Managerial Finance
Ronald F. Singer
FINA 6335
Review
Lecture 10
Outline
• Capital Budgeting Decision
–
–
–
–
–
NPV Rule
Arbitrage and Risk
Time Value of Money
Financial Statement Analysis
Complicated Decisions
• Investments
– Risk versus Return
– Optimal Portfolio Selection (CML)
– Equilibrium Prices (SML and CAPM)
Capital Budgeting
• The Net Present Value Rule
– What is it?
– Why does it work?
– Why would all investors regardless of their
personal preferences for current versus future
consumption agree on the NPV Rule?
– Present Value and the No-Arbitrage Price
• Why securities should sell at a price that is equal
to the PV of the Cash Flow to the holders.
First Separation Principle
• The firm can make a capital budgeting
decision independently of how the project
will be financed.
• Eventually, the firm will have to worry
about how to finance the project, but the
simple question right now is:
– Are the benefits from investing greater than
the cost?
• i.e. is the NPV of the project positive?
Risk
• Securities are priced as if the market in general
is “risk averse”. That is, the typical investor
appears to prefer a less risky alternative to a
more risky alternative.
• So in order to induce investors to hold risky
investments, the investment must be priced so
as to reward the investor for the risk he takes on.
• This reward is called the risk premium
associated with the expected return of risky
securities, and projects.
Risk versus Return
• That is:
• E(Return of a risky venture)
= The reward for waiting plus
compensation for taking on risk.
= Risk free return plus a risk premium.
Present value of what?
• We talk about the “Value” of something
being equal to the “present value” of
something.
What is this “something”?
CASH!!!
So, when we consider the value of a security
or of a project, or of a firm, or any
investment activity, we want to know what
the Cash Flow will be and how to discount
it.
Central Role of Cash Flow
• Capital Budgeting: Must consider
Incremental Cash Flow
• Bonds and Stock (Dividends, interest,
repurchases, principle)
• Investments (Free Cash Flow)
• Firm Valuation (Free Cash Flow)
Bond valuation
• What is the cash flow expected from a typical
bond?
– You must be careful here to distinguish between the
Coupon Rate and the Required Return.
• The coupon rate describes how the bond gets some of its
cash flow out to the holders. It reflects the risk and interest
rate of the Bond at the time the bond was originally issued,
and may or may not be representative of the risk and level of
interest rates today.
Stock
• Again, we need to find the Present Value
of the Dividend stream.
– Predicting the dividend stream is not easy.
– We generally rely on fundamental analysis of
the value of the issuer.
– Then value the firm and subtract the nonequity securities issued by the firm to get the
value of the Equity.
Investments
• Here the real question is how does a rational
investor choose a portfolio of securities?
• There are three things that needs to be
considered:
– The Efficient set of Risky Assets
• Diversification
– The Efficient Risky Portfolio (CML)
– the Relationship Between Risk and Expected Return
for:
• Portfolios
• Individual Securities
return
Efficient Set of Risky Assets
minimum
variance
portfolio
Individual Assets
P
return
Efficient Risky Portfolio
M
rf
P
Relationship between Risk and
Return
• Efficient Portfolios (Capital Market Line)
Rp = Rf + Risk Premium
= Rf + (Rm - Rf) p
M
Relationship between Risk and
Return
• Individual Securities (Capital Asset Pricing
Model)
Ri = Rf + Risk Premium
= Rf + (Rm - Rf) bi