2 Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing
3 Net Present Value Net Present Value - Present value of cash flows minus initial investments. Opportunity Cost of Capital - Expected rate of return given up by investing in a project
4 Net Present Value Example Q: Suppose we can invest $50 today & receive $60 later today. What is our increase in value? A: Profit = - $50 + $60 = $10 $10 $50 Added Value Initial Investment
5 Net Present Value Example Suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return? Profit = This is the definition of NPV 1.10 $4.55 $4.55 Added Value $50 Initial Investment
6 Net Present Value NPV = PV - required investment NPV C 0 Ct ( 1 r) t NPV C 0 C1 C2 Ct ( 1 r) ( 1 r) ( 1 r) t
7 Net Present Value Terminology C = Cash Flow t = time period of the investment r = opportunity cost of capital The Cash Flow could be positive or negative at any time period.
8 Net Present Value Net Present Value Rule Managers increase shareholders wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value.
9 Net Present Value Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building?
10 Net Present Value Example - continued $466,000 $450,000 $16,000 $16,000 $16,000 Present Value ,953 14, ,395 $409,323
11 Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?
12 Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building? NPV NPV 16, , , 000 ( 107. ) ( 107. ) $59, , 000 ( 107. ) 1 2 3
13 Payback Method Payback Period - Time until cash flows recover the initial investment of the project. The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period.
14 Payback Method Example The three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision. Cash Flows Project C 0 C 1 C 2 C 3 Payback A ,249 B C
15 Using the Payback Rule
16 Using the Payback Rule
17 Other Investment Criteria Internal Rate of Return (IRR) - Discount rate at which NPV = 0. Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital. Rate of Return = C 1 - investment investment
18 Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?
19 Internal Rate of Return Example You can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment? 0 350, , , , 000 ( 1 IRR) ( 1 IRR) ( 1 IRR) IRR = 12.96%
20 Internal Rate of Return Calculating IRR by using a spreadsheet Year Cash Flow Formula 0 (350,000.00) IRR = 12.96% =IRR(B3:B7) 1 16, , ,000.00
22 Internal Rate of Return Example You have two proposals to choice between. The initial proposal (H) has a cash flow that is different than the revised proposal (I). Using IRR, which do you prefer? NPV (1 IRR) (1 IRR) (1 IRR) % NPV (1 IRR) %
23 Internal Rate of Return Example You have two proposals to choice between. The initial proposal has a cash flow that is different than the revised proposal. Using IRR, which do you prefer? Project C 0 C 1 C 2 C 3 IRR Initial Proposal % $ 24,000 Revised Proposal % $ 59,000
25 Internal Rate of Return Pitfall 1 - Mutually Exclusive Projects IRR sometimes ignores the magnitude of the project. The following two projects illustrate that problem. Pitfall 2 - Lending or Borrowing? With some cash flows (as noted below) the NPV of the project increases as the discount rate increases. This is contrary to the normal relationship between NPV and discount rates. Pitfall 3 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates.
26 NPV of Star s $1 million Book Deal When the benefits of an investment occur before the costs, the NPV is an increasing function of the discount rate. Copyright 2007 Pearson Addison-Wesley. All rights reserved.
27 NPV of Lecture Contract No IRR exists because the NPV is positive for all values of the discount rate. Thus the IRR rule cannot be used. Copyright 2007 Pearson Addison-Wesley. All rights reserved.
28 NPV of Star s Book Deal with Royalties In this case, there is more than one IRR, invalidating the IRR rule. If the opportunity cost of capital is either below 4.723% or above %, Star should make the investment. Copyright 2007 Pearson Addison-Wesley. All rights reserved.
29 Project Interactions When you need to choose between mutually exclusive projects, the decision rule is simple. Calculate the NPV of each project, and, from those options that have a positive NPV, choose the one whose NPV is highest.
30 Mutually Exclusive Projects Example Select one of the two following projects, based on highest NPV. System Faster C C C C NPV Slower assume 7% discount rate
31 Investment Timing Sometimes you have the ability to defer an investment and select a time that is more ideal at which to make the investment decision. A common example involves a tree farm. You may defer the harvesting of trees. By doing so, you defer the receipt of the cash flow, yet increase the cash flow.
32 Investment Timing Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer?
33 Investment Timing Example You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? Year Cost PV Savings NPV at Purchase NPV Today Date to purchase
34 Equivalent Annual Annuity Equivalent Annual Cost - The cash flow per period with the same present value as the cost of buying and operating a machine. Equivalent annual annuity = present value of cash flows annuity factor
35 Annuity Factor 1 1 Annuity Factor t,r = r (1 r) t
36 Equivalent Annual Annuity Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual annuity method. Year Mach E.A.A. F G
37 Equivalent Annual Annuity Example (with a twist) Select one of the two following projects, based on highest equivalent annual annuity (r=9%). Project C0 C1 C2 C3 C4 A B NPV EAA
38 Capital Rationing Capital Rationing - Limit set on the amount of funds available for investment. The act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on the specific sections of the budget. Companies may want to implement capital rationing in situations where past returns of investment were lower than expected.
