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FINA 6092 AFM Tutorial 4.pptx - FINA 6092 AFM Tutorial 4...

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FINA 6092 AFM Tutorial 4Anna HanOct 3, 2022
1. A Bit More on NPV & IRRNPV and IRR will generally give us the same decision if there are:-Conventional cash flows, where cash flow time 0 is negative, and remainingcash flows are positive.- Projects (investments) are independent, where the decision to accept/reject thisproject does not affect the decision to accept/reject any other project. To be morespecific, independent = not mutually exclusive.
IRR Formula=IRR(values,[guess])The IRR function uses the following arguments:- Values (required argument) – This is an array of values that represent the seriesof cash flows. Cash flows include investment and net income values. Values canbe a reference to a range of cells containing values.- [Guess] (optional argument) – This is a number guessed by the user that isclose to the expected internal rate of return (as there can be two solutions for theinternal rate of return). If omitted, the function will take a default value of 0.1(=10%).Be mindful of how unconventional cash flows could have multiple IRRs.
For projects having unconventional cash flows (changing direction more thanonce), these projects may have multiple IRRs. To find multiple IRRs, use theIRR function in Excel with different parameters for the guess value.In in doubt for the existence of multiple IRRs, we can use guess=0 for the lowerIRR, and guess=1 for the higher IRR to see whether there are different value ofIRRs.- IRR for Non-conventional Cash Flows.xlsx
2. Payback PeriodThe payback period is the number of years it takes to recover the initial cost ofthe investment.
Advantages:- Easy to calculate- Easy to explain- Indicator of project liquidity (shorter payback period indicates greater projectliquidity)Disadvantages:- Does not consider cash flows after payback period (not useful for projectprofitability evaluation)- Does not consider time value of money- Does not consider risk of a project
For example, if you have an investment opportunity which requires an initialinvestment of 100mn USD, and is expected to generate 30mn USD per yeargoing forward. The payback period will be somewhere between the third and thefourth year.Assuming the cash flow is generated at steady pace regardless of different timeof the year, the timing for investment payback will be10/30 of the fourth year, meaning that the total investment payback period will be3+10/30CF0CF1CF2CF3CF4-10030303030

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