Week 2 Seminar Principles of Corporate Finance Eighth Edition Chapter 2, 3, and 4 Adopted from slides by Matthew Will Copyright © 2006 by The McGraw-Hill

Week 2 Seminar

Principles of

Corporate FinanceEighth Edition

Chapter 2, 3, and 4

Adopted from slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Present and Future Value

Present Value

Value today of a future cash

flow.

Future Value

Amount to which an investment will grow after earning interest


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Discount Factors and Rates

Discount Rate

Interest rate used to compute

present values of future cash flows. Discount Factor

Present value of a $1 future payment.


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Future Values

Future Value of $100 = FV

FV r t $100 ( )1


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Future Values

FV r t $100 ( )1

Example - FV

What is the future value of $5400,000 if interest is compounded annually at a rate of 5% for one year?

000,420$)05.1(000,400$ 1 FV


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Present Value

1factordiscount =PV

PV=ValuePresent

C


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Present Value

Discount Factor = DF = PV of $1

Discount Factors can be used to compute the present value of any cash flow.

DFr t

1

1( )


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Valuing an Office Building

Step 1: Forecast cash flows

Cost of building = C0 = 400

Sale price in Year 1 = C1 = 420

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market

offer a return of 5%, then

Cost of capital = r = 5%


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Valuing an Office Building

Step 3: Discount future cash flows

Step 4: Go ahead if PV of payoff exceeds investment

400)05.1(420

)1(1 r

CPV

30370400 NPV


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Net Present Value

r

C

1C=NPV

investment required-PV=NPV

10


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Risk and Present Value

Higher risk projects require a higher rate of return

Higher required rates of return cause lower PVs

400.051

420PV

5%at $420 C of PV 1


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Risk and Present Value

400.051

420PV

5%at $420 C of PV 1

375.121

420PV

12%at $420 C of PV 1


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Risk and Net Present Value

$5,000

370,000-75,0003=NPV

investment required-PV=NPV


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Managers and Shareholder Interests

Tools to Ensure Management Pays Attention to the Value of the Firm

– Manger’s actions are subject to the scrutiny of the board of directors.

– Shirkers are likely to find they are ousted by more energetic managers.

– Financial incentives such as stock options


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Goals of The Corporation

Shareholders desire wealth maximization

Do managers maximize shareholder wealth?

Mangers have many constituencies “stakeholders”

“Agency Problems” represent the conflict of interest between management and owners


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Chapter 3

Principles of


How To Calculate Present Values

Slides by

Matthew Will


McGraw-Hill/Irwin


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Present Values

Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time

tt

t r

CCDFPV

)1(


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Present Values

Example

You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

PV 30001 08 2 572 02

( . )$2, .


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Present Values

PVs can be added together to evaluate multiple cash flows.

PV C

r

C

r

1

12

21 1( ) ( )....


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Present Values

PVs can be added together to evaluate multiple cash flows.

88.26521 )0771(200

)07.1(100

PV


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Present Values

Present Value

Year 0

100/1.07

200/1.0772

Total

= $93.46

= $172.42

= $265.88

$100

$200

Year0 1 2


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Present Values

Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%.

87.

83.

2

1

)07.1(00.1

2

)20.1(00.1

1

DF

DF


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Present Values

Example

Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

000,320000,100000,170

2Year 1Year 0Year


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Present Values

Example - continued


011,25$

249,290000,320907.2

238,95000,100952.1

000,170000,1700.10Value

Present

Flow

Cash

Factor

DiscountPeriod

205.11

05.11

TotalNPV


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Present Values

Present Value

Year 0

-170,000

-100,000/1.05

320,000/1.052

Total = NPV

-$170,000

= -$170,000

= $95,238

= $290,249

= $25,011

-$100,000

+$320,000

Year0 1 2

Example - continued



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Short Cuts

Annuity - An asset that pays a fixed sum each year for a specified number of years.

trrrC

1

11annuity of PV


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Annuity Short Cut

Example

You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?


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Annuity Short Cut

Example - continuedYou agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

10.774,12$

005.1005.

1

005.

1300Cost Lease 48

Cost


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Chapter 4

Principles of


Value of Bond and Common Stocks

Slides by

Matthew Will


McGraw-Hill/Irwin


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Valuing a Bond

Example

If today is January 2004, what is the value of the following bond?

