FIN 509 & FIN510 Class Web Page, Spring '19

Business Finance Online, an interactive learning tool for the Corporate Finance student   (could be very helpful)

Weekly SCHEDULE, LINKS, FILES and Questions

Week

Coverage, HW, Supplements

-        Required

Equations

Videos (optional)

Week 0

Market Watch Game

Use the information and directions below to join the game.

http://www.marketwatch.com/game/jufin510-19spring

2.     Password for this private game: havefun.

4.     If you are an existing MarketWatch member, login. If you are a new user, follow the link for a Free account - it's easy!

Week1,2

Capital Flow Chart (pdf)

Chapter 5 Time value of money 1

Concept of FV, PV, Rate, Nper

Calculation of FV, PV, Rate, Nper

Concept of interest rate, compounding rate, discount rate

Chapter 6 Time Value of Money 2

Concept of PMT, NPV

Calculation of FV, PV, Rate, Nper, PMT, NPV, NFV

Concept of EAR, APR

Calculation of EAR, APR

HOMEWORK of Chapters 5 and 6  (due with midterm exam)

1. The Thailand Co. is considering the purchase of some new equipment. The quote consists of a quarterly payment of \$4,740 for 10 years at 6.5 percent interest. What is the purchase price of the equipment? (\$138,617.88)

2. The condominium at the beach that you want to buy costs \$249,500. You plan to make a cash down payment of 20 percent and finance the balance over 10 years at 6.75 percent. What will be the amount of your monthly mortgage payment? (\$2,291.89)

3. Today, you are purchasing a 15-year, 8 percent annuity at a cost of \$70,000. The annuity will pay annual payments. What is the amount of each payment? (\$8,178.07)

4. Shannon wants to have \$10,000 in an investment account three years from now. The account will pay 0.4 percent interest per month. If Shannon saves money every month, starting one month from now, how much will she have to save each month? (\$258.81)

5. Trevor's Tires is offering a set of 4 premium tires on sale for \$450. The credit terms are 24 months at \$20 per month. What is the interest rate on this offer? (6.27%)

6. Top Quality Investments will pay you \$2,000 a year for 25 years in exchange for \$19,000 today. What interest rate are you earning on this annuity? (9.42%)

7. You have just won the lottery! You can receive \$10,000 a year for 8 years or \$57,000 as a lump sum payment today. What is the interest rate on the annuity? (8.22%)

8. Around Town Movers recently purchased a new truck costing \$97,000. The firm financed this purchase at 8.25 percent interest with monthly payments of \$2,379.45. How many years will it take the firm to pay off this debt? (4.0 years)

9.  Expansion, Inc. acquired an additional business unit for \$310,000. The seller agreed to accept annual payments of \$67,000 at an interest rate of 6.5 percent. How many years will it take Expansion, Inc. to pay for this purchase? (5.68 years)

10. You want to retire early so you know you must start saving money. Thus, you have decided to save \$4,500 a year, starting at age 25. You plan to retire as soon as you can accumulate \$500,000. If you can earn an average of 11 percent on your savings, how old will you be when you retire? (49.74 years)

11. You just received a credit offer in an email. The company is offering you \$6,000 at 12.8 percent interest. The monthly payment is only \$110. If you accept this offer, how long will it take you to pay off the loan? (82.17 months)

12. Fred was persuaded to open a credit card account and now owes \$5,150 on this card. Fred is not charging any additional purchases because he wants to get this debt paid in full. The card has an APR of 15.1 percent. How much longer will it take Fred to pay off this balance if he makes monthly payments of \$70 rather than \$85? (93.04 months)

13. Bridget plans to save \$150 a month, starting today, for ten years. Jordan plans to save \$175 a month for ten years, starting one month from today. Both Bridget and Jordan expect to earn an average return of 8 percent on their savings. At the end of the ten years, Jordan will have approximately _____ more than Bridget. (\$4,391)

14. What is the future value of weekly payments of \$25 for six years at 10 percent? (\$10,673.90)

15. At the end of this month, Bryan will start saving \$80 a month for retirement through his company's retirement plan. His employer will contribute an additional \$.25 for every \$1.00 that Bryan saves. If he is employed by this firm for 25 more years and earns an average of 11 percent on his retirement savings, how much will Bryan have in his retirement account 25 years from now? (\$157,613.33)

16. Sky Investments offers an annuity due with semi-annual payments for 10 years at 7 percent interest. The annuity costs \$90,000 today. What is the amount of each annuity payment? (\$6,118.35)

17. Mr. Jones just won a lottery prize that will pay him \$5,000 a year for thirty years. He will receive the first payment today. If Mr. Jones can earn 5.5 percent on his money, what are his winnings worth to him today? (\$76,665.51)

