FNCE 604 - Accelerated Corporate Finance: Alex Edmans

FNCE 604 Accelerated Corporate Finance
Alex Edmans
The Wharton School
Summer 2013
Alex Edmans FNCE 604 Summer 2013 1
Introduction
Acknowledgements
A signicant amount of this material is taken from lecture notes by
Professor Simon Gervais, who taught this course for many years at
Wharton. I am extremely grateful to Simon for allowing me to use his
notes.
I also thank present and past teaching assistants Lucia Bonilla, Nacer
Bouhitem, Michael Graham, Adeel Ikram, Michelle Khundakar, Jon
Mensing, Ryan Peters, Jonathan Vogan, and Austin Zalkin for valued
input, and Indraneel Chakraborty and James Park for their help in
typesetting this packet.
Introduction
0. Introduction
Introduction
0. Introduction
Readings: Brealey, Myers and Allen, Chapter 1
This section will be especially relevant for:
FNCE 726: Advanced Corporate Finance.
FNCE 731: International Corporate Finance
Introduction
The Finance Function and the Financial Manager
Broadly stated, the nance function is concerned with the ow of
funds between the capital markets and the rms operations
These ows include: (1) issues of securities to raise cash; (2)
purchases of real assets used in the rms operations; (3) cash inows
generated by the real assets; this cash is either (4a) reinvested in the
rm or (4b) returned to the rms investors.
The nancial manager therefore faces two main tasks:
Investment decisions (allocating funds to investments)
Financing decisions (choosing what instruments to issue to raise funds)
Introduction
The Objective of the Financial Manager
Although many claimholders have a stake in the rms income, the
shareholders are the owners, and managers should act in their interest
We will see that shareholders are made better o by any decision
which increases the value of their stake in the rm. Therefore,
managers should act to maximize the value of the rms shares.
This is more complex than prot maximization and requires an
understanding of how nancial assets are valued.
Several institutional arrangements exist to ensure that managers will
indeed follow this objective:
Stock and option compensation
Reputation in managerial labor markets
Hostile takeovers
Boards
Introduction
Objective of this Course
The course is intended to provide a framework for analyzing the
investment and nancing decisions made by corporations.
Since such a framework requires an understanding of the
determinants of value, the course provides an introduction to the
concepts underlying both corporate nance and asset pricing.
Introduction
Checkpoint: BMA - Sections 1-3 and 1-4
Material relevant to this section:
BMA: chapter 1
Problem set: 1, 2, 4
Bulk pack problem set: none
What is next?
BMA: chapter 2 and section 3-5
Look at the Math/Stat reminder in Additional Materials; this will
be useful for the problem sets
Investment Decisions
I. Investment Decisions
Investment Decisions
I. Investment Decisions
Investment Decisions Compounding and Discounting
I.1 Compounding and Discounting
I.1.1 Constant Interest Rate
I.1.1 Constant Interest Rate
Readings:
BMA chapter 2 and section 3-5
FNCE 725: Fixed Income Securities.
FNCE 728: Corporate Valuation.
Motivation
At the most general level, an investment is a claim to a stream of
cash ows.
This denition encompasses both real and nancial investments.
In order to choose between alternative investments, we must therefore
nd a way to compare cash ows diering in size, timing, and risk.
We will at rst ignore risk and compare certain cash ows.
The techniques of compounding and discounting allow us to compare
cash ows diering in size and timing.
Compounding and Future Value
Suppose that you invest $C in a bank account paying r %, and that
interest is credited once a year.
Money in the account after one year:
Investment: $C
Interest (C r %): $Cr
Total: $C(1 +r )
Money in the account after two years:
Investment: $C(1 +r )
Interest (C r %): $C(1 +r )r (> $Cr )
Total: $C(1 +r )
2
= $C(1 +r )(1 +r )
Continuing this reasoning, you have $C(1 +r )
T
after T years
$C(1 +r )
T
is the future value in T years of $C at r % compounded
annually. The quantity
CF
T
= (1 +r )
T
is called the T-period compounding factor.
More Frequent Compounding (Numerical Example)
Suppose that you invest $100 in a bank account paying an interest
rate of 10%, and that interest is credited twice a year.
Every six months, your account will generate
10%
2
= 5% interest.
Money in the account after 6 months:
Investment: $100.00
Interest (100
10%
2
): $5.00
Total: $105.00 = $100(1.05)
Money in the account after one year (12 months):
Investment: $105.00
Interest (105
10%
2
): $5.25 (> $5.00)
Total: $110.25 = $100(1.05)
2
Does it make sense that you get more than $110.00?
You can continue this reasoning to show that youll have
$100(1.05)
2T
after T years (i.e. 2T periods of six months)
More Frequent Compounding
More generally, suppose that you invest $C in a bank account paying
an interest rate of r , and that interest is credited to your account
twice a year.
You can then show that you will have $C(1 +
r
2
) after 6 months,
$C(1 +
r
2
)
2
after a year, ..., $C(1 +
r
2
)
2T
after T years.
$C(1 +
r
2
)
2T
is the future value in T years of $C at the annual rate r
compounded semiannually (i.e. two times a year)
Even more generally, the future value in T years of $C at the annual
rate r compounded m times a year is
FV
T
= C
_
1 +
r
m
_
mT
and the T-year compounding factor is
CF
T
=
_
1 +
r
m
_
mT
The Eect of More Frequent Compounding
The following table shows the value after T years of $100 invested at
the rate of 10%, compounded m times a year.
T
m 1 5 10 30
1 110.00 161.05 259.37 1,744.94
2 110.25 162.89 265.33 1,867.92
4 110.38 163.83 268.51 1,935.81
12 110.47 164.53 270.70 1,983.74
365 110.51 164.86 271.79 2,007.73
Notice that more frequent compounding (as you go down each
column) means a higher eective annual rate. How far can we push
the benets of more and more frequent compounding?
The Eect of More Frequent Compounding (contd)
A standard result from algebra states that
lim
m
C
_
1 +
r
m
_
mT
= Ce
rT
,
where e 2.718 is the base for natural logarithms.
We express this result by saying that the future value in T years of
$C invested at an interest rate of r continuously compounded is
FV = Ce
rT
Important note: In this course (and all nance courses that you will
take here), log always means the natural logarithm ln.
Eective Annual Rate (Numerical Example)
Suppose that you invest $100 at an annual rate of 10% compounded
semi-annually.
From slide 16, you get $100(1 +
10%
2
)
2
= $110.25 after one year.
Question: What is the interest rate r (compounded annually) that
would generate the same amount after one year?
We need to solve
100(1 +r ) = 110.25 =r = 10.25%.
So the future value of $100 invested at an annual rate of 10%
compounded semi-annually is the same as the future value of $100
invested at an annual rate of 10.25% compounded annually.
This 10.25% is called the eective annual rate or the equivalent
annual rate (EAR).
The 10% is called the annual percentage rate (APR) or the annual
rate. It tells you how much interest is paid each year but not how
frequently the interest is paid. Therefore, it is an incomplete picture
Eective Annual Rate
More generally, suppose that you invest $C at an APR of r
compounded m times a year.
From slide 17, you will have $C(1 +
r
m
)
m
after one year.
The EAR r corresponding to an APR r compounded m times a year
satises
1 +r =
_
1 +
r
m
_
m
Similarly, the EAR r corresponding to an APR r continuously
compounded satises
1 +r = e
r
Notice that r = r if r is compounded annually (m = 1).
In what follows, unless otherwise specied, we will always assume that
APRs are compounded annually, i.e. are also EARs.
Eective Annual Rate: Example
Eective Annual Rate: Example (contd)
Why do these certicates of deposits (CDs) seem to oer two
dierent interest rates?
The small print says that the interest rate (APR) is a daily
compounded rate. This means that $1 invested in these CDs will
grow to
CF
1
=
_
1 +
0.065
365
_
365
= 1.0672
after one year
What they call the annual percentage yield is simply the eective
annual rate r , which can be found as follows:
1 +r = 1.0672 =r = 6.72%.
Eective Monthly (Weekly, Daily, etc.) Rate
Just as we can compute the eective annual rate, we can compute
the eective rate over a month (or a week, or a day).
The eective monthly rate r
M
corresponding to an annual interest
rate r compounded m times a year satises
(1 +r
M
)
12
=
_
1 +
r
m
_
m
= r
M
=
_
1 +
r
m
_
m
12
1
In particular, if r is compounded annually (m = 1), then
r
M
= (1 +r )
1/12
1 =
12
_
1 +r 1.
If r is compounded monthly (m = 12), then r
M
=
r
12
.
Similarly, the eective weekly rate r
W
satises
(1 +r
W
)
52
=
_
1 +
r
m
_
m
= r
W
=
_
1 +
r
m
_
m
52
1
A Source of Confusion
People can get confused about the link between the following rates:
Annual percentage rate r compounded monthly vs. monthly rate r
M
:
CF
1
=
_
1 +
r
12
_
12
= (1 +r
M
)
12
.
Annual percentage rate r compounded weekly vs. weekly rate r
W
:
CF
1
=
_
1 +
r
52
_
52
= (1 +r
W
)
52
.
Annual percentage rate r compounded daily vs. daily rate r
D
:
CF
1
=
_
1 +
r
365
_
365
= (1 +r
D
)
365
.
To practice, check the following are equivalent to a 10% EAR:
9.5690% compounded monthly, or a monthly rate of 0.7974%;
9.5398% compounded weekly, or a weekly rate of 0.1835%;
9.5323% compounded daily, or a daily rate of 0.0261%.
On Canvas I have posted a rate calculator, RateEquiv.xls, to help
convert between rates
Compounding and Eective Rates: Example
You want to invest $1,000 in a savings account for two years.
After visiting three dierent banks, you discover that you have three
possible options:
1
an annual percentage rate of 12.5%, compounded annually;
2
an annual percentage rate of 12%, compounded quarterly;
3
a continuously compounded rate of 11.75%.
Which savings account should you choose?
What is the eective monthly rate that you will then be getting?
Compounding and Eective Rates: Example (contd)
In two years, the three dierent accounts would respectively accrue to
1
1, 000(1 + 0.125)
2
= 1, 265.63;
2
1, 000
_
1 +
0.12
4
_
42
= 1, 266.77;
3
1, 000e
0.11752
= 1, 264.91.
