MIN 100 Investment Analysis: University of Stavanger E-Mail

MIN 100
Investment Analysis
Roy Endr Dahl
University of Stavanger

E-mail: roy.e.dahl@uis.no
1
0-2
MIN 100 Investment Analysis
Week / date Chapters / Topic Note
35 29.08.2011
1-3 / Introduction and basic
concepts.
Part 1: Overview
37 12.09.2011
4-5 / Net present value, bonds,
markets
Part 2: Valuation and Capital
budgeting
38 19.09.2011
6-7 / Stocks, NPV and other
investment rules
39 26.09.2011
8-9 / Cash flow and capital
budgeting, decision tree, sensitivity,
Monte Carlo
40 03.10.2011
10-11 / Return and Risk, expected
return, CAPM
Part 3: Risk and Return
41
Mandatory assignment
42 17.10.2011
11-12 / CAPM, Risk, Cost of Capital
43 24.10.2011
13-14 / Financing, capital structure,
Modigliani & Miller
Part 4: Capital Structure and Dividend
Policy
44 31.10.2011
15-16 / Use of debt, leverage,
dividends
45 07.11.2011
17 / Financial and Real Options. Part 5: Special topics
Review of questions from last lecture
We are scheduled until 1600. How long will the
lectures be?
A typical lecture will be until 1500, but it might be
shorter depending on complexity of the theme and
time spent presenting problems in Excel.
Will you be giving grades for the mandatory
assignment?
No. There will only be passed or not passed. In
order to take the exam you must pass the mandatory
assignment.
3
Discounted Cash Flow Valuation
Chapter 4
McGraw-
Hill/Irwin
4-5
Appreciate the significance of compound vs. simple
interest
Describe and compute the future value and/or present
value of a single cash flow or series of cash flows
Define and calculate the return on an investment
Comprehend and calculate time value metrics for
perpetuities and annuities
Familiarization with loan types

Key Concepts and Skills
4-6
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 Loan Types and Loan Amortization
4.6 What Is a Firm Worth?
Chapter Outline
Opening Case
The education dilemma
http://www.tu.no/jobb/article289898.ece
7
Opening Case
After graduating from High School at around 20
years of age, you can choose to either:
Start working as an unskilled employee
Start a higher education (Bachelor/Master)
Assuming the following:
You will have work your entire career, regardless of
education, and will work until you are 67 years of age.
Unskilled employees start at 200 000 a year.
The cost of education is 55 000 a year.
How much do you have to earn after your
Masters degree to justify (economically)
taking an education?
8
Opening Case
The opening case shows that due to the postponed
entrance in the work market and the extra loan needed
to take the education, the skilled worker need to earn
230 000 (or 15% more) each year compared to the
unskilled worker.
However, this is a simplified version, and we will revisit
this question at the end of chapter 4.
9
Opening Case
10
Source: http://www.ssb.no/lonn/
Junior High
School
High School
1 - 4 years at
University
More than 4
years at
University
Female 27100 30800 36900 45500
Male 30300 37500 46300 55900
0
10000
20000
30000
40000
50000
60000
Average monthly salary in Norway
Female
Male
Almost 50%
increase
4-11
A dollar today is more valuable than a
dollar to be received in the future

Why?
A dollar today is more valuable because:
It can be invested to make more dollars
It can be immediately consumed
There is no doubt about its receipt

The Essential Premise
4.1 The One-Period Case
A seller gets two offers:
1. Sell his property now for $10 000.
2. Sell his property in one year for $11 424.
If the risk free interest rate in the bank is 12%, is option
(1) or (2) the best decision?

You can evaulate this using two methods:
Present Value: The value today of a payment to be received in
the future.
Future Value: The value in the future of a sum invested today.
12
4-13
The Net Present Value (NPV) of an investment is
the present value of the expected cash flows,
less the cost of the investment.

Suppose an investment that promises to pay
$10,000 in one year is offered for sale for
$9,500. Your interest rate is 5%.

