APS 1016H Fall 2021
Lecture notes to accompany PPT slides. Please add “speak” to the task bar, if you want to read this
material aloud.
Week 3: September 22nd 2021
Introduction:
Hope you all had a good week
Hope you all had a chance to read Chapters 5 and 6 from Ross
This week I want to introduce to you another ancillary text book: “Valuation. Measuring and
managing the value of Companies. Authors: Tim Koller, Marc Goedhart and David Wessels.
Mckinsey & Company. Publishers Wiley. Fifth Edition. This is a great book, reads like a text book
and urge you all to look at it. I also want to introduce to you an ancillary text “understanding
financial statements, Ninth edition Fraser and Ormiston Publishers Prentice Hall. This is a great
book and very relevant to last week’s lectures on “How to read an annual report”
For next week’s class please read Chapter 9 (Net Present Value and other investment criteria).
Ross
I have posted case assignment 1 on the course website, please go over it. If you have any
comments please post them under discussion board or send me a note by email.
I have started posting end of chapter solutions from Ross on the course website. I urge you to
try and solve some of these problems. This exercise will help you better master the concepts
learnt in each of those chapters.
I have also posted the following document “how to use financial Calculator BA II Plus”, on the
course website. You may want to purchase this calculator, it’s a handy tool
Business news: As far as business news is concerned the focus on the US stock market is
expectations of increase in corporate tax rates which is having a dampening effect on stock
valuations, there is also a bit of a worry on rising inflation rates.
It is nice to get your comments on the “introductions” under the discussion portal. For next two
weeks of discussion, I have asked you all to post your comments on selected gold mining
companies, do some basic financial metrics and ratio calculations and comment on the
implications of these results, you get participation marks for your efforts! You may contribute
your comments as a group.
Now let us go on to today’s lectures
SLIDE 1
This chapter is all about carrying out DCF analysis. DCF stands for discounted cash flow. So let us
try and define what DCF means
Let us start with cash flow (CF). Companies generate cash flow from their operations, generally
known as operating cash flow. From that value we can generate value of free cash flow as
explained in last week’s lectures.
Discounted refers to the discount rate we must use in order to discount the cash flow to its
present value. The discount rate is determined by the inherent risk in the business. A business
that is more risky will demand a higher return by the investors compared to a business that is
less risky. For example an aerospace business is more risky than a grocery store business. When
calculating a discount rate for an aerospace company you will find that it will have a higher value
1
than that for a grocery store. In subsequent lectures we will learn how to calculate discount rate
for different companies from 1st principles.
The cash flow value resides in the numerator of the equation and the discount rate resides in
the denominator. You can calculate net present value of a project by simply solving the
following equation
Net present value =- Initial investment + cash flow year 1/(1+r) + cash flow year 2/(1+r) to the
power 2 + cash flow year 3/(1+r) to the power 3 and so on
Cash flows are calculated at the end of each year, while the value of r is what is known as the
discount rate or the required rate of return
DCF analysis can be used for a number of purposes. For instance by carrying out discounted cash
flow analysis of a project to determine its Net present value we can determine whether to
accept or reject a project. If the NPV is positive we accept a project if negative we reject the
project. Positive net present value implies value creation whereas negative NPV implies value
destruction.
SLIDE 2
We will learn how to calculate present and future values of cash flows. Detailed examples in
subsequent slides.
We calculate PV of future cash flows, because management decisions have to be made today
(hence present). When we have several choices, we need to determine which project to select
out of many. The determination of PV tells us how much each of the project is worth today. On
the other hand by determining future value(FV) of any investment we are able to tell what will
the value be of that investment at a particular moment in time
SLIDE 3
We will learn how to calculate present and future values of multiple cash flows. An investment
in an annuity allows us to receive a fixed amount of cash over fixed intervals for a prescribed
period of time. A perpetuity on the other hand allows us to receive a fixed amount of cash over
fixed intervals forever. Investing in a common share can be interpreted as investing in a
perpetuity, because valuation of a share of stock is based on the premise that dividends that a
company pays will last forever, of course a lot of these companies do not last forever. An
investment in a bond is an example of an annuity
SLIDE 4
This is a fairly basic example, do try your hand at these problems on your own. There are
worked out examples in subsequent slides. Not much theoretical explanations here
SLIDE 5
Example worked out in the slide. Also try and solve this type of a problem using a financial
calculator or Excel. I have posted such examples on the course website
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SLIDE 6, 7 and 8
Example worked out. Try your hand at it
SLIDE 9
This problem can be solved by calculating PV. You reject this proposal because the PV of the
stream of cash flows that you will receive sometimes in the future is worth less than what you
are asked to invest currently.
SLIDE 10 and 11
The magic of compounding, also known as the 8 th wonder of the world by some investment
Guru. The earlier you invest the greater the impact of compounding be.
SLIDE 12 and 13
Annuity defined as equal amount of payments, spaced by equal period of time, for a fixed
amount of time. The PV of an annuity formula is a short form of calculating PV of future cash
flows.
We will use the annuity formula in subsequent lectures to calculate PV of a bond
SLIDES 14 and 15
Another annuity example that you can work out yourself
SLIDE 16
Try your hand at using Excel to calculate PV of an annuity
SLIDE 17
You can try your hand at calculating the value of the payment using the long formula or using
Excel or the financial calculator
SLIDES 18 to 25
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Try your hand at solving these problems, they are all worked out in the slides
SLIDES 26 and 27
Ideally you want to invest in a growing perpetuity. For example if you invest in stock whose
dividends grow at a constant rate forever, then that is an example of a growing perpetuity. Its
value can be calculated using Gordon Growth Model. Po = D1/r-g , where Po = price of one share
of stock, D1 is the value of dividends a year from now, r is the discount rate or the required rate
of return and g is the rate of growth of dividends
Well it was nice talking to you today, talk to you again next week. Have a great week
