Corporate Finance Assignment

as well as. Student: Otto Martinez Student Number: 10062289 Cohort: MFMC FT14-15 Module: Corporate Finance Lecturer Name: Drs. C.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). and Profitability Index (PI).” This report was created exclusively by me specifically for the Financial and Management Accounting module at The Hague University of Applied Sciences. listed after the conclusion under “References. Internal Rate of Return (IRR).Corporate Finance Assignment 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.J. Net Present Value (NPV).

.....0 Works Cited.......................1 Payback Period (PBP) Strengths and Weaknesses..................................4 Profitability Index (PI)...4 PI calculation...........................3....................................0 Disclaimer.....................................2......................................................................................3 Net Present Value (NPV) Strengths and Weaknesses.....7 3...............0 Strengths and Weaknesses of PBP........8 3.....................1 1...................9 3.......... NPV and PI...............................................................1 Initial Cash Outflow..2 Incremental Cash Outflows.................................2 IRR calculation.....................................................................................1 Payback Period (PBP)......................................................................................................................4 3...............................2 Internal Rate of Return (IRR) Strengths and Weaknesses....................................................................5 3.................................10 5..................................................3 PSP projects appraisal.............................................3 Terminal Year Incremental Cash Outflows................................................1 2..............3...........................................3 Net Present Value (NPV)...........2 2..............6 3................1 1.............................................3............2 Cash Flow Statement.............2..........0 Preferred Investment Project..................................3 3..................2 2................. NPV and PI......1 Provided information.......3 NPV calculation.....0 Theoretical essentials of PBP..3................ IRR...............................2 Internal Rate of Return (IRR)..9 3........1 1.........................5 3.................3 2......................12 ......................9 4................. IRR.......................7 3..........................4 3..4 Profitability Index (PI) Strengths and Weaknesses......11 6..............2.......................0 PSP Electronic Projects’ Valuation..........................................................1 PBP calculation....................Table of Contents 1.......................................2 2..................1 1.................................

......................7 Table 6 PSP projects appraisal based on PBP...........4 Table 3 PSP projects A & B initial cash outflow.5 Table 4 PSP projects A & B incremental cash outflows............................................................................................. IRR.....4 Table 2 Depreciation Classes.........List of Tables Table 1 PSP projects initial investments and required yearly savings..........7 ........6 Table 5 PSP projects A & B terminal year incremental cash outflows............................................... NPV and PI.........

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. IRR.155).2 Internal Rate of Return (IRR) According to Brealey et al. Myers and Allen. Payback p. Myers and Allen p. 1. 1. The Internal Rate of Return p. 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.107).150). and it discounts the cash flows properly by taking into consideration the time value of money (Hillier.present value minus initial investment” (Brealey.156).165). 1. 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. Myers and Allen p. NPV three attributes are that it uses cash flows. NPV basic investment rule is summarized as following: “accept a project if the NPV is greater than zero. NPV and PI 1.115). IRR. According to Hillier et al. Ross and Westerfield p.0 Theoretical essentials of PBP. Reject a project if NPV is less than zero” (Hillier.0 Theoretical essentials of PBP. This ratio tells its user which project will offer the highest net present value per dollar of initial outlay (Brealey. when projects are independent an Page 1 of 12 . Ross and Westerfield p. The PI is applied in three situations.149). it uses all the cash flows of the project.105).1 Payback Period (PBP) A project’s payback period is the number of years that it takes before the cumulative cash flow equals the initial investment (Brealey.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.932).1. Ross and Westerfield p.3 Net Present Value (NPV) NPV is defined as “A project’s contribution to wealth . IRR is the “discount rate at which investment has zero net present value” (p. Ross and Westerfield. NPV and PI 1. First.

