70391 - finance module 2: value...

70391 - Finance

Module 2: Value MaximizationThe objective of the firm, the Net Present Value (NPV) rule and thecost of capital

09.05.2016 21:22

Module Organization

This week and next:

:1: Objective of the firm: maximize shareholder value

:2: Implementation:

:: Choose investments with returns higher than the cost of capital

:: Choose investments with positive net present value (NPV)

:3: Objective of the firm: maximize shareholder value

:: What does this really mean?

Corporate Form of Business Organization

:: What is a “Corporation?”

:: What should the objective of the corporation be?

Maximize shareholder value

Implementation: Preliminary Quiz #2

Tesla’s battery project:

:: Q1-Q3: Return on project exceeds opportunity cost of capital... good project!

:: Q4: Alternative way to say this ... project has positive NPV

:: Q5: Computing PV:I Multiply by discount rateI Divide by discount factor + 1

:: Q6: Project increases shareholder value

:: Q7: Project is risky ... cost of capital is higher, NPV isnegative, bad project

:: Q8: Risky project destroys value

Overview

Future Free Cash Flow (FCF)

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Market Interest Rates

Efficient Markets Market forces will tend to drive market value toward intrinsic value

Cost of Capital (%)

Investors required rate-of-return

Intrinsic Value of Operations (Discounted FCF)

Market Value of the Firm

Total Debt

Market Value of Equity

Share Price

Number of Shares

Non-Operating Assets (Cash)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

Overview

Profitability and Efficiency

Profit margins Operating efficiency Capital (asset) efficiency ROIC

Growth Opportunities New customers New products R&D, innovation

Sustainability Barriers to entry Specialized skills, processes Patent protection Brand loyalty

Cost of Capital (%)

Intrinsic Value of Operations (Discounted FCF)

Discounted by

Capital Markets Capital Structure (firm’s choice

of debt and equity)

Overview

Growth OpportunitiesNew customersNew productsR&D, innovation

Cost of Capital (%)

Intrinsic Value of Operations(Discounted FCF)

Discountedby

Capital MarketsCapital Structure (firm’s choice

of debt and equity)

Overview

SustainabilityBarriers to entry Specialized skills,

processesPatent protection Brand loyalty

Cost of Capital (%)

Discountedby

of debt and equity)

Overview

AR, Inventory

Property, Plant & Equipment

Long-Term Cash

Long-Term AP

Equity

Implementing Value MaximizationPart 1: Financial Market Environment

Interest Rate Implicit in Tbill Price

A one-year Tbill costs 98 and pays 100

100(98)

Cash Flow

Rate of Return =100 − 98

98− 1 = 0.0204

Language:

:: The (implicit) interest rate is r = 0.0204

:: The percentage interest rate is 100 r = 2.04%

:: This is a “zero coupon discount bond:”:: No “coupon payments” between now and maturity.:: Face value = Principal = Par Value = 100

Interest Rate Implicit in Tbill Price

A one-year Tbill costs 98 and pays 100

100(98)

Cash Flow

Rate of Return =100 − 98

98− 1 = 0.0204

Language:

:: The (implicit) interest rate is r = 0.0204

:: The percentage interest rate is 100 r = 2.04%

:: This is a “zero coupon discount bond:”:: No “coupon payments” between now and maturity.:: Face value = Principal = Par Value = 100

Opportunity Cost of Capital (“Hurdle Rate”)

You are considering an investment.

“What return can I earn on my next best risk-equivalentalternative?”

:: One-year U.S. Tbill costs $98 and pays $100

:: Expected return on S&P500 is 8%

:: The opportunity cost of capital for one-year risklessinvestments is 2.04%

:: The opportunity cost of capital for investments that have thesame risk as the S&P500 is 8%.

Note: often just call it the “cost of capital.” Notation: “r”

Opportunity Cost of Capital (“Hurdle Rate”)

You are considering an investment.

“What return can I earn on my next best risk-equivalentalternative?”

:: One-year U.S. Tbill costs $98 and pays $100

:: The opportunity cost of capital for one-year risklessinvestments is 2.04%

:: The opportunity cost of capital for investments that have thesame risk as the S&P500 is 8%.

