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MIN 100 Investment Analysis

Roy Endr Dahl University of Stavanger E-mail: roy.e.dahl@uis.no

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Kumari, Raj
Lysen, Magnus Kristoffer

Rgenes, Rolf Gunnar

Yang, Hao

MIN 100 Investment Analysis


Week / date
35 29.08.2012 37 12.09.2012 38 19.09.2012 39 26.09.2012 40 03.10.2012 41 42 17.10.2012 43 24.10.2012 44 31.10.2012 49 05.12.2012

Chapters / Topic
1-3 / Introduction and basic concepts. 4-5 / Net present value, bonds, markets 6-7 / Stocks, NPV and other investment rules 8-9 / Cash flow and capital budgeting, decision tree, sensitivity, Monte Carlo 10-11 / Return and Risk, expected return, CAPM Mandatory assignment 11-13 / CAPM, Risk, Cost of Capital Workshop. Applying part 2 and 3 to a Real Estate company. 14-15/ Capital structure, Modigliani & Miller, use of debt, leverage. Review of chapter 4-12.

Note
Part 1: Overview Part 2: Valuation and Capital budgeting

Part 3: Risk and Return

Workshop. Part 4: Capital Structure and Dividend Policy Review.

0-3

Real Estate Company


We are responsible for making investment decisions for a small and growing real estate company. Today the company owns a profitable 1 500 m2 building, rented out on a long-term basis to a reliable company. The rent is set to 1 600,- per M2 per year, providing the company with an income of 2.4 million NOK per year. The income statement is provided in the next 4 slide.

Income statement
2011 2010

Revenue
Total rent Rented area Rental price Sum revenue

2 400 000 1 500 1 600 2 400 000

2 355 000 1 500 1 570 2 355 000

Earnings Before Interest and Taxes (EBIT) is positive, and in 2010 the company made 1.73 million before interest and taxes.

Cost
Maintenance Insurance Depreciation Salary Sum cost EBIT

100 000 20 000 200 000 350 000 670 000 1 730 000

95 000 20 000 200 000 340 000 655 000 1 700 000

Income statement
2011 2010

Revenue
Total rent Rented area Rental price Sum revenue

2 400 000 1 500 1 600 2 400 000

2 355 000 1 500 1 570 2 355 000

The company has debt of 2 million NOK and paid 5.0 % interest rate in 2010. The Earnings Before Taxes (EBT) are thus 1.53 million NOK.

Cost
Maintenance Insurance Depreciation Salary Sum cost EBIT Interest Long-Term Debt Interest rate EBT

100 000 20 000 200 000 350 000 670 000 1 730 000 200 000 4 000 000 5,0 % 1 530 000

95 000 20 000 200 000 340 000 655 000 1 700 000 189 000 4 200 000 4,5 % 1 511 000

Income statement
2011 2010

Revenue
Total rent Rented area Rental price Sum revenue

2 400 000 1 500 1 600 2 400 000

2 355 000 1 500 1 570 2 355 000

With a tax rate at 28%, the net income for the company is 1.102 million NOK in 2011. The company pays out 40% of its net income as dividends, which in 2011 was 440 640,-.

Cost
Maintenance Insurance Depreciation Salary Sum cost EBIT Interest Long-Term Debt Interest rate EBT Taxes (28%) Net Income Dividends Retained earnings

100 000 20 000 200 000 350 000 670 000 1 730 000 200 000 4 000 000 5,0 % 1 530 000 428 400 1 101 600 440 640 660 960

95 000 20 000 200 000 340 000 655 000 1 700 000 189 000 4 200 000 4,5 % 1 511 000 423 080 1 087 920 435 168 635 000

What is the company worth?

Company valuation: Dividend Growth Model


From chapter 6 we know how to compute the value of a company using the Dividend Growth Model.

