Chapter 5

Applied Interest Rate Analysis

Chapter 5
Section 1

Capital Budgeting

Chapter 5
Investment Decisions

To choose the best one from alternatives

Identification of the best solution: Optimization
Two phases in optimization
Modeling
Decision variables
Objective of the investment
Constraints on decision
Parameters
Formulation: Relating these components by the concepts and
formulae we learned
Optimizing
Techniques in Operations Research: Linear Programming,
Nonlinear Programming, Integer Programming, Dynamic
Programming, Simulation...
Available software packages

Chapter 5
Capital Budgeting

A senior manager may often receive several proposals for projects

from junior managers at the same time, and must allocate his
budget among these proposed projects. Each project requires some
initial cost, and will create some returns. Naturally, the amount of
capital he can allocate is limited
Independent projects:
The value of one project does not depend on another project
also being funded
Not mutually exclusive

Chapter 5
Independent Projects

Capital budgeting with independent projects

Decision variable: accept or reject a project
Objective: maximize the total profit
Constraint: budget limit
Parameters: costs and returns of projects, budget quota

Chapter 5
Formulation

Maximize Pm
P
i=1 bi xi
m
subject to i=1 ci xi ≤ C
xi = 0 or 1, i = 1, 2, · · · , m
where
m: number of projects proposed
bi : total benefit (NPV) of Project i
ci : initial cost of Project i
C: total budget available
xi (0-1 or binary decision variable): xi = 1 if Project i
accepted and xi = 0 if otherwise
A 0 − 1 programming problem (0 − 1 Knapsack Problem)

Chapter 5
An Approximate Algorithm

Assumption: Each project requires an initial outlay of funds

followed by a stream of benefits
Benefit-cost ratio: the ratio of the total present value of the
benefits to initial cost
Algorithm
(1) Rank the projects by benefit-cost ratio
(2) Choose the feasible project with the highest benefit-cost
ratio, where feasibility means
the project is not yet chosen
the budget can pay the cost of the project
(3) Repeat (2) until no feasible project is left

Chapter 5
Example: A Selection Problem

During its annual budget planning meeting, a small computer company

has identified several proposals for independent projects that could be
initiated in the forthcoming year. These projects include the purchase of
equipment, the design of new products, the lease of new facilities, and so
on. The projects all require an initial capital outlay. The total budget is
$500,000 for these projects
Project Outlay ($1,000) Present Worth ($1,000) Benefit-cost ratio
1 100 300 3.00
2 20 50 2.50
3 150 350 2.33
4 50 110 2.20
5 50 100 2.00
6 150 250 1.67
7 150 200 1.33

Chapter 5
Mathematical Formulation

Maximize 200x1 + 30x2 + 200x3 + 60x4 + 50x5 + 100x6 + 50x7

subject to 100x1 + 20x2 + 150x3 + 50x4 + 50x5 + 150x6 + 150x7 ≤ 500
xi = 0 or 1, i = 1, 2, · · · , 7

Chapter 5
Approximate vs Exact Solutions

Approximate Method ⇒ Select projects 1, 2, 3, 4 and 5 for a total

expenditure of $370,000 and a total net present value of $910,000
- $370,000 = $540,000

The exact optimal solution, however, is to select 1, 3, 4, 5 and 6

for a total expenditure of $500,000 and a total net present value of
$610,000. ⇒ Integer programming algorithm is needed

Chapter 5
Section 2

Optimal Portfolios

Chapter 5
Optimal Portfolios

Optimal Portfolios: Allocate the capital to different fixed-income

securities
Cash Matching Problem: To purchase bonds of various maturities
and use the coupon payments and redemption values to meet a
known sequence of future monetary obligations at the minimum
cost

Chapter 5
Formulation

Pm
Minimize p j xj
Pj=1
m
subject to j=1 cij xj ≥ yi , i = 1, 2, · · · , n
xj ≥ 0, j = 1, 2, · · · , m
where
m: number of bonds under consideration
n: number of periods where the obligations occur
pj : price of Bond j
cij : cash payment of Bond j at the end of period i
yi : obligation at end of period i
xj : amount of bond j to be purchased
A linear programming problem!

Chapter 5
Example: A 6-Year Match

We wish to match cash obligations over a 6-year period. We select

10 bonds for this purpose. Suppose all accounting is done on a
yearly basis, and short selling is not allowed
B1 B2 B3 B4 B5 B6 B7 B8 B9 B 10 req’d Actual
Y1 10 7 8 6 7 5 10 8 7 100 100 171.74
Y2 10 7 8 6 7 5 10 8 107 200 200.00
Y3 10 7 8 6 7 5 110 108 800 800.00
Y4 10 7 8 6 7 105 100 119.34
Y5 10 7 8 106 107 800 800.00
Y6 110 107 108 1,200 1,200.00
p 109 94.8 99.5 93.1 97.2 92.9 110 104 102 95.2 2,381.14 (cost)
x 0 11.2 0 6.81 0 0 0 6.3 0.28 0

Can we improve this model?