Should you buy?
Net Present Value
4-14
81 . 23 $
81 . 523 , 9 $ 500 , 9 $
05 . 1
000 , 10 $
500 , 9 $
=
+ =
+ =
NPV
NPV
NPV
Net Present Value
The present value of the cash inflow is greater than the cost.
In other words, the Net Present Value is positive, so the
investment should be purchased.
In the one-period case, the formula for NPV can
be written as:
NPV = -Cost + PV
4-15
The previous examples considered only
one period of time.
It is possible to compute PV & FV for
multiple periods of time.
Doing so we need to differentiate
between simple and compound interest
4.2 The Multiperiod Case
Simple vs. Compound interest
As an investor with $1000 you can choose between simple an
compound interest at an interest rate of 9.0%.
After one year you will have earned $90 (1000 x .09).

With simple interest you withdraw the $90 from the market and
reinvest only $1000 for the next year. You will therefore receive
$90 in interest also for year 2.

With compound interest you also reinvest the interest for a total of
$1090 the next year, giving you $98.10 interest for year 2, an
amount $8.10 greater than the previous year.
In other words, the earnings also earn interest or are compounded.

Compounding may not seem very compelling the early years of an
investment. But, we will see that it is a very powerful long term
force.

4-16
4-17

Compound Interest
Money makes money and the money that money
makes makes more money.
Benjamin Franklin
The compounded interest can be formulated as the sum
of simple interest and interest on interest:
Compound interest = Simple interest + Interest on interest
Assume that $1 is invested at 9% interest rate for two
years. The compounded rate can the be found as:
$1 * (1 + r) * (1 + r) = $1 * (1 + r)
2
= 1 + 2r + r
2

$1 * (1.09) * (1.09) = $1 * (1.09)
2
= $1 + $0.18 + $0.0081 = $1.1881
18
Simple
interest
Interest on
interest
Compound
interest
19
-
2,000.00
4,000.00
6,000.00
8,000.00
10,000.00
12,000.00
0 1 2 3 4 5 6 7 8 9 101112131415161718192021222324252627282930
Compound interest
Simple interest
Initial investment
4-20
The general formula for the future value of an investment
over many periods can be written as:
FV = C
0
(1 + r)
T

The general formula for the present value of an investment
over many periods can be written as:
PV = C
T
/ (1 + r)
T

Where
C
0
is cash flow at date 0,
C
T
is cash flow at date T,
r is the appropriate interest rate, and
T is the number of periods over which the cash is invested.
Multiperiod Formulas
4-21
Examples thus far have offered the time and interest
rate and solved for PV or FV
Keep in mind that there are four variables:
PV
FV
T
R
If you have any three you can solve for the fourth
The math can become cumbersome
Spreadsheets are very helpful

Solve for Any Variable
22
Base on a given series of annual cash flows
(C
0
, C
1
, C
2
, C
3
, C
4
, . . . C
n
), the present value
can be calculated as:

. . . or more elegantly as the sum:
Discounting and present value
n
n
r
C
r
C
r
C
C PV
) 1 ( ) 1 ( ) 1 (
2
2 1
0
+
+ +
+
+
+
+ =
=
+
=
n
t
t
t
r
C
PV
0
) 1 (
Would you make an investment of 13 500 NOK
if you recieved the following payout for the
next 5 years?
Year 0: 2 500
Year 1: 2 000
Year 2: 3 500
Year 3: 4 600
Year 4: 2 700
The discount rate is 6%.
23
= 15 300 NOK
24
Consider the following series of cash-flows:

Calculation of present value
) 700 2 , 600 4 , 500 3 , 000 2 , 500 2 ( ) , , , , (
4 3 2 1 0
= C C C C C
68 , 502 13
65 , 138 2 25 , 3862 99 , 114 3 79 , 886 1 500 2
) 06 , 0 1 (
700 2
) 06 , 0 1 (
600 4
) 06 , 0 1 (
500 3
06 , 0 1
000 2
500 2
4 3 2
=
+ + + + =
+
+
+
+
+
+
+
+ = NV
25
End of
year 0
NOK 2 500
End of
year 1
NOK 2 000
End of
year 2
NOK 3 500
End of
year 3
NOK 4 600
End of
year 4
NOK 2 700
Present value

Sum PV
2 500.00
1 886.79
3 114.99
3 862.25
2 138.65
13 502.68
1
(1+0.06)
1
(1+0.06)
2
1
(1+0.06)
3
1
(1+0.06)
4
PV > Cost Profitable investment!
26
The impact of discounting
0
5
10
15
20
25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
The sum of both these cash-flow profiles
equal 200 before discounting

