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Introduction to Business Finance

by: Maudie Walter

Introduction to Business Finance FINC 331

Marketplace > Radford University > Finance > FINC 331 > Introduction to Business Finance
Maudie Walter
GPA 3.67

Steven Beach

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Steven Beach
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This 39 page Class Notes was uploaded by Maudie Walter on Monday October 19, 2015. The Class Notes belongs to FINC 331 at Radford University taught by Steven Beach in Fall. Since its upload, it has received 33 views. For similar materials see /class/224671/finc-331-radford-university in Finance at Radford University.


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Date Created: 10/19/15
FINANCE 331 Business Finance CHAPTERS 4amp5 Time is Money Using a Financial Calculator The business calculator comes from the store with a couple of settings that we want to change Do this or suffer Do not mess with these settings ever again change the number of decimal places to six or more a TI BAII Plus 2nd Format 6 enter b HP10b DSP 6 Change to one compounding per period a TI BAII Plus 2nd PY 1 enter b HP10b 1 PYR For the time value of money problems we will be using ve special buttons on the calculators They are for Tl BAII Plus N lY PV PMT FV They are usually all in one row but may be a little different between calculators To give students a useful way oftackling problems with the financial calculator the calculations will be discussed using the same examples used earlier in Chapters 5amp6 Chapter4 Future Value Example The example of 1 000 invested at 5 for 8 years N8 Y5 PV1000 PMTO to do 8 N 5 W 1000 PV note that cash ows should use the same sign as figure 0 PMT CPT FV gives an answer of 1 4774554 Now change to monthly compounding n96 512 PV1000 PMTO CPT FV gives an answer of14905855 Present Value Example On calculator n5 12 PMT0 FV1000000 CPT PV gt 56742686 Solving for r l On calculator FV7986 PV60 n3 PMT0 CPT Ygt 10 easy Solving fort N On calculator 4 pv1000 pmt0 fv2000 CPT n 1767 gt 88365 years Chapter 5 Multiple Cash Flows PV 425089 503189 559673 401139 226176 2115266 Annuities PV of annuity Example On calculator N20 9 PMT200000 FV0 CPT PV gt182570913 PV of annuity due Example On calculator set the payment mode to BEGIN CPT PVgt 199002296 FV of annuity Example On calculator N60 712 PV0 PMT100 CPT FV gt 715929 FV of annuity due Example On calculator set the payment mode to BEGIN CPT FV gt 720105 Implying FVA 715929 1058333 720105 Amortized Loan Payment Example On calculator n360 625 PV200000 FV0 CPT PMT gt139843 Amortized Loan PV Example Bank says that we can only afford 850 in monthly payments How much ofa home can we afford On calculator PMT850 CPT PV gt 12156498 How much left to pay after 120 of 360 payments made Just set n 240 the number of periods remaining and calculate the present value PV 10551231 Number of Payments for an Annuity Example Set to END 1212 PV 1062169 PMT 500 FV 0 CPT n gt 24 mos 24 payments Interest or Discount Rate Set to END N 10 PV 0 PMT 300 FV 501660 CPT gt 10998 11 FINC 331 Business Finance CHAPTER 12 The Cost of Capital In the preceding chapters the discount rate has been treated as a given We have seen how important this rate is in making investment decisions In this chapter we learn how to obtain an appropriate discount rate Weighted Average Cost of Capital WACC The discount rate to use for evaluating an average risk pro39ect of a firm is the weighted average cost of capital of the firm When a firm raises additional money to finance a project it does so in the capital market where investors expect to receive at least their required rate of return This market established required return on this firm s securities is the cost of raising those funds for the firm As a result the weighted average cost of capital is the weighted average of the aftertax component costs of capital The relevant cost for all securities is the aftertax cost In the case of debt this fact is important because the tax effect appears in the calculation Since interest payments are taxdeductible paid before taxes then the firm gets a tax advantage from issuing debt instead of other securities Weighted Average Cost of Capital WACC DV 1t RD EV RE wD 1tRD wE RE where D the value of debt used by the rm E the value of equity used by the rm V DE the value of the rm wD DV the weight or proportion of debt used in nancing the firm