Postgraduate Diploma in Business and Finance Seshika Fernando B.Sc. (Hons) Computer Science [CMB], M.Sc. Finance [LSE]

Schedule  Examination – 2 nd August 2014  No assignments (100% Examination)

PowerPoint to accompany Chapter 3 The Valuation Principle: The Foundation of Financial Decision Making

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.1 Managerial Decision Making  A financial manager’s job is to make decisions on behalf of the firm’s investors that increase the value of the company.  A good decision is one for which the value of the benefits exceeds the costs.  Quantifying real-world opportunities is complex and involves skills from other disciplines such as marketing, economics, organisational behaviour, strategy and operations. 4

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.2 Cost-Benefit Analysis  The first step in decision making is to identify the costs and benefits of a decision and then to quantify them.  Any decision in which the value of the benefits exceeds the costs will increase the value of the firm.  To compare costs and benefits of a decision, we must value the options in the same terms—cash today. 5

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Problem:  Suppose you work as a customer account manager for an importer of frozen seafood. A customer is willing to purchase 300 kg of frozen fish today for a total price of $1,500, including delivery.  You can buy frozen fish on the wholesale market for $3 per kg today and arrange for delivery at a cost of $100 today.  Will taking this opportunity increase the value of the firm? 6 Example 3.1 Comparing Costs and Benefits (p.67)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Solution: Plan :  To determine whether this opportunity will increase the value of the firm, we need to value the benefits and the costs using market prices. We have market prices for our costs:  Wholesale price of fish: $3/kg  Delivery cost: $100  The customer offers $1,500 for 300 kg of delivered fish. 7 Example 3.1 Comparing Costs and Benefits (p.67)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Execute: 8 Example 3.1 Comparing Costs and Benefits (p.67)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.3 Valuation Principle  Previous examples were easy to evaluate because available current market values made converting to cash simple. Having costs and benefits in terms of ‘cash today’ is essential.  A competitive market is one in which a good can be bought and sold at the same price.  We use prices from competitive markets to determine the cash value of a good. 9

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Example 3.2 Competitive Market Prices Determine Value (pp.68-9) Problem:  You have just won a radio contest and are disappointed to find out that the prize is four tickets to the John Farnham ‘for the last time’ tour (face value $40 each). Not being a fan, you have no intention of going to the show.  However, it turns out that there is a second choice: two tickets to your favourite band’s sold- out show (face value $45 each).  You notice that on eBay, tickets to the John Farnham show are being bought and sold for $30 apiece and tickets to your favourite band’s show are being bought and sold at $50 each.  What should you do? 10

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Solution: Plan:  Market prices, not your personal preferences (or the face value of the tickets), are relevant here:  4 John Farnham tickets at $30 apiece, and  2 of your favourite band’s tickets at $50 apiece.  You need to compare the market value of each option and choose the one with the highest market value. 11 Example 3.2 Competitive Market Prices Determine Value (pp.68-9)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Execute: 12 Example 3.2 Competitive Market Prices Determine Value (pp.68-9)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Evaluate: 13 Example 3.2 Competitive Market Prices Determine Value (pp.68-9)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition  Definition  The value of a commodity or an asset to the firm or its investors is determined by its competitive market price.  The benefits and costs of a decision should be evaluated using those market prices.  When the value of the benefits exceeds the value of the costs, the decision will increase the market value of the firm Valuation Principle

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Time Value of Money  You need to spend $1000 in exactly 1 years time.  Would you like to get $1000 today or in exactly 1 years time? 15

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.4 The Time Value of Money and Interest Rates  Consider a firm’s investment opportunity with the following cash flows:  Cost of $100,000 today  Benefit of $105,000 in one year  To see why, note that if you have $1 today, you can invest it. For example, if you deposit it in a bank account paying 7% interest, you will have $1.07 at the end of one year. 16 ‘A dollar today is worth more than a dollar tomorrow’.

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.4 The Time Value of Money and Interest Rates  We call the difference in value between money today and money in the future the time value of money.  Similarly, two cash flows at two different points in time have two different values. 17 Today -$100,000 +$1.00 In one year +$105,000 +$1.07

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.4 The Time Value of Money and Interest Rates  The interest rate r is the rate at which money can be borrowed or lent over a given period.  If the interest rate is 7%, then we can express the cost of the investment as: 18 Cost =($100,000 today) x ($1.07 in one year/$ today) =$107,000 in one year

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.4 The Time Value of Money and Interest Rates  Think of this amount as the opportunity cost of spending $100,000 today. The firm gives up the $107,000 it would have had in one year if it had left the money in the bank.  Alternatively, by borrowing the $100,000 from the same bank, the firm would owe $107,000 in one year. 19 Today Investment –$100,000 Bank +$100,000 In one year Investment +$105,000 Bank–$107,000

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.4 The Time Value of Money and Interest Rates  How much would we need to have in the bank today so that we would end up with $105,000 in the bank in one year?  It is also the amount the bank would lend to us today if we promised to repay $105,000 in one year. 20 Benefit = ($105,000 in one year) = $98, today (1.07 $ in one year/$ today) Today Value of Cost Today –$100,000 Value of Benefit Today +$ 98, In one year +$105,000 $105,

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition  Discount factors and rates  The calculation below presents the price of $1 today (Present Value) in one year (Future Value).  Note that the value is less than $1—money in the future is worth less today, and so its price reflects a discount.  The interest rate is also referred to as the discount rate for an investment The Time Value of Money and Interest Rates 1 = 1 = r1.07

