LECTURE 1: INTRODUCTION AND

REVIEW ON TIME VALUE OF MONEY,

COST OF CAPITAL
FIRST PRINCIPLES & THE BIG
PICTURE

2
INVESTMENT DECISION
(PROJECT EVALUATION)
FINANCING DECISION
(CAPITAL STRUCTURE I, II, III)
CAPITAL RAISING: IPOS
DIVIDEND DECISIONS
(PAYOUT POLICY)
MERGERS AND
ACQUISITIONS
 TIME VALUE OF MONEY
 What is time value of money?

 Time value of money means that a dollar today is…….. a

dollar in the future
 To value/compare/combine cash flows occurring at different
points in time, we need to take into account the time value
of money and use a “timeline” to model the timing and
amount of all of cash flows:
Time 0 represents today or present - Cash outflows (costs)
are negative values - Cash inflows (benefits) are positive
values
 Future Value of Cash  Present Value (PV) of Cash
Flows (Rule 2) Flows (Rule 3)
EXAMPLE
 Suppose we plan to save $1000 today, and $1000 at the end of each of the next two years. If
we can earn a fixed 10% interest rate on our savings, how much will we have three years from
today?
 0 1 2 3

$1000 $1000 $1000 ?

$1331
×1.103

$1210
×1.102

$1100
×1.10

$3641
EXAMPLE
 You have just graduated and need money to buy a new car. Your rich Uncle Henry will
lend you the money as long as you agree to pay him back within four years, and you
offer to pay him the rate of interest that he would otherwise get by putting his money
in a savings account. Based on your earnings and living expenses, you think you will
be able to pay him $5000 in one year and then $8000 each year for the next three
years. If Uncle Henry would otherwise earn 6% per year on his savings, how much
can you borrow from him?
PERPETUITIES, ANNUITIES, AND SPECIAL CASES

13
PERPETUITIES
 When a constant cash flow will occur at regular intervals forever it is called
a perpetuity.
 Say you deposit $100 in an account paying 5% and withdraw the interest
every year:

0 1 2 ∞

$100 $5 $5 … $5
 The infinite stream of $5 must be worth the $100 you deposit today

C r PV C
PV 
r
PERPETUITIES
 More generally…

0 1 2 ∞

C C … C


C C
PV   PV 
1  r 
n
n 1 r
EXAMPLE
You want to endow a chair for a female professor of finance at your alma mater.
You’d like to attract a prestigious faculty member, so you’d like the endowment
to add $100,000 per year to the faculty member’s resources (salary, travel,
databases, etc.) If you expect to earn a rate of return of 4% annually on the
endowment, how much will you need to donate to fund the chair?
SOLUTION
ANNUITIES
 When a constant cash flow will occur at regular intervals for a finite
number of periods (N), it is called an annuity.

0 1 2 N

C C … C

N  To simplify this, consider a bank account

C
PV   like we used to illustrate perpetuities.
1  r 
n
n 1  If you withdraw principal and interest at
the end of N years, the present value is
still $100
PRESENT VALUE OF AN
ANNUITY 0 1 2 20

$100 $5 $5 … $5
$100

 The 20-year stream of $5 plus $100 in 20 years must be worth the $100
you deposit today
$100 PV 20-year annuity  PV $100 in 20 years 

PV 20-year annuity $100  PV $100 in 20 years 

PRESENT VALUE OF AN
ANNUITY
 Let’s call the initial deposit amount P, and the regular payment amount C
P
PV n-year annuity of C P  PV P in n years P 
1  r 
n

 Remember that we constructed the annuity so that the cash flow (C) is
equal to (r × P) so P=C/r

P  1  C 1 
PV annuity P  P  1  n
 1  n
1  r  1  r   r  1  r  
n


 
n
1  1   1  1  r 
PV annuity C   1  n
C  
r  1  r    r 
EXAMPLE
You win $2 million, and can choose from the following payout schedules:
 $2 million NOW
 $172,000 per month for 12 months starting 1 month from now

