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Masters of Financial Management and Control Assignment

- Externalities and Market Failures in Waste Management - Fogarassy et al.
- Numeric Models
- Prasanna Chandra
- Capital Budget FINAL Slide
- Extra Exam 3 Review Problems
- PM Chapter 02 Organization Strategy and Project Selection
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- Applications

You are on page 1of 16

I hereby certify that I am the sole author of this report. All assistance I have

received from outside sources have been documented in the report, as well

as, listed after the conclusion under References. This report was created

exclusively by me specifically for the Financial and Management Accounting

module at The Hague University of Applied Sciences.

Student Number: 10062289

Cohort: MFMC FT14-15

Module: Corporate Finance

Lecturer Name: Drs. C.J.H Colenbrander

Report submission date: 12/4/2014

Total number of pages of submitted work: 10

University: The Hague University of Applied Sciences

Keywords: Payback Period (PBP), Internal Rate of Return (IRR), Net Present

Value (NPV), and Profitability Index (PI).

Table of Contents

1.0 Theoretical essentials of PBP, IRR, NPV and PI...........................................1

1.1 Payback Period (PBP)..............................................................................1

1.2 Internal Rate of Return (IRR)...................................................................1

1.3 Net Present Value (NPV)..........................................................................1

1.4 Profitability Index (PI)..............................................................................1

2.0 Strengths and Weaknesses of PBP, IRR, NPV and PI..................................2

2.1 Payback Period (PBP) Strengths and Weaknesses...................................2

2.2 Internal Rate of Return (IRR) Strengths and Weaknesses.......................2

2.3 Net Present Value (NPV) Strengths and Weaknesses..............................3

2.4 Profitability Index (PI) Strengths and Weaknesses..................................3

3.0 PSP Electronic Projects Valuation..............................................................4

3.1 Provided information...............................................................................4

3.2 Cash Flow Statement..............................................................................5

3.2.1 Initial Cash Outflow...........................................................................5

3.2.2 Incremental Cash Outflows...............................................................6

3.2.3 Terminal Year Incremental Cash Outflows.........................................7

3.3 PSP projects appraisal.............................................................................7

3.3.1 PBP calculation..................................................................................8

3.3.2 IRR calculation..................................................................................9

3.3.3 NPV calculation.................................................................................9

3.3.4 PI calculation.....................................................................................9

4.0 Preferred Investment Project...................................................................10

5.0 Works Cited..............................................................................................11

6.0 Disclaimer................................................................................................12

List of Tables

Table 1 PSP projects initial investments and required yearly savings..............4

Table 2 Depreciation Classes...........................................................................4

Table 3 PSP projects A & B initial cash outflow................................................5

Table 4 PSP projects A & B incremental cash outflows.....................................6

Table 5 PSP projects A & B terminal year incremental cash outflows..............7

Table 6 PSP projects appraisal based on PBP, IRR, NPV and PI........................7

NPV and PI

1.1 Payback Period (PBP)

A projects payback period is the number of years that it takes before the

cumulative cash flow equals the initial investment (Brealey, Myers and Allen,

Payback p.105). The PBP rule for making an investment is simple: if the

project recovers its initial investment within the predetermined cutoff date it

should be accepted, else it should be rejected.

1.2 Internal Rate of Return (IRR)

According to Brealey et al. IRR is the discount rate at which investment has

zero net present value (p.107). The rationale behind the IRR is that it

provides a single number summarizing the merits of a project and this

number does not depend on the interest rate prevailing in the capital market

(Hillier, Ross and Westerfield, The Internal Rate of Return p.155). According

to Hillier et al. a project should be accepted if the IRR is higher than the

discount rate and should be rejected if the IRR is less than the discount rate

(p.156).

1.3 Net Present Value (NPV)

NPV is defined as A projects contribution to wealth - present value minus

initial investment (Brealey, Myers and Allen p.932). NPV three attributes are

that it uses cash flows, it uses all the cash flows of the project, and it

discounts the cash flows properly by taking into consideration the time value

of money (Hillier, Ross and Westerfield p.150). NPV basic investment rule is

summarized as following: accept a project if the NPV is greater than zero.

Reject a project if NPV is less than zero (Hillier, Ross and Westerfield p.149).

