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1、Corporate Finance3-0 Professor Ho-Mou WuBond Market and Alternative Investment Rules3.1ValuationofBonds3.2TheTermStructureofInterestRates3.3AlternativeInvestmentRules(1)ThePaybackPeriodRule(2)TheAverageAccountingReturn(3)TheInternalRateofReturn(4)TheProfitabilityIndex3.4WhyUseNetPresentValue?(RWJCh.
2、5,6)3-1 Professor Ho-Mou WuCorporate Finance3.1ValuationofBondsExample 1：Supposeweobservethefollowingbondpricesfordefault-freezerocouponbonds(purediscountbond,withfacevalue$1,000)：Howarethebondpricesrelatedwithinterestrates?1yearzero:Price=9262yearzero:Price=8423yearzero:Price=7584yearzero:Price=683
3、1yearbond2yearbond3yearbond4yearbondy1y2y3y4i1i2?i4?i3?(maturitydate)3-2 Professor Ho-Mou WuCorporate FinanceThePresentValueFormulasforBondsPure Discount BondsLevel Coupon BondsConsolsforT-maturitybondswithfacevalueF.Sucharateyisknownastheyield to maturity(YTM).Theyieldtomaturityisacomplicatedaverag
4、eofdifferentratesofinterest.Itcanbeausefulsummarymeasure.(3.1)(3.2)(3.3)3-3 Professor Ho-Mou WuCorporate FinanceYieldtoMaturityExample 1.(continued):wecanconvertbondpricesinto“yieldtomaturity”()hence,yn=yieldofbondswithnperiodsastimetomaturity,alsocalled“spotrates.”Plotynagainsttimetomaturity(n)”yie
5、ldcurve”tosummarizeinformationaboutbondprices(diagram1).3-4 Professor Ho-Mou WuCorporate Finance3.2TheTermStructureofInterestRatesFrombondprices,wecancomputeyields,plotthe“yieldcurve”,andcomputetheimpliedforwardrates,.implied“forwardrates”yieldcurveor“spotrates”3-5 Professor Ho-Mou WuCorporate Finan
6、ceForwardRatesisthe“break-even”interestratethatequatesthereturnsonan-periodbondtothatofa(n1)periodbondrolledoverintoaone-yearbondinyearn.Forexample,(geometricmean)or,soasanapproximation(arithmeticmean).Similarly,3-6 Professor Ho-Mou WuCorporate FinanceForecastofFutureInterestCanweuseforwardratesfnto
7、forecastfutureshort-terminterestratesin,alsocalled“shortrates”？Assumethattheinvestmenthorizonisoneyear,andinvestorsarerisk neutral.Example 2:Considertwoinvestmentalternatives：(A)buy1-yearzero-couponbond(safe,norisk).(B)buy2-yearzero-couponbondandsellitattheendof1styear(risky,subjecttoprice riskatthe
8、endof1styear.)842?10009261000(A)(B)i2=?3-7 Professor Ho-Mou WuCorporate FinancePureExpectationHypothesisExpectedreturnof(A)Expectedreturnof(B)Assumethatinvestorsarerisk-neutral.Thesetwoexpectedreturnsshouldbethesame(donotworryaboutdifferentrisksinvolvedin(A)and(B)：andweknowSo,henceTheforwardratesare
9、marketexpectationsoffutureshort-terminterestrates.ThisiscalledthePure Expectations Hypothesis：.(3.4)3-8 Professor Ho-Mou WuCorporate FinanceLiquidityPreferenceHypothesis Assume investors are Risk averse.Still with one-year investmenthorizon(preferencefor“liquidity”).Since(B)isriskier,(B)shouldhavehi
10、gherexpectedreturntoattractinvestors：.Hence.TheLiquidity PreferenceHypothesis:+riskpremium=f2.Ingeneral,fn-riskpremium=.(3.5)3-9 Professor Ho-Mou WuCorporate Finance3.3AlternativeInvestmentRulesHowlongdoesittaketheprojectto“payback”itsinitialinvestment?PaybackPeriod=numberofyearstorecoverinitialcost
11、sMinimumAcceptanceCriteria:setbymanagementRankingCriteria:setbymanagement(1)The Payback Period Rule3-10 Professor Ho-Mou WuCorporate Finance(1)ThePaybackPeriodRule(continued)Disadvantages:IgnoresthetimevalueofmoneyIgnorescashflowsafterthepaybackperiodBiasedagainstlong-termprojectsRequiresanarbitrary
12、acceptancecriteriaAprojectacceptedbasedonthepaybackcriteriamaynothaveapositiveNPVAdvantages:EasytounderstandBiasedtowardliquidity3-11 Professor Ho-Mou WuCorporate FinanceTheDiscountedPaybackPeriodRuleHowlongdoesittaketheprojectto“payback”itsinitialinvestmenttakingthetimevalueofmoneyintoaccount?Bythe