You should therefore invest in the quarterly compounded account
You could also solve this problem by calculating CF
1
for all three
rates, or by comparing EARs (denoted by r below):
1
Obviously, r = 12.50%;
2
1 +r =
_
1 +
0.12
4
_
4
=r = 12.55%;
3
1 +r = e
0.11751
=r = 12.47%;
Again, the second bank oers the best deal.
As shown on Slide 24, the eective monthly rate r
M
must satisfy
(1 +r
M
)
12
=
_
1 +
0.12
4
_
4
=r
M
=
_
1 +
0.12
4
_
1/3
1 = 0.9902%.
Discounting and Present Value
Suppose you want $C in your account in T years, and that the
current EAR is r . How much must you invest today?
Again, let PV denote this amount.
0 1 2 3 ... T
PV C
So PV must satisfy: PV(1 +r )
T
= C, or PV = C/(1 +r )
T
.
PV is the present value of $C delivered in T years from now.
You are indierent between $PV now and $C in T years. (Why?)
We can also write PV = C DF
T
, where
DF
T
=
1
(1 +r )
T
is called the T-period discount factor.
Discounting and Present Value (contd)
More generally, suppose you want to receive $C
1
in one year, $C
2
in
two years, ..., $C
T
in T years. How much must you invest today?
We wish to nd the PV of an investment paying $C
1
in one year, $C
2
in two years, ..., $C
T
in T years.
0 1 2 3 ... T
PV C
1
C
2
C
3
... C
T
Using arguments similar to the previous two slides, we should nd that
PV =
C
1
1 +r
+
C
2
(1 +r )
2
+ ... +
C
T
(1 +r )
T
=
T
t=1
C
t
(1 +r )
t
The present value of a sequence of cash ows is the sum of the
present values of each individual cash ow.
Value additivity: you value an investment by valuing each constituent
cash ow.
Discount Factors
The following gure shows discount factors DF
T
as functions of time
and EAR.
Discounting: Example
Two years ago, you put $10,000 in a savings account earning an APR of
8% compounded semiannually. At the time, you thought that these
savings would grow enough for you to buy a new car ve years later (i.e. in
three years from now). However, you just reestimated the price that you
will have to pay for the new car in three years at $18,000.
1
How much more money do you need to put in your savings account
now for it to grow to this new estimate in three years?
2
Now suppose that you know that the car company will oer you to
pay for the car over some time. In particular, you will have the
opportunity to make a downpayment of $6,000 at the time you get
the car (three years from now) and to make additional payments of
$6,500 at the end of each of the following two years. With this oer,
how much money do you need to add to your account now?
Discounting: Example (contd)
1
Let us rst gure out how much money FV is now in the account.
-2 0 ... 3
10, 000 (1.04)
4
FV ...
FV = 10, 000
_
1 +
0.08
2
_
22
= 10, 000(1.04)
4
= 11, 698.59.
Now, the account should have an amount PV in it for it to grow to
$18,000 in three years.
-2 0 ... 3
PV (1.04)
6
PV =
18, 000
_
1 +
0.08
2
_
23
=
18, 000
(1.04)
6
= 14, 225.66.
So, you need to put $14, 225.66 $11, 698.59 = $2, 527.07 in the
account.
2. The PV (at time 0, or two years after the initial investment) of these
three payments is
PV =
6, 000
_
1 +
0.08
2
_
23
+
6, 500
_
1 +
0.08
2
_
24
+
6, 500
_
1 +
0.08
2
_
25
= 13, 882.54.
So, you need to add $13, 882.54 $11, 698.59 = $2, 183.95 to the
account
Shortcuts to Calculating PVs: Perpetuities
A perpetuity is an investment paying a xed sum C
1
at the end of
every period forever. (We will typically consider a period being one
year, but other period lengths are possible).
0 1 2 3 4 ...
PV C
1
C
1
C
1
C
1
...
From our general formula, the PV of the perpetuity is given by:
PV
0
=
C
1
1 +r
+
C
1
(1 +r )
2
+
C
1
(1 +r )
3
+ ...
How do we nd the value of this innite sum?
Dividing both sides of the above equation by 1 +r gives
PV
0
1 +r
=
C
1
(1 +r )
2
+
C
1
(1 +r )
3
+
C
1
(1 +r )
4
+ ...
Shortcuts to Calculating PVs: Perpetuities (contd)
We now subtract the second equation from the rst to obtain
PV
0
PV
0
1 +r
=
C
1
1 +r
+
C
1
(1 +r )
2
+
C
1
(1 +r )
3
+ ...
C
1
(1 +r )
2

C
1
(1 +r )
3
...
Notice that all but one term on the right can be canceled out.
We now solve for PV as follows (provided r > 0):
PV
0
PV
0
1 +r
=
C
1
1 +r
= PV
0
(1 +r ) PV
0
= C
1
= PV
0
r = C
1
= PV
0
=
C
1
r
Example: UK Consols
In the 1800s, the British government decided to consolidate the huge
debt accumulated during the Napoleonic wars and to replace it with a
single issue of bonds with no termination date and a coupon rate of
2
1
2
%. These bonds, called consols, are still traded today.
Suppose that the current interest rate in the U.K. is 9%. What is the
PV of a consol with a 1, 000 face value?
This is just a perpetuity promising to pay 25 each year. Its PV is
PV
0
=
25
0.09
= 277.78.
A More Challenging Example: Deferred Perpetuities
A rich entrepreneur would like to set up a foundation that, every year,
will pay $5,000 in the form of a scholarship to one deserving student
The rst such scholarship is to be awarded in three years, and a
scholarship will be awarded in perpetuity every year after that (even
after the entrepreneurs death).
How much money should the entrepreneur put in the foundations
account, if that account earns 8% compounded annually?
A More Challenging Example: Deferred Perps (contd)
First, let us calculate how much money will need to be in the account
at the end of the second year; let us denote that amount by PV
2
0 1 2 3 4 5 ...
PV
+
=
5000
0.08
5000 5000 5000 ...
For the account to be worth this much in two years, the amount that
the entrepreneur needs to contribute initially is
PV
0
= PV
2
1
1.08
2
=
5, 000
0.08

1
1.08
2
= 53, 583.68.
The perpetuity starts in three years, but the exponent on the discount
factor is a two.
The perpetuity formula used in the rst step calculates the value of a
stream of cash ows starting a year later, i.e. the perpetuity formula
from slide 36 gives us the value of the stream at time 2.
Shortcuts to Calculating PVs: Growing Perpetuities
A growing perpetuity is an investment paying, at the end of each
period, an amount C
1
that grows at an annual rate g forever.
0 1 2 3 4 ...
PV C
1
C
1
(1 +g) C
1
(1 +g)
2
C
1
(1 +g)
3
...
From our general formula, the PV of the growing perpetuity is:
PV
0
=
C
1
1 +r
+
C
1
(1 +g)
(1 +r )
2
+
C
1
(1 +g)
2
(1 +r )
3
+ ...
We now use a trick similar to that on slide 35. We multiply both
sides of the above equation by
1+g
1+r
:
PV
0
_
1 +g
1 +r
_
=
C
1
(1 +g)
(1 +r )
2
+
C
1
(1 +g)
2
(1 +r )
3
+ ...
Shortcuts to Calculating PVs: Growing Perps (contd)
Again, we subtract the second equation from the rst:
PV
0
PV
0
_
1 +g
1 +r
_
=
C
1
1 +r
+
C
1
(1 +g)
(1 +r )
2
+
C
1
(1 +g)
2
(1 +r )
3
+ ...
C
1
(1 +g)
(1 +r )
2

C
1
(1 +g)
2
(1 +r )
3
+ ...
As before, all but one term on the right can be canceled out
We can now solve for PV as follows (provided that g < r ):
PV
0
PV
0
_
1 +g
1 +r
_
=
C
1
1 +r
= PV
0
(1 +r ) PV
0
(1 +g) = C
1
= PV
0
(r g) = C
1
= PV
0
=
C
1
r g
Example: A Stock
Morgan Stanley has just paid a dividend of $1. It will grow its
dividend at 5% forever. With an interest rate of 10%, what is its
share price?
Example: A Stock (contd)
We have r = 10%, g = 5%. Note that $1 is C
0
, not C
1
.
C
1
= $1 1.05 = $1.05. Therefore,
PV
0
=
C
1
r g
=
1.05
0.10 0.05
= $21.
Another Shortcut to Calculating PVs: Annuities
An annuity is an investment paying a xed sum C
1
at the end of
every period for a given number T periods.
0 1 2 ... T 1 T T + 1 T + 2 ...
PV C
1
C
1
C
1
C
1
C
1
From our general formula, we can write the PV of the annuity as:
PV
0
=
C
1
1 +r
+
C
1
(1 +r )
2
+ ... +
C
1
(1 +r )
T
.
Another Shortcut to Calculating PVs: Annuities (contd)
A more convenient expression can be obtained by observing that the
cash ows from the annuity equal the dierence between the cash
ows of two perpetuities, one starting at time 1 and the other starting
at time T + 1:
0 1 2 ... T 1 T T + 1 T + 2 ...
PV
1
C
1
C
1
C
1
C
1
C
1
C
1
C
1
...
PV
2
C
1
C
1
...
The PV of the rst perpetuity is PV
1
0
=
C
1
r
, as derived on slide 36
What about the second perpetuity, which is deferred for T periods?
Let us rst calculate the value of that perpetuity after T periods. We
call this value PV
2
T
.
0 1 2 ... T 1 T T + 1 T + 2 ...
PV
+
2
=
C
1
r
C
1
C
1
...
Now, since PV
2
T
is the value in T periods from now, we need to
discount this value to time 0 to get the value of the perpetuity:
0 1 2 ... T 1 T T + 1 T + 2 ...
PV
2
(1 +r )
T
PV
+
2
PV
2
0
=
PV
2
T
(1 +r )
T
=
C
1
/r
(1 +r )
T
.
The calculation for the PV of the annuity then simply involves a
dierence of two perpetuities:
Perpetuity Cash Flow Present
starting at 1 2 ... T T + 1 T + 2 ... Value
1 C
1
C
1
... C
1
C
1
C
1
... PV
1
0
=
C
1
r
T + 1 0 0 ... 0 C
1
C
1
... PV
2
0
=
C
1
r
1
(1+r )
T
Annuity C
1
C
1
... C
1
0 0 ... PV
0
= PV
1
0
PV
2
0
The PV of the annuity is therefore given by:
PV
0
=
C
1
r
_
1
1
(1 +r )
T
_
.
