cost of capital is 13%.

What is the appropriate cost of capital for the mini car project?

**Honda is also considering manufacturing a new motorcycle.
**

What is the appropriate cost of the motorcycle project? The average cost of capital for Harley-Davidson and Kawasaki is 15.2%.

**Using WACC for All Projects Example
**

Consider the following projects in the firm. Project Required Return for this project

A B C 20% 15% 10%

IRR

17% 18% 12%

Which Projects should we take?

**Using WACC for All Projects Example
**

Consider the following projects in the firm. Project Required Return IRR Take?

A B C 20% 15% 10% 17% 18% 12% No Yes Yes

**Using WACC for All Projects Example
**

Assume the WACC = 15% What happens if we use the WACC for all projects regardless of risk?

Project A B C Required Return 20% 15% 10% IRR 17% 18% 12%

**Divisional Costs of Capital
**

If a firms has different divisions with different risk, using one cost of capital is not appropriate Note:

Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project

**Divisional Cost of Capital
**

Seagrams, a premium manufacturer of alcoholic beverages is considering acquiring Columbia Tristar, a motion picture studio. Seagrams cost of capital is 13%. The average cost of capital for motion picture studios is 20%. What is the discount rate used to evaluate the decision?

**Market vs. Book Weights
**

The following is the summary balance sheet of Firm A.

Assets

Assets

**Liabilities and Shareholder Equity
**

647 Debt Shareholders Equity 647 Total Value 194 453 647

% 30% 70%

Total Value

The Market Value of Firm A’s Equity is 700. What are the Capital structure weights?

**Market vs. Book Value
**

Use Market Value weights rather than Book Value weights. Book value of debt will be different from market value if the interest rates have changed. Usually, this is not large. So market value weights are

Total value = 194 + 700 = 894 Weight of Equity = 700/894 = 78.3 Weight of Debt = 194/894 = 21.7

Floatation Costs

These are costs incurred in issuing securities. When the firm raises debt or issues equity, the funds it finally gets

Amount raised – Floatation Costs

**How do we account for these costs? Basic Approach
**

Compute the weighted average flotation cost Use the target weights because the firm will issue securities in these percentages over the long term

**Example – Floatation Costs
**

Your company is considering a project that will cost $1 million. The project will generate after-tax cash flows of $156,000 for ever. The cost of capital is 15%. The firm has 62.5% equity and 37.5% debt. The flotation cost for equity is 5% and the flotation cost for debt is 3%. What is the NPV for the project after adjusting for flotation costs? Average Floatation costs

fA = (.375)(3%) + (.625)(5%) = 4.25% If need $ 1 million, then need to raise 1,000,000/(1-.0425) = 1,044,386

**Example – Floatation Costs
**

Present Value of Cash flows = 156,000/.15 =1,040,000 NPV = 1,040,000 – 1,044,386 = -4386 The project has a negative NPV with floatation costs so do not undertake it If we had ignored floatation costs then NPV = 1,040,000 – 1,000,000 = 40,000 For projects with small NPV this is important. Many firms deal with floatation costs by increasing the cost of capital. That is not the correct way to deal with them

Summary

CAPM can be used to get cost of equity Cost of Capital for a project is the weighted average cost of equity and debt As debt is tax advantaged, need to take the after tax cost of debt The cost of capital for a firm is there given by WACC = wERE + wDRD(1-TC)

Summary

WACC is used to discount the cash flows of the project

Takes care of the risk of the cash flow It takes care of the tax benefit to debt

Capital Structure

The division between debt and equity is called capital structure .

The firm with no debt is called an all equity firm. When it has debt, the firm is said to be levered

Two Questions:

Does it matter what capital structure the firm has? If it does, what is the optimal capital structure

**Answer it in two stages?
**

Simple world: no taxes In a world with taxes and other frictions

Cost of Capital

When there were no taxes:

Cost of capital was referred to as the Average Cost of Capital ACC = wERE + wDRD

**In a world with taxes
**

Cost of Capital was referred to as the Weighted Average Cost of Capital (WACC) WACC = wERE + wDRD(1-TC)

**Average Cost of Capital
**

Let us go back to a simple world with no taxes. ACC = wERE + wDRD

wE and wD : market weights of debt and equity RE is the cost of equity RDcost of debt

This would be the cost of capital for the firm. It is the required rate of return we need to discount the cash flows of the firm

**Example: Cost of Capital
**

Pinnacle’s stock accounted for 80% of firm value and debt accounted for 20% of firm value.

Beta of equity = 1.5 Market Risk Premium = 7% Risk free rate = 4% Cost of debt = 5%

**Cost of equity = 4% + 1.5(7%) = 14.5% Firm Cost of Capital is
**

= .2 (5%) + .8 (14.5%) = 12.6%

Questions

Facts:

Cost of debt = 5% Cost of equity = 14.5% Total cost of capital =.2 (5%) + .8 (14.5%) = 12.6%

Why is Debt Cheaper? Can the firm reduce its cost of capital by issuing more debt? What happens when you issue more debt?

Cost of Debt

Note:

Cost of debt is 5% while the cost of equity is 14.5%

Debt is cheaper than equity. Debt is less risky. It gets paid before equity gets paid.

Does this mean that the firm can issue more debt and reduce its cost of capital?

A lower cost of capital means a higher NPV from projects, and higher firm value. The answer is NO.

Capital Structure Nov 7th

Prof. Simi Kedia Financial Management Rutgers Business School

**Weighted Average Cost of Capital (WACC)
**

In a world of taxes, the cost of capital for the firms is WACC = wERE + wDRD(1-TC) Where

RD = required return on debt TC is the corporate tax rate wE,, wD) are the weights of equity and debt RE required return on equity

Capital Structure

The division between debt and equity is called capital structure .

The firm with no debt is called an all equity firm. When it has debt, the firm is said to be levered

Two Questions:

Does it matter what capital structure the firm has? If it does, what is the optimal capital structure

**Answer it in two stages?
**

Simple world: no taxes In a world with taxes and other frictions

Cost of Capital

When there were no taxes:

Cost of capital was referred to as the Average Cost of Capital ACC = wERE + wDRD

**In a world with taxes
**

Cost of Capital was referred to as the Weighted Average Cost of Capital (WACC) WACC = wERE + wDRD(1-TC)

**Example: Average Cost of Capital
**

Pinnacle’s stock accounted for 80% of firm value and debt accounted for 20% of firm value.

