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## Finance 1 (FEB12003)

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## Erasmus Universiteit Rotterdam

Studiejaar: 2018/2019

Boeken in lijstCorporate FinanceCorporate FinanceCorporate Finance and InvestmentFundamentals of Corporate FinanceCorporate Finance: the core

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6. Valuing Bonds 6 Bond Cash Flows, Prices and Yields The bond certificate indicates the amounts and dates of all payments to be made until the maturity date of the bond The time remaining until this date is the term of the month Coupons are the promised interest payments of a bond Computed using face value The coupon rate is the amount of each coupon payment Coupon Coupon Rate Face Value Number of Coupon Payments per Year Bonds Does not make coupon payments Pure discount bonds: trade at a discount The IRR is the rate of return that investors will earn on their money if they buy the bond at its current price and hold it to maturity The yield to maturity of a bond is the discount rate that sets the present value of the promised bond payments equal to the current market price of the bond FV n ( M n ) YT M FV P 1 n ( ) Interest Rate with Maturity n: r n M n Coupon Bonds pay investors their face value at maturity, plus regular coupon interest payments Yield to Maturity of a Coupon Bond: 1 1 FV N y ( y ) ( y )N ( ) 6 Dynamic Behavior of Bond Prices Coupon bonds may trade at a discount, a premium or a par Discounts and premiums o Discount Yield to maturity will exceed coupon rate o Premium Yield to maturity less than coupon rate o Par Coupon rate is equal to yield to maturity Market price of a bond changes over time As time passes, the bond gets closer to its maturity date Changes in market interest rates affect the yield to maturity and its price Time and bond prices If a yield to maturity has not changes, then the IRR of an investment in the bond equals its yield to maturity even if you sell the bond early Interest Rate Changes and Bond Prices As interest rates and bond yields rise, bond prices will fall, and vice versa The sensitivity of a price to changes in interest rates is measured the duration 6 The Yield Curve and Bond Arbitrage CPN Price of a Coupon Bond: M 1 CPN CPN FV 2 n ( M 2 ) ( M n ) The yield curve is the plot of the yields of coupon bonds of different maturities 6 Corporate Bonds The credit risk of a bond means that the cash flows are not known with certainty No default If a bond is risk free, it must have the same yield as a bill Certain default Perfectly predicted, so still We calculate the yield and price using the promised cash flows The yield of maturity of a defaultable bond exceeds the expected return of investing in the bond Risk of default The bonds expected return, which is equal to the debt cost of capital, is less than the yield to maturity if there is a risk of moreover, a higher yield to maturity does not necessarily imply that a expected return is higher Several companies rate the creditworthiness of bonds and make this information available to investors bonds have a low default risk Speculative bonds, junk bonds or bonds have a high default risk The credit spread or default spread is the difference between the yields of the corporate bonds and the Treasury yields 3. Relies on an ad hoc decision criterion 7 Choosing Between Projects NPV rule and mutually exclusive investments Pick the project with the highest NPV IRR rule and mutually exclusive investments When projects differ in their scale of investment, the timing of their cash flows, or their riskiness, then their IRRs cannot be meaningfully compared Why? o Differences in scale o Differences in timing o Differences in risk The incremental IRR IRR of the incremental cash flows that would result from replacing one project with the other Discount rate at which it becomes profitable to switch from one project to the other o May not exist o May not be unique o Does not indicate whether either project has a positive NPV on its own o Not obvious to what cost of capital the incremental IRR should be compared to 7 Project Selection with Resource Constraints Profitability Index: Value Created NPV Resource Consumed Resource Consumed 1. The set of projects taken following the profitability index ranking completely exhausts the available resource 2. There is only a single relevant resource constraint 8. Fundamentals of Capital Budgeting 8 Forecasting Earnings A capital budget lists the projects and investments that a company plans to undertake during the coming year Begin determining incremental earnings of a project Incremental Earnings Forecast Capital Expenditures and Depreciation Interest expenses o Often not included in capital budgeting decisions o Result is unlevered net income Taxes Marginal corporate tax rate Tax rate on any incremental dollar of income Income Tax EBIT c Unlevered Net Income Calculation o Unlevered Net Income o EBIT ( c ) ) ( c ) Indirect Effects on Incremental Earnings Opportunity Costs o The value a resource could have provided in its best alternative use Project Externalities o Indirect effects of the project that may increase or decrease the profits of other business activities of the firm o Cannibalization: when sales of a new product displace sales of an existing product Sunk Costs and Incremental Earnings A sunk cost is any unrecoverable cost for which the firm is already liable Have been or will be paid regardless of the decision about whether or not to proceed Not incremental with respect to current decision: should not be included in analysis If our decision does not affect the cash flow, then the cash flow should not affect our decision Fixed Overhead Expenses: associated with activities that are not directly attributable to a single business activity o If they are fixed, they are not incremental o You should include additional overhead expenses Past Research and Development Expenditures Unavoidable Competitive Effects o If sales are likely to decline as a result of new products introduced competitors, these lost sales are a sunk cost 8 Determining Free Cash Flow and NPV Earnings do not represent real profits: cannot be used to buy goods etc. Cash is needed to do this Free cash flow: incremental effect of a project on the available cash Calculating Free Cash Flow from Earnings Capital Expenditures and Depreciation o Depreciation is no cash expense o Not included in cash flow forecast o Actual cash cost of asset is included Net Working Capital o Net Working Capital Current Assets Current Liabilities Cash Inventory Receivables Payables When we are uncertain regarding the input to a capital budgeting decision, it is often useful to determine the level of that input o Level for which investment has an NPV of zero o We can calculate the value for which the NPV is zero for each parameter The EBIT for sales is the level of sales for which the EBIT is zero Sensitivity Analysis Breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change We learn which assumptions are the most important We can calculate and assumptions Scenario Analysis Considers the effect of the NPV of changing multiple project parameters