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Value and Money

When we talk about the value of any asset we use Monetary value as the common denominator

The value of cash is easy to understand A bank account with €10m in it is worth €10M The value of other assets is more difficult to

ascertain. How much are bank loans transferred to NAMA with a book value of €77 Billion really worth?

What can you do with your Money ? Spend it (Consume it)

If you don’t spend your money? You save or invest it. Why would you do this? So that you could consume more at a later

date. Investing involves foregoing current

consumption in anticipation of greater future consumption.

Wealth

The maximum that you could spend today is your wealth.

Definition: An individual's wealth is equal to the present value of all his future income plus his existing assets. This is the maximum amount that he can consume now.

The needs the Shareholder/Investor To maximise wealth This is achieved by maximising the value of

his investments. If all companies that the shareholder has

invested in maximise their own value this maximises the value of the investor’s investments and hence his/her wealth.

What determines Value ?

An Asset’s value is determined by the benefits that its owner derives for holding it.

The benefits from a business asset are represented by its future cash flows.

Example: an apartment owned in a rental area derives its value from the rent it can command.

Cash Flows and Value

The greater the future cash flows that are expected to accrue from ownership of an asset the greater its value

But the future sometimes does not turn out as expected – what if there is a chance the asset will not generate the amount of cash that you expect or may be nothing at all!

The riskier the future cash flows from a asset, ceteris paribus, the less valuable it is.

The time value of money

The timing of cash flows significantly affects their value.

The sooner a cash flow is received the more valuable it is.

Why are far off cash flows less valuable? Say you are offered €50,000 to be lodged in your

bank account anytime in the next 50 years. When will you take it? Obviously ASAP You have things that you could do with €50K now

(immediate consumption needs) A nice car would be a lot more useful now that in 50 years

time. You could be dead in 50 years time.

People prefer to consume now rather than later.

Three Reasons €1 in the future is less valuable than expectation of €1 now Can invest €1 in a bank to get more in the

future Inflation: a euro now will generally purchase

more than a euro in the future. Risk/Uncertainty

Cannot be absolutely sure that you will receive the euro in the future

Cannot be sure how much you will be able to purchase with a euro in the future relative to now.

Because of the above three reasons: money or capital has a cost The opportunity cost of capital is the price of getting

money (capital) today rather than in the future. For example if you borrow money from a bank: this

is a cost of capital. Alternatively you are foregoing putting the money in the bank and earning interest.

Large companies can usually get money from different sources.

For the moment let us just assume that there is one big bank or market that provides cash and charges the cost of capital.

Perfect Capital Market

The last assumption is effectively assuming that we have a perfect capital market and complete certainty

Perfect capital market You can lend or borrow as much as you want Information is costless and freely available No taxes or other transactions cost Borrowing rate = lending rate Instantaneous access to the market.

If we allow assume certainty the cost of capital is just the interest rate.

Investors’ Objectives

Investors are trying to achieve two things:

1. More consumption – maximisation of wealth will achieve this.

2. A consumption pattern that suits them – this involves maximising the utility for a given level of wealth.

Spreading consumption over time – in a very simple one period model If an investor has €100 and the interest rate

in the capital market is 10% he can consume that €100 now.

Alternatively, he can invest the €100 in the capital market and consume €110 in one years time.

So we get a sense that €100 now is equivalent to €110 in one years time.

The interest rate in the capital market reflects the price of money in the future in terms of money today.

If i = interest rate = 10% then £100 now is worth (1.1)£100 = £110 in one years time.

Similarly the present value of £110 to be received in one year's time is £110/(1.1) = £100.

The rate of return on the £100 in the above situation is clearly 10%

10%=100

100-110

Many One-Period Investments Suppose that as well as investing in the

market an individual could invest in several real assets offering the following payoffs.

Investment Outlay in t0 Payoff in t1 Return

A 100 110 10%

B 100 125 25%

C 100 150 50%

D 100 200 100%

How much should the investor invest? If there is no capital market it depends on his

or her own consumption preferences If there is a capital market s/he should invest

in real assets so long as the return on these assets exceed the return s/he could earn in the capital market

Extension of the four project example to include a capital market Assume the capital market pays 20%. An investor faced with the projects A B C D

outlined above would only invest in D C and B. He would reject A since it gives return of only 10% while he could get 20% in the capital market.

Cash Flow After Investing in D B & C This would give him the

following consumption pattern assuming that he did not use the capital market.

T0 T1

Cash 400 0

Invest 300475

Consume 100 475

Cash Flow After Investing in D B & C This would give him the

following consumption pattern assuming that he DID use the capital market other than as an investment for his final €100.

T0 T1

Cash 400 0

Invest 300475

Invest in Market

Total

100

0

120

595

Cash Flow from in investing in ABCD

T0 T1

Cash 400 0

Invest 400

Payoff

585

Consume 0 585

Terminal Values

We have compared the terminal values or cash flows at the end of the project

If we invest in all four projects. The terminal value is just the cash inflows at t1 from those projects that is 585.

If we invest in only the three best projects we must invest the remaining 100 in the capital market at 20%. This gives a terminal value of 475 + 100(1.2) = 595

Comparison of both Strategies To compare the two investment strategies we

must bring the cash flows from each to a common period.

We did this in the previous slide by ensuring all cash flows were received at t1 – the end of the project – (we compute the Terminal Value).

The normal procedure is to get the present value of the cash flows

The PV of Cash Flows from investingin D C & B only

T0 T1 PV

Cash 400 0

Invest 300

Payoff475

NCF 100 475

Divide By 11.2

PV 100 396 496

PV of Cash Flows from A B C D

T0 T1 PV

Cash 400 0

Invest 400

Payoff585

NCF 0 585

Divide by1

1.2

0 488 488

Investment Decision Rule

Invest in all projects whose rate of return is greater than that of the capital market.

If you invest in a project with a rate of return that is less than the opportunity cost of capital this will reduce your wealth. This is precisely what happens when you invest in project A.

In the example above the individual’s wealth is €496 if he invests in B C and D but only €488 if he invests in all four projects.

The (Internal) Rate of Return Rule The above rule is called the internal rate of

return (IRR) rule. Invest in all projects that have a rate of return

greater than the expected rate of return in the capital market (cost of capital).