wE EN the weight or proportion of equity used in nancing the firm RD the cost of debt RE the cost of equity retained earnings or RE the cost of equity newly issued stock Including use of preferred stock financing WACC DV 1t RD EV RE PV Rp wD 1tRD wE RE wP Rp where V DEP the value of the firm Wp PV the weight proportion of preferred equity used in financing Rp the cost of preferred stock equity Note that we will use marketvalued not bookvalued weightings and market not historical costs Furthermore the historical weighting is not used instead the target weightings of the firm will be used So for instance if the firm is raising 1000000 in capital it is assumed the new capital is raised at the target weights Bonds 500000 at a cost of 949 Retained cash representing the cost of existing equity 300000 at cost of 1269 Preferred stock 200000 at a cost of 101 Tax rate 40 gt WACC Note that we used the cost of retained earnings as the RE The impact of the tax deduction for debt financing RD 949 RDAT 5694 The Cost of Debt Before considering the flotation costs of issuing debt we can assert that the cost of debt financing is the return that investors require from buying the bonds The cost of debt for a bond RD YTM The YTM can be estimated from the YTM on similar bonds In particular the outstanding bonds issued by this firm likely offer the best bonds for the purpose of estimating the cost of the new debt Aftertax cost of debt RDAT 1t RD Since interest payments are taxdeductible paid before taxes then the firm gets a tax advantage from issuing debt Example Your firm has some semiannual payment bonds outstanding that have a market price of 104533 a coupon rate of 10 per year and 20 years to maturity On an issue of similar bonds 10 annual coupon rate with a 30year maturity the market value is estimated to be 105041 The Cost of Preferred Stock In the absence of financing costs the cost of preferred stock capital is the required return of investors in the market P0DpRp gt RpDpPo Example Your firm has some preferred stock that pays a 5 per year dividend and has a current market price of 4950 per share The cost of preferred stock is estimated to be The Cost of Equity Two methods we ll examine 1 SML CAPM 2 Discounted Cash Flow CAPM R R 3 Market Risk Premium Ri Rf Bi ERM Rf Note that our sources can give different 3 estimates In addition the estimate of the market risk premium can vary from source to source Let us assume we are using but one 3 estimate Using an estimate of the market premium RM R 66 RE DCF Approach P0D1REQ gtRED1Po9 We may choose to estimate the growth rate with the historical growth rate in the dividends Dnew Dold 1 gn n For example if the most recent dividend were 1 15 for the year and 5 years ago the annual dividend was 100 we have a growth rate of Then with a P0 12 the cost of retained earnings is Assume investors are not expected to pay a full 12 per share for a new issue of stock but the expected average price if new stock is issued will be 1176 The cost of new stock is WACC for this company 1 If Retained Earnings used this is the example at the start of the lecture forthis chapter 2 If an issue of new equity is needed Weighted Marginal Cost of Capital not in text If capital can be raised using retained earnings only up to the 300000 of retained cash we can identify the 1000000 level of capital budget as a break point in the Investment Opportunity Schedule Assume that only 600000 of bond capital can be raised before its aftertax and after flotation cost rises to 7 The cost of capital above 1200000 will be So if the firm has three projects under consideration as follows Invest IRR A 600000 12 800000 10 C 300000 9 on Then the company would have a capital budget of 1 400000 CHAPTER 3 Working with Financial Statements From a rm s nancial statements some important measures of rm performance can be calculated These measures are known as nancial ratios Ratio analysis is useful in two ways 1 Crosssectional gt 2 Trend analysis gt FINANCIAL RATIOS ETC Li uidit or Shortterm Solvenc Net Working Capital C Assets C Liabilities Working Capital C Assets Current Ratio Current Assets Current Liabilities Quick or AcidTest Ratio Current AssetsInventory Current Liabilities Cash Ratio Cash Current Liabilities LonqTerm Solvencv Ratios or Debt Ratios Debt Ratio Total Debt Total Assets Total Assets Total Equity Total Debt Total Equity vs LongTerm Debt Ratio Longterm debt Longterm Debt Total Equity DebttoEquity Total Debt Total