Example: DiMaggios Vow
When Marilyn Monroe died, her ex-husband Joe DiMaggio vowed to
place fresh owers on her grave every Sunday (starting the week after
her death) as long as he lived.
A bouquet of fresh owers cost $4.00 a week after she died
Based upon actuarial tables, Joe could expect to live for 30 more
years when Monroe died.
Assuming that the cost of owers would grow every week at a rate
equivalent to 2% per year and that 6% was an appropriate annually
compounded discount rate, what was the PV of this commitment?
Hint: First derive the PV formula for an annuity that grows at rate g:
PV
0
=
C
1
r g
_
1
_
1 +g
1 +r
_
T
_
.
Note: the detailed solution is included in Additional Materials.
Example: DiMaggios Vow (contd)
To use the formula, we must calculate the equivalent weekly interest
rate r
W
, the equivalent weekly growth rate g
W
, as well as the number
of periods T. The rst cash ow is simply C
1
= 4.
Using slide 24, we have
(1 +r
W
)
52
= 1.06 =r
W
= (1.06)
1/52
1 = 0.1121%.
Using slide 24 again, we have
(1 + g
W
)
52
= 1.02 = g
W
= (1.02)
1/52
1 = 0.0381%.
The number of weeks over which owers will have to be bought is:
T = 52 30 = 1, 560.
Therefore, the PV of DiMaggios commitment is
PV =
4
0.1121%0.0381%
_
1
_
1.000381
1.001121
_
1,560
_
= 3, 699.21.
Other Useful Formulas
The formulas for perpetuities and annuities that we derived on slides
36, 40, 44 and 47 all assume that payments are always made at the
end of the year.
If the payments are made at the beginning of the year (i.e. the rst
payment is C
0
, paid immediately), these PV formulas become:
perpetuity: PV
0
=
C
0
(1 +r )
r
;
growing perpetuity: PV
0
=
C
0
(1 +r )
r g
;
annuity: PV
0
=
C
0
(1 +r )
r
_
1
1
(1 +r )
T
_
;
growing annuity : PV
0
=
C
0
(1 +r )
r g
_
1
_
1 +g
1 +r
_
T
_
.
Some Notation
The following notation for annuities will sometimes be useful. r
represents the EAR.
The PV of a T-year annuity of $1, payable at the end of each year:
a
T[r
=
1
r
_
1
1
(1 +r )
T
_
.
The PV of a T-year annuity of $1, payable at the start of each year:
a
T[r
=
1 +r
r
_
1
1
(1 +r )
T
_
.
These are called annuity factors, as any (constant) annuity can be
calculated using these factors.
For example, the PV of a T-year annuity of $C payable at the end of
each year is equal to PV = Ca
T[r
.
Nominal versus Real Interest Rates: Numerical Example
Suppose that all you buy are apples, which cost $1 each today, and
that r = 26%. Can you buy 26% more apples next year?
Answer: It will depend on the price of apples in one year.
Example:
Suppose that you have $100 today, and that the price of apples goes
up by 5% during the year.
Let us compare how many apples you could buy today vs. in one year.
today in one year
money available $100 $126
price of apples $1.00 $1.05
can buy
100
1.00
= 100 apples
126
1.05
= 120 apples
Since you can only buy 20% more apples, you are only 20% better o
(not 26%). In other words, your real rate of return is 20%.
Nominal versus Real Interest Rates
More generally, suppose that you invest for one year in the bond
market. Your investment next year is worth $ (1 +r ) for each dollar
invested. Does this mean you are better o by saving?
The answer depends on what happens to ination. Suppose that the
one-year rate of ination is i . Then, in order to buy the same amount
of goods you could have purchased with $1 today, you will need
$ (1 +i ) a year from now. This means that your actual return,
measured in todays dollars is given by
1 +R =
1 +r
1 +i
== R =
1 +r
1 +i
1.
R is known as the real rate of return, as opposed to r , which is a
nominal rate.
Nominal versus Real Interest Rates (contd)
People often calculate the real rate of return R to be the dierence
between the nominal rate of return r and the ination rate i :
R = r i .
This is only approximately true.
Indeed, notice that
1 +r = (1 +R)(1 +i ) = 1 +R +i + (R i )
. .
small
1 +R +i ,
so that
R r i .
Why Real Rates Are Important
Suppose you are in Germany at the beginning of 1923. Someone
oers you a one-year German Treasury bill denominated in marks with
a face value of DM10,000,000 ( $700) at the bargain price of
DM5,000,000. Since this implies a rate of return of
r =
10, 000, 000
5, 000, 000
1 = 100%,
you accept. Did this turn out to be a good deal?
The ination rate in Germany in 1923 turned out to be about
4,530,000,000%, so that the real return on your investment was
R =
1 + 100%
1 + 45, 300, 000
1 99.9999956%.
In other words, your investment was practically worthless at the end
of 1923!
Key Takeaways: Constant Interest Rate
Compounding factor gives future value of $1
CF
T
=
_
1 +
r
m
_
mT
= e
rT
if m
Eective annual rate gives equivalent rate under once-a-year
compounding
r =
_
1 +
r
m
_
m
1
Discount factor gives present value of $1
DF
T
= 1/CF
T
Growing perpetuity: PV
0
= C
1
/ (r g)
Annuity factor gives PV of $1 for T years. a
T[r
=
1
r
_
1
1
(1+r )
T
_
Real rate of return R =
1+r
1+i
1
Checkpoint: Constant Interest Rate
BMA: chapter 2
Problem set: 1, 2, 5, 9, 13, 22, 24, 29, 32
BMA: chapter 3
Problem set: none
Bulk pack problem set #1
What is next?
BMA: sections 3-3 and 3-4
I.1.2 Term Structure
I.1.2 Term Structure
Readings: BMA sections 3-3 and 3-4
FNCE 717: Financial Derivatives.
FNCE 731: International Corporate Finance.
FNCE 738: Funding Investments.
Accounting for the Term Structure of Interest Rates
Our PV formulas have assumed that the interest rate is the same for
all maturities. In practice, the interest rate at which you can
borrow/invest for, say, 1 year is typically dierent from the rate at
which you can borrow/invest for, say, 5 years.
The relationship among interest rates for dierent maturities is known
as the term structure of interest rates
In a at term structure, the interest rates are the same for all maturities
With a non-at term structure,
the cash ow at time: 1 2 3 ...
should be discounted at: r
1
r
2
r
3
...
where r
t
is known as the t-year spot rate. The PV formula of slide 29 has
to be modied to
PV =
C
1
1 +r
1
+
C
2
(1 +r
2
)
2
+ ... +
C
T
(1 +r
T
)
T
=
T
t=1
C
t
(1 +r
t
)
t
.
Term Structure: Example
More on Discount Factors
Letting
DF
t
=
1
(1 +r
t
)
t
we can write the PV formula of slide 60 as
PV = (C
1
DF
1
) + ... + (C
T
DF
T
) =
T
t=1
(C
t
DF
t
) .
DF
t
is known as the t-period discount factor, since multiplication by
DF
t
converts a cash ow C
t
in t periods into its PV.
Since r
t
_ 0, DF
t
< 1, i.e. $1 is worth less than $1 today. In fact, we
must have
1 > DF
1
> DF
2
> > DF
T
,
i.e. $1 the day after tomorrow is worth less than $1 tomorrow, and so
on.
Proof that DF
t
> DF
t+1
Suppose that r
1
= 20% and r
2
= 7%. This implies
DF
1
=
1
1.20
= 0.83 and DF
2
=
1
(1.07)
2
= 0.87,
so that DF
1
< DF
2
. Why can such a situation not occur?
The reason is that anyone who could borrow and lend at these rates
could become a billionaire overnight. How would you proceed?
Cash ows at the end of year
Strategy 0 1 2
Borrow $1,000 at 7% for 2 yrs +1,000.00 0 -1,144.90
Invest (lend) $954.08 at 20% for 1 yr -954.08 +1,144.90 0
Total +45.92 +1,144.90 -1,144.90
Since you can store the $1,144.90 that you receive after the rst year to
repay your loan at the end of the second year, the $45.92 represents an
arbitrage opportunity.
Proof that DF
t
> DF
t+1
(contd)
You borrow $1,000 at 7% for two years and invest $954.08 out of
these $1,000 at the rate of 20% for one year. After one year, your
investment will be worth $954.08(1.20) = $1,144.90. You owe the
bank $1,000(1.07)
2
= $1,144.90 at the end of the second year. If you
just store the proceeds from your investment under your mattress for
one year, you can be sure to have enough money to repay the loan.
The remaining $(1,000-954.08) = $45.92 is a free lunch.
Of course, there is no reason to limit yourself to borrowing $1,000.
Similarly, other investors will rush into borrowing at 7% and lending
at 20%. Eventually, r
1
will have to decrease and r
2
will have to
increase until DF
1
becomes greater than DF
2
.
Money machines like the one we just discussed are called arbitrage
opportunities. Arbitrage opportunities cannot exist for long in a well
functioning market.
Forward Rates: Numerical Example
Your friend tells you that he will have to borrow money for one year in
one year from now.
You agree (today) to lend him the money at that time (in one year)
at a rate f
2
specied today, i.e. you enter a forward rate agreement
with your friend. What is the correct rate?
For every dollar that you invest for two years, you now have two
possible investment alternatives:
Lend for 2 years at a rate of r
2
: FV
2
= (1 +r
2
)
2
.
Lend for 1 year at a rate of r
1
, and then lend to your friend at the
pre-specied rate of f
2
: FV
2
= (1 +r
1
)(1 +f
2
).
Since both investment alternatives involve no risk, neither should
result in a larger future value in two years, that is
(1 +r
2
)
2
= (1 +r
1
)(1 +f
2
) =f
2
=
(1 +r
2
)
2
1 +r
1
1.
The rate f
2
is known as a forward rate.
Forward Rates
More generally, suppose you were oered a forward rate agreement
(FRA), structured as follows. Your counterparty wishes to borrow for
a year at the end of year t 1 at a rate f
t
specied today. What
should this rate be?
Again, you could invest $1 today for t years in two dierent ways:
Lend for t years at the rate r
t
, resulting in (1 +r
t
)
t
at the end of year
t.
Lend for t 1 years at the rate r
t1
, and enter into a FRA, resulting in
(1 +r
t1
)
t1
(1 +f
t
) at the end of year t.
