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Lecture notes EC3100 Financial Management (EC3100)
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Lecture notes of 10 pages for the course EC3100 Financial Management at City (a)
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EC3100 Financial Management Notes RewrittenWeek 5: Project Evaluation
NPV and Stand-Alone Projects
NPV is the golden rule. Sometimes alternative investment rules may give the same
answers as NPV but when they conflict, we follow the NPV rule.
EXAMPLE: 10 mil investment 15 mil return vs 100 mil investment 120 mil return. 10%
15 120
discount rate. NPV 1=−10+ NPV 2=−100+ . NPV 2 > NPV 1 so
( 1+10 % ) (1+10 %)
we choose option 2.
In the example, despite option 1 having the higher rate of return (50% > 20%), we
still pick option 2 as it has a higher NPV.
The Internal Rate of Return Rule
Internal Rate of Return (IRR) is the discount rate which makes the NPV = 0.
15 15
FROM THE EXAMPLE ABOVE: Option 1 :−10+ =0 → =1+ IRR → IRR=50 %
1+ IRR 10
120 120
Option 2 :−100+ =0→ =1+ IRR → IRR=20 %
1+ IRR 100
We accept any investment where IRR > cost of capital and turn down any investment
where IRR < cost of capital.
The IRR investment rule will give the same answer as NPV in most (not all) situations.
IRR and NPV may be in conflict when there are delayed investments, non-existent
IRR and multiple IRRs.
The Payback Rule
The payback period is the amount of time it takes to recover it pay back the initial
investment.
If the payback period is less than a pre-specified length of time, you accept the
project, otherwise you reject.
Despite being used by many companies for its simplicity, some limitations include
the ignoring of cash flows after the payback period, the ignoring of the project’s cost
of capital and time value of money, and that it relies on an ad hoc decision criterion.
Choosing Between Projects
When you must choose only one project among several possible projects, the choice
is mutually exclusive. We choose the project with the highest NPV. Choosing the
project with the highest IRR will lead to problems.
Forecasting Earnings
Capital Budget: Lists the investments a company plans to undertake.
, Capital Budgeting: Process used to analyse alternate investments and decide which
one to accept.
Incremental Earnings: The amount by which the firm’s earnings are expected to
change as a result of the investment decision.
Straight Line Depreciation: The asset’s cost is divided equally over its life.
In capital budgeting decisions, interest expense is not typically included. The
rationale is that the project should be judged on its own not on how it’ll be financed.
Week 6: Stock Valuation
The Dividend-Discount Model
Assuming there is a 1 year investor, their potential cash flows could be from
dividends or a sale of the stock.
As these cash flows are risky, we must discount them at the equity cost of capital
¿1+ P 1
which is: P 0=( ).
1+ ℜ
¿1+ P 1 ¿ 1 P 1−P 0
This can be rewritten as ℜ= −1= + with the yellow being the
P0 P0 P0
dividend yield and the green being the capital gain rate. Both of them together gives
us the total return.
¿ 1 ¿ 2+ P 2
In a multi-year example, this model can be presented as P 0= 1+ ℜ + with
( 1+ ℜ )2
this showing a 2 year example.
Applying the Dividend-Discount Model
The simplest forecast for the firm’s future dividends state that they will grow at a
constant rate (g) forever. The value of the firm depends on the current dividend
DivN +1
level, cost of equity and the growth rate. PN = with the equity cost being re
ℜ−g
and growth rate being g.
Earnings Growth Rate (g) = Retention Rate x Return on New Investment. If this is
constant, the growth rate in earnings will equal the growth rate in dividends.
Although we cannot use the constant dividend growth model directly when growth
isn’t constant, we can use the general form of the model to value a firm by applying
the constant growth model to calculate the future share price of the stock once
expected growth rate stabilizes.
Small changes in the dividend growth rate can lead to large changes in the stock
prices + there is a lot of uncertainty associated with forecasting a firm’s dividend
growth rate + future dividends.
Total Payout and Free Cash Flow Valuation Models
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