18. You want to save \$75 a month for the next 15 years and hope to earn an average rate of return of 14 percent. How much more will you have at the end of the 15 years if you invest your money at the beginning of each month rather than the end of each month? (\$530.06)

19. What is the effective annual rate of 10.5 percent compounded semi-annually? (10.78%)

20. What is the effective annual rate of 9 percent compounded quarterly? (9.31%)

21. Fancy Interiors offers credit to customers at a rate of 1.65 percent per month. What is the effective annual rate of this credit offer? (21.70%)

22. What is the effective annual rate of 12.75 percent compounded daily? (13.60 percent)

23. Your grandparents loaned you money at 0.5 percent interest per month. The APR on this loan is _____ percent and the EAR is _____ percent. (6.00; 6.17)

24. Three years ago, you took out a loan for \$9,000. Over those three years, you paid equal monthly payments totaling \$11,826. What was the APR on your loan? (18.69%)

FYI only: help for homework

Part 1(Qs 1-2)         Part 2(Qs 4-8)          Part 3(Qs 9-12)

Part 4(Qs 13-16)     Part 5(Qs 17-20)      Part 6(Qs 21-24)

First week’s class videos (FYI)

Second week’s class videos (FYI, new)

Calculators (FYI)

© 2002 - 2019 by Mark A. Lane, Ph.D.

Math Formula

FV = PV *(1+r)^n

PV = FV / ((1+r)^n)

N = ln(FV/PV) / ln(1+r)

Rate = (FV/PV)1/n -1

Annuity:

N = ln(FV/C*r+1)/(ln(1+r))

Or

N = ln(1/(1-(PV/C)*r)))/ (ln(1+r))

EAR = (1+APR/m)^m-1

APR = (1+EAR)^(1/m)*m

Excel Formulas

To get FV, use FV function.

=abs(fv(rate, nper, pmt, pv))

To get PV, use PV function

= abs(pv(rate, nper, pmt, fv))

To get r, use rate function

= rate(nper,  pmt, pv, -fv)

To get number of years, use nper function

= nper(rate,  pmt, pv, -fv)

To get annuity payment, use PMT function

= abs(pmt(rate, nper, pv, -fv))

To get Effective rate (EAR), use Effect function

= effect(nominal_rate, npery)

To get annual percentage rate (APR), use nominal function

APR = nominal(effective rate,  npery)

Fall of Lehman Brother part i

Fall of Lehman Brother part ii

Fall of Lehman Brother part iii

Fall of Lehman Brother part iv

Fall of Lehman Brother part v

Fall of Lehman Brother part vi

6 Signs a Business Has Bad Management | Phil Town (a good video to watch)

Week3

Chapter 7 Bond Pricing

Simplified Balance Sheet of WalMart

 In Millions of USD As of 2019-01-31 Total Assets 219,295,000 Total Current Liabilities 77,477,000 Long Term Debt 43,520,000 Total Liabilities 139,661,000 Total Equity 72,496,000 Total Liabilities & Shareholders' Equity 219,295,000

For discussion:

·         What is this “long term debt”?

·         Who is the lender of this “long term debt”?

So this long term debt is called bond in the financial market. Where can you find the pricing information and other specifications of the bond issued by WMT?

How Bonds Work (video)

FINRA – Bond market information

http://finra-markets.morningstar.com/BondCenter/Default.jsp

WAL-MART STORES INC

http://finra-markets.morningstar.com/BondCenter/BondDetail.jsp?ticker=C104227&symbol=WMT.GP

7.550

%

02/15/2030

WMT.GP

931142BF9

\$138.45

3.318%

03/18/2019

Credit and Rating Elements

 Moody's® Rating Aa2 (10/14/2015) Standard & Poor's Rating AA (02/10/2000) TRACE Grade Investment Grade Default — Bankruptcy N Insurance — Mortgage Insurer — Pre-Refunded/Escrowed — Additional Description Senior Unsecured Note

Classification Elements

 Bond Type US Corporate Debentures Debt Type Senior Unsecured Note Industry Group Industrial Industry Sub Group Retail Sub-Product Asset CORP Sub-Product Asset Type Corporate Bond State — Use of Proceeds — Security Code —

Special Characteristics

 Medium Term Note N

Issue Elements

 *dollar amount in thousands Offering Date 02/09/2000 Dated Date 02/15/2000 First Coupon Date 08/15/2000 Original Offering* \$1,000,000.00 Amount Outstanding* \$1,000,000.00 Series — Issue Description — Project Name — Payment Frequency Semi-Annual Day Count 30/360 Form Book Entry Depository/Registration Depository Trust Company Security Level Senior Collateral Pledge — Capital Purpose —

Bond Elements

 *dollar amount in thousands Original Maturity Size* 1,000,000.00 Amount Outstanding Size* 1,000,000.00 Yield at Offering 7.56% Price at Offering \$99.84 Coupon Type Fixed Escrow Type

For class discussion:

Fed has hiked interest rates. So, shall you invest in short term bond or long term bond?