27
The impact of discounting
0
5
10
15
20
25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
NV = 144,84
NV = 105,69
The we discount with 5% discount rate

Opening Case Revisited
After graduating from High School when 18 or 19 years
of age, you can choose to either:
Start working as an unskilled employee
Start a higher education (Bachelor/Master)
Would you choose education (based on economical
factors only), considering the following assumptions:
Starting salary at 200 000 as an unskilled worker with an
average increase in salary of 3,5%.
Starting salary at 230 000 as a skilled worker with an average
increase in salary of 4,0%.
Inflation rate is 2,5% and education costs 54 480,- each year
(loan from Lnekassen after scholarship money has been
deducted).
28
Earlier we saw that when the salary for the skilled
worker was 230 000 from 26 an onwards, the skilled and
unskilled worker earned the same throughout their
working careers.
Now, we have given the skilled worker a higher increase
in salary per year (4,0% vs. 3,5%), which when we sum
up their complete salary payment over their career puts
the skilled worker in front with close to 1 million.
But due to inflation the unskilled worker is far better off,
with 366 520,- . This is due to:
Skilled worker has costs early in the career (financing the
education) which is comparatively more expensive money
than the higher salary at the end of the career.
29
Education dilemma
Inflation 2.50 %
Case 1: Unskilled worker
Salaray 200 000
Loan -
Yearly wage rise 3.50 %
Case 2: 5 years Master's degree
Salary 230 000
Loan pr year 54 480
Cash flow 20 21 22 23 24 25 66 67
Case 1 200 000 207 000 214 245 221 744 229 505 237 537 973 388 1 007 457
Case 2 -54480 -54480 -54480 -54480 -54480 230 000 1 148 404 1 194 340
Difference -254 480 -515 960 -784 685 -1 060 909 -1 344 893 -1 352 430 765 913 952 796
Difference at 67 952 796
NPV Cash flow 20 21 22 23 24 25 66 67
Case 1 200 000 392 147 591 095 791 984 994 832 1 199 660 11 564 925 11 872 875
Case 2 -54 480 -105 006 -155 596 -204 952 -253 104 -54 776 11 141 280 11 506 355
Difference -254 480 -497 154 -746 691 -996 936 -1 247 937 -1 254 437 -423 644 -366 520
NPV Difference at 67 -366 520
30
When summing up education expenses and
total salary until pension age at 67, the skilled
worker seems to be a better solution with 953
000,- greater total.

However when adjusting for inflation, the
unskilled worker is better off, with 367 000,-
higher payoff.

4-31
All examples thus far have assumed annual
compounding: Interest or return have been yearly.
However, banks may compound interest quarterly,
monthly or daily and mortgage companies often
compound interest monthly.
Yet, almost all interest rates are expressed annually
If a rate is expressed annually, but compounded more
frequently, then the effective rate is higher than the
stated rate. This concept is called the Effective
Annual Rate or EAR.
4.3 Compounding Periods
Credit Loan
32

4-33
You have been offered a credit loan of 100 000
with no security at only 1 500 a month.
Calculate the Effective Annual Rate (EAR).
What we have is a loan with a monthly interest
rate of 1.5% or a yearly interest rate of 18%.
This is equivalent to a loan with an annual
interest rate of 19.56%.
Effective Annual Rates of
Interest
1956 . 1 ) 015 . 1 (
12
18 .
1 1
12
12
= =
|
.
|
\
|
+ =
|
.
|
\
|
+
m
m
r
4-34
The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C
0
e
rT
Where
C
0
is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a constant that is approximately equal to
2.718.
Continuous Compounding
4-35
Perpetuity
A constant stream of cash flows that
lasts forever
Growing perpetuity
A stream of cash flows that grows at a
constant rate forever
Annuity
A stream of constant cash flows that
lasts for a fixed number of periods
Growing annuity
A stream of cash flows that grows at a
constant rate for a fixed number of
periods
4.4 Simplifications
(
+
=
T
r r
C
PV
) 1 (
1
1
(
(
|
|
.
|
\
|
+
+
=
T
r
g
g r
C
PV
) 1 (
) 1 (
1
r
C
PV =
g r
C
PV
=
Annuity example (4.19)
Lottery valuation
Mark Young won the state lottery, paying
$50 000 for 20 years. This was advertised
as a Million Dollar Lottery, since $50 000 *
20 = $1 000 000.
But, what is the true value if the interest
rate is 8%?
36
PV = 50 000 *[ (1 (1 / 1.08
20
)) / 0.08]
PV = 50 000 * 9.8181
PV = $490 905
4-37
Growing Annuity: Example
You are evaluating an income generating property. Net
rent is received at the end of each year.

