UGBA 103 Introduction to Finance
Dmitry Livdan
Walter A. Haas School
Fall 2015
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Welcome to UGBA103  Intro to Finance!
I am an Associate Professor of Finance at the Haas School
I have been teaching here since 2007
I have received my PhD in Finance from Wharton
Before doing Finance I was a physicist
My research is on Corporate Finance, Market MIcrostructure, and
Macro Finance
You can learn more about my research @
http://scholar.google.com/citations?user=9inOJX8AAAAJ&hl=en
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Administrative Topics
Assignments
Homeworks should be done individually. They are available on
MyFinanceLab.
HBS cases can be done in groups of 3 to 4.
* Hand in one copy, with all names on it. But everyone should keep a
copy to bring for the class discussion.
* They are available on study.net or with Custom edition of the book.
* Be ready for the inclass discussion!
Class Reps
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Learning Materials and Grading
Text book and lecture slides
Assignments  20%
Problem sets (4) (This is a secret to success)
Cases (3)
Problems on MyFinanceLab (Again secret to success)
Class participation:
GSI section attendance  10%
Exams  I tend to randomize answers!
Midterm 1, October 2  17.5%
Midterm 2, October 30  17.5%
Final, in the Syllabus  35%
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Course Materials
All course materials, including syllabus, problem sets, cases, lecture
notes, and other materials will be available on bCourses.
Lecture format: I strongly encourage you to ask questions, oer
opinions, etc. as we go along.
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Course Content
PVs, FVs, Interest rates, bonds and capital budgeting  Part 1
(Chapters 1 to 8 in textbook)
Present value, discounting and interest rates
Real versus nominal interest rates/ination
Bonds and loans
Capital budgeting discounting cash ows
Risk and Return  Part 2a (Chapters 10 to 13)
Diversication, risk and the CAPM
The choice of discount rate
Stock valuation  Part 2b (Chapter 9)
Capital structure and valuing a company  Part 3 (Chapters 14, 15,
and 18)
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Honing Your Computational Skills
Make sure you can replicate the results in all the lecture notes,
starting with this set.
The Berk and DeMarzo text has excellent problems at the end of
each chapter.
The Berk and DeMarzo text comes with an online learning tool called
MyFinanceLab  use it at will!
Class examples and any extra problems done on your own are the key
learning tool.
Extra problems+solutions during GSI sessions.
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0. Introduction
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UGBA 103
Fall 2015
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0. Introduction
Readings: Berk and DeMarzo: Chapter 1.
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Fall 2015
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The Financial System
The Financial System
Transfers Capital from Suppliers to Users
Suppliers of
Capital
Individuals
Institutions
Pension Funds
Hedge Funds
Mutual Funds
Insurance
Companies
Etc.
Financial Markets
Exchanges and
Over the Counter
Bonds and Loans
Equity (stocks)
Derivatives
Forex
Insurance/other
Repayment by Users to Suppliers
Coupons/Principal on bonds
Dividends/Repurchase on stocks
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Users of Capital
Governments
Private firms
Public firms
Consumers
Regulators
SEC
Fed
CFPB
FDIC
Etc.
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Components of a Financial System
Institutions: These are rms than specialize in making the fund
transfers to borrowing entities.
Examples: Investment banks, commercial banks, broker/dealers,
mutual funds, etc.
Instruments; Most nancial transactions involve the borrowers
promise to make repayments.
Financial instruments are the legal evidence and specication of the
promise.
Markets: Most nancial transactions occur in organized markets with
standardized rules.
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Legal Infrastructure
A wellfunctioning nancial system depends, as well, on the rule of
law:
Huge amounts of money still transfer based on a promise to pay and
telephone conrmation.
Legal system sets standards; some examples:
Investment Company Act for mutual funds;
New suitability rules for mortgages from Consumer Finance Project
Bureau;
SEC disclosure rules on public security issues.
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Securities and Exchange Commission (SEC) vs. Fabric
Tourre/Goldman Sachs
Law example: Investment bank making public security issue must
disclose all material information it possesses that could inuence
investor decisions.
New York Times August 2, 2013 TOURRE FOUND LIABLE IN FRAUD
CASE
The former Goldman Sachs trader Fabrice Tourre lost a closely watched
legal battle on Thursday, when a jury found him liable on six counts of civil
securities fraud after a threeweek trial in Lower Manhattan.
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Corporate Securities
Equity (Common Stock): Investor cash ows are dividends (after
tax) plus value upon sale.
Debt (Bonds and Loans): Lender cash ows include interest
payments and principal repayment.
Preferred stock is a hybrid between debt and equity.
Derivatives are more complex securities with returns based on debt
and equity. For example, a call option provides an investor the upside
of equity, but at a xed cost that limits the downside.
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What Is Finance About
Finance is about pricing assets
Price = E[PV (Everything Asset Pays)] .
{z
}


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Ca$h Generated (2 nd part)
{z
Timing of Payments (1 st part)
{z
Uncertainty About Future (1 st part)
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The Finance Function and the Financial Manager
Broadly stated, the nance function is concerned with the ow of
funds between the capital markets and the rms operations
These ows include: (1) issues of securities to raise cash; (2)
purchases of real assets used in the rms operations; (3) cash inows
generated by the real assets; this cash is either (4a) reinvested in the
rm or (4b) returned to the rms investors.
The nancial manager therefore faces two main tasks:
Investment decisions (allocating funds to investments)
Financing decisions (choosing what instruments to issue to raise funds)
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The Objective of the Financial Manager
Although many claimholders have a stake in the rms income, the
shareholders are the owners, and managers should act in their interest
We will see that shareholders are made better o by any decision
which increases the value of their stake in the rm. Therefore,
managers should act to maximize the value of the rms shares.
This is more complex than prot maximization and requires an
understanding of how nancial assets are valued.
Several institutional arrangements exist to ensure that managers will
indeed follow this objective:
Stock and option compensation
Reputation in managerial labor markets
Hostile takeovers
Boards
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Objective of this Course
The course is intended to provide a framework for analyzing the
investment and nancing decisions made by corporations.
Since such a framework requires an understanding of the
determinants of value, the course provides an introduction to the
concepts underlying both corporate nance and asset pricing.
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Checkpoint: Berk and DeMarzo or Custom Edition Chapter 1
Material relevant to this section:
Berk and DeMarzo: Chapter 1.
Problem set: None
What is next?
Berk and DeMarzo: Chapter 4 and Chapter 5, Section 1.
Look at the Math/Stat reminder in Additional Materials; this will
be useful for the problem sets.
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I. Investment Decisions
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I. Investment Decisions
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I.1 Compounding and Discounting
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I.1.1 Constant Interest Rate
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I.1.1 Constant Interest Rate
Readings:
Berk and DeMarzo Chapter 4 and Chapter 5, Section 1.
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Cash Flows: The Atoms of Finance
Cash ows refer to an amount of money, on a specic date, that is
either received (treated as positive) or sent (treated as negative).
+$100 on October 1, 2014 is an example.
Securities consist of a series of cash ows, a negative cash ow when
it is purchased and a series of positive cash ows for the returns.
Investment projects are also a series of cash ows, negative for the
investment, positive for returns.
Text chapters 2 and 8 discuss cash ows further.
In order to choose between alternative investments, we must therefore
nd a way to compare cash ows diering in size, timing, and risk.
We will at rst ignore risk and compare certain cash ows.
The techniques of compounding and discounting allow us to compare
cash ows diering in size and timing.
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Investment Opportunity
Investment opportunity ) ability to invest $ to earn some $
Commercial banks (we are going to use them as primary investment
opportunity)
* When you put $ into bank you are a lender and bank is a borrower
* Banks use deposits to make $ by making loans to rms and other banks
* You get a service fee (interest) for providing liquidity to banks
Projects
* Businesses
* R&D
Market
* Stocks, bonds, USTs, mutual funds, hedge funds, etc.
* VC and PE
Direct lending to individuals
If you lose an investment opportunity (either by choice or negligence)
you lose the extra $
Opportunity cost of cash is lost interest
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Compounding and Future Value
Suppose that you invest a principal of $C in a bank account paying
Annual Percentage Rate or APR of r %, credited once a year.
Money in the account after one year:
Investment:
Interest (C
Total:
r %):
$C
$Cr
$C (1 + r )
Money in the account after two years:
Investment:
Interest (C
Total:
r %):
$C (1 + r )
$C (1 + r )r
$C (1 + r )2
= $C (1 + r )(1 + r )
Continuing this reasoning, you have $C (1 + r )T after T years
$C (1 + r )T is the future value in T years of $C at r % compounded
annually. The quantity
CFT = (1 + r )T
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More Frequent Compounding (Numerical Example)
Suppose that you invest $100 in a bank account paying an interest
rate of 10%, and that interest is credited twice a year.
Every six months, your account will generate 10%
2 = 5% interest.
Money in the account after 6 months:
Investment:
Interest (100
Total:
10%
2 ):
$100.00
$5.00
$105.00
= $100(1.05)
Money in the account after one year (12 months):
Investment:
Interest (105
Total:
10%
2 ):
$105.00
$5.25
$110.25
(> $5.00)
= $100(1.05)2
Does it make sense that you get more than $110.00?
You can continue this reasoning to show that youll have
$100(1.05)2T after T years (i.e. 2T periods of six months)
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More Frequent Compounding
More generally, suppose that you invest $C in a bank account paying
an APR of r , and that interest is credited to your account twice a
year.
You can then show that you will have $C (1 + 2r ) after 6 months,
$C (1 + 2r )2 after a year, ..., $C (1 + 2r )2T after T years.
$C (1 + 2r )2T is the future value in T years of $C at the APR r
compounded semiannually (i.e. two times a year)
Even more generally, the future value in T years of $C at the APR r
compounded m times a year is
FVT = C 1 +
r
m
mT
and the T year compounding factor is
CFT = 1 +
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r
m
mT
.
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The Eect of More Frequent Compounding
The following table shows the value after T years of $100 invested at
the rate of 10%, compounded m times a year.
m
1
2
4
12
365
T
1
110.00
110.25
110.38
110.47
110.51
5
161.05
162.89
163.83
164.53
164.86
10
259.37
265.33
268.51
270.70
271.79
30
1,744.94
1,867.92
1,935.81
1,983.74
2,007.73
Notice that more frequent compounding (as you go down each
column) means a higher eective annual rate. How far can we push
the benets of more and more frequent compounding?