Equity or LT Debt Total Equity Equity Multiplier Total Assets Total Equity TA TEq TD TEq Eq 1 TDTEq Times Interest Earned EBIT Interest Expense Cash Coverage EBIT Depreciation Interest Expense EBDIT Interest Expense Asset Utilization Ratios Inventory Turnover COGS Inventory Days Sales in Inventory 365 Inventory Turnover Receivables Turnover Sales Accounts Receivable Days Sales in Receivables 365 Receivables Turnover Fixed Asset Turnover Sales Net Fixed Assets Total Asset Turnover Sales Total Assets Capital Intensity Total Assets Sales Pro tability Ratios Operating Profit Margin Operating Income Sales Net Profit Margin Net Income AT Sales Return on Assets ROA Net Income AT Total Assets Return on Equity ROE Net Income AT Total Equity Earnings Per Share EPS Net Income Shares Outstanding Price to Earnings Ratio PE Ratio Price per share EPS One way ratios can be utilized to provide important information is through DuPont Analysis ROI ROA Net Pro t Margin gtlt TA TO Net lncomegAT gtlt Sales TA Sales NIlAT TA Which can be too low if Net Income is low Total Assets are too high Net Pro t Margin is low or Total Asset Turnover is low ROE ROA gtlt Equity Multiplier NIAT X E TA TEq NetlncomeAT gtlt Sales X E Sales TA TEq NIAT Eq Where the Equity Multiplier is equal to 1 DebtEquity Financial Leverage the proportion of debt in the rm s capital structure Total Debt Total Assets EFFECTS OF FINANCIAL LEVERAGE gt Also note the increased risk Thus Increased leverage gt increased required return FINC 331 Business Finance CHAPTERS 4 amp 5 Part 1 Time is Money Importance of Time Value of Money The tools ofthese chapters help us to answer questions like 1 How much should we spend on an advertising campaign today if it will increase sales by 5 in the future 2 Is it worth buying a new computerized lathe for 120000 if it reduces material waste by 15 3 Which strategy should we employ given their respective costs and estimated contributions to future earnings 4 How much do I need to save each month in order to have enough for a down payment on a house The Time Value of Money A friend wants to borrow 100 How much should you charge himher for renting your money for a year The bank pays you 5 interest per year Remember from the Introduction that higher risk should be rewarded with higher return There is more risk that your friend won t pay than the bank won t pay 80 you and your friend agree to a 10 interest rate Time line Loan 100 at 10 compounded annually gt Now consider that your friend wants to pay you back after 2 years instead of 1 General form r interest rate or discount rate per period t number of periods Example 1000 deposited into a 5 compounded annual savings acct on my 10th birthday Today is my 18th birthday How much is in the account FVB Compounding The previous example assumes that the bank pays the interest into the account at the end of each year We call this compounding annually Some loans are structured to compound more often EX bonds pay semiannually car loans pay monthly To compound more often than annually we must adjust the tand the rof our equation t must be the number of periods r must be the rate per period annual rate periods per year From example above What if bank compounds monthly Then t r Answer is FVge Note that compounding more often creates more money Present Value The earlier equation was FVt PV 1 r t solving for PV gives Notice that the PV and FV calculations are the inverse of each other Example You inherit 1 million But the money is to be held in trust for 5 year before you can get your hands on it To get money now you visit a bank It will lend you money at 12 interest How much money can you borrow so that you will owe that bank exactly 1 million in 5 years PV Note that this is considerably smaller than 1 million bucks Calculating present value is often called discounting the present value is smaller and the interest rate is called the discount rate Solving for interest rate and number of periods In some cases we know the present and future cash flows but we don t know either the interest rate or the number of periods We can solve the PVFV equation for these variables r FVtPV 1 and t W l ln1r Now we are starting to see the usefulness ofthe nancial calculator Solving for r example 3 yrs ago I bought a stock for 60 and now is worth 7986 What is the annual return I received what is the implicit discount rate On the tables Find FVIF 1331 for t 3 gt 10 In the parenthesis you find 1 holding period return