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You are on page 1of 96

02_PreFinal.ppt

Stangeland © 2002 1

Introduction

Today’s Goal

Highlight important topics to review

Work through more difficult concepts

Answer questions raised by students

No new material

No extra exam hints

Stangeland © 2002 2

Lecture 1 Material

Stangeland © 2002 3

II. Types of Businesses

1. Sole Proprietorship

2. Partnership

3. Corporation

Stangeland © 2002 4

Value of Debt at time of Repayment

(repayment due = $10 million)

35

Contingent Value of the

Firm's Securities ($

30

25

millions)

20

15

10

5

0

0 5 10 15 20 25 30 35 40 45

Value of the Firm's Assets at the time the debt

is due ($ millions)

Stangeland © 2002 5

Value of Equity at time of Debt Repayment

(repayment due = $10 million)

35

Contingent Value of the

Firm's Securities ($

30

25

millions)

20

15

10

5 Never Negative – Limited Liability

0

0 5 10 15 20 25 30 35 40 45

Value of the Firm's Assets at the time the debt

is due ($ millions)

Stangeland © 2002 6

Total Value of the Firm

= Debt + Equity

Contingent Value of the Firm's

35

Total Firm Value Equity

Securities ($ millions)

30

25

20

15

Debt

10

0

0 5 10 15 20 25 30 35 40 45

Value of the Firm's Assets at the time the debt

is due ($ millions)

Stangeland © 2002 7

IV. The Principal-Agent (PA) Problem

Corporations are owned by shareholders

but are run by management

There is a separation of ownership and control

Shareholders are said to be the principals

Managers are the agents of shareholders

and are are supposed to act on behalf of the

shareholders

The PA problem is that managers may not

always act in the best way on behalf of

shareholders.

Stangeland © 2002 8

V. Self study – will be examined

Financial Institutions

Financial Markets

Money vs. Capital Markets

Primary vs. Secondary Markets

Listing

Foreign Exchange

Trends in Finance

Stangeland © 2002 9

Lecture 2 Material

Stangeland © 2002 10

Arbitrage Defined

Arbitrage – the ability to earn a risk-free

profit from a zero net investment.

competition in markets, prices adjust so

that arbitrage possibilities do not persist.

Stangeland © 2002 11

III. Two-period model

Consider a simple model where an

individual lives for 2 periods, has an

income endowment, and has

preferences about when to consume.

Endowment (or given income) is

$40,000 now and $60,000 next year

Stangeland © 2002 12

Two-period model: no market

Without the ability to

borrow or lend using

Thousands

$120

Income

financial markets, the

Consumption t+1

$100 Endowment

individual is restricted to

$80

just consuming his/her

$60

endowment as it is earned:

$40

i.e., consume $40,000 now and consume

$20 $60,000 in one year.

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 13

Intertemporal Consumption

Opportunity Set

Assume a market for borrowing

or lending exists and the interest

Thousands

$120

rate is 10%. This opens up a large

Consumption t+1

$100

set of consumption patterns

$80

across the two periods.

$60

$40

$20

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 14

Intertemporal Consumption

Opportunity Set

1. What is the slope of the consumption

opportunity set?

today and how is this achieved?

t+1 and how is this achieved?

Stangeland © 2002 15

Intertemporal Consumption

Opportunity Set

Maximum @ t+1 = ?

Thousands

$120

Consumption t+1

$100

$80

Slope =

$60

$20

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 16

Intertemporal Consumption

Opportunity Set

A person’s preferences will

impact where on the

Thousands

$120

consumption opportunity set

Consumption t+1

$100

Patient they will choose to be.

$80

$60

$40

$20 Hungry

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 17

An increase in interest rates

Thousands

Consumption t+1

economy exactly equates the demands of

$80

borrowers and savers. As demands change,

$60 the interest rate adjusts to equate the supply

and demand for funds across time.

$40

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 18

Real Investment Opportunities –

Example 1

Consider an investment opportunity that costs

$35,000 this year and provides a certain

cash flow of $36,000 next year.