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UGBA 103
Fall 2015
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The Eect of More Frequent Compounding (contd)
A standard result from algebra states that
r mT
= Ce rT ,
m !
m
where e ' 2.718 is the base for natural logarithms.
lim C 1 +
We express this result by saying that the future value in T years of
$C invested at an interest rate of r continuously compounded is
FV = Ce rT
Important note: In this course (and all nance courses that you will
take here), log always means the natural logarithm ln.
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Discounting and Present Value
Suppose you want to have $C in your account in one year, and that
the current APR is r (compounded annually). How much must you
invest today?
Let PV denote this amount.
0
PV
...
So PV must satisfy: PV (1 + r ) = C , or PV = C /(1 + r ).
PV is the present value of $C delivered in one year from now.
You are indierent between $PV now and $C in one year.
We can also write PV = C DF1 , where
1
DF1 =
1+r
is called the oneperiod discount factor.
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Discounting and Present Value (contd)
Now, suppose you want $C in your account in T years. How much
must you invest today?
Again, let PV denote this amount.
0
PV
...
So PV must satisfy: PV (1 + r )T = C , or PV = C /(1 + r )T .
PV is the present value of $C delivered in T years from now.
You are indierent between $PV now and $C in T years.
We can also write PV = C DFT , where
1
DFT =
(1 + r )T
is called the T period discount factor.
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Discounting and Present Value (contd)
More generally, suppose you want to receive $C1 in one year, $C2 in
two years, ..., $CT in T years. How much must you invest today?
We wish to nd the PV of an investment paying $C1 in one year, $C2
in two years, ..., $CT in T years.
0
...
PV
C1
C2
C3
...
CT
Using arguments similar to the previous two slides, we should nd that
PV =
T
C1
C2
CT
Ct
+
+
...
+
=
2
t
T
1+r
(1 + r )
(1 + r )
t =1 (1 + r )
The present value of a sequence of cash ows is the sum of the
present values of each individual cash ow.
Value additivity: you value an investment by valuing each constituent
cash ow.
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Discount Factors
The following gure shows discount factors DFT as functions of time
and APR.
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Practice Problem Ch 4.
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Practice Problem Ch 4.
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Practice Problem Ch 4.
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Practice Problem Ch 4.
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Discounting: More Serious Example
Two years ago, you put $10,000 in a savings account earning an APR of
8% compounded semiannually. At the time, you thought that these
savings would grow enough for you to buy a new car ve years later (i.e. in
three years from now). However, you just reestimated the price that you
will have to pay for the new car in three years at $18,000.
1
How much more money do you need to put in your savings account
now for it to grow to this new estimate in three years?
Now suppose that you know that the car company will oer you to
pay for the car over some time. In particular, you will have the
opportunity to make a downpayment of $6,000 at the time you get
the car (three years from now) and to make additional payments of
$6,500 at the end of each of the following two years. With this oer,
how much money do you need to add to your account now?
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Discounting: Example (contd)
Let us rst gure out how much money FV is now in the account.
2
10, 000
FV = 10, 000 1 +
Dmitry Livdan (Haas)
(1.04)4
!
0.08
2
...
FV
...
2 2
= 10, 000(1.04)4 = 11, 698.59.
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Discounting: Example (contd)
Now, the account should have an amount PV in it for it to grow to
$18,000 in three years.
2
...
(1.04)
PV
PV =
18, 000
1+
0.08 2 3
2
So, you need to put $14, 225.66
account.
Dmitry Livdan (Haas)
18, 000
(1.04)6
= 14, 225.66.
$11, 698.59 = $2, 527.07 in the
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Discounting: Example (contd)
2. The PV (at time 0) of these three payments is
PV =
6, 000
1+
0.08 2 3
2
6, 500
1+
0.08 2 4
2
So, you need to add $13, 882.54
account
Dmitry Livdan (Haas)
6, 500
1+
0.08 2 5
2
= 13, 882.54.
$11, 698.59 = $2, 183.95 to the
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Practice Problem Ch 4.
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Shortcuts to Calculating PVs: Perpetuities
A perpetuity is an investment paying a xed sum Ct = C at the end
of every period forever. (We will typically consider a period being one
year, but other period lengths are possible).
0
...
PV0
...
From our general formula, the PV of the perpetuity is given by:
PV0 =
C
C
C
+
+
+ ...
2
1+r
(1 + r )
(1 + r )3
How do we nd the value of this innite sum?
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Shortcuts to Calculating PVs: Perpetuities (contd)
Multiplying both sides of the above equation by 1 + r gives
PV0 (1 + r )
{z
}

=C+
Value if invested for 1 year
C
C
C
+
+
+ ...
2
1+r
(1 + r )
(1 + r )3
{z
}

PV 0
We now solve for PV0 as follows (provided r > 0):
PV0 (1 + r )
Dmitry Livdan (Haas)
PV0 = C
UGBA 103
, PV0 r = C
C
, PV0 =
r
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Example: UK Consols
In the 1800s, the British government decided to consolidate the huge
debt accumulated during the Napoleonic wars and to replace it with a
single issue of bonds with no termination date and a coupon rate of
2 12 %. These bonds, called consols, are still traded today.
Suppose that the current interest rate in the U.K. is 9%. What is the
PV of a consol with a 1, 000 face value?
This is just a perpetuity promising to pay 25 each year. Its PV is
PV0 =
Dmitry Livdan (Haas)
25
= 277.78.
0.09
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Practice Problem Ch 4.
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Shortcuts to Calculating PVs: Growing Perpetuities
A growing perpetuity is an investment paying, at the end of each
period, an amount C that grows at an annual rate g forever,
Ct = C (1 + g )t 1 .
0
...
PV0
C (1 + g )
C (1 + g )2
C (1 + g )3
...
From our general formula, the PV of the growing perpetuity is:
PV0 =
Dmitry Livdan (Haas)
C
C (1 + g ) C (1 + g )2
+
+
+ ...
1+r
(1 + r )2
(1 + r )3
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Shortcuts to Calculating PVs: Growing Perps (contd)
We now use a trick similar to that on slide 45. We multiply both
sides of the above equation by 1 + r :
PV0 (1 + r ) = C +
C (1 + g ) C (1 + g )2
+
+ ... =
(1 + r )
(1 + r )2
2
7
6
2 7
6 C
C
(
1
+
g
)
C
(
1
+
g
)
+
...7
= C + (1 + g ) 6
6 (1 + r ) +
(1 + r )2
(1 + r )3 7
5
4
{z
}

PV 0
We can now solve for PV0 as follows (provided that g < r ):
PV0 (1 + r )
Dmitry Livdan (Haas)
PV0 (1 + g ) = C
UGBA 103
, PV0 (r
g) = C
C
, PV0 =
r g
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Sanity Check 1: A Stock
Morgan Stanley has just paid a dividend of $1. It will grow its
dividend at 5% forever. With an APR of 10%, what is its share price?
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Sanity Check 2: Deferred Sale
You plan to buy Morgan Stanleys stock today and sell it 4 years from
now. Assuming that nothing will change in the stocks behavior, i.e.
it will continue to grow its dividends at 5% forever, what is the
present value of the prots from such transaction?
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More on Growing Perps: Morgan Stanley
You estimate that MSs earnings will grow at 3%, what return shell
you expect if you purchase MSs stock at $38.93?
You want to earn expected return of 13% by purchasing MSs stock
at $38.93. What does this imply about MSs earnings growth rate?
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Another Shortcut to Calculating PVs: Annuities
An annuity is an investment paying a xed sum C at the end of every
period for a given number T periods.
0
...
PV
T +1
T +2
...
From our general formula, we can write the PV of the annuity as:
PV0 =
Dmitry Livdan (Haas)
C
C
C
+
+ ... +
.
2
1+r
(1 + r )
(1 + r )T
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Another Shortcut to Calculating PVs: Annuities (contd)
A more convenient expression can be obtained by observing that the
cash ows from the annuity equal the dierence between the cash
ows of two perpetuities, one starting at time 1 and the other starting
at time T + 1:
0
(1 )
PV0
(2 )
PV0
Dmitry Livdan (Haas)
...
UGBA 103
T +1
T +2
...
C
C
C
C
...
...
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Another Shortcut to Calculating PVs: Annuities (contd)
(1 )
The PV of the rst perpetuity is PV0 = Cr , as derived on slide 46
What about the second perpetuity, which is deferred for T periods?
Let us rst calculate the value of that perpetuity after T periods. We
(2 )
call this value PVT .
...
(2 )
PVT
C
r
T +1
T +2
...
...
Now, since PVT2 is the value in T periods from now, we need to
discount this value to time 0 to get the value of the perpetuity:
(2 )
PV0
Dmitry Livdan (Haas)
...
(1 + r )
T +1
T +2
...
(2 )
PVT
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Another Shortcut to Calculating PVs: Annuities (contd)
The calculation for the PV of the annuity then simply involves a
dierence of two perpetuities:
Perpetuity
starting at
1
T +1
1
C
0
2
C
0
...
...
...
Cash Flow
T T +1 T +2
C C
C
0 C
C
...
...
...
Present
Value
(1 )
PV0 =
(2 )
PV0 =
Annuity
...
...
PV0 =
C
r
C
1
r (1 +r )T
(1 )
(2 )
PV0
PV0
The PV of the annuity is therefore given by:
PV0 =
Dmitry Livdan (Haas)
C
r
1
(1 + r )T
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Practice Problem Ch 4.
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Practice Problem Ch 4.
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Other Useful Formulas
The formulas for perpetuities and annuities that we derived on slides
28, 45, 54 and 57 all assume that payments are always made at the
end of the year.
If the payments are made at the beginning of the year (i.e. the rst
payment is C , paid immediately), these PV formulas become:
C (1 + r )
;
r
C (1 + r )
growing perpetuity:
PV0 =
;
r g
1
C (1 + r )
1
annuity:
PV0 =
r
(1 + r )T
"
C (1 + r )
1+g
growing annuity : PV0 =
1
r g
1+r
perpetuity:
Dmitry Livdan (Haas)
PV0 =
UGBA 103
;
T
Fall 2015
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Some Notation
The following notation for annuities will sometimes be useful. r
represents the EAR.
The PV of a T year annuity of $1, payable at the end of each year:
aT j r =
1
1
r
1
(1 + r )T
The PV of a T year annuity of $1, payable at the start of each year:
e
aT j r =
1+r
1
r
1
(1 + r )T
These are called annuity factors, as any (constant) annuity can be
calculated using these factors.
For example, the PV of a T year annuity of $C payable at the end of
each year is equal to PV = CaT jr .
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Actual Computations
The PV formulas are ugly and laborious to use (even with a
calculator).
