capital budgeting plus some stocks and bonds review question a bond has a coupon rate of 8%. it...
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Capital Budgeting
Plus some stocks and bonds
Review question
A bond has a coupon rate of 8%. It sells today at par, that is, for $1000. What is the yield? 8% Prove it. Calculate value at 8%. Maturity can be anything.
Growing perpetuity
Time 0 1 2 3 …Cash flow 0 1 (1+g) (1+g) 2̂ …
grgrPVGPF
1),(
Example: share of stock
The market expects a dividend of $4 in one year.
It expects the dividend to grow by 5% per year
The discount rate for such firms is 16%. What is the price of a share?
Solution
P=4*(1/(.16-.05)) =36.3636...
Decomposition of value
Absent growth, as a cash cow,value = 4*(1/.16)
= 25. Remaining value of 36.3636… - 25 is
net present value of growth opportunities (NPVGO).
=11.3636...
Example: whole firm
The market expects $30M in one year and growth of 2% thereafter. Discount rate = 17%. Value of the firm is $200M. That is 30M*(1/(.17-.02))
continued
A new line of business for the firm is discovered.
The market expects $20M in a year, with growth at 7% thereafter. Value of the new growth opportunity is
$200M (at r = 17%).
Whole value:400M = 200M + 200M
Note that the value is gross, not net. Share price? Divide by the number of shares.
Arguing for your project
Capital budgeting CFO receives proposals from divisions Projects described by cash flows
Arguing means applying measures
Net present value is the right measure. Many smart people use the wrong
ones. Alternative ways to the same end.
Uses of measures
Project acceptance Mutually exclusive alternatives.
Capital Budgeting Techniques
Kim, Crick, and Kim, Management Accounting
Nov. 1986, p. 49-52
Survey of use of measures by corporations
Measure Primary Secondary
Internal rate of return 49% 15%Accounting rate of return 8% 19%Net present value 21% 24%Payback period 19% 35%Other 17% 7%
Total responses 587 469
Make no mistake
NPV is the right measure always. Others work sometimes. NPV measures value to owners, their
wealth.
Objectives of a good measure
Value cash flows. Respond to the market.
NPV’s merits
Values cash flows as the market does. Responsive because the discount rate
is the current market rate. Measures increase in shareholder
value.
Payback period is
The time required for undiscounted cash flows to add up to the initial investment.
e.g., build a Wendy’s if it “pays for itself” in two years or less.
Payback merits
Based on cash flows
Payback defects
No market response. When r is high, the satisfactory payback
period should be shorter. Subtracts time-t dollars from time-0
dollars, a cardinal sin. Ignores cash flow after payback. Ignores timing during payback.
Defects are not necessarily fatal
Repeated, similar investments. Stable financial conditions.
The well-informed capital budgeter knows
When to accept payback period as a measure.
When it is likely to fail.
Accounting rate of return
Doesn’t value cash flows No market response Ignores market values Scaling problems: melons or malls
Merits of accounting r.o.r.
Easily understood. Sometimes okay in stable markets. Smart application can overcome
defects.
Internal rate of return
Definition: IRR is the discount rate that makes NPV = 0
CFCF
r
CF
r
CF
rTT0
1 221 1 1
0
( )
. . .( )
That is, IRR is the r such that
Internal rate of return
Definition: IRR is the discount rate that makes NPV(r) = 0.
NPV(r) is a function. RWJ Figures 6.4 and 6.5.
IRR is almost the same as bond yield
Bond yield is r such that
0)2
1(
1000...
)2
1(2
1 22
Trc
rc
rc
P
Project
Time 0 1 2 3Cash flow -200 100 100 100
Figure 6.4: NPV(r)=0 at r=23.37%
NPV
r
100
NPV(r)
NPV(.1) = 48.68520
.1
IRR =23.3748.685
Figure 6.4
NPV (r) = 0 at r = 23.37%
Applications of IRR measure
Hurdle rate = market rate Project acceptance: Accept a project if
IRR > hurdle rate. Mutually exclusive projects: Take the
one with the highest IRR (> hurdle rate)????? Don’t rely on it.
Project acceptance:
NPV and IRR give the same conclusion when ...
Cash flows have one sign change. In the example: IRR = 23.37% > hurdle
= 10% for an investment project. IRR = 23.37% < hurdle rate = 30% for a
financing or “borrowing from nature” project.
Merits
Uses cash flows. Responds to the market when the
hurdle rate changes
Objective
Learn to recognize the times when NPV and IRR are the same.
and also the problems with IRR
Defects of IRR -- project acceptance
Lending to nature or borrowing from her?
Multiple IRR's may occur.
Financing (borrowing from nature)
Seek IRR < hurdle rate Same as NPV > 0
Multiple IRR's
Time in decades 0 1 2Cash flows -1 5 -6
IRR’s at r = 1 and r = 2
100% per decade = 7.17735% per year. 200% per decade = 11.61232% per
year.
IRR’s at r=1 and r=2.
NPV
r
100% 200%
Descartes’ Rule
The number of internal rates of return is no more than the number of sign changes.
The number of positive roots of a polynomial with real coefficients is at most equal to the number of sign changes in the coefficients.
Interest rates are more than -100%
Defects of IRR -- mutually exclusive projects
Ignores market values. Scale problems -- melons or malls.
Typical hour exam question
What is the scale problem in using IRR to choose between mutually exclusive projects?
Scale problem in IRR
Time 0 1 IRR NPV(r=.1)Little dam -100 200 1 81.8181…Big dam -1000 1500 0.5 363.6363…
One canyon, one dam.
Sketch of answer
The smaller dam has the higher IRR. The big dam has higher value. The big dam extends consumption
possibility of owners more than the little dam does.
It is wrong to take the higher IRR in this case.
Capital Budgeting Jiu Jitsu
Consider the project of replacing the little dam by the big dam.
Cash flows are -900, +1300. IRR of the project is 4/9 = .4444 > .1 NPV is 281.8181… So replace the little dam. Capital budgeting jiu jitsu.
Scale problems in IRR
Time 0 1 IRR NPV(r=.1)
Littledam
-100 200 1 81.8181...
Bigdam
-1000 1500 .5 363.63...
r
NPV
50% 100%
100
500
Big dam
Little dam
IRR IRR
Big dam, little dam
NPV
NPV of the big dam
NPV of the small dam
500
100
.51
r
r*
For hurdle rates below r*,the big dam is preferred.
r* = .4444...