The first year's rent is expected to be $8,500, and rent is
expected to increase 7% each year.

What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?
4-38
Growing Annuity: Example
Remember that the following formula will give you the net present
value for a cash flow C given a discount rate r:
=NPV(r, C) (English)
=NNV(r; C) (Norwegian)
Growing annuity
Initial cash $8 500,00 C
Growing rate 7 % g
Discounting rate 12 % r
YEAR 1 2 3 4 5
Yearly rent $8 500,00 $9 095,00 $9 731,65 $10 412,87 $11 141,77
Discounted $7 589,29 $7 250,48 $6 926,80 $6 617,56 $6 322,14
PV $34 706,26
$34 706,26 =NPV(r , YearlyRent)
(
(
|
|
.
|
\
|
+
+
=
T
r
g
g r
C
PV
) 1 (
) 1 (
1
4-39
1. Pure Discount Loans are the simplest form of loan. The
borrower receives money today and repays a single
lump sum (principal and interest) at a future time.
2. Interest-Only Loans require an interest payment each
period, with full principal due at maturity.
3. Amortized Loans require repayment of principal over
time, in addition to required interest. This is usually
divided in two groups:
Serial (regular amortized loan)
Annuity (amortized loan with fixed principal payment)
4.5 Loan Types and Loan Amortization
4-40
You are investing in your first apartment, and
other than your private equity from BSU at 150k
NOK, you have to borrow 2000k NOK at 5% fixed
interest rate. The bank advices you to choose
annuity over 30 years, to keep costs low in the
beginning.

Is this a sound advice, or should you ask for a
serial loan?
Mortgage / Loan on property
Mortgage / Loan on property
House loan
Amount 2 000 000 NOK
Maturity 30 Years
Intereste rate 5,0 % Pr year
Inflation rate 2,5 % Pr year
SERIAL LOAN 0 1 2 3 4 29 30
Investment -2 000 000
Downpayment 66 667 66 667 66 667 66 667 66 667 66 667
Interest 100 000 96 667 93 333 90 000 6 667 3 333
Yearly outlay 166 667 163 333 160 000 156 667 73 333 70 000
Monthly outlay 13 889 13 611 13 333 13 056 6 111 5 833
Total paid 3 550 000
NPV paid 2 604 647
ANNUITY LOAN 0 1 2 3 4 29 30
Investment -2 000 000
Downpayment 30 103 31 608 33 188 34 848 118 007 123 907
Interest 100 000 98 495 96 914 95 255 12 096 6 195
Yearly outlay 130 103 130 103 130 103 130 103 130 103 130 103
Monthly outlay 10 842 10 842 10 842 10 842 10 842 10 842
Total paid 3 903 086
NPV paid 2 723 091
41
Comparing the total sum paid, serial loan is
350k cheaper than an annuity. However, after
discounting the difference is smaller, and
considerations about higher downpayments
during the first years should be considered.
4-42
Conceptually, a firm should be worth the
present value of the firms cash flows.
The tricky part is determining the size,
timing and risk of those cash flows.

We will focus on valuating a projects
worth, and later chapters include several
techniques for this.
4.6 What Is a Firm Worth?
43
Closing Case
The MBA decision
Ben is 28 years and currently employed at East Coast Yachts, where
his salary is $50 000 per year, increasing at 3,0% each year.
He expects to work for 40 more years.
Through his savings account he can afford to take a 2 year MBA
degree at Wilton University, which costs $67 500 each year
including books and tuition and $5 000 more in health insurance
and room expenses.
After graduation he will receive a job offer worth $90 000 per year,
with a $15 000 signing bonus and 4,0 % increase in salary per year.
His marginal tax will increase from 26 percent to 31 percent.
Discount rate is 6.5 %.

