1. Week 2 Seminar Principles of Corporate Finance Eighth Edition Chapter 2, 3, and 4 Adopted from slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

2. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 2 McGraw-Hill/Irwin Present and Future Value Present Value Value today of a future cash flow. Future Value Amount to which an investment will grow after earning interest

3. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 3 McGraw-Hill/Irwin Discount Factors and Rates Discount Rate Interest rate used to compute present values of future cash flows. Discount Factor Present value of a $1 future payment.

4. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 4 McGraw-Hill/Irwin Future Values Future Value of $100 = FV

5. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 5 McGraw-Hill/Irwin Future Values Example - FV What is the future value of $5400,000 if interest is compounded annually at a rate of 5% for one year?

6. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 6 McGraw-Hill/Irwin Present Value

7. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 7 McGraw-Hill/Irwin Present Value Discount Factor = DF = PV of $1 Discount Factors can be used to compute the present value of any cash flow.

8. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 8 McGraw-Hill/Irwin Valuing an Office Building Step 1: Forecast cash flows Cost of building = C 0 = 400 Sale price in Year 1 = C 1 = 420 Step 2: Estimate opportunity cost of capital If equally risky investments in the capital market offer a return of 5%, then Cost of capital = r = 5%

9. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 9 McGraw-Hill/Irwin Valuing an Office Building Step 3: Discount future cash flows Step 4: Go ahead if PV of payoff exceeds investment

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 10 McGraw-Hill/Irwin Net Present Value

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 11 McGraw-Hill/Irwin Risk and Present Value  Higher risk projects require a higher rate of return  Higher required rates of return cause lower PVs

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 12 McGraw-Hill/Irwin Risk and Present Value

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 13 McGraw-Hill/Irwin Risk and Net Present Value

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 14 McGraw-Hill/Irwin Managers and Shareholder Interests  Tools to Ensure Management Pays Attention to the Value of the Firm –Manger’s actions are subject to the scrutiny of the board of directors. –Shirkers are likely to find they are ousted by more energetic managers. –Financial incentives such as stock options

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 15 McGraw-Hill/Irwin Goals of The Corporation  Shareholders desire wealth maximization  Do managers maximize shareholder wealth?  Mangers have many constituencies “stakeholders”  “Agency Problems” represent the conflict of interest between management and owners

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 16 McGraw-Hill/Irwin Chapter 3 Principles of Corporate Finance Eighth Edition How To Calculate Present Values Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 17 McGraw-Hill/Irwin Present Values  Replacing “1” with “t” allows the formula to be used for cash flows that exist at any point in time

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 18 McGraw-Hill/Irwin Present Values Example You just bought a new computer for $3,000. The payment terms are 2 years same as cash. If you can earn 8% on your money, how much money should you set aside today in order to make the payment when due in two years?

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 19 McGraw-Hill/Irwin Present Values  PVs can be added together to evaluate multiple cash flows.

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 20 McGraw-Hill/Irwin Present Values  PVs can be added together to evaluate multiple cash flows.

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 21 McGraw-Hill/Irwin Present Values Present Value Year 0 100/1.07 200/1.077 2 Total = $93.46 = $172.42 = $265.88 $100 $200 Year 0 12

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 22 McGraw-Hill/Irwin Present Values  Given two dollars, one received a year from now and the other two years from now, the value of each is commonly called the Discount Factor. Assume r 1 = 20% and r 2 = 7%.

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 23 McGraw-Hill/Irwin Present Values Example Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 24 McGraw-Hill/Irwin Present Values Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 25 McGraw-Hill/Irwin Present Values Present Value Year 0 -170,000 -100,000/1.05 320,000/1.05 2 Total = NPV -$170,000 = -$170,000 = $95,238 = $290,249 = $25,011 -$100,000 +$320,000 Year 0 12 Example - continued Assume that the cash flows from the construction and sale of an office building is as follows. Given a 5% required rate of return, create a present value worksheet and show the net present value.

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 26 McGraw-Hill/Irwin Short Cuts Annuity - An asset that pays a fixed sum each year for a specified number of years.

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 27 McGraw-Hill/Irwin Annuity Short Cut Example You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 28 McGraw-Hill/Irwin Annuity Short Cut Example - continued You agree to lease a car for 4 years at $300 per month. You are not required to pay any money up front or at the end of your agreement. If your opportunity cost of capital is 0.5% per month, what is the cost of the lease?

