MBA6002 Financial Management · Dr. Takor Ronald · Topic 2: Valuation & Investment · Benninga Ch.

4–6 · All values in

FCFA

TOPIC 2 | PART 2: INVESTMENT & VALUATION

Valuation & Investment

MBA6002 · Dr. Takor Ronald · Benninga Ch. 4–6 · All values in FCFA · 1 USD = 600
FCFA

HOW THIS TOPIC FITS IN MBA6002

Topic 2 is the engine room of Part 2 (Investment & Valuation). Everything from Topic 1 —
present value, time value of money, risk-return — is now applied to the two most important
investable assets in finance: BONDS and STOCKS.

Dr. Takor: 'Once we understand the VALUE of an investment, it is easy to make the
decision to invest in it. There are many different techniques that finance people use to
calculate the value of projects. These techniques help us to have the valuation of these
projects, then it becomes easier to make decisions.'

Principles most active: P1 (Time Value of Money), P2 (Law of One Price), P5 (Market Price
Is Best Estimate)
Benninga reference: Chapters 4 (Bond Valuation), 5 (Stock Valuation), 6 (Alternative
Investment Rules)
Assessment connection: Bond and stock valuation calculations appear in CATs and are
foundational to the cohort valuation defence in the final exam.

LEARNING OUTCOMES
1. Define a bond and identify all its components: face value, coupon rate, maturity, yield.
2. Calculate bond price using the present value of future cash flows formula.
3. Calculate yield to maturity (YTM) and interpret what it means for an investor.
4. Explain the inverse relationship between bond prices and interest rates.
5. Define a share (stock) and explain the two sources of return: dividends and capital
gains.
6. Apply the Dividend Discount Model (DDM) including the Gordon Growth Model to value
shares.
7. Apply alternative investment decision rules: NPV, IRR, Payback Period, and Profitability
Index.
8. Identify when different investment rules give conflicting signals and explain which to
trust.
9. Connect all valuation concepts to the cohort's own financial instruments and investment
decisions.

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SESSION 1: Bond Valuation — Pricing Debt Securities

2.1 What Is a Bond? Building Intuition First
Dr. Takor: "How are you going to raise money for your cohort? Would you get money
personally? Would you borrow? Are you going to get money from shares? Are you
going to get money from bonds? Is there any kind of other financial instrument that you
can put together locally to get this money? What even is a financial instrument? These
are all the things we are going to be learning about."
Context: Dr. Takor explicitly connects bond and share valuation to cohort fundraising.
Understanding these instruments is not academic — it is directly applicable to your cohort's
capital-raising activities.

A bond is a debt instrument — a formal, legally binding agreement in which a borrower (the
ISSUER) promises to pay a lender (the BONDHOLDER) a series of fixed interest payments (called
coupons) plus the repayment of the original borrowed amount (the FACE VALUE or PAR VALUE)
at a specified future date (the MATURITY DATE).
Think of a bond as a formalised loan with a document attached. When the government of
Cameroon issues Treasury bonds through the BEAC, or when a company like MTN Cameroon
issues corporate bonds on the DSX, they are essentially borrowing money from investors and
promising to repay it with interest over time. The bond document specifies exactly how much
interest will be paid, when, and when the principal will be returned.
TERM DEFINITION
Face Value (Par Value) The amount the issuer promises to repay at maturity. Typically
FCFA 10,000 or FCFA 100,000 per bond in CEMAC markets.
This is the 'principal' of the loan.
Coupon Rate The annual interest rate stated on the bond, expressed as a
percentage of face value. A 10% coupon rate on a FCFA
100,000 bond pays FCFA 10,000 per year in interest.
Coupon Payment The actual FCFA amount paid periodically (usually annually or
semi-annually). Coupon = Face Value × Coupon Rate. Fixed
throughout the bond's life.
Maturity Date The date on which the issuer repays the face value to the
bondholder. Bonds can have short maturities (1-3 years, called
notes) or long maturities (10-30+ years).
Yield to Maturity (YTM) The actual annual return an investor earns if they buy the bond
today at the current market price and hold it until maturity. This is
the bond's 'true' interest rate — it may differ from the coupon
rate.
Current Price What the bond trades for in the market right now. May be above
face value (trading at a premium), below face value (at a
discount), or exactly at face value (at par).
Bond Issuer The borrower — government (sovereign bonds), parastatal
bodies, or corporations. In CEMAC: Cameroon government

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bonds are the most common, plus BEAC securities.

2.2 The Bond Valuation Formula

PRINCIPLE 1: Time Value of Money — Discounting Future Cash Flows
Valuing a bond is a direct application of Principle 1 (Time Value of Money). A bond generates
future cash flows — coupon payments each period and the face value at maturity. To find the
bond's present value (its fair price), we discount all these future cash flows back to today using the
yield to maturity as the discount rate.