We know the dividends this year was 440 640,-, We know the opportunity cost (or required return of stockholders) used for real estate companies is 12.5%. We will use this for the discount rate (r). And, from chapter 3 we can calculate g
g = Retention Ratio * Return on Equity

Company valuation: Dividend Growth Model


g = Retention Ratio * Return on Equity Retention ratio = (1 Dividends ratio) = 1 0.4 = 0.6
= = 17.99% 1 101 600 = 6 125 000

From the balance sheet we find total equity = 6 125 000, And income statement says net income = 1 101 600,-

g = Retention Ratio * Return on Equity g = 0.6 * 0.1799 = 0.1079


9

Company valuation: Dividend Growth Model


By applying dividends (Div), growth (g) and discount rate (r), we can calculate the value of the company. 0 =
1 0 (1+)

440 640 (1+0.1079) 0.125 0.1079

28 568 914 28.6


Price / Earning = PE-ratio = 28.6 / 2.4 = 11.9

10

Expand or Purchase?
The company owner is not satisfied with the cash generation in the company and is considering expanding business by either:
1. Adding a 2nd floor. You have received tenders from multiple entrepreneurs and the best price for adding a 2nd floor is 22 MNOK. It will provide an extra 1 500 m2 for rent, and due to the high quality on this floor, you expect the rent to be 1 800 NOK pr M2 pr year. However, building time is 6 months, and you will have to close the 1st floor for 2 months. Purchasing a second property.
The price of the property is 38 MNOK. The property is 2 500 m2 and will provide rent at 1 500 NOK pr M2 11 pr year.

2.

Review of projects
PROJECTS
Cost Rentable area Rent price Building time Closed 1st floor

Expand
22 000 000 1 500 1 800 6 2

Purchase
38 000 000 2 500 1 500 0 0 NOK m2 NOK / m2 pr year months months

Although the company has some cash at hand, you acknowledge that it is necessary to issue a bond (or get a loan at your bank). By investing 15% of the cost the bank offers you a 40 year fixed interest rate bond at 6% interest rate. The company will only pay interest, before the bond is fully repaid in year 41.

12

The Bond
PROJECTS
Cost Rentable area Rent price Building time Closed 1st floor Cash invested Loan needed Interest rate Project Lifespan

Expand
22 000 000 1 500 1 800 6 2 3 300 000 18 700 000 6.0 % 40

Purchase
38 000 000 2 500 1 500 0 0 5 700 000 32 300 000 6.0 % 40 NOK m2 NOK / m2 pr year months months NOK (15% of cost) NOK (85% of cost) 40 year fixed interest bond years

For the expansion this results in a yearly interest of 1.122 MNOK, while for the purchase the yearly interest is 1.938 MNOK.

13

Operating Cash Flow


When we are evaluating a project we focus on its operating cash flow money coming in, monet going out. For this project we have the following expenses:
Interest on loan Maintenance on building Taxes (adjusted for by depreciation)

And the following income:


Rent
14

Incremental Cash Flows matters


Remember from Chapter 8 that we need to identify incremental cash flows in order to evaluate and compare the two projects. Incremental cash flows are cash flows (income or expense) that is a direct result of the project. In general, the project will provide extra income as a result of expanding the building with 1500 m2 or purchasing a second property. The two projects provides us with different timing schedules and have different size in periodic payment and initial investment. We need to compute the cash flow for both projects, before estimating their profit.

15

Incremental Cash Flow year 0


The initial investment and loan takes place in year 0, and thus imply full interest and repayment from year 1 and onwards on the loan. Note that if Earnings Before Taxes (EBT) is negative, the government will repay part of your loss through deferred taxes. This actually reduces your future tax bill, but in our case we will take this as a positive cash flow in year 0, instead of reducing future tax bills. (Extra note: In the oil industry the government actively subsidizes development and investment by repaying deferred taxes at once, as we do in this case.)
Cash flow year 0 Investment = EBT Taxes Operating cash flow year 0 Expand -3 300 000 924 000 -2 376 000 Purchase -5 700 000 1 596 000 -4 104 000