Time 0 1

Stangeland © 2002 19

Real Investment Opportunities –

Example 1

Thousands

Consumption t+1

$100

Original

$80 Endowment

$60

$40

$20

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 20

Real Investment Opportunities –

Example 1

Should the individual take the real investment opportunity?

No! It leads to dominated consumption opportunities.

Thousands

$120

Consumption Opportunity Set after real investment is taken

Consumption t+1

$100

borrowing or lending against the

$60 original endowment

$40

$20

$0

$0 $20 $40 $60 $80 $100 $120

Thousands

Consumption Today

Stangeland © 2002 21

VI. The Separation Theorem

The separation theorem in financial markets says that

all investors will want to accept or reject the same

investment projects by using the NPV rule, regardless

of their personal preferences.

Separation between consumption preferences and

real investment decisions

Logistically, separating investment decision making

from the shareholders is a basic requirement for the

efficient operation of the modern corporation.

Managers don’t need to worry about individual

investor consumption preferences – just be

concerned about maximizing their wealth.

Stangeland © 2002 22

Lecture 3 Material

Stangeland © 2002 23

PV of a Growing Annuity

C1 Cn 1 1 Subtract off the PV

PV0 of the latter part of

r g r g (1 r ) n the growing

perpetuity

PV of the

C1 C1 (1 g ) n

1 whole

PV0 growing

rg rg (1 r ) n

perpetuity

period before the

C1 (1 g ) n

first cash flow

PV0 1 n

r g (1 r )

Stangeland © 2002 24

Simple (non-growing) series of

cash flows

For constant C

annuities and PV0 regular perpetuity

r

constant

perpetuities, the C 1

time value PV0 1 n

formulas are

r (1 r) regular

simplified by annuity

setting g = 0. C

FVn (1 r) n 1

r

We can use the PMT button

on the financial calculator for

the annuity cash flows, C

Stangeland © 2002 25

IV. Some final warnings

Even though the time value calculations

look easy there are many potential

pitfalls you may experience

Be careful of the following:

PV0 of annuities or perpetuities that do not begin

in period 1; remember the PV formulas given

always discount to exactly one period before the

first cash flow.

If the cash flows begin at period t, then you

must divide the PV from our formula by (1+r)t-1

to get PV0.

Note: this works even if t is a fraction.

Stangeland © 2002 26

Be careful of annuity payments

Count the number of payments in an annuity. If

the first payment is in period 1 and the last is in

period 2, there are obviously 2 payments. How

many payments are there if the 1st payment is

in period 12 and the last payment is in period 21

(answer is 10 – use your fingers). How about if

the 1st payment is now (period 0) and the last

payment is in period 15 (answer is 16

payments).

If the first cash flow is at period t and the last

cash flow is at period T, then there are T-t+1

cash flows in the annuity.

Stangeland © 2002 27

Be careful of wording

A cash flow occurs at the

0 1 2 3 4

end of the third period.

A cash flow occurs at

time period three.

A cash flow occurs at the

beginning of the fourth C

period.

Each of the above

statements refers to the

same point in time!

Stangeland © 2002 28

Lecture 4&5 Material

Stangeland © 2002 29

Annuities and perpetuities

The annuity and perpetuity formulae require the rate

used to be an effective rate and, in particular, the

effective rate must be quoted over the same time

period as the time between cash flows. In effect:

If cash flows are yearly, use an effective rate per

year

If cash flows are monthly, use an effective rate per

month

If cash flows are every 14 days, use an effective rate

per 14 days

If cash flows are daily, use an effective rate per day

If cash flows are every 5 years, use an effective rate

per 5 years.

Etc.

Stangeland © 2002 30

Step 1: finding the implied effective rate

In words, step 1 can be described as follows:

Take both the quoted rate and its quotation

period and divide by the compounding

frequency to get the implied effective rate

and the implied effective rate’s quotation

period.

The quoted rate of 60% per year with monthly

compounding is compounded 12 times per the

quotation period of one year. Thus the implied

effective rate is 60% ÷ 12 = 5% and this implied

effective rate is over a period of one year ÷ 12 = one

month.