Beta of equity = 1.5 Market Risk Premium = 7% Risk free rate = 4% Cost of debt = 5%

**Cost of equity = 4% + 1.5(7%) = 14.5% Firm Cost of Capital is
**

= .2 (5%) + .8 (14.5%) = 12.6%

Questions

Facts:

Cost of debt = 5% Cost of equity = 14.5% Total cost of capital =.2 (5%) + .8 (14.5%) = 12.6%

Why is Debt Cheaper? Can the firm reduce its cost of capital by issuing more debt? What happens when you issue more debt?

**CoC and Capital Structure
**

Say the firm buys back some of its stock and issues more debt such that

Equity is now 60% (instead of 80%) Debt is now 40%

**When you increase debt
**

What happens to the risk of debt ? What happens to the risk of equity?

**CoC and Capital Structure
**

Say the firm buys back some of its stock and issues more debt such that

Equity is now 60% (instead of 80%) Debt is now 40%

**When you increase debt
**

What happens to the risk of debt ? It increases What happens to the risk of equity? It increases too.

Capital Restructuring

We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets Increase leverage by issuing debt and repurchasing outstanding shares Decrease leverage by issuing new shares and retiring outstanding debt

**Example: Trans Am Corp.
**

Assets have a market value of $8M. Currently Debt = 0 Shares outstanding = 400,000 Share price = 8M/400k = 20.00 Proposed capital restructuring:

Issue 4M Debt at 10% interest Buy back 4M/20 = 200,000 shares For now assume stock price stays at $20.00

Example Continued..

Current Assets Debt Equity D/E Ratio Share Price # Shares Interest Rate 8,000,000 0 8,000,000 0 20 400,000 10% Proposed 8,000,000 4,000,000 4,000,000 1 20 200,000 10%

**Current Capital Structure
**

Recession EBIT Interest NI ROE EPS 500,000 0 500,000 6.25% 1.25 Expected 1,000,000 0 1,000,000 12.5% 2.50 Expansion 1,500,000 0 1,500,000 18.75% 3.75

**Proposed Capital Structure ($4M Debt)
**

Recession EBIT Interest NI ROE EPS 500,000 400,000 100,000 2.50% 0.50 Expected 1,000,000 400,000 600,000 15.00% 3.00 Expansion 1,500,000 400,000 1,100,000 27.50% 5.50

Summary

Current Capital structure (All Equity)

ROE is : 6.25% 12.5% 18.75% EPS is: 1.25 2.50 3.75

**Proposed Capital Structure (50% equity)
**

ROE is : 2.5% EPS is: 0.5 15% 3.00 27.5% 5.50

**Break-Even EBIT
**

Find EBIT where EPS is the same under both the current and proposed capital structures If EBIT is less than the Break-Even EBIT then adding leverage reduces EPS If EBIT is greater than Break-Even EBIT then adding leverage increases EPS

**Example: Break-Even EBIT
**

EBIT 400,000 EBIT − 400,000 = 200,000 400,000 200,000

EBIT =

(EBIT

− 400,000

)

EBIT = 2EBIT − 800,000 EBIT = $800,000 800,000 EPS = 400,000 = $2.00

**Financial Leverage, EPS and ROE
**

Variability in ROE

Current: ROE ranges from 6.25% to 18.75% Proposed: ROE ranges from 2.50% to 27.50%

Variability in EPS

Current: EPS ranges from $1.25 to $3.75 Proposed: EPS ranges from $0.50 to $5.50

The variability in both ROE and EPS increases when financial leverage is increased As leverage increases, both debt and equity become more risky

**The Effect of Leverage
**

When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE

**CoC and Capital Structure
**

You cannot change the overall cost of capital of the firm by increasing debt. As you increase debt

Debt gets riskier and its cost goes up Equity gets riskier and its cost goes up Such that total cost of capital stays the same This is the irrelevance of Capital Structure in a perfect world

Modigliani and Miller won the Nobel Prize to show this

Note: The above holds only in a world with no tax asymmetries

Questions

Why is Debt Cheaper?

Because it is less risky

**What happens when you issue more debt?
**

Debt becomes riskier, Cost of Debt increases Equity becomes riskier, cost of equity increase

**Can the firm reduce its cost of capital by issuing more debt?
**

No Without Taxes, cost of capital stays the same

**Theory of Capital Structure?
**

The division between debt and equity is called capital structure .

The firm with no debt is called an all equity firm. When it has debt, the firm is said to be levered

**Does it matter what the capital structure of the firm is? Modigliani and Miller
**

With no taxes: Capital structure does not matter With taxes: It matters. Theory of how much debt the firm should have

**Start with a Simple World
**

In this world

There are no taxes There is no costs of Financial distress or cost of bankruptcy Firms Assets/ Investments are fixed Perfect Markets - Complete information No transactions costs These are the assumptions of M&M world

**Financial Claims on the Firm
**

We will assume there are 2 claims on the firm: debt (D) and equity (E).

Total value of D + E = firm value V D is the market value of debt E is the market value of equity V is the market value of the firm

Debt has a promised interest and principal payments Equity has rights to the residual cash flows and has control rights. Does how you “slice up” the firm into debt and equity change the value of the firm, V?

Goal of Management

If the goal of management is to maximize firm value, then they should pick a debt/equity ratio that produces the largest V. Changing the debt/equity ratio, changes how cash is paid out from the firm.

For example, more debt produces larger interest payments and less dividend payments.

**What Determines Firm Value?
**

Assets

Produce Discount

Cash Flows

rA

Total Firm Value

A new rate, rA , this is the discount rate of an all equity firm or the return on the asset.

