# nvestment Analysis LEC 3 by AhsanTareen

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Investment Analysis

Lecture 3

Valuation (Basics)

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

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.
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?
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

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

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

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

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
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

Investment Analysis

Cost of Capital (Warm – up)

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

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

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.
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.

Investment Analysis

Weighted Average Cost of Capital (WACC)

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.

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
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.