Fortunately, spreadsheets (Excel on PC, Numbers on iPad) or special
nancial calculators greatly facilitate the computations.
You will need to use one of these for the course problem sets and
exams.
The following starts by showing the use of Excel.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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PV of an Annuity
Suppose we want to compute the PV of an annuity with r = 0.05,
N = 10, C = 50.
Excel PV function uses slightly dierent terminology: r = Rate,
N = Nper , C = Pmt.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Excel Sheet for PV of an Annuity
FV = 0 because an annuity has no explicit repayment of principal
(called selfamortizing).
Type = 0 because we assume all payments are at year end.
PV is a negative value because Excel assumes this is the amount you
pay at date 0 to receive ows of C = 50.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
64 / 210
Excel Sheet for PV of Bond
FV = 1000 =) bond principal repaid at date N.
Type = 0 because we assume all payments are at year end.
PV is a negative value because Excel assumes this is the amount you
pay at date 0 to receive ows.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
65 / 210
Soving Other Problems with Excel
All our problems involve 5 variables: PV, FV, Pmt, Rate, and Nper.
If you are given values for any four, you can use Excel to solve for the
last one:
Use
Use
Use
Use
Use
PV (Rate, Nper, Pmt, FV) to solve for PV.
FV (Rate, Nper, Pmt, PV) to solve for FV.
Pmt (Rate, Nper, PV, FV) to solve for Pmt.
Rate (Nper, Pmt, PV, FV ) to solve for Rate.
Nper (Rate, Pmt, PV, FV) to solve for Nper.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
66 / 210
Soving with iPad Numbers or Financial Calculators
Financial functions in iPad Numbers work in virtually the same way as
Excel, although the notation is slightly dierent:
Excel
PV
Rate
Nper
Pmt
FV
Numbers
presentvalue
periodicrate
numperiods
payment
futurevalue
Financial calculators also use comparable buttons ) More during GSI
sessions.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
67 / 210
Securities with Cash Flows More Frequent Than Annually
So far our discussion and examples have focused on securities on
which payments occur only once a year (and at the end of the year
as well).
But many, even most, important securities have cash ows that occur
more frequently than annual.
We will now study how to modify computations when cash ows are
more frequent than annually.
Why do securities have cash ows > annually?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Periodic Payments (More Frequent than Annually)
When payments are more frequent than annually, the computational
inputs must match the actual payment periods. Example for a
monthly mortgage:
The interest rate is specied as a monthly rate.
The number of periods is counted in months.
Annuity payment (C ) is the monthly amount.
Monthly mortgage example:r = 0.5%, N = 360, PV = loan amount
= $100, 000. Compute PMT = C = $600 monthly.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
69 / 210
Rules for Converting Periodic Interest Rates (e.g. monthly)
to APRs
Convention is to quote mortgages and bond interest rates as annual
rates, even though the true contract interest rates are monthly
(mortgages) or semiannual (most bonds). Conversion convention:
Quoted annual rate = 12
Quoted annual rate = 2
Monthly rate;
Semiannual rate.
Mortgage example: contract rate = 0.5% monthly; APR = 6%.
Bond example: coupon rate = 3% semiannually; APR = 6%.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
70 / 210
Eective Annual Rate (EAR)
Suppose you invest $1 today and earn a monthly interest rate of 0.5%
(i.e. compounded monthly). How much is accumulated after one
year?
Answer: FV = ($1) (1.005)12 = $1.0617.
6.17% is called the eective annual rate (EAR).
It equals the annual rate that gives the same FV as the monthly rate
with monthly compounding.
The APR (6% in this example) is always less than the EAR.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Examples Annual Percentage Rates (Text Table 5.1)
Eective Annual Rates for a 6% APR with dierent compounding
periods
You should be able to replicate these results using the FV function as
illustrated on the previous slide.
The value of eective annual rate is that it allows you to compare
securities with dierent payment periods.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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General Formula Connecting EAR and APR
A security has APR compounded K times per year. Then after 1 year
we have (compare text page 144):
(1 + EAR ) =
1+
APR
K
Example: A mortgage with monthly payments is quoted with a 12%
APR. Monthly contract rate = 1%. EAR = 12.68%. (Method for
AER: compute FV of security that has r = 1%, PV = 1, N = 12).
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
73 / 210
Periodic Rates and Compounding Periods: Further
Comments
Real world examples of periodic rates:
Mortgages/auto loans use monthly interest rates;
Most bonds use semiannual interest rates;
Many banks use daily compounding for CDs;
All are normally quoted as APR, although the EAR may be the more
relevant economic rate.
Continuous compounding  not directly used in practice, but often
used in nance theory since very nice mathematical features.
See text pages 167 to 168 for further discussion.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Eective Annual Rate: Sanity Check
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Eective Annual Rate: Sanity Check (contd)
Why do these certicates of deposits (CDs) seem to oer two
dierent interest rates?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
76 / 210
Installment Loans are Annuities: Further Comments
Mortgages and auto loans are legally called installment loans,
identical to annuities. Features:
Constant monthly payments with no balloon;
Each payment includes principal repayment;
Interest component of paymentt = (r ) (balancet
Principal componentt = Paymentt Interestt .
1 );
Example: Loan = balance0 = 100000; Monthly rate = 0.5%;
N = 360. Compute PMT = $600. For the rst payment, interest
= $500, principal = $100.
For computing later loan balance, see text p. 147.
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UGBA 103
Fall 2015
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Practice Problem Ch 4.
Dmitry Livdan (Haas)
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Fall 2015
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Truth in Lending, DoddFrank, and the Consumer Finance
Protection Bureau
We are all aware of the harm created by subprime mortgages,
especially predatory lending.
Fraud: Failure to disclose true APR to investors.
Unscrupulous: Provide mortgage that must be renanced and imbed
high renance charges.
Less clear: Mortgage will succeed only if house prices continue to rise
(as in past).
DoddFrank created the Consumer Finance Protection Bureau to
expand truth in lending.
Qualied mortgage: Loans must be suitable.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Key Takeaways: Constant Interest Rate
Compounding factor gives future value of $1
CFT = 1 +
r mT
m
= e rT if m !
Eective annual rate gives equivalent rate under onceayear
compounding
EAR = 1 +
APR
m
Discount factor gives present value of $1
DFT = 1/CFT
Growing perpetuity: PV0 = C / (r
g)
Annuity factor gives PV of $1 for T years. aT jr =
Dmitry Livdan (Haas)
UGBA 103
1
r
1
(1 +r )T
Fall 2015
80 / 210
Checkpoint: Compounding and Discounting
Material relevant to this section:
Berk and DeMarzo: Chapter 4, Chapter 5, Section 1.
Practice problems: 5, 6, 7, 8, 13, 17, 21, 26, 34 (Berk and DeMarzo:
Chapter 4).
What is next?
Berk and DeMarzo: Chapter 5(3), Sections 25.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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I.1.2 Term Structure
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UGBA 103
Fall 2015
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Accounting for the Term Structure of Interest Rates
Our PV formulas have assumed that the interest rate is the same for
all maturities. In practice, the interest rate at which you can
borrow/invest for, say, 1 year is typically dierent from the rate at
which you can borrow/invest for, say, 5 years.
The relationship among interest rates for dierent maturities is known
as the term structure of interest rates.
The situation in which the interest rates are the same for all maturities
is usually referred to as a situation in which the term structure is at.
With a nonat term structure,
the cash ow at time:
should be discounted at:
1
r1
2
r2
3
r3
...
...
and the PV formula of slide 34 has to be modied to
PV =
T
C2
CT
C1
Ct
+
+
...
+
=
.
1 + r1
(1 + r2 )2
(
1
+
rt )t
(1 + rT )T
t =1
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UGBA 103
Fall 2015
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Term Structure: Example
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
84 / 210
Term Structure: Example 2
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
85 / 210
What Determines the OnePeriod Interest Rate?
The classic insight into how interest rates are determined was provided
by Irving Fishers book The Theory of Interest, published in 1930.
The interest rate is simply the price which equates the demand and
supply for capital. The supply depends on peoples willingness to
save that is, to postpone consumption while the demand depends
on the opportunities for productive investment.
Fishers theory points at the following factors as important
determinants of the oneperiod interest rate:
The
The
The
The
The
level of industrial activity
level of technological innovation
level and distribution of aggregate wealth
distribution of the populations age
expected level of ination
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Nominal versus Real Interest Rates: Numerical Example
Suppose that all you buy are apples, which cost $1 each today, and
that r = 26%. Can you buy 26% more apples next year?
Answer: It will depend on the price of apples in one year.
Example:
Suppose that you have $100 today, and that the price of apples goes
up by 5% during the year.
Let us compare how many apples you could buy today vs. in one year.
today
in one year
money available $100
$126
price of apples
$1.00
$1.05
100 = 100 apples
126
can buy
1.00
1.05 = 120 apples
Since you can only buy 20% more apples, you are only 20% better o
(not 26%). In other words, your real rate of return is 20%.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Nominal versus Real Interest Rates
More generally, suppose that you invest for one year in the bond
market. Your investment next year is worth $ (1 + r ) for each dollar
invested. Does this mean you are better o by saving?
The answer depends on what happens to ination. Suppose that the
oneyear rate of ination is i. Then, in order to buy the same amount
of goods you could have purchased with $1 today, you will need
$ (1 + i ) a year from now. This means that your actual return,
measured in todays dollars is given by
1+r
1+r
=) R =
1.
1+i
1+i
R is known as the real rate of return, as opposed to r , which is a
nominal rate.
People often calculate the real rate of return R to be the dierence
between the nominal rate of return r and the ination rate i:
1+R =
R=r
Dmitry Livdan (Haas)
UGBA 103
i.
Fall 2015
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Why Real Rates Are Important
Suppose you are in Germany at the beginning of 1923. Someone
oers you a oneyear German Treasury bill denominated in marks with
a face value of DM10,000,000 (' $700) at the bargain price of
DM5,000,000. Since this implies a rate of return of
r=
10, 000, 000
5, 000, 000
1 = 100%,
you accept. Did this turn out to be a good deal?
The ination rate in Germany in 1923 turned out to be about
4,530,000,000%, so that the real return on your investment was
R=
1 + 100%
1 + 45, 300, 000
1'
99.9999956%.
In other words, your investment was practically worthless at the end
of 1923!
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U.S. Interest Rates and Ination Rates (Text Figure 5.1)
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Current Federal Reserve Monetary Policy
Following the crisis, the Federal Reserve has been extremely
aggressive in an accommodative policy.
Operationally, Fed purchase trillions of bonds.
This raises bond price, lowers its interest rate.