Stangeland © 2002 31

Step 2: Converting to the desired

effective rate

Example: if you are doing loan

calculations with quarterly payments,

then the annuity formula requires an

effective rate per quarter.

Once we have done step 1, if our

implied effective rate is not our

desired effective rate, then we need

to convert to our desired effective

rate.

Stangeland © 2002 32

Step 2: continued

Effective to effective conversion

In the previous example, 5% per month is equivalent to

15.7625% per 3 months (or quarter year). This result is due to

the fact that (1+.05)3=1.157625

As a formula this can be represented as

Ld Ld

(1 r ) (1 r ) r (1 r ) 1

Lg Lg

g d or d g

rate.

Lg is the quotation period of the given rate and Ld is the

quotation period of the desired rate, thus Ld/Lg is the length of

the desired quotation period in terms of the given quotation

period.

Stangeland © 2002 33

Step 3: finding the final quoted rate

In words, step 3 can be described as follows:

Take both the implied effective rate and its

quotation period and multiply by the

compounding frequency of the desired final

quoted rate. This results in the desired final

quoted rate and its quotation period.

In our example, the desired quoted rate is a rate

per year compounded quarterly. Therefore the

compounding frequency is 4. We multiply

15.7625% per quarter by 4 to get 63.05% per

year compounded quarterly.

Stangeland © 2002 34

Continuous Compounding – self

study (continued)

Using the previous formula and mathematical limits …

As m , 1 reffective e quo ted

r

continuous ly compounded rate of interest

from reffective per period to rper period with continuouscompounding ,

Stangeland © 2002 35

Mortgage continued

How much will be left at the end of the 5-year contract?

After 5 years of payments (60 payments) there are 300

payments remaining in the amortization. The principal

remaining outstanding is just the present value of the

remaining payments.

the 300th payment?

When the 299th payment is made, there are 61 payments

remaining. The PV of the remaining 61 payments is the

principal outstanding at the beginning of the 300th period

and this can be used to calculate the interest charge which

can then be used to calculate the principal reduction.

Stangeland © 2002 36

Lecture 6 Material

Stangeland © 2002 37

Bond valuation and yields

A level coupon bond pays constant semiannual coupons

over the bond’s life plus a face value payment when the

bond matures.

The bond below has a 20 year maturity, $1,000 face

value and a coupon rate of 9% (9% of face value is

paid as coupons per year).

20

Year 0 0.5 1 1.5 ... 19.5

(Maturity

Date)

+ $1,000

Stangeland © 2002 38

Lecture 7 Material

Stangeland © 2002 39

Definitions – Spot Rates

The n-period current spot rate of interest denoted rn

is the current interest rate (fixed today) for a loan

(where the cash is borrowed now) to be repaid in n

periods. Note: all spot rates are expressed in the

form of an effective interest rate per year. In the

example above, r1, r2, r3, r4, and r5, in the previous

slide, are all current spot rates of interest.

Spot rates are only determined from the prices of

zero-coupon bonds and are thus applicable for

discounting cash flows that occur in a single time

period. This differs from the more broad concept of

yield to maturity that is, in effect, an average rate

used to discount all the cash flows of a level coupon

bond.

Stangeland © 2002 40

Definitions – Forward Rates

(continued)

To calculate a forward rate, the

following equation is useful:

1 + fn = (1+rn)n / (1+rn-1)n-1

where fn is the one period forward rate

for a loan repaid in period n

(i.e., borrowed in period n-1 and repaid in period n)

Calculate f3 given r3=9.5%

Stangeland © 2002 41

Forward Rates – Self Study

The t-period forward rate for a loan

repaid in period n is denoted n-tfn

E.g., 2f5 is the 3-period forward rate for a loan

repaid in period 5 (and borrowed in period 2)

The following formula is useful for

calculating t-period forward rates:

1+n-tfn = [(1+rn)n / (1+rn-t)n-t]1/t

Given the data presented before, determine 1f3

and 2f5

Results: 1f3=10.2577945%; 2f5=10.4622321%

Stangeland © 2002 42

Definitions – Future Spot Rates

Current spot rates are observable today and can be

contracted today.

