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Formula can be rearranged to compute required return, if price and dividend known: Equity Valuation As will be discussed in chapter 5, the required return on common stock is based on its beta, derived from the CAPM Valuing CS is the most difficult, both practically & theoretically Preferred stock valuation is much easier (the easiest of all) Whenever investors feel the expected return, rˆ , is not equal to the required return, r , prices will react: If exp return declines or reqd return rises, stock price will fall If exp return rises or reqd return declines, stock price will rise Asset prices can change for reasons besides their own risk Changes in asset’s liquidity, tax status can change price Changes in market risk premium can change all asset values Most dramatic change in market risk: Russian default Fall 98 Caused required return on all risky assets to rise, price to fall
Formula can be rearranged to compute required return, if price and dividend known: Equity Valuation As will be discussed in chapter 5, the required return on common stock is based on its beta, derived from the CAPM Valuing CS is the most difficult, both practically & theoretically Preferred stock valuation is much easier (the easiest of all) Whenever investors feel the expected return, rˆ , is not equal to the required return, r , prices will react: If exp return declines or reqd return rises, stock price will fall If exp return rises or reqd return declines, stock price will rise Asset prices can change for reasons besides their own risk Changes in asset’s liquidity, tax status can change price Changes in market risk premium can change all asset values Most dramatic change in market risk: Russian default Fall 98 Caused required return on all risky assets to rise, price to fall
If there are not enough investments that earn the hurdle rate, return the cash to shareholders.
The form of returns - dividends and share buybacks - will depend upon the shareholders’ characteristics .
Objective:
Maximize the Value of the Firm
5.
Investment Appraisal
6.
The Manager’s Duty
Invest in projects that yield a return greater than the minimum acceptable rate .
Returns on projects should be measured based on cash flows generated and the timing of these cash flows
The minimum acceptable rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
they should also consider both positive and negative side effects of these projects
7.
Measuring the Project Cash Flow
Cash Flows on Projects Are
OUT
Purchase of Assets
Fixed Assets, Working Capital, Intangible Assets,
Operating Costs, Taxes
IN
Sales of Assets
Fixed Assets, Working Capital, Intangible Assets
Operating Income
Note Financing Costs are excluded from this cash flow – this would be double counting
8.
Question
9.
Measuring the Cash Flow
10.
The Cash Flow
The cash flow occurs during time periods
The initial outlay occurs in year zero
Depreciation is NOT a cash flow
It is an accounting convention which attempts to spread the cost of buying an asset over the time periods during which the asset will be used
This called the MATCHING PRINCIPLE – one of the fundamental accounting principles
Depreciation may be used for calculating the Profit for the purposes of tax computation
11.
Calculate the Cash Flow
12.
Time Value of Money
13.
Consider the Cash Flow
Consider the cash flow timing
Is £1 today worth more than £1 next year?
We must find some way of making the cash flows in each year equivalent to each other
14.
Future Value
The Value of a Lump Sum or Stream of Cash Payments at a Future Point in Time
FV n = PV x (1+r) n
Future Value depends on:
Interest Rate
Number of Periods
Compounding Interval
15.
Future Value of £200 ( 4 Years, 7% Interest ) What if the Interest Rate Goes Up to 8% ? 0 1 2 3 4 PV = £200 End of Year FV 1 = £214 FV 2 = £228.98 FV 3 = £245 FV 4 = £262.16
16.
Future Value of £200 ( 4 Years, 8% Interest ) 0 1 2 3 4 PV = £200 End of Year Compounding – The Process of Earning Interest in Each Successive Year FV 1 = £216 FV 2 = £233.28 FV 3 = £251.94 FV 4 = £272.10
17.
The Power Of Compound Interest Periods 0% Future Value of One Pound (£) 1.00 0 2 4 6 8 10 12 14 16 18 20 22 24 10.00 15.00 20.00 25.00 30.00 5.00 10% 5% 15% 20% 40.00
18.
Present Value
Today's Value of a Lump Sum or Stream of Cash Payments Received at a Future Point in Time
19.
Present Value of £200 ( 4 Years, 7% Interest ) What if the Interest Rate Goes Up to 8% ? 0 1 2 3 4 Discounting End of Year PV = £200 FV1 = £214 FV2 = £228.98 FV3 = £245 FV4 = £262.16
20.
Present Value of £200 ( 4 Years, 8% Interest ) 0 1 2 3 4 Discounting End of Year PV = £200 FV1 = £216 FV2 = £233.28 FV3 = £252 FV4 = £272.10
21.
The Power Of High Discount Rates Periods Present Value of One Pound (£) 0 2 4 6 8 10 12 14 16 18 20 22 24 0.5 0.75 1.00 0.25 10% 5% 15% 20% 0%
22.
Present Value Summary
Much Of Finance Involves Finding Future And (Especially) Present Values
Central To All Financial Valuation Techniques
Techniques Used By Investors & Firms Alike
23.
Discounting the cash flow: Question 6
Cost of Capital is 10%
24.
Other Methods of Investment Appraisal
Payback period
How long is it before we get our money back
25.
Payback Period Critique
Measures how long funds are at risk
Simple to calculate
BUT
Does not take into account cash flows after the payback
26.
Other Methods of Investment Appraisal
Accounting Rate of Return (ARR)
27.
Accounting Rate of Return Critique
Does not take account of timing of cash flows
Spreads costs of assets over asset life
Reality is that cash flows out when asset is purchased
Profit is a Concept
Cash is a Reality
28.
Other methods
Internal Rate of Return
Similar to Net Present Value
Involves calculating which rate of return will make Net Present Value = zero and comparing this with required rate of return
Inferior to NPV
More complex to calculate
Can give multiple rates if large negative cash flows at end of project
29.
The Manager’s Duty
Invest in projects that yield a return greater than the minimum acceptable rate .
Returns on projects should be measured based on cash flows generated and the timing of these cash flows
The minimum acceptable rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
they should also consider both positive and negative side effects of these projects