13、timeyouhavediscountedthecashflows,youmightaswellcalculatetheNPV.3-12 Professor Ho-Mou WuCorporate Finance(2)TheAverageAccountingReturnRuleAnotherattractivebutfatallyflawedapproach.RankingCriteriaandMinimumAcceptanceCriteriasetbymanagementDisadvantages:IgnoresthetimevalueofmoneyUsesanarbitrarybenchma
14、rkcutoffrateBasedonbookvalues,notcashflowsandmarketvaluesAdvantages:TheaccountinginformationisusuallyavailableEasytocalculate3-13 Professor Ho-Mou WuCorporate Finance(3)TheInternalRateofReturn(IRR)RuleIRR:thediscountthatsetsNPVtozeroMinimumAcceptanceCriteria:AcceptiftheIRRexceedstherequiredreturn.Ra
15、nkingCriteria:SelectalternativewiththehighestIRRReinvestmentassumption:AllfuturecashflowsassumedreinvestedattheIRR.Disadvantages:Doesnotdistinguishbetweeninvestingandborrowing.IRRmaynotexistortheremaybemultipleIRRProblemswithmutuallyexclusiveinvestmentsAdvantages:Easytounderstandandcommunicate3-14 P
16、rofessor Ho-Mou WuCorporate Finance(3)TheInternalRateofReturn:ExampleExample 3Considerthefollowingproject:0123$50$100$150-$200Theinternalrateofreturnforthisprojectis19.44%3-15 Professor Ho-Mou WuCorporate FinanceTheNPVPayoffProfileforThisExampleIfwegraphNPVversusdiscountrate,wecanseetheIRRasthex-axi
17、sintercept.IRR=19.44%3-16 Professor Ho-Mou WuCorporate FinanceProblemswiththeIRRApproachMultipleIRRs.AreWeBorrowingorLending?TheScaleProblem.TheTimingProblem.3-17 Professor Ho-Mou WuCorporate FinanceMultipleIRRsExample 4:TherearetwoIRRsforthisproject:0 1 2 3$200$800-$200-$800100%=IRR20%=IRR1Whichone
18、shouldweuse?3-18 Professor Ho-Mou WuCorporate FinanceTheScaleProblemWouldyourathermake100%or50%onyourinvestments?Whatifthe100%returnisona$1investmentwhilethe50%returnisona$1,000investment?3-19 Professor Ho-Mou WuCorporate FinanceTheTimingProblem0 1 2 3$10,000$1,000$1,000-$10,000ProjectA0 1 2 3$1,000
19、$1,000$12,000-$10,000ProjectBThepreferredprojectinthiscasedependsonthediscountrate,nottheIRR.Example 5:3-20 Professor Ho-Mou WuCorporate FinanceTheTimingProblem10.55%=crossover rate12.94%=IRRB16.04%=IRRAExample 5:3-21 Professor Ho-Mou WuCorporate FinanceCalculatingtheCrossoverRateComputetheIRRforeit
20、herproject“A-B”or“B-A”10.55%=IRRExample 5:3-22 Professor Ho-Mou WuCorporate FinanceMutuallyExclusivevs.IndependentProjectMutuallyExclusiveProjects:onlyONEofseveralpotentialprojectscanbechosen,e.g.acquiringanaccountingsystem.RANKallalternativesandselectthebestone.IndependentProjects:acceptingorreject
21、ingoneprojectdoesnotaffectthedecisionoftheotherprojects.MustexceedaMINIMUMacceptancecriteria.3-23 Professor Ho-Mou WuCorporate Finance(4)TheProfitabilityIndex(PI)RuleMinimumAcceptanceCriteria:AcceptifPI1RankingCriteria:SelectalternativewithhighestPIDisadvantages:Problemswithmutuallyexclusiveinvestme
22、ntsAdvantages:MaybeusefulwhenavailableinvestmentfundsarelimitedEasytounderstandandcommunicateCorrectdecisionwhenevaluatingindependentprojects3-24 Professor Ho-Mou WuCorporate Finance3.4WhyUseNetPresentValue?AcceptingpositiveNPVprojectsbenefitsshareholders.NPVusescashflowsNPVusesallthecashflowsofthep
23、rojectNPVdiscountsthecashflowsproperly3-25 Professor Ho-Mou WuCorporate FinanceTheNetPresentValue(NPV)RuleNetPresentValue(NPV)=TotalPVoffutureCFs+InitialInvestmentEstimatingNPV:1.Estimatefuturecashflows:howmuch?andwhen?2.Estimatediscountrate3.EstimateinitialcostsMinimumAcceptanceCriteria:AcceptifNPV
24、0RankingCriteria:ChoosethehighestNPV3-26 Professor Ho-Mou WuCorporate FinanceGoodAttributesoftheNPVRule1.Usescashflows2.UsesALLcashflowsoftheproject3.DiscountsALLcashflowsproperlyReinvestmentassumption:theNPVruleassumesthatallcashflowscanbereinvestedatthediscountrate.3-27 Professor Ho-Mou WuCorporate FinanceThePracticeofCapitalBudgetingVariesbyindustry:Somefirmsusepayback,othersuseaccountingrateofreturn.ThemostfrequentlyusedtechniqueforlargecorporationsisIRRorNPV.