10
PART I Value
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firms land in financial distress because of poor operating performance
or excessive borrowing. We will also consider how financing decisions
may affect decisions about the firms investment projects.
Part 6 int
CHAPTER 4 The Value of Common Stocks
PV =
FCF1
+
1+r
FCF2
+
11 + r 2 +
2
PVH
FCFH
+
11 + r 2 H
11 + r 2
H
cfw_
PV(free cash flow)
PV(horizon value)
Of course, the concatenator business will continue after the horizon,
but its not practical to forecast fr
CHAPTER 7
Introduction to Risk, Return, and the Opportunity Cost of Capital
7.3 CALCULATING PORTFOLIO RISK
We have given you an intuitive idea of how diversification reduces risk,
but to un- derstand fully the effect of diversification, you need to know
h
CHAPTER 5
Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
109
is not much point in elaborate selection procedures if the cash-flow
forecasts of the division are seriously biased.
Even if capital is not rationed, other resour
102
PART I Value
Perhaps project E is a manually controlled machine tool and project F is
the same tool with the addition of computer control. Both are good
investments, but F has the higher NPV and is, therefore, better.
However, the IRR rule seems to in
THIS BOOK IS about financial decisions made by corporations. We should start by saying
what these decisions are and why they are important.
Corporations face two broad financial questions: What investments should the firm
make? and How should it pay for t
CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
139
Two Old Machines
Annual output per
machine
Operating cost per
machine PV
operating cost per
machine
PV operating cost
of two machines
750 units
2 750 =
$1,500
1,500/.10 =
$15,000
2
72
PART I Value
The earningsprice ratio, therefore, equals
EPS
= ra1
P
PVGO
P
0 b
0
It will underestimate r if PVGO is positive and overestimate it if PVGO is
negative. The latter case is less likely, since firms are rarely forced to
take projects with ne
46
PART I Value
States since 1926. During the Great Depression there was actual
deflation; prices of goods on average fell. Inflation touched a peak just
after World War II, when it reached 18 percent. This figure, however,
pales into insignificance compa
CHAPTER 9 Capital Budgeting and Risk
249
a. A geologist proposes to discount the cash flows of the new wells at 30
percent to offset the risk of dry holes. The oil companys normal cost of
capital is 10 percent. Does this proposal make sense? Briefly expla
40
PART I Value
You should always be on the lookout for ways in which you can use
these for- mulas to make life easier. For example, we sometimes need
to calculate how much a series of annual payments earning a fixed
annual interest rate would amass to by
CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
in service for 20 years or more, and during that time there is a steady
demand for replacement parts. Some engine manufacturers also run
profitable service and overhaul facilities. Fina
CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
of capital, so Flanel can evaluate an investment in France by
discounting the expected euro cash flows at the euro cost of
capital. To calculate the opportunity cost of capital for the
14
PART I Value
2.1 INTRODUCTION TO PRESENT VALUE
Your warehouse has burned down, fortunately without injury to you or
your em- ployees, leaving you with a vacant lot worth $50,000 and a
check for $200,000 from the fire insurance company. You consider
reb
CHAPTER 4 The Value of Common Stocks
DIV1
r=
g P0
+
The market capitalization rate equals the dividend yield (DIV1/P0) plus
the ex- pected rate of growth in dividends (g).
These two formulas are much easier to work with than the general
statement that pri
IN CHAPTER 2 we learned how to work out the value of an
asset that produces cash exactly one year from now. But
we did not explain how to value assets that produce cash
two years from now or in several future years. That is the
first task for this chapter
PREFACE
xiii
Shrinivasan Sundaram Ball State University
Winfried Hallerbach Erasmus University, Rotterdam
Milton Harris University of Chicago
Mark Griffiths Thunderbird, American School of
International Management
Jarl Kallberg NYU, Stern School of Busine
22
PART I Value
2.3 A FUNDAMENTAL RESULT
Our justification of the present value rule was restricted to two periods
and to a certain cash flow. However, the rule also makes sense for
uncertain cash flows that extend far into the future. The argument
goes l
138
PART I Value
The net present value (at t = 0) for other harvest dates is as follows:
Year of Harvest
Net present value ($ thousands)
0
1
2
3
4
5
50
58.5
64.0
67.2
68.3
67.9
The optimal point to harvest the timber is year 4 because this is the
point th
CHAPTER 3 How to Calculate Present Values
bank actually earns more than 6 percent per year. Suppose that the
bank starts with $10 million of automobile loans outstanding. This
investment grows to
2
$10 1.005 = $10.05 million after month 1, to $10 1.005 =
8
PART I Value
working lifestyle; they may shun unpopular decisions, or they may
attempt to build an empire with their shareholders money.
