Lecture - Financial Evaluations of Projects Part II

# Lecture - Financial Evaluations of Projects Part II -...

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Financial Evaluation of Projects Part 2 4ET3 Winter 2015

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NPV NPV = Present value of cash inflows Initial investment Decision criteria: If the NPV is greater than \$0, accept the project. If the NPV is less than \$0, reject the project. If the NPV is greater than \$0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV. 2
Internal Rate of Return (IRR) The Internal Rate of Return (IRR) is a sophisticated capital budgeting technique; the discount rate that equates the NPV of an investment opportunity with \$0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows. 3

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Internal Rate of Return (IRR) Decision criteria: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project. These criteria guarantee that the firm will earn at least its required return. Such an outcome should increase the market value of the firm and, therefore, the wealth of its owners. 4
Sample Project Data You are looking at a new project and have estimated the following cash flows, net income and book value data: Year 0: CF = -165,000 Year 1: CF = 63,120 NI = 13,620 Year 2: CF = 70,800 NI = 3,300 Year 3: CF = 91,080 NI = 29,100 Average book value = \$72,000 Your required return for assets of this risk is 12%. 5

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Computing NPV for the Project Using the formula: NPV = -165,000/(1.12) 0 + 63,120/(1.12) 1 + 70,800/(1.12) 2 + 91,080/(1.12) 3 = 12,627.41 Capital Budgeting Project NPV Required Return = 12% Year CF Formula Disc CFs 0 (165,000.00) =(-165000)/(1.12)^0 = (165,000.00) 1 63,120.00 =(63120)/(1.12)^1 = 56,357.14 2 70,800.00 =(70800)/(1.12)^2 = 56,441.33 3 91,080.00 =(91080)/(1.12)^3 = 64,828.94 12,627.41 n 0 t t t ) R 1 ( CF NPV 6
7 Display You Enter ' C00 165000 S!# C01 63120 !# F01 1 !# C02 70800 !# F02 1 !# C03 91080 !# F03 1 !#) IRR % 16.1322 Cash Flows : CF0 = -165000 CF1 = 63120 CF2 = 70800 CF3 = 91080 Computing IRR for the Project Using the TI BAII+ CF Worksheet

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Calculating IRR with Excel Start with the cash flows as you did to solve for NPV Use the IRR function Enter the range of cash flows, beginning with the initial cash flow (Cash flow 0) You can enter a guess, but it is not necessary The default format is a whole percent 8