Last and this year tapering has been the buzz word in nancial
markets. This means reversing the purchases.
Ultimately, interest rates will rise, and ination may also begin to
accelerate.
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UGBA 103
Fall 2015
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Key Takeaways: Term Structure
Spot rate rT is the rate per year for T years starting today
The term structure is the graph of r1 , r2 , ... for dierent T
With a nonat term structure, PV = Tt=1
Dmitry Livdan (Haas)
UGBA 103
Ct
(1 +r t )t
Fall 2015
92 / 210
Checkpoint: Term Structure
Material relevant to this section:
Berk and DeMarzo: Chapter 5(3), Sections 25
Problem set: None
What is next?
Berk and DeMarzo: Chapter 6(4)
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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I.2 The Valuation of Certain Cash Flows:
Pricing Bonds
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I.2 The Valuation of Certain Cash Flows: Pricing Bonds
Readings: Berk and DeMarzo, Chapter 6.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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What Is a Bond?
A bond is essentially a loan: the issuer (borrower) promises to repay
the investor (lender) the amount borrowed plus interest over some
specied period of time.
A coupon bond promises a periodic interest payment (e.g. every six
months) and repayment of the face value (F ) at the maturity
date (T ). The periodic interest payment is known as the coupon (C )
and the APR on the face value is called the coupon rate (i.e., CF is the
coupon rate).
...
C (coupon)
...
T (maturity date)
C + F (face value)
For a zero coupon bond there are no periodic coupon payments, and
both principal and interest are paid together at the maturity date.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Treasury Securities
The U.S. Treasury is the largest single issuer of debt in the world.
U.S. Treasury securities are backed by the full faith and credit of the
U.S. government, so that they are viewed by market participants as
having no (or very low) default risk (i.e. no risk that the issuer will
default on his payments of interest and/or principal).
There are three major types of Treasury securities:
Treasury Bills are issued with maturities of 3, 6, or 12 months.
Treasury Notes are issued with maturities between 2 and 10 years.
Treasury Bonds are issued with maturities greater than 10 years.
Treasury bills are zerocoupon bonds (ZCBs), while Treasury notes
and bonds are coupon bonds with interest paid every 6 months.
A coupon bond is basically a portfolio of several zerocoupon bonds,
one for each coupon or principal payment. The Treasury allows buyers
of Tbonds or Tnotes to exchange them for the individual
component ZCBs. These ZCBs corresponding to unbundled Treasury
coupon bonds are called Treasury Strips.
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UGBA 103
Fall 2015
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How Treasury Securities Are Quoted
Treasury bills are quoted in terms of a discount rate (in percent), not
of a price. If d is the quoted discount rate, N the maturity (in days)
and F the face value, then the price is computed according to the
formula
N
P=F 1 d
360
For example, if the quote for a 100day Tbill with a face value of
$100,000 is 8.75, then the price is
$100,000 1
0.0875
100
360
= $97,569.
Treasury coupon securities and Treasury strips are quoted in terms of
prices (in percent of face value), with the decimal part expressed in
units of 1/32. For example, a quote of 92:14 refers to a price of 92
and 14/32, or 92.4375 for a security with $100 face value.
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UGBA 103
Fall 2015
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How Treasury Securities Are Quoted: Example
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How Treasury Securities Are Quoted: Example (contd)
For example, if we look at the Treasury bill with the Dec 26 96
maturity date, the Wall Street Journal tells us:
The bond has 135 days to maturity.
The (best) bid discount is 5.05%, which means that the price at
which you can sell that Tbill with a face value of $100,000 is
100,000 1
0.0505
135
360
= 98,106.25.
The (best) ask discount is 5.03%, which means that the price at
which you can buy that Tbill with a face value of $100,000 is
100,000 1
Dmitry Livdan (Haas)
0.0503
UGBA 103
135
360
= 98,113.75.
Fall 2015
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Pricing a Coupon Bond
Suppose that the term structure of interest rates is as follows:
r0.5 = 4%, r1 = 4.1%, r1.5 = 4.3%, r2 = 4.5%. What is the current
price of a Tnote with 2 years to maturity, a coupon rate of 8%
semiannual, and a face value of $100?
Using the general PV formula, we have:
P=
4
4
104
4
+
+
+
= 106.756
0.5
1.5
(1.040)
(1.041) (1.043)
(1.045)2
Does it make sense that P > $100?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Estimating the Term Structure
Since bond prices reect the current term structure, we can use bond
prices to estimate the term structure, provided we have a su cient
number of bonds with diering maturities and/or coupons.
Some nd it simpler to rst solve for the discount factors, and then
obtain the interest rates from the discount factors.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Estimating the Term Structure: Example
Suppose you observe the following prices for a bond with $100 face
value:
Bond
A
B
C
D
Security
Tbill
Tbill
Tnote
Tnote
Coupon
6%
8%
Maturity
180 days
360 days
2 years
2 years
Quote
4.98
5.44
99:10
103:01
Price
97.51000
94.56000
99.31250
103.03125
Determine the 6, 12, 18 and 24 month interest rates (spot rates).
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
103 / 210
Estimating the Term Structure: Example (contd)
First, let us gure out the timing of the bondspayments
Bond
Bond
Bond
Bond
A
B
C
D
Dmitry Livdan (Haas)
Cash ow at the end of
6 months 12 months
(0.5 year) (1 year)
100
0
0
100
3
3
4
4
UGBA 103
18 months
(1.5 year)
0
0
3
4
24 months
(2 years)
0
0
103
104
Fall 2015
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Estimating the Term Structure: Example (contd)
Let us now calculate the discount factors that are consistent with the
bondsprices and the above payments. In particular, each bond must
satisfy the PV formula on slide:
97.51000 = (100
DF0.5 )
94.56000 = (0
DF0.5 ) + (100
99.31250 = (3
DF0.5 ) + (3
DF1 ) + (3
DF1.5 ) + (103
DF2 )
103.03125 = (4
DF0.5 ) + (4
DF1 ) + (4
DF1.5 ) + (104
DF2 )
DF1 )
Solving the above system gives DF0.5 = 0.9751, DF1 = 0.9456,
DF1.5 = 0.9165 and DF2 = 0.8816.
We can then use the fact that DFt = (1 +1rt )t (see slide ??) to nd
r0.5 = 5.17%, r1 = 5.75%, r1.5 = 5.99% and r2 = 6.51%.
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UGBA 103
Fall 2015
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Bond Yields
The yield to maturity or internal rate of return (IRR) for a bond is
the rate y that solves
T
P=
(1 + y )t
t =1
F
(1 + y )T
(1)
If you recall (from the PV formula on slide 83) that
T
P=
(1 + rt )t
t =1
F
,
(1 + rT )T
you will see that the yield of a bond is a complicated average of the
current interest rates. In particular, the yields of two bonds with the
same maturity but with dierent coupon rates will generally dier.
Solving for y in (1) involves solving a polynomial of degree T .
For a zerocoupon bond with maturity T , or if the term structure is
at, we have y = rT .
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Yields of Treasury Securities
When nancial practitioners talk of the yield of a Treasury security,
they dont generally refer to the rate y as dened on page 106, but to
the annual percentage rate under semiannual compounding y given
by
y 2
1+
= 1 + EAY .
2
where EAY is the eective annual yield (under annual compounding).
y is also referred as a bondequivalent yield.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Problems with Bond Yields
You should never use the information on bond yields reported by the
nancial press as a substitute for the term structure of interest rates.
Knowing the term structure of interest rates allows you to price any
riskless asset.
Knowing the yield of a bond tells you the price of that particular bond
only.
Two bonds with the same maturity but dierent coupons will in
general have dierent yields.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Bond Prices: Premium and Discount
We have seen that when YTM = coupon rate, then bond price = par
value (normally $1, 000.00).
When YTM > coupon rate, then bond sells at a discount (market
price < par value).
When YTM < coupon rate, then bond sells at a premium (market
price > par value).
Selftest: Using bond of the previous slide, show:
If YTM = 6.00%, then price = $957.35 (discount)
If YTM = 4.00%, then price = $1, 044.91 (premium).
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Investor Returns on Discount and Premium Bonds
If a coupon bond trades at a premium (coupon rate > market rate),
investors earn a return from receiving the high coupons but this
return will be diminished by receiving a face value less than the price
paid for the bond.
If a coupon bond trades at a discount (coupon rate < market rate),
investors will earn a low return from the low coupons but this return
will be increased by receiving a face value greater than the price paid
for the bond.
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Fall 2015
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The Eect of Time on Bond Prices (Text Figure 6.1,
30year Bonds, Par Value $100)
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Interest Rate Changes and FixedIncome Security Prices
There is an inverse relationship between xedincome security prices
and market interest rates.
As market interest rates rise, all xedincome security prices fall.
As market interest rates fall, all xedincome security prices rises.
Intuition: Market interest rates are used to discount the bond cash
ows to get the PV = market price.
As discount rate rises, PV = price falls.
As discount rate falls, PV = price rises.
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UGBA 103
Fall 2015
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Interest Rate Changes , Security Prices, and Duration
When interest rates rise, all security prices fall.
But longer duration > greater % price decline.
Duration is the eective maturity of a bond.
For a zero coupon bond, duration = maturity.
For coupon bonds, duration < maturity, because most coupon
payments come before maturity.
So when interest rates rise, zero coupon bond prices will fall more
(percentage wise) that coupon bonds of the same maturity.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Two Inevitable Topics: Default and Taxes
We now turn to two inevitable topics: (not death and taxes, but that
is close. . . .)
Default. As we know only too well from the recent nancial crises,
borrowers default.
Taxes. Interest income is taxable to the investor (even though it is
generally deductible for corporate borrowers).
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UGBA 103
Fall 2015
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Default Risk (Text pages 186 to 191)
You may notice we have been assuming that investors receive all
promised cash ows.
In the real world, of course, borrowers sometimes default mortgages,
corporate bonds, sovereigns.
Bond ratings are one measure of this risk.
Sovereign debt ratings measure countrys default risk (remember
Argentina).
Where this risk is present, bond prices are reduced and, equivalently,
interest rates are higher.
We will discuss this a lot more later.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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AfterTax Interest Rates
Taxes reduce the amount of interest an investor can keep, and we
refer to this reduced amount as the aftertax interest rate.
r
(tax rate = )
r = r (1
Municipal bonds are an important exception, since interest on these
bonds is generally exempt from federal income taxation. There is thus
a breakeven tax rate, , above which investors prefer munis:
rmuni > rtaxable (1
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Fall 2015
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Financial Investment Decisions
In choosing nancial securities, investors consider:
Riskiness (higher risk allows higher return);
Maturity (longer maturity allows higher return);
Taxable status (higher tax rates favor munis).
