ross chapter 01 - introduction to investment rules, (jra) 2013-2

8/13/2019 Ross Chapter 01 - Introduction to Investment Rules, (JRA) 2013-2

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Chapter One

Introduction to Net Present Value andInvestment Criteria

Based on:

Ross, Westerfield & Jordan, Financial Foundations

Blank & Tarquin, Engineering Economy

11/8/2013 Jorge Ramirez Arroyo 1

Financial Management - Review

There are three basic forms of business organization: SoleProprietorship (Empresa Individual), General or Limited Partnership(Soc. Colectiva, SAC), and Corporation (S.A.A.)

Corporations: The most important form of business organization. Canoccur debts, can sue and be sued, enter into legal contracts. Exists asa separate legal entity from the owners.

Advantages:

- Separation of ownership and management

- Limited liability of owners (share holders)

- Transfer of ownership is easy (shares of common stock easily transferred)

- Unlimited lifespan

- Easier to raise capital

Disadvantages:

- Separation of ownership and management (Agency Problem)

- Double taxation (corporate income tax + dividends are taxed)

- Slightly complicated to setup (Articles of incorporation (charter), Bylaws)



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Financial Management - Review What should be the firms objective? (A for-profit business)

Maximize market value?

Maintain steady earnings growth?

Maximize sales revenue or market share?

Maximize profits?

Minimize costs?

To avoid bankruptcy and financial distress?

To defeat the competitors

To survive

Maximize CEO wealth?

What about these other goals?

Maximize customer satisfaction

Environmental responsibility Ethical behavior

The goal of the financial management of the firm is to increase themarket value of the shares, it means, the value of the firm.


Financial Management - Review There are three questions on Finance:

1. How do they manage their Working Capital? (Which and howmuch s h o r t t e r m r e s o u r ce s do they prefer? How do theymanage their cash, receivables, stocks and payables?) - Day-to-day operations or L i q u i d i t y D e c i si o n s .

2. From where and which mix are t h e l o n g t e r m r e s ou r c e s to paytheir investments? (Do they ask for more equity or do they borrowmore debt?) Cap i t a l S t r u c t u r e or Financing Decisions.

3. What and how much f i x e d a s s e t s are necessary to buy? (Whichlong term investments: buildings, machinery or equipment; Whichproduct lines to have) - Budget Capital or I n v e s t m e n t D e c is io n s .

4. How should the firm Identify, measure and hedge the riskexposure? Financial Risk Management



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Capital Structure (2) Addresses the question of how a firm should obtain and manage the long term

financing needed to support its long term investments:

it is the specific mixture of long term debt and equity capital

the decision on how much debt vs. Equity impacts the risk level for the firmand the firms cost of capital

Capital Structure is the specific mix of short-term debt, long-term debt andequity.

Raising long-term financing can be expensive, so the different possibilities mustconsidered carefully.

A firms capital structure is the specific mix of debt and equity used to finance thefirms operations.

Decisions need to be made on both the financing mix and how and where to raisethe money.

Key Questions

How should the firm pay for its assets? Debt or equity?

How much should the firm borrow?

What is the least expensive source of funds?

How, when and where to raise the money?


The Capital Structure Decision

How should the firm

raise funds for the

selected investments?

Shareholders

Equity

Current Liabilities

Long-Term Debt

Current Assets

Fixed Assets

1 Tangible

2 Intangible



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Capital StructureThe value of the firm can be thought of as a pie.

The goal of the manager is toincrease the size of the pie.

The Capital Structure decision can be viewed ashow best to slice up a the pie.

If how your slice of the pie

affects the size of the pie,then the capital structuredecision matters.

50%Debt

25%Debt

75%Equity

70%Debt

30%

Equity

50%Debt

50%Equity

50%Equity


Financial Risk Management (4)

The process of identifying, quantifying and decisions to managecertain types of risk:

currency risks

interest rate risks

commodity price risk

Other risks such as strategic, operating and commercial risks need tobe considered by the firm as a whole - ideally looking at risk onan enterprise wide basis (holistic risk management)



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Strategic-technology & information

- knowledge management-industry value chain transformation

Crisis Management-environmental disasters-brand crisis/computer system failure

Operating Risks-distribution networks-manufacturing

Commercial Risks- new competitor(s)- customer service expectations- new pricing models

- supply chain management

Financial Risk-price - interest & fx. rate-commodity price

Organization wide

Risk

Identification Impact Response

Integrated Risk Management


Investing Decisions

Interesting issues are the way in which the firm decide its CapitalStructure on the long term, or the way it manage its day-by-dayoperational activities with its Working Capital, but the fixed assets arewhich define the firms business.

