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Week 1- Session 1 and Session 2

Summer 2012

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The Classical Viewpoint

Van Horne: "In this book, we assume that the objective of the firm is to

maximize its value to its stockholders"

Brealey & Myers: "Success is usually judged by value: Shareholders are

made better off by any decision which increases the value of their stake in

the firm... The secret of success in financial management is to increasevalue."

Copeland & Weston: The most important theme is that the objective of

the firm is to maximize the wealth of its stockholders."

Brigham and Gapenski: Throughout this book we operate on the

assumption that the management's primary goal is stockholder wealthmaximization which translates into maximizing the price of the common

stock.

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The Objective in Decision Making

In traditional corporate finance, the objective in decision making is to maximize the

value of the firm.

A narrower objective is to maximize stockholder wealth. When the stock is traded

and markets are viewed to be efficient, the objective is to maximize the stock price.

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flows

Little o r No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in management

Perpetual Lives

Growth Assets

Existing Investments

Generate cashflows todayIncludes long lived (fixed) and

short-lived(workingcapital) assets

Expected Value that will becreated by future investments

Maximize

firm value

Maximize equity

valueMaximize market

estimate of equity

value

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Capital Budgeting

The NPV and required rate of return are parts of the process called capital

budgeting. Capital budgeting is process of identifying and evaluating

capital projects, that is projects where the cash flow to the firm will be

received over a period longer than a year.

Decisions about whether to buy a new machine, expand business inanother geographic area, move to the corporate headquarters to another

location, or replace a delivery truck, to name a few, can be examined using

the capital budgeting analysis

Capital budgeting may be the most important responsibility that a financial

manager has. Why? Firstly, since capital budgeting decision often involves the purchase of

costly long-term assets with lives of many years, the decision made may

determine future successes of the firm

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Capital Budgeting

Second, the principles underlying the capital budgeting process may also

apply to other CF decisions like working capital management and making

strategic decision like M&As

Finally, making good capital budgeting decisions is consistent with

management's primary goal of maximizing shareholder valueCategories of Capital Budgeting process

Replacement projects to maintain the business are normally made without

detailed analysis. The only issues are whether the existing operations

should continue and if so, whether existing procedures or processes should

be maintained.

Expansion projects are undertaken to grow the business and involve a

complex decision making process since they require the explicit forecast of

future demand. A very detailed analysis is required

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Capital Budgeting

New product or market development also entails a complex decision

making process since they require an explicit forecast of future demand.

Mandatory projects may be required by a governmental agency or

insurance company and typically involve safety-related or environmental

concerns. These projects typically generate little or no revenueFive key principles of capital budgeting

1. Decisions are based on cash flows, not accounting income

2. Cash flows are based on opportunity costs

3.The timing of cash flows is important

4. Cash flows are analyzed on after-tax basis

5. Financing costs are reflected in the projects required rate of return

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Net Present Value

NPV = PV required investment; or,

NPV = C0 + C1/(1+r)

Where, C0

is the cash flow at time zero, that is today

Future cash flows are not certain. They represent the best forecast or

estimate, therefore, another basic financial principle is that a safe dollar is

worth more than a risky one. Most investors avoid risk when they can do

so without sacrificing return.

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Present Value and rates of return

Any projects present value is equal to its future income discounted at the

rate of return offered by these securities

This can be put in another way a venture is worth undertaking because

its rate of return exceeds the cost of capital. The rate of return on the

investment in a venture is simply the profit as a proportion of the initialoutlay:

Return = Profit/Investment

The cost of capital is the return foregone by not investing in securities. If a

project is as risky as investing in stock market, for example, and the returnon stock market investment is 12%, then the cost of capital is 12%.

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Present Value, rates of return and OCC

Based on the previous slides, then:

Net Present Value Rule: Accept investments that have a positive NPV

Rate-of-return Rule: Accept investments that offer rates of return in excess

of their OCC

Any projects present value is equal to its future income discounted at the

rate of return offered by these securities

Opportunity Cost of Capital (OCC)

You have the following opportunity: Invest PKR 100,000 today, and

depending on the state of economy at the end of the year you will receive

the following pay offs:

Slump: PKR 80,000, Normal: PKR 110,000, Boom: PKR 140,000

You expect the pay off to be C1 = PKR 110,000, a 10% return on the PKR

100,000 investment. But whats the right discount rate?

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Opportunity Cost of Capital

You search for a common stock with the same risk as the investment. Its

called Stock X and has a current price of PKR 95.65 and is expected to have

a price of PKR 110 at the end of the year, if the economy is normal

The expected rate of return on Stock X is calculated, it comes to 15% (try

the calculation). This is the expected return that you are giving up byinvesting in the project rather than the stock market, therefore, this is the

projects opportunity cost of capital. The PV of the project is PKR 95,650

(how?), and the NPV is PKR (4,350). Result: project NOT worth

undertaking

The same conclusion occurs if the project is compared on rate of returnbasis. The expected return on project is 10% which is less than the 15%

return that could be earned if invested elsewhere.

Any time you find and launch a positive-NPV project, the companys

stockholders are made better off.

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Cost of Capital

After understanding what opportunity cost of capital is, it is important to

note how it is calculated in the capital budgeting process and in financial

management

The capital budgeting process involves discounted cash flow analysis, for

which we need to know the proper discount rate. This discount rate is theweighted average cost of capital or WACC

WACC = rD(D/V) + rE(E/V) = r, a constant, independent of D/V

Where r is the opportunity cost of capital, the expected rate of return

investors would demand if the firm had not debt at all; rD and rE are the

expected rates of return on dent and equity. The weights D/V and E/V arethe fractions of debt and equity. Since debt is tax deductible:

WACC = rD(1-Tc)D/V + rE(E/V), where Tc is the marginal corporate tax rate.

WACC evaluates average risk projects, and is based on target capital

structure, not present capital structure

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Using WACC

How does the formula change when there are more than two sources of

financing?

What about short term debt?

Numerical example on WACC

In practice: Equity, Debt and Cost of Capital for Banks

Note that we did not estimate a cost of capital for banks even though we have

estimates of the costs of equity and debt for the firm. The reason is simple

and goes to the heart of how firms view debt. For nonfinancial service firms,

debt is a source of capital and is used to fund real projectsbuilding a factory

or making a movie. For banks, debt is raw material that is used to generate

profits. Boiled down to its simplest elements, it is a banks job to borrow

money (debt) at a low rate and lend it out at a higher rate. It should come as

no surprise that when banks (and their regulators) talk about capital, they

mean equity capital.