Forward Rates (contd)
Since both strategies involve no risk, we must have
(1 +r
t
)
t
= (1 +r
t1
)
t1
(1 +f
t
),
which implies
f
t
=
(1 +r
t
)
t
(1 +r
t1
)
t1
1 =
DF
t1
DF
t
1
The rates f
t
dened by the above equation are known as forward
rates.
Notice that saying that DF
t1
> DF
t
is equivalent to saying that
f
t
> 0.
The Relationship Between Interest Rates and Forward
Rates
The following gures show the relationship that exists between spot
rates and forward rates.
Nominal versus Real Interest Rates Revisited
The relationship between nominal and real interest rates derived on
slide 53 also applies to the one-year spot rates:
R
1
=
1 +r
1
1 +i
1
1.
More generally, the t-period real interest rate R
t
satises
1 +R
t
=
1 +r
t
1 +i
t
Key Takeaways: Term Structure
Spot rate r
T
is the rate per year for T years starting today
The term structure is the graph of r
1
, r
2
, ... for dierent T
With a non-at term structure, PV =
T
t=1
C
t
(1+r
t
)
t
Forward rate f
t
is the rate for 1 year starting at t 1 and ending at t:
f
t
=
(1+r
t
)
t
(1+r
t1
)
t1
1
Checkpoint: Term Structure
BMA: chapter 3
Problem set: 14, 18, 20, 25, 32
What is next?
BMA: section 3-1
Investment Decisions The Valuation of Certain Cash Flows: Pricing Bonds
I.2 The Valuation of Certain Cash Flows:
Pricing Bonds
I.2 The Valuation of Certain Cash Flows: Pricing Bonds
Readings: BMA section 3-1
FNCE 717: Financial Derivatives.
FNCE 738: Funding Investments.
What Is a Bond?
A bond is essentially a loan: the issuer (borrower) promises to repay
the investor (lender) the amount borrowed plus interest over some
specied period of time.
A coupon bond promises a periodic interest payment (e.g. every six
months) and repayment of the face value (F) at the maturity
date (T). The periodic interest payment is known as the coupon (C)
and the APR on the face value is called the coupon rate (i.e.,
C
F
is the
coupon rate).
0 1 2 3 ... T 1 T (maturity date)
C (coupon) C C ... C C +F (face value)
For a zero coupon bond there are no periodic coupon payments, and
both principal and interest are paid together at the maturity date.
Treasury Securities
The U.S. Treasury is the largest single issuer of debt in the world.
U.S. Treasury securities are backed by the full faith and credit of the
U.S. government, so that they are viewed by market participants as
having no (or very low) default risk (i.e. no risk that the issuer will
default on his payments of interest and/or principal).
There are three major types of Treasury securities:
Treasury Bills are issued with maturities of 3, 6, or 12 months.
Treasury Notes are issued with maturities between 2 and 10 years.
Treasury Bonds are issued with maturities greater than 10 years.
Treasury bills are zero-coupon bonds (ZCBs), while Treasury notes
and bonds are coupon bonds with interest paid every 6 months.
A coupon bond is basically a portfolio of several zero-coupon bonds,
one for each coupon or principal payment. The Treasury allows buyers
of T-bonds or T-notes to exchange them for the individual
component ZCBs. These ZCBs corresponding to unbundled Treasury
coupon bonds are called Treasury Strips.
How Treasury Securities Are Quoted
Treasury bills are quoted in terms of a discount rate (in percent), not
of a price. If d is the quoted discount rate, N the maturity (in days)
and F the face value, then the price is computed according to the
formula
P = F
_
1 d
N
360
_
For example, if the quote for a 100-day T-bill with a face value of
$100,000 is 8.75, then the price is
$100,000
_
1 0.0875
100
360
_
= $97,569.
Treasury coupon securities and Treasury strips are quoted in terms of
prices (in percent of face value), with the decimal part expressed in
units of 1/32. For example, a quote of 92:14 refers to a price of 92
and 14/32, or 92.4375 for a security with $100 face value.
How Treasury Securities Are Quoted: Example (contd)
For example, if we look at the Treasury bill with the Dec 26 96
maturity date, the Wall Street Journal tells us:
The bond has 135 days to maturity.
The (best) bid discount is 5.05%, which means that the price at
which you can sell that T-bill with a face value of $100,000 is
100,000
_
1 0.0505
135
360
_
= 98,106.25.
The (best) ask discount is 5.03%, which means that the price at
which you can buy that T-bill with a face value of $100,000 is
100,000
_
1 0.0503
135
360
_
= 98,113.75.
See Additional Materials for the meaning of ask yld (not part of
this course)
Present Value and Market Price
Consider a Treasury bill with 1 year to maturity and a face value of
$100. If the 1-year interest rate is 10%, we know that the PV of the
T-bill is 100/1.10 = 90.91.
Why must $90.91 be its market price?
Since the current interest rate is 10%, nobody would buy the bill if P
> $90.91, since it would be possible to obtain $100 in a year by
lending $90.91 at 10% for one year.
Conversely, if P < $90.91, nobody would sell it, since it would be
possible to obtain $90.91 today by borrowing this amount from a bank
at 10% and using the payo from the bill a year from now to repay the
loan.
Therefore, the market price of the bill must be $90.91.
These no-arbitrage arguments are shown on the following pages:
In a well-functioning (ecient) market, the price of an investment
equals its present value.
Things of equal value trade at equal prices.
Present Value and Market Price (contd)
If the T-bill on page 79 were priced at $90:
Cash ow
Strategy 0 1
Buy T-bill -90.00 100
Borrow $90.91 90.91 -100
Total 0.91 0
This $0.91 is an arbitrage opportunity.
If the T-bill on page 79 were priced at $92:
Cash ow
Strategy 0 1
Sell (short) T-bill 92.00 -100
Lend $90.91 -90.91 100
Total 1.09 0
This $1.09 is an arbitrage opportunity.
Pricing a Coupon Bond
Suppose that the term structure of interest rates is as follows:
r
0.5
= 4%, r
1
= 4.1%, r
1.5
= 4.3%, r
2
= 4.5%. What is the current
price of a T-note with 2 years to maturity, a coupon rate of 8%
semiannual, and a face value of $100?
Using the general PV formula, we have:
P =
4
(1.040)
0.5
+
4
(1.041)
+
4
(1.043)
1.5
+
104
(1.045)
2
= 106.756
Does it make sense that P > $100?
Estimating the Term Structure
Since bond prices reect the current term structure, we can use bond
prices to estimate the term structure, provided we have a sucient
number of bonds with diering maturities and/or coupons.
Some nd it simpler to rst solve for the discount factors, and then
obtain the interest rates from the discount factors.
Estimating the Term Structure: Example
Suppose you observe the following prices for a bond with $100 face
value:
Bond Security Coupon Maturity Quote Price
A T-bill 180 days 4.98 97.51000
B T-bill 360 days 5.44 94.56000
C T-note 6% 2 years 99:10 99.31250
D T-note 8% 2 years 103:01 103.03125
Determine the 6, 12, 18 and 24 month interest rates (spot rates).
Estimating the Term Structure: Example (contd)
First, let us gure out the timing of the bonds payments
Cash ow at the end of
6 months 12 months 18 months 24 months
(0.5 year) (1 year) (1.5 year) (2 years)
Bond A 100 0 0 0
Bond B 0 100 0 0
Bond C 3 3 3 103
Bond D 4 4 4 104
Estimating the Term Structure: Example (contd)
Let us now calculate the discount factors that are consistent with the
bonds prices and the above payments. In particular, each bond must
satisfy the PV formula on slide 52:
97.51000 = (100 DF
0.5
)
94.56000 = (0 DF
0.5
) + (100 DF
1
)
99.31250 = (3 DF
0.5
) + (3 DF
1
) + (3 DF
1.5
) + (103 DF
2
)
103.03125 = (4 DF
0.5
) + (4 DF
1
) + (4 DF
1.5
) + (104 DF
2
)
Solving the above system gives DF
0.5
= 0.9751, DF
1
= 0.9456,
DF
1.5
= 0.9165 and DF
2
= 0.8816.
We can then use the fact that DF
t
=
1
(1+r
t
)
t
(see slide 62) to nd
r
0.5
= 5.17%, r
1
= 5.75%, r
1.5
= 5.99% and r
2
= 6.51%.
On Canvas I have posted a spreadsheet, TermStructure.xls, which
estimates the term structure from bonds.
Bond Yields
The yield to maturity or internal rate of return for a bond is the rate
y that solves
P =
T
t=1
C
(1 +y)
t
+
F
(1 +y)
T
(1)
If you recall (from the PV formula on slide 60) that
P =
T
t=1
C
(1 +r
t
)
t
+
F
(1 +r
T
)
T
,
you will see that the yield of a bond is a complicated average of the
current interest rates. In particular, the yields of two bonds with the
same maturity but with dierent coupon rates will generally dier.
Solving for y in (1) involves solving a polynomial of degree T.
For a zero-coupon bond with maturity T, or if the term structure is
at, we have y = r
T
.
Computing the Yield of a Bond
We compute yields by trial and error: pick a y and compute the PV
at this rate; if PV > bond price, try a higher y and vice-versa.
For example, suppose we want to compute the yield of a 3-year bond
with a face value of $100, paying an annual coupon of 10%, and
selling for $103.83. That is, we want to solve for y in
103.83 =
10
1 +y
+
10
(1 +y)
2
+
110
(1 +y)
3
.
The following table and graph show the required computations.
y PV
9.00% 102.53
8.00% 105.15
8.50% 103.85
There is an inverse relationship between price and yield. (Why?)
Yields of Treasury Securities
When nancial practitioners talk of the yield of a Treasury security,
they dont generally refer to the rate y as dened on page 86, but to
the annual percentage rate under semi-annual compounding y given
by
_
1 +
y
2
_
2
= 1 + y.
where y is the eective annual yield (under annual compounding).
Note that the eective semi-annual yield (see slide 25) is y
S
= y/2
y is also referred as a bond-equivalent yield.
Problems with Bond Yields
You should never use the information on bond yields reported by the
nancial press as a substitute for the term structure of interest rates.
Knowing the term structure of interest rates allows you to price any
riskless asset.
Knowing the yield of a bond tells you the price of that particular bond
only.
Two bonds with the same maturity but dierent coupons will in
general have dierent yields.