The most important part of the Financial Management is the CapitalBudgeting.

Any firm have many possible investment opportunities, some arevaluable, some are not.

The type of investment opportunities are supposed to depend on thenature of the firms business, and they must have more value thantheir of acquisition. It means that they generate more cash inflowvalue than their cost.

This chapters goal is to learn how to identify them.



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The Capital Budgeting Decision

What long-terminvestmentsshould the firm

choose?

Current Assets

Fixed Assets

1 Tangible

2 Intangible

Shareholders

Equity

Current

Liabilities

Long-Term Debt


Investing Decisions

St r at e g ic P la nn in g a nd Ca p i t a l B ud g et in g : The most importantdecision of the firm have to do with its product lines. What services willthey supply? In which markets will they compete? What new productswil l launch? Each question implies the use of its scarce and valuablecapital in certain assets.

T im e a n d Co st s : Its useful to think on the future having two parts,the short term and the long term; but they arent mean periods of time, they depend on the type of cost we are talking of. If the costsere fixed, we are talking of the short term. In the long term every costis variable.

We are interested on the volume o s i z e o f t h e am o un t s , the specificmoment or t i m i n g , and in the r i s k or uncertainty of the future cash

flows.



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Valuation of Durable Assets

Simple and Compound Interest One period (time value of the money)

1

1

Many periods 1

1

Due vs. in advance

105100

100 1 100

10095

1001001

: 1 1

1

1

1 1



Simple and Compound Interest

In advance

105

100

1

1 1

100

95

1

1 1

1

1 1 1

1

1



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Valuation of Durable AssetsPresent Value of a Perpetuity


Valuation of Durable AssetsPresent Value of a Growing Perpetuity



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1 1 2 1 3 1 .Then, 11 1 11 1 11 2 11 1 11 1

11 1 11 11 1

11 1 11

11 1 11 1

1 11 1 1

1 11 1 1 11 1 11 1 11

1 1 .Note: | 1 1

Present Value of an Annuity



Future Value of an Annuity 1 1 1 2 1 2 1 1 1 1 1 2 1 2 1 1 1

1 1 1 1 1 1 1 1 .

Note1: 1 1 1 1 1 1

1 1 .Note2: | 1 1



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Valuation of Durable AssetsPresent Value of a Growing Annuity



Future Value of a Growing Annuity1. FutureValue

1 1 1 1 2 1 21 1 1 1

1 11 11 11 1 2 1 21 1 1 1

1 11 1 1 1 21 2

1 11 1

1 1 1 1 1

1 1 1 1 1

1 1 1 1 1 1

1

1 1 1

1

1

1

1 1

1

1

1 1 1 1

.



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Due vs. In advance Annuities

1r

Immediately and Deferred

In advance (PV & FV)

Perpetuity

Constant (PV)

G. Growing (PV)

Annuities

Constant (PV & FV)

G. Growing (PV & FV)

Due (PV & FV)

Perpetuity

Constant (PV)

G. Growing (PV)

Annuities

Constant (PV & FV)

G. Growing (PV & FV)


Valuation of Durable AssetsConsol - Perpetuity

Characteristics

debt instrument

Term - infinite

Fixed interest payment

Price adjusts to accommodate risk

PInt

rm0 00967

12 $15

. $155.

Anual TEA Sem. TEA

IntC= 15 7.5 Cuntos15hayen 1,000.00

rm= 9.67% 4.84% 66.67

r= 1.50% 1.500% 0.75% 1.506%

PV= Po = 155.12 155.12 Cuntos7.5hayen 1,000.00

1,000.00 1,000.00 133.33



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Pure Discount Bonds

Information needed for valuing pure discount bonds:

Time to maturity (T) = Maturity date - todays date

Face value (F)

Discount rate (r)

Tr

FPV

)1(

Present value of a pure discount bond at time 0:

0

0$

1

0$

2

0$

1T

F$

T

A bond that will make only one payment of principal and interest. Alsocalled a zero-coupon bond or a single-payment bond.