Note: often just call it the “cost of capital.” Notation: “r”NPV 8

Implementing Value MaximizationPart 2: Business Decisions Using IRR vs Cost of Capital

Case I: No Risk

:: Tesla Motors has proposed project

:: Costs = $700m

:: Payoff = $749m in 1 year

NPV 10

Case I: IRR vs Cost of Capital

Most basic opportunity cost of capital analysis:

:: Project’s rate of return is 7.0%:

IRR =749 − 700

700− 1 = 0.07

:: Project-specific rate of return is called the internal rate ofreturn (IRR)

:: Cost of capital is r = 2.04%: what investors could earnelsewhere, risk-free

:: Project should be undertaken: IRR is greater than the cost ofcapital (greater than the “hurdle rate” for good investments).

NPV 11

Case I: IRR vs Cost of Capital

:: Project’s rate of return is 7.0%:

IRR =749 − 700

700− 1 = 0.07

:: Project-specific rate of return is called the internal rate ofreturn (IRR)

:: Cost of capital is r = 2.04%: what investors could earnelsewhere, risk-free

:: Project should be undertaken: IRR is greater than the cost ofcapital (greater than the “hurdle rate” for good investments).

NPV 11

Case II: Risk

:: Costs = $700m

:: Expected payoff = $749m in 1 year

:: Risk is equivalent to S&P500

NPV 12

Case II: Expected IRR vs Cost of Capital

:: Project’s expected (internal) rate of return is 7.0%:

IRR =Expected Payoff

700− 1 =

700− 1 = 0.07

:: Cost of capital is r = 8%: what investors could earn elsewhereby bearing equivalent risk

:: Project should not be undertaken: IRR is less than the cost ofcapital

NPV 13

Case II: Expected IRR vs Cost of Capital

:: Project’s expected (internal) rate of return is 7.0%:

IRR =Expected Payoff

700− 1 =

700− 1 = 0.07

:: Cost of capital is r = 8%: what investors could earn elsewhereby bearing equivalent risk

:: Project should not be undertaken: IRR is less than the cost ofcapital

NPV 13

Summary

Investment rule:

Invest if IRR > r

:: NPV rule: a (slightly preferred) alternative to “IRR − r”

:: Dollar units, not return units:: Works better for multi-period problems

:: ... but first: future value and present value

NPV 14

Summary

Investment rule:

Invest if IRR > r

:: NPV rule: a (slightly preferred) alternative to “IRR − r”

:: Dollar units, not return units:: Works better for multi-period problems

:: ... but first: future value and present value

NPV 14

Implementing Value MaximizationPart 3: Future Value and Present Value

NPV 15

Future Value: Riskless

“How much will $100 turn into?”(if invested risklessly)

NPV 16

Future and Present Value: Riskless

Future Value: “What will $100 turn into?”

Present Value: “What will turn into $100?”

NPV 17

Computing Present Value and Future Value: Riskless

The riskless cost of capital is r . Years ahead is T :

FV of 100 = 100 (1 + r)T

PV of 100 =100

(1 + r)T

Important language:

:: The discount rate is r:: r comes from the interest rate on the Tbill:: Compute PV by dividing the future value by (1 + r)T

:: “Discount rate” and “cost of capital” are synonyms

:: The discount factor is 11+r

:: Compute PV by multiplying the future value by 1(1+r)T

NPV 18

Computing Present Value and Future Value: Riskless

The riskless cost of capital is r . Years ahead is T :

FV of 100 = 100 (1 + r)T

PV of 100 =100

(1 + r)T

Important language:

:: The discount rate is r:: r comes from the interest rate on the Tbill:: Compute PV by dividing the future value by (1 + r)T

:: Compute PV by multiplying the future value by 1(1+r)T

NPV 18

Future and Present Value: Risky

Future Expected Value: “What is $100 invested in the S&P500expected to turn into?”

Present Expected Value: “How much must I invest now (in theS&P500) in order to expect to get $100?”