Study guide

1.      Find bond sponsored by WMT

just go to www.finra.orgè Investor center è market data è bond è corporate bond

Corporate Bond

 Issuer Name Callable Coupon Maturity Moody S&P Fitch Price Yield WMT No 7.55 2/15/2030 Aa2 AA AA 138.45 3.318 WMT yes 6.75 4/2/2043 Aa2 AA AA 110.45 4.065

(see below for details)

WALMART INC

4.750

%

10/02/2043

WMT4055720

931142DK6

04/02/2043

Yes

\$110.45

4.065%

03/14/2019

US Treasury Yield

 Prospectus

2.      2. Understand what is coupon, coupon rate, yield, yield to maturity, market price, par value, maturity, annual bond, semi-annual bond, current yield.

3.      3. Understand how to price bond

Bond price = abs(pv(yield, maturity, coupon, 1000))  ------- annual coupon

Bond price = abs(pv(yield/2, maturity*2, coupon/2, 1000)) ------- semi-annual coupon

Also change the yield and observe the price changes. Summarize the price change pattern and draw a graph to demonstrate your findings.

Again, when yield to maturity of this semi_annual coupon bond is 4%, how should this WMT bond sell for?

4.      Understand how to calculate bond returns

Yield to maturity = rate(maturity, coupon,  -market price, 1000) – annual coupon

Yield to maturity = rate(maturity*2, coupon/2,  -market price, 1000)*2 – semi-annual coupon

Bond Calculator (www.jufinance.com/bond)

For example, when the annual coupon bond is selling for \$1,100, what is its return to investors?

For example, when the semi-annual coupon bond is selling for \$1,100, what is its return to investors?

5.      Current yield: For the above bond, calculate current yield.

6.      Zero coupon bond: coupon=0 and treat it as semi-annual coupon bond.

Example: A ten year zero coupon bond is selling for \$400. How much is its yield to maturity?

A ten year zero coupon bond’s yield to maturity is 10%. How much is its price?

7.      Understand what is bond rating and how to read those ratings.

a.       Who are Moody, S&P and Fitch?

b.      What is WMT’s rating?

c.       Is the rating for WMT the highest?

d.      Who earned the highest rating?

Homework (Due with mid term)

1.  Firm AAA’s bonds price = \$850.  Coupon rate is 5% and par is \$1,000. The bond has six years to maturity. Calculate for current yield? (5.88%)

2. For a zero coupon bond, use the following information to calculate its yield to maturity. (14.35%)  Years left to maturity = 10 years. Price = \$250.

3.  For a zero coupon bond, use the following information to calculate its price. (\$456.39) Years left to maturity = 10 years. Yield = 8%.

4.  Imagine that an annual coupon bond’s coupon rate = 5%, 15 years left. Draw price-yield profile. (hint: Change interest rate, calculate new price and draw the graph).

5. IBM 5 year 2% annual coupon bond is selling for \$950. How much this IBM bond’s YTM?  3.09%

6.  IBM 10 year 4% semi-annual coupon bond is selling for \$950. How much is this IBM bond’s YTM?  4.63%

7. IBM 10 year 5% annual coupon bond offers 8% of return. How much is the price of this bond?   798.7

8. IBM 5 year 5% semi-annual coupon bond offers 8% of return. How much is the price of this bond?  \$878.34

9.  IBM 20 year zero coupon bond offers 8% return. How much is the price of this bond? 208.29

10.   Collingwood Homes has a bond issue outstanding that pays an 8.5 percent coupon and matures in 18.5 years. The bonds have a par value of \$1,000 and a market price of \$964.20. Interest is paid semiannually. What is the yield to maturity? (8.90%)

11.  Grand Adventure Properties offers a 9.5 percent coupon bond with annual payments. The yield to maturity is 11.2 percent and the maturity date is 11 years from today. What is the market price of this bond if the face value is \$1,000?

(\$895.43)

12.  The zero coupon bonds of D&L Movers have a market price of \$319.24, a face value of \$1,000, and a yield to maturity of 9.17 percent. How many years is it until these bonds mature? (12.73 years)

13.  A zero coupon bond with a face value of \$1,000 is issued with an initial price of \$212.56. The bond matures in 25 years. What is yield to maturity?  (6.29%)

14.   The bonds issued by Stainless Tubs bear a 6 percent coupon, payable semiannually. The bonds mature in 11 years and have a \$1,000 face value. Currently, the bonds sell for \$989. What is the yield to maturity? (6.14%)

Videos --- homework help

Class Videos of this week

Mid Term (for chapters 5, 6, 7) (on blackboard)