Key Takeaways: Pricing Bonds
Treasury bills pay no coupon, and are quoted in terms of a discount
rate: P = F
_
1 d
N
360
_
Treasury notes and bonds pay a semiannual coupon (
C
2
every 6
months), and are quoted in units of 1/32
The price of a bond is P =
T
t=1
C
(1+r
t
)
t
+
F
(1+r
T
)
T
where r
t
is the
t-year spot rate
The yield of a bond is the single constant discount rate y that solves
P =
T
t=1
C
(1+y )
t
+
F
(1+y )
T
. It is a (weighted geometric) average of
the spot rates
For Treasuries, quoted yields are semiannual APRs: y given by
_
1 +
y
2
_
2
= 1 + y
The coupon of a bond is xed. Its yield depends on market
conditions, and is inversely related to its price
Checkpoint: Pricing Bonds
BMA: chapter 3
Problem Set: 4, 8.
Bulk pack problem set #2.
The institutional details of short-selling are carefully explained in
Additional Materials.
What is next?
BMA: section 5-1
Investment Decisions Capital Budgeting Under Certainty
I.3 Capital Budgeting Under Certainty
I.3 Capital Budgeting Under Certainty
Three questions:
What is a good rule for selecting projects? (section I.3.1)
How do we apply it? (section I.3.2)
What are the alternatives, and are they useful at all? (section I.3.3)
I.3.1 The NPV Rule: Theoretical Foundation
I.3.1 The NPV Rule: Theoretical Foundation
Readings: BMA section 5-1
Motivation
Suppose you are at a Volkswagen shareholders meeting. Two
shareholders are quite vocal about what the rm should do.
An old man wants money right now: he wants VW to invest in sport
cars which would yield a quick prot.
A little childs trust fund representative wants money a long way in the
future: he wants VW to invest in developing electric cars.
What do you think VWs managers should do?
To answer this question we will look at how an individual should
choose among dierent investment opportunities. We will show that
there is a simple rule that managers should follow, regardless of
shareholders preferences. Hence both VW shareholders will agree on
the same project.
Until Part III, we will ignore the impact on investment decisions of
taxes and other complications.
Mr. Rossis Problem
Mr. Rossi has inherited $1M. He grew up in Italy and has developed a
real aversion to work, which he completely detests. He therefore plans
to use his inheritance to nance himself for the rest of his life.
For simplicity, we will divide his life into two periods, youth and old
age.
We are going to assume that the current interest rate available in
capital markets (for borrowing or lending) is 20%, so that for every
dollar Mr. Rossi saves in his youth, he gets $1.20 in old age.
How the Capital Market Helps Smooth Consumption
Once the possibility of borrowing/lending is taken into account, here
are some of the possibilities available to Mr. Rossi:
Go on a fantastic trip around the world, spend the whole $1M and then
live in poverty in his old age.
Spend $0.5M in his youth, put $0.5M in the bank, and have $0.6M in
his old age.
Spend nothing in his youth and take a $1.2M trip in old age.
More generally, the capital markets allow him to choose any
combination in the following gure:
The Eect of Real Investment Opportunities
While borrowing/lending gives him some choice as to how to allocate
his money, Mr. Rossi also has real investment opportunities. He
fancies himself as an entrepreneur and sits down to work out what
investments he can make.
Mr. Rossi is a wine lover. He reckons that a small vineyard that has
just come on the market will cost him $50,000 and will yield $200,000
for his old age. This is the best project he can think of.
Mr. Rossi is also a gourmet. His next best project is to run a
restaurant. This will cost $100,000 now and give $140,000 in old age.
The Eect of Real Investment Opportunities (contd)
We can represent these and the other projects Mr. Rossi can think of
through the following curve:
Should Mr. Rossi Invest in the Vineyard?
Suppose Mr. Rossi invests in the vineyard. He is left with
$1M $0.05M = $0.95M now;
$0.20M later
Instead of simply consuming these amounts, Mr. Rossi could use
borrowing and lending to achieve other consumption patterns:
Suppose he invests the whole $0.95M. This will generate
$0.95M 1.2 = $1.14M later, so he is left with
$0 now (since the whole $1M was invested);
$1.14M + $0.2M = $1.34M later
Or he can borrow the PV of $0.2M, that is $0.2/1.2 = $0.167M, and
repay $0.2M later. So Mr. Rossi is left with
$0.95M + $0.167M = $1.117M now;
$0.2M $0.2M = $0 later
In fact, by borrowing or lending, Mr. Rossi could achieve any
consumption on the following line. (see next slide)
Should Mr. Rossi Invest in the Vineyard? (contd)
Investing in the vineyard expands his consumption possibility frontier
Should Mr. Rossi Invest in the Vineyard? (contd)
Mr. Rossi is better o by investing in the vineyard.
If he chose to consume everything today, he could consume $1.117M
now. In other words, his current wealth is increased by
$1.117M $1M = $0.117M.
Notice that this increase in wealth corresponds exactly to the
projects net present value (the PV minus the initial cost):
NPV
Vineyard
=
$0.2M
1.2
$0.05M = $0.117M.
More generally, Mr. Rossi can consume more both in his young and
old age.
Optimal decision rule: accept (reject) all projects with positive
(negative) NPV
Should Mr. Rossi Invest in the Restaurant?
Similarly, if Mr. Rossi also invests in the restaurant, in addition to
investing in the vineyard, he will be left with
$1M $0.05M $0.1M = $0.85M now
$0.20M + $0.14M = $0.34M later.
As before, instead of simply consuming these amounts, Mr. Rossi can
borrow and lend to achieve other consumption patterns:
Suppose he invests the whole $0.85M. This will generate
$0.85M (1.2) = $1.02M later, so he is left with
$0 now (since the whole $1M was invested);
$1.02M + $0.34M = $1.36M later
Or he can borrow the PV of $0.34M, that is $0.34M/1.2 = $0.283M,
and repay $0.34M later. So he is left with:
$0.85M + $0.283M = $1.133M now
$0.34M $0.34M = $0 later
Should Mr. Rossi Invest in the Restaurant? (contd)
In fact, by borrowing or lending the appropriate amounts, Mr. Rossi
can achieve any consumption on the following line:
Should Mr. Rossi Invest in the Restaurant? (contd)
Mr. Rossi is better o by investing in both the vineyard and the
restaurant, than just the vineyard:
If he chose to consume everything today, he could consume $1.133M
now. In other words, his current wealth is increased by
$1.133M $1.117M = $0.016M.
Again, this increase in wealth corresponds exactly to the projects
NPV (i.e. the PV minus the initial cost)
NPV
restaurant
=
$0.14M
1.2
$0.1M = $0.016M.
The consumption possibility frontier is pushed further out, i.e. he can
consume more in both periods.
Therefore, Mr. Rossi should invest in the restaurant: this is true no
matter what his preferences are, as long as he prefers more to less.
How Much Should Mr. Rossi Invest?
Clearly, Mr. Rossi should keep investing as long as he can keep
pushing out the consumption possibility frontier, i.e. as long as he can
nd positive-NPV investments. Again, this is true independently of
his preferences.
How Much Should Mr. Rossi Invest? (contd)
By investing I
+
, Mr. Rossi would be investing up to the point at which
the slope of the investment opportunity line just equals (minus) 1 +r
The slope of the investment opportunity line tells you how many more
dollars tomorrow you can have for an additional dollar of investment
today, and thus equals (minus) 1 plus the rate of return of the
marginal investment. Therefore, we can also say that Mr. Rossi
should invest for as long as he can nd investments whose rates of
return are above the interest rate.
r is also known as the opportunity cost of capital. By investing $1
in a project, Mr. Rossi forgoes the opportunity to put the dollar in the
bank and earn r . Thus, it is ecient to invest in the project if and
only if it gives a return of at least r
This links to the IRR rule analyzed in more detail later
Solution to Mr. Rossis Problem
Now that Mr. Rossi has decided how much to invest in real
investment opportunities, he can choose how much to borrow/lend.
This will depend on his preferences for consumption in youth versus
consumption in old age, as represented by the shape of his
indierence curves.
Implications for the Financial Manager
When facing investment decisions managers should accept
investments with positive NPV regardless of the preferences of
individual shareholders.
The managers sole objective is to maximize shareholder wealth. Once
their wealth is maximized, individual shareholders can use the capital
market to achieve their preferred prole of consumption.
This powerful result is the Fisher separation theorem. A rms
optimal choice of investments is separate from its owners attitudes
towards the investments. This allows dierent shareholders to be
willing to own shares in the same rm and delegate the running of the
rm to a professional manager.
A Word of Caution
The FST (and optimality of the NPV rule) requires the market to be:
Complete: markets for shares and borrowing/lending exist
Ecient: market prices reect all available information
Perfect: no distorting taxes and frictions (such as transaction costs);
individuals can borrow and lend at the same rate.
What happens if investors face dierent interest rates?
Behavioral nance studies nancial decisions under market ineciency.
Key Takeaways: Capital Budgeting Under Certainty
The required rate of return on a project is determined exclusively by
the rate of return available elsewhere in the capital market
It is independent of shareholders preferences for consumption today vs.
consumption tomorrow
A nancial manager can therefore ignore shareholder preferences.
His/her goal is simply to maximize shareholder value, by taking
positive-NPV projects and rejecting negative-NPV projects
Once shareholder value is maximized, shareholders can use borrowing
and lending to choose whatever consumption pattern suits their
individual preferences
The Fisher separation theorem assumes capital markets are complete,
ecient and perfect
Checkpoint: Capital Budgeting Under Certainty
BMA: chapter 5
Problem set: none
Bulk pack problem set #3
What is next?
BMA: chapter 6
I.3.2 Using the NPV Rule for Capital Budgeting
I.3.2 Using the NPV Rule for Capital Budgeting
Readings: BMA, chapter 6.
FNCE 750: Venture Capital and the Finance of Innovation.
The NPV Formula
We have seen that nancial managers act in the best interest of the
shareholders by undertaking investments with positive NPV.
For a one-period investment the NPV formula is
NPV = C
0
+
C
1
1 +r
1
where C
0
is the initial cash ow (which is generally negative) and C
1
is the end-of-period cash ow (which is usually positive).
The general formula is
NPV = C
0
+
T
t=1
C
t
(1 +r
t
)
t
=
T
t=0
C
t
(1 +r
t
)
t
We have already discussed how to use bond prices to infer the interest
rates r
t
. We now discuss how to compute the cash ows C
t
.
