Financial Management Session2 2022-2023

Introduction Valuation assumptions Cash-flow based investment rules Stock valuation Cost of equity capital References
Financial Management
Session 2 - Valuing projects and stocks
Léonore Raguideau1
1
Université Paris Nanterre - EconomiX
Léonore Raguideau (UPN- EconomiX) Financial Management - Valuing projects and stocks October 16th, 2021 1 / 44
Financial Management - Valuing projects and stocks
1 Introduction
2 Valuation assumptions
3 Cash-flow based investment rules
4 Stock valuation
5 Cost of equity capital
6 References
Introduction
Discussed in Introductory Session

I Financial Management cycle
I Corporate financing stylized facts (linked to financial instruments, financial
markets, liquidity management)
I Any question?
To understand how financing decisions are taken, we first need to understand
how Financial Managers take an investment decision
Today’s course objective: To understand investment project and stock
valuations
I Financing assumption: taken independently from the investment decision; as if
the investment were all-equity financed
I Asset pricing assumptions: central to this course, discussed in first Section
Introduction No Arbitrage Efficient Markets Hypothesis EMH implications and testing Alternatives to EMH and No Arbitrage
1 Introduction
Introduction
No Arbitrage
Efficient Markets Hypothesis
EMH implications and testing
Alternatives to EMH and No Arbitrage
4 Stock valuation
6 References
Introduction
Financial assets (securities) definition / Credit: Prof Denis Gromb

I They transfer resources across time (bank accounts, govies, stocks, etc..)
I They transfer resources across ”states of the world”: insurance policies,
options, etc...
I They trade on a market at a certain price
Basic Financial Asset Pricing: we define the asset as a stream of cash flows
(more or less risky), we value these assets given cash flows and discount rates
and we take this price for granted
Behind any valuation model that is related to asset prices (typically,
investment projects...), there are two key assumptions developed hereafter:
No Arbitrage (Law of One Price)

No Arbitrage and the Law of One Price
Arbitrage opportunity: Two securities with identical cash flows and the same
risk have different prices
Arbitrage: Investment strategy that exploits some market inefficiency (in our
case, price differences) and guarantees a positive NPV (sure profit)
I You sell the more expensive one
I You buy the less expensive one
I Arbitrage portfolio insures unlimited profits for investors with no liquidity
constraints
If no-arbitrage condition holds
I Asset price is unique: you can use one market price to valuate your project
(and not check all market prices)
I NPV of a financial instrument is zero: we can analyze separately investment
and financing opportunities (Separation Principle)
Definition of an efficient market: ”We [. . . ] saw that a situation where

successive price changes are independent is consistent with the existence of
an “efficient” market for securities, that is, a market, where given the
available information, actual price at every point in time represent very good
estimates of intrinsic values” (Fama 1965a)
EMH: Deals with three levels of informational efficiency of financial markets

(Fama 1970)
I Weak form: if current prices fully reflect all information about past prices
I Semi-strong form: if current prices fully reflect all publicly available
information
I Strong form: if current prices fully reflect all information (public or private)
Combined with no-arbitrage condition, the price of the financial asset is

unique and reflects its fundamental value (given its risk)
EMH implications and testing
Several implications of the weak form

I Prices are not predictable based on the past: prices follow a random walk
(or a martingale to allow for autocorrelation of returns)
I It’s not possible to generate superior returns by using trading strategies based
on historical prices
Main implications of the semi-strong form
I NPV of investing in financial securities is zero (you don’t make a profit by
buying a financial instrument whose price already incorporates all public
information)
I Securities with the same risk should have the same expected return (p.342)
I It’s not possible to beat the market in terms of return unless you do insider
trading (forbidden)
Empirical research usually does not reject the semi-strong EMH:
Event studies on stock prices’ reactions to news (earnings annoucement, new
stock issue, takeover bids)
Alternatives to EMH and No Arbitrage
There exist large observed price deviations that point towards the rejection of
EMH - ”Market anomalies”
I Short-run momentum: the tendency of an asset’s recent performance to
continue into the near future
I Long-term mean reversion: price convergence towards its fundamental value
I High volatility of asset prices relative to measures of discounted future payoff
streams
I Asset price bubbles
Anomalies regarding asset pairs with closely related payoffs (”Siamese-twin”
stocks trading at very different prices)
Development of alternative theories to explain these stylized facts
I Behavioural Finance: relaxation of agent rationality; investors’ psychological
biases and cognitive limitations
I Limits to arbitrage: Arbitragers face capital and leverage constraints, which
have asset pricing implications
Behavioural finance
• Definition : The object of behavioral finance is to explain stock market anomalies by taking into account the
psychology of the investor and the cognitive " biases".
• Behavioral finance is justified by :