NPV 19

Computing Present Value and Future Value: Risky

The cost of capital for risky assets with the same riskas the S&P500 is r = E (rSP500). Years ahead is T :

Expected FV of 100 = 100 (1 + r)T

PV of an Expected 100 =100

(1 + r)T

Important language::: The discount rate is r

:: r is the expected return on the S&P500

:: Compute PV by dividing the expected future value by (1 + r)T

:: Compute PV by multiplying the expected future value by1

(1+r)T

NPV 20

Computing Present Value and Future Value: Risky

The cost of capital for risky assets with the same riskas the S&P500 is r = E (rSP500). Years ahead is T :

Expected FV of 100 = 100 (1 + r)T

PV of an Expected 100 =100

(1 + r)T

Important language::: The discount rate is r

:: r is the expected return on the S&P500

:: Compute PV by dividing the expected future value by (1 + r)T

:: Compute PV by multiplying the expected future value by1

(1+r)T NPV 20

Multi-Period Cash Flows

Assume: cost of capital same for all time horizons: r = 6%.1

years infuture 0 1 2 3

20 30 40

PV =20

1 + r+

(1 + r)2+

(1 + r)3

1 + 0.06+

(1 + 0.06)2+

(1 + 0.06)3

= 79.1526

1Are these cash flows riskless or risky? Are these discount rates Tbill interest rates or are they expected

returns on stock portfolios like the S&P500? Answer: could be either. Interpret as you like. If the numerators areexpected values, then the denominators must be expected returns. If the numerators are sure things, then thedenominators must be interest rates from (particular) riskless bonds.

NPV 21

Net Present Value (NPV)

NPV = PV − Cost

:: NPV > 0 means “value creation”

NPV 22

Implementing Value MaximizationPart 4: Business Decision Using the NPV Rule

NPV 23

Case I: No Risk

:: Market environment

:: One-year Tbill costs 98 and pays 100

:: Costs = $700m

:: Payoff = $749m in 1 year

NPV 24

NPV Analysis

:: Cost of capital r = 0.0204

:: Present value (PV), in millions:

PV =749

1 + r=

1.0204= 0.98 × 749 = 734.02

:: Net present value (NPV):

NPV = PV − Cost = 734.02 − 700 = 34.02 > 0

:: Same answer: good project since NPV > 0

NPV 25

NPV Analysis

PV =749

1 + r=

1.0204= 0.98 × 749 = 734.02

NPV = PV − Cost = 734.02 − 700 = 34.02 > 0

NPV 25

NPV Analysis

PV =749

1 + r=

1.0204= 0.98 × 749 = 734.02

NPV = PV − Cost = 734.02 − 700 = 34.02 > 0

NPV 25

NPV Analysis

PV =749

1 + r=

1.0204= 0.98 × 749 = 734.02

NPV = PV − Cost = 734.02 − 700 = 34.02 > 0

NPV 25

Balance Sheets Before Undertaking Project

NPV 26

Balance Sheets After Undertaking Project

NPV 27

Case II: Risk

:: Market environment

:: One-year Tbill costs 98 and pays 100

:: Costs = $700m

:: Expected payoff = $749m in 1 year

:: Risk is equivalent to S&P500

NPV 28

NPV Analysis

PV =749

1 + r=

1.08= 0.9259 × 749 = 693.519

NPV = PV − Cost = 693.519 − 700 = −6.481 < 0

:: Same answer: bad project since NPV < 0

NPV 29

NPV Analysis

PV =749

1 + r=

1.08= 0.9259 × 749 = 693.519

NPV = PV − Cost = 693.519 − 700 = −6.481 < 0

NPV 29

NPV Analysis

PV =749

1 + r=

1.08= 0.9259 × 749 = 693.519

NPV = PV − Cost = 693.519 − 700 = −6.481 < 0

NPV 29

NPV Analysis

PV =749

1 + r=

1.08= 0.9259 × 749 = 693.519

NPV = PV − Cost = 693.519 − 700 = −6.481 < 0

NPV 29

Balance Sheets After Undertaking Project

NPV 30

Summary

Investment decision making:

:: Compare project’s IRR to the risk-appropriate cost of capital

:: Compute NPV:

:: Discount expected cash flow using cost of capital, subtract cost

:: Effect of risk

:: Higher cost of capital:: Higher discount rate (expected cash flow “discounted” more as

risk increases):: Lower discount factor

NPV 31

Implementing Value MaximizationPart 6: Going Deeper on Cost of Capital

NPV 32

Question

What does “same risk as the stock market” really mean?

NPV 33

Environment

:: Market information::: One-year U.S. Tbill costs $98 and pays $100:: Stock market costs 2,100

I Pays 1,890 in recession (Prob = 0.4)I Pays 2,520 in boom (Prob = 0.6)

Expected return = 8% (as before ... verify this)

:: Tesla’s project costs 700. Payoffs::: Recession: 665 (Prob = 0.4):: Boom: 805 (Prob = 0.6):: Expected payoff = 749 (as before ... verify this)

:: If project has “same risk as stock market,”

NPV =749

1.08− 700 = −6.5

:: Bad project!