A future spot rate will be the rate for a loan obtained

in the future and repaid in a later period. Unlike

forward rates, future spot rates will not be fixed (or

contracted) until the future time period when the loan

begins (forward rates can be locked in today).

Thus we do not currently know what will happen to

future spot rates of interest. However, if we

understand the theories of the term structure, we can

make informed predictions or expectations about

future spot rates.

We denote our current expectation of the future spot

rate as follows: E[n-trn] is the expected future spot

rate of interest for a loan repaid in period n and

borrowed in period n-t.

Stangeland © 2002 43

Term Structure Theories:

Pure-Expectations Hypothesis

The Pure-Expectations Hypothesis states

that expected future spot rates of interest

are equal to the forward rates that can be

calculated today (from observed spot

rates).

In other words, the forward rates are

unbiased predictors for making

expectations of future spot rates.

What do our previous forward rate

calculations tell us if we believe in the Pure-

Expectations Hypothesis?

Stangeland © 2002 44

Liquidity-Preference Hypothesis

Empirical evidence seems to suggest that

investors have relatively short time

horizons for bond investments. Thus, since

they are risk averse, they will require a

premium to invest in longer term bonds.

The Liquidity-Preference Hypothesis states

that longer term loans have a liquidity

premium built into their interest rates and

thus calculated forward rates will

incorporate the liquidity premium and will

overstate the expected future one-period

spot rates.

Stangeland © 2002 45

Liquidity-Preference Hypothesis

Reconsider investors’ expectations for inflation and

future spot rates. Suppose over the next year,

investors require 4% for a one year loan and expect

to require 6% for a one year loan (starting one year

from now).

Under the Liquidity-Preference Hypothesis, the current

2-year spot rate will be defined as follows:

(1+r2)2=(1+r1)(1+E[1r2]) + LP2

where LP2 = liquidity premium: assumed to be

0.25% for a 2 year loan

(1+r2)2 = (1.04)x(1.06) + 0.0025 so r2=5.11422%

Stangeland © 2002 46

Liquidity-Preference Hypothesis

Restated, if we don’t know E[1r2], but

we can observe r1=4% and

r2=5.11422%,

then, under the Liquidity-Preference

Hypothesis, we would have E[1r2] < f2 =

6.24038%.

From this example, f2 overstates E[1r2] by

0.24038%

If we know LP2 or the amount f2 overstates

E[1r2], then we can better estimate E[1r2].

Stangeland © 2002 47

Projecting Future Bond Prices

Consider a three-year bond with annual coupons (paid

annually) of $100 and a face value of $1,000 paid at

maturity. Spot rates are observed as follows: r1=9%,

r2=10%, r3=11%

What is the current price of the bond?

What is its yield to maturity (as an effective annual

rate)?

What is the expected price of the bond in 2 years?

under the Pure-Expectations Hypothesis

under the Liquidity-Preference Hypothesis

assume f3 overstates E[2r3] by 0.5%

Stangeland © 2002 48

Lecture 8&9 Material

Stangeland © 2002 49

Conventional Cash Flows or Unconventional

Lending/Investing Type Project Cash Flows or

Borrowing Type

IRR Problem Cases: Borrowing vs. Lending

Project

Consider the

following two Project A Project B

Year Cash Cash

projects.

Flows Flows

Evaluate with IRR

given a hurdle rate

of 20%

For borrowing 0 -$10,000 +$10,000

projects, the IRR

rule must be

reversed: accept the

project if the 1 +$15,000 -$15,000

IRR≤hurdle rate

Stangeland © 2002 50

The non-existent or multiple IRR problem

Year

Do the of Project A of Project B

evaluation using

IRR and a 0 -$312,000 +$350,000

hurdle rate of

15%

1 +$800,000 -$800,000

IRRA=?