The Bond Valuation Formula

Bond Price = Σ [ Coupon / (1 + YTM)^t ] + Face Value / (1 + YTM)^n

Where:
Coupon = Annual coupon payment (FCFA) = Face Value × Coupon Rate
YTM = Yield to Maturity (the required return / discount rate)
t = Each individual period (year 1, 2, 3...)
n = Total number of periods until maturity
Face Value = Par value repaid at maturity

Expanded for an n-year bond:

Price = C/(1+r)¹ + C/(1+r)² + C/(1+r)³ + ... + C/(1+r)ⁿ + FV/(1+r)ⁿ

Simplified using the annuity formula:

Price = C × [1 - (1+r)^(-n)] / r + FV / (1+r)^n

In Excel (Benninga Ch.4): =PV(YTM, n, -Coupon, -FaceValue) or =PRICE(settlement,

maturity, rate, yld, redemption, frequency)

Notice what this formula is doing: it is adding up the present value of every single coupon payment
plus the present value of the face value payment at maturity. Every future cash flow is discounted
back to today. This is pure Principle 1 in action.

WORKED EXAMPLE: Bond Valuation — Government of Cameroon Treasury

Bond
A Cameroonian investor is considering buying a BEAC Treasury bond with the following
characteristics:
Face Value: FCFA 100,000
Coupon Rate: 8.5% per year (annual payments)
Maturity: 5 years
Yield to Maturity (market rate): 10%

STEP 1: Calculate annual coupon payment

Coupon = Face Value × Coupon Rate = FCFA 100,000 × 8.5% = FCFA 8,500 per year

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STEP 2: List all cash flows

Year 1: FCFA 8,500 (coupon)
Year 2: FCFA 8,500 (coupon)
Year 3: FCFA 8,500 (coupon)
Year 4: FCFA 8,500 (coupon)
Year 5: FCFA 8,500 (coupon) + FCFA 100,000 (face value) = FCFA 108,500

STEP 3: Discount each cash flow at YTM = 10%

PV(Year 1) = 8,500 / (1.10)¹ = 8,500 / 1.1000 = FCFA 7,727.27
PV(Year 2) = 8,500 / (1.10)² = 8,500 / 1.2100 = FCFA 7,024.79
PV(Year 3) = 8,500 / (1.10)³ = 8,500 / 1.3310 = FCFA 6,386.17
PV(Year 4) = 8,500 / (1.10)⁴ = 8,500 / 1.4641 = FCFA 5,805.61
PV(Year 5) = 108,500 / (1.10)⁵ = 108,500 / 1.6105 = FCFA 67,369.56

STEP 4: Sum all present values

Bond Price = 7,727.27 + 7,024.79 + 6,386.17 + 5,805.61 + 67,369.56
= FCFA 94,313.40

INTERPRETATION:
The bond is priced BELOW its face value of FCFA 100,000 — it trades at a DISCOUNT.
WHY? Because the coupon rate (8.5%) is LOWER than the market yield (10%).
Investors demand 10% on the market, but this bond only pays 8.5% coupon.
So they will only buy it at a price low enough that the total return (coupons + capital gain
from price rising to FCFA 100,000 at maturity) equals the required 10%.

In Excel: =PV(10%, 5, -8500, -100000) = FCFA 94,313.40 ✓

2.3 The Critical Relationship: Bond Prices and Interest Rates

PRINCIPLE 1+2: Time Value + Law of One Price — The Price-Yield Inverse Relationship
This is one of the most important and most frequently examined concepts in bond valuation. Bond
prices and interest rates (yields) move in OPPOSITE directions. When yields go up, prices go
down. When yields go down, prices go up. Understanding WHY this is true — not just that it is true
— is the hallmark of financial understanding.

Why Prices and Yields Move in Opposite Directions

Imagine you hold a bond paying FCFA 8,500 per year on a FCFA 100,000 face value (8.5%
coupon).
Now interest rates in the market rise to 12%.

A NEW bond issued today pays FCFA 12,000 per year on FCFA 100,000 (12% coupon).
Why would anyone buy YOUR old 8.5% bond at face value when they can buy a new 12%

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bond at face value?

They will NOT — unless your old bond is CHEAPER than face value.
The price of your old bond must FALL until its total return (coupons + capital gain to face
value) = 12%.

The reverse: if rates fall to 6%, your 8.5% bond is now BETTER than new 6% bonds.
Investors will PAY MORE than face value for your bond — its price RISES.