Which is the best alternative? Assume your monthly interest rate is 0.5%
A. 2m now
B. $172,000 per month
SOLUTION
WHAT IF…
How would your answer change if the $172,000 payments were at the beginning of the month
instead of the end of the month?
A. PV would be lower, but no change to decision
B. PV would be lower, need to re-calculate
C. PV would be higher, need to re-calculate
D. PV would be higher, but no change to decision
SOLUTION
FUTURE VALUE OF AN
ANNUITY
FV annuity  PV 1  r 
N


C 1 
 1  (1  r )N  1  r 
N

r
 
1

FV  C  1  r   1
r
N

ANNUITY EXAMPLE
1
FV C   1  r   1
n

r  

You want to be able to buy a yacht when you retire in 20 years

 You can afford to make quarterly payments of $1,250 into your bank account (first
payment 3 months from now)
 Assume your bank account pays 1.75% every quarter
 How much will you be able to spend on your yacht?
 0 1 2 20×4

$1250 $1250 … $1250

1 
1.0175
204
1250   1 214,742.28
0.0175  
TRY IT…
How would your answer change if you could make your $1,250 deposits at the beginning of
each quarter instead of the end? Your first payment would be today, and your last payment
would be one quarter before you purchase the yacht.

A. 214,742.28
B. 218,500.27
C. 222,324.02
D. No idea
SOLUTION
0 1 2 79 80

$1250 $1250 $1250 … $1250

1
C  1 r   1 1 r 
n
FV20yrs
r 
GROWING PERPETUITIES
 Assume you expect the amount of your perpetual payment to increase at a
constant rate, g.
0 1 2 3 n

C C×(1+g) C×(1+g)2 … C×(1+g)n-1 …

 Present Value of a Growing Perpetuity

C
PV growing perpetuity 
r  g
TRY IT OUT…
Recall the example on earlier slides.
Given an interest rate of 4% per year, the required donation was $2.5 million.
The University has asked you to increase the donation to account for the effect
of inflation, which is expected to be 2% per year.
How much will you need to donate to satisfy that request?
A. $2.5m
B. $5m
C. $7.5m
D. $10m
SOLUTION
0 1 2 3 n

$100,000 …

 The cost of the endowment will start at $100,000, and increase by 2% each
year. This is a growing perpetuity.

 You would need to donate $5.0 mil to endow the chair.

GROWING ANNUITIES
 The present value of a growing annuity with the initial cash flow C,
growth rate g, and interest rate r is defined as:
 Present Value of a Growing Annuity

1  1 g  
N

PV C  1    

(r  g )   1  r  
EXAMPLE
Your employer is required to put 9.25% of your salary into superannuation (a retirement
account)
Assume you graduate and get a job paying $60,000 per year. You have 40 years until
retirement and your salary should grow by 3% per year.
Assuming your superannuation account earns 5% per year, How much will you have when
you retire?
 For simplicity, assume payments into the account are at the end of each year, and ignore the 15% tax.
 N
1   1 g  

SOLUTION
PV C   1 
(r  g )   1 r 



 NET PRESENT VALUE (NPV)
 We can use Rule 2 and Rule 3 to compute present and future values of cash flows. Rule 1 highlights
that in order to compare or combine cash flows, we must value them at the same point in time.
 Net present value of a project compares cash inflows (benefits) to cash outflows (costs) of that
project at the present time (today)

 Example: You have been offered the following investment opportunity: if you invest $1000 today, you
will receive $500 at the end of each of the next three years. If you could otherwise earn 10% per
year on your money, should you undertake this investment opportunity?
THE INTERNAL RATE OF
RETURN (IRR)
 Given a discount rate and the timing and the amount of cash flows of an investment opportunity,
you can estimate the net present value. However, in some situation you may wish to know what
is the discount rate that makes the net present value to be equal to zero? That is the internal
rate of return (IRR)

