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Corporate Finance Assignment

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, 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: Otto Martinez


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

1.0 Theoretical essentials of PBP, IRR,


NPV and PI

1.0 Theoretical essentials of PBP, IRR, 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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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

independent project should be accepted if PI is larger than 1 and rejected if


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).

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


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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1.0 Theoretical essentials of PBP, IRR,


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2.4 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). 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.

3.0 PSP Electronic Projects Valuation


3.1 Provided information

Table 1 PSP projects initial investments required and yearly savings

(Colenbrander)

Table 2 Depreciation Classes

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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

(Colenbrander)

Tax Rate: 34%


Required Rate of Return: 14%
Net Working Capital: 0

3.2 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.xlsx

3.2.1 Initial Cash Outflow


Table 3 PSP projects A & B initial cash outflow

(10062289_Martinez_Corporate_Finance_Valuation_Models)
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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

3.2.2 Incremental Cash Outflows


Table 4 PSP projects A & B incremental cash outflows

(10062289_Martinez_Corporate_Finance_Valuation_Models)

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1.0 Theoretical essentials of PBP, IRR,


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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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

3.3 PSP projects appraisal


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

(10062289_Martinez_Corporate_Finance_Valuation_Models)

3.3.1 PBP calculation


Payback formula (based on lectures)

First it is necessary to calculate cumulative cash flows:

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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

Then apply formula.

3.3.2 IRR calculation


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

PI was calculated by adding one to the previously calculated NPV divided by


the ICO.

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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

4.0 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. However, due to the
many weaknesses of the PBP and that no cutoff period was provided my decision remained
in favor of project B.

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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

5.0 Works Cited


"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.
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1.0 Theoretical essentials of PBP, IRR,


NPV and PI

"The Profitability Index." Hillier, David, et al. Corporate Finance European


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.

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