16

Incremental Cash Flow year 1


Due to an increase in quality in the 2nd floor compared to the 1st floor, the rental price will be 1 800 NOK pr M2 pr year, resulting in a monthly rental at 225 000 NOK (=1 800 * 1 500 / 12). If we decide to expand we will get income in 6 months in the 2nd floor, and lose income for 2 months in the 1st floor. If we decide to purchase we will have full rent for 2 500 m2 at 1 500,- pr M2. The investment is depreciated straight-line through 40 years. Tax rate is equal to 28%.
Expand 1 350 000 -400 000 -100 000 -550 000 -1 122 000 -822 000 230 160 -41 840 Purchase 3 750 000 -300 000 -950 000 -1 938 000 562 000 -157 360 1 354 640

Cash flow year 1 Extra income Lost income 1st floor Extra maintenance Depreciation Interest on loan EBT Taxes Operating cash flow year 1

=Rent * Rentable area

=Cost / 40 =Loan * Interest rate =-EBT * Tax rate =EBT-Taxes+Depreciation

Incremental Cash Flows


The project has a lifetime of 40 years (equal to the bond). From year 2 to 40, the cash flow will be equal to:
Expand 2 700 000 -100 000 -550 000 -1 122 000 928 000 -259 840 1 218 160 Purchase 3 750 000 -300 000 -950 000 -1 938 000 562 000 -157 360 1 354 640 =Rent * Rentable area =Cost / 40 =Loan * Interest rate =-EBT * Tax rate =EBT-Taxes+Depreciation Cash flow year 2-40 Extra income Extra maintenance Depreciation Interest on loan EBT Taxes OCF year 2-40

In year 41 we will repay the loan, providing us with a cash flow in year 41 equal to:
Cash flow year 41 Repayment loan = EBT Taxes Operating cash flow year 41

Expand
-18 700 000 -18 700 000

Purchase
-32 300 000 -32 300 000

Notice that the repayment of loan does not provide us with any tax 18 benefits. The tax benefits of our investment are already accounted for with depreciation.

Cash Flows
We now have the following cash flows for our project using the two tenders:
Year 0 1 2 3 ... 40 41 A -2 376 000 -41 840 1 218 160 1 218 160 ... 1 218 160 -18 700 000 B -4 104 000 1 354 640 1 354 640 1 354 640 ... 1 354 640 -32 300 000

19

Cash Flows
Expand 1 218 160 1 218 160 1 218 160

-2 376 000 Purchase

-41 840

-18 700 000

1 354 460

1 354 460

1 354 460

1 354 460

-4 104 000

20 -32 300 000

Investment rules
Chapter 7 provided us with a set of investment rules:
Net Present Value Internal Rate of Return Payback Period Method Discounted Payback Period Method Profitability Index

We will calculate and evaluate the two tenders using all of these methods.

But, first we need to estimate the appropriate discount rate.


21

Discount rate
By using the income statement calculated earlier with the balance sheet for the company, we can find the Return on Equity (chapter 3):

Since the project is within the same industry as the company in general we assume the required return on equity is the same for the project. However, since this project is partially financed by debt, we need to use Weighted Average Cost of Capital or WACC (chapter 12). 22

WACC
The cost of capital for a company is decided by the return required by its stockholders (ROE = rE) and the interest demanded by bondholders (rD). In addition, since interest is tax deductible, the coorporate tax rate (tC) will affect the cost of capital. The companys cost of capital is found by taking the weighted average between equity and debt:

23

WACC
For our project we know that 15% will be financed through equity and 85% through debt. With a tax rate of 28%, rE = ROE = 17.99% and the interest rate on debt rD = 6.00%, we find rWACC as:

Remember that the after tax cost of debt = (0.06 * (1 0.28)) = 0.0432 = 4.32%, and that 85% of the project is financed at this rate.