RULE: Coupon Rate > YTM → Bond trades at PREMIUM (price > face value)
Coupon Rate = YTM → Bond trades at PAR (price = face value)
Coupon Rate < YTM → Bond trades at DISCOUNT (price < face value)

WORKED EXAMPLE: Price-Yield Relationship — Same Bond, Three Scenarios

(FCFA)
Bond: FCFA 100,000 face value, 8.5% coupon, 5-year maturity

Scenario 1: YTM = 8.5% (coupon rate = market rate)

Price = PV of coupons + PV of face value = FCFA 100,000 exactly (AT PAR)
Excel: =PV(8.5%, 5, -8500, -100000) = FCFA 100,000

Scenario 2: YTM = 10% (market rate ABOVE coupon)

Price = FCFA 94,313 (DISCOUNT — bond worth less than face value)
As calculated above. Bond is cheap to compensate for below-market coupon.

Scenario 3: YTM = 6% (market rate BELOW coupon)

Price = PV(6%, 5, -8500, -100000)
= 8,500/1.06 + 8,500/1.06² + 8,500/1.06³ + 8,500/1.06⁴ + 108,500/1.06⁵
= 8,018.87 + 7,565.91 + 7,137.65 + 6,733.63 + 81,086.17
= FCFA 110,542 (PREMIUM — bond worth MORE than face value)
Excel: =PV(6%, 5, -8500, -100000) = FCFA 110,542 ✓

SUMMARY TABLE:
YTM 6% → Price FCFA 110,542 → PREMIUM (price > face value)
YTM 8.5% → Price FCFA 100,000 → AT PAR (price = face value)
YTM 10% → Price FCFA 94,313 → DISCOUNT (price < face value)

2.4 Calculating Yield to Maturity (YTM)

Often in practice, you know the bond's current market price and need to find the yield — the actual
return the bond offers. This is the reverse of the pricing problem. YTM is the discount rate that
makes the present value of all future cash flows equal to the current market price.

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YTM cannot be solved algebraically for bonds with more than two periods — it requires either trial
and error, financial calculator, or Excel's RATE or IRR function. This is one of the reasons
Benninga built his finance course around Excel.

WORKED EXAMPLE: Finding YTM — A BEAC Bond (FCFA)

A BEAC government bond has the following market data:
Current market price: FCFA 96,500
Face value: FCFA 100,000
Annual coupon payment: FCFA 9,000 (coupon rate = 9%)
Years to maturity: 4 years

QUESTION: What is the YTM (the actual return this bond offers at its current price)?

SET UP: We need to find r such that:

96,500 = 9,000/(1+r)¹ + 9,000/(1+r)² + 9,000/(1+r)³ + 109,000/(1+r)⁴

Excel method (Benninga's approach):

Set up cash flows in a column: Year 0 = -96,500 (you pay this); Years 1-3 = +9,000; Year
4 = +109,000
Use: =IRR(cashflow_range) → gives YTM directly
OR: =RATE(4, 9000, -96500, 100000) → gives YTM = 10.17%

VERIFICATION (confirming YTM = 10.17%):

Price = 9,000/1.1017 + 9,000/1.1017² + 9,000/1.1017³ + 109,000/1.1017⁴
= 8,168 + 7,413 + 6,729 + 74,190 = FCFA 96,500 ✓

INTERPRETATION:
This bond trades at a DISCOUNT (FCFA 96,500 < FCFA 100,000 face value)
because YTM (10.17%) > Coupon Rate (9%).
An investor buying this bond today at FCFA 96,500 earns exactly 10.17% per year
(including both the annual FCFA 9,000 coupons AND the FCFA 3,500 capital gain
when the bond matures at FCFA 100,000).

EXAM TIP: Bond valuation questions appear in almost every financial management
exam. The most important things to demonstrate: (1) set up the cash flow stream
correctly; (2) apply the correct discount rate (YTM); (3) explain the
premium/discount/par relationship using the coupon rate vs. YTM comparison; (4)
connect to Principle 1 (TVM) and Principle 2 (Law of One Price — equivalent bonds
must yield the same rate). Always show your working — the methodology earns marks
even if you make an arithmetic error.