Valuation of Durable AssetsLevel-Coupon Bonds

Information needed to value level-coupon bonds:

Coupon payment dates and time to maturity (T)

Coupon payment (C) per period and Face value (F)

Discount rate

TTr

F

rr

CPV

)1()1(

11

Value of a Level-coupon bond= PV of coupon payment annuity + PV of face value

0

C$

1

C$

2

C$

1T

FC $$

T



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Zero Growth Dividends Shares Assume that dividends will remain at the same level forever

rP

rrrP

Div

)1(

Div

)1(

Div

)1(

Div

0

3

3

2

2

1

10

321 DivDivDiv

Since future cash flows are constant, the value of a zero growth stockis the present value of a perpetuity:


Valuation of Durable AssetsConstant Growth Dividends Shares

)1(DivDiv 01 g

Since future cash flows grow at a constant rate forever, the value of aconstant growth stock is the present value of a growing perpetuity:

grP

10

Div

Assume that dividends will grow at a constant rate, g, forever. i.e.

2

012 )1(Div)1(DivDiv gg

3

023 )1(Div)1(DivDiv gg .

.

.



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Delayed Differential Growth Dividends

Share

Year 0 1 2 3

Cash flow $1.50 $1.65 $1.82 dividend + P3

PV of cash flow 22.38$05.10.

05.182.13

P

81.32$)10.1(

22.38$82.1$

)10.1(

65.1$

)10.1(

50.1$320

P

= $1.82 + $38.22


Valuation of Durable AssetsLoans

n P ri nci p I nt ere st A mo rt iz . P ay me nt

0 1000.00

1 750.00 100.00 250.00 350.00

2 500.00 75.00 250.00 325.00

3 250.00 50.00 250.00 300.00

4 0.00 25.00 250.00 275.00

Total 250.00 1000.00 1250.00

n P ri nci p I nte re st A mo rti z. P ay me nt

0 1000.00

1 1000.00 100.00 0.00 100.00

2 1000.00 100.00 0.00 100.00

3 1000.00 100.00 0.00 100.00

4 0.00 100.00 1000.00 1100.00

Total 400.00 1000.00 1400.00

n P ri nci p I nt ere st A mo rt iz. P ay me nt

0 1000.00

1 784.53 100.00 215.47 315.47

2 547.51 78.45 237.02 315.47

3 286.79 54.75 260.72 315.47

4 0.00 28.68 286.79 315.47

Total 261.88 1000.00 1261.88

There are three types: Discount Loans Pure Interest Loans Amortization Loans

1,000.00

10%

4

. .

1 1



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Arithmetic Growing Annuity (1) 1 1 2 21 3 31 4 11 1 1 11 1 11 2 11 3 11 1

1 2 21 3 31 4 31 2 21 1 11 .1st.Step:

1 1 11 1 11

1 1 1 1 1

1

1 1 .2nd.Step:

1 2 21 3 31 4 31 2 21 1 11 11/8/2013 Jorge Ramirez Arroyo 29

Arithmetic Growing Annuity (2)Multiplyingbothsidesby1 , 1 1 21 2 31 3 31 3 21 2 11 1So1

1 21 2 1 2 31 3 21 3 21 2 31 2 11 1 21 1 11

1 1 2 1 3 1 2 1 1 11

1

1 2

1 3

1 1

1 1

11 11 2 11 3 11 1 11 1 1 1 11 11 2 11 3 11 1 1



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Then,

1 1 11 1 11

1 1 1 11 1 11

1 1 1 1

1 1 1 1 1 1

1

11 1

Then, 1 1 1 1 1

Arithmetic Growing Annuity (3)


Arithmetic Growing Annuity (Ex.)

Calculate the cash flow of an arithmetic progression starting inS/.1,000 with an increase of S/.300 until the period 10. Then calculateits PV and FV at a 10% of minimum rate of return .

1,000; 1,300; 1,600; 1,900; 2,200; 2,500; 2,800; 3,100; 3,400; 3,700

1,0001 1.10

.10

300

.10

1 1.10

.10

10

1.10 13,011.97

1.10 33,749.70

FAS(10%,10)= 6. 144567

10/1.10^10

= 3.85543

r= 10.0%

T= 10.00 PV= 13,011.97

C= 1, 000. 00 FV= 33,749.70

G= 300.00



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Arithmetic Growing Annuity (Ex.) Calculate the cash flow of an geometric progression starting in S/.1,000

with an increase of 3.00% until the period 10. Then calculate its PV andFV at a 10% of minimum rate of return .