24

Rule #1: Net Present Value (NPV)


NPV turns all future cash flows into present value, telling us how much the future cash flows are worth today. This means that it takes into account the time value of money: Money today is more worth than money tomorrow. In general, NPV can be defined as:
NPV = PV of future cash flows Investment today

25

Calculating NPV
We can calculate the NPV by realizing that we have 4 different types of cash flows for each project: A. Investment today (cash flow year 0) B. Cash flow year 1 C. Equal cash flows year 2 40 D. Repayment of loan in year 41 (B) needs to be discounted for one year, (D) needs to be discounted for 41 years, and (C) can be calculated as an annuity in year 2 and 26 then be discounted for one year.

NPV Expand
1 218 160

1 218 160

1 218 160

-2 376 000 -39 334

-41 840

-18 700 000

17 403 466 16 361 284

-1 486 929
12 459 022 >0
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NPV Purchase
1 354 460 1 354 460

1 354 460

1 354 460

-4 104 000 1 273 519

-32 300 000

19 353 742 18 194 369

-2 568 332
12 795 556 >0
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Rule #2: Internal Rate of Return (IRR)


The internal rate of return is the discount that returns a Net Present Value (NPV) = 0.
NPV(A) = 0 @ IRR(A)

Notice that we will not have any problems with IRRs pitfalls for these projects:
There is no question of borrowing or lending (pitfall #1) The cash flow does not change sign, so we will not have any problem with multiple IRRs (pitfall #2) The two projects have approximately the same scale (pitfall #3) The cash flows occur at the same time, and we therefore avoid the timing problem (pitfall #4)
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Calculating IRR
When calculating the Internal Rate of Return by hand, we need to do this by trial and error. Although this is a 40 year cash flow, it may be possible to calculate since we have narrowed it down to only 4 different parts (investment, cash flow year 1, annuity cash flow year 2-40, repayment of loan year 41). However, the exact IRR can be found with Excel, using =IRR(cash flow) or =IR(cash flow) in Norwegian.
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Internal Rate of return


35,000,000 30,000,000

NPVExpand. > NPVPurchase NPVExpand. = NPVPurchase NPVExpand. < NPVPurchase

25,000,000

20,000,000 Net Present Value

15,000,000

10,000,000

NPVExpand. > NPVPurchase IRRPurchase = 33.01%

NPV (Expand) NPV (Purchase)

5,000,000

IRRExpand = 36.96%

0% -5,000,000 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

Crossover rates
Discount rate

31

Crossover rate
In order to find at what discount rate it is more profitable to choose project A over project B, we can calculate the crossover rate. The crossover rate, is the discount rate where the Net Present Value (NPV) of both projects are equal:
NPV(A) = NPV(B) @ crossover rate

We can calculate this by subtracting the cash flow of one project from the other, and then find the Internal Rate of Return (IRR) of this cash flow.
NPV(A-B) = 0 @ IRR(A-B) where IRR(A-B) = crossover rate
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Calculating Crossover rate


Year 0 1 2 3 4 ... 40 41 Expand -2 376 000 -41 840 1 218 160 1 218 160 1 218 160 1 218 160 -18 700 000 Purchase -4 104 000 1 354 640 1 354 640 1 354 640 1 354 640 1 354 640 -32 300 000 Expand - Purchase 1 728 000 -1 396 480 -136 480 -136 480 -136 480 -136 480 13 600 000

The right column provides us with the difference between project A and project B. By calculating IRR of this cash flow, we find the crossover rate = 19.91%. However, notice that the sign of our cash flow is changing twice. This suggest that we may have a problem of multiple IRRs. And by looking at our previous graph, comparing the NPV of the two projects at a range of discount rates, it is clear that there are more than one crossover rates. This is confirmed when we create a figure of the NPV of the crossover project, see next slide.

Crossover rate
6,000,000 4,000,000

NPVExpand. > NPVPurchase NPVExpand. < NPVPurchase .

