MBA Jump Start Finance Day 3

Thomas Gilbert September 21st 2012

Todays Plan
Excel is a very important tool for finance (and also for the other courses) Model building Pricing Sensitivity analysis

Today, we will cover Time value of money in Excel Simple valuation models in Excel Wrap-up the course

Finance Day 3

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On the Jump Start Website

I posted: Answers to quizzes 1-4 Day 1 and 2 slides with my Tablet notes and answers Answer to the home mortgage assignment from yesterday I will post: Day 3 slides with my Tablet notes and answers A spreadsheet with todays mini-valuation cases done Answers to quiz 5 Answers to the recommended textbook problems If you are missing something, you can always email me

Finance Day 3

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Quick Review Problem

Your company has just undertaken a new venture for a cost of $2m (all spent at t = 0). No cashflows are expected in the first two years, but starting at t = 3, you are forecasting an annual profit of $100,000 for 8 years. After that, the project will be terminated. Assuming a discount rate of 12%, was this project a good idea?

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Discount Rates, Again

What does the rt represent? The discount rate used for computing NPV should represent the best alternative use of your capital This is sometimes referred to as the hurdle rate or opportunity cost of capital In practice, the discount rate often comes from the return on an asset (bond, traded stock, etc.) with comparable risk This is called the risk-adjusted discount rate In the world of riskless payoffs, we can get the rate from U.S. Government bonds and bills (since they are considered riskless)

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1. Finance in Excel
Please download spreadsheet from course website

Discounting in Excel
Build an Excel table to calculate the PV at year 0 of each of the following cashflows and the resulting PV of the stream of cashflows for the given discount rates
Year 1 2 3 4 5 CF 50 60 100 80 150 Discount Rate 0.04 0.05 0.055 0.08 0.07 PV PV(CF) =C4/(1+D4)^B4 =C5/(1+D5)^B5 =C6/(1+D6)^B6 =C7/(1+D7)^B7 =C8/(1+D8)^B8 =SUM(E4:E8) 48.0769230769231 54.421768707483 85.1613664183823 58.8023882237163 106.94792692255 353.410373349055

Key points: Insert formulas using = Insert the formula in the top row and then drag Excel can easily handle problems with different discount rates It can also handle cashflows that are not evenly spaced
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Finance Day 3

NPV Function
What if the discount rate is constant for all years (flat term structure), say 6%? HP-12C can handle that Use the same table as before and replace all the discount rates with 6% There is a shortcut: the NPV function How do we enter a function? Go to the cell where you want the result Enter = followed by the name of the function and then ( or Go to Insert, Function, Financial, and find the one you need Enter all the parameters you need and press enter So we have: = npv(rate , cashflows)

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Thomas Gilbert

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NPV Function (2)

What is the PV at year 0 of the previous stream of cashflows with a constant discount rate of 6%? Trick with the NPV function: It actually calculates the PV of a stream of cashflows with constant discount rate, where the first cashflow is one period ahead of where you want the PV Change the discount rate to 5%. What is the PV? Change the discount rate to 10%. What is the PV? Key points: Put all the primitives at the top of your model, so that you can change them easily Use F4 to block the fixed cells before dragging (here, you need to block the discount rate)
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Finance Day 3

Project NPV in Excel

The previous stream of cashflows actually are the expected cashflows from a new venture which cost $400 today to set up What is the NPV of the project and should you invest in it?

Key point: Since the NPV function assumes that the first cashflow is one year ahead, you need to add the year 0 cashflow separately You can change the discount rate and see how the NPV changes As the discount rate decreases, the NPV increases since the PV of the future cashflows increases
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Finance Day 3

Bonds in Excel
What is the price of a 10-year Eurobond with $1,000 face value, 6% coupons, and a yield-to-maturity of 7.5%? Lets use both methods: Full PV table NPV function However, there is another shortcut for bonds: All the HP-12C functions (n, i, PV, PMT, and FV) are in Excel Functions: nper(), rate(), pv(), pmt(), and fv() For the price, we want to use pv(), where the primitives are the yield, the number of years, the coupon payment, and the face value

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Thomas Gilbert

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Bonds in Excel (2)

In Excel, it becomes easy to see what happens when you change some parameters This is called sensitivity analysis: how does the outcome change when you change the base parameters? What happens to the price when you raise the yield? What happens to the price when you decrease the yield? Hence the answer to the classic investment banking interview question: What happens to bond prices when interest rates rise? They fall!!!