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SESSION 2: Stock Valuation — Pricing Equity Securities

2.5 What Is a Share? Equity vs. Debt
A share (or stock) represents a unit of ownership in a company. When you buy a share of MTN
Cameroon on the Douala Stock Exchange, you become a part-owner of that company — entitled
to a proportional share of its profits (as dividends) and its assets (if the company is liquidated).
Unlike bonds, shares have no maturity date and no guaranteed return.
DIMENSION BOND (DEBT) SHARE (EQUITY)
Nature Loan to the company Ownership stake in the company
Return Fixed coupon payments Variable dividends + capital gains
Maturity Fixed date — principal repaid No maturity — company
continues indefinitely
Priority in liquidation Paid BEFORE shareholders Paid LAST — residual claimants
Risk Lower — promised payments Higher — residual, uncertain
returns
Upside Capped — only receive promised Unlimited — profits grow, share
coupon price rises
Voting rights None typically Yes — shareholders vote on
company decisions
CEMAC example BEAC T-bills, government bonds, MTN Cameroon shares, SEMC
corporate bonds on DSX shares on DSX

The Two Sources of Shareholder Return

• Dividends: Cash payments made to shareholders from the company's profits. Not
guaranteed — the board decides whether to pay dividends and how much. Some high-
growth companies pay zero dividends (reinvesting all profits for growth). Others, especially
mature stable companies, pay consistent high dividends.
• Capital gains: The increase in the share price over time. If you buy a share at FCFA 12,000
and sell it later at FCFA 18,000, you earn a capital gain of FCFA 6,000. Capital gains are
the primary return driver for growth stocks.

2.6 The Dividend Discount Model (DDM)

PRINCIPLE 1: Time Value of Money — Discounting Expected Future Dividends
The Dividend Discount Model (DDM) values a share as the present value of all expected future
dividend payments. This is mathematically identical to bond valuation — we are discounting a
stream of future cash flows — except that dividends are: (a) not fixed; (b) potentially infinite; and
(c) uncertain. These differences make stock valuation more complex and more assumption-
dependent than bond valuation.

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The General DDM Formula

Share Price (P₀) = D₁/(1+r)¹ + D₂/(1+r)² + D₃/(1+r)³ + ... + D∞/(1+r)∞

Where:
P₀ = Current fair value of the share (today's price)
Dₜ = Expected dividend in year t
r = Required return on equity (the appropriate discount rate for this company's risk)

Problem: This requires forecasting dividends infinitely far into the future.
Solution: Make assumptions about the GROWTH RATE of dividends.

Three scenarios:
1. Zero growth: dividends are constant forever → simplified to perpetuity formula
2. Constant growth: dividends grow at a constant rate g forever → Gordon Growth Model
3. Multi-stage: different growth rates in different periods → extended DDM

Case 1: Zero Growth (Perpetuity)

If a company is expected to pay the same dividend forever (zero growth), the share is valued as a
perpetuity — an infinite stream of equal cash flows.

Zero Growth DDM — Perpetuity Formula

P₀ = D / r

Where: D = constant annual dividend; r = required return on equity

Example: AgroBank Cameroun pays a constant dividend of FCFA 2,400 per share per
year.
Investors require a 12% return on this stock.
P₀ = 2,400 / 0.12 = FCFA 20,000 per share

Interpretation: At a required return of 12%, FCFA 2,400/year forever is worth FCFA 20,000
today.
If AgroBank shares are trading below FCFA 20,000 on the DSX, they are UNDERVALUED
— buy signal.
If they are trading above FCFA 20,000, they are OVERVALUED — sell or avoid.

Case 2: Constant Growth — The Gordon Growth Model (GGM)

PRINCIPLE 1+5: TVM + Market Price — The Most Important Stock Valuation Model
The Gordon Growth Model (GGM) is the most widely used stock valuation model in practice. It
assumes that dividends grow at a constant annual rate g forever. This is more realistic than zero
growth for established, growing companies.

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The Gordon Growth Model

P₀ = D₁ / (r - g)

Where:
P₀ = Current fair value of the share
D₁ = Next year's expected dividend = D₀ × (1 + g)
r = Required return on equity (cost of equity)
g = Constant annual dividend growth rate
Condition: r > g (required — if g ≥ r, the formula gives infinite/negative value)

Key relationships from the GGM:

→ Higher expected dividend (D₁) → HIGHER share price
→ Higher growth rate (g) → HIGHER share price
→ Higher required return (r) → LOWER share price (more risk = lower value)
→ r - g is the 'capitalisation rate' — the wider it is, the less the share is worth

In Excel (Benninga approach): =D1/(r-g) — a simple formula, but the inputs require
judgment

WORKED EXAMPLE: Gordon Growth Model — MTN Cameroon Style Example

(FCFA)
A telecommunications company listed on the DSX has the following data:
Most recent dividend paid (D₀): FCFA 1,500 per share
Expected constant growth rate (g): 5% per year
Required return on equity (r): 13% per year

STEP 1: Calculate next year's expected dividend

D₁ = D₀ × (1 + g) = FCFA 1,500 × 1.05 = FCFA 1,575

STEP 2: Apply GGM formula

P₀ = D₁ / (r - g) = 1,575 / (0.13 - 0.05) = 1,575 / 0.08 = FCFA 19,688

STEP 3: Compare to current market price

Assume the stock is trading at FCFA 22,000 on the DSX.
Our model value: FCFA 19,688
Market price: FCFA 22,000
Conclusion: The stock appears OVERVALUED relative to our model.
The market is either: (a) expecting higher growth than 5%; or (b) accepting a lower
required return than 13%; or (c) our model assumptions need revisiting.