39 Capital Rationing ABC Corp. has a cost of capital of 10% but that the company has undertaken too many projects, many of which are incomplete. This causes the company's actual return on investment to drop well below the 10% level. As a result, management decides to place a cap on the number of new projects by raising the cost of capital for these new projects to 15%. Starting fewer new projects would give the company more time and resources to complete existing projects.
40 Capital Rationing Soft Rationing - Limits on available funds imposed by management. Hard Rationing - Limits on available funds imposed by the unavailability of funds in the capital market.
41 Profitability Index
42 Profitability Index Profitability Project PV Investment NPV Index J /3 =.33 K /5 =.20 L /7 =.43 M /6 =.33 N /4 =.25
43 Profitability Index with a Human Resource Constraint
44 Profitability Index with a Human Resource Constraint
45 Capital Budgeting Techniques
46 EVA in Period n (When Capital Lasts Forever)
47 Calculating EVA When Invested Capital is Constant
48 Calculating EVA When Invested Capital is Constant
Project Management Seminars Financial Management of Projects.inproject managementandsystems engineering, is a deliverable-oriented decomposition of a project into smaller components. (source: Wikipedia)
Capital Budgeting: Decision Criteria Example Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows
1 2 Net present value is the difference between a project s value and its costs. We need to calculate the Present Value of future cash flows (discounted by the opportunity cost of capital) and subtract
Net Present Value and Capital Budgeting (Text reference: Chapter 7) Topics what to discount the CCA system total project cash flow vs. tax shield approach detailed CCA calculations and examples project
1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability
1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project has created: $1,300 + 1,500 + 1,900 = $4,700 in cash flows.
Investment Decisions and Capital Budgeting FINANCE 350 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University 1 Issues in Capital Budgeting: Investment How should capital
The Time Value of Money Future Value - Amount to which an investment will grow after earning interest. Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original
Which projects should the corporation undertake Investment criteria 1. Investment into a new project generates a flow of cash and, therefore, a standard DPV rule should be the first choice under consideration.
Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a
Finance for Cultural Organisations Lecture 7. Net Present Value and Other Investment Criteria Lecture 6: Net Present Value and Other Investment Criteria Be able to compute payback and discounted payback
EXAM 2 OVERVIEW Binay Adhikari FEDERAL RESERVE & MARKET ACTIVITY (BS38) Definition 4.1 Discount Rate The discount rate is the periodic percentage return subtracted from the future cash flow for computing
Introduction to Discounted Cash Flow and Project Appraisal Charles Ward Company investment decisions How firms makes investment decisions about real projects (not necessarily property) How to decide which
Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 8 Capital Budgeting Concept Check 8.1 1. What is the difference between independent and mutually
University of Science and Technology Beijing Dongling School of Economics and management Chapter 5 Net Present Value and Other Investment Rules Oct. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Be
Lecture 5 (Chapter 9) Investment Criteria Up to now, we have analyzed how to finance a firm (capital structure) Today we switch to analyzing what to do with the money once we ve got it (capital budgeting
Capital Budgeting Finance 100 Prof. Michael R. Roberts 1 Topic Overview How should capital be allocated?» Do I invest / launch a product / buy a building / scrap / outsource...» Should I acquire / sell
FIN 301 Class Notes Chapter 7: Net Present Value and Other Investment Criteria Project evaluation involves: 1- Estimating the cash flows associated with the investment project (ch. 8) 2- Determining the
What s next? Capital Budgeting: involves making decisions about real asset investments. Chapter 7: Net Present Value and Other Investment Criteria Chapter 8: Estimating cash flows for a potential investment.
21-18 Capital budgeting methods, no income taxes. The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% 5.216 1a. Net present value $28,000 (5.216) $146,048 $36,048
Alternative Investment Rules (Text reference: Chapter 6) Topics data for examples net present value (NPV) rule internal rate of return (IRR) rule payback rule discounted payback rule average accounting
Oklahoma State University Spears School of Business NPV & Other Rules Slide 2 Why Use Net Present Value? Accepting positive NPV projects benefits shareholders. NPV uses cash flows NPV uses all the cash
Answers to Warm-Up Exercises E10-1. Answer: E10-2. Answer: Payback period The payback period for Project Hydrogen is 4.29 years. The payback period for Project Helium is 5.75 years. Both projects are acceptable
Chapter 1 The Overall Process Capital Expenditures Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase
Chapter 10 Capital Budgeting Techniques Copyright 2012 Pearson Prentice Hall. All rights reserved. Overview of Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments
Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows 1 Topics Overview and vocabulary Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life 2 What
12-1 Planning for Capital Investments Managerial Accounting Fifth Edition Weygandt Kimmel Kieso 12-2 study objectives 1. Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.
