FINC 560 Lecture 2_recording.ppt - Lecture 2 NPV and Other Investment Rules Key Topics Capital Budgeting Administrative Considerations in Capital

FINC 560 Lecture 2_recording.ppt - Lecture 2 NPV and Other...

This preview shows page 1 out of 33 pages.

You've reached the end of your free preview.

Want to read all 33 pages?

Unformatted text preview: Lecture 2: NPV and Other Investment Rules Key Topics Capital Budgeting Administrative Considerations in Capital Budgeting Capital Budgeting Decision Rules -Payback Method (PB) -Discounted Payback Method (DPB) -Net Present Value (NPV) -Internal Rate of Return (IRR) -Modified Internal Rate of Return (MIRR) -Profitability Index (PI) Comparison between NPV and IRR A. Capital Budgeting - Capital budgeting is the whole process of analyzing projects and deciding whether they should be included in the capital budget. B. Administrative Considerations in Capital Budgeting - Search for and discovery of investment opportunities. - Collection of data. - Evaluation and decision making. - Reevaluation and adjustment. C. Capital Budgeting Decision Rules a. Payback Period (PB) - It is defined as the expected number of years required to recover the original investment in the project. - Payback = Year before full recovery + (Unrecovered cost at start of year) / (Cash flow during year) C. Capital Budgeting Decision Rules - If a few projects are mutually exclusive, according the payback rule, the project with the lowest payback (periods) should be accepted. C. Capital Budgeting Decision Rules Example 1: Assume a $50,000 investment and the following cash flows for two alternatives. 1 2 3 4 5 |----------|-----------|----------|----------| 10,000 11,000 13,000 16,000 30,000 Project A 1 2 3 4 |----------|-----------|----------| 20,000 25,000 15,000 30,000 Project B Which alternative would you select under each payback period? C. Capital Budgeting Decision Rules Example 1: C. Capital Budgeting Decision Rules Example 1: C. Capital Budgeting Decision Rules Example 1: For Project A: Payback = 4 years For Project B: Payback = 2 + (50000-20000-25000)/15000 = 2.33 years C. Capital Budgeting Decision Rules b. Discounted Payback Period (DPB) - This method evaluates projects in term of the length of time required to cover the investment’s cost from discounted cash flows. It ignores the cash flows after the discounted payback period. C. Capital Budgeting Decision Rules Example 2: Assume the cost of capital of 5% is used. Calculate DPB. Which alternative would you select under each payback period? C. Capital Budgeting Decision Rules Example 2: C. Capital Budgeting Decision Rules Example 2: For Project A: PV of CF in Year 1 = 10,000/1.05 = 9,524 PV of CF in Year 2 = 11,000/1.052 = 9,977 PV of CF in Year 3 = 13,000/1.053 = 11,230 PV of CF in Year 4 = 16,000/1.054 = 13,163 PV of CF in Year 5 = 30,000/1.055 = 23,505 DPB: [4 + (50,000-9,524-9,977-11,230-13,163)/23,505] = 4 + (6,105/23,505) = 4.26 years C. Capital Budgeting Decision Rules Example 2: For Project B: PV of CF in Year 1 = 20,000/1.05 = 19,048 PV of CF in Year 2 = 25,000/1.052 = 22,675 PV of CF in Year 3 = 15,000/1.053 = 12,957 PV of CF in Year 4 = 30,000/1.054 = 24,681 DPB: [2 + (50,000-19,048-22,675)/12,957] = 2 + (8,277/12,957) = 2.64 years C. Capital Budgeting Decision Rules c. Net Present Value (NPV) - Find the present value of each cash flow, discounted at the project's cost of capital - Sum these discounted cash flows to obtain the project's NPV - Accept the project if the NPV is positive. C. Capital Budgeting Decision Rules Example 3: Altman Hydraulic Corporation will invest $160,000 in a project that will produce the cash flows at shown below. The cost of capital is 11%. Should the project be undertaken? 