Bond Pricing Formula (FYI)

Bond Pricing Excel Formula

Summary of bond pricing excel functions

To calculate bond price (annual coupon bond):

Price=abs(pv(yield to maturity, years left to maturity, coupon rate*1000, 1000)

To calculate yield to maturity (annual coupon bond)::

Yield to maturity = rate(years left to maturity, coupon rate *1000, -price, 1000)

To calculate bond price (semi-annual coupon bond):

Price=abs(pv(yield to maturity/2, years left to maturity*2, coupon rate*1000/2, 1000)

To calculate yield to maturity (semi-annual coupon bond):

Yield to maturity = rate(years left to maturity*2, coupon rate *1000/2, -price, 1000)*2

To calculate number of years left(annual coupon bond)

Number of years =nper(yield to maturity,  coupon rate*1000, -price, 1000)

To calculate number of years left(semi-annual coupon bond)

Number of years =nper(yield to maturity/2,  coupon rate*1000/2, -price, 1000)/2

To calculate coupon (annual coupon bond)

Coupon = pmt(yield to maturity, number of years left, -price, 1000)

Coupon rate = coupon / 1000

To calculate coupon (semi-annual coupon bond)

Coupon = pmt(yield to maturity/2, number of years left*2, -price, 1000)*2

Coupon rate = coupon / 1000

CME Group to Trade Bitcoin Futures | BTC at All-Time High Above \$6,404 - NEWSBTC 11/1/2017 (Video)

Week4

Chapter 8 Stock Valuation

1.    Introduction

 Previous Close 99.06 Open 98.58 Bid 0.00 x 1000 Ask 0.00 x 1800 Day's Range 97.94 - 99.53 52 Week Range 81.78 - 106.21 Volume 6,708,131 Avg. Volume 7,824,006 Market Cap 285.529B Beta (3Y Monthly) 0.64 PE Ratio (TTM) 43.49 EPS (TTM) 2.26 Earnings Date May 16, 2019 Forward Dividend & Yield 2.12 (2.14%) Ex-Dividend Date 2019-05-09 1y Target Est 109.07

WMT 10-year price chart

In Millions of USD (except for per share items)

As of 2019-01-31

Total Assets

219,295,000

Total Liabilities

139,661,000

Redeemable Preferred Stock, Total

-

Preferred Stock - Non Redeemable, Net

-

Common Stock, Total

288,000

-

Retained Earnings (Accumulated Deficit)

80,785,000

Treasury Stock

-11,542

Capital Surplus

2,965,000

Other Stockholder equity

Total Equity

-11,542

Total Liabilities & Shareholders' Equity

72,496,000

Stock screening tools

·        Reuters stock screener to help select stocks

·        FINVIZ.com

·        WSJ stock screen

·        Simply the Web's Best Financial Charts

You can find analyst rating from MSN money

For instance,

ANALYSTS RATINGS

Zacks average brokerage recommendation is Moderate Buy

 RECOMMENDATIONS CURRENT 1 MONTH AGO 2 MONTHS AGO 3 MONTHS AGO Strong Buy 26 26 25 24 Moderate Buy 4 4 4 4 Hold 8 8 8 9 Moderate Sell 0 0 0 0 Strong Sell 0 0 0 0 Mean Rec. 1.51 1.51 1.53 1.58

How to pick stocks

Capital Asset Pricing Model (CAPM)Explained

Ranking stocks using PEG ratio

Summary of stock screening rules from class discussion

PEG<1

PE<15  (? FB’s PE>100?)

Growth rate<20

ROE>10%

Zacks average =1 (from Ranking stocks using PEG ratio)

current price>5

Useful website

money.msn.com/investing

zacks.com

minyanville.com

moneychimp.com

nasdaq.com

marketwatch.com

superstockscreener.com

gurufocus.com

portfoliomoney.com

stockconsultant.com

moderngraham.com

stockpickr.com

stockta.com

thestreet.com

quotes.wsj.com

oldschoolvalue.com

fool.com

analystratings.com

barchart.com

stock2own.com

theonlineinvestor.com

seekingalpha.com

Week4

For discussion:

·         Stockholders’ rights

·         Risk and return – where to find how risky the stock is

2.      Calculate stock prices

1)      Given next dividends and price expected to be sold for

Po=

Po=  +

Po=  + +

Po=  + ++

……

2) Given all dividends Dividend growth model

Po= D1/(r-g) or Po= Do*(1+g)/(r-g)

R = D1/Po+g = Do*(1+g)/Po+g

D1=Do*(1+g); D2= D1*(1+g)…

g= r-D1/Po = r- Do*(1+g)/Po

Capital Gain yield = g

Dividend Yield = r – g = D1 / Po = Do*(1+g) / Po

(www.jufinance.com/stock)

Exercise:

1. Consider the valuation of a common stock that paid \$1.00 dividend at the end of the last year and is expected to pay a cash dividend in the future. Dividends are expected to grow at 10% and the investors required rate of return is 17%. How much is the price? How much is the dividend yield? Capital gain yield?