It facilitates the decision to make comparisons with Treasury
securities of comparable maturities.
The yield on the Treasury bond then becomes the opportunity cost.
Investors compare the yield on other investment relative to the
opportunity cost of the Treasury benchmark.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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The Role of Opportunity Cost in Corporate Investment
Decisions
Corporations use opportunity cost when evaluating their investment
opportunities sometimes called the hurdle rate.
If the corporation has plenty of cash, then the opportunity cost equals
the best alternative use of the funds (compared to the proposed
investment).
This can include dividends or stock repurchase.
If the corporation has to borrow or issue new shares, then opportunity
cost is the cost of capital.
We will discuss this in detail later.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Key Takeaways: Pricing Bonds
Treasury bills pay no coupon, and are quoted in terms of a discount
N
rate: P = F 1 d 360
Treasury notes and bonds pay a semiannual coupon ( C2 every 6
months), and are quoted in units of 1/32
The price of a bond is P = Tt=1
tyear spot rate
C
(1 +r t )t
F
(1 +r T )T
where rt is the
The yield of a bond is the single constant discount rate y that solves
P = Tt=1 (1 +Cy )t + (1 +Fy )T . It is a (weighted geometric) average of
the spot rates
For Treasuries, quoted yields are semiannual APRs: y given by
2
1 + y2 = 1 + EAY
The coupon of a bond is xed. Its yield depends on market
conditions, and is inversely related to its price
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Checkpoint: Pricing Bonds
Material relevant to this section:
Berk and DeMarzo: Chapter 6
Practice problems: 2, 6, 10, 24.
What is next?
Berk and DeMarzo: Chapter 3, Section 3, Chapter 8.
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Practice Problem Ch 6.
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UGBA 103
Fall 2015
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Practice Problem Ch 6.
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UGBA 103
Fall 2015
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Practice Problem Ch 6.
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UGBA 103
Fall 2015
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Practice Problem Ch 6.
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UGBA 103
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I.3 Capital Budgeting Under Certainty
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UGBA 103
Fall 2015
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I.3 Capital Budgeting Under Certainty
Three questions:
What is a good rule for selecting projects? (section I.3.1)
How do we apply it? (section I.3.2)
What are the alternatives, and are they useful at all? (section I.3.3)
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Fall 2015
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I.3.2 Using the NPV Rule for Capital Budgeting
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UGBA 103
Fall 2015
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I.3.2 Using the NPV Rule for Capital Budgeting
Readings: Berk and DeMarzo: Chapter 3, Section 3, and Chapter 8.
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Fall 2015
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Capital Budgeting: Basic Terms
Capital Budgeting: Process to analyze alternate investments and
decide which ones to accept.
Incremental Earnings: The amount by which the rms earnings are
expected to change as a result of the investment decision.
Incremental Free Cash Flows (we will use Ct as a notation): The
amount by which the rms free cash ows are expected to change as
a result of the investment decision.
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Free Cash Flow Is Not Prot
Net income (prot) is how much the company earns in year t,
according to its accounts
Ct is how much cash physically ows into the rm and is available to
investors, after all other claimants have been paid o
Time value of money: cash can be invested elsewhere, unlike prot
Key dierences:
Capital expenditure aects cash ow but not prot
Depreciation aects prot but not cash ow, except via its eect on
taxes T
T = tc (Revenues Expenses Depreciation + Extraordinary Gains)
where tc is the corporate tax rate
Free cash ow = Cash from operations Capex
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Fall 2015
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Incremental Earnings Forecast Table 8.2 from Text
Glossary
EBIT  earnings before interest and taxes
EBITDA  earnings before interest, taxes, depreciation, and
amortization
COGS  costs of goods sold
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Fall 2015
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Depreciation
We consider linear depreciation over T years
BV0 (or Capex) BVT
D=
.
T
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Cash From Operations
Three equivalent ways to calculate cash from operations:
1
Start from net income and add back depreciation:
CFO = (R


D + X) (1
}
EBIT
{z
tc ) + D
Net Income
Add up only the cash items
CFO = R
{z
E+X
tc EBIT
Tax the cash items and add back the depreciation tax shield
CFO = (R
E + X)(1
tc ) + tc D
Free Cash Flow
FCF = CFO
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UGBA 103
Capex
Fall 2015
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Working Capital
Where there is working capital, the Free Cash Flow equation becomes
FCF = CFO
Increase in Working Capital
Capex
Working capital = Current Assets (restricted cash, inventories, accounts
receivable, others)
Current Liabilities (accounts payable, others)
Net Trade credit = Receivables  Payables
An investment in working capital is a cash outow, just like an investment in
capital expenditure
Cash is treated as working capital only if it is necessary for the companys
operations e.g. cash in a cash register cannot be put in a bank to earn
interest. In most cases, cash is assumed to be earning interest in a bank and
thus not counted as working capital
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Resale of the Asset
When the asset is sold companies have to pay taxes:
Market value of the asset () the resale price Psale ;
Book value of the asset ) purchasing price net of depreciation
BVT = CAPEX
(D1 + ... + DT );
Sales Tax when asset is sold @ T :
Sales Tax = tc (Psale
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BVT )
Fall 2015
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The NPV Formula
The general NPV formula is
C1
C2
CT
NPV = C0 +
+
+ ... +
2
{z} 1 + r1
(1 + r2 )
(1 + rT )T
<0
For example, look at Table 8.5 from the text:
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Fall 2015
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Dierence in Excel NPV Assumption
Excels Assumption:
0
NPV =
1000
1.1
1500
1.1 2
1000
1500
Our Assumption
0
NPV = 1000 +
1500
1.1
1500
Rule for conversion: Multiply the Excel value by (1 + r ).
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Fall 2015
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H. O. Coy
H. O. Coy Company is considering purchasing a machine costing
$26,000 using excess cash generated through other projects.
The machine will generate revenues of $50,000 per year for ve years.
The cost of materials and labor needed to generate these revenues
will total $35,000 per year.
Even though the machine is expected to sell for $1,500 in 5 years, it
will be depreciated on a straightline basis over 5 years to a $1,000
book value.
The rms tax rate is 34% and its opportunity cost of capital is 10%.
Should the company purchase the machine?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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H. O. Coy (contd)
The cash ows are shown below:
End of Year
1
(1)
Revenues
50,000
50,000
50,000
50,000
50,000
(2)
Material & labor cost
35,000 35,000 35,000 35,000 35,000
(3)
Prot on machine sale
(4)
Depreciation
5,000
5,000
5,000
5,000
(5)
EBIT ((1)+(2)+(3)+(4))
10,000
10,000
10,000
10,000
10,500
(6)
Tax @ 34%
3,400
3,400
3,400
3,400
3,570
(7)
Net income ((5)+(6))
6,600
6,600
6,600
6,600
6,930
(8)
Add back depreciation
5,000
5,000
5,000
5,000
5,000
(9)
Machine purchase/sale
11,600
11,600
11,600
(10) Free cash ow
Dmitry Livdan (Haas)
500
26,000
26,000 11,600
UGBA 103
5,000
1,000
12,930
Fall 2015
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H. O. Coy (contd)
Purchase of machine for $26,000 does not aect prot: merely
transforms one asset (cash) into another (machine). However, it
aects cash ow
Sale of machine for $1,500 is comprised of 2 elements:
Sale for book value of $1,000 aects cash ow, but not prot
Prot of $500 above book value aects prot and cash ow
Ct can be calculated in three ways:
Net income + depreciation  capex ((7) + (8) + (9))
Add up only the cash items ((1) + (2) + (3) + (6) + (9))
Tax the cash items and add the DTS
(((1) + (2) + (3)) (1 tc ) + (4)tc + (9))
NPV is calculated as:
NPV
Dmitry Livdan (Haas)
11,600
11,600
12,930
+ ... +
+
4
1.10
(1.10)
(1.10)5
= 18,798.95 > 0 so purchase
26,000 +
UGBA 103
Fall 2015
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How to Treat Ination
Either discount nominal cash ows at the nominal interest rate or
discount real cash ows at the real interest rate. If properly applied,
both methods should produce the same NPV, that is
NPVreal = NPVnominal .
To see this, remember that the real rate Rt is given by
1 + Rt =
so that
1 + rt
,
1 + it
Ctnominal
Ctreal (1 + it )t
Ctreal
=
=
.
(1 + rt )t
(1 + rt )t
(1 + Rt )t
This makes intuitive sense: real and nominal dollars are the same
today .
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UGBA 103
Fall 2015
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Example: BICCs Toad Ranch
The Biological Insect Control Corporation (BICC) is planning to
invest in a ranch to breed toads, which the company plans to sell as
ecologically desirable insectcontrol mechanisms.
The company anticipates that the business will continue in perpetuity.
Following negligible startup costs, BICC will incur the following
(nominal) cash ows at the end of the rst year:
Revenues
Labor costs
Other costs
Dmitry Livdan (Haas)
$150,000
80,000
40,000
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Fall 2015
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Example: BICCs Toad Ranch (contd)
The company will lease the ranch and equipment for $20,000 a year.
The rst lease payment will be due at the end of the year.
The rate of ination is expected to be 6%. Revenues and other costs
are expected to remain constant in real terms. However, labor costs
will increase at 1 percent per year in real terms. Lease payments are
xed in nominal terms.
The real discount rate is 5%.
What is the NPV of BICCs toad ranch?
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UGBA 103
Fall 2015
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Example: BICCs Toad Ranch (contd)
We will do the NPV calculations in nominal terms and in real terms:
NPV = PV (Revs)
PV (Other Costs)
PV (Labor Costs)
PV (Lease).
We have i = 6% and R = 5%. We get for nominal rate, r :
1+R =
1+r
) r = (1 + R )(1 + i )
1+i
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UGBA 103
1 = (1.05)(1.06)
1 = 11.3%.
Fall 2015
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Example: BICCs Toad Ranch (Nominal Terms I)
Revenues
Other
Labor
Lease
1
150, 000
40, 000
80, 000
20, 000
Cash Flow at End of
2
150, 000(1 + i )
40, 000(1 + i )
80, 000(1.01)(1 + i )
20, 000
Year
3
150, 000(1 + i )2
40, 000(1 + i )2
80, 000(1.01)2 (1 + i )2
20, 000
...
...
...
...
...