:: But how do we know that risk is same as S&P500?

NPV 34

Environment

NPV =749

1.08− 700 = −6.5

:: Bad project!

NPV 34

Environment

NPV =749

1.08− 700 = −6.5

:: Bad project!

NPV 34

Environment

NPV =749

1.08− 700 = −6.5

:: Bad project!

NPV 34

Environment

:: Market information:

:: One-year U.S. Tbill costs $98 and pays $100:: Stock market costs 2,100

:: Tesla’s project costs 700. Payoffs:

:: Recession: 665 (Prob = 0.4):: Boom: 805 (Prob = 0.6)

NPV 35

Valuation by No-Arbitage

:: If two portfolios have the same payoff they must have thesame price (present value).

I “Law of One Price”I “Law of No Free Lunches”

:: Violations of this “law” result in “arbitrage opportunities.”Competition drives these to zero.

:: Super important in all aspects of finance. The valuationengine underlying derivatives industry (among other things)

NPV 36

What’s Going On?

NPV 37

What’s Going On?

:: The replicating portfolio is:I 34% bonds (r = 2.04%)I 66% stocks (r = 8%)

:: The expected return on replicating portfolio, and therefore onthe project, must be

r = 0.34 × 0.0204 + 0.66 × 0.08 = 0.06

:: The project is less risky than the stock market. So wediscount the expected cash flow less than market-cash-flows... and the NPV is positive! Good project!

NPV =749

1.06− 700 ≈ 6.77

NPV 38

What’s Going On?

r = 0.34 × 0.0204 + 0.66 × 0.08 = 0.06

NPV =749

1.06− 700 ≈ 6.77

NPV 38

What’s Going On?

r = 0.34 × 0.0204 + 0.66 × 0.08 = 0.06

NPV =749

1.06− 700 ≈ 6.77

NPV 38

Exercise

Suppose that the project cash flows were

I Recession (Prob = 0.4): 560

I Boom (Prob = 0.6): 875

What’s the NPV? Why?

Exercise

NPV 39

Takeways

:: Not all risky cash flows have the same “risk” as the stockmarket.

:: Some have less (e.g., Utilities):: Some have more (e.g., Financials)

:: Tesla (using our numbers) has just a little less: 6% vs 8%

:: “Risk premium” is expected return minus riskless rate.:: Risk premium is 4% for Tesla, 6% for S&P500

:: Overall:

:: Compute PV by discounting expected cash flow at appropriateexpected return

:: Here, “appropriate” means expected return on replicatingportfolio

:: More generally, we’ll use the CAPM (“Capital Asset PricingModel”). Coming later.

NPV 40

Takeways

:: Overall:

NPV 40

Takeways

:: Overall:

NPV 40

Takeaways

I Financial-asset cash flows are what trade in financial markets. From their priceswe can figure out their cost of capital: the expected return that investors requirein order to own them, given their risk. Higher risk means higher expected return.

I Managers need to value business cash flows. To do so they must figure out thebusiness cash flow’s cost of capital: the expected return that investors couldearn on their money if they invested it in financial assets that have the same riskas the business cash flows.

I Figuring out what “the same risk” means is the hard part.I In our case it meant that the business cash flows were “part bond and

part stock,” or “part safe and part risky.” A larger “bond part” meansrelatively little risk and a relatively small cost of capital. Apple Computer,for example, has lots and lots of cash on its balance sheet. This is thebond part. The other part (the Iphone part) is pretty sensitive to (global)business cycles and therefore “moves” in tandem with stock markets. SoApple is risky in the same way that the stock market is, but less so inmagnitude. Therefore its cost of capital is lower than that of the stockmarket.

I More generally, it means “how correlated are the business cash flows withthe stock market?” Later in the course we’ll see that it’s only thecorrelation that matters for the cost of capital, because the uncorrelatedpart can be diversified away. So high-cost-of-capital projects have a largecomponent of their cash flows that move in tandem with the markets.