SENSITIVITY ANALYSIS — what if growth is 7% instead of 5%?

D₁ = 1,500 × 1.07 = FCFA 1,605

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P₀ = 1,605 / (0.13 - 0.07) = 1,605 / 0.06 = FCFA 26,750

At 7% growth, the stock at FCFA 22,000 is actually UNDERVALUED!

KEY LESSON: GGM results are highly sensitive to the growth rate assumption.
Small changes in g dramatically change the estimated price. This is Principle 4
(No Complete Model) in action — the model is only as good as its assumptions.

Case 3: Multi-Stage Growth Model

Many companies go through distinct growth phases: high growth initially (perhaps when a new
product launches or a new market is entered), then moderate growth, then stable mature growth.
The multi-stage DDM handles this by discounting dividends explicitly in each phase, then applying
the GGM from the stable growth phase onwards.

WORKED EXAMPLE: Multi-Stage DDM — Growing Logistics Company (FCFA)

TransCargo Cameroun goes public on the DSX. Financial analysis suggests:
Phase 1 (Years 1-3): High growth — dividends grow at 20% per year
Phase 2 (Years 4+): Stable growth — dividends grow at 6% forever
Most recent dividend (D₀): FCFA 800 per share
Required return (r): 15%

STEP 1: Calculate Phase 1 dividends (high growth at 20%)

D₁ = 800 × 1.20 = FCFA 960
D₂ = 960 × 1.20 = FCFA 1,152
D₃ = 1,152 × 1.20 = FCFA 1,382.40

STEP 2: Calculate the terminal value at end of Year 3 (start of stable phase)
D₄ = D₃ × (1 + g_stable) = 1,382.40 × 1.06 = FCFA 1,465.34
Terminal Value (P₃) = D₄ / (r - g_stable) = 1,465.34 / (0.15 - 0.06)
= 1,465.34 / 0.09 = FCFA 16,281.60

STEP 3: Discount ALL cash flows back to today at r = 15%

PV(D₁) = 960 / 1.15¹ = FCFA 834.78
PV(D₂) = 1,152 / 1.15² = FCFA 871.46
PV(D₃) = 1,382.40 / 1.15³ = FCFA 909.23
PV(P₃) = 16,281.60 / 1.15³ = FCFA 10,706.09

STEP 4: Sum to get current fair value

P₀ = 834.78 + 871.46 + 909.23 + 10,706.09 = FCFA 13,321.56

INTERPRETATION:
The intrinsic value of TransCargo shares is approximately FCFA 13,322.
Notice: FCFA 10,706 (80%) of the total value comes from the terminal value (stable
phase).

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This is typical — most of a growth company's value lies in its long-term stable cash flows.
This makes the growth rate assumption (g = 6% stable) the MOST CRITICAL input.

EXAM TIP: Multi-stage DDM questions are a favourite in final examinations because
they test: (1) ability to calculate dividends growing at different rates; (2) ability to
calculate terminal value using GGM; (3) ability to discount correctly across periods.
Practice setting up the cash flow table systematically — one row per year. In the exam,
show each calculation step separately; partial marks are awarded at each step.

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SESSION 3: Alternative Investment Rules — Beyond NPV

2.7 The Investment Decision Framework
Dr. Takor: "When we understand the value of a project, it is easy to make the decision
to invest in this project. There are many different techniques that finance people use to
understand the value of projects, to calculate the value of projects."
Context: Dr. Takor identifies investment valuation as central to the entire course — every
technique we study is a tool for answering the investment decision question: should we
invest?

The investment decision — whether to commit capital to a project, asset, or business — is the
most consequential decision in corporate finance. Several analytical tools exist to help make this
decision. They sometimes agree and sometimes conflict. Understanding when each is reliable —
and when to override it — is a critical financial management skill.

2.8 Net Present Value (NPV) — The Gold Standard

PRINCIPLE 1+7: TVM + Risk-Return — The Most Reliable Investment Rule
Net Present Value is the present value of all future cash inflows from an investment, minus the
initial investment cost. It directly operationalises Principle 1 (Time Value of Money) and
incorporates Principle 7 (Risk-Return Trade-off) through the discount rate. NPV is considered the
most reliable investment decision rule because it directly measures the amount of value the
investment creates for shareholders.

