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
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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
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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
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PART I Value
5
annual growth of 6.6 percent. This, together with the dividend yield,
gave an esti- mate of the cost of equity capital:
DIV1
r=
P0
+ g = .033 + .066 = .099, or 9.9%
An alternative approach to estimating long-run growth starts with
the pa
CHAPTER 2 Present Value and the Opportunity Cost of Capital 31
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a. What are the expected cash inflows of projects B and C?
b. What are the expected rates of return offered by stocks X, Y, and Z?
c. What are the opportunity cos
140
PART I Value
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We worked through a detailed numerical example (IM&Cs
guano project),
showing the basic steps in calculating project NPV. Remember to track
changes in working capital, and stay alert for differences between t
CHAPTER 1
Finance and the Financial Manager
Differences in information
Different objectives
Stock prices and returns (13)
Managers vs. stockholders (2,
12, 33, 34)
Issues of shares and other
securities (15, 18, 23)
Dividends (16)
Financing (18)
Top manage
CHAPTER 4 The Value of Common Stocks
American Corp.
CH Energy Corp.
CLECO Corp.
DPL, Inc.
Hawaiian Electric
Idacorp
Pinnacle West
Potomac Electric
Puget Energy
TECO Energy
UIL Holdings
Stock
Price,
P0
$41.71
43.85
46.00
30.27
36.69
39.42
49.16
22.00
23.49
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PART I Value
we call the growth rate in salaries g, we can write down the present
value of this stream of cash flows as follows:
PV =
C1
+
1+r
C2
C3
11 + r 2
3
+
2
+
11 + r 2 2
C1 11 + g 2
C1 11 + g 2
C1
=
+
+
+
1+r
11 + r 2 2
11 + r 2 3
Fortunately,
CHAPTER 4 The Value of Common Stocks
Everything is the same in year 2 except that Fledgling will invest $3.67,
10 percent more than in year 1 (remember g = .10). Therefore at t = 2
an investment is made with a net present value of
NPV2 = 3.33
1.10 +
.83
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PART I Value
The answer given by the LP method is somewhat different from the
one we ob- tained earlier. Instead of investing in one unit of project A
and one of project D, we are told to take half of project A, all of project
B, and three-quarters of
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PART I Value
roughly match those projected for the concatenator business in year 6.
Suppose fur- ther that these companies tend to sell at priceearnings
ratios of about 11. Then you could reasonably guess that the price
earnings ratio of a mature conca
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PART I Value
the stockholder books and accelerated depreciation on the tax books.
The IRS doesnt object to this, and it makes the firms reported earnings
higher than if accelerated de- preciation were used everywhere. There
6
are many other difference
than Other Criteria
CHAPTER 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
111
FURTHER
READING
Classic articles on the internal rate of return rule include:
J. H. Lorie and L. J. Savage: Three Problems in Rationing Capita
x
PREFACE
same time we have rewritten Chapter 14 as a freestanding introduction to the nature of the corpora- tion,
to the major sources of corporate financing, and to
financial markets and institutions. Some readers will
turn first to Chapter 14 to see t
CHAPTER 2 Present Value and the Opportunity Cost of Capital 19
In the previous example there was just one person (you) making 100
percent of the investment and receiving 100 percent of the payoffs
from the new office build- ing. In corporations, investmen
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PART I Value
EXCEL
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EXCEL
1. A factory costs $800,000. You reckon that it will produce an inflow after
operating costs of $170,000 a year for 10 years. If the opportunity cost of
capital is 14 percent, what is the net prese
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PART I Value
Not all investments are equally risky. The office development is more
risky than a government security but less risky than a start-up biotech
venture. Suppose you believe the project is as risky as investment in
the stock market and that s
CHAPTER 4 The Value of Common Stocks
We know that present value in any period equals the capitalized value
of next periods earnings, plus PVGO:
PVt = earnings
t+ 1
r
+ PVGO
But what if PVGO = 0? At the horizon period H, then,
earningsH + 1
PVH =
r
In othe
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PART I Value
1. Draw a figure like Figure 2.1 to represent the following situation.
a. A firm starts out with $10 million in cash.
b. The rate of interest r is 10 percent.
c. To maximize NPV the firm invests today $6 million in real assets. This
leaves
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PART I Value
FIGURE 3.3
Dollars, log
The same story as Figure scale
3.2, except that the vertical scale is logarithmic. A constant
compound rate of growth means a straight ascending line. This graph makes clear
40
that the growth rate of funds invested
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PART I Value
Most well-known corporations in the United States are public
companies. In many other countries, its common for large companies
to remain in private hands.
By organizing as a corporation, a business can attract a wide
variety of in- vestors
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PART I Value
a. Which investment is most valuable?
b. Suppose each investment would require use of the same parcel of land.
Therefore you can take only one. Which one? Hint: What is the firms
objective: to earn a high rate of return or to increase firm
CHAPTER 4 The Value of Common Stocks
by the return that can be earned in the capital market on securities of
comparable risk. Shareholders receive cash from the company in the
form of a stream of divi- dends. So
PV(stock) = PV(expected future dividends)
A
CHAPTER 4 The Value of Common Stocks
What Do PriceEarnings Ratios Mean?
The priceearnings ratio is part of the everyday vocabulary of
investors in the stock market. People casually refer to a stock as
selling at a high P/E. You can look up P/Es in stock q
CHAPTER 5
Why Net Present Value Leads to Better Investment Decisions Than Other Criteria
Actual calculation of IRR usually involves trial and error. For example,
consider a project that produces the following flows:
Cash Flows ($)
C0
C1
C2
4,000
+2,000
+4