**What Determines Firm Value?
**

Assets

Produce Discount

Cash Flows

rA

Total Firm Value

CFD

Discount

rD

Value Debt Value Equity

CFE

Discount

rE

+

=

**What Determines Firm Value?
**

Assets

Produce Discount

Cash Flows

rA

Total Firm Value

CFD

Discount

rD

Value Debt

CFE

Discount

rE

Value Equity

+

=

Conservation of Value

You can split up claims to cash flows anyway you want, but as long as you don’t change the total payout to the claims, you don’t change the total value of the claims.

Or, $100 dollars is $100 dollars.

Conservation of value is the concept that underlies capital structure irrelevance.

MM Propositions

Modigliani & Miller MM Proposition I

Vu

VE VD VL

Vu = VE + VD = VL

= = = =

Value of an all equity firm Value of equity Value of debt Value of a levered firm

Statement about conservation of firm value

MM Propositions

How come this is true?

We know that debt is cheaper than equity. Can’t we reduce the cost of capital by increasing debt. We saw earlier that as Debt increased

Debt got riskier, i.e., cost of debt increased Equity got riskier. Cost of equity also increased These increased such that ACC = (E/V)RE + (D/V)RD = Ra = stayed the same

MM Proposition II

rE = ra +

D ( ra − rD ) E

Example

changed its capital structure to 45% debt and 55% equity, the cost of debt = 10%. What is the cost of

equity? (there are no taxes) Using MM Proposition II

D rE = ra + ( ra − rD ) E

Firm A has 100% equity. Its cost of capital is 16%. If it

RE = .16 + (.16 - .10)(.45/.55) = .2091 = 20.91% The cost of equity is going to rise such that the total cost of capital stays the same

Example

Firm A has 100% equity. Its cost of capital is 16%.

the new capital structure? (there are no taxes)

Under a new proposed capital structure the cost of equity will be 25% and the cost of debt = 10%. What is the debt-to-equity ratio in

Example

proposed capital structure the cost of equity will be 25% and the cost of debt = 10%. What is the debt-to-equity ratio in the new

capital structure? (there are no taxes) Using the MM proposition II Firm A has 100% equity. Its cost of capital is 16%. Under a new

D rE = ra + ( ra − rD ) E

.25 = .16 + (.16 - .10)(D/E) D/E = (.25 - .16) / (.16 - .10) = 1.5 Based on this information, what is the percent of equity in the firm? E/V = 1 / 2.5 = 40%

Example 2

Firm A’s old capital structure is

Debt: 20% at cost of 6% Equity: 80% at cost of 13%

**The new proposed capital structure is
**

Debt: 50% at cost of 8% Equity: 50%

What will be the cost of equity in the new proposed capital structure?

Example 2

Total cost of capital in the old structure is = .2 (6%) + .8(13%) = 11.6% Let the cost of equity in the new proposed capital structure be r 11.6% = 0.5r +0.5(8%) r = 15.2%

Graphical representation

Proposition I

Value V L= V u

Proposition II

rE

ra rD

D/E

Summary of M&M

If the assumptions of M&M hold then

Capital structure choice is irrelevant Shifting between debt and equity does not change firm value or cost of capital. It does change the distributions of risk (and return) between debt and equity

M&M assumptions never hold As we relax the assumptions, one at a time, capital structure will become important. This gives us a way to handle the complexity of the real world.

**In a world with Taxes
**

There is an asymmetry between debt and equity

Payments to Debt holders, i.e., interest is tax deductible Payments to Equity holders, i.e., dividends are not tax deductible This implies that the cost of debt is effectively lower than the required rate we calculated

**Due to this tax benefit, the effective cost of debt is actually
**

After-tax cost of debt = RD(1-TC) Where RD = required return on debt we calculated TC is the corporate tax rate

**Weighted Average Cost of Capital (WACC)
**

In a world of taxes, the cost of capital for the firms is WACC = wERE + wDRD(1-TC)

wE and wD : market weights of debt and equity RE is the cost of equity RD(1-TC) is the after tax cost of debt

Now, as you increase debt the firm’s overall cost of capital or WACC will fall.

**Tax Advantage of Debt
**

Consider two identical firms (except for capital structure).

Firm U is unlevered or all equity firm Firm L has $100 of interest payments.

Each firm has $1000 of pretax earnings. What is the total payout to each firm’s claimants (shareholders and debtholders)? Assume corporate tax rate is 34%

**What is the Tax Advantage of Debt?
**

Earnings interest paid pretax income 34% tax Net Income Firm U 1000 0 1000 (340) 660 0 660 660 340 Firm L 1000 100 900 (306) 594 100 594 694 306

Payout to Debt Holders Payout to Equity Holders Total Firm value Payment to Govt.

Tax Saving or the Tax advantage of debt = $34 This tax shield = Interest Payment x Tax rate = 100 x 34% = $34

**Valuing the Tax Shield
**

Let D = face value of perpetual debt. Let rD = borrowing rate for the firm. Interest paid per year = rD D Annual corporate tax shield = rD D x τcorp

Τcorp = corporate tax shield Earn this tax shield every year

**Value of this shield is
**

Present value of all future annual tax shields

**Valuing the Tax Shield
**

Every year the firm saves = rD D x τcorp What is the risk of these savings?

What discount rate should be used to get the present value of these tax savings? The discount rate used is the cost of debt or rD

**If the firm and its borrowing of D is perpetual then can use the perpetuity formula
**

PV(tax shield) = [rD Dτcorp]/ rD = Dτcorp less if debt is not perpetual, or if tax shield will be eliminated sometime in the future.

**Example: Value of Tax Shield
**

Forever Inc has Debt outstanding of 1.5 million dollars. The cost of debt is 6% and the corporate tax rate is 35%. What is the value of the tax shield from Debt? Annual Interest payments=1.5m x 6%= 90000 Annual Tax shield = 90,000 x 34% = 31,500 PV of Tax Shield = 31,500/.06 = $525,000 or Use the formula = Dτcorp = 1.5m x 35% = $525,000

**Example 2: Value of Tax Shield
**

Forever Inc has Debt outstanding of 1.5 million dollars. The cost of debt is 6% and the corporate tax rate is 35%. They plan to repay 1 million in the beginning of the fifth year and another .5 million at the beginning of 10th year. What is the value of the tax shield from Debt?

