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project should return to the chart on page 15 and remind themselves of how

it is constructed and how it can help to illustrate NPV, discounted payback,

investment efficiency and IRR.

Part 4: Individual work assignments

1. If your cost of capital is 10%, what is the present value of $100 in one yearâ€™s

time?

2. By how much would this change if your cost of capital was (a) 5% and (b)

15%?

3. What is the present value of $100 in ten yearsâ€™ time if your cost of capital

was (a) 5%, (b) 10% or (c) 15%?

4. An investment offers the potential to earn $10 per annum for the next five

years with the first cash flow being in one yearâ€™s time. If your cost of capi-

tal is 12% what is the maximum amount you should be prepared to pay for

the investment?

5. The discount factor and annuity factor tables given above only cover a

limited range. Extend them to cover a wider range that can still fit on a

single sheet of paper. For example, discount rates going from 1% to 15%

and a longer time horizon covering, say, 1â€“20 years plus also columns for

25, 30 and 40 years. Do this for both mid-year and end-year cash flows. If

you are able to, print these tables out on both sides of a sheet of paper and

get it laminated as a reference sheet.

6. An investment of $100 will yield you a cash flow of $15 for every year into

the future with the initial cash flow being in one yearâ€™s time.

27 Building block 1: Economic value

a. If your cost of capital is 12%, how much value does the investment

make?

b. How many years will it take before your investment has earned back at

least its cost of capital?

7. Your engineering team can only cope with one further investment next

year and you have to choose from three possible projects. Project A involves

a capital spend during the year of $20m and will then generate cash flows

of $8m per annum for the following four years. Project B involves a capital

spend of $7.5m and will then generate cash flows of $2m per annum for

each of the next ten years. Project C involves a capital spend of $36m and

will then generate cash flows of $11m for each of the next five years. Your

cost of capital is 12% and it is now the middle of the present year (so end

year discount tables can be applied).

a. Which project would you recommend?

b. Are there any circumstances which would make you change this rec-

ommendation?

8. You own a retail outlet that you expect to generate cash flows of $1m pa

for each of the next four years but then you expect sales to fall dramatic-

ally when a relief road for the town is opened. Your current expectation is

that you will close the site when this happens and that your sales proceeds

net of remediation costs will be $0.5m. Your cost of capital is 12%. It is the

beginning of the year and the retail site therefore has 4 years of economic

life left. You have just received an offer of $3.6m for the site. Should you

sell? How would your answer change if your cost of capital was (a) 5% or

(b) 15%?

9. Build a spreadsheet model to investigate the following project. It is 1 January

and your time value of money is 8%. The capital cost of the project is $20m

and this will be spent during the current year. There will then be ten years

of operation. In the first of these years the cash flow will be $2m; in the

second it will be $3m. During years 3 to 9 of operation the annual cash

flow will be $4m but in the final year this will fall to $1m. For the initial

evaluation assume no closure costs. What is the NPV, IRR, discounted pay-

back and investment efficiency? Investigate also what capital cost increase

would cause the project to have a zero NPV. Finally, identify what closure

cost incurred at the end of the project life would cause a zero NPV.

ChAPTer

2

Building block 2: Financial

markets

Summary

This chapter explains briefly where companies get their money from and

what it costs. In the first part we will consider debt, which is how people will

choose to invest in a company if they do not want to take any significant risks.

In the second part we will consider equity, which is invested by people who

are prepared to take higher risks in return for the chance of greater rewards.

In the third part we will consider how to allow for the cost of these two very

different types of finance and how to link this in to our calculation of value.

In this part we will also meet the idea of separating investment decisions

from financing decisions and also the perhaps surprising presumption that

if you have a good project, then money should always be available to finance

it. The final part will contain the individual work assignments, answers to

which are to be found in the Appendices at the end of the book.

The purpose of this building block is to provide the necessary background

for individuals who are considering investment decisions inside companies.

In particular it will give a basic understanding of where the cost of capi-

tal comes from and why we treat financing decisions separately from asset

investment decisions. Although some insights may be gained regarding how

to make oneâ€™s personal investment decisions, this is not the main intention.

Indeed there are good reasons why companies and individuals should adopt

very different approaches to financial decision making.1

Two key reasons are that individuals have only a limited amount of money available and will also have

1

very different attitudes to risk.

28

29 Building block 2: Financial markets

Part 1: Debt, an initial overview

Debt can take many forms and tends to be given different names2 but its fun-

damental characteristics always remain that:

â€¢ the lender (typically a bank) considers it to be low risk

while the borrower takes on the obligations:

â€¢ to pay interest; and

â€¢ to repay the principal according to an agreed repayment schedule.

There are two sides to the transaction: the borrower and the lender. From

the perspective of the lender, debt is expected to be a low or even a no risk

investment. In recognition of this the interest rate tends to be relatively low.

If there is some risk that the interest or the principal will not be repaid then

the lender will charge a higher interest rate. Lenders typically lend to lots of

borrowers and they look to their overall portfolio of loans to give a sufficient

return to cover any under-recovery on a particular loan.

The best example of what would be considered a no risk loan would be a

short term loan to the US government. It issues instruments called T bills

which are, in effect, borrowings by the US government from lenders. The rea-

son they are considered risk free is that the US government can always print

more money in order to repay them. The so-called 90 day T bill is sold for a

small amount below its face value of $1,000. This amount represents interest

since the full $1,000 is repaid after 90 days.

Debt is not low risk to borrowers. This is because debt carries with it the

legal obligation to make repayments. So if a company cannot repay a loan the

lender can apply to the courts and, in the limit, force a company into liquida-

tion for failure to repay. We will see later on in this building block how debt

increases the risk of the equity in a company. To borrowers, debt is a high risk

but low cost source of finance.

Loans can be for more or less any period. It is possible to borrow money for

just a single day and equally possible to borrow for, say, 20 years. The interest

rate on a loan can either be fixed at the time the loan is taken out or it can be

what is called floating. In this case the interest rate will be set at a fixed pre-

mium or discount to some benchmark interest rate. The overall level of inter-

est rates is set through a complex interaction between governments, central

For example, in addition to debt it can be called borrowing, g

mpl , n d i ion n e l d o ro n , gearing, l ve g , a mo g g , an over-

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