VIEWS: 15 PAGES: 20 CATEGORY: Investment Banking POSTED ON: 4/13/2011 Public Domain
Investment Analysis Lecture 3 Valuation (Basics) 4/13/2011 Nadir Khan Mengal Investment Analysis Fundamental Principle The value of any asset or investment equals the net present value of the expected cash flows: CF1 CF2 CF3 NPV = CF0 + + + . . . (1+r) (1+r)2 (1+r)3 4/13/2011 Nadir Khan Mengal Investment Analysis Fundamental Principle (cont‟d …) Risk should be incorporated into r The discount rate for the investment equals the rate of return that could be earned on an investment in the financial markets with similar risk r = „opportunity cost of capital‟ or „required rate of return‟ A project creates value only if it generates a higher return that similar investments in the financial market. 4/13/2011 Nadir Khan Mengal Investment Analysis Importance of required rate of return Example • You have invented a new search algorithm for computer database. One company offers you $7000 for the idea, but first you must develop a software that implements the idea. A second company offers $500 but does not require you to develop the software. A programmer requires $6000 payable immediately to program your idea. Programming will take one year. What should you do? 4/13/2011 Nadir Khan Mengal Investment Analysis Example (cont‟d …) • We need to evaluate a stream of cash flows. • Basic idea: Convert all cash flows into current (today‟s) cash flows. • Cash flows are: -6000 7000 Years 0 1 • Suppose that $7000 in a year is worth x today. Suppose also that the annual interest rate is 5%. Then x(1+5%) = $7000 x = $6667 • PV in our example: PV = -6000 + 6667 = 667 > 500 Choose first company 4/13/2011 Nadir Khan Mengal Investment Analysis Example (cont‟d …) • What if annual interest rate were 20%? x ( 1 + 20%) = $7000 x = $5833 PV = -6000 + 5833 = -167 < 500 Choose second company 4/13/2011 Nadir Khan Mengal Investment Analysis Shortcut Formulas Present value CF1 CF2 CF3 CF4 CF5 PV = + + + + +… (1+r) (1+r)2 (1+r)3 (1+r)4 (1+r)5 • Annuity Level cash flow for a given number of years • Perpetuity Level cash flow stream forever • Growing Perpetuity Cash flows grow by a fixed percent forever 4/13/2011 Nadir Khan Mengal Investment Analysis Annuity (level cash flow for t years) 11 PV = C x - r r(1+r)t Perpetuity (level cash flow forever) C PV = r Growing Perpetuity (growing cash flow forever) C PV = r-g 4/13/2011 Nadir Khan Mengal Investment Analysis Example Firms in the KSE 100 are expected to pay, collectively, $20 in dividends next year. If growth is constant, what should the level of the index be if dividends are expected to grow 5% annually? 6% annually? Assume r = 8%. • Growing Perpetuity 20.0 g = 5%: PV = = $667 0.08 – 0.05 20.0 g = 6%: PV = = $1,000 0.08 – 0.06 4/13/2011 Nadir Khan Mengal Investment Analysis Example You just moved to Dubai and after seeing the affordable prices, decide to get a home. If you borrow $800,000, what is your monthly mortgage payment? The interest rate on a 30 year fixed rate mortgage is 5.7% (or 0.475% monthly, 5.7% / 12) • Annuity 11 PV = 800,000 = C x - 0.00475 0.00475(1.00475)360 172.295 C = 800,000 / 172.295 = $4,643.20 4/13/2011 Nadir Khan Mengal Investment Analysis Cost of Capital (Warm – up) 4/13/2011 Nadir Khan Mengal Investment Analysis Cost of Capital: KD, KE, KP, WACC & MCC • Cost of Capital is the expected rate of return that the market requires in order to attract funds to a particular investment. • In economic terms, the cost of capital for a particular investment is an opportunity cost – the cost of forgoing the next best alternative investment. In this, it relates to the economic principle of substitution – that is, an investor will invest in a particular asset if there is a more attractive substitute. • Since the cost of anything can be defined as the price one must pay to get it, the cost of capital is the return a company must promise in order to get capital from the market, either debt or equity. A company does not set its own cost of capital; it must go into the market to discover it. Yet meeting this cost is the financial market‟s one basic yardstick for determining whether a company‟s performance is adequate. 4/13/2011 Nadir Khan Mengal Investment Analysis Most Common Source of Capital • Debt o Bank loans o Bond issues o Convertible bonds o Delaying payment on accounts payable • Preferred Equity • Common Equity o Common stock issues o Retained Earnings 4/13/2011 Nadir Khan Mengal Investment Analysis Cost of Equity “KE,” Debt “KD,” Preferred Stocks “KP” • The cost of equity KE is the rate of return investors require on an equity investment in a firm. • The cost of debt KD is the yield that the investors require on a long-term lending to a firm. • The cost of preferred equity KP is the rate of return investors require on investments in a firm‟s preferred shares. 4/13/2011 Nadir Khan Mengal Investment Analysis Effect of taxes on the cost of capital • Interest payments are a deductible expense, but returns to stockholders (i.e., dividends, retained earnings) are not. • For every dollar of return paid on equity, the firm must earn 1/(1-t) dollars of income before taxes. • For every dollar of interest paid, the firm needs to earn one dollar of income before taxes. • The effective „after-tax‟ cost of debt = (1-t) KD • The after-tax cost of equity is rs. 4/13/2011 Nadir Khan Mengal Investment Analysis Weighted Average Cost of Capital (WACC) • When we talk about the cost of ownership capital (i.e., the expected return to a stock or partnership investor), we usually use the phrase “cost of equity capital.” • When we talk about the cost of capital to the firm overall (i.e., the average cost of capital for both ownership interests and debt) we usually use the phrase “weighted average cost of capital (WACC).” • The most obvious instance in which to use WACC is when the objective is to value the entire capital structure of a company. • Sometimes WACC is also used even when the objective is ultimately to value only the equity. One would value the entire capital structure and then subtract the market value of the debt to estimate the value of the equity. This procedure frequently is used in highly leveraged situations. 4/13/2011 Nadir Khan Mengal Investment Analysis WACC (cont‟d …) • The critical point in WACC‟s calculation is that relative weightings of debt and equity or other capital components are based on the market values of each component and not on the book values. DE WACC = kD (1-t) +kE D+ED+E 4/13/2011 Nadir Khan Mengal Investment Analysis Cost of Capital – Summary • Cost of capital is a function of investment. • Cost of capital is forward looking. • Cost of capital is based on market value not book value. • Cost of capital is equal discount rate. 4/13/2011 Nadir Khan Mengal