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 29 McGraw-Hill/Irwin Chapter 4 Principles of Corporate Finance Eighth Edition Value of Bond and Common Stocks Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 30 McGraw-Hill/Irwin Valuing a Bond Example If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. Cash Flows

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 31 McGraw-Hill/Irwin Valuing a Bond Example continued  If today is January 2004, what is the value of the following bond?  A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.  The price at a 3.8% YTM is as follows

32. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 32 McGraw-Hill/Irwin Valuing a Bond Example continued  If today is January 2004, what is the value of the following bond?  A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO.  The price at a 2.0% YTM is as follows

33. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 33 McGraw-Hill/Irwin Stocks & Stock Market Common Stock - Ownership shares in a publicly held corporation. Secondary Market - market in which already issued securities are traded by investors. Dividend - Periodic cash distribution from the firm to the shareholders. P/E Ratio - Price per share divided by earnings per share.

34. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 34 McGraw-Hill/Irwin Stocks & Stock Market Book Value - Net worth of the firm according to the balance sheet. Liquidation Value - Net proceeds that would be realized by selling the firm’s assets and paying off its creditors. Market Value Balance Sheet - Financial statement that uses market value of assets and liabilities.

35. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 35 McGraw-Hill/Irwin Valuing Common Stocks Expected Return - The percentage yield that an investor forecasts from a specific investment over a set period of time. Sometimes called the market capitalization rate.

36. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 36 McGraw-Hill/Irwin Valuing Common Stocks Example: If Fledgling Electronics is selling for $100 per share today and is expected to sell for $110 one year from now, what is the expected return if the dividend one year from now is forecasted to be $5.00?

37. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 37 McGraw-Hill/Irwin Valuing Common Stocks The formula can be broken into two parts. Dividend Yield + Capital Appreciation

38. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 38 McGraw-Hill/Irwin Valuing Common Stocks Capitalization Rate can be estimated using the perpetuity formula, given minor algebraic manipulation.

39. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 39 McGraw-Hill/Irwin Valuing Common Stocks Return Measurements

40. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 40 McGraw-Hill/Irwin Valuing Common Stocks Dividend Discount Model - Computation of today’s stock price which states that share value equals the present value of all expected future dividends. H - Time horizon for your investment.

41. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 41 McGraw-Hill/Irwin Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

42. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 42 McGraw-Hill/Irwin Valuing Common Stocks Example Current forecasts are for XYZ Company to pay dividends of $3, $3.24, and $3.50 over the next three years, respectively. At the end of three years you anticipate selling your stock at a market price of $94.48. What is the price of the stock given a 12% expected return?

43. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 43 McGraw-Hill/Irwin Valuing Common Stocks If we forecast no growth, and plan to hold out stock indefinitely, we will then value the stock as a PERPETUITY. Assumes all earnings are paid to shareholders.

44. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 44 McGraw-Hill/Irwin Valuing Common Stocks Constant Growth DDM - A version of the dividend growth model in which dividends grow at a constant rate (Gordon Growth Model).

45. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 45 McGraw-Hill/Irwin Valuing Common Stocks Example- continued If the same stock is selling for $100 in the stock market, what might the market be assuming about the growth in dividends? Answer The market is assuming the dividend will grow at 9% per year, indefinitely.

46. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 46 McGraw-Hill/Irwin Chapter 2 Practice Questions  Aparcel of land costs $500,000. For an additional $800,000 you can build a motel on the property. The land and motel should be worth $1,500,000 next year. Suppose that common stocks with the same risk as this investment offer a 10 percent expected return. Would you construct the motel? Why or why not?

47. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 47 McGraw-Hill/Irwin Chapter 2 Practice Question Answer NPV =  $1,300,000 + ($1,500,000/1.10) = +$63,636 Since the NPV is positive, you would construct the motel. Alternatively, we can compute r as follows: r = ($1,500,000/$1,300,000) – 1 = 0.1539 = 15.39% Since the rate of return is greater than the cost of capital, you would construct the motel.

48. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 48 McGraw-Hill/Irwin Chapter 3 Practice Question

49. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 49 McGraw-Hill/Irwin Chapter 3 Practice Question Answer

50. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 50 McGraw-Hill/Irwin Chapter 4 Practice Question  A 6-year government bond makes annual coupon payments of 5 percent and offers a yield of 3 percent annually compounded. Suppose that one year later the bond still yields 3 percent. What return has the bondholder earned over the 12-month period?  Now suppose instead that the bond yield is 2 percent at the end of the year. What return would the bondholder earn in this case?

51. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 2- 51 McGraw-Hill/Irwin Chapter 4 Practice Question Answer