Chapter 5
Section 3

Valuation of a Firm

Chapter 5
Valuation of a Firm

Firm is valuable because it is expected to create profits in the

future
The value of a firm can be evaluated by the PV of its future
profit cash flow stream
What is the future profit stream?
Dividends of stockholders or the net earnings of the company?
Future profits are random (but we assume they are
deterministic in this discussion)

Chapter 5
Valuation of a Firm (Cont’d)

Different interpretations lead to different evaluations

These differences spring from the question of just which cash
flows should form the basis of analysis:
dividends to a stockholder
the net earning to the company
to a single individual or to the group who owned the company

Chapter 5
Dividend Discount Model

For the owner of a share:

D1 D2 D3
V0 = + 2
+ + ···
1 + r (1 + r) (1 + r)3
where
Dk : expected dividend in year k
r: (fixed) interest rate
V0 : value of the firm

Chapter 5
Constant-Growth Dividend Model

Dk+1 = (1 + g)Dk , k = 1, 2, · · ·

D1 D1 (1+g) D1 (1+g)2 P∞ (1+g)k−1

V0 = 1+r + (1+r)2
+ (1+r)3
+ · · · = D1 k=1 (1+r)k
If g ≥ r, then V0 = +∞
D1 (1+g)D0
If g < r, then V0 = r−g , or V0 = r−g

Chapter 5
Discounted Growth Formula

Consider a dividend stream that grows at a rate of g per period.

Assign r > g as the discount rate per period. Then the present
vale of the stream, starting one period from the present is

(1 + g)D0
V0 =
r−g
where D0 is the current dividend

Chapter 5
Example: The XX Corporation

The XX corporation has just paid a dividend of $1.37M. The

company is expected to grow at 10% for the future, and hence
most analysts project a similar growth in dividends. The discount
rate used for this type of company is 15%. Assume there are 1M
shares outstanding
Question: What is the fair price of the stock of this corporation?
Solution:
D0 = 1.37M , r = 0.15, g = 0.1
(1+g)D0 1.1×1.37M
V0 = r−g = 0.15−0.1 = 30, 140, 000
Price per share P = V0 /1, 000, 000 = 30.14

Chapter 5
Free Cash Flow

Dividend determined by board of directors, may not represent firm’s

financial status
Free cash flow: maximum present value that can be taken out of
the company and distributed to the owners
Free cash flow method: evaluated by free cash flow (FCF)
FCF: cash generated through operations minus investment necessary
to sustain those operations and anticipated growth
Operation of a firm:
Before-tax earning of Yn in year n, and invest a portion u each
year to attain earnings growth
Growth rate is g(u): Yn+1 = (1 + g(u))Yn
Depreciation is a fraction α of the current capital
Capital Cn follows: Cn+1 = (1 − α)Cn + uYn

Chapter 5
Income Statement

Before-tax cash flow from operations Yn

Depreciation αCn
Taxable income Yn − αCn
Taxes (34%) 0.34(Yn − αCn )
After-tax income 0.66(Yn − αCn )
After-tax cash flow (after-tax income plus depreciation) 0.66(Yn − αCn ) + αCn
Sustaining investment uYn
Free cash flow 0.66(Yn − αCn ) + αCn − uYn

Chapter 5
Free Cash Flow (Cont’d)

Two explicit formulae:

Yn = (1 + g(u))n Y0
n n +(1+g(u))n
o
(1+g(u))n
Cn = (1 − α)n C0 + uY0 −(1−α)g(u)+α ≈ uY0g(u)+α
 
αu
FCFn = 0.66 + 0.34 − u (1 + g(u))n Y0
g(u) + α
Hence the PV of this free cash flow stream is
 
αu 1 + g(u)
V0 = 0.66 + 0.34 −u Y0
g(u) + α r − g(u)
Maximise over u!

Chapter 5
Example: The YY Corporation

The YY corporation has current earnings of Y0 = $10M , and the

initial capital C0 = $19.9M . The interest rate is 15%, the
depreciation factor is α = 10%, and the relation between
investment rate and growth rate is g(u) = 0.12(1 − e5(α−u) )
Question: What is the value of this company?

Chapter 5
Solution to The YY Corporation

If u = 0, Cn = (1 − α)n C0 → 0, and the PV is approximately

$29M
If u = α = 0.1, Yn = Y0 , and the PV is approximately $39.6M
If u = 0.5, the PV is approximately $52M
The optimal re-investment rate is approximately 37.7%, with
g(u) = 9%, and the PV approximately $58.3M (value of the
company)

Chapter 5