IRRB=?

2 -$500,000 +$500,000

Stangeland © 2002 51

NPV Profile – where are the IRR's?

$80,000

$60,000

$40,000

Project A

$20,000

NPV

Project B

$0

0% 20% 40% 60% 80% 100%

-$20,000

-$60,000

Stangeland © 2002 52

No or Multiple IRR Problem – What to do?

the only solution is to revert to another

method of analysis. NPV can handle these

problems.

How to recognize when this IRR problem

can occur

When changes in the signs of cash flows happen

more than once the problem may occur

(depending on the relative sizes of the individual

cash flows).

Examples: +-+ ; -+- ; -+++-; +---+

Stangeland © 2002 53

Special situations for DCF analysis

When projects are independent and the firm has few

constraints on capital, then we check to ensure that

projects at least meet a minimum criteria – if they do,

they are accepted.

NPV≥0; IRR≥hurdle rate; PI≥1

If the firm has capital rationing, then its funds are

limited and not all independent projects may be

accepted. In this case, we seek to choose those projects

that best use the firm’s available funds. PI is especially

useful here.

Sometimes a firm will have plenty of funds to invest, but

it must choose between projects that are mutually

exclusive. This means that the acceptance of one

project precludes the acceptance of any others. In this

case, we seek to choose the one highest ranked of the

acceptable projects.

Stangeland © 2002 54

Incremental Cash Flows: Solving

the Problem with IRR and PI

As you can see, individual IRR's and PIs are not good

for comparing between two mutually exclusive

projects.

However, we know IRR and PI are good for evaluating

whether one project is acceptable.

Therefore, consider “one project” that involves

switching from the smaller project to the larger

project. If IRR or PI indicate that this is worthwhile,

then we will know which of the two projects is better.

Incremental cash flow analysis looks at how the cash

flows change by taking a particular project instead of

another project.

Stangeland © 2002 55

Using IRR and PI correctly when projects are

mutually exclusive and are of differing scales

flows tells us which of two projects are

better.

project, you should always check to see

that the better project is good on its own

(i.e., is it better than “do nothing”).

Stangeland © 2002 56

Incremental Analysis – Self Study

For self-study, Incremental

consider the Cash Cash flows

following two Cash flows of A instead

Year flows of

investments and of Project A of B

Project B

do the (i.e., A-B)

incremental IRR

and PI analysis.

The opportunity 0 -$100,000 -$50,000

cost of capital is

10%. Should

either project be

1 +$101,000 +$50,001

accepted? No,

prove it to

yourself!

Stangeland © 2002 57

Capital Rationing

Recall: If the firm has capital rationing, then its

funds are limited and not all independent projects

may be accepted. In this case, we seek to choose

those projects that best use the firm’s available funds.

PI is especially useful here.

Note: capital rationing is a different problem than

mutually exclusive investments because if the capital

constraint is removed, then all projects can be

accepted together.

Analyze the projects on the next page with NPV, IRR,

and PI assuming the opportunity cost of capital is

10% and the firm is constrained to only invest

$50,000 now (and no constraint is expected in future

years).

Stangeland © 2002 58

Capital Rationing – Example

(All $ numbers are in thousands)

2 $0 $0 $37.862 $0 $0

Stangeland © 2002 59

Capital Rationing Example:

Comparison of Rankings

NPV rankings (best to worst)

A, D, C, B, E

A uses up the available capital

Overall NPV = $4,545.45

IRR rankings (best to worst)

E, D, B, A, C

E, D, B use up the available capital

Overall NPV = NPVE+D+B=$6,181.82

PI rankings (best to worst)

E, D, C, B, A

E, D, C use up the available capital

Overall NPV = NPVE+D+C=$6,381.82

The PI rankings produce the best set of investments

to accept given the capital rationing constraint.

Stangeland © 2002 60

Capital Rationing Conclusions

PI is best for initial ranking of

independent projects under capital

rationing.

Comparing NPV’s of feasible

combinations of projects would also

work.

IRR may be useful if the capital

rationing constraint extends over

multiple periods (see project C).