The investment provided total return of Con rm this Evaluating Investments What if you could have invested the money in a similar stock that provided a 12 return Usually the investment that we are considering should be examined by comparison to the alternative investment recall that higher returns on alternative investments will reduce the value ofthe current investment Find the PV In other words the 60 investment I bought was truly only worth 5684 at that time lfl had bought it at 5684 and its price now were 7986 then I would have obtained a 12 return Chapter 10 Some Lessons Return mainly Risk 7 chance of loss Risk 7 variability variance of returns Percentage Returns Total Return 7 P 11 Pt CH1 P t Error Bookmark not de ned Rm 2 Pt Price of asset at time t C 1 Cash ow from asset over time tto time t1 Can use this expression for any asset Bonds Stocks Land Video Machine For Stock R PtlPtDthl t1 Pt Div 1 Dividend over time tto time t1 0A 203 60 O gt u Total Return A R 11 B Rt1 Actual Return 7 if these prices and dividends existed Realized Return 7 if investor bought and sold at given prices Total Return capital gain yield dividend yield Total Return ki P Pt A Rt 2 B Rt 2 D note connectlon to RF1 g 0 Return 7 Total Return Dividend Yield Dividend Growth Rate Chap 8 R D1 P0 g Now Rt Dm Pt PM Pt Pt Example R0 D1 P0 P1 7 P0 P0 Total Return Dividend Yield Capital Gains Yield Historical Returns and Risk Premiums Risk Premium 7 additional required return for taking additional risk RPiRiRf Market Ef ciency 7 Expected Return Required Return FINC 331 Business Finance Chapter 2 Financial Statements Taxes and Cash Flow Basic Financial Statements use US Corporation in textbook Assets Liabilities Equity 1 Balance Sheet BS These two sides must equalll Assets Current Fixed Liabilities Current Longterm Net working capital Current assets current liabilities Should be gt 0 what we will receive in cash in one year or less should be more than what we owe in one year or less gt Liquidity the ability to sell an asset without loss in value Thus net working capital is a way of noting the liquidity of a rm Shareholder Equity Assets Liabilities What is the Equity Account Equity at par value 500000 shares 150 per share Paid in Capital equity in excess of par Retained Earnings par value an arbitrary value assigned to shares of stock for accounting purposes retained earnings is not cash accumulated Net Income that is not paid out as dividends What price did the stock sell for This is all put on the books according to GAAP using historical costs Thus on the books tells us about the past Finance is interested in today and the future gt Market value tells us what the firm is worth today Financial managers focus on market values not book values 2 Income Statement IS Summary Revenues Expenses Net Income or Earnings GAAP matches expenses to revenues accrued in a particular period This can be very different from the cash received from sales less cash paid out for costs of producing those sales Main reason accounting income and net cash ow differ are noncash items primarily depreciation 3 Statement of Retained Earnings SRE not in text Reconciles a Net Income Nl b Dividends Paid Div c Change in Retained Earnings RE ARE Example RE t0 RE 2005 BS Nl to gt t1 NI 2006 IS Div to gt t1 Div 2006 IS RE t 1 RE 2006 BS In other words ARE RE t1 RE to Range of Taxable Business Taxa Marginal Tax Rate tion Corporate Tax Rate Base Tax Schedule Total Tax Income marginal tax in range 0 50000 15 0 15 X Income gtlt 50000 7500 50000 75000 25 7500 7500 X 25000 6250 25 X Income gt 50000 75000 100000 34 X 25000 8500 75006250 13750 13750 34 X Income gt 75000 1ooooo335ooo 39 137508500 22250 X 235000 91650 22250 39 X Income gt 100000 335000 34 2225091650 34 X Income 10 Million gtlt 9665000 113900 3286100 10 Million 35 113900 34 million 15 Million gtlt 5000000 3286100 34m 35 X Income gt 10 m 1750000 15 Million 38 3400000 1750000 515 million 18333333 gtlt 3333333 5150000 38 X Income gt 15 m 1266667 Above 18333333 35 5150000 1266667 6416667 6416667 35 X Income gt 18333333 Finance FIN 331 Business Finance Finance is the art and science of managing money Four major areas in finance Corporate Finance managing the firm 2 Investments 3 Financial Institutions or Markets and Institutionsquot 4 International Finance The first three areas are closely related People working in any one of the areas must also have a good understanding of the other two International finance is a specialization