Financial Markets for corporate and retail clients

FINANCIAL DECISION MAKING AND THE LAW OF ONE PRICE

Identify costs and benefits: the analysis need help from other firm's areas

• Marketing
• Economics
• Organizational behaviour
• Strategy
• Operations

Once the analysis of these other disciplines has been completed to quantify the costs and benefits associated with a decision, the financial manager must compare the costs and benefits and determine the best decision to make for the value of the firm.

In order to compare the costs and benefits, we need to evaluate them in the same terms.

Example:

Suppose a jewellery manufacturer has the opportunity to trade 10 ounces of gold and receive 20 ounces of palladium today. To compare the costs and benefits, we first need to convert them to a common unit.

Similarly, if the current market price for palladium is $600 per ounce, then the 20 ounces of palladium we receive has a cash value of (20 ounces of palladium) * ($600) = $12,000.

Suppose gold can be bought and sold for a current market price of $1,300.

per ounce. Then the 10 ounces of gold we give up has a cash value of (10 ounces of gold) * ($1.300) = $13.000

Therefore, the jeweller's opportunity has a benefit of $12,000 today and a cost of $13,000 today. In this case, the net value of the project today is $12,000 - $13,000 = -$1,000 (negative); the costs exceed the benefits and for this reason the jeweller should reject the trade.

Using market prices to determine cash values: in evaluating the jeweller's decision, we used the current market price to convert from ounces of silver or gold to dollars.

Competitive market: market in which goods can be bought and sold at the same price. That price determines the value of the good.

Example: Jeweller's decision: we used the current market price to convert from ounces of platinum or gold to dollars; no concern about whether the jeweller thought that the price was fair or whether the jeweller would use the silver or gold.

Example

You have just won four tickets for a concert: face

Sell the motorcycle for $12,000. Which prize should you choose?

Competitive markets are relevant here: you should accept the motorcycle, sell it for $12,000, use $2,000 to pay for your car repairs and still have $10,000 left over.

Example

You are the operations manager at your firm. Due to a pre-existing contract, you have the opportunity to acquire 200 barrels of oil and 3,000 pounds of copper for a total of $12,000.

Current competitive market prices: for oil is $50 per barrel, for copper is $2 per pound. You are not sure you need all of the oil and copper and are concerned that the value of both commodities may fall in the future. Should you take this opportunity?

First, convert the costs and benefits to their cash values using market prices:

(200 barrels of oil) * $50 = $10,000

(3,000 pounds of copper) * $2 = $6,000

Net value of the opportunity = $10,000 + $6,000 - $12,000 = $4,000 today

The net value is positive so you should acquire them.

It depends only on the current market price for oil and copper.

Even if you do not need all the oil or copper, or expect their values to fall, you can sell them at current market prices and obtain their values of $16,000. Thus, the opportunity is a good one for the firm, and will increase its value by $4,000.

Exercise

Investment opportunity: in exchange for $50,000 today, you will receive 2,500 shares of stock in the Ford Motor Company and 10,000 euros today. Current market price for Ford stock = $14 per share and current exchange rate = $1.12 per €.

Should you take this opportunity? Would your decision change if you believed the value of the euro would rise over the next month?

The costs and benefits must be converted to their cash values. Assuming competitive market prices:

2500 shares * $14 = $35,000

10000 euros * $1.12 = $11,200

Net value of the opportunity = $35,000 + $11,200 - $50,000 = -$3,800. You should not take the opportunity.

Our personal opinion about the future prospects of the euro and Ford does not alter the value of the decision.

today.Time value of money: for most financial decisions, unlike in the examples presented so far, costs and benefits occur at different points in time. For example, typical investment projects incur costs upfront and provide benefits in the future.