1,000; 1,300; 1,690;2,197; 2,856; 3,713; 4,827; 6,275; 8,157; 10,604

1,000

.10 0.03 1

1.03

1.10

6,883.74

1.10 17,854.66

1 2 3 4 5 6 7 8 9 10

1,000

1,300

1,690

2,197

2,856

3,713

4,827

6,275

8,157

10,604

r= 10. 0%

T= 10. 00 PV= 6,883.74

C= 1, 000 FV= 17, 854. 66

g= 3.0%



Different Economic Life

Machinery

G

Machinery

H

Initial Cost, P US$.62,500 US$.77,000

Operating Anual Cost 15,000 21,000

Rescue Value, VS 8,000 10,000

Economic life, aos 4 6

Consider two machines for a continuous production process, that havethe following costs. Use an interest rate of 15%, and decide whichmachine might be kept on the firm.

0 4 8 12

0 6 12

77,000 21,0001 1.15

0.15

10,000

1.15

77,000

1.15

10,000

1.15 217,929.82

62,500 15,0001 1.15

0.15

8,000

1.15

62,500

1.15

8,000

1.15

62,500

1.15

8,0001.15

191,290.73



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It is the owning and operating cost per year of an asset over its entirelifespan.

It is useful when the NPV or IRR is not possible. It is often used whencomparing investment projects of unequal lifespans. We must chose thelower cost EAC or CAUE.

EAC is calculated by dividing the NPV of a project by the present value ofan annuity factor. Equivalently, the NPV of the project may be multipliedby the loan repayment factor.

We do not need mcm for appraise two project with different economiclife.

Formulae

1 1

1 1

1 1

1 1

/,, /,,


Annual Equivalent Cost


If the life cycle project runs one or more times, the EquivalentAnnual Cost (CAUE) doesnt change.

Example: An asset has a cost of US$20,000, an annual operatingcost of US$8,000 and a useful life of 3 years. Find the CAUE ofone lifecycle. Use a discount rate of 22%.

20,0000.22

1 1.22 8,000 9,793.16 8,000 17,793.16

Find the CAUE for two lifecycles.

20,0000.22

1 1.22 20,000

0.22

1 1.221

1.22

8,000

17,793.16





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Example: An asset has a cost of US$20,000, an annual operating cost ofUS$8,000 and a useful life of 3 years. Find the CAUE of one lifecycle. Usea discount rate of 22%.


Annual Equivalent Cost - Excel

0 1 2 3

Cost 20,000

AnualOp. 8,000 8,000 8,000

Total 20,000 8,000 8,000 8,000

VNA@22% 36,338 CAUE@22% 17,793.16

CAUE= 17,793.16 FAS(22%,3) 2.042241421

FAS(22%,3)^1 0.489658074

22%,4:4 4 22%, 3,5


Calculate the AEC from one machine with an initial cost of US$8,000and a salvage value of US$500 after 8 years. The annual operatingcosts (AOC) for the machine are estimated at a US$900 and theinterest rate is 20%.

8,000 /, 20%, 8 500 /,20%,8 900

8,000.2

1 1.2 500

.2

1.2 1 900

2,084.88 30.30 900 2,954.57



0 1 2 3 4 5 6 7 8

Cost 8,000

SalvageVa lue 500

Anual Op. 900 900 900 900 900 900 900 900

Total 8,000 900 900 900 900 900 900 900 400

VNA@20% 11,337.2 CAUE@20% 2,954.57



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When the project has an indefinite operating life (perpetuity) , we usecapitalized cost.

Steps:

1. Draw the Cash Flow Diagram

2. PV of all the non periodic expenses

3. Find the EAC from periodic expenses and annual costs series ofone life cycle

4. Divide the EAC by the interest rate.


The Capitalized Cost


Calculate the capitalized cost of a project that has an initial investment of US$150,000 and an additional investment of US$50,000 after 10 years. Annualoperating costs are US$5,000 for the first 4 years and US$8,000 thereafter. Inaddition is expected to be a recurrent cost of over hold for US$15,000 every 13years. Assume that 15%

1 150,000 50,000

1.15 162,359.23 . 1

3 5,0001 1.15

.15 1.15

8,000

.15

1

1.15

1.15 14,274.89 30,493.51

44,768.40

2 3,000

.15

1

1.15

11,435.06 2

Mantainance Cost3 15,000.15

1.15 1 436.66

436.66 5,000

.15 2,911.11 33,333.33 36,244.44 3

1 2 3 210,038.74 1 44,768.40 2,911.11 210,038.74

The Capitalized Cost


ross chapter 01 - introduction to investment rules, (jra) 2013-2

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