1. Value and Money
When we talk about the value of any asset
we use Monetary value as the common
denominator
The value of cash is easy to understand
A bank account with €10m in it is worth €10M
The value of other assets is more difficult to
ascertain. How much are bank loans
transferred to NAMA with a book value of €77
Billion really worth?
2. What can you do with your Money ?
Spend it (Consume it)
3. If you don’t spend your money?
You save or invest it.
Why would you do this?
So that you could consume more at a later
date.
Investing involves foregoing current
consumption in anticipation of greater future
consumption.
4. Wealth
The maximum that you could spend today is your
wealth.
Definition: An individual's wealth is equal to the
present value of all his future income plus his
existing assets. This is the maximum amount that
he can consume now.
5. The needs the Shareholder/Investor
To maximise wealth
This is achieved by maximising the value of
his investments.
If all companies that the shareholder has
invested in maximise their own value this
maximises the value of the investor’s
investments and hence his/her wealth.
6. What determines Value ?
An Asset’s value is determined by the
benefits that its owner derives for holding it.
The benefits from a business asset are
represented by its future cash flows.
Example: an apartment owned in a rental
area derives its value from the rent it can
command.
7. Cash Flows and Value
The greater the future cash flows that are
expected to accrue from ownership of an
asset the greater its value
But the future sometimes does not turn out as
expected – what if there is a chance the
asset will not generate the amount of cash
that you expect or may be nothing at all!
The riskier the future cash flows from a asset,
ceteris paribus, the less valuable it is.
8. The time value of money
The timing of cash flows significantly affects
their value.
The sooner a cash flow is received the more
valuable it is.
9. Why are far off cash flows less valuable?
Say you are offered €50,000 to be lodged in your
bank account anytime in the next 50 years. When
will you take it?
Obviously ASAP
You have things that you could do with €50K now
(immediate consumption needs)
A nice car would be a lot more useful now that in 50 years
time.
You could be dead in 50 years time.
People prefer to consume now rather than later.
10. Three Reasons €1 in the future is less
valuable than expectation of €1 now
Can invest €1 in a bank to get more in the
future
Inflation: a euro now will generally purchase
more than a euro in the future.
Risk/Uncertainty
Cannot be absolutely sure that you will receive the
euro in the future
Cannot be sure how much you will be able to
purchase with a euro in the future relative to now.
11. Because of the above three reasons:
money or capital has a cost
The opportunity cost of capital is the price of getting
money (capital) today rather than in the future.
For example if you borrow money from a bank: this
is a cost of capital. Alternatively you are foregoing
putting the money in the bank and earning interest.
Large companies can usually get money from
different sources.
For the moment let us just assume that there is one
big bank or market that provides cash and charges
the cost of capital.
12. Perfect Capital Market
The last assumption is effectively assuming that we
have a perfect capital market and complete certainty
Perfect capital market
You can lend or borrow as much as you want
Information is costless and freely available
No taxes or other transactions cost
Borrowing rate = lending rate
Instantaneous access to the market.
If we allow assume certainty the cost of capital is
just the interest rate.
13. Investors’ Objectives
Investors are trying to achieve two things:
1. More consumption – maximisation of wealth
will achieve this.
2. A consumption pattern that suits them – this
involves maximising the utility for a given
level of wealth.
14. Spreading consumption over time – in a
very simple one period model
If an investor has €100 and the interest rate
in the capital market is 10% he can consume
that €100 now.
Alternatively, he can invest the €100 in the
capital market and consume €110 in one
years time.
So we get a sense that €100 now is
equivalent to €110 in one years time.
15. The interest rate in the capital market reflects the price of money in
the future in terms of money today.
If i = interest rate = 10% then £100 now is worth (1.1)£100 = £110 in
one years time.
Similarly the present value of £110 to be received in one year's time is
£110/(1.1) = £100.
The rate of return on the £100 in the above situation is clearly 10%
110 - 100
= 10%
100
16. Many One-Period Investments
Suppose that as well as investing in the
market an individual could invest in several
real assets offering the following payoffs.
Investment Outlay in t0 Payoff in t1 Return
A 100 110 10%
B 100 125 25%
C 100 150 50%
D 100 200 100%
17. How much should the investor invest?
If there is no capital market it depends on his
or her own consumption preferences
If there is a capital market s/he should invest
in real assets so long as the return on these
assets exceed the return s/he could earn in
the capital market
18. Extension of the four project example to
include a capital market
Assume the capital market pays 20%.
An investor faced with the projects A B C D
outlined above would only invest in D C and
B. He would reject A since it gives return of
only 10% while he could get 20% in the
capital market.
19. Cash Flow After Investing in D B & C
This would give him the
following consumption
pattern assuming that T0 T1
he did not use the Cash 400 0
capital market. Invest 300
475
Consume 100 475
20. Cash Flow After Investing in D B & C
This would give him the
following consumption
pattern assuming that T0 T1
he DID use the capital Cash 400 0
market other than as an Invest 300
investment for his final 475
€100. Invest in Market 100 120
Total 0 595
21. Cash Flow from in investing in ABCD
T0 T1
Cash 400 0
Invest 400
Payoff
585
Consume 0 585
22. Terminal Values
We have compared the terminal values or
cash flows at the end of the project
If we invest in all four projects. The terminal
value is just the cash inflows at t1 from those
projects that is 585.
If we invest in only the three best projects we
must invest the remaining 100 in the capital
market at 20%. This gives a terminal value of
475 + 100(1.2) = 595
23. Comparison of both Strategies
To compare the two investment strategies we
must bring the cash flows from each to a
common period.
We did this in the previous slide by ensuring
all cash flows were received at t1 – the end of
the project – (we compute the Terminal
Value).
The normal procedure is to get the present
value of the cash flows
24. The PV of Cash Flows from investing
in D C & B only
T0 T1 PV
Cash 400 0
Invest 300
Payoff
475
NCF 100 475
Divide By 1
1.2
PV 100 396 496
25. PV of Cash Flows from A B C D
T0 T1 PV
Cash 400 0
Invest 400
Payoff
585
NCF 0 585
1
Divide by 1.2
0 488 488
26. Investment Decision Rule
Invest in all projects whose rate of return is
greater than that of the capital market.
If you invest in a project with a rate of return
that is less than the opportunity cost of capital
this will reduce your wealth. This is precisely
what happens when you invest in project A.
In the example above the individual’s wealth
is €496 if he invests in B C and D but only
€488 if he invests in all four projects.
27. The (Internal) Rate of Return Rule
The above rule is called the internal rate of
return (IRR) rule.
Invest in all projects that have a rate of return
greater than the expected rate of return in the
capital market (cost of capital).