**Valuing the Tax Shield
**

Year 1 2 3 4 5 6 7 8 9 10 Debt Interest Annual Tax PV of tax oustanding Payments Shield shield ( in Millions) (in thousands) 1.5 90 31.5 29.717 1.5 90 31.5 28.035 1.5 90 31.5 27.211 1.5 90 31.5 24.951 0.5 30 10.5 7.846 0.5 30 10.5 7.402 0.5 30 10.5 6.983 0.5 30 10.5 6.588 0.5 30 10.5 6.215 0 0 0 144.948

Total Debt Tax Shield (thousands)

**Tax Advantage of Debt: Another Example
**

Firm A has 500 thousand dollar of debt at 8%. They are planning to maintain this level of debt in the future. The corporate tax rate is 34%. What is the tax advantage of debt? Annual Interest payments=500,000 x 8%= 40,000 Annual Tax shield = 40,000x 34% = 13,600 PV of Tax Shield = 13,600/.08 = $170,000 or Use the formula = Dτcorp = .5m x 34% = $170,000

**Tax Advantage of Debt: Another Example
**

If firm A has 10,000 shares outstanding, What is the change in stock price when it announces it will issue debt. The tax advantage of debt = $170,000 Per share value = 170,000/ 1000 = $ 17 Share price will increase by $ 17 dollars

**Value of a Levered Firm with Corporate Taxes
**

Value of a levered firm is MM Proposition I with taxes

VL = VU + PVTS (Present Value Tax Shield)

As the value of the levered firm > value of an unlevered firm

**Capital Structure with Taxes
**

VL=Vu+ PVTS

Total Firm Value Vu

MM: Vu=VL

D/E

PVTS = Present Value of Tax Shields =txD

**Expected Return and Leverage (With Taxes)
**

MM Proposition II with taxes

D rE = ra + ( ra − rD )(1 − Tc ) E

Where Ra is the return to an all equity firm or to assets D and E is the market value of debt and equity

Example

The EXES company is assessing its present capital structure. It is currently financed entirely with common stock, of which, 1000 share are outstanding. Given the risk of the underlying cash flows, investors currently require 20% return on its stock. The company pays out all its earnings as dividends. EXES expects to generate cash flows of $ 3000 in perpetuity. Assume that taxes are zero. What is the value of EXES company? The Value of the firm = $3000/0.20 = $15,000

Example cont..

The president of the firm has decided that shareholders will be better off if the company had equal proportions of debt and equity. He therefore proposes to issue $7,500 of debt at an interest rate of 10%. He will use the proceeds to repurchase 500 shares of common stock. • What will the new value of the firm be? • What will the value of the EXES debt be? • What will the value of EXES equity be?

Example cont..

The value of the firm stays the same at $15,000. Equity price

The share price before was 15,000/ 1000 = $15. The new share price will be $ 15. The value of equity is 500 x $15 = $7500. The value of debt is $7500.

Example

Suppose the president’s proposal is implemented • What is the required return on equity? • What is firm’s overall cost of capital? The total cost of capital for the firm does not change with leverage (note: there are no taxes).

20% = 0.5 x 10% + 0.5 x re. re = 30%.

Another Example

Firm ABC earns EBIT of 25 million per year forever. It has debt of $75 million at a cost of 9%. Nolever, an identical firm with no leverage has cost of capital of 12%. The corporate tax rate is 35%

What is the value of Nolever What is the value of the tax shields for firm ABC What is the value of ABC? What is the value of ABC’s equity?

Another Example

Unlevered cost of capital = 12% The value of Nolever is

Vu = 25(1-.35)/ .12 = $135.42

**The value of the tax shields is
**

75x.35 = 26.25m

**The value of ABC is
**

VL = 135.42 + 26.25 = 161.67 Value of equity = 161.67 – 75 = 86.67

Example Continued

What is the rate of return on ABC equity?

.12 + 75/86.67 (1-.35)(.12 - .09) = 13.69%

**What is ABC’s WACC?
**

=10.05% 86.67/ 161.67 (13.9%) + 75/161.67 (1-.35) x.09

Example 3

The Holland company expects perpetual EBIT of 4m per year. The firm all equity rate of return is 15% and tax rate is 35%. The cost of debt is 10% and the firm has 10m of debt What is Holland Value? What is Holland’s cost of equity? What is Holland’s WACC?

Example 3 cont..

Value of all equity firm = 4 (1-.35)/.15 = 17.33m Value of tax shield = Dxt = 10x.35 = 3.5 m Value of Holland = 17.33 + 3.5 = 20.83 Value of equity = 20.83 – 10 = 10.83 Cost of equity = 15% + 10/10.83(1-.35)(.15 -.10) = 18% WACC = 10.83/20.83 (18%) + 10/20.83 (1-.35)10% = 12.48%

**Trade-off Theory
**

Should firms move towards 100% debt? No, firms should not go to 100% debt Benefits of debt (assumption 1)

Tax benefits:

**Costs of debt: Costs of financial distress
**

When firms cannot pay back debt they are taken to bankruptcy court or are said to be in financial distress Relaxation of M&M assumption 2

Trade-off between the benefits of debt (tax shield) and the cost of debt (costs of financial distress)

Conclusions

As you increase leverage

Equity gets riskier Debt get riskier

**With no Taxes: With Taxes
**

Total cost of capital stays constant ACC = wERE + wDRD Debt has a tax advantage WACC = wERE + wDRD(1-TC)

Optimal Capital Structure is determined by the tradeoff between benefit of debt (tax advantage) and cost of debt (financial distress)

Capital Structure Nov 14th

Prof. Simi Kedia Financial Management Rutgers Business School

**Value of a Levered Firm with Corporate Taxes
**

Value of a levered firm is MM Proposition I with taxes

VL = VU + PVTS (Present Value Tax Shield)

As the value of the levered firm > value of an unlevered firm

Capital Structure with Taxes

Total Firm Value

VL=Vu+ PVTS

Vu

MM: Vu=VL

D/E

PVTS = Present Value of Tax Shields =txD

**Expected Return and Leverage (With Taxes)
**

MM Proposition II with taxes

D rE = ra + ( ra − rD )(1 − Tc ) E

Where Ra is the return to an all equity firm or to assets D and E is the market value of debt and equity

Example 3

The Holland company expects perpetual EBIT of 4m per year. The firm all equity rate of return is 15% and tax rate is 35%. The cost of debt is 10% and the firm has 10m of debt What is Holland Value? What is Holland’s cost of equity? What is Holland’s WACC?

