nvestment Analysis LEC 3 by AhsanTareen

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									                                     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

								
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