- the lack of market efficiency, the limits of the vision of classic finance, financial bubbles
• Key behavioral biases are :
- mental accounting, anchoring phenomenon, sunk cost biais, disposition effect, confirmation bias
• "Prospect Theory" is founder of economics and behavioral finance :

- It challenges the theory of expected utility, it describes how people asymmetrically assess their prospects for loss and gain. (
Kahneman,Trevsky 1992 )
• A solution : Behavioral heritage which makes it possible to apply fundamental principles despite the
existence of these biases made up of :
- Risk-free heritage, dynamic heritage
Credit: Wissam AMMAR
What consequences?
From profit loss for a few individuals to

global economic recession
Different steps of a bubble:
Asset Price Bubbles
Credit: Flavien VILBERT and Gabriel REIGNER

How to respond to asset price bubbles using the monetary policy?
- Be aware of macroeconomic variables : inflation, employment, aggregate

demand
- Danger of a tightening monetary policy in case of misidentified bubble
- Deviant behaviour from participants can lead to a controversial result of the

policy (interest rates)
- The monetary policy (modifying an economic variable) cannot target only one
bubble but the whole sector
… Is the monetary policy an efficient tool to help against asset price bubbles ?
Credit: Flavien VILBERT and Gabriel REIGNER

NPV Payback Period Discounted PP Exercises IRR NPV and IRR PI Exercise Survey

1 Introduction

Investment Net Present Value
Payback Period
Discounted Payback Period
Exercises
IRR
NPV and IRR
Profitability Index
Exercise
Investment decisions in practice
4 Stock valuation
6 References
Investment Net Present Value

Investment project generates a risky cash flow stream
C1 , C2 , ..., Cn : Stream of cash flows at date 1, 2, ..., n
DFn = (1+r1 n )n : Appropriate discount factor for Cash Flow n risk
Value additivity : Value of a sum of cash flow streams equals the sum of the
values of each cash flow stream
C1 C2 Cn
Present Value = + 2 + ... + n
1 + r1 (1 + r2 ) (1 + rn )
Investment project requires an initial investment I0

Project’s Net Present Value (NPV) is
C1 C2 Cn
Net Present Value = −I0 + + 2 + ... + n
1 + r1 (1 + r2 ) (1 + rn )
NPV Investment Rule: Invest in the project if NPV>0
Payback Period
Definition: The minimum period of time needed to recover the initial

investment
PT
Smallest T such as i=1 Ct > I0
Investment decision rule:
I Decide on a hurdle/ cutoff period
I For independent projects: Accept all projects with T < Hurdle
I For mutually exclusive projects: undertake the one with shortest T
Payback rule shortcomings
I It ignores the time value of money
I It ignores all cash flows after the cutoff date: this can lead to accept poor
short-dated projects (even with negative NPV)
I It gives equal weights to all cash flows before the cutoff date: this can lead to
wrongly rank mutually exclusive projects
Discounted Payback Period
Definition: The minimum period of time needed for discounted cash flows to
recover the initial investment
PT Ct
Smallest T such as t=1 (1+r t)
t > I0

I Decide on a hurdle/ cutoff period
I For independent projects: Accept all projects with T < Hurdle
I For mutually exclusive projects: undertake the one with shortest T
Issues with this investment rule
I It can still lead to undertake negative NPV projects because it does not take
into account cash flows after T
I It is insensitive to cash flow sizes and may wrongly rank mutually exclusive
projects
Payback Period - Exercises
Project I0 C1 C2 C3 C4 NPV Payback Rule Disc.P. Rule Invest?

Z -100 108 0 0 0 8.00 €
A -100 0 120 120 0 140.00 €
B -100 60 60 120 0 140.00 €
C -100 0 0 200 -220 -100.00 €
D -100 0 0 0 300 104.90 €
Cutoff period: T=3

