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Learn how market values influence investment decisions through real-world examples and practical insights from finance experts. Uncover the common pitfalls in capital budgeting and differentiate truly positive NPVs. Explore the importance of forecasting accuracy in determining project profitability.

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Last Study Topics

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  1. Last Study Topics • Numerical • Cases • Statements

  2. Today’s Study Topics • Look First To Market Values. • Case 1: Departmental Store • Case 2: Gold Mine • Forecasting Economic Rents

  3. Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Chapter 11 Where Positive Net Present Values Come From Lu Yurong McGraw Hill/Irwin

  4. Introduction • Important point is that one should not focus on the arithmetic of DCF and thereby ignore the forecasts that are the basis of every investment decision. • Senior managers are continuously bombarded with requests for funds for capital expenditures. • All these requests are supported with detailed DCF analyses showing that the projects have positive NPVs.

  5. Continue • How, then, can managers distinguish the NPVs that are truly positive from those that are merely the result of forecasting errors? • One has to review certain common pitfalls in capital budgeting relating to answer the above query of the financial managers.

  6. Market Values • Let us suppose that you have persuaded all your project sponsors to give honest forecasts. • Although those forecasts are unbiased, they are still likely to contain errors, some positive and others negative. • The average error will be zero, but that is little consolation because you want to accept only projects with truly superior profitability.

  7. Market Values • If you were to jot down your estimates of the cash flows from operating various lines of business, you would probably find that about half appeared to have positive NPVs. • This may not be because you personally possess any superior skill inorder to figure out positive NPVs, but because you have inadver-tently introduced large errors into your estimates of the cash flows

  8. Continue • If you were to extend your activities to making cash-flow estimates for various companies, you would also find a number of apparently attractive takeover candidates. • In some of these cases you might have genuine information and the proposed investment really might have a positive NPV. • But in many other cases the investment would look good only because you made a forecasting error.

  9. Market Values • Security analysts whenever they value a company’s stock they must consider the information that is already known to the market about a company, and they must evaluate the information that is known only to them. • They can start with the market price of the stock and concentrate on valuing their private information.

  10. Case 1: Departmental Store • Example: Investing in a New Department Store • A department store chain that estimated the present value of the expected cash flows from each proposed store, including the price at which it could eventually sell the store. • Its conclusions were heavily influenced by the forecasted selling price of each store.

  11. Continue • Once the financial managers realized this, they always checked the decision to open a new store by asking the following question: • Let us assume that the property is fairly priced. • What is the evidence that it is best suited to one of our department stores rather than to some other use?

  12. Market Values • In other words, • “If an asset is worth more to others than it is to you, then beware of bidding for the asset against them”. • Suppose that the new store costs $100 million.You forecast that it will generate after-tax cash flow of $8 million a year for 10 years. • Real estate prices are estimated to grow by 3% a year, so the expected value of the real estate

  13. Continue • At the end of 10 years is 100 (1.03)10 $134 million. • At a discount rate of 10 percent, your propos-ed department store has an NPV of $1 million. • This can generate different results if the “ending value” of the project changes

  14. NPV = -100 + + . . . + = $ 1 million [assumes price of property appreciates by 3% a year] 8 8 + 134 1.10 1.1010 Department Store Rents

  15. Continue • Once the site had been acquired, it would be better to rent it out at $10 million than to use it for a store generating only $8 million. • Suppose, on the other hand, that the property could be rented for only $7 million per year. • The department store could pay this amount to the real estate subsidiary and still earn a net operating cash flow of 8 - 7 = $1 million.

  16. Continue • It is therefore the best current use for the real estate. • Will it also be the best future use? Maybe not, depending on whether retail profits keep pace with any rent increases. • Suppose that real estate prices and rents are expected to increase by 3% per year.

  17. NPV = -100 + + . . . + = $ 1 million [assumes price of property appreciates by 3% a year] Rental yield = 10 - 3 = 7% NPV = + + . . . + + = $1 million 8 8 + 134 1.10 1.1010 8 - 78 - 7.218 - 8.878 - 9.13 1.10 1.102 1.109 1.1010 Department Store Rents

  18. Continue • The real estate subsidiary must charge 7 x 1.03 = $7.21 million in year 2, 7.21 x 1.03 = $7.43 million in year 3, and so on. • Figure on the next slide shows that the store’s income fails to cover the rental after year 5.

  19. Understanding • If these forecasts are right, the store has only a five-year economic life; from that point on the real estate is more valuable in some other use. • Whenever you make a capital investment decision, think what bets you are placing. • Our department store example involved at least two bets—one on real estate prices and another on the firm’s ability to run a successful department store.

  20. Pricing the Gold • Suppose the current price of gold is $280 per ounce. • Hotshot Consultants advises you that gold prices will increase at an average rate of 12% for the next two years. • After that the growth rate will fall to a long-run trend of 3% per year. • What is the price of 1 million ounces of gold produced in eight years? Assume that gold prices have a beta of 0 and that the risk-free rate is 5.5%.

  21. Continue • The price of $280 per ounce represents the discounted value of expected future gold prices. • Hence, the present value of 1 million ounces produced 8 years from now should be: • ($280 × 1 million) = $280 million

  22. Summary • Look First To Market Values. • Case 1: Departmental Store • Example: Pricing a Gold

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