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Financial
Markets
The World The Firm Investors
Invest- Financ- Financial
ments ing
Intermed.
C1 C2 C3 C4 t
1 r n 1
PVperp lim PVAn lim PMT
r 1 r
n n n
PV = $100 / 7% = $1,428.57
Growth Perpetuities:
PMTt = PMT0(1+g)t
PVgrowth = PMT1/(r-g) (... r > g)
Corporate Financial Management 1 16
Compounding Frequency (1)
Compare annual return on deposit
with 6% interest paid annually and
monthly.
FVA = PV(1 + 6%) = PV1.06
rA = (FVA-PV) / PV = .06PV/PV = 6%
FVM = PV(1 + 6%/12)12 = PV1.00512
= PV1.0617
rM = (FVM-PV) / PV = 6.17%
t Ct PV n
Ct
1 $ 80 $ 73.39 V
1 r
t
2 $ 80 $ 67.33 t 0
3 $ 80 $ 61.77
4 $ 80 $ 56.67 For bond w/semi-annual
... ... ... coupons n=24, Ct=$40.
8 $ 80 $ 40.15 To put required return on
9 $ 80 $ 36.83 same basis as annual
10 $ 80 $ 33.79 bond, one should
11 $ 80 $ 31.00 assume EAR = 9% =
12 $1,080 $ 383.98 (1+rS)2 - 1, i.e. rS = \/1.09 -
r= 9% $ 928.39 1 = 4.4%.
3,5
2,5
r 2
1,5
0,5
0
0 2 4 6 8 10 12
t
1.00
Eq
2
Eq
HT1
0 5 8.5 12.5
Actual Return (%)
E(rP) = 7.25%
P = 6.1%
Corporate Financial Management 1 33
Portfolio Risk (2)
p (=6.1%) is much lower than:
either Eq 1 (19.4%) or Gold (7.5%).
average of Eq 1 and Gold (13.5%).
The portfolio offers a decent return
(average of Eq 1 and Gold returns) with
low risk.
The key is low (actually negative)
correlation between Eq 1 and Gold
returns, facilitating diversification.
Corporate Financial Management 1 34
Managing Portfolio Risk
Systematic and Specific Risk [Law of
Large Numbers] (Insurance,
Consumer Credit)
Equilibrium Theories, e.g. Capital
Asset Pricing Model [Sharpe, Lintner]
(Equity Markets, Capital Investments)
Portfolio Theory [Markowitz] (Market
Portfolios), based on function
P=(w1,w2,w3,..,1,2,3,..,12, 13,
23,..)
Corporate Financial Management 1 35
Effect of Diversification
(%)
Specific (Diversifiable)
35 Risk
Total Risk
20
Systematic Risk
0
10 20 30 40 N
Corporate Financial Management 1 36
Capital Asset Pricing Model
In an efficient market, the required return
will equal the expected return.
efficient market => equilibrium price
transactional, informational efficiency
efficient market arbitrage
An assets required return is the sum of
the riskless return and an asset-specific
risk premium.
Beta () is a measure of the assets market
(systematic, undiversifiable) risk.
SML: ri = rF + (rM - rF)
Corporate Financial Management 1 37
Beta as a Sensitivity Measure
ri = rF + (rM - rF)
ri
=1
0<<1
rF
=0
45
rM
Corporate Financial Management 1 38
CAPM Utilization Problem
out-of-the-money in-the-money
S p p
at-the-money Time Value
WACC = 30%6%(1-40%)+
5%5.8%+ 65%12% = 9.17%
Generate ideas
Estimate the expected future cash flows
from the project.
Assess the risk and determine a required
return (cost of capital, hurdle rate, discount
rate).
Compute present value of cash flows; if
project has a positive NPV, it creates value
=> should be accepted.
Alt.: Find market price or compare with similar asset
Corporate Financial Management 1 54
Types of Projects
Capital budgeting projects include:
New products and new businesses
Maintenance projects
Cost saving/ revenue enhancement
Capacity expansion
Projects required by regulation/ policy
Independent/Exclusive Projects
Conventional/Nonnormal Cash Flows
Corporate Financial Management 1 55
Alternative Budgeting Measures
Net Present Value
Internal Rate of Return (=Expected Rtrn)
Profitability Index
Modified IRR (includes cost of capital)
Payback ... ignores time value of
money and cash flows beyond payback
Discounted Payback
Year 0 1 2 3 4
CF -70,000 30,000 30,000 30,000 20,000
DCF -70,000 27,273 24,793 22,539 13,660
PB = 2 + (10,000/30,000) = 2.3 years
DPB = 2 + (17,934/22,539) = 2.8 years
NPV = DCF = $18.266
PI = DCF[1-4] / |CF0| = 1.26
IRR = 22.24%
MIRR = (129,230/70,000)1/4 - 1 = 16.56%
9,450 Assets =
7,560 (A/S)Sales
= 0.63($3,000)
= $1,890
Sales
0 12,000 15,000
A/S = $7,560/$12,000 = 0.63 = $9,450/$15,000
(i.e. Capital Intensity Ratio remains unchanged)
Corporate Financial Management 1 73
Calculating AFN
AFN = Required Increase in Assets -
Spontaneous Increase in Liabilities -
Increase in Retained Earnings
AFN= A(S/S0)- L*(S/S0)- MS1(1-P)
= $7,56025% - $1,80025% -
6%$15,00075% = $1,890-$450-$675
= $765,000
DR0=3,600/7,560=48%; DR1=4,815/9,450=51%
CR0=4,560/2,600=1.75; CR1=5,700/3,815=1.49
Corporate Financial Management 1 75
Corp. Valuation & Governance
Chapter 13