Corporate Financial Theory

1. Corporate Financial Theory • Introduction • Class Review • Tests • Homework • Syllabus • Web sites & Supplements • Goal of Finance

2. Corporate Financial Theory • Goal of Finance • Maximize the value of the firm

3. Time Value of Money • Q: Which is greater? • $100 today or $110 next year

4. Time Value of Money • Q: Which is greater? • $100 today or $110 next year • A: It Depends on Inflation.

5. Time Value of Money • Q: Which is greater? • $100 today or $110 next year • A: It Depends on Inflation. • Ex. • Bike Cost (today) = B0 = $100 • Bike Cost (next year) = B1 = $110

6. Time Value of Money • Q: Which is greater? • $100 today or $110 next year • A: It Depends on Inflation. • Ex. • Bike Cost (today) = B0 = $100 • Bike Cost (next year) = B1 = $110 • B0 = B1 • $100 (today) = $110 (next year)

7. Time Value of Money • Q: Which is greater? • $100 today or $110 next year • A: It Depends on Inflation. • Ex. • Bike Cost (today) = B0 = $100 • Bike Cost (next year) = B1 = $110 • B0 = B1 • $100 (today) = $110 (next year) • 100= 110/(1+.10)

8. Time Value of Money • PV0 = C1 • 1 + r • Ex. • Bike Cost (today) = B0 = $100 • Bike Cost (next year) = B1 = $110 • B0 = B1 • $100 (today) = $110 (next year) • 100= 110/(1+.10)

9. Time Value of Money • PV0 = C1 • 1 + r • Modified formula for unknown time frame: • PV0 = Ct • (1+r)t

10. Net Present Value • Example • Q:Suppose we can invest $50 today & receive $60 later today. What is our profit?

11. Net Present Value • Example • Q:Suppose we can invest $50 today & receive $60 later today. What is our profit? • A: Profit = - $50 + $60 • = $10

12. Net Present Value • Example • Q: Suppose we can invest $50 today and receive $60 in one year. What is our profit? (assume 10% inflation)

13. Net Present Value • Example • Q: Suppose we can invest $50 today and receive $60 in one year. What is our profit? (assume 10% inflation) • A: Profit = -50 + 60 = - 50 + 54.55 = $4.55 • 1 + .10 • This is the definition of NPV

14. Net Present Value • NPV = C0 + Ct • (1 + r)t

15. Net Present Value • NPV = C0 + Ct • (1 + r)t • For multiple periods we have the • Discounted Cash Flow (DCF) formula

16. Net Present Value • Terminology • C = Cash Flow • t = time period • r = “discount rate” or “cost of capital”

17. Net Present Value • Terminology • C = Cash Flow • t = time period • r = “discount rate” or “cost of capital” • Notes • C is not an accounting number • r is not inflation • r is the cost at which you can raise capital. The cost depends on the risk.

18. Risk and Present Value • Example • Q:If you can invest $50 today and get $60 in return one year from now. What is your profit? (assume you can borrow money at 12%)

19. Risk and Present Value • Example • Q:If you can invest $50 today and get $60 in return one year from now. What is your profit? (assume you can borrow money at 12%) • A: NPV = C0 + Ct • (1 + r)t • NPV = - 50 + 60 = 3.57 • (1 + .12)1

20. Valuing an Office Building • Step 1: Forecast cash flows • Cost of building = C0 = 350 • Sale price in Year 1 = C1 = 400 • Step 2: Estimate opportunity cost of capital • If equally risky investments in the capital market • offer a return of 7%, then • Cost of capital = r = 7%

21. Valuing an Office Building • Step 3: Discount future cash flows • Step 4: Go ahead if PV of payoff exceeds investment

22. Risk and Present Value • Higher risk projects require a higher rate of return • Higher required rates of return cause lower PVs

23. Risk and Present Value

24. Decision Time

25. Rate of Return Rule • Accept investments that offer rates of return in excess of their opportunity cost of capital

26. Rate of Return Rule • Accept investments that offer rates of return in excess of their opportunity cost of capital • Example • In the project listed below, the foregone investment opportunity is 12%. Should we do the project?

27. Net Present Value Rule • Accept investments that have positive net present value

28. Net Present Value Rule • Accept investments that have positive net present value • Example • Suppose we can invest $50 today and receive $60 in one year. Should we accept the project given a 10% expected return?

29. Short Cuts • Perpetuity • Constant Growth Perpetuity • Annuity

30. Short Cuts NOTE

31. Application of PV, NPV, DCF • Value bonds • Value stocks • Value projects • Value companies (M&A) • Value Capital Structure (debt vs. equity)

32. Opportunity Cost of Capital • How much “return” do you EXPECT to earn on your money?

33. Opportunity Cost of Capital • Example • The company may invest $100,000 today. Depending on the state of the economy, they may get one of three possible cash payoffs:

34. Opportunity Cost of Capital • Example - continued • The stock is trading for $95.65. Depending on the state of the economy, the value of the stock at the end of the year is one of three possibilities:

35. Opportunity Cost of Capital • Example - continued • The stock’s expected payoff leads to an expected return.

36. Opportunity Cost of Capital • Example - continued • Discounting the expected payoff at the expected return leads to the PV of the project

37. Internal Rate of Return • IRR is related to Opportunity Cost of Capital • Pay Attention to Math

38. Internal Rate of Return • Example • You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

39. Internal Rate of Return • Example • You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

40. Internal Rate of Return • Example • You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

41. Internal Rate of Return IRR=28%

42. Internal Rate of Return • Pitfall 1 - Lending or Borrowing? • With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. • This is contrary to the normal relationship between NPV and discount rates.

43. Internal Rate of Return • Pitfall 1 - Lending or Borrowing? • With some cash flows (as noted below) the NPV of the project increases s the discount rate increases. • This is contrary to the normal relationship between NPV and discount rates. NPV Discount Rate

44. Internal Rate of Return • Pitfall 2 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates. • The following cash flow generates NPV=0 at both (-50%) and 15.2%.

45. Internal Rate of Return • Pitfall 2 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates. • The following cash flow generates NPV=0 at both (-50%) and 15.2%. NPV 1000 IRR=15.2% 500 Discount Rate 0 -500 IRR=-50% -1000

46. Internal Rate of Return • Pitfall 3 - Mutually Exclusive Projects • IRR sometimes ignores the magnitude of the project. • The following two projects illustrate that problem.

47. Internal Rate of Return • Pitfall 4 - Term Structure Assumption • We assume that discount rates are stable during the term of the project. • This assumption implies that all funds are reinvested at the IRR. • This is a false assumption.

48. Internal Rate of Return • Calculating the IRR can be a laborious task. Fortunately, financial calculators can perform this function easily. Note the previous example.

49. Application of PV, NPV, DCF • Value bonds • Value stocks • Value projects (Capital Budgeting) • Value companies (M&A) • Value Capital Structure (debt vs. equity)

50. Valuing a Bond • Example • If today is October 2001, what is the value of the following bond? • An IBM Bond pays $115 every Sept for 5 years. In Sept 2006 it pays an additional $1000 and retires the bond. • The bond is rated AAA (WSJ AAA YTM is 7.5%) • Cash Flows • Sept 02 03 04 05 06 • 115 115 115 115 1115