 Example: You have been offered the following investment opportunity: if you invest $1000 today,
you will receive $500 at the end of each of the next three years. What is your estimate of the
IRR of this project?
COST OF CAPITAL
 Cost of Capital
o Returns/Compensation demanded by investors when they invest in the firm/supply funds to
the company 9 Cost of funds used to finance a firm’s business activities such as investment
projects
 A company normally can finance its investment projects through the following sources
of funds:
o Equity (issuing stocks)
o Debt (borrowing by issuing bonds)
o A combination of both debt and equity

 Cost of capital can generally be referred to as:

o Cost of equity
o Cost of debt
o Asset cost of capital and weighted average cost of capital
COST OF EQUITY
EXAMPLE
Suppose that you estimate that Disney’s stock (DIS) has a volatility of 20% and a beta
of 1.25 and Chipotle’s stock (CMG) has a volatility of 30% and a beta of 0.55. If the risk-
free rate is 3% and you estimate the market’s expected return to be 8%.
- Which stock carries more total risk?
- Which has more market risk?
- Which has a higher cost of equity?
ESTIMATE EQUITY BETA
Use historical returns and linear regression to estimate beta
Identify the best-fitting line in the plot of the security’s excess return versus the market
excess return.
COST OF DEBT
 Cost of debt (R ) is the expected return required by lenders (bond investors, bond
d
holders) - investors’ expected return on a bond.
 Cost of debt and taxes: because interest payments on debt reduce corporate taxable
income. This reduction reduces the effective cost of debt. If R d is the before-tax (or
pretax) cost of debt and t is the corporate tax rate, then the after-tax cost of debt =
Rd(1-t)
 Yield to maturity of a bond is the IRR (internal rate of return) an investor will earn from
holding the bond to maturity and receiving its promised payments
COST OF DEBT
 Can we use yield to maturity of a bond as an estimate of the cost of debt?

If there is little risk the firm will default, yield to maturity is a reasonable estimate of the cost of debt

If there is a significant risk of default, yield to maturity overestimates investors’ expected return on a bond

where the probability of default is often estimated below (Table 12.2) and the Expected Loss Rate is the expected loss per $1

of debt in the event of default.

COST OF DEBT
 Can we use CAPM to estimate the cost of debt? Yes or No?

 Debt betas are difficult to estimate because corporate bonds are traded infrequently. We can

approximate beta using estimates of betas of bond indices by rating category as shown below
(Table 12.3)
EXAMPLE:
 Homebuilder KB Home has outstanding 6-year bonds with a yield to maturity of 6% and a B
credit rating with the expect loss rate of 60%. If the corresponding risk-free rate is 1% and the
market risk premium is 5% and the corporate tax rate is 30%. a. Given the expected default rate
in Table 12.2, estimate the cost of debt using the yield to maturity b. Given the estimate of beta
in Table 12.3, estimate the cost of debt using CAPM and the corresponding after-tax cost of
debt.
WEIGHTED AVERAGE COST OF CAPITAL
(WACC)
PROJECT COST OF CAPITAL
To estimate a project’s cost of capital, the most common method is to identify a comparable firm
in the same line of business as the project (having the same business risk). Why? The project is
generally not a publicly traded security.
If the project is financed by all equity, we use the comparable firm’s return on assets ( 𝑅𝑅𝐴𝐴) or
the pretax WACC as the project cost of capital. Why? Does the project has the tax benefits of
debt? Is the project similar to the comparable firm’s asset? -> The firm’s asset beta as the beta of
the project
If the project is financed by both debt and equity, we use the comparable firm’s WACC as the
project cost of capital. Why? Does the project has the tax benefits of debt? Why the comparable
firm’s WACC (not the pretax WACC)?
WACC, PRETAX WACC, AND PROJECT COST OF CAPITAL
EXAMPLE:
Alpha Corp. has a market capitalization of $100 million, and $25 million in outstanding
debt. The firm’s cost of equity and cost of debt are 10% and 6%, respectively. If the
corporate tax rate is 40%.
a. Calculate the unlevered cost of capital or pretax WACC
b. Calculate WACC
c. If project A has the same risk and the same mix of debt and equity financing as
Alpha, estimate the project cost of capital
d. If project B has the same risk as Alpha but is financed by all equity, estimate the
project cost of capital