Week 1- Session 1 and Session 2 Summer 2012

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 increase value." 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 wealth maximization which translates into maximizing the price of the common stock.

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. Maximize firm value
Assets
Existing Investments Ass ets in Place Generate cas hflow s today Includes long lived (fixed) and short-lived(working capital) ass ets Debt

Maximize equity value

Liabilities

Maximize market estimate of equity value

Fixed Claim on cas h flows Little or No role in management Fixed Maturity Tax Deductible

Expected Value that will be created by future investments

Grow th As sets

Equity

Res idual Claim on cas h flow s Significant Role in management Perpetual Lives

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 in another 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

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 value Categories 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

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 revenue Five 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

Present Value
The fundamental objective of Corporate Finance (CF) is to maximize the

current market value of the firms outstanding shares. What does value mean for a corporation? In finance and in making financial decisions, the element of time is fundamental. This is because something today holds more value than tomorrow. Therefore, in corporate finance Time Value of Money is the building stone and an essential concept. The Present Value of PKR 100,000 one year from now MUST be less than PKR 100,000 today. Thus, the present value of a payoff is found by multiplying it with a discount factor, which is less than 1. If C1 denotes pay off at period 1, then: Present Value (PV) = discount factor x C1 Where, discount factor = 1/(1+r) and r is the rate of return investors demand for accepting delayed payment

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.

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 initial outlay: 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 return on stock market investment is 12%, then the cost of capital is 12%.

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?

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 by investing 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 return basis. 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.

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 the weighted 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 are the 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

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.