According to this figure, purchasing is the best option if the discount rate is between 5.07% and 19.09%. Otherwise, expanding is the best option.

2,000,000

0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50%

NPV(Expand - Purchase) NPV(Purchase - Expand)

-2,000,000

Crossover rate = 5.07%

Crossover rate = 19.09%

-4,000,000

-6,000,000

NPVExpand. = NPVPurchase

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Rule #3: Payback Period


This answers how long it will take for the inital investment to be paid back by future earnings. In our case, we need to find out how long it will take to pay back either 2.376 MNOK or 4.104 MNOK (investment after tax) for the two projects.

35

Calculating payback period


Cash flow calculations Year 0 1 2 3 4 5 6 ... 40 41 Cash Flows Expand -2 376 000 -41 840 1 218 160 1 218 160 1 218 160 1 218 160 1 218 160 1 218 160 -18 700 000 Purchase -4 104 000 1 354 640 1 354 640 1 354 640 1 354 640 1 354 640 1 354 640 Cumulative Expand -2 376 000 -2 417 840 -1 199 680 18 480 1 236 640 2 454 800 3 672 960 45 090 400 26 390 400 Purchase -4 104 000 -2 749 360 -1 394 720 -40 080 1 314 560 2 669 200 4 023 840 50 081 600 17 781 600

1 354 640 -32 300 000

The payback period for expansion are more than 2 years, while for purchase it is more than 3 years. We can calculate more precisely by assuming a straight line cash flow, and calculate the fraction of year 3 and 4 respectively to have a cumulative cash flow equal to 0:

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Rule #4: Discounted Payback


The payback period method has some major problems:
1. Arbitrary decision about correct payoff date. 2. Cash flow after the payback period. 3. Timing of cash flows.

The timing is addressed by the discounted payback period method, which uses the present value of the cash flows.

37

Calculating payback period


Cash flow calculations Year 0 1 2 3 4 5 6 ... 40 41 PV Cash Flows @rWACC Expand Purchase -2 376 000 -4 104 000 -39 334 1 273 519 1 076 633 1 197 257 1 012 160 1 125 561 951 549 1 058 158 894 567 994 792 840 997 935 220 103 032 -1 486 929 114 575 -2 568 332 Cumulative Expand Purchase -2 376 000 -4 104 000 -2 415 334 -2 830 481 -1 338 701 -1 633 224 -326 541 -507 663 625 008 550 495 1 519 574 1 545 287 2 360 571 2 480 507 13 945 951 12 459 022 15 363 888 12 795 556

Present Value is calculated at discount rate = rWACC According to our calculations the discounted payback period for both projects are the same: more than 3 years. Once again we get more accurate estimates by:

Note: Purchase still has the lowest payback period of the two. Note: Payback period increased by 0.36 and 0.45 with PV Cash flow.

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Rule #5: Profitability Index (PI)


The profitability index is used to rank the discounted cash flows of several projects. It takes into account the size and the timing of the cash flows by using present value cash flows (discounting) and comparing it to the initial investment.

39

Calculating Profitability Index

Since both projects have a PI > 1, they both have acceptable returns. In this case, JIT Entr. has the highest PI and should be preferred.

40

Ranking the projects


Investment rule NPV IRR Payback Period Discounted Payback PI Crossover rate Expand 12 459 022 36.96 % 2.98 years 3.34 years 6.24
[0 %, 5.07%] or [19.09%, ]

Purchase 12 795 556 33.01 % 3.03 years 3.48 years 4.12


[5.07 %, 19.09%]

Ranking Purchase > Expand Expand > Purchase Expand > Purchase Expand > Purchase Expand > Purchase

4 of 5 investment rules prefer expansion over purchase. Still, remember: -The payback and discounted payback period both ignores cash flow after 3 or 4 years, and the differences are too small to matter. - The PI tells us that expansion are more efficient, giving us a higher return on our investment. If we could repeat expansion until we reach the same invested amount as the purchase, NPV of expansion would be higher than for the purchase. Finally, we should keep in mind that NPV, IRR and PI are all dependent on the discount 41 rate which we estimated at rWACC = 6.37 %. If the crossover rate is close to this, you should consider whether it is likely that the discount rate will be above/below this crossover rate.

