MIDTERMS

INVESTMENT AND PORTFOILO MANAGEMENT

Investment Valuation Principles

A. Future Value Method - measures the nominal future sum of money that a
given sum of money is "worth" at a specified time in the future assuming a
certain interest rate, or more generally, rate of return.

Where : FV = Future Value

PV = Present Value
r = rate of return
t = time

Ex. Suppose you are offered the following investment opportunity by a

company: Lend the company $90 today, and you will be paid $100 one year
from today by the company. If your other opportunities with the same amount
of uncertainty provide a return of 10%, is this loan a good investment?

Given:

Solution:

B. Present Value Method - is the value on a given date of a future payment or

series of future payments, discounted to reflect the time value of money and
other factors such as investment risk.
a. Time Preference - If offered a choice between P100 today or P100 in
one year and there is a positive real interest rate throughout the year
ceteris paribus, a rational person will choose P100 today

Where: FV = Future Value

i = rate of return
N = time/period

Ex1. P100 in 1 years at a 10% rate of return

Given:

Sol:

Ex2. Suppose you have an opportunity to buy an asset expected to give you
P500 in one year and P600 in two years. If your other investment
opportunities with the same amount of risk give you a return of 5% a year,
how much are you willing to pay today to get these two future receipts?
 Given:

Sol:

C. Weighted Average Cost of Capital (WACC) - the overall required return on

the firm as a whole and, as such, it is often used internally by company
directors to determine the economic feasibility of expansionary opportunities
and mergers. It is the appropriate discount rate to use for cash flows with risk
that is similar to that of the overall firm.

- WACC is the average of the costs of these

sources of financing, each of which is weighted by its respective use in the
given situation. By taking a weighted average, we can see how much
interest the company has to pay for every peso it finances.

- A calculation of a firm's cost of capital in which

each category of capital is proportionately weighted. All capital sources
- common stock, preferred stock, bonds and any other long-term debt - are
included in a WACC calculation. All else equal, the WACC of a firm
increases as the beta and rate of return on equity increases, as an
increase in WACC notes a decrease in valuation and a higher risk.

- The WACC equation is the cost of each capital

component multiplied by its proportional weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value
(NPV) of a project, using the formula:
NPV = Present Value (PV) of the Cash Flows discounted at WACC.
WACC Example:

A firm is considering a new project which would be similar in terms of risk to its existing
projects. The firm needs a discount rate for evaluation purposes. The firm has enough
cash on hand to provide the necessary equity financing for the project. Also, the firm:
- has 1,000,000 common shares outstanding
- current price $11.25 per share
- next year’s dividend expected to be $1 per share
- firm estimates dividends will grow at 5% per year after that
- flotation costs for new shares would be $0.10 per share
- has 150,000 preferred shares outstanding
- current price is $9.50 per share
- dividend is $0.95 per share
- if new preferred are issued, they must be sold at 5% less
than the current market price (to ensure they sell) and involve
direct flotation costs of $0.25 per share
- has a total of $10,000,000 (par value) in debt outstanding. The debt is in the
form of bonds with 10 years left to maturity. They pay annual coupons at a
coupon rate of 11.3%. Currently, the bonds sell at 106% of par value.
Flotation costs for new bonds would equal 6% of par value.

The firm’s tax rate is 40%. What is the appropriate discount rate for the new project?
Solution:

Market value of common = 11.25(1000000) = $11,250,000

Market value of preferred = 9.50(150000) = $1,425,000
Market value of debt = 10000000(1.06) = $10,600,000
Total value of firm = $23,275,000

Cost of common:
(Note: floatation costs ignored for common equity because cash on hand is
enough to finance the project.)
Div 1
r= +g
P
1
= + 0.05
11 .25
= 0.1389

Cost of preferred:
Div
r=
net P
0.95
=
9.50 (1 − 0.05 ) − 0.25
= 0.1083
Cost of debt:
Net price = 106% - 6% = 100% of par value
Net price = par
Therefore, cost of debt = coupon rate
r = 11.3%

Therefore:

 11250000   1425000   10600000 

WACC =  ( 0.1389 ) +  ( 0.1083 ) +  ( 0.113 )(1 − 0.4 )
 23275000   23275000   23275000 
= 0.1046
= 10 .46 %

D. Net Present Value - The difference between the present value of cash
inflows and the present value of cash outflows. NPV is used in capital
budgeting to analyze the profitability of an investment or project.

- NPV analysis is sensitive to the reliability of future cash inflows that an

investment or project will yield.

Ex. Determine the net present value for a project that costs $104,000 and would
yield after-tax cash flows of $16,000 the first year, $18,000 the second year, $21,000
the third year, $23,000 the fourth year, $27,000 the fifth year, and $33,000 the sixth
year. Your firm's cost of capital is 12.00%.

Given:

Sol: