Prepared By Kashan Pirzada

pg. 1

Time value of money
Time Line Tool used in time value of money analysis; it is a graphical representation used to show the timing of cash flows. Outflow (Outlay) A cash deposit, cost, or amount paid. It has a minus sign. Inflow A cash receipt. Compounding The arithmetic process of determining the final value of a cash flow or series of cash flows when compound interest is applied. Discounting It is the process of finding the present value(PV) of future cash flow or series of cash flows; discounting is the reciprocal, or reverse, of compounding. Future Value (FV) The amount to which a cash flow or series of cash flows will grow over a given period of time when compound at a given interest rate. PMT=payment. This key is used only if the cash flows involve a series of equal or constant payments (an annuity). If there are no periodic payments in a particular problem then PMT=0. Opportunity Cost Rate The rate of return on the best available alternative investment of equal risk. Present Value (PV) The value today of a future cash flow or series of cash flows. Annuity

pg. 2

A series of payments of an equal amount at fixed intervals for a specified number of periods. Ordinary (Deferred) Annuity An annuity whose payments occur at end of each period. Annuity Due An annuity whose payments occur at beginning of each period. FVAn The future value of an annuity over n periods. FVA=Cfs x FVIFAi,n PVAn The present value of an annuity over n periods. PVA=Cfs x PVIFAi,n Perpetuity A stream of equal payments expected to continue forever. PV=Cfs/i Uneven Cash Flow Stream A stream of cash flows in which the amount varies from one period to the next. Payment (PMT) This term designates equal cash flows coming at regular intervals. Cash Flow (CF) This term designates uneven cash flows. Terminal Value (Future Value) The future value of an uneven cash flow stream. Nominal Rate It is also called the Annual Percentage Rate (or APR), or the Stated or Quoted Rate. Periodic Rate = APR/m m = No. of times interest is compounded in a single year

pg. 3

n = No. of years x m

Effective Rate It is abbreviated as EFF%, and it is also called the Equivalent Annual Rate (or EAR).

Usage of EAR The EFF% is not used in calculations. However it should be used to compare the effective cost or rate of return on loans or investments when payment periods differ. Amortized Loan A loan that is repaid in equal payments over its life.

The Cost of Capital
Capital Component Items on right hand side of a firm¶s balance sheet-various types of debt, preferred stock, and common equity are called capital components. kd, kp , ks Before-tax Cost of Debt = i After-tax Cost of Debt kd =i(1-T) The relevant cost of new debt, taking in to account the tax deductibility of interest used to calculate the WACC. Cost of Preferred Stock, kp The rate of return investors require on the firm¶s preferred stock. kp=Dp/Pp Cost of Retained Earnings, ks The rate of return required by stockholder¶s on a firm¶s common stock.

pg. 4

ks=D1/P0+g ke The designation for the cost of common equity raised by issuing new stock, or external equity. ke=D1/P0+g Cost of New Common Stock The cost of external equity based on the cost of retained earnings, but increased or flotation costs. Flotation Cost, F The percentage cost of issuing new common stock. Net price =po(1-f)

Weighted Average Cost of Capital, WACC The target proportions of debt, preferred stock, and common equity along with the cost of these components, are used to calculate the firm¶s WACC. WACC=wd kd+wp kp+weks

Capital Budgeting
The process of planning expenditure on assets whose cash flows are expected to extend beyond one year. Capital Budgeting Decision Rules Six key methods are used to rank projects and to decide whether or not they should be accepted for inclusion in the capital budget:

pg. 5

(1) Payback Period

(2) Discounted Payback

(3) Net Present Value (NPV) (5) Modified

(4) Internal Rate of Return (IRR) internal rate of return (MIRR) (6) Profitability Index (ratio) Payback Period

The length of time required for an investment¶s net revenues to cover its cost. Shorter the recovery period sooner the recovery of cost, better the project. Drawbacks of Payback Period 1. Assumes that cash flows are equally distributed over the entire period. 2. Ignores the time value of money. 3. Ignores the cash flows beyond the payback period. 4. Arbitrary cut-off period. Merits of Payback Period (1) Simple (2)Easy to calculate (3)Easy to communicate (4)Consider liquidity

Mutually Exclusive Projects A set of projects where only one can be accepted. Independent Projects Projects whose cash flows are not affected by the acceptance or nonacceptence of other projects.