2.      The current market price of stock is \$90 and the stock pays dividend of \$3 with a growth rate of 5%. What is the return of this stock? How much is the dividend yield? Capital gain yield?

3.      How to pick stocks Does it work?

PE ratio

PEG ratio (peg ratio vs. PE ratio video)

HOMEWORK (Due with final )

1. Northern Gas recently paid a \$2.80 annual dividend on its common stock. This dividend increases at an average rate of 3.8 percent per year. The stock is currently selling for \$26.91 a share. What is the market rate of return? (14.60 percent)

2. Douglass Gardens pays an annual dividend that is expected to increase by 4.1 percent per year. The stock commands a market rate of return of 12.6 percent and sells for \$24.90 a share. What is the expected amount of the next dividend? (\$2.12)
3.  IBM just paid \$3.00 dividend per share to investors. The dividend growth rate is 10%. What is the expected dividend of the next year? (\$3.3)

4. The current market price of stock is \$50 and the stock is expected to pay dividend of \$2 with a growth rate of 6%. How much is the expected return to stockholders? (10%)

5.  Investors of Creamy Custard common stock earns 15% of return. It just paid a dividend of \$6.00 and dividends are expected to grow at a rate of 6% indefinitely. What is expected price of Creamy Custard's stock? (\$70.67)

Class Videos of this week

Homework Video of this week

To learn about non-constant growth of dividend (Here dividend growth model will not work), please refer to the following calculator (FYI, not required)
calculator

FYI:

Po = Do*(1+g1) / r + Do*(1+g1) *(1+g2) / (r2)+ ... Do*(1+g1) *(1+g2)*...(1+gn-1)/ (rn-1) + Do*(1+g1) *(1+g2)*...(1+gn-1)*(1+gn)/(r-gn)

g1: next year's growth rate; gn: nth year's growth rate; Po: current stock price

If non-constant dividend growth rates in the next several years are not given, refer to the following equations.

g1 = D1/Do-1; g2 = D2/D1-1; g3=D3/D2-1,... Until dividend growth rate stays fixed.

Week5-1

Chapter 9 Capital Budgeting

1.      NPV Excel syntax

Syntax

NPV(rate,value1,value2, ...)

Rate     is the rate of discount over the length of one period.

Value1, value2, ...     are 1 to 29 arguments representing the payments and income.

·         Value1, value2, ... must be equally spaced in time and occur at the end of each    period. NPV uses the order of value1, value2, ... to interpret the order of cash flows. Be sure to enter your payment and income values in the correct sequence.

2.      IRR Excel syntax

Syntax

IRR(values, guess)

Values  is an array or a reference to cells that contain numbers for which you want to calculate the internal rate of return.

Guess     is a number that you guess is close to the result of IRR.

Or, PI = NPV / CFo +1

Profitable index (PI) =1 + NPV / absolute value of CFo

3.     MIRR( valuesfinance_ratereinvest_rate )

Where the function arguments are as follows:

 Values - An array of values (or a reference to a range of cells containing values) representing the series of cash flows (investment and net income values) that occur at regular periods. These must contain at least one negative value (representing payment) and at least one positive value (representing income). finance_rate - The interest rate paid on the money used in the cash flows. reinvest_rate - The interest rate paid on the reinvested cash flows.

Modified Rate of Return: Definition & Example (video)

(www.jufinance.com/npv)

Chapter 9 Study Guide

Part I: Single project

Consider the following scenario.

You are reviewing a new project and have estimated the following cash flows:

Year 0:            CF = -165,000

Year 1:            CF = 63,120; NI = 13,620

Year 2:            CF = 70,800; NI = 3,300

Year 3:            CF = 91,080; NI = 29,100

Your required return for assets of this risk level is 12%.

1)      Using payback period method to make capital budgeting decision.

2)      Using discounted payback period method to make capital budgeting decision.

3)      Using net present value method (NPV)  (answer: \$12,627.41)

4)      Using profitable index method (PI) (answer: 1.077)

5)      Using the Internal Rate of Return method (answer: 16.13%)

6)      Using modified IRR method (MIRR, using 12% for both investment rate and financing rate. Answer: 14.79%)

Part II: Multi-Projects

 Period Project A Project B 0 -500 -400 1 325 325 2 325 200 IRR NPV

If the required rate of return is 10%. Which project shall you choose?