The NPV Formula and Decision Rule

NPV = -C₀ + C₁/(1+r)¹ + C₂/(1+r)² + ... + C ₙ/(1+r)ⁿ

Or equivalently:
NPV = Σ[ Cₜ / (1+r)^t ] for t = 0 to n

Where: C₀ = Initial investment (negative — it is a cash OUTFLOW)

Cₜ = Net cash flow in period t
r = Discount rate (= required return = cost of capital)
n = Project life

DECISION RULE:
NPV > 0: INVEST — the project creates value; accept it
NPV = 0: Indifferent — project just covers its cost of capital; break even
NPV < 0: DO NOT INVEST — the project destroys value; reject it

WHY NPV > 0 MEANS INVEST:

A positive NPV means: the present value of all future cash flows EXCEEDS the investment
cost.
The excess (the NPV itself) is the amount of shareholder wealth created in today's money.

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Example: NPV = FCFA 5,000,000 means the project makes shareholders FCFA 5M richer
in
present value terms — beyond just recovering the investment and its cost of capital.

In Excel: =NPV(rate, cashflows_year1_to_n) + initial_investment

or: =NPV(rate, cashflows_year1_to_n) - |C₀| [initial investment is not discounted — it
happens now]

WORKED EXAMPLE: NPV — TransCargo Cameroun Truck Investment (FCFA)

TransCargo Cameroun is considering buying 15 new trucks for FCFA 1,200,000,000.
Expected net cash flows over 8 years: FCFA 280,000,000 per year (after operating costs
and tax).
Salvage value of trucks at end of year 8: FCFA 120,000,000.
Cost of capital (required return): 12%

STEP 1: Set up cash flows

Year 0: -FCFA 1,200,000,000 (initial investment — negative)
Years 1-8: +FCFA 280,000,000 per year (annual operating cash flows)
Year 8 (additional): +FCFA 120,000,000 (salvage value — added to Year 8 total)
Year 8 total: +FCFA 400,000,000

STEP 2: Calculate PV of annual cash flows (Years 1-7)

These are an annuity of FCFA 280,000,000 for 7 years at 12%:
PV = 280,000,000 × [1 - (1.12)^(-7)] / 0.12
= 280,000,000 × [1 - 0.4523] / 0.12
= 280,000,000 × 4.5638
= FCFA 1,277,864,000

STEP 3: Calculate PV of Year 8 total cash flow

PV(Year 8) = 400,000,000 / (1.12)^8 = 400,000,000 / 2.4760
= FCFA 161,550,000

STEP 4: Calculate NPV

NPV = -1,200,000,000 + 1,277,864,000 + 161,550,000
= -1,200,000,000 + 1,439,414,000
= +FCFA 239,414,000

DECISION: NPV > 0 → INVEST IN THE TRUCKS

Interpretation: This investment creates FCFA 239,414,000 (≈ FCFA 239 million) of
additional
shareholder wealth in present value terms, beyond recovering the cost and earning the
required 12%.

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In Excel: Place -1,200,000,000 in B1; 280,000,000 in B2:B8; 400,000,000 in B9

NPV = =NPV(12%, B2:B9) + B1 = FCFA 239,414,000 ✓

2.9 Internal Rate of Return (IRR)

The Internal Rate of Return is the discount rate at which the NPV of an investment equals exactly
zero. It is the 'break-even return' — the rate the investment actually earns. If the IRR exceeds the
required return (cost of capital), the investment creates value. If it falls below, the investment
destroys value.

IRR Definition and Decision Rule

IRR is the value of r that solves: 0 = -C₀ + C₁/(1+r)¹ + C₂/(1+r)² + ... + C ₙ/(1+r)ⁿ

IRR cannot be solved algebraically — requires Excel's IRR function or trial and error.

DECISION RULE:
IRR > Cost of Capital: INVEST (investment earns more than it costs)
IRR < Cost of Capital: DO NOT INVEST (investment earns less than it costs)
IRR = Cost of Capital: Indifferent (break even)

CONNECTION TO NPV:
When IRR > cost of capital → NPV > 0 (consistent — both say invest)
When IRR < cost of capital → NPV < 0 (consistent — both say reject)
The IRR is simply the discount rate at which the NPV crosses zero.