Chapter 9 Capital Budgeting Techniques 1 Learning Outcomes Chapter 9 Describe the importance of capital budgeting decisions and the general process that is followed when making investment (capital budgeting)
CAPITAL BUDGETING Net Present Value and Other Investment Criteria Net Present Value (NPV) Net present value is the difference between an investment s market value (in today s dollars) and its cost (also
CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. In this context, an opportunity cost refers to the value of an asset or other input that will
Mariusz Próchniak Chair of Economics II Warsaw School of Economics CAPITAL BUDGETING Managerial Economics 1 2 1 Future value (FV) r annual interest rate B the amount of money held today Interest is compounded
HO-23: METHODS OF INVESTMENT APPRAISAL After completing this exercise you will be able to: Calculate and compare the different returns on an investment using the ROI, NPV, IRR functions. Investments: Discounting,
Vol. 2, Chapter 4 Capital Budgeting Problem 1: Solution Answers found using Excel formulas: 1. Amount invested = $10,000 $21,589.25 Compounding period = annually Number of years = 10 Annual interest rate
CHAPTER 7: NPV AND CAPITAL BUDGETING I. Introduction Assigned problems are 3, 7, 34, 36, and 41. Read Appendix A. The key to analyzing a new project is to think incrementally. We calculate the incremental
WHAT IS CAPITAL BUDGETING? Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial
BUA321 Chapter 10 Class Notes Capital Budgeting Techniques 1. What kinds of projects are analyzed with capital budgeting? Expansion (easiest to forecast) Replacement (more complicated) We must forecast
DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #1 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Two years ago, you put $20,000 dollars in a savings account earning
Chapter 2: Introduction 2.1 Introduction In order to assess the feasibility of any investment project, some capital budgeting techniques should be used to evaluate that project. This part illustrates the
Part 7. Capital Budgeting What is Capital Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture
e C P M 1 5 : P o r t f o l i o M a n a g e m e n t f o r P r i m a v e r a P 6 W e b A c c e s s Capital Budgeting C o l l a b o r a t i v e P r o j e c t M a n a g e m e n t e C P M 1 5 C a p i t a l
CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means
Excellence in Financial Management Course 3: Capital Budgeting Analysis Prepared by: Matt H. Evans, CPA, CMA, CFM This course provides a concise overview of capital budgeting analysis. This course is recommended
1 Simple interest 2 5. Time value of money With simple interest, the amount earned each period is always the same: i = rp o We will review some tools for discounting cash flows. where i = interest earned
How to Calculate Present Values Michael Frantz, 2010-09-22 Present Value What is the Present Value The Present Value is the value today of tomorrow s cash flows. It is based on the fact that a Euro tomorrow
Al Imam Mohammad Ibn Saud Islamic University College of Economics and Administrative Sciences Department of Finance and Investment Level 4: All branches Investment Decision Under Certainty Exercise 1 A
CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project
Chapter 9: Net Present Value and Other Investment Criteria Faculty of Business Administration Lakehead University Spring 2003 May 20, 2003 Outline 9.1 Net Present Value 9.2 The Payback Rule 9.3 The Average
9. Time Value of Money 1: Present and Future Value Introduction The language of finance has unique terms and concepts that are based on mathematics. It is critical that you understand this language, because
MODULE 2 Capital Budgeting Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting
WSG12 7/7/03 4:25 PM Page 191 12 Capital Budgeting OVERVIEW This chapter concentrates on the long-term, strategic considerations and focuses primarily on the firm s investment opportunities. The discussions
T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization! 9.1 Net Present Value! 9.2 The Payback Rule! 9.3 The Average Accounting Return! 9.4 The Internal Rate
Valuing common stocks Application of the DCF approach TIP If you do not understand something, ask me! The plan of the lecture Review what we have accomplished in the last lecture Some terms about stocks
INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY 10.SHORT-TERM DECISIONS & CAPITAL INVESTMENT APPRAISAL 4 Topic List INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY
apital Budgeting Formula Not in the book. Wei s summary If salvage value S is less than U n : If salvage value S is greater than U n : Note: IF t : incremental cash flows (could be negative) )(NW): change
What is a Balance Sheet? A Balance Sheet is a financial statement which shows the ASSETS, LIABILITIES and CAPITAL of a business on a particular date. Assets Are Are items owned by by the the business or
Learning Objectives 1-1 Capital Budgeting Cash Flows 1 Corporate Financial Management 3e Emery Finnerty Stowe 1-2 Calculate incremental after-tax cash flows for a capital budgeting project. Explain the
Copyright 2008 by the Foundation of the American College of Healthcare Executives 6/11/07 Version 9-1 CHAPTER 9 Time Value Analysis Future and present values Lump sums Annuities Uneven cash flow streams
Chapter 8 Capital Budgeting Process and Techniques MULTIPLE CHOICE 1. The capital budgeting process involves a. identifying potential investments b. analyzing the set of investment opportunities, and identifying
Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14 I. Additional Issues in Capital Budgeting. A. Capital rationing: Use profitability index
Chapter 7: Net Present Value and Capital Budgeting 7.1 a. Yes, the reduction in the sales of the company s other products, referred to as erosion, should be treated as an incremental cash flow. These lost
Capital Investment Appraisal Techniques To download this article in printable format click here A practising Bookkeeper asked me recently how and by what methods one would appraise a proposed investment
Productivity Financial Tools There are a number of financial tools that can be used to measure the financial performance and potential contribution of improvement projects to the productivity of a business.