within the other three areas Contrasts with ECON Goal Marginal Benefit gt Profit Finance asks Profit per what Unit of Risk Unit of Time Risk In finance we ll assume RISK AVERSION Time Rich uncle dies today gives you a choice Egt Time value of money for some value in 20 years you will be indifferent ACCT Goal Accrual gt Profit Finance asks What can owners get Not Sales Expenses Net Profit Examine Net Cash Flows available to owners of firm Why 1 Firm can only pay bills with cash 2 Can only pay owners ofthe rm with cash dividends to shareholders FINANCE Goal Shareholder Wealth Maximization SWM How Note Stock value is based on expected future performance No Really HOW does the rm maximize shareholder wealth Managers should invest in projects with a value greater than the capital used to nance the project ie Net Present Value NPV gt0 VALUE is determined by 4 factors FACTOR Value of Pro39ect to Firm 1 Expected Cash Flow SIZE 2 TIMING of Cash Flow 3 RISK of Cash Flow 4 Returns available on alternative investments Why SWM 1 Ethics a Shareholders are owners Managers work for them b Achieves many social goals i Maximize welfare of society efficient allocation of resources ii Ethical conduct benefits stock price 2 Consistent across firms gt eases monitoring by investors SWM is unique to CORPORATE FINANCE Unique concerns not relevant in sole proprietorships partnerships Why Managers who run the firm do not own the firmthey are agents of the owners of the firm Stockholders A share of stock is a portion share of ownership in the firm All the billsdebts must be paid first the residual cash can go to the shareholders Then Dividends can be paid r Shareholders get cash from liquidation of firm in bankruptcy or acquisition Separation of ownership and management results in 1 Information Asymmetry 2 Agency Problem manager puts personal goals ahead of corporate goals 1 Excessive Perks 2 Empire Building Bigger companies pay higher salaries 3 Shirking not working to full capabilities The Agency Problem does not exist if managers own the firm completely Addressing the Agency Problem 1 Agency Costs costs of ensuring that managers follow SWM principle 2 ways to encourage SWM a lncentive plans stocks stock options b Performance plans 2 Market forces Hostile takeover Outsiders not chosen by managers buy controlling shares of the company 50 Often 1 Sell poorly managed divisions 2 Fire certain managers to reduce agency costs FINC 331 Business Finance Chapters 8 and 9 Capital Budgeting and Net Present Value Capital Budgeting the process of evaluating and selecting longterm investments consistent with the firm s goal of shareholder wealth maximization Proposal Generation Marketing New products to develop new markets to enter Production Applying new technology replacing old equipment Management Diversifying the rm s projects Restructuring the firm It is the job of the nance management to evaluate the proposals Review Is it appropriate for this company Is it economically feasible The Valuation Process Evaluate investment opportunities based on Initial Cost Initial Investment Expected Cash ows Required rate of return based on risk ofthe investment PV Cash Flows Net Present Value PVOperating Cash Flows Initial Investment U39PFDNT Remember that calculation of Present Value considers a Size of CFs Expected CFs b Timing of CFs 0 Required Return R Decisionmaking Ultimate decision is by Top Management EXAMPLE1 GM and the Saturn experiment EXAMPLE2 Microsoft and Windows NT and V ndows95 Project Selection The Decision is Among Independent Projects Mutualy Exclusive Projects that require an eitheror decision Independent All cash ows for analysis are independent from other projects Estimating Project Cash Flows Incremental Cash Flows The Stand Alone Principle Expansion projects Replacement projects Some points to remember about Incremental Cash Flows 1 Ignore sunk costs 2 Consider opportunity costs 3 Side Effects consider incidental effects like erosion 4 Net Working Capital changes 5 Financing Costs are dealt with elsewhere 6 Taxation and Depreciation 7 Shipping and Installation 8 Inflation 9 Allocated costs rarely change as a result of a project Why are these points important Net Present Value criteria is established A reliable decision tool Net Present Value Net Present Value Present value of future cash flows Initial investment NPV calculates the dollar amount that the project is worth if accepted Total Project Cash Flow Operating CFs Change