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Thomas Gilbert

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Yield-to-Maturity in Excel
Lets price the following bond: Cashflow $50 $50 $50 $50 $1,050 Discount Rate 3% 4% 5.5% 8% 7% Year 1 2 3 4 5

What is the yield-to-maturity of the bond? Use the function rate()

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Break
No quiz Just a 10-minute break today

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2. Mini-Valuation Cases

Model-Building in Excel
The power of Excel for valuation is that if you have built your spreadsheet in a fully-linked way, you can easily see the impact of a change in the primitives Therefore, here are some things you should always do Put all your primitives (assumptions) at the top Build your spreadsheet so that all the formulas flow from these primitives (no manual entries of numbers half-way through) Valuation Cases: For each of the next two problems, you will work on your own or in groups (2-4 people) for 15 minutes and then one of you will present his/her results to the rest of the class

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P-pod Investment
Mr. Gonzales owns an import/export business. He is investigating whether to import a new gadget from Asia a P-pod, which can be used to watch family photos while driving. Mr. Gonzales estimates the market size for the gadget to be 10,000 units the first three years and then 50,000 for three years. After this, the gadget will be obsolete. Mr. Gonzales thinks he can price the gadget at $100 the first two years, at $75 the following two years and at $40 the final two years. There is a cost of $10 associated with selling a gadget (shipping), and Mr. Gonzales pays $25 per gadget to the manufacturer. Mr. Gonzales expects these per-gadget costs to be the same every year. Moreover, Mr. Gonzales will need to rent a warehouse at a cost of $50,000 per year. Finally, if Mr. Gonzales goes ahead, he must pay the Japanese manufacturer a one-time license fee of $3 million, to obtain the proprietary rights to sell the gadget in the US for six years. Mr. Gonzales is not sure how future cash flows should be discounted (they are uncertain), but he thinks using a discount rate of somewhere between r = 8% and r = 15% makes sense. Should Mr. Gonzales go ahead with this project?
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Introduction to Company Valuation

The price of one Google share on July 19, 2006 was $398, which implied a company market value of $120.5B (= price per share * number of shares). Google reported annual earnings of $1.5B for 2005.

a) Assume that Googles earnings will be constant in perpetuity. Which discount rate would motivate Googles current market value?

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Introduction to Company Valuation (2)

b) From a), clearly Google is expected to expand. Assume that Googles earnings will be constant for 3 years, then jump to a new, higher, rate and thereon be constant in perpetuity. Assume the correct discount rate is 12%. How much would Googles earning have to jump to motivate its current market value?

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3. Wrap-Up

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Expectations
I am attaching a final quiz (Quiz #5), which you should be able to solve on your own at the end of this workshop If you are having trouble, please get help before the start of the quarter Remember that the topics covered in this workshop will be assumed known at the start of your core finance class You will have to hand in a bond valuation case on the second day of class I advise you to look back through these notes and problems the week before the start of the quarter, in order to refresh your memory

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What We Covered
Time value of money Present values, discounting Future values, compounding Net present values Annuities and perpetuities Bonds Bond pricing Yield-to-maturity EAR vs. APR Mortgages Model-building in Excel

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Whats To Come
In the core finance class, you will learn to value much more complex projects A firm is a group of projects A key role of managers is to choose the best projects: NPV > 0 You will learn how to rank projects What makes one project better than another? What techniques do we use to account for the risk of projects? What criteria should managers use to rank projects? What criteria do investors want managers to use? Your knowledge of accounting will become important since financial information is always summarized in accounting statements

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Conclusion
Thank you for a very fun week Hopefully, you have learned a lot about finance And you are excited about learning more this quarter Do not hesitate to contact me if you have any question See you next week!!!

Always Remember Gordon Gekko : Money never sleeps pal. This is your wake-up call. Go to work.
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