Is the MBA a good investment?
How does Bens age affect the decision?

Closing Case
The MBA decision
Discount rate 6.50 %
Case 1: No MBA
Salaray 50 000
Cost pr year -
Marginal tax rate 26.0 %
Case 2: 2 year MBA
Salary 90 000
Signing bonus 15 000
Cost pr year 72 500
Marginal tax rate 31.0 %
Cash flow 28 29 30 31 67 68 69
Case 1 37 000 38 110 39 253 40 431 117 180 0 0
Case 2 -14500 -14500 72 450 64 584 265 048 275 650 286 676
Difference -51 500 -104 110 -70 913 -46 760 2 530 261 2 805 912 3 092 588
Difference after 40 years 2 530 261
NPV Cash flow 28 29 30 31 67 68 69
Case 1 37 000.00 68 341.82 100 837.63 132 265.50 779 402.90 779 402.90 779 402.90
Case 2 -14 500.00 -26 399.08 33 578.58 83 781.22 1 284 167.45 1 305 013.54 1 325 370.28
Difference -51 500 -94 741 -67 259 -48 484 504 765 525 611 545 967
Difference after 40 years 504 765
44
When summing up education expenses and
total salary until pension age after 40 years of
work, the decision is easy as with an MBA the
total is 2,5 million (dollars) better.

Also after adjusting for the discount rate at
6,50% the MBA is a good investment as NPV
MBA > NPV no MBA.
Interest Rates and Bond Valuation
Chapter 5
McGraw-
Hill/Irwin
5-45
Know the important bond features and bond types
Comprehend bond values and why they fluctuate
Compute bond values and fluctuations
Appreciate bond ratings, their meaning, and
relationship to bond terms and value
Understand the impact of inflation on interest rates
Grasp the term structure of interest rates and the
determinants of bond yields
Key Concepts and Skills
5-46
5.1 Bonds and Bond Valuation
5.2 More on Bond Features
5.3 Bond Ratings
5.4 Some Different Types of Bonds
5.5 Bond Markets
(5.6 Inflation and Interest Rates)
(5.7 Determinants of Bond Yields)

Chapter Outline
5-47
Bonds
48

A bond is a legally binding agreement between a
borrower and a lender that specifies the:
Par (face) value
Coupon rate
Coupon payment
Maturity Date
The yield to maturity is the required market
interest rate on the bond.
Do not confuse the coupon rate with the
required market interest rate

5.1 Bonds and Bond Valuation
5-49
Primary Principle:
Value of financial securities = Present Value
of expected future cash flows
Bond value is, therefore, determined by
the present value of the coupon
payments plus the present value of the
par, or face, value
Interest rates are inversely related to
present (i.e., bond) values.
Bond Valuation
5-50
Xanth Co. has issued a 10 year bond with an 8% annual coupon. The cash
flows from the bond would be paid as follows:

Conceptual Cash Flow of a 10 Year Bond
T
T
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(
+
=
The first term is the present value of the coupon payments (an annuity).
The second term is the present value of the bonds face value.
C = 80
R = 8%
T = 10
F = 1000
Bond Value = 80 * (1 1/1.0810) / 0.08
+ 1000 / 1.0810
= 536.81 + 463.19 = 1000
T
T
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(
+
=
5-52
Bond terms dictate the frequency of coupon payments
The coupon rate is expressed in annual terms
If the rate is expressed annually and the payments are more
frequent (N), calculation of bond value requires:
Dividing the annual coupon payment by the number of compounding
periods per year to arrive at the value of each coupon payment (C);
Dividing the annual required rate of return by the number of
compounding periods per year to arrive at the desired periodic yield (r);
Multiplying the remaining years of the bonds life by the number of
compounding periods per year to arrive at the remaining number of
coupon payments (T).