in NWC Capital Spending Capital Spending Operating CFs Change in NWC Initial Investment Operating CFs Terminal CF Operating Cash Flows Consider 1 Cash revenue 2 Cash expenses 3 Taxes Do not consider 1 Interest or other capital costs 2 Depreciation except to calculate taxes Net Operating Cash Flow EBIT Taxes Depreciation Which are the relevant Incremental Operating CFs Net Operating Cash Flow Net Income Depreciation Interest Expense Net Working Capital Net Working Capital Current Assets Current Liabilities Net Working Capital needs on a yearly basis Textbook style example 10 of sales 0 1 2 3 4 Sales 150000 150000 200000 250000 NWC 10000 15000 15000 20000 25000 lnit NWC 10000 Increase NWC 10000 5000 0 5000 5000 Recover NWC 25000 Change NWC CF 10000 5000 0 5000 20000 Cumulative Change 10000 15000 15000 20000 0 What if sales in year 4 were predicted to be 150000 0 1 2 3 4 Sales 150000 150000 200000 150000 NWC 10000 15000 15000 20000 15000 lnit NWC 10000 Increase NWC 10000 5000 0 5000 5000 Recover NWC 15000 Change NWC CF 10000 5000 0 5000 20000 Cumulative Change 10000 15000 15000 20000 0 Capital Spending this summarizes the initial outlay initial investment and the cash ow from ending the project terminal cash ow except putting NWC into Init Invest and TCF In this part ofthe analysis it is particularly important to keep track of Depreciation and its Tax Effects MACRS depreciation schedule Table 97 a Initial Investment 1 Project cost cash out ow including installation 2 Change in net working capital needs cash outflow or in ow 3 Sale of existing assets if this is a replacement project A The sale creates a cash in ow B Tax effect ifdifferent than salvage value in or outflow b Project Termination 1 Income from sale of project assets 2 Tax effect of sale 3 Recovery of net working capital Net Present Value NPV the value added to the rm from accepting a project NPV Present value of future cash ows Initial investment CF NPV Z tt II 1 R Internal Rate of Return IRR oz 1IRR n F Z C I 11 1IRRZ I21 Decision criteria for independent projects with conventional cash ow stream Let R be the Required Return NPV gt O IRR gt R gt Accept project NPV O IRR R gt Indifferent NPV lt O IRR lt R gt Reject project Capital Budgeting Example Typical Cash Flow Components 1 Initial Investment II Net cash out ow at t0 2 Operating Cash In ows Incremental AfterTax Operating Cash In ows from the project 3 Terminal Cash Flow Aftertax nonoperating cash ow associated with ending the project On a time line II CF1 CFz CF3 CFn Terminal CF I I I I I I I 0 n 1 Initial Investment Example Price of New Asset Installation Costs Proceeds from Sale of Old Asset Tax Liability from Sale of Old Asset Change in Net Working Capital Initial Investment Tax Liability from Sale of Old Asset Selling Price of old Asset 7 Book Value of Old Asset Taxable Amount Taxable Amount gtlt Tax Rate Tax Liability Old Asset Installed Cost 40000 Depreciation 5year MACRS Age at Sale 3 years 2 Operating Cash In ows A Estimate the AfterTax Cash In ows with ProForma Income Statement amp Statement of Cash Flows B Calculate Incremental Cash Flow each year by CF accept 7 CF reject Example 30000 per year 3 Terminal Cash Flow Example Proceeds from Sale of New Asset Tax Liability from Sale of Asset Recove of Net Working Capital Terminal Cash Flow Tax Liability from Sale of New Asset New Asset Installed Cost 120000 Depreciation 5year MACRS Age at Sale 5 years Est Sale Price 20000 These calculations assume that the replaced old project is 1 Fully Depreciated at t0 2 Sold at t0 COMPARING IRR AND NPV When evaluating mutually exclusive projects our decision criteria does not appear to be as clear as for the situation in which one considers independent projects If you rank projects with NPV gt0 by 1 NPV and 2 IRR the ranking is not always the same What causes the differences WHY 1 SIZE DIFFERENCES Differences in Initial Investment 2 TIMING DIFFERENCES Timing of CFs What is the cause IRR discounts all cash flows at the IRR gt NPV discounts all cash flows at the required rate of return gt NPV is more conservative and more realistic Three reasons to use NPV over IRR 1 Reinvestment rate assumption 2 Value creation 3 Multiple IRRs Corporate Capital Budget Value additivity the value of the firm is the aggregation summation of the value of the individual investments of the firm SCENARIO AND OTHER WHATIF ANALYSES A Scenario Analysis Best Case Base Case Worst Case B Sensitivity Analysis Focus on Finding