BFW1001 Foundations of Finance

Lecture 4
Capital Budgeting and Money Market
Prof. Keshab Shrestha
[email protected]

April 8, 2020 (Wednesday) : Updated April 7, 2020

Contents
1 Capital Budgeting 2

2 Money Market Instruments 5

1
 BFW1001 Foundations of Finance Lec. 4

In this lecture, we discuss two different topics: (i) Capital Budgeting and (ii)
Money Market Instruments.

1. Capital Budgeting
Capital budgeting is a complicated process that involves estimating cash inflows,
outflows and cost-of-capital. However, here we will discuss the main idea as an
application of valuation were the expected cash flows and cost-of-capital are assumed
to be given.

• Capital budgeting is the process by which organizations determine whether their

long-term physical investments, instead of financial investments, are worth pur-
suing. Example of these physical investment includes purchasing new machin-
ery, replacing old machinery and starting new plants or new products (Creative
Destruction - innovation that creates new product but destroys the existing
ones).1

– The main question is “Do these capital investments create value for the
firm?”
– Bare existence of a firm has to do with their historical ability of finding
capital investment projects that create value.
– A Pharmaceutical company has to decide if the R&D (Research and De-
velopment) investment in finding a cure for a particular disease adds value
to the firm.
– Is it worth the time and money invested in getting a Bachelor’s degree
from Monash University - ’worth’ here means getting more in return than
the cost?

• The main objective of capital budgeting decisions is to select investments in real

assets that will increase the value of the company.

• Capital budgeting decisions cannot be taken lightly because these investments

– involve large cash outlays

– create value when the cash flows they generate are worth more than they
cost.
1
Steven Sasson while working for Eastman Kodak Company (founded in September 4, 1888)
developed prototype of the first digital camera in 1975. In 1989, Sasson and Robert Hills made the
first DSLR (Digital Single Lens Reflex) camera. But, Kodak did not sell the camera for fear it would
cannibalize film sales. However, it made billions from the digital camera patent until the patent ran
out in 2007. Kodak filed for bankruptcy in 2012.
France’s competition and fraud watchdog fined Apple 25 million euros for deliverately slowing
down older iPhone without making it clear to consumers (BBC News, February 7, 2020).

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BFW1001 Foundations of Finance Lec. 4

– once made, these investments are not easily reversed.

– Malaysian Government had to decide if it was worth to build the North-
South Expressway (480 miles) - thinking started in 1977, the construction
started in 1981 and completed in 1994 (Wikipedia).

A capital investment is associated with a series of expected cash flows. Normally,

the initial expected cash flow is negative (representing cash outflow) followed by pos-
itive expected cash flows (representing cash inflows). Let Ct represent the expected
cash flow due in year t, where the capital investment project lasts n years.

C0 C1 C2 C3 ... Cn

0 1 2 3 ... n

Figure 1: Cash Flows associated with an Investment Project.

The cash flows are shown in Figure 1. Given the cost-of-capital of the project (k),
the financial value today of the project is given by:
C0 C1 C2 Cn
V0 = 0 + 1 + 2 + ··· +
(1 + k) (1 + k) (1 + k) (1 + k)n

Since anything, other than zero, to the power zero is one. Therefore, above
valuation formula can be written as
C1 C2 Cn
V 0 = C0 + 1 + 2 + ··· +
(1 + k) (1 + k) (1 + k)n

Note the following:

• Here use used the same (multiple cash flows) valuation principle used for the
valuation of financial security.

– Therefore, it does not matter whether the expected cash flows are generated
from financial investments in financial securities or physical investment.

• The cash flows are so called net cash flows used in the capital budgeting context.

– In any year, there are cash inflows and outflows.

– We only care about the net cash flows - cash inflows minus cash outflows.

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BFW1001 Foundations of Finance Lec. 4

– Here, we simply refer to them as cash flows.