when projects are mutually exclusive PI needs to be corrected using incremental. However. 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. Finally.152). PBP is used because it is easier to forecast short term cash flows than long term cash flows.151).1. 2. Furthermore.2 Internal Rate of Return (IRR) Strengths and Weaknesses IRR Strengths: Page 2 of 12 . Lastly.106). Lastly. Myers and Allen p.166). Additionally. 2. Because of this short term orientation valuable long-term projects might be ignored (Hillier. Ross and Westerfield p. PBP Weaknesses: PBP can result in misleading answers because it ignores all cash flows after the cutoff date (Brealey. Capital markets help estimate the discount rate used in the NPV method.151).1 Payback Period (PBP) Strengths and Weaknesses PBP Strengths: PBP period is the simplest way of communicating an idea of project profitability.0 Strengths and Weaknesses of PBP. IRR. Ross and Westerfield p. PBP are used as a measure of liquidity. IRR. there is an arbitrary standard for the payback period. when the firm does not has enough capital to fund all positive NPV projects and needs to implement capital rationing (Hillier. NPV and PI 2. Ross and Westerfield p. Second. NPV and PI independent project should be accepted if PI is larger than 1 and rejected if PI is lower than 1. PI is a ratio and thus ignores differences of scale for mutually exclusive projects. Ross and Westerfield p. there is no guide for choosing the payback cut-off date so the choice is somewhat subjective (Hillier.0 Theoretical essentials of PBP.

0 Theoretical essentials of PBP. 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. In such cases an IRR less the opportunity of cost of capital is required (Brealey. Lastly. A second disadvantage of the NPV is that it excludes real options that may exist within the project. NPV Weaknesses: One of the weaknesses of NPV is its sensitivity to discount rates. Myers and Allen p. 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. Page 3 of 12 . when receiving financing a low rate of return is desired. Calculating the percentage number to an investment to represent a risk premium is not an exact science. NPV and PI IRR accounts for Time Value of Money. Myers and Allen p. Ross and Westerfield p. IRR Weaknesses: The first weakness of IRR is when comparing an investing or financing decision. 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. To illustrate. In some cases there might be no internal rate of return (Brealey.150). Additionally. IRR ignores differences of scale of cash flows in mutually exclusive projects because it’s a ratio. Third.3 Net Present Value (NPV) Strengths and Weaknesses NPV Strengths: NPV is based on cash flows. the IRR does not account for more than one opportunity cost of capital (Brealey. Myers and Allen p.1.110). the level of subjectivity in the discount rate (however small as it might be) represents a disadvantage to the NPV methodology.109). 2. When investing a high rate of return is desired. considers all cash flows and is less subjective.113). Contrastingly. IRR. Therefore.

1 Provided information Table 1 PSP projects initial investments required and yearly savings (Colenbrander) Table 2 Depreciation Classes Page 4 of 12 . Additionally. PI Weaknesses: PI weaknesses are similar to those of the NPV.0 PSP Electronic Projects’ Valuation 3.116). NPV and PI 2. PI only provides relative profitability and can potentially lead to ranking problems. PI is a ratio and thus ignores differences of scale for mutually exclusive projects (Brealey. IRR. Myers and Allen p. 3.1. Myers and Allen p.115). Moreover.0 Theoretical essentials of PBP. Consequently. when funds are limited PI helps pick the projects that offer the highest net present value per dollar of initial outlay (Brealey.4 Profitability Index (PI) Strengths and Weaknesses 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).

xlsx 3.1.0 Theoretical essentials of PBP.2 Cash Flow Statement For a detailed explanation of results and analysis please double click on the excel icon below: 10062289_Martinez_ Corporate_Finance_Valuation_Models. IRR.1 Initial Cash Outflow Table 3 PSP projects A & B initial cash outflow (10062289_Martinez_Corporate_Finance_Valuation_Models) Page 5 of 12 .2. NPV and PI (Colenbrander)  Tax Rate: 34%  Required Rate of Return: 14%  Net Working Capital: 0 3.

0 Theoretical essentials of PBP. IRR.2. NPV and PI Notes:      Cost of “new” assets are given No capitalized expenditures given No working capital No sale of old asset(s) No tax savings due to sale old assets 3.2 Incremental Cash Outflows Table 4 PSP projects A & B incremental cash outflows (10062289_Martinez_Corporate_Finance_Valuation_Models) Page 6 of 12 .1.