The revenues and other costs are perpetuities growing at rate i:
150,000
150,000
=
= 2,830,188.68;
r i
0.113 0.06
40,000
40,000
PV (Other Costs) =
=
= 754,716.98.
r i
0.113 0.06
PV (Revenues) =
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
145 / 210
Example: BICCs Toad Ranch (Nominal Terms II)
The labor costs are a perpetuity growing at rate g , where
1 + g = (1.01)(1 + i )
g = 7.06%.
Therefore,
PV (Labor Costs) =
80,000
80,000
=
= 1,886,792.45.
r g
0.113 0.0706
The lease is a regular perpetuity:
PV (Lease) =
20,000
20,000
=
= 176,991.15.
r
0.113
Finally, NPV = 11, 688.09 > 0, so the project should be undertaken.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Example: BICCs Toad Ranch (Real Terms I)
Cash Flow at End of Year
1
2
Revenues
Other costs
Labor costs
Lease
150,000
1 +i
40,000
1 +i
80,000
1 +i
20,000
1 +i
150,000
1 +i
40,000
1 +i
80,000 (1.01 )
1 +i
20,000
(1 +i )2
150,000
1 +i
40,000
1 +i
80,000 (1.01 )2
1 +i
20,000
(1 +i )3
...
...
...
...
...
The revenues and the other costs are both regular perpetuities:
150,000/(1 + i )
150,000/(1.06)
=
= 2,830,188.68;
R
0.05
40,000/(1 + i )
40,000/(1.06)
PV (Other Costs) =
=
= 754,716.98.
R
0.05
PV (Revenues) =
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UGBA 103
Fall 2015
147 / 210
Example: BICCs Toad Ranch (Real Terms II)
The labor costs are a perpetuities growing at 1%:
PV (Labor Costs) =
80,000/(1 + i )
80,000/1.06
=
= 1,886,792.45.
R 0.01
0.05 0.01
The lease is a decreasing perpetuity ) convert to growing perpertuity
1
1
= 1+G ) G =
1+i
1.06
1=
5.66038%.
We then nd:
PV (Lease) =
Dmitry Livdan (Haas)
20,000/1.06
20,000/(1 + i )
=
= 176,991.15.
R G
0.05 ( 0.0566038)
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Fall 2015
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Example: Financing Project with New Equity
Rubicon corporation has market cap of $1,000 and 1,000 shares
outstanding (i.e. it is currently traded @ $1 per share). Rubicon has
an opportunity to invest in a project with PV(CFs) = $650 and Capex
= $150, i.e. NPV = PV(CFs)  Capex = $500. Rubicon plans to
nance Capex by issuing new equity shares. How many new shares it
needs to issue? Assume that all information is public knowledge.
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UGBA 103
Fall 2015
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Example: Buying a Stock
You have acquired latest analystsearnings forecast of Microsoft.
Microsoft is currently traded at $47.27 and it has historic annual
equity return (not risk adjusted) of 0.2381. What is the NPV of
buying MSFT at this price?
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UGBA 103
Fall 2015
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Further Factors for Determining FCFs
Opportunity Cost: This is the cost of not going forward with a
project. For example, include cost of using the space in an alternative
way (e.g., renting it out).
Externality: aects the proposed project may have on other parts of
the rm. The most important side eect is called
erosion/canibalization: cash ow transferred from existing operations
to the project.
Sunk/Fixed Costs: Normally not included. These are the initial
outlays required to analyze a project that cannot be recovered even if
a project is accepted.
Liquidation or Continuation Value: Equals market value of future
cash ow at/after termination date.
Taxes including tax loss carryforwards.
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UGBA 103
Fall 2015
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Example: Opportunity Cost
You are a nancial analyst for a company that is considering a new
project. If theproject is accepted, it will use a fraction of a storage facility
that the company already owns but currently does not use. The project is
expected to last 10 years, and the APR is 10% (compounded annually).
You research the possibilities, and nd that the entire storage facility can
be sold for $100,000 and a smaller (but big enough) facility can be
acquired for $40,000. The book value of the existing facility is $60,000,
and both the existing and the new facilities (if it is acquired) would be
depreciated straight line over 10 years (down to a zero book value). The
corporate tax rate is 40%. What is the PV of savings from switching to
the new storage facility?
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UGBA 103
Fall 2015
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Example: Project Interaction
Until now we have assumed that the company is free to undertake all
the investments that have positive NPV. In fact, the nancial
manager often faces eitheror decisions.
Instances of such decisions typically arise in the following cases:
Choosing between mutually exclusive projects.
Deciding when to replace an existing machine.
Deciding how to invest when resources are limited.
We next turn to these issues.
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UGBA 103
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Mutually Exclusive Projects
The baseline rule for choosing between alternative investments is
simple: pick the one with the highest NPV. However, care should be
taken when comparing investments with dierent lives if the
investment can/must be repeated at the end of its life.
In this case we can use one of three equivalent criteria:
Repeat each project enough times to make the investment horizons
comparable, and then use the NPV rule to choose between them.
Compute an equivalent annual cash ow for each investment and
choose the investment with the highest EACF. The EACF is the cash
ow of an annuity having the same life and PV as the investment. It is
the rate you would pay to lease the asset in a competitive market
Repeat each project indenitely, and compare with the NPV rule.
The implicit assumption in using the above criteria is that once an
investment is chosen, the company will reinvest in the same project at
all subsequent dates.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Example: Choosing Between Machines with Dierent Lives
Suppose you are considering two alternative machines, A and B,
having identical capacity. The rst machine will last three years and
the second two years. The costs associated with operating them are
as follows:
Machine
A
B
Endofyear costs (in $000)
C0 C1 C2 C3
15 4
4
4
10 6
6

PV at 6%
25.69
21.00
Should we choose machine B, which has a lower PV of costs? Not
necessarily, because B will have to be replaced a year earlier.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Example: Machines with Dierent Lives (contd)
One way to compare the two investments is to compute the PV of
cost over a 6 year period, at the end of which both machines would
have to be replaced.
Machine
A
B
Endofyear costs (in $000)
C0 C1 C2 C3 C4 C5
15 4
4
19 4
4
10 6
16 6
16 6
C6
4
6
PV at 6%
47.26
56.32
Therefore, we should prefer machine A.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
156 / 210
Example: Machines with Dierent Lives (contd)
An equivalent way is to compute the equivalent annual cost: the cash
ow C of an annuity having the same life and PV as the machine.
Thus, for machine A, we look for CA that will make the PV of the
following two streams of cash ows equal.
0
15
4
CA
4
CA
4
CA
PV = 25.69
,! CA a3 j6% =
CA
0.06
1
(1.06)3
= 25.69
) CA = 9.61.
The machine would rent for $9, 610 per year in an e cient market.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Example: Machines with Dierent Lives (contd)
Similarly, for machine B:
0
10
6
CB
6
CB
PV = 21.00
CB
0.06
) CB = 11.45.
,! CB a2 j6% =
1
(1.06)2
= 21.00
Again, since CB > CA , we should choose machine A.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Example: Machines with Dierent Lives (contd)
If we repeat the project (either over a 6year horizon or to innity), it
is much easier to compare the EACFs than the original cash ows.
Original cash ows:
...
15
10
4
6
4
6 + 10
4 + 15
6
4
6 + 10
4
6
4 + 15
6 + 10
...
...
EACFs:
0
...
9.61
11.45
9.61
11.45
9.61
11.45
9.61
11.45
9.61
11.45
9.61
11.45
9.61
11.45
...
...
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UGBA 103
Fall 2015
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Example: Arnolds Armory
Arnold is tired of the Commando business, so he starts a gun shop for
people with annoying neighbors.
His shop needs a new delivery van. Arnold has narrowed his choice down to
two dierent models. Both require $1,000 in annual maintenance, and have
exactly the same cargo space. The dierences are their fuel e ciency, useful
life and initial purchase price.
Model
A
B
Miles
per gallon
20
30
Purchase
price
$12,000
$18,000
Useful
Life
3 years
5 years
Resale
Value
$1,100
$2,000
The van will be used approximately 24,000 miles per year, and the cost of
gasoline is $1 per gallon. The cost of capital is 10%. All gures are in
nominal terms.
Suppose that the tax rate is 30% and that the vans will be depreciated
straightline (to zero) over their useful life. Which van should Arnold buy?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
160 / 210
Example: Arnolds Armory (contd)
Here are the aftertax cash ows for van A:
End of Year
Cash Flows
Purchase van A
12,000
1 and 2
calculations
Maintenance
700
700
Fuel
840
840
Depreciation tax shield
1,200
1,200
[= 1, 000 (1 30%)]
1 (1 30%)]
[= 24,000
20
[= 12,000
30%
]
3
[= 1, 100 (1 30%)]
Sale of van A
770
Original cash ows
12,000
Equivalent Cash Flows
,! NPVA =
12,000
430
CF A
CF A
430
= 12, 267.02 = CFA a3 j10%
(1.10)3
CFA = 4, 932.75
340a2 j10% +
)
Dmitry Livdan (Haas)
340
UGBA 103
Fall 2015
161 / 210
Example: Arnolds Armory (contd)
Here are the aftertax cash ows for van B:
End of Year
Cash Flows
Purchase van B
18,000
1 to 4
calculations
Maintenance
700
700
Fuel
560
560
Depreciation tax shield
1,080
[= 1, 000 (1 30%)]
1 (1 30%)]
[= 24,000
30
18,000
[= 5
30%]
[= 2, 000 (1 30%)]
Sale of van B
Original cash ows
18,000
Equivalent Cash Flows
,! NPVB =
1,080
1,400
18,000
1,220
CF B
CF B
180a4 j10% +
)
Dmitry Livdan (Haas)
180
CFB =
1, 220
= 17,813.05 = CFB a5 j10%
(1.10)5
4,699.04 > CFA
UGBA 103
Fall 2015
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Example: When to Replace Existing Equipment
In the previous example we have taken the life of each machine as
given. In fact, the time at which to replace a machine should also be
the result of a capital budgeting decision.
Suppose your machine is expected to produce a cash ow of $4,000 in
one year and $3,000 in two years. After that it will have to be
replaced. The resale value is $1,000 if you replace now, $500 next
year, and zero otherwise. The best alternative is a new machine that
will be optimally replaced every 3 years, giving the following cash
ows (inclusive of the resale value in year 3):
C0
15,000
Cash Flows
C1
C2
8,000 8,000
C3
10,000
PV at 6%
8,063.33
When should you replace your existing machine? (Assume no taxes.)
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
163 / 210
Example: When to Replace Existing Equipment (contd)
First, let us calculate the equivalent annual cash ow EACF for the
new machine:
0
15, 000
PV = 8, 063.33
8, 000
EACF
8, 000
EACF
10, 000
EACF
EACF
0.06
) EACF = 3,016.57.