– Even though, the cash inflows and outflows occur through out the year,
we assume that they occur at the end of the year.
• In capital budgeting context, the value V0 of the project is also kwon as net
present value, (NPV), of the project.
• The main decision here is whether to “accept’ or “reject” the project. The
proper decision process is as follows:
– “Accept the project” if V0 or NPV is positive. It will increase the value of
the firm by V0 .
– “Reject” it if V0 is negative.
– If V0 = 0, accepting the project does not add any value to the firm.
Example 1: You are a start-up company and have an idea for an investment
project that uses a recently developed AI (Artificial Intelligent) technology that will
cost RM10 million today. It is expected to generate RM3 and RM5 million in year 1
and year 2 respectively. In three years, you expect to sell the project to your com-
petitor, which happens to be a well established company that uses older technology,
at RM10 million.
i. If the cost-of-capital is 10% and there are no other cash flows associated with
the project, what is the value of your idea? Should you invest in your idea?
ii. Suppose that the Government is thinking about subsidizing the investments
that use AI by guaranteeing the loans to stimulate the adaption of AI as part of
Industry 4.0 Master Plan. If the Government implements the subsidy strategy,
it will reduce your cost of capital by 1% to 9%. It has no effect on the cash flows.
What is the value of the project if the Government implements the strategy?
Solution: The value of the idea is RM4.3727 million as shown below
3 5 10
V0 = −10 + 1 + 2 + = +4.3727
(1 + 0.1) (1 + 0.1) (1 + 0.1)3
| {z } | {z } | {z }
2.7273 4.1322 7.5131
Since the value is positive, you should invest on your idea.
If the Government implements the Master Plan, the value of the idea will go up
to RM4.6825 million as shown below:
3 5 10
V0 = −10 + 1 + 2 + = +4.6825
(1.09) (1.09) (1.09)3
| {z } | {z } | {z }
2.7523 4.2084 7.7218

The value of your idea will increase by RM309,876.2. How much are you willing
to spend on lobbying the Government?

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2. Money Market Instruments

Money market instruments or securities have original maturities of one year or less.
For example, a $100,000 face value 90-day Treasury bills matures in 90 days which
is less than one year. This security will pay $100,000 in 90 days and there are no
other cash flows associated with this security. After the payment of $100,000 in
90 days, the security will cease to exist. The maturity of this security is 90 days.
These instruments use special quoting conventions - the prices are quoted in terms of
discount yields intead of actual prices.
For example Treasury bills and commercial papers are quoted on the discount
yields basis. This is similar to the discount posted in department stores.
For example, a 30% discount means, whatever the original price, you pay 30%
less. Let the discount be denoted by D. If the original price is Por , the actual price
you pay P0 is given by

P0 = Por (1 − D) (1)
Similarly, when you purchase Treasury bills or Commercial papers, you will receive
(from the issuer which is the US Government) an amount equal to the face value (F )
of the instrument on the maturity day of the instrument. The price with discount D
should be given by

P0 = F (1 − D) (2)
Instead of quoting the actual discount D, it is annualized by multiplying it by the
number of maturities in the year (similar to m in the nominal interest rate). However,
it is assumed that there are 360 days in a year, regardless of the actual number of
days in that particular year. Let h denote maturity (i.e., the number of days until
maturity) of the instrument. The annualized discount is called the discount yield
(idy ) and is given by

360
idy = D × (3)
h
Note that in the definition of discount yield, it is assumed that the number of
days in a year to be 360 for calculation purposes. Money market instruments like
Treasury bills and Commercial papers are quoted using the discount yield, idy . Given
the quoted discount yield idy , you compute the price (P0 ) today as follows:

 
h 
P0 = F 1 − idy × (4)

| {z360}

D

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In order to be able to compare the rate of return we earn on different money market
instruments with different maturities, we can compare the equivalent effective
annual Yield or Return (rA ) which can be computed as follows:

rA = (1 + R)m − 1 (5)

where
F − P0
return = R = (2, Lec.3)
P0
and
365
m= .
h
Note that in the computation of equivalent effective annual return (RA ), we used
365 days in a year.
We also ignore the uncertainty associated the payment (F ) in the definition of
the return. This is because the assumption that the U.S. Treasury has zero default
risk - it will pay what it promises. Also, the maturity being less than or equal to one
year means very low cash flow risk.
Example 2: Consider a $2 million face value 90-day commercial paper which is
quoted to have a discount yield of 2%. Compute the price of the commercial paper
and the equivalent effective annual rate of return.
Answer
Using equation (4)
 
 
h  90
P0 = F 1 − idy ×  = 2m 1 − 0.02 × = 1.99m

| {z360} 360
D

90-day return is given by (one period return with length of the period equal to 90
days)
F − P0 2.0 − 1.99
R= = = 0.005025
P0 1.99
Therefore, the equvalent effective annual rate of return is given by
365
rA = (1 + 0.005025) 90 − 1 = 0.020537 = 2.0537%

Prof. Keshab Shrestha 6