Sensitivity analysis (chapter 9)


We have made several assumptions so far, concerning key variables. All of these might change from our base assumptions, and we should therefore conduct what-if analysis on the following variables: Rent
are we sure customers will pay 1 800 or 1 500 NOK pr M2 pr year? Can it be lower or higher?

Coverage
Can we guarantee that the entire rentable area is rented out?

Interest rate on debt


Will the bank give us the same interest rate when we increase leverage?

Cost
Will the cost of expansion be more or less than estimated? Can the purchase price increase or decrease?

Building time and closed 1st floor?

Sensitivity analysis
25,000,000 20,000,000

NPV

15,000,000

10,000,000

5,000,000

NPV (Expand) Rent NPV (Expand) Interest rate on debt NPV (Expand) Cost NPV (Purchase) Rent NPV (Purchase) Interest rate on debt NPV (Purchase) Cost

-20% 7,054,234 16,207,012 15,110,909 5,035,074 18,239,161 17,376,088

-10% 9,756,628 14,259,830 13,784,966 8,915,315 15,410,910 15,085,822

0% 12,459,022 12,459,022 12,459,022 12,795,556 12,795,556 12,795,556

10% 15,161,416 10,791,011 11,133,079 16,675,797 10,373,301 10,505,290

20% 17,863,811 9,243,639 9,807,135 20,556,038 8,126,425 8,215,024

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Sensitivity analysis
Have seen that rent is the most sensitive factor in our project (has the biggest spread). This also implicates coverage, since rent and coverage will have the same effect when experiencing the same percentage change. We should therefore consider doing some market research, to reduce the uncertainty about the rent and coverage in our estimates. Still, remember that a sensitivity analysis does not take into account the probability of a change.
Is it more likely with a 10% move in cost, or in rent?
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Scenario analysis
The sensitivity analysis only consider one variable at a time. Often, more than one variable may covariate, and as a result change our investment analysis by a lot.
E.g. if the market is bad (good), both the coverage and the rent may change with a negative (positive) sign.

In the following scenario analysis we compare our base assumptions with the following scenarios occur:
p % positive (negative) deviation, meaning that:
Rent is p % higher (lower) Coverage is p% higher (lower) Interest rate is p% lower (higher) Cost is p% lower (higher)
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Scenario analysis
50,000,000 40,000,000

30,000,000

20,000,000

NPV (Expand) NPV (Purchase)

10,000,000

20% negative deviation -10,000,000 10% negative deviation Base assumptions 10% positive deviation 20% positive deviation

-20,000,000

Only if all of these factors experience a 20% negative deviation, do you experience a negative NPV. This may seem unlikely, but keep in mind that for the purchase option, a 10% negative deviation comes close to a loss.

46

Market efficiency (chapter 13)


Since both projects provide us with a positive NPV and they are not mutually exclusive, the company should take both. But, since the company does not have enough money to fund both projects, they are dependent on the market providing the extra cash. If the market were efficient, the market would take this opportunity and provide cash for both projects. So far, we have only considered borrowing money from the bank. Now, you want to see if issuing stocks may be a possible alternative to raise cash for both projects.
47

Issuing stocks

By issuing stocks we will alter the capital structure of the firm, and thus the capital structure of the projects. We need a total of 60 MNOK to take on both projects. The bank will borrow a maximum 35 MNOK, and the balance sheet tells us that the company has 4 MNOK. We therefore need to issue stocks worth 21 MNOK.
This will change the weighted average cost of capital for our projects:
ISSUING STOCKS
Equity financed Debt financed Return on Equity Interest rate Equity-ratio Tax rate r(WACC) 25 MNOK 35 MNOK 17.99 % 6.00 % 41.67 % 28.00 % 10.01 %

Since this rWACC is below the IRR previously calculated for both projects, we should go ahead and take on both projects! The combined NPV would then be 16 490 528, compared to 12 795 556 when only taking on the purchase check with Excel!

