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BFC1001 Lecture Notes - Lecture 5: Capital Budgeting, Downside Risk, Cash Flow

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School
Monash University
Department
Business Finance
Course
BFC1001
Professor
Jason

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Document Summary

Risk = uncertainty of cash flows in terms of the timing and magnitude of cash flows. Risk is typically measured through the standard deviation of cash flows. When risk increases, a greater return is needed to compensate for the added risk burden. This relates to risk = return. Holding all else equal, when future cash flows become more risky, the pv of their worth today falls. When cf risk , the discount rate . Since the discount rate is the denominator in the. Pv formula, its increase causes a pv. If the price falls but the cfs remain the same, the yield increases (because the price is the denominator yield = cf/price) Higher risk > lower value > lower price > higher return. Upside = uncertainty in timing and magnitude of future cash flows that provides benefit. Downside = uncertainty in timing and magnitude of future cash flows that provides a disadvantage or added cost.

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Related Questions

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

When interest rates move up or down, bond prices move in the _________________ direction.

_____________ are referred to as non-amortized debt, which means interest is paid regularly during the term, usually semiannually, whereas repayment of principal does not occur until the maturity date.

The longer a bond has to maturity, _______________ sensitive the bond’s price is to changes in market interest rates. This is called ________________________.

Bonds with short maturities expose investors to high ____________________, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.

A bond with an annual coupon payment of $100 originally sold at par for $1,000. Market interest rates are currently 12%. This bond would be selling at a _____________ in order to compensate the purchaser for the below market coupon rate.

Once a bond has been issued, if the holder of the bond retains it until maturity the market value of the bond may ________________, but the ________________ will not.

An unsecured bond is referred to as a(n) __________________.

____________________ can generally be issued at somewhat lower interest rates than regular bonds.

Double-B and lower bonds are speculative, to be called _______________.

Bonds are assigned _____________ that reflect the probability of their going into default. The higher it is, the lower its risk and therefore its interest rate.

When the yield curve slopes upward, it is said to be _______________, because it is like this most of the time. Conversely, a downward-slopping yield curve is termed ______________.

Which of the following is correct?

NPV will be higher if sunk costs are included in a project's cash flows
A good example of a sunk cost is a situation where a company builds a restaurant and that results in lower sales by another of its restaurants.
A good example of a sunk cost is a situation where a company builds a restaurant and closes another of its restaurants.
A good example of a sunk cost is a situation where a company evaluated a site for a new restaurant last year, expensed the cost on its income statement, and now builds the restaurant

none of the above

2.

TUNDRA Corporation's stock sells for $50 per share. A call option on the stock has a strike price of $55. A put option on the stock also has a strike price of $55. Which of the following is correct?

The call option is in-the-money
The put option is in-the-money
Both the call option and the put option are out-of-the money
The call option has a value of $5

none of the above

3.

A firm plans to purchase equipment for $1.5 million. It will cost 200,000 to modify it for use in the firm's facility. The equipment is in the 3-year MACRS class. Calculate depreciation expense for Year 3.

222,150
$251,770
$566,667
$500,000

none of the above

4.

A proposed project is much riskier than average. The best way to account for its added risk is:

Ignoring it because project risk cannot be measured accurately.
Decreasing the discount rate to account for the higher risk
Increasing the discount rate to account for the higher risk
Reducing the NPV by 5% to account for the higher risk

none of the above

5.

A company needs to decide whether to invest in a project now or wait a year until better information is available. The project has a positive expected NPV, but it could be negative if cash flows are less than expected. No competitors are likely to invest in a similar project if the company decides to wait. Which of the following best describes the issues the company is facing in making its decision?

The more uncertainty about the future cash flows, the more reason to go ahead with the project today.
NPV should be even higher by waiting a year, since it is positive today.
The project should be adopted now to lock in the expected positive NPV.
Waiting would probably reduce the project's risk.

none of the above

6.

A stock is currently selling for $25. A 6-month call option on the stock has a strike price of $30 and sells for $0.50. Calculate the exercise value of the option?

$0.00
$4.50
$5.00
$24.50

none of the above

7.

Which of the following is not a real option?

The option to switch the type of vehicle manufactured in a plant
The option to expand into a foreign country
The option to buy shares of stock if its price goes up.
The option to abandon a project.

none of the above

8.

