Transcript Lecture 25.ppt

Last Study Topics
• Numerical
• Cases
• Statements
Today’s Study Topics
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Look First To Market Values.
Case 1: Departmental Store
Case 2: Gold Mine
Forecasting Economic Rents
Principles of
Corporate
Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Lu Yurong
McGraw Hill/Irwin
Chapter 11
Where Positive Net Present
Values Come From
Introduction
• Important point is that one should not focus on
the arithmetic of DCF and thereby ignore the
forecasts that are the basis of every investment
decision.
• Senior managers are continuously bombarded
with requests for funds for capital expenditures.
• All these requests are supported with detailed
DCF analyses showing that the projects have
positive NPVs.
Continue
• How, then, can managers distinguish the NPVs
that are truly positive from those that are
merely the result of forecasting errors?
• One has to review certain common pitfalls in
capital budgeting relating to answer the above
query of the financial managers.
Market Values
• Let us suppose that you have persuaded all
your project sponsors to give honest forecasts.
• Although those forecasts are unbiased, they
are still likely to contain errors, some positive
and others negative.
• The average error will be zero, but that is little
consolation because you want to accept only
projects with truly superior profitability.
Market Values
• If you were to jot down your estimates of the
cash flows from operating various lines of
business, you would probably find that about
half appeared to have positive NPVs.
• This may not be because you personally
possess any superior skill inorder to figure out
positive NPVs, but because you have inadvertently introduced large errors into your
estimates of the cash flows
Continue
• If you were to extend your activities to making
cash-flow estimates for various companies,
you would also find a number of apparently
attractive takeover candidates.
• In some of these cases you might have
genuine information and the proposed
investment really might have a positive NPV.
– But in many other cases the investment would
look good only because you made a forecasting
error.
Market Values
• Security analysts whenever they value a
company’s stock they must consider the
information that is already known to the
market about a company, and they must
evaluate the information that is known only to
them.
– They can start with the market price of the stock
and concentrate on valuing their private
information.
Case 1: Departmental Store
• Example: Investing in a New Department
Store
• A department store chain that estimated the
present value of the expected cash flows from
each proposed store, including the price at
which it could eventually sell the store.
– Its conclusions were heavily influenced by the
forecasted selling price of each store.
Continue
• Once the financial managers realized this, they
always checked the decision to open a new
store by asking the following question:
• Let us assume that the property is fairly
priced.
• What is the evidence that it is best suited to
one of our department stores rather than to
some other use?
Market Values
• In other words,
– “If an asset is worth more to others than it is to
you, then beware of bidding for the asset against
them”.
• Suppose that the new store costs $100
million.You forecast that it will generate aftertax cash flow of $8 million a year for 10 years.
• Real estate prices are estimated to grow by 3%
a year, so the expected value of the real estate
Continue
• At the end of 10 years is 100 (1.03)10 $134
million.
• At a discount rate of 10 percent, your proposed department store has an NPV of $1 million.
– This can generate different results if the “ending
value” of the project changes
Department Store Rents
NPV = -100 +
8
1.10
+ ... +
8 + 134 = $ 1 million
1.1010
[assumes price of property appreciates by 3% a year]
Continue
• Once the site had been acquired, it would be
better to rent it out at $10 million than to use
it for a store generating only $8 million.
• Suppose, on the other hand, that the property
could be rented for only $7 million per year.
– The department store could pay this amount to
the real estate subsidiary and still earn a net
operating cash flow of 8 - 7 = $1 million.
Continue
• It is therefore the best current use for the real
estate.
• Will it also be the best future use? Maybe not,
depending on whether retail profits keep pace
with any rent increases.
– Suppose that real estate prices and rents are
expected to increase by 3% per year.
Department Store Rents
NPV = -100 + 8
+ ... +
8 + 134
= $ 1 million
1.1010
1.10
[assumes price of property appreciates by 3% a year]
Rental yield = 10 - 3 = 7%
NPV = 8 - 7 + 8 - 7.21
1.10
1.102
+ . . . + 8 - 8.87 + 8 - 9.13
1.109
1.1010
= $1 million
Continue
• The real estate subsidiary must charge 7 x 1.03
= $7.21 million in year 2, 7.21 x 1.03 = $7.43
million in year 3, and so on.
– Figure on the next slide shows that the store’s
income fails to cover the rental after year 5.
Understanding
• If these forecasts are right, the store has only
a five-year economic life; from that point on
the real estate is more valuable in some other
use.
• Whenever you make a capital investment
decision, think what bets you are placing.
– Our department store example involved at least
two bets—one on real estate prices and another
on the firm’s ability to run a successful
department store.
Pricing the Gold
• Suppose the current price of gold is $280 per
ounce.
• Hotshot Consultants advises you that gold
prices will increase at an average rate of 12%
for the next two years.
• After that the growth rate will fall to a longrun trend of 3% per year.
– What is the price of 1 million ounces of gold
produced in eight years? Assume that gold prices
have a beta of 0 and that the risk-free rate is 5.5%.
Continue
• The price of $280 per ounce represents the
discounted value of expected future gold
prices.
• Hence, the present value of 1 million ounces
produced 8 years from now should be:
– ($280 × 1 million) = $280 million
Summary
• Look First To Market Values.
• Case 1: Departmental Store
• Example: Pricing a Gold