Decision tree (chapter 9)


Although your company is involved in 2 relatively big projects, you have been invited to develop a new area of town. The local government has divided this area in 3 parcels, where each will cover different basic needs.

In competition with other entrepreneurs, one parcel of land will be awarded at a time, and you have decided that you will at most take on one more project.
In order to evaluate the profitability of this opportunity, you have decided to do a decision tree analysis.
49

Decision tree
The parcels will cover the following needs:
1. Sleeping/Living = Apartment house 2. Food = Grocery/Supermarket 3. Work = Office house

You have experience from office and apartment houses, but not from supermarkets, and you have accounted for this in your estimates:
Project 1. Apartment 2. Supermarket 3. Office Application cost NPV if success 1.0 MNOK 1.5 MNOK 1.0 MNOK 6.0 MNOK 3.5 MNOK 5.0 MNOK Probability of success 40% 20% 50%
50

Decision tree
40 % NPV = 6.0 MNOK 20 % NPV = 3.5 MNOK 50 % NPV = 5.0 MNOK

1.
60 %
New application

2.
80 %
New application

3.
50 %
NPV = -3.5 MNOK

NPV = -1.0 MNOK

NPV = -2.5 MNOK

1. Apartment House Application cost Estimated NPV if success Probability of success

1.0 MNOK 6.0 MNOK 40 %

2. Grocery/Supermarket Application cost Estimated NPV if success Probability of success

1.5 MNOK 3.5 MNOK 20 %

3. Office House Application cost Estimated NPV if success Probability of success

1.0 MNOK 5.0 MNOK 50 %

NPV(1) = 0.4 * 6.0 0.6 * 1.0 = 3.0 MNOK NPV(1+2) = 0.2 * 3.5 0.8 * 2.5 = - 1.3 MNOK NPV(1+2+3) = 0.5 * 5.0 0.5 * 3.5 = 0.75 MNOK
51

Buying a competitor
The high return on equity rate of your company (17.99%) and new optimism from two projects providing an NPV of 12.8 MNOK, has given you courage to consider buying out a competitor. The competitor is trading on the stock exchange, and is currently valued to 32 MNOK. However, since you know the market, you evaluate this as cheap, as you believe the return on equity should be higher than what the competitor currently achieves at 14.00% and a growth rate of only 1.50%. You decide to estimate the value by expecting to increase the growth rate to your companys average at 10.79% within 3 years.

Competitor valuation Differential growth model


We assume that the purchased company will rise linearly from its old growth rate at 1.50% to the companys growth rate of 10.79%.
Year 1 Year 2 Year 3 Company growth from year 4 TOTAL VALUE
Growth rate Dividends (MNOK) Present Value (MNOK) 1,50 % 4,06 3,61 4,60 % 4,25 3,36 7,69 % 4,57 3,21 10,79 % 5,07 28,47 38,65

Note that 5.07 / 0.125 is the present value of the perpetuity in year 3. We therefore need to discount it over 3 years to get the present value today.

53

Buying a competitor
The difference (38.65 32) = 6.65 MNOK might not be sufficient as the company probably will have to pay a premium in the market to get a majority of the shares to go through with a merger of the two companies. Even though you consider it probable to add some synergy effects, you conclude not to purchase your competitor and instead focus on diversifying your portfolio.

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Diversification with a porfolio Increase return and reduce risk


Your company provides you with a steady positive cash flow, and you wish to expand and increase the expected return by diversification. You have identified 4 companies, which all have different characteristics. You will combine this with investment in your own company:
Asset/Stock Your company HTC Statoil Telenor Toyota Risk Free Rate Return 17,99 % 30,88 % 14,60 % 16,11 % 4,38 % 2,00 % Standard deviation 8,00 % 28,33 % 8,57 % 10,86 % 4,90 % 0,00 %

In order to find the best portfolio you decide to use Excel and create several portfolios.