Example 3 cont..

Value of all equity firm = 4 (1-.35)/.15 = 17.33m Value of tax shield = Dxt = 10x.35 = 3.5 m Value of Holland = 17.33 + 3.5 = 20.83 Value of equity = 20.83 – 10 = 10.83 Cost of equity = 15% + 10/10.83(1-.35)(.15 -.10) = 18% WACC = 10.83/20.83 (18%) + 10/20.83 (1-.35)10% = 12.48%

**Trade-off Theory
**

Should firms move towards 100% debt? No, firms should not go to 100% debt Benefits of debt (assumption 1)

Tax benefits:

**Costs of debt: Costs of financial distress
**

When firms cannot pay back debt they are taken to bankruptcy court or are said to be in financial distress Relaxation of M&M assumption 2

Trade-off between the benefits of debt (tax shield) and the cost of debt (costs of financial distress)

Limits to the Use of Debt Chapter 16

**Costs of Financial Distress
**

As debt increases, is become more likely that the firm will not be able to pay its debt obligations In this case, the debtholders can take the firm to bankruptcy Till now we have assumed zero costs of bankruptcy

In reality, there are costs to financial distress

**Example: Company in Distress
**

Assets BV MV Cash $200 $200 Fixed Asset $400 $0 Total $600 $200 Liabilities LT bonds Equity Total BV MV $300 $200 $300 $0 $600 $200

What happens if the firm is liquidated today?

The bondholders get $200; the shareholders get nothing.

**What do we mean by costs of Financial Distress?
**

Two firms which are similar Firms Nodistress has to make interest payments of $50 Firm Distress has more debt and has to make interest payments of $150 We will assume investors are risk neutral

Special assumption to simplify things The do not ask a higher rate for more risk - same rate of return for debt and equity – say 10%

Example cont..

Cash Flow Interest Flows to Equity Nodistress Recession Boom 100 50 50 500 50 450 Distress Recession Boom 100 100 0 500 150 350

Debt Value = 0.5(50) + 0.5(50) / 1.1 = $45.45 Equity Value = 0.5(50) +0-.5(450) / 1.1 = $227.72 Total value = 45.45 + 227.27 = 272.27

D = 0.5(100) + 0.5(150) / 1.1 = $113.64 E = 0.5(0) + 0.5(350) / 1.1 = $159.09 Total value = 113.64 + 159.09 = 272.72

Value of an all equity firm = 0.5(100) + 0.5(500) / 1.1 = 272.72

This is MM Proposition I without taxes. There is financial distress or bankruptcy but no costs of distress Say the cost of distress – when you are not able to pay interest are $40. What are the debt, equity and firm values?

**With Distress Costs
**

Nodistress Recession Boom 100 50 50 Distress Recession Boom 100 60 0

Cash Flow Interest Flows to Equity

500 50 450

500 150 350

Debt Value = 0.5(50) + 0.5(50) / 1.1 = $45.45 Equity Value = 0.5(50) +0-.5(450) / 1.1 = $227.27 Total value = 45.45 + 227.27 = 272.72

D = 0.5(60) + 0.5(150) / 1.1 = $95.45 E = 0.5(0) + 0.5(350) / 1.1 = $159.09 Total value = 113.64 + 159.09 = 254.54

Value of an all equity firm = 0.5(100) + 0.5(500) / 1.1 = 272.72 PV of costs of financial distress = 0.5(40)/1.1 = 18.18

**What happens with Financial Distress
**

What triggers financial distress

When the firm is unable to make a promised payment interest or principal Sometimes when the firm is in violation of covenants

**Who can file for Bankruptcy
**

Voluntary: Managers realize the firm is insolvent and file for bankruptcy Involuntary: Creditors file for Bankruptcy

Types of Bankruptcy

Workout: consensual restructuring of liabilities Chapter 11: Reorganization Chapter 7: Liquidation by court appointed trustee

**Bankruptcy Law Overview (US)
**

Automatic Stay: Creditors are put to bay, managers get to stay Restructuring: Management proposes plan, creditors vote by class, majority rule within class, all classes must approve Debtor in Possession (DIP) Financing: New debtors are allowed seniority Recontracting: Firm can break executory contracts

**Bankruptcy Law in other Countries
**

France:

Court appointed official helps with reorganization plan

U.K.

Administration: Accountant or lawyer runs the firm Administrative receivership: Secured Creditors run firm

Japan

Informal rescues more common than formal bankruptcy

Germany:

Liquidations more frequent

Sweden:

Court appointed official auctions the firm

**Costs of Financial Distress
**

Actual costs of resolution or liquidation. Also called direct costs. Includes things like lawyer fees e.t.c Loss of competitive position

Many companies loose market share Many firms get caught up in the proceeding and miss opportunities A large fraction of firms that emerge from chapter 11 reenter chapter 11 (US Airways)

How large are these costs?

**Estimates of Costs of Financial Distress
**

Study of 31 highly levered transactions that became distressed was about 10% to 20%

Study of 3000 firms: In industries that experience downturns, highly levered firms experience operating income, sales and stock returns that are 7%, 17% and 16% lower than industry average

**Estimates of Costs of Financial Distress
**

Fire sales: Distressed airlines sell aircraft at significant discounts (upto 30%) especially when industry is depressed and buyer is a financial buyer

Direct costs of bankruptcy: 3.1% of value

Capital Structure with COFD

Total Firm Value Vu MM: Vu=VL VL=Vu- COFD

D/E

COFD = Costs of Financial Distress

Agency Costs

Risk Shifting Under-investment Milking the property

**Agency Cost 1: Risk Shifting
**

Consider a firm with some assets and $150 of interest payments. The firm is choosing between two projects A and B. A is the safer project and B is the risky project

Risk Neutral – discount rate is 10%

Project A Recession Boom Value of Firm with Project 150 400 Interest Payment 150 150 Project B Recession Boom 100 150 440 150

Which Project should they do?

