Instructor: Mr. Wajid Shakeel Ahmed Last Study Topics Opportunity Cost of Capital Rate of an Alternative investment opportunity having a similar risk. Investment vs. Consumption Manager finds it difficult to reconcile the different objectives of the shareholders. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Topics Covered Calculations of NPV & ROR Managers and the Interests of Shareholders Fundamental Study Result Valuing Long-Lived Assets PV Calculation Short Cuts

Calculation of NPV and ROR The opportunity cost of capital is 20 percent for all four investments. Initial Cash Cash Flow Investment Flow, C0 in Year 1, C1 1 10,000 18,000 2 5,000 9,000 3 5,000 5,700 4 2,000 4,000 a. Which investment is most valuable? b. Suppose each investment would require use of the same parcel of land. Therefore you can take only one. Which one? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Answer to question ‘a’; Investment 1, since this investment with respect to others has generate highest NPV with Max rate of return. Answer to question ‘b’; Investment 1, since this investment with respect to others has highest contributed net value. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Decision Rules Here then we have two equivalent decision rules for capital investment; Net present value rule; Accept investments that have positive net present values. Rate-of-return rule; Accept investments that offer rates of return in excess of their opportunity costs of capital. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Fundamental Result Our justification of the present value rule was restricted to two periods and to a certain cash flow. However, the rule also makes sense for uncertain cash flows that extend far into the future. The argument goes like this: 1- A financial manager should act in the interests of the firm’s owners, its stockholders. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue 2- Stockholders do not need the financial manager’s help to achieve the best time pattern of consumption. 3- How then can the financial manager help the firm’s stockholders? There is only one way: by increasing the market value of each stockholder’s stake in the firm. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Despite the fact that shareholders have different preferences, they are unanimous in the amount that they want to invest in real assets. This means that they can cooperate in the same enterprise and can safely delegate operation of that enterprise to professional managers. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue These managers do not need to know anything about the tastes of their shareholders and should not consult their own tastes. Their task is to maximize net present value. If they succeed, they can rest assured that they have acted in the best interest of their shareholders. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Managers and Shareholder Interests Do managers really looking after the interests of shareholders? This takes us back to the principal–agent problem. Several institutional arrangements that help to ensure that the shareholders’ pockets are close to the managers’ heart. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Utilizing their Voting power; If shareholders believe that the corporation is underperforming and that the board of directors is not sufficiently aggressive in holding the managers to task, they can try to replace the board in the next election. E.g; chief executives of Eastman Kodak, General Motors, Xerox, Lucent, Ford Motor, etc were all forced to step aside. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue As a result the stock price tumbles. This damages top management’s reputation and compensation. Part of the top managers’ paychecks comes from bonuses tied to the company’s earnings or from stock options, which pay off if the stock price rises but are worthless if the price falls below a stated threshold. This should motivate managers to increase earnings and the stock price. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue If managers and directors do not maximize value, there is always the threat of a hostile takeover. The further a company’s stock price falls, due to lax management or wrong-headed policies, the easier it is for another company or group of investors to buy up a majority of the shares. The old management team is then likely to find themselves out on the street and their place is taken by a fresh team. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Should managers look after the interests of shareholders? For this question we need to understand that In most instances there is little conflict between doing well (maximizing value) and doing good. Profitable firms are those with satisfied customers and loyal employees and vice versa; 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Ethical issues do arise in business as in other walks of life. when we say that the objective of the firm is to maximize shareholder wealth, we do not mean that anything goes. In business and finance, as in other day-to-day affairs, there are unwritten, implicit rules of behavior. To work efficiently together, we need to trust each other. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition How to Calculate Present Values Chapter 3 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

Instructor: Mr. Wajid Shakeel Ahmed Present Values Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Discount Factors can be used to compute the present value of any cash flow. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example Suppose you will receive a certain cash inflow of $100 next year (C1 = $100) and the rate of interest on one-year U.S. Treasury notes is 7 percent (r1 = 0.07). What would be the present value of Cash inflow ? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example Suppose you will receive a certain cash inflow of $100 in two year (C2 = $100) and the rate of interest on two-year U.S. Treasury notes is 7.7 percent (r1 = 0.077). What would be the present value of year 2 Cash inflow ? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values PVs can be added together to evaluate multiple cash flows. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values PVs can be added together to evaluate multiple cash flows, and called as discounted cash flow or (DCF) formula; 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values If a dollar tomorrow is worth less than a dollar today, one might suspect that a dollar the day after tomorrow should be worth even less. But, lets assume - given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r1 = 20% and r2 = 7%. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue If First we lend $1,000 for one year at 20 percent, we have; FV = PV (1+rt)t = Go to the bank and borrow the present value of this $1,200 at 7 percent interest, we have; PV = FV / (1+rt)t 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue If we going to find out the net present value of our investment we get, NPV = PV – Investment = $1121 - $1200 “Just imagine in this game of lending and borrowing How much money you can earn without taking risks” 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Of course this story is completely fanciful. “There is no such thing as a money machine.” In well-functioning capital markets, any potential money machine will be eliminated almost instantaneously by investors who try to take advantage of it. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Present Values Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 7% required rate of return, create a present value worksheet and show the net present value. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed NPV Formula Mathematically; PV @ 7% ∑PV = PV of C1+ PV of C2 = -$93,500 + $261,900 = $168,400 NPV = ∑ PV - INV = $168,400 - $150,000 = $18,400 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Summary Calculations of NPV & ROR Managers and the Interests of Shareholders Fundamental Study Result Valuing Long-Lived Assets

Instructor: Mr. Wajid Shakeel Ahmed Short Cuts Sometimes there are shortcuts that make it very easy to calculate the present value of an asset that pays off in different periods. These tolls allow us to cut through the calculations quickly. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Short Cuts Perpetuity - Financial concept in which a cash flow is theoretically received forever. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Case : Investment A An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9 percent, what is the NPV? PV = C / r = $1533.33 NPV = PV - INV = $1533.33 - $1548 = -$ 14.67 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Case: leasing a car Example You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Continue Example - continued You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Case: Endowment Funds Example - Suppose, for example, that we begins to wonders what it would cost to contribute in a endowment fund with an amount of $100,000 a year for only 20 years? 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Alternatively We can simply look up the answer in the annuity table given on the next slide. This table gives the present value of a dollar to be received in each of t periods. In our example t = 20 and the interest rate r = .10, and therefore; We look at the twentieth number from the top in the 10 percent column. It is 8.514. Multiply 8.514 by $100,000, and we have our answer, $851,400. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed

Instructor: Mr. Wajid Shakeel Ahmed Compound Interest There is an important distinction between compound interest and simple interest. When money is invested at compound interest, each interest payment is reinvested to earn more interest in subsequent periods. In contrast, the opportunity to earn interest on interest is not provided by an investment that pays only simple interest. 11/16/2014 Instructor: Mr. Wajid Shakeel Ahmed