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READING ASSIGNMENT BMA 2 part II

Alex Kane

1

IPCOR421 Finance

**PV and NPV
**

• Suppose a firm can invest in a project that costs C(0)= –$90 (negative for outflow) and yields C(1)=$100 next year (nothing after), and the DF is 0.95 • The PV of the project is DF*C(1)=0.95*100=$95 • We define the net present value of the project (NPV) by:

NPV = C(0)+PV=C(0)+C(1)/(1+r)= –90+95 = $5

• NPV measures the increase in the value of the corporation (hence, shareholders’ wealth) from this activity

Alex Kane 2 IPCOR421 Finance

Risk and PV (I)

• • • The future CF from a project is never certain We observe: riskier financial assets sell for less Conclusion

1. 2. 3. 4. a risky (future) dollar is worth less than a safe one humans are risk averse speculation = take risk for a sufficient reward gambling = paying for taking risk. In the small it is taken as entertainment; when compulsive it is a disease

•

**To put a value on a risky CF we
**

1. project the probability distribution of the future cash flow, and compute the expected value 2. discount the expected cash flow by a higher rate (use a smaller DF) -- commensurate with the assessed degree of risk (from the probability distribution above)

3

Alex Kane

IPCOR421 Finance

**Risk, PV and NPV
**

• Suppose the CF of the previous project is uncertain and estimated by scenario analysis • Event: (i=1) Slump (i=2) Normal (i=3) boom Probability: 0.2 0.5 0.3 C(1): 45 110 120 • E[C(1)] = ΣPr(i)*CF(i) = sumproduct(Pr,CF) = 0.2*45+0.5*110+0.3*120 = $100 • We must determine the DF, or equivalently, the hurdle rate for the risky project?

Alex Kane 4 IPCOR421 Finance

**Required rates of return on risky projects
**

• Just as we obtain the required rate on safe assets from observed prices of U.S. bonds, we look for required rates on risky assets from prices of risky assets in financial markets • Suppose we observe: price of a stock (S), with a probability distribution of CF identical to our project, and S= $91. We determine the required 1-year rate of return for such risk from:

1+r =E[C(1)]/C(0)=100/91=1.0989 (r=9.89%); DF=.91

Alex Kane

5

IPCOR421 Finance

**The required risky rate
**

• Admittedly, finding a stock with probability distribution identical to a given project is difficult. We take on this issue later • However, observation of a huge number of assets over many years assures us that

– a statistical relationship (that can be estimated) exists between risk and expected returns – investors are, in the aggregate, quite consistent in pricing risky assets (and quite risk averse)

**• Hence, the relatively high required rate for this risky project (9.89%) is no accident
**

Alex Kane 6 IPCOR421 Finance

**The NPV and expected return
**

• With a required rate of 9.89%, the NPV of our project is

1. Using hurdle rate: –90+100/1.0989= –90+91= $1 2. Using the DF: –90 +.91*100 = $1

•

We can compute the expected return on our project (not the same as the required rate!) by:

E(r) = expected return = expected profit/investment = (100–90)/90=0.1111 (11.11%)

•

Notice: the expected return (11.11%) is greater than the cost of capital (9.89%), indicating the project has a positive NPV, as we already know

7 IPCOR421 Finance

Alex Kane

**Real-life analysis
**

• Using only three scenarios is quite crude. In practice, more scenarios are used, and often a continuous probability distribution (e.g. normal) is projected, yielding the expected return • In real life, it’s not likely to find one stock that matches a project. In practice, a portfolio of financial assets (not just stocks) is compiled to match a project. The expected rate of return of the portfolio is then taken as the required rate for the project

Alex Kane 8 IPCOR421 Finance

Foundation of NPV

• The NPV of a project comes from

1. the project: expected cash flows and risk assessment 2. market: the required rate for the assessed risk

•

•

The expected rate of return which depends ONLY on project data -- cannot, alone, be used for decision making (need a benchmark) One role of financial markets in corporate management is to supply data on prices of projects already in place. These imply benchmarks for new projects (DF, required rate)

