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Chapter 5

Principles of Corporate Finance Eighth Edition. Chapter 5. Why Net Present Value Leads to Better Investment Decisions Than Other Criteria. Internal Rate of Return. Example

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Chapter 5

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  1. Principles of Corporate Finance Eighth Edition Chapter 5 Why Net Present Value Leads to Better Investment Decisions Than Other Criteria

  2. Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

  3. Internal Rate of Return Example You can purchase a turbo powered machine tool gadget for $4,000. The investment will generate $2,000 and $4,000 in cash flows for two years, respectively. What is the IRR on this investment?

  4. Internal Rate of Return Pitfall 1 - Lending or Borrowing? • With some cash flows (as noted below) the NPV of the project increases the discount rate increases. • This is contrary to the normal relationship between NPV and discount rates.

  5. Internal Rate of Return Pitfall 2 - Multiple Rates of Return • Certain cash flows can generate NPV=0 at two different discount rates. • The following cash flow generates NPV=$A 3.3 million at both IRR% of (-44%) and +11.6%. • The problem arises from change in the sign of cash flow Cash Flows (millions of Australian dollars)

  6. Principles of Corporate Finance Chapter 8 Risk and Return

  7. R = rf + B ( rm - rf ) Capital Asset Pricing Model CAPM

  8. Principles of Corporate Finance Eighth Edition Chapter 18 How Much Should a Firm Borrow?

  9. Total Cash Flow All Equity = 585 *1/2 Debt = 620 (520 + 100) Capital Structure & Corporate Taxes Example - You own all the equity of Space Babies Diaper Co. The company has no debt. The company’s annual cash flow is $900,000 before interest and taxes. The corporate tax rate is 35% You have the option to exchange 1/2 of your equity position for 5% bonds with a face value of $2,000,000. Should you do this and why?

  10. Capital Structure & Corporate Taxes D x rD x Tc rD PV of Tax Shield = (assume perpetuity) = D x Tc Example: Tax benefit = 2,000,000 x (.05) x (.35) = $35,000 PV of $35,000 in perpetuity = 35,000 / .05 = $700,000 PV Tax Shield = $2,000,000 x .35 = $700,000

  11. Capital Structure & Corporate Taxes Firm Value = Value of All Equity Firm + PV Tax Shield Example All Equity Value = 585 / .05 = 11,700,000 PV Tax Shield = 700,000 Firm Value with 1/2 Debt = $12,400,000

  12. Principles of Corporate Finance Chapter 19 Financing and Valuation

  13. Topics Covered • After Tax WACC • Valuing Businesses • Using WACC in Practice • Adjusted Present Value • Your Questions Answered

  14. After Tax WACC Tax Adjusted Formula

  15. After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

  16. After Tax WACC Example - Sangria Corporation - continued

  17. After Tax WACC Example - Sangria Corporation - continued

  18. After Tax WACC Example - Sangria Corporation - continued Debt ratio = (D/V) = 500/1,250 = .4 or 40% Equity ratio = (E/V) = 750/1,250 = .6 or 60%

  19. After Tax WACC Example - Sangria Corporation - continued

  20. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  21. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  22. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

  23. After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

  24. After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

  25. After Tax WACC Example - Sangria Corporation – continued Perpetual Crusher project

  26. Capital Budgeting Valuing a Business or Project • The value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H). • The valuation horizon is sometimes called the terminal value.

  27. Capital Budgeting • Valuing a Business or Project PV (free cash flows) PV (horizon value) In this case r = wacc

  28. Valuing a Business Example: Rio Corporation

  29. Valuing a Business Example: Rio Corporation – continued - assumptions

  30. Valuing a Business Example: Rio Corporation – continued FCF = Profit after tax + depreciation - investment in fixed assets - investment in working capital FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = $3.5 million

  31. Valuing a Business Example: Rio Corporation – continued

  32. Valuing a Business Example: Rio Corporation – continued

  33. Valuing a Business Example: Rio Corporation – continued

  34. Principles of Corporate Finance Eighth Edition Chapter 28 Managing International Risks

  35. Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The baht spot price is 34.56 baht per dollar and the 1 year forward rate is 34.14 per dollar, what is the premium and discount relationship?

  36. Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The baht spot price is 34.56 per dollar and the 1 year forward rate is 34.14 per dollar, what is the premium and discount relationship?

  37. Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The baht spot price is 34.51 baht per dollar and the 1 year forward rate is 34.14 baht per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 1.2% discount, relative to the baht. The baht is selling at a 1.2% premium, relative to the dollar.

  38. Exchange Rate Relationships • Basic Relationships equals equals equals equals

  39. Exchange Rate Relationships 1) Interest Rate Parity Theory • The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates. • Forward prices of baht is difference between the interest rates on deposit of baht and dollar.

  40. Exchange Rate Relationships Example - You have the opportunity to invest 1,000,000 baht for one year. All other things being equal, you have the opportunity to obtain a 1 year baht bond (in baht) @ 3.4 % or a 1 year US bond (in dollars) @ 4.4%. The spot rate is 34.51 baht:$1 The 1 year forward rate is 34.14 baht:$1 Which bond will you prefer and why? Ignore transaction costs

  41. Exchange Rate Relationships Example - You have the opportunity to invest $1,000,000 for one year. All other things being equal, you have the opportunity to obtain a 1 year Thai bond (in baht) @ 3.4 % or a 1 year US bond (in dollars) @ 4.4%. The spot rate is 34.51 baht:$1 The 1 year forward rate is 34.14 baht:$1 Which bond will you prefer and why? Ignore transaction costs Value of U.S. bond = 1,000,000 x 1.044 = $1,044,000 Value of Thai bond = $1,000,000 x 34.51 = 34,510,000 baht exchange 34,510,000 x 1.034 = 35,683,340 bond pmt in one year 35,683,340 / 34.14 = $1,045,200 exchange

  42. Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.

  43. Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries.

  44. Exchange Rate Relationships Example - If inflation in the US is forecasted at 1.5% this year and Mexico is forecasted at 6.5%, what do we know about the expected spot rate? Given a spot rate of 10.9815 peso:$1 solve for Es Es = 11.5225

  45. Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates

  46. Exchange Rate Relationships Example - The real interest rate in each country is about the same

  47. Principles of Corporate Finance Chapter 4 Value of Bonds and Common Stocks

  48. Bond Valuation • PV (Bond) = PV (Coupon Payment) + PV (Principal) • PV (Bond) = Coupon (Annuity Factor) + PV Principal • Annuity Factor =

  49. Valuing a Bond Example If today is January 2004, what is the value of the following bond? A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. Cash Flows

  50. Valuing a Bond • Example continued • If today is January 2004, what is the value of the following bond? • A German Government bond (Bund) pays a 5.375 percent annual coupon, every year for 6 years. The par value of the bond is 100 EURO. • The price at a 3.8% YTM is as follows

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