Discounted Payback Period The length of time required for an investment¶s cash flows, discounted at the investment¶s cost of capital, to cover its cost. Net Present Value (NPV) Method A method of ranking investment proposals using the NPV, which is equal to the present value of future net cash flows, discounted at the cost of capital.

pg. 6

NPV=PV of Cfs - Cost NPV Decision If NPV is positive project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPV are mutually exclusive, the one with higher NPV should be chosen. If NPV is zero it depends upon the judgment of financial manager to accept the project or reject it. Merits of NPV 1. Takes into account, the time value of money. 2. Consider entire cash flow statement. 3. Analyses the management objective and shareholder wealth maximization.

RATIONALE FOR THE NPV METHOD An NPV of zero signifies that projects net cash flows are exactly sufficient to repay the invested capital and to provide the required rate of return on that capital. If a Project has positive NPV then it is generating more cash than is needed to service its debt and to provide the required return to shareholders, and this access cash accrues solely to the firm¶s stockholders. Therefore if a firm takes on a project with a positive NPV, the position of stockholders is improved.

Internal Rate of Return Method (IRR) A method of ranking investment proposals using the rate of return on an investment, calculated by finding the discount rate that equates the present value of future cash inflows to the project¶s cost. or equivalently the rate that forces the NPV to equal zero: PV of cfs = Cost Cost of Capital Raising fund from any internal or external source. In Mutually Exclusive Projects conflict arises b/w NPV and IRR. If both are same then there is no problem. If conflict b/w IRR and NPV in that case we rely on NPV b/c NPV is

pg. 7

based on cost of capital which is stronger source and IRR is based on internal rate of return which is less stronger than cost of capital.

RATIONALE FOR THE IRR METHOD Why is the particular discount rate that equates a project¶s cost with present value of its receipts (the IRR) so special? The reason is based on this logic :( 1) The IRR on a project is its expected rate or return. (2) If the internal rate of return exceeds the cost of funds used to finance the project, a surplus remains after paying for the capital, and this surplus accrues to the firm¶s stockholders.(3)Therefore taking in a project whose IRR exceeds its cost of capital increase shareholders¶ wealth. On the other hand, if the internal rate of return is less than the cost of capital, then taking on the project imposes a cost on current stockholders. It is this ³breakeven´ characteristic that makes the IRR useful in evaluating capital projects. NPV=0whenever a project¶s cost of capital is less than its IRR, its NPV is positive. Modified Internal Rate of Return (MIRR) The discount rate at which the present value of a project¶s cost is equal to the present value of its terminal value. If two projects are of equal size and have same life, then NPV and MIRR will always lead to the same decision. Our conclusion is that MIRR is superior to regular IRR as an indicator to the project¶s ³true´ rate of return, or ³expected long-term rate of return´, but NPV is still best way to choose among competing projects because it provides the best indication of how much each project will increase the value of firm. Payback and discounted payback both provide an indication of both risk and liquidity of a project. Profitability Index Profitability Index = PV of Cfs /Cost P.I. >1, Accept the Project

pg. 8

P.I. <1, Reject the Project If any conflict arises b/w NPV and P.I then we rely on P.I. b/c it gives answer in units.

Managing Current Assets
Working Capital A firm¶s investment in short term assets²cash, marketable securities, inventory and accounts receivable. Net Working Capital: Current assets minus current liabilities. Inventory Conversion Period: Average time required to convert material in finished goods and then to sell those goods. Receivables Collection Period: Average length of time required to convert firm¶s receivable I n to cash i.e.to collect cash following a sale. Cash Conversion Cycle Average length of time a dollar is tied up incurrent assets Operating Cycle-Payable Period or Inventory Conversion Period + Receivables Conversion Period ±Payable Period=Cash Conversion Cycle. Operating Cycle It is time period that takes b/w purchase of inventory and collecting cash on it. Shortening the Cash Conversion Cycle The firm¶s goal should be to shorten its cash conversion cycle as much as possible without hurting operations. This would improve profits b/c longer the cash conversion cycle he greater need for external financing, and financing has a cost. The cash conversion cycle can be shortened (1) by reducing inventory conversion period by processing and selling goods more quickly (2) by reducing the receivable collection period by spending up collections (3) by lengthening payable period by slowing down firms own payments. Reasons for Holding Cash

pg. 9

Transactional Motive Cash balance is necessary in business operations. Payments must be made in cash and receipts are deposited in cash account. To pay off liabilities and to extend business activities. Precautionary Motive A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows Holding cash for contingencies. When monetary policy is tightened. Speculative Motive A cash balance held in firm¶s account to expect future opportunities.

pg. 10

Sign up to vote on this title
UsefulNot useful