9 IPCOR421 Finance

Alex Kane

**Project background (how Fig.2.1is made)
**

• A venture capital fund (VC) has only one project on the docket. The fund has $5 million to invest • The project’s nature is such that it will take only one year for cheap imitations to end the life of the project • For the one year of profitable operations, the VC must choose the scale of production • A larger scale means

– build larger capacity – sell more units, but at a lower price

• Given the risk, the required rate for this projects is 10% • Total unit cost is $3 at any capacity (no returns to scale) • Must decide the optimal scale

Alex Kane 10 IPCOR421 Finance

**Project data (except for unit price and profit margin, all quantities in millions)
**

Investment Units Price Margin Cash flow NPV Return(h*) 5 12.5 3.38 0.38 4.75 –0.68 –5% 4.5 11.25 3.4 0.40 4.5 –0.41 0 4 10 3.42 0.42 4.2 –0.18 5 3.5 8.75 3.44 0.44 3.85 0 10 3 7.5 3.46 0.46 3.45 0.14 15 2.5 6.25 3.48 0.48 3 0.23 20 2 5 3.50 0.50 2.5 0.27 25 1.5 3.75 3.52 0.52 1.95 0.27 30 1 2.5 3.54 0.54 1.35 0.23 35 0.5 1.25 3.56 0.56 0.7 0.14 40

Alex Kane 11 IPCOR421 Finance

Choice of scale

• The optimal scale is 3.75 million units (investment=$1.5) • This scale maximizes NPV • Why can the rate of return be misleading?

– because it is an average, not incremental – each increase in scale is a project unto itself – The excel file computes the incremental return from increased scale – It shows the incremental return on increasing scale from 1.5 to 2 mil units is 10%, which is why the NPV does not change

**• NPV is the one and only correct measure of project value
**

Alex Kane 12 IPCOR421 Finance

**The transformation curve of the Project (subtext for Fig.2.1 in text)
**

Operating income from investment slope of tangent equals 1+h (the incremental rate h<h*)

Notes

(1) h is the rate of return on the incremental project. (2) notice the difference between the incremental (marginal) h and average h*. (3) The curve shows a decreasing incremental rate, h. (4) The incremental rate may even turn negative.

project Income = I(1+h*)

**slope=1+h* h*=average h Invested in financial markets Invested in project
**

13

R=5

Resources and Investments

IPCOR421 Finance

Alex Kane

**How the market rate is determined
**

• Suppose at any one time we take all the projects of the same risk characteristics and order them from high to low expected rate of return • We can now measure the rate of return against the amount of investment in the economy (at that level of risk) • Supply of capital determines the aggregate level of investment • As in the market for goods/services, projects of other level of risk compete with these projects, so supply is affected by the quality of projects of other risk classes

Alex Kane 14 IPCOR421 Finance

**Marginal efficiency of capital and the market rate
**

Rate of return supply of capital marginal efficiency of capital average rate of return in the economy

required rate

aggregate investment

Alex Kane 15

Investment

IPCOR421 Finance

**Expected annual increase in wealth
**

• Note that accepted projects (in all risk classes) earn a rate of return greater than the cost of capital, that is, generate positive NPV • The aggregate NPV of the projects is the expected increase in wealth of the economy • These numbers are all forward looking, hence we are talking about EXPECTED increase in wealth • How can we actually see this? The total market value of the business sector will increase by NPV

Alex Kane 16 IPCOR421 Finance

**Actual increase/decrease in wealth
**

• In the 1990s, forecasts of demand for high-tech products, particularly broad-band capacity, was very high. Aggregate NPV of projects was high • Huge capacity was built and the NPV reflected in NASDAQ = 5000 • In 2000, realization set in that forecasts will not be realized. Many projects were terminated (value fell to zero) revised NPV of others fell sharply • Revision in forecasts caused assets prices to fall, NASDAQ fell to about 1200!!

Alex Kane 17 IPCOR421 Finance

Maximizing profit

• You hear a lot about ‘profit maximizing’ in economics courses and on the street • Really it means maximizing NPV. Otherwise

– profit of which year? – using which accounting convention?

Alex Kane

18

IPCOR421 Finance

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