Free Cash Flow Is Not Prot
Net income (prot) is how much the company earns in year t,
according to its accounts
C
t
is how much cash physically ows into the rm and is available to
investors, after all other claimants have been paid o
Time value of money: cash can be invested elsewhere, unlike prot
Key dierences:
Capital expenditure aects cash ow but not prot
Depreciation aects prot but not cash ow, except via its eect on
taxes T
T = t
c
(Revenues Expenses Depreciation + Extraordinary Gains)
where t
c
is the corporate tax rate
Free cash ow = Cash from operations Capex
Cash From Operations
Three equivalent ways to calculate cash from operations:
1
Start from net income and add back depreciation:
CFO = (R E D +X)(1 t
c
) + D
2
Add up only the cash items
CFO = R E +X t
c
(R E D +X)
3
Tax the cash items and add back the depreciation tax shield
CFO = (R E +X)(1 t
c
) + t
c
D
Working Capital
Where there is working capital, the Free Cash Flow equation becomes
FCF = CFO Increase in Working Capital Capex
Working capital = Current Assets (restricted cash, inventories,
accounts receivable, others) Current Liabilities (accounts payable,
others)
An investment in working capital is a cash outow, just like an
investment in capital expenditure
Cash is treated as working capital only if it is necessary for the
companys operations e.g. cash in a cash register cannot be put in
a bank to earn interest. In most cases, cash is assumed to be earning
interest in a bank and thus not counted as working capital
We will not consider working capital in FNCE604; however, it is
featured in the case in FNCE612
H. O. Coy
H. O. Coy Company is considering purchasing a machine costing
$26,000 using excess cash generated through other projects.
The machine will generate revenues of $50,000 per year for ve years.
The cost of materials and labor needed to generate these revenues
will total $35,000 per year.
Even though the machine is expected to sell for $1,500 in 5 years, it
will be depreciated on a straight-line basis over 5 years to a $1,000
book value.
The rms tax rate is 34% and its opportunity cost of capital is 10%.
Should the company purchase the machine?
H. O. Coy (contd)
The cash ows are shown below:
End of Year
0 1 2 3 4 5
(1) Revenues 50,000 50,000 50,000 50,000 50,000
(2) Material & labor cost -35,000 -35,000 -35,000 -35,000 -35,000
(3) Prot on machine sale 500
(4) Depreciation -5,000 -5,000 -5,000 -5,000 -5,000
(5) Pre-tax prot 10,000 10,000 10,000 10,000 10,500
(6) Tax @ 34% -3,400 -3,400 -3,400 -3,400 -3,570
(7) Net income 6,600 6,600 6,600 6,600 6,930
(8) Add back depreciation 5,000 5,000 5,000 5,000 5,000
(9) Machine purchase/sale -26,000 1,000
(10) Free cash ow -26,000 11,600 11,600 11,600 11,600 12,930
H. O. Coy (contd)
Purchase of machine for $26,000 does not aect prot: merely
transforms one asset (cash) into another (machine). However, it
aects cash ow
Sale of machine for $1,500 is comprised of 2 elements:
Sale for book value of $1,000 aects cash ow, but not prot
Prot of $500 above book value aects prot and cash ow
C
t
can be calculated in three ways:
Net income + depreciation - capex ((7) + (8) + (9))
Add up only the cash items ((1) + (2) + (3) + (6) + (9))
Tax the cash items and add the DTS
(((1) + (2) + (3)) (1 t
c
) + (4)t
c
+ (9))
NPV is calculated as:
NPV = 26,000 +
11,600
1.10
+ ... +
11,600
(1.10)
4
+
12,930
(1.10)
5
= 18,798.95 > 0 so purchase
Estimating Cash Flows
Only cash ows are relevant
Cash ows are simply the dierence between dollars received and
dollars paid out. Do not confuse cash ows with accounting prots:
ignore depreciation
Estimate cash ows on an after-tax basis
Record cash ows at the time they actually occur (e.g. if selling items
on credit)
Estimate cash ows on an incremental basis
Include all incidental eects, including opportunity costs
Forget sunk costs
Separate the eect of investment and nancing decisions
Treat ination consistently
How to Treat Ination
Either discount nominal cash ows at the nominal interest rate or
discount real cash ows at the real interest rate. If properly applied,
both methods should produce the same NPV, that is
NPV
real
=
T
t=0
C
real
t
(1 +R
t
)
t
=
T
t=0
C
nominal
t
(1 +r
t
)
t
= NPV
nominal
.
To see this, remember (from slide 69) that the real rate R
t
is given by
1 +R
t
=
1 +r
t
1 +i
t
,
so that
C
nominal
t
(1 +r
t
)
t
=
C
real
t
(1 +i
t
)
t
(1 +r
t
)
t
=
C
real
t
(1 +R
t
)
t
.
This makes intuitive sense: real and nominal dollars are the same
today.
Example: BICCs Toad Ranch
The Biological Insect Control Corporation (BICC) is planning to
invest in a ranch to breed toads, which the company plans to sell as
ecologically desirable insect-control mechanisms.
The company anticipates that the business will continue in perpetuity.
Following negligible start-up costs, BICC will incur the following
(nominal) cash ows at the end of the rst year:
Revenues $150,000
Labor costs 80,000
Other costs 40,000
Example: BICCs Toad Ranch (contd)
The company will lease the ranch and equipment for $20,000 a year.
The rst lease payment will be due at the end of the year.
The rate of ination is expected to be 6%. Revenues and other costs
are expected to remain constant in real terms. However, labor costs
will increase at 1 percent per year in real terms. Lease payments are
xed in nominal terms.
The real discount rate is 5%.
There are no taxes.
What is the NPV of BICCs toad ranch? (Solution in Additional
Materials)
We will do the NPV calculations in nominal terms and in real terms.
Of course, according to slide 124, the results should be exactly the
same. More precisely, we will calculate
NPV = PV(Revs) PV(Other Costs) PV(Labor Costs) PV(Lease).
We have i = 6% and R = 5%. From slide 124, we get
1 +R =
1 +r
1 +i
=r = (1 +R)(1 +i ) 1 = (1.05)(1.06) 1 = 11.3%.
In nominal terms, the cash ows (below) need to be discounted at r :
Cash Flow at End of Year
1 2 3 ...
Revenues 150, 000 150, 000(1 +i ) 150, 000(1 +i )
2
...
Other 40, 000 40, 000(1 +i ) 40, 000(1 +i )
2
...
Labor 80, 000 80, 000(1.01)(1 +i ) 80, 000(1.01)
2
(1 +i )
2
...
Lease 20, 000 20, 000 20, 000 ...
The revenues and other costs are perpetuities growing at rate i :
PV(Revenues) =
150,000
r i
=
150,000
0.113 0.06
= 2,830,188.68;
PV(Other Costs) =
40,000
r i
=
40,000
0.113 0.06
= 754,716.98.
The labor costs are a perpetuity growing at rate g, where
1 +g = (1.01)(1 +i ) = g = 7.06%.
Therefore,
PV(Labor Costs) =
80,000
r g
=
80,000
0.113 0.0706
= 1,886,792.45.
The lease is a regular perpetuity:
PV(Lease) =
20,000
r
=
20,000
0.113
= 176,991.15.
Finally, NPV = 11, 688.09 > 0, so the project should be undertaken.
In real terms, the cash ows need to be discounted at R, and they are
as follows:
Cash Flow at End of Year
1 2 3 ...
Revenues
150,000
1+i
150,000
1+i
150,000
1+i
...
Other costs
40,000
1+i
40,000
1+i
40,000
1+i
...
Labor costs
80,000
1+i
80,000(1.01)
1+i
80,000(1.01)
2
1+i
...
Lease
20,000
1+i
20,000
(1+i )
2
20,000
(1+i )
3
...
The revenues and the other costs are both regular perpetuities:
PV(Revenues) =
150,000/(1 +i )
R
=
150,000/(1.06)
0.05
= 2,830,188.68;
PV(Other Costs) =
40,000/(1 +i )
R
=
40,000/(1.06)
0.05
= 754,716.98.
The labor costs are a perpetuities growing at 1%:
PV(Labor Costs) =
80,000/(1 +i )
R 0.01
=
80,000/1.06
0.05 0.01
= 1,886,792.45.
The lease is a decreasing perpetuity. If G is the real growth rate, we
have 1 +g = (1 +G) (1 +i ). Thus,
G =
1
1.06
1 = 5.66038%.
We then nd:
PV(Lease) =
20,000/(1 +i )
R G
=
20,000/1.06
0.05 (0.0566038)
= 176,991.15.
Notice that all the PVs are the same as on page 128. So, as
expected, we get the same NPV as before.
Example: Project Interaction
Until now we have assumed that the company is free to undertake all
the investments that have positive NPV. In fact, the nancial
manager often faces either-or decisions.
Instances of such decisions typically arise in the following cases:
Choosing between mutually exclusive projects.
Deciding when to replace an existing machine.
Deciding how to invest when resources are limited.
We next turn to these issues.
Mutually Exclusive Projects
The baseline rule for choosing between alternative investments is
simple: pick the one with the highest NPV. However, care should be
taken when comparing investments with dierent lives if the
investment can/must be repeated at the end of its life.
In this case we can use one of three equivalent criteria:
Repeat each project enough times to make the investment horizons
comparable, and then use the NPV rule to choose between them.
Compute an equivalent annual cash ow for each investment and
choose the investment with the highest EACF. The EACF is the cash
ow of an annuity having the same life and PV as the investment. It is
the rate you would pay to lease the asset in a competitive market
Repeat each project indenitely, and compare with the NPV rule.
The implicit assumption in using the above criteria is that once an
investment is chosen, the company will reinvest in the same project at
all subsequent dates.
Example: Choosing Between Machines with Dierent Lives
Suppose you are considering two alternative machines, A and B,
having identical capacity. The rst machine will last three years and
the second two years. The costs associated with operating them are
as follows:
End-of-year costs (in $000)
Machine C
0
C
1
C
2
C
3
PV at 6%
A 15 4 4 4 25.69
B 10 6 6 - 21.00
Should we choose machine B, which has a lower PV of costs? Not
necessarily, because B will have to be replaced a year earlier.
Example: Machines with Dierent Lives (contd)
One way to compare the two investments is to compute the PV of
cost over a 6 year period, at the end of which both machines would
have to be replaced.
End-of-year costs (in $000)
Machine C
0
C
1
C
2
C
3
C
4
C
5
C
6
PV at 6%
A 15 4 4 19 4 4 4 47.26
B 10 6 16 6 16 6 6 56.32
Therefore, we should prefer machine A.