Stangeland © 2002 61

Other methods to analyze

investment projects – self study

Payback – the simplest capital budgeting

method of analysis

Know this method thoroughly.

Discounted Payback

Not Required.

Average Accounting Return (AAR)

You will not be asked to calculate it, but you

should know what it is and why it is the most

flawed of the methods we have examined.

Stangeland © 2002 62

Lecture 10 Material

Stangeland © 2002 63

Relevant cash flows

The main principles behind which

cash flows to include in capital

budgeting analysis are as follows:

1. Only include cash flows that change as a

result of the project being analyzed.

Include all cash flows that are impacted

by the project. This is often called an

incremental analysis – looking at how

cash flows change between not doing

the project vs. doing the project.

Stangeland © 2002 64

Which cash flows are relevant to

the project analysis, which are not?

Examples Type of Cash Flow Is it Relevant to

the analysis? Why?

Sunk Costs

Opportunity Costs

incidental effects)

Interest Expense

(or financing

charges)

Stangeland © 2002 65

Conclusions on real and nominal

cash flows

It is possible to express any cash flow

as either a real amount or a nominal

amount.

Since the real and nominal amounts

are equivalent, the PV’s must be

equivalent, so remember the rule:

Discount real cash flows with real rates.

Discount nominal cash flows with

nominal rates.

Stangeland © 2002 66

Use of real cash flows

If a project’s cash flows are expected

to grow with inflation, then it may be

more convenient to express the cash

flows as real amounts rather than

trying to predict inflation and the

nominal cash flows.

Stangeland © 2002 67

Tax consequences and after tax cash

flows (assume a tax rate, Tc, of 40%)

Item Before-tax Before-tax After-tax

amount cash flow cash flow

$10 $10 =$10(1-.4)

=$6

Expense Exp -Exp =-Exp(1-Tc)

$10 -$10 =-$10(1-.4)

=-$6

CCA CCA $0 =+CCATc

$10 =+$10 0.4

=+$4

Stangeland © 2002 68

Yearly cash flows after tax

Normally we project yearly cash flows for a

project and convert them into after-tax

amounts.

CCA deductions are due to an asset

purchase for a project. CCA is calculated as

a % of the Undepreciated Capital Cost

(UCC). Since a % amount is deducted each

year, the UCC will never reach zero so CCA

deductions can actually continue even after

the project has ended (and thus shelter

future income from taxes). All CCA-caused

tax savings should be recognized as cash

inflows for the project that caused them.

Stangeland © 2002 69

Lecture 11 Material

Stangeland © 2002 70

PV CCA Tax Shields

k

1

C d Tc 2 S n d Tc 1

PVCCA Tax Shields

k d 1 k k d 1 k n

C = cost of asset

D = CCA rate

Tc = Corporate tax rate

k = Discount rate for CCA tax shields

Sn = Salvage value of asset sold in period n with lost CCA

deductions beginning in period n+1

Stangeland © 2002 71

Summary of Capital Budgeting

Items and Tax Effects

The following formula may help summarize the project’s

NPV calculation.

NPV = -initial asset cost1

+ PVSalvage Value or Expected Asset Sale Amount1

+ PVincremental cash flows caused by the project2

+ PVincremental working capital cash flows caused by the project1

– PVCapital Gains Tax3

+ PVCCA Tax Shields

Footnotes:

1. These items usually have the same before-tax amounts and

after-tax amounts. I.e., there is no tax effect. For asset

purchases/sales the tax effect is done through CCA effects.

2. These items usually have the after-tax cash flow equal to the

before tax cash flow multiplied by (1-Tc).

3. Capital gains tax is only triggered when the asset is sold for an

amount greater than its initial cost.

Stangeland © 2002 72

Qualitative checks (continued)

Remember, a positive NPV indicates wealth is being

created. This is equivalent to the economic concept of

“positive economic profit”.

When does positive economic profit occur?

When there is not perfect competition; i.e., when

there is a competitive advantage.