Important Variable C Monte Carlo Simulation Iterative Process Employing Probability Distributions CORPORATE RISK Can a rm reduce its risk by diversifying operations The concept of diversi cation in investments to lower market risk does not apply to rms as it does to security investments Why not a Firms will have lower risk in projects connected to products and geographic locations in which they are more familiar b Investment diversi cation for rms is costlier than for stock portfolios Firms occasionally violate the NPV criterion by instituting capital rationing Capital rationing a rm sets a maximum capital budget for a period ie it will make less than some established level of investment EXAMPLE Assume a firm sets its maximum capital budget for the year at 80000 It has 5 investment opportunities as given Invest NPV Rank by NPV A 30000 1 000 B 25000 1 200 C 35000 2500 D 20000 2000 E 35000 1 500 Under capital rationing we will accept However without the constraint we accept ALTERNATIVE METHODS Average Accounting Return not covered Profitability lndex not covered Payback Rule A weak alternative to NPV and IRR analysis Payback period number ofyears to recoup initial investment Criteria Take projects with shorter payback Example or What is Wrong with Payback Period Project A Project B t Cash Flow CUM CFs t Cash Flow CUM CFs 0 50000 0 50000 1 10000 1 50000 2 30000 2 0 3 20000 3 0 4 1000000 4 0 It is a naive analysis which ignores timing size of CFs and cost of capital Managerial Options the opportunities to modify a project after it is accepted Managerial options have a positive value and they are often considered in advance of accepting a project through contingency planning The option to expand a pro table project The option to abandon a losing project The option to wait until you have more information or the economy improves All of these options have value but are often not included in traditional discounted cash flow analysis FINC 331 Business Finance CHAPTER 7 Equity Markets and Stock Valuation How the time value equations can be used for the valuation of securities Preferred stock Zero Growth A share of preferred stock is a perpetuity They pay a stated dividend every year forever They fall in priority between bonds and common stock for bankruptcy purposes No dividends can be paid to common stockholders until all preferred dividends have been paid Example Assume a preferred stock with yearly dividend of10 Assume a real rate of 3 and an in ation expectation of 3 and the risk premium is 25 what is the market price for a share of this stock Common Stock A Growing Perpetuitv Common Stock dividends are equally spaced through time and continue indefinitely thus it acts like a perpetuity On the other hand the dividend may be changed unlike a perpetuity In general dividends grow over time thus it can be referred to as a growing perpetuity One ofthe most signi cant constructs in nance is the idea that the value ofa share of common stock is the expected future dividends discounted back to the present at the appropriate required rate of return An efficient market will price all stocks in this way Dividend Growth Model The Gordon Growth Model This model assumes constant growth ofthe dividend g does not change Rgtg is assumed Example A stock just paid 200 annual dividend dividends are expected to grow at 2 per year inde nitely the required rate of return is 8 on this stock what is the current price Components in Reguired Return Rearranging the Dividend Growth Model gives us a useful look at the items that make up the return investors receive P0D1Rg gt R D1Po g Total Return Dividend yield capital gains yield The total return is a combination ofthe return investors get from the dividend cash ows and the rate at which the value ofthe investment grows capital gains yield Nonconstant Growth Model Usually this approach applies to high growth companies and industries ie high tech stocks in the recent past Thus applied to situation in which the rm has an initial period of abnormally high growth followed by an indefinite normal growth period Thus our formula merely applies our time value of money concepts Example A tech stock has an initial growth rate of 25 per year and will sustain this rate for 4 years After the initial 4 years the rm is expected to grow at 9 per year Last year the rm paid a 050 dividend What should this stock sell for right now if the discount rate is 17


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