An equivalent way is to compute the equivalent annual cost: the cash
ow C of an annuity having the same life and PV as the machine.
Thus, for machine A, we look for C
A
that will make the PV of the
following two streams of cash ows equal.
0 1 2 3
15 4 4 4
C
A
C
A
C
A
PV = 25.69
, C
A
a
3[6%
=
C
A
0.06
_
1
1
(1.06)
3
_
= 25.69
= C
A
= 9.61.
The machine would rent for $9, 610 per year in an ecient market.
Similarly, for machine B:
0 1 2 3
10 6 6
C
B
C
B
PV = 21.00
, C
B
a
2[6%
=
C
B
0.06
_
1
1
(1.06)
2
_
= 21.00
= C
B
= 11.45.
Again, since C
B
> C
A
, we should choose machine A.
If we repeat the project (either over a 6-year horizon or to innity), it
is much easier to compare the EACFs than the original cash ows.
Original cash ows:
0 1 2 3 4 5 6 ...
15 4 4 4 + 15 4 4 4 + 15 ...
10 6 6 + 10 6 6 + 10 6 6 + 10 ...
EACFs:
0 1 2 3 4 5 6 ...
9.61 9.61 9.61 9.61 9.61 9.61 9.61 ...
11.45 11.45 11.45 11.45 11.45 11.45 11.45 ...
Example: Arnolds Armory
Arnold is tired of the Commando business, so he starts a gun shop for
people with annoying neighbors.
His shop needs a new delivery van. Arnold has narrowed his choice
down to two dierent models. Both require $1,000 in annual
maintenance, and have exactly the same cargo space. The dierences
are their fuel eciency, useful life and initial purchase price.
Miles Purchase Useful Resale
Model per gallon price Life Value
A 20 $12,000 3 years $1,100
B 30 $18,000 5 years $2,000
The van will be used approximately 24,000 miles per year, and the
cost of gasoline is $1 per gallon. The cost of capital is 10%. All
gures are in nominal terms.
Suppose that the tax rate is 30% and that the vans will be
depreciated straight-line (to zero) over their useful life. Which van
should Arnold buy?
Example: Arnolds Armory (contd)
Here are the after-tax cash ows for van A:
End of Year
Cash Flows 0 1 and 2 3 calculations
Purchase van A -12,000
Maintenance -700 -700 [= 1, 000 (1 30%)]
Fuel -840 -840 [=
24,000
20
1 (1 30%)]
Depreciation tax shield 1,200 1,200 [=
12,000
3
30%]
Sale of van A 770 [= 1, 100 (1 30%)]
Original cash ows -12,000 -340 430
Equivalent Cash Flows CF
A
CF
A
,NPV
A
= 12,000 340a
2[10%
+
430
(1.10)
3
= 12, 267.02 = CF
A
a
3[10%
= CF
A
= 4, 932.75
Example: Arnolds Armory (contd)
Here are the after-tax cash ows for van B:
End of Year
Cash Flows 0 1 to 4 5 calculations
Purchase van B -18,000
Maintenance -700 -700 [= 1, 000 (1 30%)]
Fuel -560 -560 [=
24,000
30
1 (1 30%)]
Depreciation tax shield 1,080 1,080 [=
18,000
5
30%]
Sale of van B 1,400 [= 2, 000 (1 30%)]
Original cash ows -18,000 -180 1,220
Equivalent Cash Flows CF
B
CF
B
,NPV
B
= 18,000 180a
4[10%
+
1, 220
(1.10)
5
= 17,813.05 = CF
B
a
5[10%
= CF
B
= 4,699.04 > CF
A
Example: When to Replace Existing Equipment
In the previous example we have taken the life of each machine as
given. In fact, the time at which to replace a machine should also be
the result of a capital budgeting decision.
Suppose your machine is expected to produce a cash ow of $4,000 in
one year and $3,000 in two years. After that it will have to be
replaced. The resale value is $1,000 if you replace now, $500 next
year, and zero otherwise. The best alternative is a new machine that
will be optimally replaced every 3 years, giving the following cash
ows (inclusive of the resale value in year 3):
Cash Flows
C
0
C
1
C
2
C
3
PV at 6%
-15,000 8,000 8,000 10,000 8,063.33
When should you replace your existing machine? (Assume no taxes.)
Example: When to Replace Existing Equipment (contd)
First, let us calculate the equivalent annual cash ow EACF for the
new machine:
0 1 2 3
-15, 000 8, 000 8, 000 10, 000
PV = 8, 063.33 EACF EACF EACF
, EACFa
3[6%
=
EACF
0.06
_
1
1
(1.06)
3
_
= 8,063.33
= EACF = 3,016.57.
The three options are:
(a) replace now;
(b) replace in one year;
(c) replace in two years.
The cash ows for each of these options can be represented as follows:
0 1 2 3 4 ...
(a) 1, 000 3, 016.57 3, 016.57 3, 016.57 3, 016.57 ...
(b) 4, 500 3, 016.57 3, 016.57 3, 016.57 ...
(c) 4, 000 3, 000 3, 016.57 3, 016.57 ...
The PVs of these cash ows are calculated as follows:
PV
a
= 1,000 +
3,016.57
0.06
= 51,276.21;
PV
b
=
4,500
1.06
+
1
1.06
_
3,016.57
0.06
_
= 51,675.67;
PV
c
=
4,000
1.06
+
3,000
(1.06)
2
+
1
(1.06)
2
_
3,016.57
0.06
_
= 51,189.22.
The best option is to replace in one year.
Notice that the cash ows after year 2 are the same for all three
options. Thus we could have compared the three options by
comparing their PVs over the rst two years only.
Capital Budgeting Under Resource Constraints
Projects also interact if they require the same limited resources. We
assume that this resource is money, but the same principle applies to
other resources.
One possibility is to get the biggest bang for the buck by choosing
the projects with the highest ratio of NPV to initial outlay (the
protability index). PI =
NPV
C
0
.
This rule has two key limitations:
It fails when more than one resource is constrained or there is any
other constraint on project choice (e.g. mutual exclusivity).
It is not valid if it is not possible to undertake fractional investments.
If you have $11m in the following example, you will choose B and C
Project Cost (millions) PV (millions) Protability Index
A 10 31.0 2.1
B 6 18.0 2.0
C 5 14.5 1.9
Key Takeaways: Using the NPV Rule
Free Cash Flow = Cash From Operations - Capex
CFO is not prot. It is after tax, ignores sunk costs, and includes
opportunity costs. 3 ways to calculate:
1
(R E D +X) (1 t
c
) +D
2
R E +X t
c
(R E D +X)
3
(R E +X) (1 t
c
) +t
c
D
Discount nominal cash ows at a nominal discount rate; discount real
cash ows at a real discount rate
If dierent lives, calculate Equivalent Annual Cash Flow: the cash
ow of an annuity with the same life and PV as the investment.
Equals the annual lease rate
If resource constraints, calculate Protability Index: PI =
NPV
C
0
Checkpoint: Using the NPV Rule
BMA: chapter 6
Problem set: 1, 6, 8, 9, 14, 26, 29
Bulk pack problem set #4, questions 1-6
Additional Materials provides an overview of Linear Programming,
which is sometimes used with resource constraints
What is next?
BMA: chapter 5
I.3.3 Alternatives to the NPV Investment Rule
I.3.3 Alternatives to the NPV Investment Rule
Readings: BMA, chapter 5.
FNCE 750: Venture Capital and the Finance of Innovation.
NPVs Competitors
Despite the optimality of the NPV rule, alternative investment rules
have beenand to some extent still areused by businesses.
We will now look at four common alternatives to NPV. They are:
1. Payback period.
2. Accounting rate of return.
3. Internal rate of return.
4. Protability index.
We will see that the internal rate of return and the protability index,
when properly used, lead to the same decisions as the NPV rule.
NPVs Competitors (contd)
As the following survey shows, many of the above investment rules
were still broadly used in the 1980s.
U.S. U.S. Japan
Method (1950s) (1980s) (1980s)
Payback 34% 12% 40%
Acctg rate of return 34% 8% 19%
IRR 19% 49% 15%
NPV - 19% 9%
Other 6% 10% 2%
None 6% 2% 15%
NPVs Competitors (contd)
The most recently available comprehensive survey shows that net
present value (NPV) and internal rate of return (IRR) are being
increasingly commonly used in the U.S.:
% of CFOs using
Protability index 12%
Acctg rate of return 20%
Payback 57%
NPV 75%
IRR 76%
Source: Graham and Harvey (2001): The Theory and Practice of
Finance: Evidence From the Field. Journal of Financial Economics
Features of the NPV Rule
When looking at NPVs competitors, it is important to keep in mind
the main features of the NPV rule:
Time value of money: $1 today > $1 tomorrow.
NPV depends only on all the forecasted cash ows from the project
and the opportunity cost of capital.
* Any rule ignoring some of the projects cash ows will lead to
suboptimal decisions.
* Any rule aected by the managers tastes, the protability of the
companys existing business, or the protability of other independent
projects will lead to inferior decisions.
Since PVs are all measured in todays dollars, you can add them up.
* The NPV rule can thus identify whether joint projects are better than
single projects.
Clear benchmark: accept if NPV > 0
The alternatives to the NPV rule often fail to satisfy one or more of
these critical features.
The Payback Period Rule
The payback period of a project is the number of years it takes to
recover the initial investment. The payback period rule accepts a
project if the payback period is less than some given cuto.
Here are some examples:
Cash Flows Payback NPV
Project C
0
C
1
C
2
C
3
Period at 10%
A 2, 000 2, 000 1 181.82
B 2, 000 1, 000 1, 000 1, 000 2 486.85
C 2, 000 1, 000 1, 000 10, 000 2 7, 248.69
The basic weaknesses of the payback rule are:
It ignores the time value of money.
It ignores the cash ows beyond the cuto period.
It gives no indications on what the cuto rule should be.
Some companies discount the cash ows before computing the
payback rule. This only addresses the rst weakness.
The Accounting Rate of Return
The accounting rate of return (also known as average return on book
value)is computed by dividing the average net income from a project
(prot after taxes) by the average book value of the investment:
(beginning investment - ending investment)/2
This ratio is then compared with the book rate of return for the rm
as a whole (or some other equally absurd yardstick).