Sources of competitive advantage include:

Being the first to enter a market or create a product

Low cost production

Economies of scale and scope

Preferred access to raw materials

Patents (create a barrier to entry, or preserve a low-

cost production process).

Product differentiation

Superior marketing or distribution, etc.

Stangeland © 2002 73

Midterm 2 Question

Stangeland © 2002 74

1. Fritz, of Fritz Plumbing, has been given the opportunity to

carry Moen fixtures for the next 10 years. He needs your

advice and has supplied the following information for your

analysis of the “Moen Project”:

Current Office Lease Costs$30,000 per yearCurrent Insurance

Costs$8,000 per yearCurrent Wages of Employees$200,000

per yearCurrent Required Inventory$60,000 Current revenue

$500,000 per year

No working capital changes are expected due to the project.

Revenues are expected to rise to $800,000 per year over the

life of the project and will fall back to their original levels

following the project. One more employee will be required for

the life of the project and the salary will be $30,000 per year.

In addition, Fritz will need to upgrade his fleet of trucks to

accommodate the new Moen fixtures. If the Moen project is

accepted he will sell his current trucks now for $100,000 and

purchase new trucks now for $500,000; the new trucks would

then be sold for $50,000 in 10 years. If the Moen project is

not accepted, he will sell his current trucks in 10 years for

scrap value of $5,000. If the project is accepted Fritz will take

out a bank loan to partially finance the truck and the bank will

require annual interest charges of $1,000 per year for the next

5 years.

Stangeland © 2002 75

(a)Specify all relevant incremental after-tax

cash flows (and their timing) that would

occur if the Moen project is accepted.

Assume a corporate tax rate of 40%.

(Ignore CCA tax shields at this point.) Do

not do any discounting at this point.

(b)What is the present value of the

incremental CCA tax shields if the Moen

project is accepted? Assume a CCA rate of

30% and the appropriate discount rate is

equal to the risk free rate of 4%.

Stangeland © 2002 76

Note: from Lecture 15 material

(c) Assume that the incremental cash

flows in (a) are of the same risk level as the

other assets of Fritz Plumbing. Currently, Fritz

Plumbing is financed as follows: 40% debt,

60% equity. The debt has a market price of

$1,462 per bond and pays semiannual coupons

of $60 each. The debt matures in 8 years and

has a par value of $1,000 per bond. The stock of

Fritz Plumbing has a of 1.5. The expected

return on the market is 12%, Rf is 4% and TC is

40%. What discount rate should be used for the

NPV analysis of the incremental cash flows

specified in (a).

Stangeland © 2002 77

(d) Assume your answer to (c) is 12%,

your answer to (b) is $150,000, and you

determined the following after tax cash

flows in (a) to be as follows:

Time of cash flowAfter-tax amountYear

0 (now)-$500,000Each of Years 1-

10$250,000Year 10$50,000 What is the

NPV of the project? What is your advice to

Fritz?

Stangeland © 2002 78

(e) Suppose that the risk of the Moen project was

much higher than the risk of the firm.

(i) Without doing any calculations, explain how

your analysis, NPV, and advice would likely change

assuming the above risk difference was due to high

unsystematic risk?

(2 points)

(ii) Without doing any calculations, explain how

your analysis, NPV, and advice would likely change

assuming the above risk difference was due to high

systematic risk?

Stangeland © 2002 79

Lecture 12-14 Material

Stangeland © 2002 80

Examples

What would be your portfolio beta, βp, if you had

weights in the first four stocks of 0.2, 0.15, 0.25, and

0.4 respectively.

What would be E[Rp]? Calculate it two ways.

Suppose σM=0.3 and this portfolio had ρpM=0.4, what

is the value of σp?

Is this the best portfolio for obtaining this expected

return?

What would be the total risk of a portfolio composed

of f and M that gives you the same β as the above

portfolio?

How high an expected return could you achieve while

exposing yourself to the same amount of total risk as

the above portfolio composed of the four stocks. What

is the best way to achieve it?