Frequency of Coupon Payments
T
T
r) (1
F
r
r) (1
1
- 1
C Value Bond
+
+
(
(
(
(
+
=
N
N
N
N
N
N
5-53
Bonds can be traded like any other financial asset, and
the price is set by comparing the bond interest rate with
the market interest rate.
Bond prices and market interest rates move in opposite
directions.
With the current bond price, we can calculate the
implied rate of return, called the Yield To Maturity
(YTM).
When coupon rate = YTM, price = par value
When coupon rate > YTM, price > par value (premium
bond)
When coupon rate < YTM, price < par value (discount
bond)

Bond Concepts
5-54
If the market interest rate is 5% or 10%, how does this
affect the value of this bond?
At 5%, the value is

At 10% the value is
Premium
Discount
5-55
YTM and Bond Value
800
1000
1100
1200
1300
0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.10 0.11
Discount Rate
B
o
n
d

V
a
l
u
e

When the YTM = coupon, the
bond trades at par.
When the YTM < coupon, the bond trades at a premium.
When the YTM > coupon, the bond trades at a discount.
5-56
Price Risk
Change in price due to changes in interest rates
Long-term bonds have more price risk than short-
term bonds
Low coupon rate bonds have more price risk than
high coupon rate bonds.
Reinvestment Rate Risk
Uncertainty concerning rates at which cash flows can
be reinvested
Short-term bonds have more reinvestment rate risk
than long-term bonds.
High coupon rate bonds have more reinvestment rate
risk than low coupon rate bonds.
Interest Rate Risk
5-57
Yield to maturity is the rate implied by the current bond
price.
Finding the YTM requires trial and error if you do not
have a financial calculator and is similar to the process
for finding r with an annuity.

Given a bond value, coupon, time to maturity and face
value, it is possible to find the implicit discount rate, or
yield to maturity, by trial and error only.

Computing Yield to Maturity
5-58
Bonds of similar risk (and maturity) will be
priced to yield about the same return,
regardless of the coupon rate.
If you know the price of one bond, you
can estimate its YTM and use that to find
the price of the second bond.
This is a useful concept that can be
transferred to valuing assets other than
bonds.

Bond Pricing Theorems
5-59
There are two kinds of securities issued by
corporations:
Equity Ownership Interest
Debt Short or Long Term Borrowing

Bonds are classified as Debt

5.2 More on Bond Features
5-60
Debt
Not an ownership interest
Creditors do not have voting
rights
Interest is considered a cost
of doing business and is tax
deductible
Creditors have legal recourse
if interest or principal
payments are missed
Excess debt can lead to
financial distress and
bankruptcy

Equity
Ownership interest
Common stockholders vote
for the board of directors and
other issues
Dividends are not considered
a cost of doing business and
are not tax deductible
Dividends are not a liability of
the firm, and stockholders
have no legal recourse if
dividends are not paid
An all-equity firm cannot go
bankrupt
Debt versus Equity
5-61
High Grade
Moodys Aaa and S&P AAA capacity to pay is
extremely strong
Moodys Aa and S&P AA capacity to pay is very
strong
Medium Grade
Moodys A and S&P A capacity to pay is strong,
but more susceptible to changes in circumstances
Moodys Baa and S&P BBB capacity to pay is
adequate, adverse conditions will have more
impact on the firms ability to pay
5.3 Bond Ratings Investment Quality
5-62
Low Grade
Moodys Ba and B
S&P BB and B
Considered speculative with respect to capacity
to pay.
Very Low Grade
Moodys C
S&P C & D
Highly uncertain repayment and, in many cases,
already in default, with principal and interest in
arrears.
Bond Ratings - Speculative
5-63

U.S. Treasury issues, unlike essentially all other bonds, have
no default risk because (we hope) the Treasury can always
come up with they money to make the payments.

Corporate Finance
Core Principles & Applications

U.S. credit rating was downgraded by
S&P last year, from AAA to AA+
S&P downgrade US credit rating
64

Number of countries in debt-crisis increases:
Portugal
Ireland
Greece
Spain
Italy
France
UK

Germany one of few countries making money, and are trying to keep the Euro alive.
But, increasing insecurity about risk, results in higher risk premium and lower credit ratings.
The downgrade of USA will affect the evaluation of European countries.

How does this relate to investment analysis on a project or a company based level?
How does US debt compare to
the debt-crisis in Europe?
65

As we have seen AA is considered a good investment grade. It involves low risk, and is
therefore recommended for pension funds etc.
However, according to the 3 agencies in USA, they all rated:
Bear Stearns rated A2 a month before it went bankrupt
Lehman Brothers rated A2 just days before it collapsed
AIG rated AA within days of being bailed out
Fannie Mae & Freddie Mac AAA rating before being bailed out by the government
Citigroup A2 before receiving a bail out package from the Government
Merrill Lynch A2 before being sold to Bank of America
And when asked how they missed these obvious cases and were put to trial for their bad
advices, they claimed freedom of speech.