1 2 3 4 5 |----------|-----------|----------|----------| 54,000 66,000 (60,000) 57,000 120,000 Net Present Value = PV of Cash Inflow – PV of Cash Outflow C. Capital Budgeting Decision Rules Example 3: PV of Cash Flow = 54,000/1.11 + 66,000/1.112 + (-60,000)/1.113 + 57,000/1.114 + 120,000/1.115 =167,106 Initial Investment = -160,000 Net Present Value = 167,106 – 160,000 = 7106. C. Capital Budgeting Decision Rules d. Internal Rate of Return (IRR) - The internal rate of return (IRR) is defined as the discount rate, which equates the present value of a project's expected cash inflows to the present value of its expected costs. - A project will be accepted if IRR is higher than the cost of capital. C. Capital Budgeting Decision Rules Example 4: You buy a new piece of equipment for $11,778 and you receive a cash inflow of $2,000 per year for 10 years. What is the internal rate of returns? PV = -11,778 N = 10 PMT = 2,000 => I = IRR=11% C. Capital Budgeting Decision Rules e. Modified Internal Rate of Return (MIRR) - It is defined as the discount rate at which the present value of a project’s cost is equal to the present value of its terminal value. C. Capital Budgeting Decision Rules - Terminal value is found as the sum of the future values of the cash inflows, compound at the firm’s cost of capital. C. Capital Budgeting Decision Rules Example 5: Assume the cost of capital of 10%. Calculate MIRR. 0 1 2 3 4 |----------|-----------|----------|----------| -1,000 500 400 300 100 C. Capital Budgeting Decision Rules Example 5: Terminal Value = 100 + 300*(1.1) + 400*(1.1)2 + 500*(1.1)3 = 100 + 330 + 484 + 665.50 = 1,579.50 PV of Terminal Value = 1,000 = 1,579.50/(1+MIRR)4 => MIRR = 12.11% C. Capital Budgeting Decision Rules f. Profitability Index (PI) - It is the value increase per dollar invested. This method measure of the margin for error and hence is an indicator of risk. - PI = 1 + (NPV/Initial Investment) C. Capital Budgeting Decision Rules Example 6: Suppose you have the following investment opportunities, but only $90,000 available for investment. Which projects should you take? Project NPV of Future CF Investment PI 1 $5,000 $10,000 1.50 2 $5,000 $5,000 2.00 3 $10,000 $90,000 1.11 4 $15,000 $60,000 1.25 5 $15,000 $75,000 1.20 6 $3,000 $15,000 1.20 C. Capital Budgeting Decision Rules Example 7: Calculate the PIs for the projects with the following cash flows. The firm’s cost of capital is 10%. Year Project P Project Q -------------------------------------------0 ($2,800) ($3,000) 1 200 2,000 2 500 1,100 3 800 600 4 1,300 290 5 1,970 100 C. Capital Budgeting Decision Rules Example 7: PV of Cash Flow For P: 200/(1.1) + 500/(1.1)2 + 800/(1.1)3 + 1,300/(1.1)4 + 1,970/(1.1)5 = $3,307.11 For Q: 2,000/(1.1) + 1,100/(1.1)2 + 600/(1.1)3 + 290/(1.1)4 + 100/(1.1)5 = $3,437.98 C. Capital Budgeting Decision Rules Example 7: NPV For P: $3,307.11 - $2,800 = $507.11 For Q: $3,437.98 - $3,000 = $437.98 C. Capital Budgeting Decision Rules Example 7: Initial Investment For P: $2,800 For Q: $3,000 Profitability Index For P: 1 + (507.11/2,800) = 1.181 For Q: 1 + (437.98/3,000) = 1.146 D. Comparison between NPV and IRR NPV = [C1/(1+COC)] + [C2/(1+COC)^2] + [C3/(1+COC)^3] – Investment D. Comparison between NPV and IRR NPV = 0 = [C1/(1+IRR)] + [C2/(1+IRR)^2] [C3/ (1+IRR)^3] – Investment => Investment = [C1/(1+IRR)] + [C2/(1+IRR)^2] [C3/ (1+IRR)^3] D. Comparison between NPV and IRR -Two basic conditions can lead to conflicts between NPV and IRR: (i) Project size (or scale) (ii) Timing differences ...
View Full Document

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern

Our tutors were helpful last time, right? Ask another question!
A+ icon
Ask Expert Tutors You can ask 0 bonus questions You can ask 1 question (1 expires soon) You can ask 1 question (will expire )
Answers in as fast as 15 minutes