Stangeland © 2002 81

Lecture 15

Stangeland © 2002 82

Conclusions on factors that affect β

The three factors that affect an equity

β are as follows

Cyclicality of Revenues Only these two

Operating Leverage affect asset β

Financial Leverage

Note: the financial leverage does not affect

asset β, it only affects equity β.

Stangeland © 2002 83

Lecture 16 Material

Stangeland © 2002 84

Relationship among the Three

Different Information Sets

All information

relevant to a stock

Information set

of publicly available

information

Information

set of

past prices

Stangeland © 2002 85

Conclusions on Informational Efficiency

weak-form informationally efficient.

Market is generally regarded as being

semi-strong-form informationally

efficient.

Market is generally regarded as NOT

being strong-form informationally

efficient.

Stangeland © 2002 86

Lecture 17&18 Material

Stangeland © 2002 87

Self Study – fill in the blank cells

Construction of a Synthetic European Put:

initial transactions at date t

Initial Transactions: fill in the empty cells

short 1 share of stock

Invest the present value of the exercise

price (E) at the risk free rate (or long

the risk-free asset)

Buy a call option on the stock with

same exercise price and same

expiration date

Initial net cash flow (will be an outflow):

where St is the stock price at time t

Cet is the price at time t of the European call option

Stangeland © 2002 88

Self Study – fill in the blank cells

Synthetic European Put:

transactions on the expiration date (T)

Final cash flows given the different relevant states of nature

(which depend on whether ST is less than or greater than E):

ST < E ST ≥ E

liquidate the short stock position

(buy the stock)

liquidate the long risk-free asset

position (collect the proceeds from

the investment)

liquidate the long call option position

(discard or exercise depending upon

which is optimal)

Net cash flow at the expiration date T: E-ST 0

Stangeland © 2002 89

Lecture 19-20 Material

Stangeland © 2002 90

Integration of all effects on capital

structure

(1 TC ) (1 TS )

VL VU 1 B

1 TB

PVSavings of Agency Costs of Equity

PVExpected financial DistressCosts

Stangeland © 2002 91

Lecture 21 Material

Stangeland © 2002 92

Speculating Example

Zhou has been doing research on the price of gold and

thinks it is currently undervalued. If Zhou wants to

speculate that the price will rise, what can he do?

Give a strategy using futures contracts.

Zhou can take a long position in gold futures; if the

price rises as he expects, he will have money given

to him through the marking to market process, he

can then offset after he has made his expected

profits.

Give a strategy using options.

Zhou can go long in gold call options. If gold prices

rise, he can either sell his call option or exercise it.

Stangeland © 2002 93

Compare Speculating Strategies

(assuming contracts on one troy ounce

of gold)

Derivative Used: Long Futures Long Call Option,

Contract @ $310 E=$310

Initial Cost $0 -$12

Net amount received (final payoff net of initial cost) given

final spot prices below:

Spot = $280 -$30 -$12

Spot = $300 -$10 -$12

Spot = $320 $10 -$2

Spot = $340 $30 $18

Spot = $360 $50 $38

Stangeland © 2002 94

Speculating: Futures vs. Options

Net Profit Received from Speculating in

Gold Long Futures

Contract Profit

$100

$75

$50

Speculating

Profit from

$25

$0

$200

$225

$250

$275

$300

$325

$350

$375

$400

-$25

-$50

-$75

-$100 Long Call

-$125 Option Profit

Final Spot Price of Gold

Stangeland © 2002 95

Should hedging or speculating be

done?

Speculating: If the market is informationally efficient,

then the NPV from speculating should be 0.

Hedging: Remember, expected return is related to

risk. If risk is hedged away, then expected return will

drop.

Investors won’t pay extra for a hedged firm just

because some risk is eliminated (investors can easily

diversify risk on their own).

However, if the corporate hedging reduces costs that

investors cannot reduce through personal

diversification, then hedging may add value for the

shareholders. E.g., if the expected costs of financial

distress are reduced due to hedging, there should be

more corporate value left for shareholders.

Stangeland © 2002 96

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