Risk Shifting

If they do project A

Value of the firm: 0.5 * (150) + 0.5*(400)/1.1 = 250 Value of Debt = 150/1.1 = 136.36 Value of Equity = 250 – 136.36 = 113.63

**If they do Project B
**

Value of the firm = 0.5 (100) + 0.5(440)/1.1 = 245.45 Value of Debt = 0.5(100) + 0.5(150)/1.1 = 113.63 Value of Equity = 245.45 – 113.64 = 131.82

Risk Shifting

Which project should be taken? If there was only equity, which project will be taken? In the current scenario, which project will be taken?

**Agency Cost 2: Under-investment
**

Consider a firm with some assets and $150 of interest payments. The firm has a project that will pay $50 in both states and cost $40.

Risk Neutral – discount rate is 10%

Old Cash Flow New Project Total Cash flows Interest Payment

Firm Without Project Recession Boom 100 300 100 150 300 150

Firm With Project Recession Boom 100 300 50 50 150 350 150 150

Under Investment

Should the project be done?

Value of project = 0.5 (50) + 0.5(50)/1.1 = 45.45 NPV = $45.45 – $40 = $5.45 Yes it should be done?

Will it be done?

Bond Value without project = 0.5(100) + 0.5(150)/ 1.1 = 113.63 With the project = 150/1.1 = 136.36 Value of Equity without project = 0.5 (150)/ 1.1 = 68.18 Value of Equity with Project = 0.5(200)/1.1 = 90.90

Equity

Raise $40 to do the project Value increases by 90.90 – 68.18 = 22.72 Debt value increases by = 136.35 – 113.63 = 22.72 Total increase in value = 22.72 + 22.72 = 45.44

**Agency Cost 3: Milking the property
**

Firms close to distress or doing badly may

Start paying hefty dividends Sell out the profitable assets and pay out the profits as dividends Generally cannot do these

**All these agency costs happen
**

When the firm is close to bankruptcy Too much debt payments relative to cash flow Not seen in healthy companies

**Covenants: Reducing the Costs of Debt
**

Negative Covenants: Things shareholder promise not to do

How much dividends that can be paid Cannot issue senior debt Cannot sell assets / merge with other firms

**Positive Covenants: Things they promise to do
**

Maintain Interest coverage ratios, working capital Furnish financial statements

Costs of Debt

Costs of Financial Distress

Direct Costs Indirect Costs

Agency Costs

Risk Shifting Under-investment Milking the property

**Tax Effects and Financial Distress
**

There is a trade-off between the tax advantage of debt and the costs of financial distress. The value of the firm is now:

VL = VU + PVTS - PV of financial distress

**PV of financial distress is determined by:
**

No Precise Formula Probability of financial distress

How much debt does the firm have How much does its income vary

Costs of FD

Asset tangibility: get more from liquidations Growth opportunities

**Trade Off Theory
**

The value of a firm can now be written: ValueL = ValueU + PVTS - PVFD Trade off theory says that firms should increase debt until it will cause the PVFD to increase more than the PVTS.

**Tax Effects and Financial Distress
**

Value of firm (V)

Present value of tax shield on debt Value of firm under MM with corporate taxes and debt VL = VU + TCB Maximum firm value Present value of financial distress costs V = Actual value of firm VU = Value of firm with no debt

0

B* Optimal amount of debt

Debt (B)

Summary of Cases

Case I – no taxes or bankruptcy costs

No optimal capital structure

**Case II – corporate taxes but no bankruptcy costs
**

Optimal capital structure is 100% debt Each additional dollar of debt increases the cash flow of the firm

**Case III – corporate taxes and bankruptcy costs
**

Optimal capital structure is part debt and part equity Occurs where the benefit from an additional dollar of debt is just offset by the increase in expected bankruptcy costs

**Consider the following situation
**

The CEO of a public firm wants more capital. The share price is trading at $10. He knows that the firm has a great R&D project that will work out great. When it does the share price should be at least $20.

Would be like to issue Equity now?

Say he knows that the firm will be sued for a problematic product. Would he like to issue equity now? As Investors, when you see that a firm is issuing equity what do you think?

**Stock Price Reaction On Equity Issues
**

On average the stock price declines when the firm announces that it is issuing equity

Investors infer that on average the firm does not have good news If it had good news, it would be issuing debt This means that it on average firms would rather not issue equity if they can help it.

This gives rise to the Pecking Order Theory of Capital Structure

**The Pecking-Order Theory
**

Theory states that firms prefer to issue debt rather than equity if internal financing is insufficient.

Rule 1 Use internal financing first. Rule 2 Issue debt next, new equity last.

**The pecking-order theory is at odds with the tradeoff theory:
**

There is no target D/E ratio. Profitable firms use less debt. Companies like financial slack.

**Observed Capital Structure
**

Most corporations have low Debt-Value ratios.

These were 48% in US Higher in other countries:

Japan 72% France and Italy: 60%

**There are many firms who have no debt
**

Coca Cola, Microsoft (negative debt) These tend to very profitable firms Generating a lot of internal cash flows: enough to finance growth and more

**Observed Capital Structure
**

Capital structure does differ by industries Differences according to Cost of Capital 2000 Yearbook by Ibbotson Associates, Inc.

Lowest levels of debt

Drugs with 2.75% debt Computers with 6.91% debt

**Highest levels of debt
**

Steel with 55.84% debt Department stores with 50.53% debt

**Why vary with Industry?
**

Costs of financial distress

Probability of getting distressed Costs when distressed

Asset Tangibility

More tangible: sell easily and recover more Costs when distressed are low

**Growth options and R&D
**

When distressed loose all these options Costs are higher

**Business is very cyclical or volatile
**

Higher probability of getting distressed

**Matched Capital Structures
**

FIRM Industry Debt/Total Capital (MV) 0.37 0.62 0.00 0.75 0.00 0.00 0.00 0.62 0.48 0.55 0.03

CATERPILLAR INC EDISON INTERNATIONAL FREEMARKETS INC HOST MARRIOTT CORP MICROSOFT CORP NAVIGANT CONSULTING INC PHARMACYLICS INC RENT-A-CENTER INC RJ REYNOLDS UAL CORP YOUNG AND RUBICAM INC.