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The stocks Risk and return


35.00% 30.00%

HTC

Expectet return

25.00%

20.00%

You
Telenor Statoil

15.00%

10.00%

5.00%

Risk free
2.00% 4.00% 6.00%

Toyota

0.00% 0.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Standard deviation = Risk

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Expected return and variance of a portfolio (chapter 11)


The expected return of a portfolio is the weighted return of its assets/stocks:

The variance of a portfolio consisting of two assets is:

We will use Excels function MMULT in order to calculate the variance for a portfolio of many assets.

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Portfolios
35.00% 30.00%

50% You 50% HTC

Expectet return

25.00%

20.00%

15.00%

10.00%

5.00%

0.00% 0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Standard deviation = Risk

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Risk averse (chapter 10 extra)


According to how much risk you like, you would choose a combination of the portfolio (50/50 HTC and your company) and the risk free interest rate. If you are risk averse, you would choose to put some of the money in the risk free rate (lending). If you are risk neutral, you would choose the 50/50portfolio. If you are a risk lover, you would choose to borrow money at the risk free rate, in order to increase your investment in the 50/50-portfolio.

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Portfolios
Risk lover (borrowing)
35.00%

30.00%

Risk neutral

Expectet return

25.00%

20.00%

Risk averse (lending)

15.00%

10.00%

5.00%

0.00% 0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Standard deviation = Risk

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Final portfolio
Although you want maximum return you are risk averse and cannot tolerate more than 6.0% standard deviation. In order to achieve this you will combine your portfolio (50/50 HTC + Real Estate company) and the risk free interest rate. Remember that when we are combining assets in a portfolio, we can calculate the combined standard deviation as the square root of:

In this case, we know that the standard deviation of the risk-free interest rate is 0. Therefore, both the 2nd and 3rd part is omitted.

This will help us calculate what share we will have to invest in the 61 50/50 portfolio in order to have a 6% standard deviation.

Final portfolio
New portfolio
Tolerated std. Dev 50/50 Portfolio std. Dev Share in 50/50 50/50 portfolio return Risk-free interest rate Expected return 6% 9.22 % 65.07 % 24.43 % 2.00 % 16.60 %

35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 0.00%

E.g. investing 1 MNOK, you would put 650 000,- in the 50/50 portfolio (325 000,- each in HTC and the real estate company), and 350 000 in risk free interest rate. This would give you an expected return at 16.6% and a standard deviation at 6.0% 62
5.00% 10.00% 15.00% 20.00%

Portfolio (CAPM)
Before you decide to invest in HTC, you want to check their riskiness compared to the market by calculating its beta. Beta is defined as i im/Var(rm) Remember that a beta > 1, identifies a stock more risky than the index.
Capital Asset Pricing Model
Market Variance Expected Market return Risk-free rate Asset/Stock HTC Statoil Telenor Toyota S&P 500 0,21 % 2,37 % 2,00 % Return Cov(i, M) Beta 30,88 % 0,00225 14,60 % 0,00202 16,11 % 0,00290 4,38 % 0,00133 2,37 % 0,00208

1,08 0,97 1,40 0,64 1

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Workshop summary
Chapter 6
Company valuation Dividend Growth Model

Chapter 7
Investment rules (NPV, IRR, Payback, PI)

Chapter 8
Incremental Cash Flows

Chapter 9
Decision tree Sensitivity / Scenario analysis

Chapter 11
Portfolio. CML CAPM. Beta.

Chapter 12
WACC
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Workshop summary
Content not covered:
Chapter 8, investments of unequal lives. Chapter 9, real options, monte carlo simulation and break-even analysis. Chapter 11, Security Market Line.

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