Discount rate r=10%
Internal Rate of Return
Definition: The constant discount rate for which the project’s NPV would be
zero
PT Ct
It is the solution to: t=1 (1+IRR) t = I0
IRR is not equivalent to a cost of capital: it is a profitability measure and not a

standard of profitability
I Decide on threshold IRR: usually, the return on other alternative investments
on the market with same risk and return = the cost of capital
I For independent projects: Accept all projects with IRR > Threshold
I For mutually exclusive projects: we cannot use the highest IRR rule unless
investments have the same scale, timing and risk
The IRR Investment rule is largely used even though it has many flaws
I Wrong decision if cash flows are negative
I A cash flow stream can have several IRRs
I A cash flow stream can have no IRR
NPV and IRR
€2 500 €400
€2 000 €200
€1 500 €0
12%
15%
18%
21%
24%
27%
30%
33%
36%
39%
42%
45%
48%
51%
54%
0%
3%
6%
9%
€1 000 (€200)
€500 (€400)
€0 (€600)
12%
15%
18%
21%
24%
27%
30%
33%
36%
39%
42%
45%
48%
51%
54%
0%
3%
6%
9%
(€500) (€800)
(€1 000) (€1 000)
(€1 500) (€1 200)
NPV: negative function of discount rate Multiple IRR case (final negative cash flow)
All cash flows have the same sign IRR1=1.59% and IRR2=18.75%
Indicates sensitivity of the NPV to estimation
error in the cost of capital
Credit: Yasmin HAMMOUD
COMPARISON BETWEEN NPV AND IRR
Outcome: The NPV method results in a dollar value that a project will produce, while IRR generates
the percentage return that the project is expected to create.
Purpose: The NPV method focuses on project surpluses, while IRR is focused on the breakeven cash
flow level of a project.
Decision support: The NPV method presents an outcome that forms the foundation for an investment
decision, since it presents a dollar return. The IRR method does not help in making this decision, since
its percentage return does not tell the investor how much money will be made.
Reinvestment rate: The presumed rate of return for the reinvestment of intermediate cash flows is
the firm's cost of capital when NPV is used, while it is the internal rate of return under the IRR
method.
Discount rate issues: The NPV method requires the use of a discount rate, which can be difficult to
derive, since management might want to adjust it based on perceived risk levels. The IRR method does
not have this difficulty, since the rate of return is simply derived from the underlying cash flows.
Generally, NPV is the more heavily-used method. IRR tends to be calculated as

part of the capital budgeting process and supplied as additional information.
Profitability Index
Useful in case of capital rationing and when NPV rule does not give a definite
answer between projects
Definition: Ratio of NPV of future cash flows over the initial investment
Ct
−I0 + T
P
t=1 (1+rt )t
Calculation: PI = I0
Investment rule:
I For independent projects: Accept all projects with PI >1
I For mutually exclusive projects: Amongst all projects with PI>1, accept the
one with the highest PI. You can also rank projects based on PI and identify
an optimal combination of projects to undertake
Caveats: PI calculation is based on only one resource constraint and its
exhaustion (ie do not select projects that do not exhaust the resource)
Exercise: PI with constraint
Source: BDM Chapter 7
Investment decisions in practice
Source: Graham, John and Campbell Harvey (2002), “How do CFOs make capital budgeting and capital
structure decisions?”, Journal of Applied Corporate Finance
Sensitivity and simulation analysis: done on investment cash flow forecasts
Real Options and APV (Adjusted Present Value): discussed in other Sessions
Introduction DDM Example Gordon Model Financial ratios AMZN UQ Multiples P/E decompo PE-MTB value Exercise DCF DCF example Discuss

1 Introduction
4 Stock valuation
Introduction
Dividend Discount Model
Example of stock valuation with DDM
Gordon Model
Financial ratios
AMZN UQ financial ratios
Valuation multiples
McKinsey analysis on P/E multiples
P/E and Market-to-Book Value comparison
Exercise
Discounted Free Cash Flows valuation
DCF example
Discussion on AMZN UQ DCF valuation
Introduction
Why should we care about market value of equity?

I Corporation goal: maximizing shareholders’ wealth translates into maximizing
share price
I Key determinant of the market value of the firm
Based on accounting identity Assets = Liabilities + Shareholder’s equity, we
have:
F Market Value of the Firm= Sum of discounted expected cash flows generated
by assets
F Market Value of Equity= Sum of discounted expected dividends
F Market Value of Debt= Sum of discounted expected coupons and notional
Three main models used to determine stock price
I Discounted Dividends
I Valuation multiples
I Discounted (Free) Cash Flows
By valuing stocks, we also start discussions on how to determine cost of
equity capital, which is a key parameter to value investment projects
Dividend Discount Model
We assume company expects to pay a regular (annual) dividend up to