1.4 Profitability Index (PI)

PI is the ratio of present value cash flows subsequent to initial investment

divided by the amount of initial investment (Hillier, Ross and Westerfield

p.165). This ratio tells its user which project will offer the highest net present

value per dollar of initial outlay (Brealey, Myers and Allen p.115). The PI is

applied in three situations. First, when projects are independent an

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NPV and PI

PI is lower than 1. Second, when projects are mutually exclusive PI needs to

be corrected using incremental. PI is a ratio and thus ignores differences of

scale for mutually exclusive projects. Lastly, when the firm does not has

enough capital to fund all positive NPV projects and needs to implement

capital rationing (Hillier, Ross and Westerfield p.166).

2.1 Payback Period (PBP) Strengths and Weaknesses

PBP Strengths:

PBP period is the simplest way of communicating an idea of project

profitability. Additionally, PBP is used because it is easier to forecast short

term cash flows than long term cash flows. Lastly, PBP are used as a

measure of liquidity.

PBP Weaknesses:

PBP can result in misleading answers because it ignores all cash flows after

the cutoff date (Brealey, Myers and Allen p.106). Because of this short term

orientation valuable long-term projects might be ignored (Hillier, Ross and

Westerfield p.151). Furthermore, PBP does not consider timing of cash flows

(Time Value of Money) and thus gives equal weight to all cash flows before

the cutoff date (Hillier, Ross and Westerfield p.151). Finally, there is an

arbitrary standard for the payback period. Capital markets help estimate the

discount rate used in the NPV method. However, there is no guide for

choosing the payback cut-off date so the choice is somewhat subjective

(Hillier, Ross and Westerfield p.152).

2.2 Internal Rate of Return (IRR) Strengths and Weaknesses

IRR Strengths:

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NPV and PI

IRR accounts for Time Value of Money, considers all cash flows and is less

subjective.

IRR Weaknesses:

The first weakness of IRR is when comparing an investing or financing

decision. When investing a high rate of return is desired. Contrastingly, when

receiving financing a low rate of return is desired. In such cases an IRR less

the opportunity of cost of capital is required (Brealey, Myers and Allen

p.109). A second weakness of the IRR is that when there are changes in the

signs of cash flows there will be multiple rates of return. In some cases there

might be no internal rate of return (Brealey, Myers and Allen p.110). Third,

IRR ignores differences of scale of cash flows in mutually exclusive projects

because its a ratio. Lastly, the IRR does not account for more than one

opportunity cost of capital (Brealey, Myers and Allen p.113).

2.3 Net Present Value (NPV) Strengths and Weaknesses

NPV Strengths:

NPV is based on cash flows. Additionally, it includes all the cash flows of the

project and discounts the cash flows properly because it considers the time

value of money when handling cash flows (Hillier, Ross and Westerfield

p.150).

NPV Weaknesses:

One of the weaknesses of NPV is its sensitivity to discount rates. Calculating

the percentage number to an investment to represent a risk premium is not

an exact science. Therefore, the level of subjectivity in the discount rate

(however small as it might be) represents a disadvantage to the NPV

methodology. A second disadvantage of the NPV is that it excludes real

options that may exist within the project. To illustrate, a company that is

currently losing money may expand greatly in a few years time however

NPV does not give the option to include the value of real options.

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NPV and PI

PI Strengths:

The strengths of the PI are similar to the NPV since it is based on discounted

present value cash flows minus initial cash outflow divided by the initial cash

outflow (or NPV divided by the initial cash outflow + one). Additionally, when

funds are limited PI helps pick the projects that offer the highest net present

value per dollar of initial outlay (Brealey, Myers and Allen p.115).

PI Weaknesses:

PI weaknesses are similar to those of the NPV. Moreover, PI is a ratio and

thus ignores differences of scale for mutually exclusive projects (Brealey,

Myers and Allen p.116). Consequently, PI only provides relative profitability

and can potentially lead to ranking problems.

3.1 Provided information

(Colenbrander)

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NPV and PI

(Colenbrander)

Required Rate of Return: 14%

Net Working Capital: 0

For a detailed explanation of results and analysis please double click on the

excel icon below:

10062289_Martinez_

Corporate_Finance_Valuation_Models.xlsx

Table 3 PSP projects A & B initial cash outflow

(10062289_Martinez_Corporate_Finance_Valuation_Models)

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NPV and PI

Notes:

No capitalized expenditures given

No working capital

No sale of old asset(s)

No tax savings due to sale old assets

Table 4 PSP projects A & B incremental cash outflows

(10062289_Martinez_Corporate_Finance_Valuation_Models)

