Chapter 1, BOC Question 5 (ch01-M)

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5. Finance is all about valuationhow do we estimate asset values, and what can we do to
increase them? We develop and use Excel models throughout the book. We start this process
in this chapter with simple models used to value bonds, stocks, and capital budgeting projects.
Working through the model will give you a refresher in valuation plus a refresher (or
preview) of Excel. The model can be accessed from the books CD or web site, Beginning of
Chapter Models, and its filename is ch01-M. (The M is for "model". ch01-Q is the file for the
questions. If you have never used Excel at all, then you should not attempt to answer this
question, or if you do, you should not get frustrated if you have trouble with it.

Click on the tab at the bottom, "Spreadsheet Model," to access the model itself.

what can we do to
We start this process
budgeting projects.
efresher (or
site, Beginning of
-Q is the file for the
t to answer this
th it.

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1/30/03

Worksheet for Chapter 1 BOC Questions (ch01-M)

a. Use Excel to find the value of an 8%, annual payment, $1,000 par value, 5 year bond if the going
rate of interest is 7%. Check your answer with a calculator.
Principal amount of bond:
Coupon interest rate:
Market interest rate:
Time line of payments:
Interest
Principal
Total CF

$1,000
8.0%
7.0%

Years to maturity:
Annual interest:

1
$80

2
$80

3
$80

4
$80

$80

$80

$80

$80

5
$80

5
$80
1,000
$1,080

The bond's value can be found in several ways, as shown below:

Method #1. Find PV of interest and PV of principal, and sum them.
PV of interest payments:
PV of maturity payment:
Value of bond:

$328.02
$712.99
$1,041.00

Click fx > Financial > PV and then fill in as shown in dialog box below.
Just use algebra to find PV.

Notes:
1. We could have used numbers,
but we used cell references to
provide greater flexibility.
2. We could have left FV and Type
blank, but we put in 0.
3. The result shows as a negative
number, so we pt a minus sign
after the equal sign in cell C16
to convert to positive value.

Method #2. Use the same PV function, but insert $1,000 as the FV:
Click fx > Financial > PV and then fill in as shown in dialog box below.
Value of bond:

$1,041.00
Notes:
1. All the inputs are the same as
above except for FV, where we
inserted C3.
2. Note that this Excel function is
identical to the procedure that
would be used to find the value of
the bond with many financial
calculators.
3. Again, we inserted a minus sign

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after the equal sign to convert
the answer to a positive number.

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Note that if you change any of the input values, the bond's value as shown in cells C18 and C39 will instaneously change to
reflect the new conditions. To see this, change C5 to 15% and watch the bond's price fall. As we will see in later chapters, the
process for making such changes is called "sensitivity analysis," or, if several variables are changed at the same time,
"scenario analysis." Furthermore, Excel has very useful features called "Data Tables" and "Scenario Manager" that
automate this process. We will use these features often.
Note too that in our bond valuation problem we assumed that the bond will make its next interest payment exactly one year from
today. We could use the Excel bond "Price" function to find the bond's value between interest payment dates, and we will do so
in Chapter 4.

Stock Valuation
b. Use Excel to find the value of a stock if the last dividend was $1, the expected growth rate for the
next 3 years is 20%, the long-run growth rate is 5%, and the required rate of return is 12%. Again,
you can check your answers with a calculator.

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Last dividend (D0):

Required rate of return (r):
Time line of payments:
Dividend
Stock value end of Year 3:
Total cash flow:

0
$1.00

1
$1.20

2
$1.44

$1.00

$1.20

$1.44

PV of cash flow:

$1.07

Value of the stock:

Notes:

Growth rate next 3 years (g1-3):

Growth rate thereafter (gn):

1
12%

$1.15

3
$1.73
$25.92
$27.65

20%
5%

4
$1.81

$19.68

$21.90

1. The first dividend that will be received is the $1.20, because the $1 has been paid.
2. The growth rate drops to 5% after Year 3.
3. The PV of the dividends from Year 4 to infinity is found as D4/(r - gn) = $25.92.
The calculation assumes that the stock is, or can be, sold at the $25.92 at the end of Year 3.

Again, we could change the inputs and see instantly how the stock price varies. For example, if you change r to 10%
and gn to 7%, the stock price will more than double, rising from $21.90 to $49.88. Thus, if management could lower
the firm's risk (and thus r) and raise the growth rate, this would greatly enhance shareholder value.

Capital Budgeting
c. Use Excel to find the NPV and the IRR of a project that is expected to cost $10,000 and to
provide net cash flows of $2,000 per year for the next 10 years. The cost of capital is 11%.
Excel is excellent for analyzing capital budgeting problems. Here is an example:
Project cost:
-$10,000
Project life (years):
10
Annual net cash flow:
$2,000
Cost of capital:
11%
Time line:
Cash flow

0
-$10,000

Net Present Value (NPV):

Internal Rate of Return (IRR):
Notes:

1
$2,000

2
$2,000

3
$2,000

4
$2,000

5
$2,000

6
$2,000

7
$2,000

$1,778
15.1%

1. The completed dialog boxes shown below illustrate how to use Excel to calculate the NPV and IRR.
2. You get the dialog boxes by clicking fx > Financial > NPV or IRR.
3. Excel's NPV function assumes that the first cash flow occurs at the end of the year. However, the cost

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$2,000

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occurs at the beginning of the period. Therefore, to use the NPV function we first calculate the NPV of the
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flows that occur after Period 0, and we add to the value thus calculated the (negative) cost.
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4. Excel's IRR function assumes that the cash flows occur at the beginning of each period, so when we
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calculate the IRR we can simply specify the entire range (B97:L97). Also, we leave "guess" blank and let
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Excel starts the iterative process with a 10% cost of capital discount rate.
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110 Again, we could vary the inputs and see how the NPV and IRR change, and we will be doing a lot of this later in the book.
111 As we will see, using Excel to analyze capital budgeting projects is an easy way to evaluate potential projects, and it can
112 also be used by management to help design projects so that they maximize the firm's value.