Book Rate of Return and Payback

1. Book Rate of Return Net present value depends only on the project’s cash flows and the opportunity cost of capital. But when companies report to shareholders, they do not simply show the cash flows. They also report book—that is, accounting—income and book assets. Financial managers sometimes use these numbers to calculate a book

2 Comments

Internal (or Discounted Cash Flow) Rate of Return

Whereas payback and return on book are ad hoc measures, internal rate of return has a much more respectable ancestry and is recommended in many finance texts. If we dwell more on its deficiencies, it is not because they are more numerous but because they are less obvious. In Chapter 2, we noted that

5 Comments

Choosing Capital Investments When Resources Are Limited

Our entire discussion of methods of capital budgeting has rested on the proposition that the wealth of a firm’s shareholders is highest if the firm accepts every project that has a positive net present value. Suppose, however, that there are limitations on the investment program that 9In Chapter 22, we discuss when it may

Applying the Net Present Value Rule

Many projects require a heavy initial outlay on new production facilities. But often the largest investments involve the acquisition of intangible assets. For example, U.S. banks invest huge sums annually in new information technology (IT) projects. Much of this expenditure goes to intangibles such as system design, programming, testing, and training. Think also of

1 Comments

Corporate Income Taxes

Look at Table 6.1, which shows corporate income tax rates in 11 countries. These are the tax rates imposed by the national governments, but corporations may also need to pay tax to a regional government. For example, in Canada, the provincial governments levy an additional tax of between 11% and 16%. In the United

2 Comments

Example – IM&C’s Fertilizer Project

1. The Three Elements of Project Cash Flows You can think of an investment project’s cash flow as composed of three elements: Total cash flow = cash flow from capital investment + operating cash flow                                    + cash

2 Comments

Using the NPV Rule to Choose among Projects

Almost all real-world investment decisions entail either-or choices. Such choices are said to be mutually exclusive. We came across an example of mutually exclusive investments in Chapter 2. There we looked at whether it was better to build an office block for immediate sale or to rent it out and sell it at the

Over a Century of Capital Market History in One Easy Lesson

Financial analysts are blessed with an enormous quantity of data. There are comprehensive databases of the prices of U.S. stocks, bonds, options, and commodities, as well as huge amounts of data for securities in other countries. We focus on a study by Dimson, Marsh, and Staunton that measures the historical performance of three portfolios

1 Comments

Diversification and Portfolio Risk

You now have a couple of benchmarks. You know the discount rate for safe projects, and you have an estimate of the rate for average-risk projects. But you don’t know yet how to estimate discount rates for assets that do not fit these simple cases. To do that, you have to learn (1) how

2 Comments

Calculating Portfolio Risk

We have given you an intuitive idea of how diversification reduces risk, but to understand fully the effect of diversification, you need to know how the risk of a portfolio depends on the risk of the individual shares. Suppose that 60% of your portfolio is invested in Southwest Airlines and the remainder is invested

2 Comments

How Individual Securities Affect Portfolio Risk

This brings us to our next major takeaway: The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio. Tattoo that statement on your forehead if you can’t remember it any other way. It is one of the most important ideas in this book. 1. Market Risk

1 Comments

Diversification and Value Additivity

We have seen that diversification reduces risk and, therefore, makes sense for investors. But does it also make sense for the firm? Is a diversified firm more attractive to investors than an undiversified one? If it is, we have an extremely disturbing result. If diversification is an appropriate corporate objective, each project has to

1 Comments

Harry Markowitz and the Birth of Portfolio Theory

Most of the ideas in Chapter 7 date back to an article written in 1952 by Harry Markowitz.[1] Markowitz drew attention to the common practice of portfolio diversification and showed exactly how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together. But Markowitz did

2 Comments

The Relationship between Risk and Return

In Chapter 7, we looked at the returns on selected investments. The least risky investment was U.S. Treasury bills. Since the return on Treasury bills is fixed, it is unaffected by what hap­pens to the market. In other words, Treasury bills have a beta of 0. We also considered a much riskier investment, the

Validity and Role of the Capital Asset Pricing Model

Any economic model is a simplified statement of reality. We need to simplify in order to interpret what is going on around us. But we also need to know how much faith we can place in our model. Let us begin with some matters about which there is broad agreement. First, few people quarrel

1 Comments

Some Alternative Theories of Portfolio Theory and the Capital Asset Pricing Model

The capital asset pricing model pictures investors as solely concerned with the level and uncertainty of their future wealth. But this could be too simplistic. For example, investors may become accustomed to a particular standard of living, so that poverty tomorrow may be particularly difficult to bear if you were wealthy yesterday. Behavioral psychologists

2 Comments

Company and Project Costs of Capital

The company cost of capital is defined as the expected return on a portfolio of all the com­pany’s outstanding debt and equity securities. It is the opportunity cost of capital for an invest­ment in all of the firm’s assets, and therefore the appropriate discount rate for the firm’s average-risk projects. If the firm has

Measuring the Cost of Equity

To calculate the weighted-average cost of capital, you need an estimate of the cost of equity. You decide to use the capital asset pricing model (CAPM). Here you are in good company: As we saw in the last chapter, most large U.S. companies do use the CAPM to estimate the cost of equity, which

1 Comments

Analyzing Project Risk

Suppose that a coal-mining corporation needs to assess the risk of investing in a new com­pany headquarters. The asset beta for coal mining is not helpful. You need to know the beta of real estate. Fortunately, portfolios of commercial real estate are traded. For example, you could estimate asset betas from returns on Real

Certainty Equivalents – Another Way to Adjust for Risk

In practical capital budgeting, a single risk-adjusted rate is used to discount all future cash flows. This assumes that project risk does not change over time, but remains constant year- in and year-out. We know that this cannot be strictly true, for the risks that companies are exposed to are constantly shifting. We are

2 Comments