Consider an investment opportunity with the following cash flows:

Cost: $100.000 today

Benefits: $105.000 in one year

Net value is $105,000 - $100,000 = $5000; but this calculation ignores the timing of the costs and benefits, and it treats money today as equivalent to money in one year. In general, a dollar today is worth more than a dollar in one year. We call the difference in value between money today and money in the future the time value of money. 67J. Cologni – Financial Markets for Corporate and Retail Clients

Interest rates: the rate at which we can exchange money today for money in the future is determined by the current interest rate.

Suppose the current annual interest rate is 7%. We put money in the bank. By investing or borrowing at this rate,

Present vs future value: if we convert from dollars today to dollars in one year, we obtain (- $1.870 today) * 1.07 = - $2.000 in one year

The two results are equivalent but expressed as values at different points in time.

When we express the value in terms of dollars today, we call it the present value (PV) of the investment. If we express it in terms of dollars in the future, we call it the future value (FV) of the investment.

Discount factors and rate:

It's the price today for $1 in one year. The amount 1/(1+r) is called the one-year discount factor. The risk-free rate is also referred to as the discount rate for a risk-free investment.

Exercise:

The cost of rebuilding the San Francisco Bay Bridge to make it earthquake-safe was approximately $3 billion in 2004. At the time, engineers estimated that if the project were delayed to 2005, the cost would rise by 10%. If the interest rate were 2%, what would be the cost of a delay in terms of dollars in

2004?If the project were delayed, it would cost: $3 billion × 1.10 = $3.3 billion in 2005To compare this amount to the cost of $3 billion in 2004, we must convert it using the interest rate of 2%:($3.3 billion in 2005) / (1.02) = $3.235 billion in 2004Therefore, the cost of a delay of one year was: $3.235 billion - $3 billion = $235 million in 2004Delaying the project for one year was equivalent to giving up $235 million in cash.

ExerciseThe cost of replacing a fleet of company trucks with more energy efficient vehicles was €100 million in2016. The cost is estimated to rise by 8.5% in 2017. If the interest rate is 4%, what is the cost of a delay interms of euros in 2017?If the project were delayed, its cost in 2017 will be: €100 million × (1.085) = €108.5 million.68J. Cologni – Financial Markets for Corporate and Retail ClientsCompare this amount to the cost of $100 million in 2016 using the interest rate of 4%: €108.5 million /(1.04) =

€104.33 million in 2016 euros.

The cost of a delay of one year would be: $104.33 million − $100 million = $4.33 million in 2016 euros.

Net present value: the NPV of a project or investment is the difference between the present value of its benefits and the present value of its costs.

NPV = PV (Benefits) – PV (Costs)

NPV = PV (All project cash flows)

Example

Suppose your firm is offered the following investment opportunity: In exchange for $500 today, you will receive $550 in one year with certainty. If the risk-free interest rate is 8% per year then:

PV (benefit) = 550 / 1.08 = 509,26 today; the PV is the amount we need to put in the bank today to generate $550 in one year; in other words, the PV is the amount you need to invest at the current interest rate to recreate the cash flow.

NPV = 509,26 – 500 = 9,26 today.

The NPV decision rule: When making an investment decision, take the alternative with the highest NPV. Choosing this alternative is equivalent to receiving its NPV.

In cash today, accepting or rejecting a project? We reject a project with NPV = 0 (there are no new costs or benefits from not doing the project); we should accept a project with positive NPV because accepting them is equivalent to receiving their NPV in cash today, and we should reject those projects with negative NPV, because accepting them would reduce the wealth of investors.

Exercise: A firm needs to buy a new $9.500 copier. The manufacturer has offered to let the firm pay $10.000 in one year, rather than pay cash today. Suppose the risk-free interest rate is 7% per year. Is this offer a good deal? Show that its NPV represents cash in your pocket.

Benefit: won't have to pay $9.500 today; cost: $10.000 in one year

PV (cost) = 10.000 / 1.07 = $9.345,79

NPV = 9.500 - 9.345,79 = 154,21

The investment is good because NPV > 0. It is equivalent to getting a cash discount today of $154,21 and only paying $9345,79 today for the copier.