horizon T
We discount the cash flows on the cost of equity capital corresponding to
their risk, that we assume constant
Viewed from today, we have the following non-arbitrage price:
PT E0 (Divt ) PT
P0 = t=1 (1+rE )t + (1+rE )T
E0 (DivT +1 ) PT +1
We can write, viewed from 0, PT = (1+rE )T +1
+ (1+rE )T +1
P∞ E0 (Divt )
We finally get stock price P0 = t=1 (1+rE )t
Model based on forecast dividends, which means: forecasting firm’s earnings,

dividend payout rate and future share count
Example of stock valuation with DDM
Source: BMA Chapter 4
Gordon Model
Constant Growth Dividend model
We discount the cash flows on the cost of equity capital corresponding to
their risk, that we assume constant, rE
Assumption: Dividends will grow in the future at a constant rate g < rE
Derivation of the stock price based on perpetuity calculation

E0 (Div1 )
P0 = rE −g
Rearranging terms, this model allows us to compute a cost of equity capital,

based on dividend yield and expected growth rate
E0 (Div1 )
rE = P0 +g
Discussion: unrealistic assumption of constant dividend growth for ”growth”

companies. What could be a solution ?
Financial ratios
Earnings Per Share (EPS): net income reported on a per-share basis (dilution)
I 2018 median for US firms
Price to Book Value: Ratio of market capitalization of the firm to the book
value of shareholder’s equity (P/BVPS)
Price over Sales (Price/Sales)

Price over Operating Cash Flows (P/OCF)
What’s the main difference between EPS and Price to Book Ratio and the
two other ratios?
AMZN UQ financial ratios
ESO: Employee Stock Options

CS adjusted: Current shares adjustment
Net debt=Total Debt - Cash short-term investments (measure of firm leverage)
Valuation multiples
We use intra-industry comparables (”comps”) to value stocks
Price Earnings ratio (P/E): ratio of the market value of equity to the firm’s
Share Price
earnings, either on a total basis or on a per-share basis: Earnings Per share
I P/E tends to be highest for industries with high expected growth rates
(2018 median for US firms=24; software=33)
I If earnings are negative, we use entreprise value relative to sales
I Actual P/E versus Expected (Forward) P/E
Valuation multiples with no mismatch (cf previous slide)

I Entreprise Value= Market Value of Debt and Equity - Cash
I EV/Sales: Ratio of Entreprise Value over Sales
I EV/EBIT: Ratio of Entreprise Value over EBIT
McKinsey analysis on P/E multiples

Idea: P/E can be decomposed into Fundamentals to understand determinants
Basic decomposition from constant DDM, with gn the expected growth rate:
Div1 gn
Dividend Payout Ratio 1− ROE
Forward P/E= reEPS
−gn =
1
re −gn == re −gn
P/E is then determined by dividend payout ratio, return on equity and
expected growth in earnings
They use a two-stage model with high growth and stable growth periods (so
two assumptions of expected growth) and a ROIC decomposition
P/E and Market-to-Book Value comparison
Source: BMA Chapter 4
Exercise on Valuation ratios

DCF methodology
Two types of stock valuations: relative to equity or relative to entreprise value

Free Cash Flow ”to the firm”: what the firm has available to pay both debt
and equity holders
Step 1: Calculate FCF from Earnings
I Add back Depreciation to Earnings (non-cash expense); substract Capital
Expenditures; substract the net Working Capital
I NB: Depreciation expenses have a positive impact on FCF (depreciation shield)
I Unlevered FCF= EBIT x (1 - Tax rate) + Depreciation - Capital Expenditure -
Increase in Working Capital
Step 2: Determine the Entreprise Value as the present value of free cash
flows, and the subsequent share price
P∞ E0 (FCF ) 0 +Cash0 −Debt0
EV0 = t=1 (1+r E +D )
t P0 = EVShares outstanding
Discounted Cash Flow analysis of AMZN UQ
Discussion on AMZN UQ DCF assumptions
Discount rate: Weighted Average Cost of Capital of 10.50%

Market implied WACC methodology: they discount their FCF estimates from
2017 to 2022 (5y) to arrive at the stock’s current trading price
Unlevered FCF Perpetual Growth rate of 3%: used to compute the terminal
value of the firm; they do not explain this assumption
FCFN+1 1+gFCF
VN = rWACC −gFCF = rWACC −gFCF x FCFN
Last columns: growth assumption on each line of the valuation (CAGR=

Compound annual growth rate)
Discussion: How do you reduce uncertainty around these estimates ?
Introduction CAPM CML CML graph Two risks Beta Cost of capital estimation Project beta

