The idea that money available at the present time is worth more than the same amount in the

future, due to its potential earning capacity

X Y

Year 0 1 2

X -100 10 60

Y -100 70 50

80

20

Payback Period:

X : 3 years ( 1 + 1 + 30/80 = 2.375) Y : 2 years ( 1 + 30/50 = 1.6)

Advantages
Provides an indication of a projects risk and liquidity Easy to calculate and understand

Disadvantages
Ignores the time value of money Ignores CFs occurring after the payback period Arbitrary choice of cut off period

Discounted Payback Period

Year 0 1 2 3 X Y

-100 10 60 80

-100 $9.09 $49.59 $60.11

-100 70 50 20

-100 $63.64 $41.32 $15.03

Disadvantage
Arbitrary Cut-off period Complex Calculation

The present value of an investment's future net cash flows minus the initial investment. If positive, the investment should be made (unless an even better investment exists), otherwise it should not

Year 0 1 2 3 NPV

X -100 10 60 80 -100 $9.09 $49.59 $60.11 18.78 -100 70 50 20

Y -100 $63.64 $41.32 $15.03 19.98

The rate of return that would make the present value of future cash flows plus the final market value of an investment or business opportunity equal the current market price of the investment or opportunity
0 = - Investment + CF1/(1 + IRR)1 + CF2/(1 + IRR)2 + ... +CFn/(1 + IRR)n

Project is selected if discount rate is less than IRR X : 18.13%; Y : 23.56%

Comparison
Reinvestment Rate Assumption Mutually Exclusive projects Multiple Values

NPV is a better method

-10.00

-20.00 10.00 20.00 30.00 40.00 50.00 60.00 0.00 0.00% 0.72% 1.44% 2.16% 2.88% 3.60% 4.32%

5.04%
5.76% 6.48% 7.20% 7.92% 8.64% 9.36% 10.08% 10.80% 11.52% 12.24% 12.96% 13.68% 14.40% 15.12% 15.84% 16.56% 17.28% 18.00% 18.72% 19.44% 20.16% (8.68,22.32)

20.88%
21.60% 22.32% 23.04% 23.76% 24.48%

Franchise L

X Franchise S Y

Year
0 1 2

Cash Flow
-0.8 5 -5

Discounted Cash Flow -0.8 4.54 -4.13

-1.00 0.00 0.20 0.40 0.60 1% 17% 33% 49% 65% 81% 97% 113% (25,0.00)

-0.80

-0.60

-0.40

-0.20

129%
145% 161% 177% 193% 209% 225% 241% 257% 273% 289% 305% 321%

Project P

337%
353% 369% 385% 401% 417% 433% 449% 465% 481% 497% (400,0.00)

Project P

Equity Preference Shares Term Loans Bonds/ Debentures

Represents ownership capital

Limited liability
Right to control

Right in liquidation

Advantages No compulsion to pay dividend No maturity, no obligation to redeem Disadvantages: Sale of equity share to outsiders dilute control of existing owners Dividend is not tax deductible expense High floatation/issue cost

Features of equity
Dividends are paid out of distributable profits
Not a tax deductible expense

Features of debt
Dividend rate is fixed

Finite maturity period

No voting rights

Advantages: No dividend obligation No impact on control Security is not required Disadvantages: Skipping dividend affect image Prior claim on the earnings and assets May carry voting rights if dividend is skipped for certain period of time

Interest rate depends on the risk profile of the project/company Secured against assets Restrictive covenants For a period of 10-15 years

Advantages: Interest is tax deductible expense Does not result into dilution of control Disciplines management

Disadvantages: Non-payment of interest and principal cause financial embarrassment/bankruptcy Higher debt leads to higher cost of equity Operating flexibility is restricted

Types of debt instruments for borrowing funds for a given interest rate Trustee to protect the interest of debenture holders Interest rate may be fixed/floating Maturity of 1-15 years Call/put features Convertible/Nonconvertible/Zero Coupon

Source Equity

Dilution of Control Yes

Risk Nil

Control on Ope freedom No

Preference Capital Term Loans

Bonds/ Debenture

No
No No

Low
High High

No
Moderate Low

A derivative is an instrument whose value depends (derived from) on the values of other more basic underlying variables

Futures Contracts Forward Contracts Options Swaps

It is an agreement to buy/sell as asset at a certain future time for a certain price. Forward contracts are similar to futures except that they trade in the over-the-counter market

The party that has agreed to buy - a long position The party that has agreed to sell - a short position

Option gives the owner the right, but not the obligation to buy (call option)/ sell (put option) the underlying financial asset/ commodity Seller of an option is called option writer Option premium (price of an option): the up front payment to be made to the writer of an option