A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.

Cash Flows

375.105375.5375.5375.5375.5375.5

10'09'08'07'06'05'


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Valuing a Bond

Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every

year for 6 years. The par value of the bond is 100 EURO. The price at a 3.8% YTM is as follows

31.108$

038.1

375.105

038.1

375.5

038.1

375.5

038.1

375.5

038.1

375.55432

PV


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Valuing a Bond

Example continued If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every

year for 6 years. The par value of the bond is 100 EURO. The price at a 2.0% YTM is as follows

90.118$

02.1

375.105

02.1

375.5

02.1

375.5

02.1

375.5

02.1

375.55432

PV


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Stocks & Stock Market

Common Stock - Ownership shares in a publicly held corporation.

Secondary Market - market in which already issued securities are traded by investors.

Dividend - Periodic cash distribution from the firm to the shareholders.

P/E Ratio - Price per share divided by earnings per share.


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Stocks & Stock Market

Book Value - Net worth of the firm according to the balance sheet.

Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors.

Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.


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Valuing Common Stocks

Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

Expected Return

rDiv P P

P1 1 0

0


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Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

15.100

1001105Return Expected


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The formula can be broken into two parts.

Dividend Yield + Capital Appreciation

Expected Return

rDiv

P

P P

P1

0

1 0

0


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Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

gP

Divr

gr

DivP

0

1

10 RatetionCapitaliza


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Return Measurements

0

1

P

Div YieldDividend

Sharey Per Book Equit

EPS

Equityon Return

ROE

ROE


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Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends.

PDiv

r

Div

r

Div P

rH H

H01

12

21 1 1

( ) ( )

...( )

H - Time horizon for your investment.


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Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?


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Example

Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

PV

PV

300

1 12

324

1 12

350 94 48

1 12

00

1 2 3

.

( . )

.

( . )

. .

( . )

$75.


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If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY.

Perpetuity PDiv

ror

EPS

r 0

1 1

Assumes all earnings are paid to shareholders.


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Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).


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Example- continued

If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends?

$100$3.

.

.

00

12

09

g

g

Answer

The market is assuming the dividend will grow at 9% per year, indefinitely.


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Chapter 2 Practice Questions

Aparcel of land costs $500,000. For an additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year. Suppose that common stocks with the same risk as this investment offer a 10 percent expected return. Would you construct the motel? Why or why not?


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Chapter 2 Practice Question Answer

NPV = $1,300,000 + ($1,500,000/1.10) = +$63,636

Since the NPV is positive, you would construct the motel.

Alternatively, we can compute r as follows:

r = ($1,500,000/$1,300,000) – 1 = 0.1539 = 15.39%

Since the rate of return is greater than the cost of capital, you would construct the motel.


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Chapter 3 Practice Question


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$23,696.151.12

$50,000

1.12

$68,000

1.12

$80,000

1.12

$92,000

1.12

$92,000

1.12

$85,000

1.12

$80,000

1.12

$75,000

1.12

$57,000

1.12

$50,000$380,000

(1.12)

CNPV

109876

5432

10

tt

t

0


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Chapter 4 Practice Question

A 6-year government bond makes annual coupon payments of 5 percent and offers a yield of 3 percent annually compounded. Suppose that one year later the bond still yields 3 percent. What return has the bondholder earned over the 12-month period?

Now suppose instead that the bond yield is 2 percent at the end of the year. What return

would the bondholder earn in this case?


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1. Purchase price for a 6-year government bond with 5 percent annual coupon:

1,108.34(1.03)

1,000

(1.03)0.03

1

0.03

150PV

66

Price one year later (yield = 3%):

1,091.59(1.03)

1,000

(1.03)0.03

1

0.03

150PV

55

Rate of return = [$50 + ($1,091.59 – $1,108.34)]/$1,108.34 = 3.00%

Price one year later (yield = 2%):

1,141.40(1.02)

1,000

(1.02)0.02

1

0.02

150PV

55

Rate of return = [$50 + ($1,141.40 – $1,108.34)]/$1,108.34 = 7.49%

Documents

Week 2 Seminar Principles of Corporate Finance Eighth Edition Chapter 2, 3, and 4 Adopted from slides by Matthew Will Copyright © 2006 by The McGraw-Hill