1)      How much is the cross over rate? (answer: 11.8%)

2)      How is your decision if the required rate of return is 13%? (answer: NPV of B>NPV of A)

·         Rule for mutually exclusive projects: (answer: Choose B)

More on IRR – (non-conventional cash flow)

Suppose an investment will cost \$90,000 initially and will generate the following cash flows:

–    Year 1: 132,000

Year 2: 100,000

–    Year 3: -150,000

The required return is 15%. Should we accept or reject the project?

1)      How  does the NPV profile look like? (Answer: Inverted)

Exercise

An investment project has the following cash flows:

CF0 = -1,000,000; C01 – C08 = 200,000 each

If the required rate of return is 12%, what decision should be made using NPV?

How would the IRR decision rule be used for this project, and what decision would be reached?

How are the above two decisions related?

HOMEWORK(Due with final)
Question 1: Project with an initial cash outlay of \$20,000 with following free cash flows for 5 years.

Year   Cash flows

1                    \$8,000

2                    4,000

3                    3,000

4                    5,000

5                    10,000

1)      How much is the payback period (approach one)?   ---- 4 years

2)      If the firm has a 10% required rate of return. How much is NPV (approach 2)?-- \$2456.74

3)      If the firm has a 10% required rate of return. How much is IRR (approach 3)? ---- 14.55%

4)      If the firm has a 10% required rate of return. How much is PI (approach 4)? ---- 1.12

Question 2: Project with an initial cash outlay of \$60,000 with following free cash flows for 5 years.

Year    FCF

Initial outlay    –60,000

1          25,000

2          24,000

3          13,000

4          12,000

5          11,000

The firm has a 15% required rate of return.

Calculate payback period, NPV, IRR and PI. Analyze your results.

Question 3: Mutually Exclusive Projects

1)      Consider the following cash flows for one-year Project A and B, with required rates of return of 10%. You have limited capital and can invest in one but one project. Which one?

§  Initial Outlay: A = \$200; B = \$1,500

§  Inflow:            A = \$300; B = \$1,900

2)      Example: Consider two projects, A and B, with initial outlay of \$1,000, cost of capital of 10%, and following cash flows in years 1, 2, and 3:

A: \$100                       \$200                \$2,000

B: \$650                       \$650                \$650

Which project should you choose if they are mutually exclusive? Independent? Crossover rate?

From the 20-page cellphone contract to the five-pound employee handbook, even the simple things seem to be getting more complicated.

Companies have been complicating things for themselves, tooanalyzing hundreds of factors when making decisions, or consulting reams of data to resolve every budget dilemma. But those requirements might be wasting time and muddling priorities.

So argues Donald Sull, a lecturer at the Sloan School of Management at the Massachusetts Institute of Technology who has also worked for McKinsey & Co. and Clayton, Dubilier & Rice LLC. In the book Simple Rules: How to Thrive in a Complex World, out this week from Houghton Mifflin Harcourt HMHC -1.36%, he and Kathleen Eisenhardt of Stanford University claim that straightforward guidelines lead to better results than complex formulas.

Mr. Sull recently spoke with At Work about what companies can do to simplify, and why five basic rules can beat a 50-item checklist. Edited excerpts:

WSJ: Where, in the business context, might simple ruleshelp more than a complicated approach?

Donald Sull: Well, a common decision that people face in organizations is capital allocation. In many organizations, there will be thick procedure books or algorithmsone company I worked with had an algorithm that had almost 100 variables for every project. These are very cumbersome approaches to making decisions and can waste time. Basically, any decision about how to focus resourceseither people or money or attentioncan benefit from simple rules.

WSJ: Can you give an example of how that simplification works in a company?

Sull: Theres a German company called Weima GmBH that makes shredders. At one point, they were getting about 10,000 requests and could only fill about a thousand because of technical capabilities, so they had this massive problem of sorting out which of these proposals to pursue.

They had a very detailed checklist with 40 or 50 items. People had to gather data and if there were gray areas the proposal would go to management. But because the data was hard to obtain and there were so many different pieces, people didnt always fill out the checklists completely. Then management had to discuss a lot of these proposals personally because there was incomplete data. So top management is spending a disproportionate amount of time discussing this low-level stuff.

Then Weima came up with guidelines that the frontline sales force and engineers could use to quickly decide whether a request fell in the yes,” “no or maybe category. They did it with five rules only, stuff like Weima had to collect at least 70% of the price before the unit leaves the factory.

After that, only the maybes were sent to management. This dramatically decreased the amount of time management spend evaluating these projectsthat time was decreased by almost a factor of 10.

Or, take Frontier Dental Laboratories in Canada. They were working with a sales force of two covering the entire North American market. Limiting their sales guidelines to a few factors that made someone likely to be receptive to Frontierstuff like dentists who have their own practice and dentists with a website”—helped focus their efforts and increase sales 42% in a declining market.

WSJ: Weima used five factorsis that the optimal number? And how do you choose which rules to follow?

