Why do stock prices move 1st possibility 0 1 0 Expectations of growth increase Why do stock prices move 2nd possibility 0 1 0 Risk required return yields decline Alternative valuation method Multiples When DGM is not applicable e g non dividend firm Price EPS X PE RATIO EPS earnings per share PE price earnings RATIO is usually the P E ratio of comparable firms in the industry Problems with this approach What if EPS 0 e g Amazon in 2001 What If there are no comparable firms e g Tesla This method ignores unique attributes of the firm Valuation is an extremely complex problem Example Valuation using Multiples The Perfect Rose Co has earnings of 3 18 per share The benchmark PE for the company is 18 What stock price would you consider appropriate What if the benchmark PE were 21 P Benchmark PE ratio EPS With a PE ratio of 18 we find P 18 3 18 P 57 24 And with a PE ratio of 21 we find P 21 3 18 P 66 78 Common Voting rights no upper limit on dividends residual claim Preferred No voting fixed dividend priority in receiving dividend Recap Types of stock Stock market participant Dealers vs Brokers Stock market Valuation Constant dividend P0 D R 1 Constant dividend growth Non constant dividend growth Split the problem Multiples 0 EPS X PE RATIO 0 BUAD 306 Business Finance Session 9 Investment Criteria Part I Professor Kristy Jansen Big Picture Financial management decisions Firm s operations e g projects Financial manager 2 3 1 4a 4b Financial markets e g debtholders and shareholders 1 Cash raised from investors 2 Cash invested in firm 3 Cash generated by operations 4a Cash reinvested 4b Cash returned to debtholders and shareholders Big picture Financial decisions Typical financial decisions made by corporations Planning and managing long term investments Capital Budgeting Raising the money necessary for these investments Capital Structure The next four sessions will focus on Capital budgeting It is the process of identifying and selecting the investments in long lived assets that will maximize the owners wealth Capital budgeting in practice Issues faced by a corporation in capital budgeting Should it launch a new product Should it enter a new market Should it buy out another firm Should it use a new technology Corporation has limited resources to undertake projects wants to allocate them in the best possible way Capital budgeting is a key issue in corporate finance A roadmap for the next lectures Investment decisions Capital budgeting techniques next 2 sessions What decision rule should we use Use financial statements to infer projected cash flows one session What are the projected cash flows of your project firm Identify relevant cash flows last session How to determine the relevant cash flows for a project Classified by risk Risk of a project uncertainty surrounding its cash flows Replacement projects Investments in replacement of existing plant Expansion projects Investments broadening existing product lines markets New products and markets Investments introducing a new product market Mandated projects Investments required by law e g CO2 emission rules Classified by dependence on other projects Independent project When project cash flows aren t related to cash flows of any other project Mutually exclusive project Its acceptance prevents acceptance of other projects Contingent project It depends on the acceptance or outcome of another project Complementary project It enhances cash flows of one or more other projects How to select a project We select the project maximizing the value of the firm How do we check that Evaluation Methods Quantitative Average Accounting Return Net Present Value NPV Payback Rule Internal Rate of Return IRR Profitability Index Good decision criteria The decision rule adjusts for the time value of money The decision rule accounts for risk The decision rule tells us whether we are creating value for the corporation Should you take this project You are looking at a new project You have estimated the following cash flows of the project Year 0 Year 1 Year 2 Year 3 CF 165 000 CF 63 120 CF 70 800 CF 91 080 Your required return for assets of this risk is 12 1 Net Present Value NPV Rule Basic idea compare the market value of a project to its cost How much value is created from undertaking an investment It is also known as Discounted Cash Flow DCF Analysis NPV PV of all benefits PV of all costs If NPV 0 then accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners How does the NPV rule work 1 Estimate the expected future cash flows This is crucial especially when there is uncertainty over the payouts of an investment USE A TIMELINE 2 Estimate the required return for the project given its risk What is the correct discount rate for the cash flows Will be given for now we learn how to estimate it later 3 Compute the PV of all cash flows and subtract the initial investment 4 An investment should be accepted if the NPV is positive and rejected if it is negative Computing NPV for the project Using the formulas NPV PV of benefits PV of costs 63 120 1 12 70 800 1 12 2 91 080 1 12 3 165 000 Using Excel pay attention to notation CF0 165 000 CF1 63 120 CF2 70 800 CF3 91 080 R 0 12 Then Net Present Value CF0 NPV R CF1 CF2 CF3 12 627 42 Do we accept or reject the project NPV 0 so accept You are looking at another project with the same projected cash flows Another example This means Year 0 Year 1 Year 2 Year 3 CF 165 000 CF 63 120 CF 70 800 CF 91 080 However the project is riskier than before So your required return for assets of this risk is higher it s now 18 What is the NPV Do we accept or reject Decision criteria test NPV Good decision criteria 1 The decision rule adjusts for the time value of money 2 The decision rule accounts for risk 3 The decision rule tells us whether we are creating value for the firm NPV Yes as cash flows are discounted back to present Yes if the discount rate is the opportunity cost of capital for assets of equivalent risk Yes it is consistent with the maximization of shareholders value NPV Rule Disadvantages Advantages 1 It is expressed in terms of dollars and not percentage points scale of projects is ignored Unclear whether we are making 100 NPV from a 10 investment or from a 1M investment 2 It does not consider the life of the project Unclear whether we are making 100 NPV from a 1yr investment or from a 15yr investment 1 NPVs are additive across projects NPV
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