Construction machinery Electric utility Internet business services Hotels and real estate Software Management consulting Drugs (ethical) Equipment rental and leasing Tobacco Air Transport Advertising

**How Firms Establish Capital Structure
**

There is some evidence that firms behave as if they had a target Debt-Equity ratio.

They also behave in accordance with Pecking order theory Some combination of the two

**Many firms value financial slack a lot
**

In case they need to borrow quickly Keep low debt levels

Valuation and Capital Budgeting for the Levered Firm Chapter 17 Very Briefly….

Introduction

We have seen that issuing debt is valuable as it generates tax savings. What is the tax advantage? VL = VU + tB This is also the Adjusted Present Value Method or the APV Value of levered firm = Value of all Equity firm + Value of all effects of Debt

**Adjusted Present Value
**

Suppose PMM, Inc. has an investment that costs $10,000,000 with expected EBIT of $3,030,303 per year forever. The investment can be financed either with $10,000,000 in equity or with $5,000,000 of 10% debt and $5,000,000 of equity. The discount rate on an all-equity-financed project in this risk class is 20%. The firm's marginal tax rate is 34%. What is the value if financed with equity? What is the value if financed with debt and equity?

Example cont.

Value of All equity firm:

Annual after-tax cash flows: (EBIT)(1- tc)

**= ($3,030,303)(1-.34) = $2,000,000
**

Value = ($2,000,000 / .2) = $10,000,000

Tax Subsidy: txD = .34 * 5m = 1.7m Value of a levered firm: = 10m + 1.7m = 11.7m

Example Continued

What is the cost of levered equity? What is the WACC? How do you use the WACC to get firm value of the levered firm?

WACC Approach

V = D + E = 11.7m E = V – D = 11.7m – 5m = 6.7m

RS = R0 + B × (1 − TC ) × ( R0 − RB ) S

RS = 20% +

5 × (1 − .34) × (20% − 10%) = 24.925% 6.7

WACC = we Re + wD (1 − TC ) RD WACC = (6.7 / 11.7)24.925% + (5 / 11.7)(1 − .34)10% = 17.094%

Value of Firm: 3,030,303(1-0.34)/ 17.094% = 11.7m

**Other Ways to Value Levered Firm
**

WACC Approach: Value of Levered Firm = Cash flow to an All equity Firm / WACC

With the tax advantage of debt WACC< ro the required rate for all equity firm If the CF are in perpetuity

A third method: Flow to equity: Value of Levered Equity ( we will not cover this)

**Comparing the Methods
**

APV

Cash Flows

WACC

All Equity All Equity CF CF Discount Rates R0 RWACC APV has the advantage that can easily put in costs of distress and other costs if wanted All methods should give the same value

Another Example

Zipper Inc. has after tax cash flows of $1000 forever. Its all equity cost of capital is 15%. It has $2000 of debt at a cost of 5%. If the tax rate is 40% what is the value of Zipper Inc.?

Using the APV method? Using the WACC method?

Example Cont.

Using APV:

Value of all equity firm = 1000/.15 = $6666.67 Value of Tax shields = 2000 x .40 = $ 800 Value of Zipper Inc = 6666.67 + 800 = 7466.67

Using WACC

Value of Zipper equity = 7466.67 – 2000 = 5466.67 Return on equity = .15 + 2000/5466.67 (.15 - .05)(1-.4) = 17.195% WACC = 5466.67/7466.67 (.17195) + 2000/7466.67(.05)(1-.4) = 13.39% Value of Zipper = 1000/.1384 = 7468

Note: Do not know the weights on equity and debt and need to calculate that for WACC

Example cont

Zipper Inc. has after tax cash flows of $1000 forever. Its all equity cost of capital is 15%. It has 24% debt at a cost of 5%. If the tax rate is 40% what is the value of Zipper Inc.?

Using the APV method? Using the WACC method?

Note: Instead of having $2000 of debt now we have a debt ratio?

Example Cont.

Using APV:

Value of all equity firm = 1000/.15 = $6666.67 How much Debt do we have: 24% of firm value (is actually levered value) Approximate by all equity value 24% x 6666.67 = 1600 Value of Tax shields = 1600 x .40 = $ 640 Value of Zipper Inc = 6666.67 + 640 = 7306.67

Note: Do not know the amount of debt and need to calculate that for APV

Example Cont.

Using WACC

Return on equity = .15 + .24/.76 (.15 - .05)(1-.4) = 16.89% WACC = .76 (.1689) +.24(.05)(1-.4) = 13.55% Value of Zipper = 1000/.1355 = 7380

**WACC and APV
**

APV

Need the level of debt for e.g. $ 4m of debt Use this to calculate the present value of tax shields Value of Levered firm = Value of all equity firm + tax shields

WACC

Need the fraction of the firm that is debt i.e. D/V Use this to get the WACC Value of levered firms = After Tax Cash Flows/ WACC

APV is the natural way if you know the level of debt and WACC is the natural way if you know the percentage of debt

Capital Structure Nov 28th

Prof. Simi Kedia Financial Management Rutgers Business School

Introduction

We have seen that issuing debt is valuable as it generates tax savings. What is the tax advantage? VL = VU + tB This is also the Adjusted Present Value Method or the APV Value of levered firm = Value of all Equity firm + Value of all effects of Debt

**Comparing the Methods
**

APV

Cash Flows

WACC

All Equity All Equity CF CF RWACC Discount Rates R0 APV has the advantage that can easily put in costs of distress and other costs if wanted All methods should give the same value

**WACC and APV
**

APV

Need the level of debt for e.g. $ 4m of debt Use this to calculate the present value of tax shields Value of Levered firm = Value of all equity firm + tax shields

WACC

Need the fraction of the firm that is debt i.e. D/V Use this to get the WACC Value of levered firms = After Tax Cash Flows/ WACC

APV is the natural way if you know the level of debt and WACC is the natural way if you know the percentage of debt

Example 1

Beecorp has after tax cash flows of $5000 in perpetuity. The all equity cost for the firm is 14%. It has $3000 of debt at 5%. The tax rate is 40%. What is the value of Beecorp using APV? Using WACC?