,! EACFa3 j6% =
1
(1.06)3
= 8,063.33
The three options are:
(a) replace now;
(b) replace in one year;
(c) replace in two years.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
164 / 210
Example: When to Replace Existing Equipment (contd)
The cash ows for each of these options can be represented as follows:
(a )
(b )
(c )
...
1, 000
3, 016.57
4, 500
4, 000
3, 016.57
3, 016.57
3, 000
3, 016.57
3, 016.57
3, 016.57
3, 016.57
3, 016.57
3, 016.57
...
...
...
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
165 / 210
Example: When to Replace Existing Equipment (contd)
The PVs of these cash ows are calculated as follows:
3,016.57
= 51,276.21;
0.06
4,500
1
3,016.57
PVb =
+
= 51,675.67;
1.06
1.06
0.06
PVa = 1,000 +
PVc =
3,000
1
4,000
+
+
2
1.06
(1.06)
(1.06)2
3,016.57
0.06
= 51,189.22.
The best option is to replace in one year.
Notice that the cash ows after year 2 are the same for all three
options. Thus we could have compared the three options by
comparing their PVs over the rst two years only.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Working with NPV in Real Life: BreakEven Analysis
The breakeven level of an input is the level that causes NPV of the
investment to equal zero.
BreakEven of Sales: Sales where EBIT equals zero.
Example:Table 8.8 from the text:
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Working with NPV in Real Life: Sensitivity Analysis
Sensitivity Analysis shows how the NPV varies with a change in one
of the assumptions, holding the other assumptions constant.
Example:Table 8.9 from the text:
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UGBA 103
Fall 2015
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Text Figure 8.1: NPV Under Best and WorstCase
Parameter Assumptions
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Text Figure 8.2: Price and Volume Combinations for
HomeNet with Equivalent NPV
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UGBA 103
Fall 2015
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Capital Budgeting Under Resource Constraints
Projects also interact if they require the same limited resources. We
assume that this resource is money, but the same principle applies to
other resources.
One possibility is to get the biggest bang for the buck by choosing
the projects with the highest ratio of NPV to initial outlay (the
protability index). PI = NPV
C0 .
This rule has two key limitations:
It fails when more than one resource is constrained or there is any
other constraint on project choice (e.g. mutual exclusivity).
It is not valid if it is not possible to undertake fractional investments.
If you have $11m in the following example, you will choose B and C
Project
A
B
C
Cost (millions)
10
6
5
Dmitry Livdan (Haas)
PV (millions)
31.0
18.0
14.5
UGBA 103
Protability Index
2.1
2.0
1.9
Fall 2015
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Key Takeaways: Using the NPV Rule
Free Cash Flow = Cash From Operations  Capex
CFO is not prot. It is after tax, ignores sunk costs, and includes
opportunity costs. 3 ways to calculate:
1
2
3
(R E D + X ) (1 tc ) + D
R E + X tc ( R E D + X )
( R E + X ) ( 1 tc ) + tc D
Discount nominal cash ows at a nominal discount rate; discount real
cash ows at a real discount rate
If dierent lives, calculate Equivalent Annual Cash Flow: the cash
ow of an annuity with the same life and PV as the investment.
Equals the annual lease rate
If resource constraints, calculate Protability Index: PI =
Dmitry Livdan (Haas)
UGBA 103
NPV
C0
Fall 2015
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Practice Problem Ch 8.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Practice Problem Ch 8.
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UGBA 103
Fall 2015
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Challenging Problem
A project requires use of spare computer capacity. If the project is not
terminated, the company will need to buy an additional disk at the end of
year 2. If it is terminated, the disk will not be required until the end of
year 4. Disks cost $10, 000 and last 5 years. The opportunity cost of
capital is 10% (an annual rate compounded annually).
1
What is the present value of the cost of this extra usage if the project
is terminated at the end of year 2?
What if the project continues indenitely?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
175 / 210
Checkpoint: Using the NPV Rule
Material relevant to this section:
Berk and DeMarzo: Chapter 8.
What is next?
Berk and DeMarzo: Chapter 7.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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I.3.3 Alternatives to the NPV Investment Rule
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UGBA 103
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I.3.3 Alternatives to the NPV Investment Rule
Readings: Berk and DeMarzo, Chapter 7.
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UGBA 103
Fall 2015
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NPVs Competitors
Despite the optimality of the NPV rule, alternative investment rules
have been and to some extent still are used by businesses.
We will now look at four common alternatives to NPV. They are:
1.
2.
3.
4.
5.
Payback period.
Accounting rate of return.
Internal rate of return.
Protability index.
Multiples
We will see that the internal rate of return and the protability index,
when properly used, lead to the same decisions as the NPV rule.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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NPVs Competitors (contd)
As the following survey shows, many of the above investment rules
were still broadly used in the 1980s.
Method
Payback
Acctg rate of return
IRR
NPV
Other
None
Dmitry Livdan (Haas)
U.S.
(1950s)
34%
34%
19%
6%
6%
UGBA 103
U.S.
(1980s)
12%
8%
49%
19%
10%
2%
Japan
(1980s)
40%
19%
15%
9%
2%
15%
Fall 2015
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NPVs Competitors (contd)
The most recently available comprehensive survey shows that net
present value (NPV) and internal rate of return (IRR) are being
increasingly commonly used in the U.S.:
Protability index
Acctg rate of return
Payback
NPV
IRR
% of CFOs using
12%
20%
57%
75%
76%
Source: Graham and Harvey (2001): The Theory and Practice of
Finance: Evidence From the Field. Journal of Financial Economics
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Features of the NPV Rule
When looking at NPVs competitors, it is important to keep in mind
the main features of the NPV rule:
Time value of money: $1 today > $1 tomorrow.
NPV depends only on all the forecasted cash ows from the project
and the opportunity cost of capital.
* Any rule ignoring some of the projects cash ows will lead to
suboptimal decisions.
* Any rule aected by the managers tastes, the protability of the
companys existing business, or the protability of other independent
projects will lead to inferior decisions.
Since PVs are all measured in todays dollars, you can add them up.
* The NPV rule can thus identify whether joint projects are better than
single projects.
Clear benchmark: accept if NPV > 0
The alternatives to the NPV rule often fail to satisfy one or more of
these critical features.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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The Payback Period Rule
The payback period of a project is the number of years it takes to
recover the initial investment. The payback period rule accepts a
project if the payback period is less than some given cuto.
Here are some examples:
Project
A
B
C
C0
2, 000
2, 000
2, 000
Cash Flows
C1
C2
2, 000
1, 000 1, 000
1, 000 1, 000
C3
1, 000
10, 000
Payback
Period
1
2
2
NPV
at 10%
181.82
486.85
7, 248.69
The basic weaknesses of the payback rule are:
It ignores the time value of money.
It ignores the cash ows beyond the cuto period.
It gives no indications on what the cuto rule should be.
Some companies discount the cash ows before computing the
payback rule. This only addresses the rst weakness.
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UGBA 103
Fall 2015
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The Accounting Rate of Return
The accounting rate of return (also known as average return on book
value)is computed by dividing the average net income from a project
(prot after taxes) by the average book value of the investment:
(beginning investment  ending investment)/2
This ratio is then compared with the book rate of return for the rm
as a whole (or some other equally absurd yardstick).
This criterion suers from several defects:
It ignores the relevant cash ow from investment and instead considers
the accounting prots (in particular, it depends critically on the
accountantschoice of a depreciation method).
It ignores the time value of money (as well as the risk of the project).
The choice of a yardstick is totally arbitrary.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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The Internal Rate of Return Rule
The internal rate of return (IRR) of a project is dened as the
constant discount rate y which makes NPV = 0. In other words, y
solves
T
Ct
NPV =
=0
t
t =0 (1 + y )
Analogy: bond yield is the discount rate that makes PV = P0 , i.e.
NPV = 0
The IRR rule says that a project should be accepted if and only if y
exceeds the yield on nancial securities (bonds) with comparable
maturity, cash ows and risk (the opportunity cost of capital).
Notice that with a at term structure (rt = r for all t), the IRR rule
implies that we should accept a project if and only if y > r .
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
185 / 210
The Internal Rate of Return Rule (contd)
For example, consider the following project:
C0
5, 000
C1
2, 000
C2
2, 000
C3
2, 000
The graph below shows that, with a at term structure, the IRR rule
is equivalent to the NPV rule.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
186 / 210
Limitations of the IRR Rule: 1. NonFlat Term Structure
The IRR rule is very di cult to apply with a nonat termstructure,
since the opportunity cost of capital is now a complicated average of
the interest rates r1 , r2 , . . ., rT .
For example, assume the following term structure,
rt
1
4.00%
2
4.50%
t
3
5.00%
4
5.50%
5
6.00%
and consider the two projects:
Project
A
B
C0
1, 000
1, 000
C1
20
50
C2
20
50
C3
20
1, 050
C4
20
C5
1, 200
IRR
5.24%
5.00%
NPV
32.32
0.89
Why does project A have higher IRR but lower NPV?
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
187 / 210
Limitations of the IRR Rule: 1. NonFlat Term Structure
(contd)
Answer: the IRR of A should be compared to a cuto dierent from
B. The IRR for project A (B) should be compared to the yield on a
5year (3year) bond with the same cash ows.
The prices P5 and P3 of such 5year and 3year bonds are
20
1,200
20
+
+
+
= 967.68,
2
1.04 (1.045)
(1.06)5
50
1,050
50
P3 =
+
+
= 1,000.89.
2
1.04 (1.045)
(1.05)3
P5 =
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Limitations of the IRR Rule: 1. NonFlat Term Structure
(contd)
The yields on these two bonds can be calculated as follows:
20
20
1,200
+
+
+
) yA = 5.96%.
2
1 + yA
(1 + yA )
( 1 + yA ) 5
50
50
1,050
1,000.89 =
+
+
) yB = 4.97%.
2
1 + yB
(1 + yB )
(1 + yB )3
967.68 =
Since IRRA < yA , we should reject project A. However, since
IRRB > yB , we should accept project B.
Note that, since NPVA = 1, 000 + 967.68 and
NPVB = 1,000 + 1,000.89, we have essentially gone back to the
NPV rule!
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
189 / 210
Limitations of the IRR Rule: 2. Lending or Borrowing?
