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Week 1- Session 1 and Session 2
Summer 2012
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The Classical Viewpoint
Van Horne: "In this book, we assume that the objective of the firm is to
maximize its value to its stockholders"
Brealey & Myers: "Success is usually judged by value: Shareholders are
made better off by any decision which increases the value of their stake in
the firm... The secret of success in financial management is to increasevalue."
Copeland & Weston: The most important theme is that the objective of
the firm is to maximize the wealth of its stockholders."
Brigham and Gapenski: Throughout this book we operate on the
assumption that the management's primary goal is stockholder wealthmaximization which translates into maximizing the price of the common
stock.
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The Objective in Decision Making
In traditional corporate finance, the objective in decision making is to maximize the
value of the firm.
A narrower objective is to maximize stockholder wealth. When the stock is traded
and markets are viewed to be efficient, the objective is to maximize the stock price.
Assets Liabilities
Assets in Place Debt
Equity
Fixed Claim on cash flows
Little o r No role in managementFixed MaturityTax Deductible
Residual Claim on cash flowsSignificant Role in management
Perpetual Lives
Growth Assets
Existing Investments
Generate cashflows todayIncludes long lived (fixed) and
short-lived(workingcapital) assets
Expected Value that will becreated by future investments
Maximize
firm value
Maximize equity
valueMaximize market
estimate of equity
value
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Capital Budgeting
The NPV and required rate of return are parts of the process called capital
budgeting. Capital budgeting is process of identifying and evaluating
capital projects, that is projects where the cash flow to the firm will be
received over a period longer than a year.
Decisions about whether to buy a new machine, expand business inanother geographic area, move to the corporate headquarters to another
location, or replace a delivery truck, to name a few, can be examined using
the capital budgeting analysis
Capital budgeting may be the most important responsibility that a financial
manager has. Why? Firstly, since capital budgeting decision often involves the purchase of
costly long-term assets with lives of many years, the decision made may
determine future successes of the firm
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Capital Budgeting
Second, the principles underlying the capital budgeting process may also
apply to other CF decisions like working capital management and making
strategic decision like M&As
Finally, making good capital budgeting decisions is consistent with
management's primary goal of maximizing shareholder valueCategories of Capital Budgeting process
Replacement projects to maintain the business are normally made without
detailed analysis. The only issues are whether the existing operations
should continue and if so, whether existing procedures or processes should
be maintained.
Expansion projects are undertaken to grow the business and involve a
complex decision making process since they require the explicit forecast of
future demand. A very detailed analysis is required
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Capital Budgeting
New product or market development also entails a complex decision
making process since they require an explicit forecast of future demand.
Mandatory projects may be required by a governmental agency or
insurance company and typically involve safety-related or environmental
concerns. These projects typically generate little or no revenueFive key principles of capital budgeting
1. Decisions are based on cash flows, not accounting income
2. Cash flows are based on opportunity costs
3.The timing of cash flows is important
4. Cash flows are analyzed on after-tax basis
5. Financing costs are reflected in the projects required rate of return
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Net Present Value
NPV = PV required investment; or,
NPV = C0 + C1/(1+r)
Where, C0
is the cash flow at time zero, that is today
Future cash flows are not certain. They represent the best forecast or
estimate, therefore, another basic financial principle is that a safe dollar is
worth more than a risky one. Most investors avoid risk when they can do
so without sacrificing return.
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Present Value and rates of return
Any projects present value is equal to its future income discounted at the
rate of return offered by these securities
This can be put in another way a venture is worth undertaking because
its rate of return exceeds the cost of capital. The rate of return on the
investment in a venture is simply the profit as a proportion of the initialoutlay:
Return = Profit/Investment
The cost of capital is the return foregone by not investing in securities. If a
project is as risky as investing in stock market, for example, and the returnon stock market investment is 12%, then the cost of capital is 12%.
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Present Value, rates of return and OCC
Based on the previous slides, then:
Net Present Value Rule: Accept investments that have a positive NPV
Rate-of-return Rule: Accept investments that offer rates of return in excess
of their OCC
Any projects present value is equal to its future income discounted at the
rate of return offered by these securities
Opportunity Cost of Capital (OCC)
You have the following opportunity: Invest PKR 100,000 today, and
depending on the state of economy at the end of the year you will receive
the following pay offs:
Slump: PKR 80,000, Normal: PKR 110,000, Boom: PKR 140,000
You expect the pay off to be C1 = PKR 110,000, a 10% return on the PKR
100,000 investment. But whats the right discount rate?
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Opportunity Cost of Capital
You search for a common stock with the same risk as the investment. Its
called Stock X and has a current price of PKR 95.65 and is expected to have
a price of PKR 110 at the end of the year, if the economy is normal
The expected rate of return on Stock X is calculated, it comes to 15% (try
the calculation). This is the expected return that you are giving up byinvesting in the project rather than the stock market, therefore, this is the
projects opportunity cost of capital. The PV of the project is PKR 95,650
(how?), and the NPV is PKR (4,350). Result: project NOT worth
undertaking
The same conclusion occurs if the project is compared on rate of returnbasis. The expected return on project is 10% which is less than the 15%
return that could be earned if invested elsewhere.
Any time you find and launch a positive-NPV project, the companys
stockholders are made better off.
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Cost of Capital
After understanding what opportunity cost of capital is, it is important to
note how it is calculated in the capital budgeting process and in financial
management
The capital budgeting process involves discounted cash flow analysis, for
which we need to know the proper discount rate. This discount rate is theweighted average cost of capital or WACC
WACC = rD(D/V) + rE(E/V) = r, a constant, independent of D/V
Where r is the opportunity cost of capital, the expected rate of return
investors would demand if the firm had not debt at all; rD and rE are the
expected rates of return on dent and equity. The weights D/V and E/V arethe fractions of debt and equity. Since debt is tax deductible:
WACC = rD(1-Tc)D/V + rE(E/V), where Tc is the marginal corporate tax rate.
WACC evaluates average risk projects, and is based on target capital
structure, not present capital structure
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Using WACC
How does the formula change when there are more than two sources of
financing?
What about short term debt?
Numerical example on WACC
In practice: Equity, Debt and Cost of Capital for Banks
Note that we did not estimate a cost of capital for banks even though we have
estimates of the costs of equity and debt for the firm. The reason is simple
and goes to the heart of how firms view debt. For nonfinancial service firms,
debt is a source of capital and is used to fund real projectsbuilding a factory
or making a movie. For banks, debt is raw material that is used to generate
profits. Boiled down to its simplest elements, it is a banks job to borrow
money (debt) at a low rate and lend it out at a higher rate. It should come as
no surprise that when banks (and their regulators) talk about capital, they
mean equity capital.