1 Introduction
4 Stock valuation

Introduction
The Capital Asset Pricing Model
CAPM Capital Market Line
Capital Market Line
Systematic versus idiosyncratic risk
The market betas of individual assets
Cost of capital estimation with CAPM model
Project beta application
6 References
Introduction
So far we have used discount rates without estimating them: they are
nevertheless a key parameter for both investment project and stock valuation
Discount rates account for the specific risk of the expected cash flow
We discussed so far
I Cost of equity capital (used in the Dividend Discount Model and in investment
project valuation)
I Weighted Average Cost of Capital (WACC) used in the DCF model, based on
both equity and debt costs of capital
This Section introduces one estimation method for the cost of equity capital,
related to the Capital Asset Pricing Model (CAPM)
Sessions 3 and 4 will deal with the WACC, in relation with the capital
structure of the firm, quite extensively
The Capital Asset Pricing Model
Market equilibrium theory of asset prices under conditions of risk, developed

by William F. Sharpe in 1968 in the Journal of Finance
I Investors are assumed to prefer a higher expected future wealth to a lower
value
I Investors exhibit risk aversion
I Homogeneity of investor expectations
Extension of the Portfolio Optimization theory (Markowitz)
Investors choose within a set of investment opportunities the one that
maximizes their utility based on expected returns, variance and covariance
considerations
In Portfolio optimization theory, investors choose mean-variance efficient
portfolios lying on the Efficient Frontier
Given risk-free asset, they invest in one single optimal portfolio of risky assets
and in the riskless asset to adjust for their risk preferences
CAPM Capital Market Line
CAPM identifies the mean-variance efficient portfolio as the Market Portfolio

I The Market Portfolio is composed of all assets held in proportion to their
market values (value-weighted)
I Given homogeneous expectations assumptions, all investors demand the same
efficient portfolio of risky assets, and the total supply of securities on markets
is the Market Portfolio
I Equilibrium between demand and supply implies Market Portfolio is the
Tangent Portfolio
Investors therefore choose mean-variance efficient portfolios that lie on the

Capital Market Line frontier (efficient frontier for the CAPM)
CAPM Capital Market Line graph
Systematic versus idiosyncratic risk
Systematic risk
I Definition: Part of an asset’s risk that is correlated with the market portfolio
I Cannot be diversified away (Undiversified Risk)
I Investors ask for a higher expected return for the cost of bearing systematic
risk
Idiosyncratic risk (firm specific)

I Part of an asset’s risk that is NOT correlated with the market portfolio
I It can be diversified away by holding a frontier portfolio (Diversifiable Risk)
I By application of the Law of One Price: the risk premium for diversifiable risk
is zero, so that investors are not compensated for holding specific risk
An asset’s idiosyncratic risk does not affect its risk premium required
by investors and therefore does not affect the firm’s cost of capital
The market betas of individual assets

For any asset i, the relevant measure of risk is measured by its beta wrt the
Market Portfolio
Beta is asset’s sensitivity to market risk (which cannot be diversified away)
The relation between an asset’s expected return (or risk premium) and its
market beta is called the Security Market Line (if CAPM holds, all stock and
portfolios lie on the SML)
cov (ri ,rMKT )

E [ri ] = rf + βi x (E [rMKT ] − rf ) βi = σ 2 rMKT
Cost of capital estimation with CAPM model

Step 1: Construction of a proxy for the Market Portfolio
I Which assets do you include to have a representative Market Portfolio?
Step 2: Determination of the risk free rate
I Which assets do you use?
Step 3: Estimation of the premium on the Market Portfolio
I Using the empirical distribution of realized returns, we estimate the expected
returns of Market Portfolio by calculating its average returns (annual)
Step 4: Estimate the market betas of individual assets β̂i
I Excess returns: Average returns in excess of the risk-free rate
I Dependent variable: Excess returns on asset i (in case of stocks: do you
include dividends?)
I Explanatory variable: Excess returns of market
I Specification: ri − rf = αi + βi x (rMKT − rf ) + i
I The estimates of αi give the estimated deviations from CPAM; residuals are
an estimate of firm-specific component in asset i’s return
Cost of capital of any investment is equal to the expected return of available
investments with the same beta
Project beta application
Project A requires an initial investment of USD 16M

It generates a single cash flow in one year with three possible states of the
world
USD Treasury yield 1y= 6%