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Problem:  The launch of Sony’s PlayStation 3 was delayed until November 2006, giving Microsoft’s Xbox 360 a full year on the market without competition.  It is November 2005 and you estimate that if the PlayStation 3 were ready to be launched immediately, you could sell $2 billion worth of the console in its first year. However, if the launch is delayed a year, you believe that this will reduce first-year sales by 20%.  If the interest rate is 8%, what is the cost of a delay in terms of dollars in 2005? 22 Example 3.4 Comparing Revenues at Different Points in Time (p.73)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Example 3.4 Comparing Revenues at Different Points in Time (p.73) Solution: Plan:  Revenue if released today: $2 billion  Revenue decrease if delayed: 20%  Interest rate: 8%  We need to calculate the revenue if the launch is delayed and compare it to the revenue from launching today.  However, we need to convert the future revenue of the PlayStation 3 if delayed into an equivalent present value of that revenue today. 23

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Execute: 24 Example 3.4 Comparing Revenues at Different Points in Time (p.73)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Evaluate: 25 Example 3.4 Comparing Revenues at Different Points in Time (p.73)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.5 The NPV Decision Rule  Net present value (NPV)  As long as we convert costs and benefits to the same point in time, we can use the Valuation Principle to make a decision.  However, most corporations prefer to measure values in terms of net present value, that is, in terms of cash today. (Eq. 3.1) 26 NPV = PV(Benefits) – PV(Costs) FORMULA!

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.5 The NPV Decision Rule  We should undertake projects with a positive NPV—projects with a negative NPV have costs that exceed the benefits.  NPV decision rule: 27 When making an investment decision, take the alternative with the highest NPV, which is equivalent to receiving its NPV in cash today.

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.5 The NPV Decision Rule  A common financial decision is whether to accept or reject a project.  Because rejecting the project generally has an NPV = 0 (there are no new costs or benefits from not doing the project), the NPV decision rule implies that we should:  Accept positive-NPV projects: accepting them is equivalent to receiving their NPV in cash today.  Reject negative-NPV projects: accepting them would reduce the value of the firm, whereas rejecting them has no cost (NPV = 0). 28

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Example 3.5 The NPV is Equivalent to Cash Today (p.76) Problem:  After saving $1,500 while working in a cafe, you are about to buy a 42-inch plasma TV.  You notice that the store is offering ‘one-year same as cash’ deal. You can take the TV home today and pay nothing until one year from now, when you will owe the store the $1,500 purchase price.  If your savings account earns 5% per year, what is the NPV of this offer? Show that its NPV represents cash in your pocket. 29

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Solution: Plan:  You are getting the TV worth $1,500 today and in exchange will need to pay $1,500 in one year.  Think of it as getting back the $1,500 as a positive cash flow.  The discount rate for calculating the present value (PV) of the payment in one year is your interest rate of 5%. Compare the PV of the cost and benefit today. 30 Example 3.5 The NPV is Equivalent to Cash Today (p.76) Today Cash Flows +$1,500 In one year – $1,500

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Execute: Example 3.5 The NPV is Equivalent to Cash Today (p.76)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Evaluate: 32 Example 3.5 The NPV is Equivalent to Cash Today (p.76)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.5 The NPV Decision Rule  Choosing among alternatives  Managers also use the NPV decision rule to choose among projects.  Suppose you own a coffee stand across from campus and you hire someone to operate it for you.  You will be graduating next year and have started to consider selling it. An investor has offered to buy the business from you for $20,000 whenever you are ready.  Your interest rate is 10% and you are considering three alternatives: 33

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.5 The NPV Decision Rule  Choosing among alternatives (cont’d)  Sell the business now.  Operate normally for one more year and then sell the business (costs are $5,000 on supplies and labour now, earnings are $10,000 at the end of the year).  Be open only in the mornings for one more year and then sell the business (costs are $3,000 on supplies and labour now, earnings $6,000 at the end of the year). 34

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Table 3.1 Cash Flows and NPVs for Coffee Stand Alternatives 35  Among the three alternatives you should choose the option with the highest NPV—operate normally for one more year and then sell the business.

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition 3.6 The Law of One Price  The Law of One Price  If equivalent investment opportunities trade simultaneously in different competitive markets, they must trade for the same price in each market.  The price of a security should equal the present value of the future cash flows obtained from owning that security. 36

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Example 3.6 Pricing a Security using the Law of One Price (p.80) Problem:  You are considering purchasing a security, a ‘bond’, that pays $1,000 without risk in one year, and has no other cash flows.  If the interest rate is 5%, what should its price be? 37

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Solution: Plan:  The security produces a single cash flow in one year:  The Law of One Price tells you that the value of a security that pays $1,000 in one year is the PV of that $1,000 cash flow, calculated as the cash flow discounted at the interest rate. 38 Example 3.6 Pricing a Security using the Law of One Price (p.80) TodayIn one year Bond Payment +$1,000

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Execute: 39 Example 3.6 Pricing a Security using the Law of One Price (p.80)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Evaluate: 40 Example 3.6 Pricing a Security using the Law of One Price (p.80)

Copyright © 2011 Pearson Australia (a division of Pearson Australia Group Ltd) – / Berk/DeMarzo/Harford / Fundamentals of Corporate Finance / 1 st edition Questions ?