Page 107 - DCOM504_SECURITY_ANALYSIS_AND_PORTFOLIO_MANAGEMENT

Security Analysis and Portfolio Management

Notes 4. The shares bought back should be extinguished and physically destroyed;
5. The company should not make any further issue of securities within 2 years, except bonus,
conversion of warrants, etc.
These restrictions were imposed to restrict the companies from using the stock markets as short
term money provider apart from protecting interests of small investors.

3.6.3 Finding the Feasibility of the Buyback

Take a firm that is 100% equity financed in an environment in which T is not equal to zero; i.e.,
there is a net tax advantage to debt. If the firm decides to issue debt and buyback shares, the
levered value of the firm then is
V = V + T(debt)
L U
The number of shares that could be repurchased then is:
n = (debt)/(price per share after relevering)

where the price per share after relevering is:
V /(original number of outstanding shares)
L
The buyback will lower the firm’s WACC.

3.7 Project Valuation

In general, each project’s value will be estimated using a discounted cash flow (DCF) valuation,
and the opportunity with the highest value, as measured by the resultant net present value
(NPV) will be selected. This requires estimating the size and timing of all of the incremental
cash flows resulting from the project. These future cash flows are then discounted to determine
their present value. These present values are then summed, and this sum net of the initial
investment outlay is the NPV.
The NPV is greatly affected by the discount rate. Thus identifying the proper discount rate—the
project “hurdle rate”—is critical to making the right decision. The hurdle rate is the minimum
acceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate
should reflect the riskiness of the investment, typically measured by volatility of cash flows,
and must take into account the financing mix. Managers use models such as the CAPM or the
APT to estimate a discount rate appropriate for a particular project, and use the weighted average
cost of capital (WACC) to reflect the financing mix selected.

!

Caution A common error in choosing a discount rate for a project is to apply a WACC that
applies to the entire firm. Such an approach may not be appropriate where the risk of a
particular project differs markedly from that of the firm’s existing portfolio of assets.

In conjunction with NPV, there are several other measures used as (secondary) selection criteria
in corporate finance. These are visible from the DCF and include discounted payback period,
IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI; see list of valuation topics.
The NPV of a capital investment made by a firm, assuming that the investment results in an
annual free cash flow P received at the end of each year beginning with the first year, and
assuming that the asset is financed using current debt/equity ratios, is equal to:
NPV = –P + P/WACC
0

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