Another problem with the IRR rule is that it is necessary to
distinguish between borrowing and lending opportunities, as the
following example shows:
Project
A (lending)
B (borrowing)
Dmitry Livdan (Haas)
C0
5, 000
5, 000
C1
3, 000
3, 000
UGBA 103
C2
3, 000
3, 000
IRR
13%
13%
Fall 2015
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Limitations of the IRR Rule: 2. Lending or Borrowing?
(contd)
In the above example, it was easy to tell that project A was lending
(and so we want IRR > discount rate) and that project B was
borrowing (and so we want IRR < discount rate).
But, how about the following case? Is this borrowing or lending?
Project
C
Dmitry Livdan (Haas)
C0
1, 000
C1
3, 600
C2
4, 320
UGBA 103
C3
1, 728
IRR
20%
Fall 2015
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Limitations of the IRR Rule: 3. Multiple or no IRRs
A project can have more than one IRR (in general, there can be as
many dierent IRRs as there are changes in the sign of cash ows). In
fact, it is also possible that the IRR does not exist for some projects.
As an example, consider the following two projects
Project
A
B
Dmitry Livdan (Haas)
C0
5, 000
5, 000
C1
20, 000
15, 000
UGBA 103
C2
18, 000
12, 500
IRR
37% and 163%
none
Fall 2015
192 / 210
Limitations of the IRR Rule: 4. Mutually Exclusive Projects
Finally, the IRR rule can be misleading when choosing between
mutually exclusive projects, as the following example shows (we
assume that the term structure is at at 10%):
Project
A
B
C0
2,000
5,000
C1
2,000
1,000
C2
3,000
9,000
IRR
82.29%
44.54%
NPV at 10%
2,298
3,347
The IRR can be salvaged in the case of mutually exclusive projects by
computing the IRR for the incremental cash ows.
Project
B A
C0
3, 000
C1
1, 000
C2
6, 000
IRR
25.73%
Since the IRR of the incremental cash ows is greater than 10%, we
should choose B over A.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
193 / 210
The Protability Index Rule
The protability index is dened as the NPV of future cash ows
divided by the initial investment:
PI =
NPV
T Ct /(1 + rt )t
= t =0
.
C0
C0
The PI index rule entails accepting a project if and only if PI > 0.
Note that since
PI =
NPV
,
C0
the PI rule is equivalent to the NPV rule (provided that C0 < 0).
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
194 / 210
The Protability Index Rule (contd)
As with the IRR rule, however, the acceptance rule has to be reversed
for borrowing projects (C0 > 0).
Moreover, the PI rule can be misleading when applied to mutually
exclusive projects, unless we look at the incremental cash ows. This
is shown in the following example (where once again we assume that
the term structure is at at 10%):
Project
A
B
BA
Dmitry Livdan (Haas)
C0
1,000
10,000
9,000
C1
2,000
15,000
13,000
UGBA 103
PI
0.82
0.36
0.31
NPV at 10%
818
3,636
2,818
Fall 2015
195 / 210
Another Alternative to NPV: Multiples
Multiples are used extensively by research analysts and investment
bankers for valuations of whole companies, but are less common in
project valuation.
The acquisition of a whole company is really just a type of project,
though, so the topic is important for this course.
It will also give us an alternative means to calculate terminal values.
The multiples approach uses the market price multiples for
comparable companies to provide an appropriate valuation range.
The use of multiples is predicated on the discussed later E cient
Markets Hypothesis (EMH) which rules out arbitrage in
wellfunctioning markets. Simply stated, the multiples approach says
that comparable companies should sell at comparable prices.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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How to Use Multiples
To implement the multiples method, rst nd a set of comparable
companies.
You are looking for rms with similar cash ow characteristics, i.e.,
similar risk, timing, and expected growth rates (technically need
proportionality).
Next, divide the comparable rmsvalue by some operating statistic
to get a pricing multiple for each. Depending on the operating
statistic, use either equity market value or total rm value (equity
plus debt). Commonly used multiples include:
Equity ValuetoNet Income (or P/E)
Equity ValuetoBook Value of Equity
Firm ValuetoEBITDA
Firm ValuetoEBIT (Operating Income)
Firm ValuetoSales
Firm ValuetoBook Value of Assets
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
197 / 210
How to Use Multiples (contd)
Next, just take an average of the comparable rmsmultiples (or use
the entire range), and multiply that by the analogous operating
statistic for the company you are trying to value.
If you used an Equity Value multiple, this gives you an estimate of
your companys (or projects) Equity Value; if you used a Firm Value
multiple, it gives you an estimate of Firm Value (or just Total Value if
its a project).
To go from Equity Value to Firm Value, just add the value of existing
debt.
To go from Firm Value to Equity Value, just subtract existing debt.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
198 / 210
Text Table 9.1 Stock Prices and Multiples for the Footwear
Industry, January 2006
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
199 / 210
Multiples: An Example
Assume you are trying to value Project X, and you have three
comparable rms, A, B, and C. You have the following information on
the three rms.
Shares
Out..ing
Market
Price
Debt
Out...ing
Revenues
Operating
Income
100
200
50
5.00
2.00
7.50
100
150
200
100
95
150
68
65
63
Company A
Company B
Company C
From this information you calculate their multiples as follows.
Company A
Company B
Company C
Dmitry Livdan (Haas)
Equity Value
Firm Value
FirmValue
Revenues
FirmValue
Oper. Inc.
500
400
375
600
550
575
6.0
5.8
3.8
8.8
8.5
9.1
UGBA 103
Fall 2015
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Multiples: An Example (contd)
Now, just apply these multiples to get an estimate of the value of
Project X whose revenues and operating income are projected to be
about 195 and 105 respectively (note that we are looking for the total
value here, which is analogous to Firm Value for a standalone rm).
Average multiple
Project X operating statistic
Implied value of Project X
Valuation based on
Revenues Operating Income
5.2
8.8
195
105
1,015
924
It is important to note that multiples are not really an alternative
to NPV. They are just a dierent way to estimate NPV.
Our normal approach is to discount future cash ows to nd PV, then
subtract the initial investment to get NPV.
Multiples just give us an alternative way to estimate PV, so we can still
subtract the initial investment to get an estimate of NPV.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
201 / 210
Key Takeaways: Alternatives to the NPV Rule
Investment rule should:
Consider time value of money
Consider all of a projects cash ows, and only these cash ows: ignore
existing projects.
Have a clear benchmark
Payback period: number of years to recover initial investment
Accounting return: net income / average investment
Internal rate of return: constant discount rate which makes NPV = 0.
Like bond yield. Accept if IRR > r . Problems if:
Nonat term structure: what r to compare against?
Lending or borrowing: if latter, accept if IRR < r
Multiple IRRs or no IRRs
Mutually exclusive projects
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
202 / 210
Checkpoint: Alternatives to the NPV Rule
Material relevant to this section:
Berk and DeMarzo: Chapter 7.
Practice problems: None
What is next?
Stats Reminder.
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
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Summary of Key Takeaways
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
204 / 210
Key Takeaways: Constant Interest Rate
Compounding factor gives future value of $1
CFT = 1 +
r mT
m
= e rT if m !
Eective annual rate gives equivalent rate under onceayear
compounding
b
r = 1+
r m
m
Discount factor gives present value of $1
DFT = 1/CFT
Growing perpetuity: PV0 = C1 / (r
g)
Annuity factor gives PV of $1 for T years. aT jr =
Real rate of return R =
Dmitry Livdan (Haas)
1 +r
1 +i
UGBA 103
1
r
1
(1 +r )T
Fall 2015
205 / 210
Key Takeaways: Term Structure
Spot rate rT is the rate per year for T years starting today
The term structure is the graph of r1 , r2 , ... for dierent T
With a nonat term structure, PV = Tt=1
Ct
(1 +r t )t
Forward rate ft is the rate for 1 year starting at t
ft =
)t
(1 +r t
(1 +r t 1 )t
Dmitry Livdan (Haas)
1 and ending at t:
UGBA 103
Fall 2015
206 / 210
Key Takeaways: Pricing Bonds
Treasury bills pay no coupon, and are quoted in terms of a discount
N
rate: P = F 1 d 360
Treasury notes and bonds pay a semiannual coupon ( C2 every 6
months), and are quoted in units of 1/32
The price of a bond is P = Tt=1
tyear spot rate
C
(1 +r t )t
F
(1 +r T )T
where rt is the
The yield of a bond is the single constant discount rate y that solves
P = Tt=1 (1 +Cy )t + (1 +Fy )T . It is a (weighted geometric) average of
the spot rates
For Treasuries, quoted yields are semiannual APRs: y given by
2
1 + y2 = 1 + yb
The coupon of a bond is xed. Its yield depends on market
conditions, and is inversely related to its price
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
207 / 210
Key Takeaways: Capital Budgeting Under Certainty
The required rate of return on a project is determined exclusively by
the rate of return available elsewhere in the capital market
It is independent of shareholderspreferences for consumption today vs.
consumption tomorrow
A nancial manager can therefore ignore shareholder preferences.
His/her goal is simply to maximize shareholder value, by taking
positiveNPV projects and rejecting negativeNPV projects
Once shareholder value is maximized, shareholders can use borrowing
and lending to choose whatever consumption pattern suits their
individual preferences
The Fisher separation theorem assumes capital markets are complete,
e cient and perfect
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
208 / 210
Key Takeaways: Using the NPV Rule
Free Cash Flow = Cash From Operations  Capex
CFO is not prot. It is after tax, ignores sunk costs, and includes
opportunity costs. 3 ways to calculate:
1
2
3
(R E D + X ) (1 tc ) + D
R E + X tc ( R E D + X )
( R E + X ) ( 1 tc ) + tc D
Discount nominal cash ows at a nominal discount rate; discount real
cash ows at a real discount rate
If dierent lives, calculate Equivalent Annual Cash Flow: the cash
ow of an annuity with the same life and PV as the investment.
Equals the annual lease rate
If resource constraints, calculate Protability Index: PI =
Dmitry Livdan (Haas)
UGBA 103
NPV
C0
Fall 2015
209 / 210
Key Takeaways: Alternatives to the NPV Rule
Investment rule should:
Consider time value of money
Consider all of a projects cash ows, and only these cash ows: ignore
existing projects.
Have a clear benchmark
Payback period: number of years to recover initial investment
Accounting return: net income / average investment
Internal rate of return: constant discount rate which makes NPV = 0.
Like bond yield. Accept if IRR > r . Problems if:
Nonat term structure: what r to compare against?
Lending or borrowing: if latter, accept if IRR < r
Multiple IRRs or no IRRs
Mutually exclusive projects
Dmitry Livdan (Haas)
UGBA 103
Fall 2015
210 / 210
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