1/What is the project’s expected one-year return?
2/ Should you invest in this project?
Cov [rA , rMKT ] = E [rA .rMKT ] − E [rA ].E [rMKT ]
1 Introduction
4 Stock valuation
6 References
References
Chadda Nidhi, McNish, Robert S. and Werner Rehm, ”All P/Es are not created equal”,
McKinseyCompany
Graham, John and Campbell Harvey (2002), “How do CFOs make capital budgeting and capital
structure decisions?”, Journal of Applied Corporate Finance
Kelleher, John and Justin J. MacCormack (2005), “Internal rate of return: a cautionary tale”,
The McKinsey Quarterly special edition: Value and performance
Fama E.F. (1965), ”The behavior of stock market prices”, Journal of Business, vol. 38, n° 1, p.
31-105
Gromb, Denis and Dimitri Vayanos (2010), “Limits Of Arbitrage: the State of the Theory”, The
Paul Woolley Centre WP 9
Ross, Stephen A (2005), “No Arbitrage: The Fundamental Theorem Of Finance”, Neoclassical
Finance, chapter 1, Princeton University Press
Sharpe, William F. (1964), “Capital Asset Prices: A Theory Of Market Equilibrium Under
Conditions Of Risk”, The Journal of Finance
Master 1 International Economics – University of Orléans
Financial Management
Course material from 2021-2022 students

Technical analysis
Credit: Cem KANTAR

Credit:
Purva Nitin GOLE
Capital Asset Pricing Model (CAPM)
The CAPM was introduced by Jack Treynor (1961, 1962),[4] William F. Sharpe (1964), John
Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory.
𝐸 𝑅𝑖 −𝑅𝑓
= 𝐸(𝑅𝑚 )-𝑅𝑓 , E(𝑅𝑖 )=𝑅𝑓 + β𝑖 (E(𝑅𝑚 ) − 𝑅𝑓 )
β𝑖
Credit: Mathilde AJAVON

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Introduction Valuation assumptions Cash-flow based investment rules Stock valuation Cost of equity capital References

Financial Management - Valuing projects and stocks

3 Cash-flow based investment rules

5 Cost of equity capital

Discussed in Introductory Session

Financial Management - Valuing projects and stocks

3 Cash-flow based investment rules

5 Cost of equity capital

Financial assets (securities) definition / Credit: Prof Denis Gromb

No Arbitrage (Law of One Price)

No Arbitrage and the Law of One Price

and financing opportunities (Separation Principle)

Efficient Markets Hypothesis

Definition of an efficient market: ”We [. . . ] saw that a situation where

EMH: Deals with three levels of informational efficiency of financial markets

Combined with no-arbitrage condition, the price of the financial asset is

EMH implications and testing

Several implications of the weak form

Alternatives to EMH and No Arbitrage

• Behavioral finance is justified by :

• Key behavioral biases are :

• "Prospect Theory" is founder of economics and behavioral finance :

From profit loss for a few individuals to

Different steps of a bubble:

Asset Price Bubbles

Credit: Flavien VILBERT and Gabriel REIGNER

- Be aware of macroeconomic variables : inflation, employment, aggregate

- Danger of a tightening monetary policy in case of misidentified bubble

- Deviant behaviour from participants can lead to a controversial result of the

Credit: Flavien VILBERT and Gabriel REIGNER

Financial Management - Valuing projects and stocks

3 Cash-flow based investment rules

5 Cost of equity capital

Investment Net Present Value

Investment project requires an initial investment I0

NPV Investment Rule: Invest in the project if NPV>0

Definition: The minimum period of time needed to recover the initial

Discounted Payback Period

Investment decision rule:

Payback Period - Exercises

Project I0 C1 C2 C3 C4 NPV Payback Rule Disc.P. Rule Invest?

Cutoff period: T=3

Internal Rate of Return

IRR is not equivalent to a cost of capital: it is a profitability measure and not a

NPV and IRR

(€1 000) (€1 000)

(€1 500) (€1 200)

COMPARISON BETWEEN NPV AND IRR

Generally, NPV is the more heavily-used method. IRR tends to be calculated as

Exercise: PI with constraint

Source: BDM Chapter 7

Investment decisions in practice

Financial Management - Valuing projects and stocks

3 Cash-flow based investment rules

Why should we care about market value of equity?

Dividend Discount Model

We assume company expects to pay a regular (annual) dividend up to

Model based on forecast dividends, which means: forecasting firm’s earnings,

Example of stock valuation with DDM

Source: BMA Chapter 4

Derivation of the stock price based on perpetuity calculation

Rearranging terms, this model allows us to compute a cost of equity capital,