Sull: You should have four to six rules. Any more than that, youll spend too much time trying to follow everything perfectly. The entire reason simple rules help is because they force you to prioritize the goals that matter. Theyre easy to remember, they dont confuse or stress you, they save time.

They should be tailored to your specific goals, so you choose the rules based on what exactly youre trying to achieve. And you should of course talk to others. Get information from different sources, and ask them for the top things that worked for them. But focus on whether what will work for you and your circumstances.

WSJ: Is there a business leader you can point to who has embraced the simple rules guideline?

Donald Sull: Lets look at when Alex Behring took over America Latina Logistica SARUMO3.BR +1.59%, the Brazilian railway and logistics company. With a budget of \$15 million, how do you choose among \$200 million of investment requests, all of which are valid?

The textbook business-school answer to this is that you run the NPV (net present value) test on each project and rank-order them by NPV. Alex Behring knows this. He was at the top of the class at Harvard Business School.

But insteadhe decided what the most important goals were. You cant achieve everything at once. In their case, their priorities were removing bottlenecks on growing revenues and minimizing upfront expenditure. So when allocating money, they had a bias for projects that both addressed the bottleneck problem and, for example, used existing tracks and trains.

Similarly, the global-health arm of the Gates Foundation gets many, many funding requests. But since they know that their goal is to have the most impact worldwide, they focus on projects in developing countries because thats where the money will stretch farther.

FYI- The application of IRR in academic studies

Using Excel for Net Present Values, IRR's and MIRR's

Week5-2

Chapter 14 Cost of Capital

For class discussion:

What is WACC?

Why is it important?

WACC increases, good or bad to stock holders?

How to apply WACC to figure out firm value?

What is DCF?

One option (if beta is given, refer to chapter 13)

Another option (if dividend is given):

WACC Formula

WACC calculator (annual coupon bond)

(www.jufinance.com/wacc)

WACC calculator  (semi-annual coupon bond)

WACC Excel Template (New)

Summary of Equations

Discount rate to figure out the value of projects is called WACC (weighted average cost of capital)

WACC = weight of debt * cost of debt   + weight of equity *( cost of equity)

Wd= total debt / Total capital  = total borrowed / total capital

We= total equity/ Total capital

Cost of debt = rate(nper, coupon, -(price – flotation costs), 1000)*(1-tax rate)

Cost of Equity = D1/(Po – Flotation Cost)  + g

D1: Next period dividend; Po: Current stock price; g: dividend growth rate

Note: flotation costs = flotation percentage * price

Or if beta is given, use CAPM model (refer to chapter 13)

Cost of equity = risk free rate + beta *(market return – risk free rate)

Cost of equity = risk free rate + beta * market risk premium

In Class Exercise:

A firm borrows money from bond market. The price they paid is \$950 for the bond with 5% coupon rate and 10 years to mature. Flotation cost is \$40.  For the new stocks, the expected dividend is \$2 with a growth rate of 10% and price of \$40. The flotation cost is \$4. The company raises capital in equal proportions i.e. 50% debt and 50% equity (such as total \$1m raised and half million is from debt market and the other half million is from stock market). Tax rate 34%. What is WACC (weighted average cost of capital, cost of capital)?  (Answer: 9.84%)

1)      Why does the firm raise capital from the financial market? Is there of any costs of doing so? What do you think?

2)      What is cost of debt?

(Kd = rate(nper, coupon, -(price – flotation costs \$)), 1000)*(1-tax rate))

3)      Cost of equity? (Ke = (D1/(Price – flotation costs \$)) +g, or Ke = Rrf + Beta*MRP))

Why no tax adjustment like cost of debt?

4)      WACC=Cost of capital = Percentage of Debt * cost of debt + percentage of stock * cost of stock = Wd*Kd + We* Ke

Meaning: For a dollar raised in the capital market from debt holders and stockholders, the cost is WACC (or WACC * 1\$ = several cents, and of course, the lower the better but many companies do not have good credits)

No homework for chapter 14

This Week’s Class Videos

Homework help videos

FYI
Walmart Inc  (NYSE:WMT) WACC %:5.72% As of Today

As of today, Walmart Inc's weighted average cost of capital is 5.72%. Walmart Inc's ROIC % is 11.27% (calculated using TTM income statement data). Walmart Inc generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases.

Amazon.com Inc  (NAS:AMZN) WACC %:11.79% As of Today

As of today, Amazon.com Inc's weighted average cost of capital is 11.79%. Amazon.com Inc's ROIC % is 31.81% (calculated using TTM income statement data). Amazon.com Inc generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases.