NPV 41

Implementing Value MaximizationPart 7: Overall Summary of NPV

NPV 42

Summary

:: Interest rate from Tbill: r , cost of capital for riskless investments

:: Expected return on traded risky assets: r , cost of capital for riskyinvestments

:: Internal rate of return (IRR): project specific return

:: “Hurdle rate rule:” invest if IRR > r

:: Future value: FV = what you get (might be random)

:: Present value: PV = divide future value by cost of capital

:: NPV = PV - Cost.

I Value creationI “NPV rule:” invest if NPV > 0

NPV 43

Overview

Cost of Capital (%)

Discountedby

of debt and equity)

NPV 44

Overview

AR, Inventory

Property, Plant & Equipment

Long-Term Cash

Long-Term AP

Equity

NPV 44

Notational Warning

The notation “r” plays more than one role:

:: Interest rate

:: Discount rate

:: Cost of capital

Sometimes all the same thing. Sometimes not (interest rates areoften NOT legitimate discount rates).

We’ll try hard to reserve “r” for the cost of capital: theappropriate discount rate.

NPV 45

Nuances

:: Cost of capital:

:: Not firm specific: project specific

:: Not a firm’s borrowing cost

:: Market value vs present value

:: Arbitrage vs NPV > 0

:: Shareholder risk aversion vs market risk aversion

NPV 46

Value MaximizationIs Shareholder’s Wealth All That Matters?

NPV 47

What is a Corporation?

Our emphasis:

:: Separation of ownership from control

:: How can this work? What if the owners (shareholders)disagree on what constitutes a good investment?

NPV 48

What is a Corporation?

Our emphasis:

:: Separation of ownership from control

:: How can this work? What if the owners (shareholders)disagree on what constitutes a good investment?

NPV 48

Context

General Electric’s shareholders are aging (baby boomers)

:: Suppose that:

:: Old people should hold less risky investments than youngpeople

:: Old people should hold shorter-term investments than youngpeople

:: Should GE make less risky investments?

NPV 49

Fisher Separation

If shareholders want:

:1: More wealth relative to less wealth

:2: Control over the timing of their wealth

:3: Control over the risk of their wealth

then, if shareholders have access to efficient financial markets

:: The unique objective for the firm that will be agreed upon byall shareholders is value maximization.

Note: different than profit maximization

NPV 50

Example: Owners Have Different Financial Needs

GE’s share price is $27.

:: GE doubles-down on nuclear. Widely perceived as a good idea.

:: Future cash flow is:: Risky:: A long time coming

:: Nervous Nellie (elderly) owns 37,000 shares ($1 million).Wants:

:: Low risk:: High dividends

:: What should poor Nellie do? Vote out the CEO?

:: No. Share price goes to $45. Her wealth goes to $1.7m. Shecan sell some shares, sell all shares, reinvest .... choose herpreferred level of risk and timing.

NPV 51

Main Point

The optimal objective for the firm:

:: Basis for “value based management.”

:: A narrow statement about shareholders “financial needs.”

:: Not a broad license for greed and reckless behavior.

NPV 52

Broader Perspective

What does value maximization mean for

:: Labor

:: The environment

:: Ethics

:: Democracy

:: Leaf fans

:: ....

Discussion

NPV 53

Summary

NPV 54

Takeaways

:: Corporate form of business organization separates ownership from control.

:: Many benefits

:: Value maximization enables this:

:: Owners can disagree on risk and timing of cash flows, but still agree onfirm’s objective: generate wealth.

:: But owners and other stakeholders can disagree on many non-financial things.

:: These things are “where the cash flows come from.” Value maximizationcan’t help you here. It is a cash flow rule. Nothing more.

:: Value maximization best understood as a constrained maximizationproblem. These non-financial things are the constraints.

:: But is this just an empty shell?

:: No. It should make you skeptical of hedging, corporate diversification, etc.Shareholders don’t need to the firm to these things. Firms should justfocus on wealth creation. Don’t forget the important caveats to this. Butthey don’t apply to shareholders of big firms.

NPV 55

Takeaways

:: Many benefits

NPV 55

Takeaways

:: Many benefits

NPV 55

Takeaways

:: Many benefits

NPV 55

Last Thought

Perhaps the most useful aspect of the Fisher Separation idea isthat it helps clarify things?

:: Oil companies get blamed for global warming.

:: Is this because they are maximizing shareholder value?

NPV 56

70391 - finance module 2: value...

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