This criterion suers from several defects:
It ignores the relevant cash ow from investment and instead considers
the accounting prots (in particular, it depends critically on the
accountants choice of a depreciation method).
It ignores the time value of money (as well as the risk of the project).
The choice of a yardstick is totally arbitrary.
The Internal Rate of Return Rule
The internal rate of return (IRR) of a project is dened as the
constant discount rate y which makes NPV = 0. In other words, y
solves
NPV =
T
t=0
C
t
(1 +y)
t
= 0
Analogy: bond yield is the discount rate that makes PV = P
0
, i.e.
NPV = 0
The IRR rule says that a project should be accepted if and only if y
exceeds the yield on nancial securities (bonds) with comparable
maturity, cash ows and risk (the opportunity cost of capital).
Notice that with a at term structure (r
t
= r for all t), the IRR rule
implies that we should accept a project if and only if y > r .
The Internal Rate of Return Rule (contd)
For example, consider the following project:
C
0
C
1
C
2
C
3
5, 000 2, 000 2, 000 2, 000
The graph below shows that, with a at term structure, the IRR rule
is equivalent to the NPV rule.
Limitations of the IRR Rule: 1. Non-Flat Term Structure
The IRR rule is very dicult to apply with a non-at term-structure,
since the opportunity cost of capital is now a complicated average of
the interest rates r
1
, r
2
, . . ., r
T
.
For example, assume the following term structure,
t
1 2 3 4 5
r
t
4.00% 4.50% 5.00% 5.50% 6.00%
and consider the two projects:
Project C
0
C
1
C
2
C
3
C
4
C
5
IRR NPV
A 1, 000 20 20 20 20 1, 200 5.24% 32.32
B 1, 000 50 50 1, 050 5.00% 0.89
Why does project A have higher IRR but lower NPV?
(contd)
Answer: the IRR of A should be compared to a cuto dierent from
B. The IRR for project A (B) should be compared to the yield on a
5-year (3-year) bond with the same cash ows.
The prices P
5
and P
3
of such 5-year and 3-year bonds are
P
5
=
20
1.04
+
20
(1.045)
2
+ +
1,200
(1.06)
5
= 967.68,
P
3
=
50
1.04
+
50
(1.045)
2
+
1,050
(1.05)
3
= 1,000.89.
(contd)
The yields on these two bonds can be calculated as follows:
967.68 =
20
1 +y
A
+
20
(1 +y
A
)
2
+ +
1,200
(1 +y
A
)
5
= y
A
= 5.96%.
1,000.89 =
50
1 +y
B
+
50
(1 +y
B
)
2
+
1,050
(1 +y
B
)
3
= y
B
= 4.97%.
Since IRR
A
< y
A
, we should reject project A. However, since
IRR
B
> y
B
, we should accept project B.
Note that, since NPV
A
= 1, 000 + 967.68 and
NPV
B
= 1,000 + 1,000.89, we have essentially gone back to the
NPV rule!
Limitations of the IRR Rule: 2. Lending or Borrowing?
Another problem with the IRR rule is that it is necessary to
distinguish between borrowing and lending opportunities, as the
following example shows:
Project C
0
C
1
C
2
IRR
A (lending) 5, 000 3, 000 3, 000 13%
B (borrowing) 5, 000 3, 000 3, 000 13%
Limitations of the IRR Rule: 2. Lending or Borrowing?
(contd)
In the above example, it was easy to tell that project A was lending
(and so we want IRR > discount rate) and that project B was
borrowing (and so we want IRR < discount rate).
But, how about the following case? Is this borrowing or lending?
Project C
0
C
1
C
2
C
3
IRR
C 1, 000 3, 600 4, 320 1, 728 20%
Limitations of the IRR Rule: 3. Multiple or no IRRs
A project can have more than one IRR (in general, there can be as
many dierent IRRs as there are changes in the sign of cash ows). In
fact, it is also possible that the IRR does not exist for some projects.
As an example, consider the following two projects
Project C
0
C
1
C
2
IRR
A 5, 000 20, 000 18, 000 37% and 163%
B 5, 000 15, 000 12, 500 none
Limitations of the IRR Rule: 4. Mutually Exclusive Projects
Finally, the IRR rule can be misleading when choosing between
mutually exclusive projects, as the following example shows (we
assume that the term structure is at at 10%):
Project C
0
C
1
C
2
IRR NPV at 10%
A -2,000 2,000 3,000 82.29% 2,298
B -5,000 1,000 9,000 44.54% 3,347
The IRR can be salvaged in the case of mutually exclusive projects by
computing the IRR for the incremental cash ows.
Project C
0
C
1
C
2
IRR
B A 3, 000 1, 000 6, 000 25.73%
Since the IRR of the incremental cash ows is greater than 10%, we
should choose B over A.
The Protability Index Rule
The protability index is dened as the NPV of future cash ows
divided by the initial investment:
PI =
NPV
C
0
=

T
t=0
C
t
/(1 +r
t
)
t
C
0
.
The PI index rule entails accepting a project if and only if PI > 0.
Note that since
PI =
NPV
C
0
,
the PI rule is equivalent to the NPV rule (provided that C
0
< 0).
The Protability Index Rule (contd)
As with the IRR rule, however, the acceptance rule has to be reversed
for borrowing projects (C
0
> 0).
Moreover, the PI rule can be misleading when applied to mutually
exclusive projects, unless we look at the incremental cash ows. This
is shown in the following example (where once again we assume that
the term structure is at at 10%):
Project C
0
C
1
PI NPV at 10%
A -1,000 2,000 0.82 818
B -10,000 15,000 0.36 3,636
B-A -9,000 13,000 0.31 2,818
The PI rule assumes that you invest only once, in year 0, and that you
cannot reinvest the proceeds in the same project or other projects later
Key Takeaways: Alternatives to the NPV Rule
Investment rule should:
Consider time value of money
Consider all of a projects cash ows, and only these cash ows: ignore
existing projects.
Have a clear benchmark
Payback period: number of years to recover initial investment
Accounting return: net income / average investment
Internal rate of return: constant discount rate which makes NPV = 0.
Like bond yield. Accept if IRR > r . Problems if:
Non-at term structure: what r to compare against?
Lending or borrowing: if latter, accept if IRR < r
Multiple IRRs or no IRRs
Mutually exclusive projects
Checkpoint: Alternatives to the NPV Rule
BMA: chapter 5.
Problem set: 1, 4, 5, 7, 8, 11, 13, 14
Bulk pack problem set #4, questions 7-9
What is next?
The Placement Exam
Summary of Key Takeaways
Summary of Key Takeaways
The following slides are the key takeaways for each of the sections of
the course
These key takeaways are already at the end of the respective sections
of the bulk pack. I am repeating them here for easy reference by
putting them all in one place, this may help with revision and also
with looking up formulas in the exam
Note that there is also a formula sheet at the end of the Problem
Sets and Solutions bulk pack
Key Takeaways: Constant Interest Rate
Compounding factor gives future value of $1
CF
T
=
_
1 +
r
m
_
mT
= e
rT
if m
Eective annual rate gives equivalent rate under once-a-year
compounding
r =
_
1 +
r
m
_
m
1
Discount factor gives present value of $1
DF
T
= 1/CF
T
Growing perpetuity: PV
0
= C
1
/ (r g)
Annuity factor gives PV of $1 for T years. a
T[r
=
1
r
_
1
1
(1+r )
T
_
Real rate of return R =
1+r
1+i
1
Key Takeaways: Term Structure
Spot rate r
T
is the rate per year for T years starting today
The term structure is the graph of r
1
, r
2
, ... for dierent T
With a non-at term structure, PV =
T
t=1
C
t
(1+r
t
)
t
Forward rate f
t
is the rate for 1 year starting at t 1 and ending at t:
f
t
=
(1+r
t
)
t
(1+r
t1
)
t1
1
Key Takeaways: Pricing Bonds
Treasury bills pay no coupon, and are quoted in terms of a discount
rate: P = F
_
1 d
N
360
_
Treasury notes and bonds pay a semiannual coupon (
C
2
every 6
months), and are quoted in units of 1/32
The price of a bond is P =
T
t=1
C
(1+r
t
)
t
+
F
(1+r
T
)
T
where r
t
is the
t-year spot rate
The yield of a bond is the single constant discount rate y that solves
P =
T
t=1
C
(1+y )
t
+
F
(1+y )
T
. It is a (weighted geometric) average of
the spot rates
For Treasuries, quoted yields are semiannual APRs: y given by
_
1 +
y
2
_
2
= 1 + y
The coupon of a bond is xed. Its yield depends on market
conditions, and is inversely related to its price
Key Takeaways: Capital Budgeting Under Certainty
The required rate of return on a project is determined exclusively by
the rate of return available elsewhere in the capital market
It is independent of shareholders preferences for consumption today vs.
consumption tomorrow
A nancial manager can therefore ignore shareholder preferences.
His/her goal is simply to maximize shareholder value, by taking
positive-NPV projects and rejecting negative-NPV projects
Once shareholder value is maximized, shareholders can use borrowing
and lending to choose whatever consumption pattern suits their
individual preferences
The Fisher separation theorem assumes capital markets are complete,
ecient and perfect
Key Takeaways: Using the NPV Rule
Free Cash Flow = Cash From Operations - Capex
CFO is not prot. It is after tax, ignores sunk costs, and includes
opportunity costs. 3 ways to calculate:
1
(R E D +X) (1 t
c
) +D
2
R E +X t
c
(R E D +X)
3
(R E +X) (1 t
c
) +t
c
D
Discount nominal cash ows at a nominal discount rate; discount real
cash ows at a real discount rate
If dierent lives, calculate Equivalent Annual Cash Flow: the cash
ow of an annuity with the same life and PV as the investment.
Equals the annual lease rate
If resource constraints, calculate Protability Index: PI =
NPV
C
0
Key Takeaways: Alternatives to the NPV Rule
Investment rule should:
Consider time value of money
Consider all of a projects cash ows, and only these cash ows: ignore
existing projects.
Have a clear benchmark
Payback period: number of years to recover initial investment
Accounting return: net income / average investment
Internal rate of return: constant discount rate which makes NPV = 0.
Like bond yield. Accept if IRR > r . Problems if:
Non-at term structure: what r to compare against?
Lending or borrowing: if latter, accept if IRR < r
Multiple IRRs or no IRRs
Mutually exclusive projects

FNCE 604 - Accelerated Corporate Finance: Alex Edmans

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