Such conflicts between shareholders and managers objectives
create principal agent problems. The shareholders are th
CHAPTER 7
Introduction to Risk, Return, and the Opportunity Cost of Capital
Risk premium, percent
12
10
8
6
4
(fro
(fro
m 2
m
19
19
15) 0
11)
Den Bel Can Swi Spa
UK
Ire Neth USA Swe Aus
Ger
It
CouFra Jap192
(ex2/3)
ntry
FIGURE 7.3
Average market risk prem
CHAPTER 9 Capital Budgeting and Risk
How Changing Capital Structure Affects Beta
We have looked at how changes in financial structure affect expected
return. Let us now look at the effect on beta.
The stockholders and debtholders both receive a share of t
188
PART II Risk
Proportion
of days
0.14
0.12
0.10
0.08
0.06
0.04
0.02
0.00
96
0
3
3Daily price
changes, percent
6
9
FIGURE 8.1
Daily price changes for Microsoft are approximately normally distributed. This plot
spans 1990 to 2001.
Figure 8.2 pictures the
CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
141
b. The initial investment in inventories of raw materials.
c. Money already spent on engineering design of the new plant.
2. M. Loup Garou will be paid 100,000 euros one year hence.
CHAPTER 5
Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
FIGURE 5.3
Net present value,
dollars
The NPV of project C
increases as the
discount rate increases.
+60
+4
0
+2
0
0
2
0
6
0
4
0
8
0
Discount
rate,
percent
10
0
20
It
182
PART II Risk
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a. What was the risk premium in each year?
b. What was the average risk premium?
c. What was the standard deviation of the risk premium?
2. Most of the companies in Tables 7.3 are covered in the Standard & Po
146
PART I Value
The market value of your land would be $100 per acre if you cut and
removed the timber this year. The value of cut-over land is also expected
to grow at 4 percent per year indefinitely.
9.
The Borstal Company has to choose between two ma
CHAPTER 2 Present Value and the Opportunity Cost of Capital 23
2.4 DO MANAGERS REAL LY LOOK AFTER THE INTERESTS OF
SHAREHOLDERS?
We have explained that managers can best serve the interests of
shareholders by investing in projects with a positive net pres
68
PART I Value
Cost of
equity,
percent
252
0
Medi
an
estim
ate
1
5
1
0
5
10-year
Treasury
bond yield
0
Jan.
86
Jan.
87
Jan.
88
Jan.
89
Jan.
90
Jan.
91
Jan.
92
FIGURE 4.2
DCF cost-of-equity estimates for a sample of 17 utilities. The median estimates
(bur
CHAPTER 3 How to Calculate Present Values
57
You may not aspire to the Jones familys way of life, but you will learn about all their activities,
from futures contracts to binomial option pricing, later in this book. Meanwhile, you may wish to
replicate Jo
CHAPTER 6 Making Investment Decisions with the Net Present Value Rule
149
19
Treasury bonds. Mr. Handy thought this was a reasonable rule of thumb for the dry- cargo
business.
Questions
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1. Calculate equivalent annual costs of
98
PART I Value
points with a smooth line, and read of the discount rate at which NPV
= 0. It is of course quicker and more accurate to use a computer or a
specially programmed calculator, and this is what most financial
managers do.
Now, the internal rat
198
PART II Risk
FIGURE 8.8
Expected
In equilibrium no stock can lie below
the security market line. For example, instead of buying stock A, investors
return
would prefer to lend part of their money
and put the balance in the market portfolio. And instead