Solutions to Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 1. Net income = ($74 $42 $10) [0.35 ($74 $42 $10)] = $22 $7.7 = $14.3 million Revenues cash expenses taxes paid =
Investment Decisions Investment Decision Making Fisher Model Criteria - Production or Real Investment chosen to maximize Wealth (= present discounted stream of consumption) Econ 422: Investment, Capital
Chapter 6 Learning Objectives Principles Used in This Chapter 1. Annuities 2. Perpetuities 3. Complex Cash Flow Streams 1. Distinguish between an ordinary annuity and an annuity due, and calculate present
Investment Appraisal Article relevant to F1 Business Mathematics and Quantitative Methods Author: Pat McGillion, current Examiner. Questions 1 and 6 often relate to Investment Appraisal, which is underpinned
BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets Ch. 3: Decision Rules Harry Campbell & Richard Brown School of Economics The University of Queensland Applied Investment Appraisal
Exercise 1 for Time Value of Money MULTIPLE CHOICE 1. Which of the following statements is CORRECT? a. A time line is not meaningful unless all cash flows occur annually. b. Time lines are useful for visualizing
NOTE: All of the information contained in this file has been collected from the various HELP files found in Excel for each of these functions. PV Returns the present value of an investment. The present
Investment Criteria 208 Net Present Value (NPV) What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment s market value and
Lease Analysis Tools 2009 ELFA Lease Accountants Conference Presenter: Bill Bosco, Pres. email@example.com Leasing 101 914-522-3233 Overview Math of Finance Theory Glossary of terms Common calculations
Project Valuation for Managers An Essential Skill Corporate Finance By Cameron Hall Key Messages The job of managers is to create value. Value in a firm comes from two sources: current operations and new
MBA 8130 FOUNDATIONS OF CORPORATION FINANCE FINAL EXAM VERSION A Fall Semester 2004 Name: Class: Day/Time/Instructor:. Read the following directions very carefully. Failure to follow these directions will
Chapter 8 NPV and Other Investment Criteria CAPITAL BUDGETING TERMS Capital budgeting is where we start to pull all of the tools and techniques we ve learned so far together (TVM, cash flow analysis, etc.)
Economic Feasibility Studies ١ Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. The difficulty with making these decisions
Investments What you must be able to explain: Future value Present value Annual effective interest rate Net present value (NPV ) and opportunity cost of capital Internal rate of return (IRR) Payback rule
Questions in Chapter 9 concept.qz 1) quantifies in dollar terms how stockholder wealth will be affected by undertaking a project under consideration. [A] Discounted payback analysis [B] The average accounting
CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-20 Capital budgeting with uneven cash flows, no income taxes. 1. Present value of savings in cash operating costs: $10,000 0.862 $ 8,620 8,000 0.743 5,944
Chapter 5 Capital Budgeting Road Map Part A Introduction to finance. Part B Valuation of assets, given discount rates. Fixed-Income securities. Common stocks. Real assets (capital budgeting). Part C Determination
Project Cost Management Guide to Mathematical Questions PMI, PMP, CAPM, PMBOK, PM Network and the PMI Registered Education Provider logo are registered marks of the Project Management Institute, Inc. Present
Topic 3: Time Value of Money And Net Present Value Laurent Calvet firstname.lastname@example.org John Lewis email@example.com From Material by Pierre Mella-Barral MBA - Financial Markets - Topic 3 1 2. Present
BF 6701 : Financial Management Comprehensive Examination Guideline 1) There will be 5 essay questions and 5 calculation questions to be completed in 1-hour exam. 2) The topics included in those essay and
CFA Level I Study Session 11 Reading 36 Reading 37 Reading 38 Reading 39 Reading 40 Reading 41 Introduction Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases: Basics
Decision making made easy (Relevant to AAT Examination Paper 4: Business Economics and Financial Mathematics) YO Lam, SCOPE, City University of Hong Kong In the competitive world of business, we need to