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NPV and PI

Notes:

Net Incr. (decr.) in operating revenue less (plus) any net incr. (decr.) in

operating expenses, excluding depr. are given (period savings)

Net Incr. (decr.) in tax depreciation

Asset Net Value for period * Depreciation rate for period

Net change in income before taxes

Period savings Depreciation

Net incr. (decr.) in taxes

Income before taxes * tax rate

Net change in income after taxes

Income before taxes - taxes

Net incr. (decr.) in tax depr. Charges

Tax depreciation

Project Incremental net cash flow for period

Income after taxes + Depreciation

3.2.3 Terminal Year Incremental Cash Outflows

Table 5 PSP projects A & B terminal year

incremental cash outflows

(10062289_Martinez_Corporate_Finance_Valuation_Models)

Notes:

Incremental net cash flow for the terminal period comes from Table 4

PSP projects A & B incremental cash outflows period 7 (terminal

period) incremental net cash flow.

No Salvage Value

No Tax savings due to asset sale or disposal of new assets

No changes in net working capital

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NPV and PI

Table 6 PSP projects appraisal based on PBP,

IRR, NPV and PI

(10062289_Martinez_Corporate_Finance_Valuation_Models)

Payback formula (based on lectures)

Page 8 of 12

NPV and PI

IRR was calculated using IRR formula in excel.

3.3.3 NPV calculation

NPV formula based on lectures

NPV was calculated using NPV formula in excel Initial cash outflow (ICO)

3.3.4 PI calculation

PI formula based on lectures

the ICO.

Page 9 of 12

NPV and PI

Based on PSP projects appraisal I would choose project B based on the

following valuation model results:

Internal Rate of Return:

Internal rate of return is higher than the discount rate

Net Present Value:

Net Present Value is greater than zero

Profitability Index:

Project PI is larger than 1

*Project B has a payback period that is slightly longer than project A. However, due to the

many weaknesses of the PBP and that no cutoff period was provided my decision remained

in favor of project B.

Page 10 of 12

NPV and PI

"An Easy Problem in Capital Rationing." Brealey, Richard, Stewart Myers and

Franklin Allen. Principles of Corporate Finance Tenth Edition. New York:

McGraw Hill, 2011. 115. PDF Book.

"Internal (or Discounted-Cash-Flow) Rate of Return." Brealey, Richard,

Stewart Myers and Franklin Allen. Principles of Corporate Finance Tenth

Edition. New York: McGraw Hill, 2011. 107. PDF Book.

"Payback." Brealey, Richard, Stewart Myers and Franklin Allen. Principles of

Corporate Finance Tenth Edition. New York: McGraw Hill, 2011. 105.

PDF Book.

. Principles of Corporate Finance Tenth Edition. New York: McGraw Hill ,

2011. PDF Book.

Colenbrander, C.J.H. "Corporate Finance Assignment." Corporate Finance

Assignment. The Hague: The Hague University of Applied Sciences, 15

November 2014. PDF Document.

"6.1 Why Use Net Present Value." Hillier, David, et al. Corporate Finance

European Edition. Berkshire: McGraw Hill, 2010. 148-150. Book.

"The Internal Rate of Return." Hillier, David, et al. Corporate Finance

European Edition. Berkshire: McGraw Hill, 2010. 155-158. Book.

"The Payback Period Method." Hillier, David, et al. Corporate Finance

European Edition. Berkshire: McGraw Hill, 2010. 150 - 151. Book.

Page 11 of 12

NPV and PI

Edition. Berkshire: McGraw Hill, 2010. 165-167. Book.

Sagastume,

Otto

Wilfredo

Martinez.

"10062289_Martinez_Corporate_Finance_Valuation_Models."

10062289_Martinez_Corporate_Finance_Valuation_Models. The Hague:

Otto Wilfredo Martinez Sagastume, 14 November 2014. Excel File.

6.0 Disclaimer

All Rights Reserved. No part of this publication may be reproduced, stored in

a retrieval system or transmitted in any form by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior

permission of the publisher, Otto Martinez.

The facts of this report are believed to be correct at the time of publication

but cannot be guaranteed. Please note that the findings, conclusions and

recommendations that Otto Martinez delivers will be based on information

gathered in good faith from both primary and secondary sources, whose

accuracy he is not always in a position to guarantee. As such Otto Martinez

can accept no liability whatever for actions taken based on any information

that may subsequently prove to be incorrect.

Page 12 of 12

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