In Excel: =IRR(cashflow_range_including_initial_investment)
Benninga Ch.6: dedicated section on IRR calculation and interpretation

WORKED EXAMPLE: IRR — TransCargo Truck Investment (FCFA)

Using the same TransCargo data:
Year 0: -FCFA 1,200,000,000
Years 1-7: +FCFA 280,000,000 each
Year 8: +FCFA 400,000,000

In Excel: =IRR({-1200000000, 280000000, 280000000, 280000000, 280000000,

280000000, 280000000, 280000000, 400000000})
= approximately 21.4%

INTERPRETATION:
IRR = 21.4% > Cost of Capital = 12%
The trucks earn 21.4% per year — well above TransCargo's 12% required return.
DECISION: INVEST — consistent with NPV analysis above.

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IRR tells you the ACTUAL return on the investment (21.4%).

NPV tells you the VALUE CREATED in FCFA (FCFA 239M).
Both tools; one answer: invest in the trucks.

2.10 Payback Period

The payback period is the simplest investment decision tool — it asks: how many years does it
take to recover the initial investment from the project's cash flows? It is widely used in practice for
its simplicity and intuitive appeal, especially for quick screening of projects.

Payback Period — Formula and Decision Rule

Payback Period = Number of years until cumulative cash flows = Initial investment

For equal annual cash flows:

Payback = Initial Investment / Annual Cash Flow

DECISION RULE: Accept if Payback Period < Maximum acceptable payback (set by
management)

ADVANTAGES: Simple to calculate and understand; focuses on liquidity; good first screen

CRITICAL WEAKNESSES (connects to Principle 1 — TVM IGNORED):

1. Ignores the time value of money — FCFA received in Year 1 treated same as Year 4
2. Ignores all cash flows AFTER the payback period — may reject highly profitable
projects
3. Arbitrary cutoff — there is no theoretical basis for any specific payback threshold
4. Can lead to opposite decisions from NPV — wrong choice for long-term value creation

SOLUTION: Discounted Payback Period — same concept but discounts cash flows first.
Better than simple payback but still ignores cash flows after recovery. NPV remains
superior.

WORKED EXAMPLE: Payback Period — TransCargo (FCFA)

Initial investment: FCFA 1,200,000,000
Annual cash flows: FCFA 280,000,000

Payback Period = 1,200,000,000 / 280,000,000 = 4.29 years

If management's maximum acceptable payback = 5 years: ACCEPT (4.29 < 5)

If management's maximum acceptable payback = 4 years: REJECT (4.29 > 4)

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PROBLEM ILLUSTRATION:
Consider two projects:
Project A: Year 0: -FCFA 1,200M; Year 1-4: +FCFA 300M each = Payback 4 years
Year 5-8: +FCFA 50M each. NPV at 12% ≈ FCFA 311M
Project B: Year 0: -FCFA 1,200M; Year 1-4: +FCFA 300M each = Payback 4 years
Year 5-8: +FCFA 500M each. NPV at 12% ≈ FCFA 553M

Payback Period is IDENTICAL for both (4 years). But NPV reveals Project B creates
FCFA 242M MORE value. Payback completely ignores the superior Years 5-8 cash flows.
This is why NPV is the gold standard and payback is only a screening tool.

2.11 When Investment Rules Conflict — Which to Trust?

PRINCIPLE 4: No Complete Model — All Rules Have Limitations
NPV, IRR, and Payback can give conflicting signals, especially when comparing two mutually
exclusive projects (you can only choose one). Understanding when and why they conflict — and
which rule to trust — is a hallmark of financial sophistication.
RULE STRENGTHS WHEN IT FAILS DR. TAKOR'S
CONCLUSION
NPV Measures actual FCFA Cannot compare projects ALWAYS correct
value created; of vastly different scales for individual
incorporates TVM and without adjustment accept/reject
risk; always gives correct decisions. Use as
accept/reject decision primary rule.
IRR Easy to communicate Multiple IRRs possible Useful
('this project earns 21%'); with non-conventional SUPPLEMENT to
no need to specify cash flows; gives wrong NPV. If IRR and
discount rate to calculate ranking for mutually NPV conflict,
exclusive projects of follow NPV.
different scale/timing
Payback Simple; intuitive; focuses Ignores TVM; ignores Only use for quick
on liquidity risk post-payback cash flows; initial screening.
arbitrary cutoff Never use alone
for important
decisions.
Profitability Useful when capital is Does not measure Use when capital
Index rationed (limited budget absolute value created is limited and you
for many projects) need to rank
projects per FCFA
invested.

Dr. Takor: "Finance people are always struggling to understand how much risk is
involved. These techniques that we use to calculate the value of projects help us to

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have the valuation of these projects, then it becomes easier to make decisions."
Context: The key word is 'easier' — not automatic. Tools inform judgment; they do not
replace it. Principle 4 (No Complete Model) means every investment rule has limitations.
The skilled financial manager knows which tool to use when, and what each tool's blind
spots are.