Example 1

Value of all equity firm: 5000/.14 = 35,714 Tax shields: t x D = .4 x 3000 = 1200 Value (APV) = 35714 + 1200 = 36,914 Cost of levered equity:

Value of equity = 36,914 – 3000 = 33,914

**= .14 + 3000/33914 (.14 - .05)(1-.4) = 14.48%
**

Wacc = 33914/36914 x 14.48% + 3000/36914 x 5%(1-.4) = 13.54% Value is 5000/.1354 = 36,927

Example 2

Austin Inc is planning on having 30% debt at a cost of 7%. It all equity cost of capital is 16%. It expects an after tax cash flow of $3000 in perpetuity. If the tax rate is 40% what is the value of Austin using WACC? Using APV?

Example 2

Cost of levered equity: = .16 + .3/.7 x (.16 - .07) (1-.4) = 18.31% Wacc = .7 x 18.31% + .3 x 7% x (1-.4) = 14.08% Value = 3000/.1408 = $21,311 Using APV: Value of all equity firm = 3000/.16 = 18,750 Level of debt (approx) = 30% x 18750 = 5625 Tax shields = Dx t = 5625x .4 = 2250 Value of firm: 18,750 + 2250 = 21,000

Example 3

Happy cards has 30% debt at 7% and a WACC of 15%. It earns after tax $4000 in perpetuity. If the tax rate is 40% what would the value of the firm be if it became an all equity firm (issued more shares to retire its debt)?

Example 3

From the WACC we can get its levered cost of equity: 0.15 = .7 Re + .3 x 7% x (1-.4) Re = 19.63% Now using the MM Prop II with taxes we can get the all equity cost 0.1963 = Ra + .3/.7(Ra-.07)x (1-.4) Ra = 17.05% Value of an all equity firm = 4000/.1705 = 23460

**Same Example – with Betas
**

Zipper Inc. has after tax cash flows of $1000 forever. It has 24% debt at a cost of 5%. If the tax rate is 40% what is the value of Zipper Inc.? The market risk premium is 8%, all equity beta is 1.5 and the risk free rate is 3%?

What is the value of Zipper?

Example cont…

Note: The cost of all equity firm is not given but the details to calculate are. Use that to get to all equity value All equity cost of capital is = 3% + 1.5(8%) = 15% The you can proceed as before

**When Discount Rates have to be Estimated
**

Eric Inc. is planning to start a business producing Sodium Chlorate. They have determined that they would like to have 10% debt at interest rate of 8%. There is only one other firm in the industry, Dominant Inc. Dominant Inc has 40% debt at interest rate of 10% and its equity has a beta of 2. The market risk premium is 7% and risk free rate is 4%. The corporate tax rate is 34%. What is the WACC for Eric Inc.?

Example

Step 1: Find Dominant’s cost of equity (using the CAPM) = 4% + 2(7%) = 18% Step 2: Find the cost of capital for the all equity or unlevered firm (using MM II with taxes) 18% = R + 0.4 × (1 − .34) × ( R − 10%)

0

0.6

0

R0 = 15.56%

Example

Step 3: Get Eric Inc. cost of equity

16.11 = 15.56% + 0 .1 × (1 − .34) × (15.56 − 8%) 0 .9

**Step 4: Get Eric Inc. WACC
**

WACC = we Re + wD (1 − TC ) RD WACC = 0.9(16.11%) + 0.1(1 − .34)8% = 15.03%

Another Example

Experiment Inc is planning a new project in manufacturing pen. It is planning to have 20% debt at an interest rate of 6%. Greatpens, a pen manufacturer, with 10% debt at cost of 5%, and an equity beta of 1.8. The riskfree rate is 4% and the risk premium is 7%. If the tax rate is 34%, what is Experiment’s WACC?

Example

Step 1: Cost of levered equity for Greatpens

= 4% + 1.8 (7%) = 16.6%

**Step 2: Cost of all equity pen manufacturer
**

(Using MMII with taxes) 16.6% = ra + .1/.9(ra-5%)(1-.34) Ra = 15.81%

**Step 3: Cost of equity for experiment
**

Re = 15.81% + .2/.8(15.81% - 6%) (1-.34) = 17.43%

Step 4: WACC is

WACC = .8(17.43%) + .2(6%)(1-.34) = 14.73%

Example 2

J. Lowes Corp currently manufactures stapes. It has debt of 20% and its WACC is 13.4%. It is considering a $1 million investment in the aircraft adhesives industry. The project generates EBIT of $300,000 into perpetuity. The firm plans to have 10% debt which is riskless

The three competitors in the new industry are currently unlevered, with betas of 1.2, 1.3 and 1.4. Assuming a risk free rate of 5%, a market risk premium of 9%, and tax rate of 34%. What is the NPV of the project?

Example 2 cont..

Average Un-levered beta (all equity): (1.2 + 1.3 + 1.4)/3 = 1.3 All equity cost of capital

= 5% + 1.3(9%) = 16.7%. (this is ra)

**Cost of levered equity =
**

= 16.7% + .1/.9(16.7% - 5%)(1-.34) = 17.56%

WACC = .9(17.56%) + .1(5%)(1-.34) = 16.13% Value = 300,000 (1-.34)/.1613 = 1,227,359 NPV = 1,227,359 – 1m = 227,359

Note

Do not consider the firms WACC if it is not in the same business Use the average of all competitors Make sure they are all unlevered or all equity betas

Example 3

Golfco is currently unlevered with a cost of capital of 12%. It is planning to put on 30% debt at 8% for the new project. What is the relevant WACC for the new project?

Example 3:

Golfco is currently unlevered with a cost of capital of 12%. It is planning to put on 30% debt at 8% for the new project. What is the relevant WACC for the new project? What is the NPV of the project? Cost of levered equity

RS = 12% + 0 .3 × (1 − .34) × (12% − 8%) = 13.13% 0 .7

WACC = 0.7(13.13%)+0.3(1-.34)8% = 10.78%

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