Apple Inc  (NAS:AAPL) WACC %:7.64% As of Today

As of today, Apple Inc's weighted average cost of capital is 7.64%. Apple Inc's ROIC % is 35.90% (calculated using TTM income statement data). Apple Inc generates higher returns on investment than it costs the company to raise the capital needed for that investment. It is earning excess returns. A firm that expects to continue generating positive excess returns on new investments in the future will see its value increase as growth increases.

Cost of Capital by Sector (US)

Date of Analysis: Data used is as of January 2019

 Industry Name Number of Firms Beta Cost of Equity E/(D+E) Std Dev in Stock Cost of Debt Tax Rate After-tax Cost of Debt D/(D+E) Cost of Capital Advertising 48 1.22 9.93% 58.46% 66.44% 5.43% 5.69% 4.07% 41.54% 7.49% Aerospace/Defense 85 1.24 10.07% 79.75% 40.77% 4.56% 11.40% 3.42% 20.25% 8.72% Air Transport 18 1.02 8.77% 52.68% 34.19% 4.18% 6.48% 3.14% 47.32% 6.10% Apparel 50 0.93 8.23% 74.07% 48.89% 4.56% 14.19% 3.42% 25.93% 6.98% Auto & Truck 14 0.79 7.41% 33.85% 38.24% 4.18% 10.15% 3.14% 66.15% 4.58% Auto Parts 52 1.17 9.63% 71.45% 44.28% 4.56% 11.57% 3.42% 28.55% 7.86% Bank (Money Center) 10 0.71 6.93% 32.91% 18.29% 3.58% 26.01% 2.69% 67.09% 4.08% Banks (Regional) 633 0.57 6.07% 56.65% 20.60% 3.58% 26.99% 2.69% 43.35% 4.60% Beverage (Alcoholic) 31 1.3 10.42% 74.53% 33.49% 4.18% 2.55% 3.14% 25.47% 8.57% Beverage (Soft) 37 1.18 9.70% 80.95% 50.32% 4.56% 3.87% 3.42% 19.05% 8.50% Broadcasting 24 1.02 8.76% 40.89% 37.29% 4.18% 2.54% 3.14% 59.11% 5.44% Brokerage & Investment Banking 38 1.21 9.87% 25.21% 32.08% 4.18% 22.47% 3.14% 74.79% 4.83% Building Materials 42 1.1 9.21% 75.19% 33.40% 4.18% 16.11% 3.14% 24.81% 7.70% Business & Consumer Services 168 1.22 9.94% 73.70% 44.86% 4.56% 7.60% 3.42% 26.30% 8.22% Cable TV 14 1.13 9.43% 58.58% 26.32% 4.18% 3.61% 3.14% 41.42% 6.82% Chemical (Basic) 39 1.55 11.92% 60.07% 54.33% 4.56% 7.33% 3.42% 39.93% 8.52% Chemical (Diversified) 6 1.82 13.51% 73.10% 32.60% 4.18% 3.18% 3.14% 26.90% 10.72% Chemical (Specialty) 89 1.17 9.65% 75.40% 42.33% 4.56% 10.71% 3.42% 24.60% 8.12% Coal & Related Energy 23 1.17 9.64% 59.74% 53.58% 4.56% 1.75% 3.42% 40.26% 7.14% Computer Services 119 1.27 10.25% 71.85% 41.69% 4.56% 8.75% 3.42% 28.15% 8.32% Computers/Peripherals 57 1.68 12.69% 79.92% 49.87% 4.56% 6.60% 3.42% 20.08% 10.83% Construction Supplies 48 1.45 11.34% 68.55% 32.24% 4.18% 13.21% 3.14% 31.45% 8.76% Diversified 23 1.36 10.78% 73.82% 39.46% 4.18% 7.41% 3.14% 26.18% 8.78% Drugs (Biotechnology) 481 1.51 11.69% 84.09% 68.96% 5.43% 0.93% 4.07% 15.91% 10.48% Drugs (Pharmaceutical) 237 1.47 11.41% 87.44% 72.45% 5.43% 2.26% 4.07% 12.56% 10.49% Education 35 1.28 10.29% 76.49% 37.66% 4.18% 6.14% 3.14% 23.51% 8.61% Electrical Equipment 116 1.32 10.56% 81.87% 57.29% 4.56% 4.36% 3.42% 18.13% 9.27% Electronics (Consumer & Office) 19 1.19 9.78% 91.10% 62.71% 4.56% 7.67% 3.42% 8.90% 9.21% Electronics (General) 160 1.02 8.74% 83.77% 46.69% 4.56% 11.67% 3.42% 16.23% 7.87% Engineering/Construction 52 1.01 8.68% 67.17% 40.14% 4.56% 7.62% 3.42% 32.83% 6.96% Entertainment 120 1.33 10.61% 83.43% 54.34% 4.56% 1.93% 3.42% 16.57% 9.42% Environmental & Waste Services 91 1.19 9.78% 74.83% 46.15%