Problem: Companies are paying agencies to do a credit rating of their financial situation.
This gives agencies and companies incentives to cooperate, as a positive credit rating
provides lower interest on bonds and are important for stock valuation (e.g. by getting rated
with a good investment grade).
Bottom line: While credit rating is usually a good indication of risk, it should not be the only
reference when evaluating a companys creditworthiness.
Does the credit rating agencies
have the answer?
66
There are many different types of bonds
Some common bonds include:
Government Bonds
Federal
State and Municipal
Zero Coupon Bonds (AKA Pure Discount Bonds)
Floating Rate Bonds
Each are discussed below
5.4 Some Different Types of
Bonds
5-67
Primarily over-the-counter transactions
with dealers connected electronically
Extremely large number of bond issues,
but generally low daily volume in single
issues
Makes getting up-to-date prices difficult,
particularly on a small company or
municipal issues
Treasury securities are an exception
5.5 Bond Markets
5-68
Default risk premium (bond ratings)
Taxability premium (municipal versus taxable)
Liquidity premium bonds that have more
frequent trading will generally have lower
required returns (remember bid-ask spreads)
Anything else that affects the risk of the cash
flows to the bondholders will affect the
required returns.
Factors Affecting Required
Return
5-69
Closing case
Coupon Bond or Zero Coupon Bond
Your company needs to generate $40
million in order to take on necessary
investments. You will use a 20-year bond,
and are considering using either a regular
coupon bond or a zero coupon bond.
The bond will have a 6.5 % coupon rate.
Which type of coupon will give your
company the best cash flow?
70
Closing case
71
Bond value 40 000 (in thousands)
Face value 1 000 USD pr bond
Coupon rate 6,50 % pr year
Years to maturity 20 years
Alternative cost 6,50 %
Case 1: Regular
Coupon price 1000
Number of bonds 40 000
(in thousands) 0 1 2 19 20
Bond sale/maturity 40 000 - - - -40 000
Interest - -2 600 -2 600 -2 600 -2 600
Cash flow 40 000 -2 600 -2 600 -2 600 -42 600
NPV Case 1 -0,00
Case 2: Zero
Coupon price 278,23
Interest - - - - -
Cash flow 40 000 - - - -143 768
NPV Case 1 -752,06
When comparing the two options net present
value at a discount rate equal to the coupon
rate, the options are close to equal.
However, bearing in mind that the company
would only pay 6.5% in coupon rate,
because it believes it can make money at a
higher rate, we must consider a higher
alternative cost to see which alternative is
better.
Closing case
72
Bond value 40 000 (in thousands)
Face value 1 000 USD pr bond
Coupon rate 6,50 % pr year
Years to maturity 20 years
Alternative cost 10,00 %
Case 1: Regular
Coupon price 1000
Interest - -2 600 -2 600 -2 600 -2 600
Cash flow 40 000 -2 600 -2 600 -2 600 -42 600
NPV Case 1 10 835,44
Case 2: Zero
Coupon price 278,23
Interest - - - - -
Cash flow 40 000 - - - -143 768
NPV Case 1 16 936,18
At 10% alternative cost, it is obvious that the
zero coupon bond is the best advice.
This is due to the belief that the company will
generate a higher interest than its coupon rate
(10%). Otherwise it would be better to not
issue a bond.
Closing case
At first glance a zero coupon seems to give the company
the best cash flow, as it provides the highest NPV and
therefore the lowest cost.
The maturity cost is still quite hefty (146 million USD),
and it may therefore be considered riskier to investors
and hence require a higher coupon rate.
And in our example, a coupon rate of 8% for a zero
coupon rate and 10% alternative cost, would provide
the same NPV when comparing it with the 6.5 % coupon
rate on a regular coupon.
73
Lecture summary
Chapter 4 Discounted Cash Flow Valuation
Future Value and Present Value
Simple and Compound Interest
Loan types
Chapter 5 Interest Rate and Bond Valuation
Bonds and bond valuation
Bond features and rating
Bond market
74

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