) in tax depr.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.2. (decr. (decr. NPV and PI Notes:  Net Incr. (decr.) in operating revenue less (plus) any net incr.1.0 Theoretical essentials of PBP. excluding depr.) 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 .  No Salvage Value  No Tax savings due to asset sale or disposal of new assets  No changes in net working capital Page 7 of 12 .) in operating expenses.taxes  Net incr. (decr. IRR. Charges  Tax depreciation  Project Incremental net cash flow for period  Income after taxes + Depreciation 3. are given (period savings)  Net Incr.

0 Theoretical essentials of PBP.1. NPV and PI 3. NPV and PI (10062289_Martinez_Corporate_Finance_Valuation_Models) 3. IRR.3.3 PSP projects appraisal Table 6 PSP projects appraisal based on PBP.1 PBP calculation Payback formula (based on lectures) First it is necessary to calculate cumulative cash flows: Page 8 of 12 . IRR.

3 NPV calculation NPV formula based on lectures NPV was calculated using “NPV” formula in excel – Initial cash outflow (ICO) 3. Page 9 of 12 .4 PI calculation PI formula based on lectures PI was calculated by adding one to the previously calculated NPV divided by the ICO. IRR. 3.1. NPV and PI Then apply formula.3.2 IRR calculation IRR was calculated using “IRR” formula in excel. 3.3.0 Theoretical essentials of PBP.3.

However. due to the many weaknesses of the PBP and that no cutoff period was provided my decision remained in favor of project B.0 Preferred Investment Project 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.0 Theoretical essentials of PBP. IRR.1. NPV and PI 4. Page 10 of 12 .

—. Corporate Finance European Edition. C.H. Principles of Corporate Finance Tenth Edition. PDF Book. 150 ." Hillier. Richard. "6. 15 November 2014. 107. Page 11 of 12 . The Hague: The Hague University of Applied Sciences. New York: McGraw Hill . et al.151. "The Internal Rate of Return. PDF Document." Brealey. Book. et al. Corporate Finance European Edition. Stewart Myers and Franklin Allen." Brealey. New York: McGraw Hill. New York: McGraw Hill. 2011. Book. Book. PDF Book. 105. 2010.J. Stewart Myers and Franklin Allen.1 Why Use Net Present Value. 148-150.0 Theoretical essentials of PBP. Colenbrander.1. Principles of Corporate Finance Tenth Edition. Richard. PDF Book. "Payback. 115. New York: McGraw Hill. Richard. "The Payback Period Method." Corporate Finance Assignment." Brealey." Hillier. David. Corporate Finance European Edition. "Corporate Finance Assignment. PDF Book.0 Works Cited "An Easy Problem in Capital Rationing. Principles of Corporate Finance Tenth Edition. David. Berkshire: McGraw Hill. David. Stewart Myers and Franklin Allen. Berkshire: McGraw Hill. "Internal (or Discounted-Cash-Flow) Rate of Return." Hillier. 2010. 2010. 2011. 155-158. 2011. NPV and PI 5. Berkshire: McGraw Hill. Principles of Corporate Finance Tenth Edition. 2011. IRR. et al.

As such Otto Martinez can accept no liability whatever for actions taken based on any information that may subsequently prove to be incorrect. David.0 Theoretical essentials of PBP. Sagastume. Book. Please note that the findings. 165-167. 14 November 2014. The facts of this report are believed to be correct at the time of publication but cannot be guaranteed. stored in a retrieval system or transmitted in any form by any means. "10062289_Martinez_Corporate_Finance_Valuation_Models. electronic. Page 12 of 12 . 2010. Otto Martinez." 10062289_Martinez_Corporate_Finance_Valuation_Models. recording or otherwise. IRR. Corporate Finance European Edition. Otto Wilfredo Martinez. No part of this publication may be reproduced. et al. Excel File. conclusions and recommendations that Otto Martinez delivers will be based on information gathered in good faith from both primary and secondary sources.0 Disclaimer All Rights Reserved." Hillier. The Hague: Otto Wilfredo Martinez Sagastume. without the prior permission of the publisher. photocopying.1. 6. mechanical. whose accuracy he is not always in a position to guarantee. Berkshire: McGraw Hill. NPV and PI "The Profitability Index.