The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option's value?

$2.99
$2.70
$2.43
$3.29

$3.62

9.

A company purchases equipment for $5 million, incurs shipping costs of $30,000 and installation costs of $50,000. It also requires additional net working capital of $100,000. What is the depreciable base?

$5,000,000
$5,180,000
$5,080,000
$5,030,000

none of the above

10.

Which of the following is an example of a real option?

An option to buy stock at a specified price for a specified period of time
An option to sell stock at a specified price for a specified period of time
An option to invest in a project today or to wait a year.
An option to buy either an American or European option
none of the above

Sabrina Gupta, an investment advisor with a major brokerage firm, was examining Wal-Mart Stores, Inc. (Wal-Mart) stock and its valuation. Gupta wondered whether to recommend the stock to any of her new clients or to existing clients who did not currently have Wal-Mart in their portfolios.

Her key task was to use an intrinsic value approach to price the shares and to then compare the resulting price with the price at which the stock was traded in the market. Gupta wanted to use alternative valuation methods and assumptions to produce intrinsic value estimates for Wal-Mart stock.

She was interested in seeing if the alternative methods would point to a consensus regarding the valuation of the stock and to see if the valuations suggested an investment opportunity given the current market price. Methods she contemplated to use were:

Multi-stage growth model

Price Earnings Multiple

Most valuation methods Gupta considered required a common set of inputs:

Future Cash Flows to Wal-Mart Investors

Growth rate of future cash flows

Discount factor or required rate of return by Wal-Mart investors

Gupta gathered data to determine each of the above.

Gupta thought that Dividends to Wal-Mart shareholders would adequately capture the cash flows to Wal-Mart shareholders; she also thought that this approach would simplify her task and she would revisit more complex valuation models if she felt the need.

Gupta thought that CAPM would provide her a relatively reliable estimate of the required rate of return. CAPM based required rate of return can be estimated by using a risk free rate, systematic risk of the firm and equity market risk premium. Gupta thought that in a valuation exercise that involve long term cash flows, 10-year government bond yield would be an appropriate risk free rate of return estimate. She checked the 10 year note rate and found out that it was about 3.68%. Gupta searched for Wal-Mart beta in Bloomberg. Bloomberg estimates betas by regressing the S&P 500 returns on the firm returns over the past two years and arrives at a “raw” beta estimate. Bloomberg makes an adjustment in raw beta based on some academic research. Gupta is confident that Bloomberg adjustment is justified and she uses Wal-Mart beta estimate of 0.66 in her analysis.

While Gupta is aware of the importance of EMRP assumption, she thinks that Bloomberg’s historical estimate of 5.05% is a safe assumption. She is aware of the fact that some studies suggest a larger risk premium of approximately six per cent, while others suggest a much lower forward-looking premium of less than four per cent. She is mindful of the arbitrariness of her assumption, and she takes a note to revisit this issue if her valuations produce unreasonable estimates.

Anticipated dividend growth (g) is often estimated in a variety of ways.

First, observed historical dividend growth can be assumed to continue in a perpetual fashion.

Second, future dividend growth can be estimated on the basis of recent estimates of analysts.

Gupta noted that the consensus annual Wal-Mart dividend for fiscal year 2011 was $1.21, and one respected analyst had estimated the expected constant dividend growth (in perpetuity) at approximately 3%.

As the chart suggests, both earnings and dividend growth rates are declining but they seem to be higher than the “respected analyst’s” estimates. Gupta decides to use several alternative perpetual growth assumptions to see the impact on price. Since Gupta decided to use variants of dividend discount model (DDM), she checked the anticipated earnings for 2011. Analyst’s estimates suggested $4.10 earnings per share. Gupta decided to use 10% growth rate from 2011 to 2012 and assumed a steady decline to 3% in 13 years (until 2024) where the perpetual growth rate of 3% resumes. She also assumed that WalMart will increase its dividend payout ratio from 30% to 55% from years 2012 to 2024. You are asked to reproduce Gupta’s analysis of multi-stage growth model and double check her valuation by using an earnings multiple. You have all the data you need to conduct the multi stage discounted growth model analysis, but you will need to do some research about the multiples valuation.