Topic 2 Summary: Key Takeaways

• A bond is a debt instrument: the issuer pays periodic coupons plus face value at maturity.
Bond price = PV of all future cash flows discounted at YTM. In Excel: =PV(YTM, n, -
Coupon, -FaceValue).
• CRITICAL: Bond prices and yields move in OPPOSITE directions. Coupon Rate > YTM →
Premium price. Coupon Rate = YTM → Par price. Coupon Rate < YTM → Discount price.
This inverse relationship is Principles 1 and 2 operating together.
• YTM is the bond's true return — the discount rate that makes PV of all cash flows equal to
current market price. Calculated in Excel using =IRR() or =RATE() on cash flow stream.
• A share provides returns through dividends and capital gains. The DDM values shares as
the PV of all expected future dividends. Three forms: zero growth (perpetuity: P = D/r),
constant growth (Gordon Growth Model: P = D₁/(r-g)), and multi-stage growth.
• Gordon Growth Model is most widely used: P₀ = D₁/(r-g). Results are highly sensitive to the
growth rate g — small changes in g produce large changes in price. This is Principle 4 (No
Complete Model) in action.
• NPV is the gold standard investment rule: NPV = PV of inflows - PV of outflows. NPV > 0
means invest. NPV measures FCFA value created for shareholders. It is always correct for
accept/reject decisions.
• IRR is the break-even return: the rate at which NPV = 0. Accept if IRR > cost of capital.
Useful to supplement NPV but can conflict for mutually exclusive projects — when they
conflict, follow NPV.
• Payback Period is the simplest tool but the weakest: ignores TVM, ignores post-payback
cash flows, has arbitrary cutoff. Use only for preliminary screening, never as the sole
decision criterion.

EXAM TIP: Topic 2 is the most calculation-intensive topic in the first half of MBA6002.
In examinations, every question type from this topic requires showing the complete
calculation — not just the answer. For bond questions: show the cash flow stream,
show each discounted value, then sum. For stock questions: show dividend
calculations, show terminal value, show discounting. For NPV/IRR: show the full cash
flow table in Excel-style layout. The methodology demonstrates understanding; the final
number demonstrates accuracy. You earn marks for both.

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Topic 2 Self-Assessment Questions

All monetary values in FCFA. Show all calculations in full.
1. A Cameroonian company issues a bond: Face value FCFA 500,000, coupon rate 9%,
annual payments, maturity 6 years, current YTM 11%. (a) Calculate the current bond price.
(b) Is the bond trading at a premium, par, or discount? Why? (c) If market interest rates fall
to 7%, what happens to the bond's price? Calculate the new price. (d) What principle(s)
explain the relationship between your answers to (b) and (c)?
2. You are considering buying a bond with: Current price FCFA 94,000, face value FCFA
100,000, annual coupon FCFA 8,000, maturity 5 years. (a) Set up the cash flow stream. (b)
Calculate the YTM using the IRR approach. (c) If your required return is 10%, is this bond a
good investment? Explain using the Law of One Price.
3. A company listed on the DSX just paid a dividend of FCFA 3,600 per share. Dividends are
expected to grow at 7% per year indefinitely. Investors require a 14% return. (a) Calculate
the current fair value of the share using the Gordon Growth Model. (b) If the share is
currently trading at FCFA 55,000, is it overvalued or undervalued? What would you
recommend? (c) If growth expectations change to 4%, what happens to the fair value?
Calculate and explain the change.
4. FreshTech Cameroun is a technology startup. Expected dividends: Year 1 = FCFA 0 (no
dividend yet), Year 2 = FCFA 1,200, Year 3 = FCFA 2,400. From Year 4 onwards, dividends
are expected to grow at 5% per year forever. Required return = 16%. Calculate the current
fair value of a FreshTech share.
5. An investment project requires an initial outlay of FCFA 800,000,000. Expected cash flows:
Years 1-5 = FCFA 200,000,000 per year; Year 6 = FCFA 350,000,000 (including salvage).
Cost of capital = 12%. (a) Calculate NPV. (b) Should the project be accepted? (c) Calculate
the payback period. (d) Explain why the payback period alone could lead to a wrong
decision in this case. (e) What is the approximate IRR? (Trial: check NPV at 18% and 22%.)
6. Two mutually exclusive projects (you can only choose one) have the following NPVs and
IRRs: Project Alpha: NPV = FCFA 180M, IRR = 25%. Project Beta: NPV = FCFA 320M,
IRR = 19%. Cost of capital = 12%. (a) Which project does IRR favour? (b) Which project
does NPV favour? (c) Which decision rule should you follow and why? (d) Explain the
principle(s) that justify your answer.

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