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QABE Lecture 3

Evaluating Time-Money Choices


School of Economics, UNSW

Contents
1 Introduction 1

2 Equations of value 2
2.1 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
2.2 Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

3 Net Present Value 3


3.1 The Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
3.2 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
3.3 The Importance of the Interest Rate . . . . . . . . . . . . . . . . . . . . . 5

4 Internal Rate of Return 5


4.1 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

5 Summary 7

1 Introduction
We spend a little more time looking at how the value of money is actually dependent on
the time at which it is in our hand. That is, as before, we note that there exists a time
value of money; would you prefer $100 in your hand today, or $101 tomorrow?
There are various explanations for this fact. As you might have reflected above –
‘I’d prefer the money today, since I’m not sure what will happen tomorrow,’ – that is
the uncertainty of our lives kicking in. Just one of the factors that contribute to the
apparent value of money changing through time.
We then move on to applying some of our new-found skills in time-value-of-money to
one of the most common problems faced in the commercial world, namely, the problem
of deciding whether or not to go ahead with a project, or if there is choice between
projects, deciding which of the projects to fund.
The reason it is so common (if not already obvious) is that in practically every
business situation, one has to ‘spend money, to make money’ – that is, make an initial
investment (called capital) and after time, begin to yield some kind of income stream
from the business. The big competition that then ensues is between that money invested
in your project, versus that money invested in the bank at some going rate – who gives
the best return will decided how you will proceed. However, the question of whether
one project is actually worth it on its own, or in comparison to another is not always
immediately obvious. Not to worry – by applying what we have learnt up till now, we
have the tools to become experts on these issues!

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ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

The methods we will develop are two of the most common – the net present value
of the project on the one hand, and the internal rate of return on the other. The
two methods are very connected, but their interpretation requires some care.

Agenda

1. Equations of value;

(a) Under simple interest;


(b) Under compound interest;

2. A campus investment conundrum;

3. The Net Present Value (NPV );

4. The Internal Rate of Return (IRR);

5. Conclusions.

2 Equations of value
Equations of value KZB 1.4,
2.6
Scenario
You owe your parents some money. At present, you owe them $500 to be paid in 6
months and $350 in 9 months. Today you pay $100. As for the rest of the debt, you
don’t want to do installments. You’d prefer to pay everything either now or in 12
months time. In negotiations, they agree to consider either simple or compounded
(quarterly) interest. What will you do?

2.1 Simple Interest


Solution technique:

1. Work out the timings;

2. Using the focal date bring all the payments and debts to it;

3. Set up the equation of value;

4. Solve.

Debts: $500 $350


t (months)
Payments: $100 3 6 9 12
↑ ↑
focal date focal date

QABE Lecture 3 2
ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

Example:
Using a focal date of now or in 12 months, and simple interest at the nominal
value of 7%, what would be the single sum you owe?

Checking the two payments (now = $715.63, 12 months = $766.63), the value of the
12 month payment is,

P = 766.63(1 + 0.07)−1
= $716.48 !!!

When using simple interest in equations of value, the focal date


must be agreed before hand, since it will affect the total value exchanged.

2.2 Compound Interest


1. Try the compound interest version yourself!

2. Check if the value of the future (12 month) payment is the same as the current
payment.

3. Which repayment method would you pick?

3 Net Present Value


3.1 The Scenario

Scenario: ‘The Bean House’ – a Micro-coffee Roasting House for the Eastern
Suburbs
You’ve recently read about the micro- coffee roasting craze that is hitting Sydney. It
seems like the perfect business propositon – value pricing (as opposed to cost-pricing),
a legally addicted market (both to the bean, and to the ‘boutique’ theme), and with
a tiny amount of skill, an easy market to get a foot in (most drinkers don’t know the
difference). You and a friend are talking one night and it turns out your friend has
already got a plan together. Knowing you are a student of QABE, she turns to you to
run the numbers. Will it work out?

The numbers ...


Upon further inquiry, the numbers (according to your friend) look like this:

QABE Lecture 3 3
ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

Year ending Costs Income Cash flow Note


0 50,000 0 -50,000 Set-up costs
1 34,000 25,000 -9,000 Two-wages @ $17,000
2 34,000 45,000 11,000
3 44,000 60,000 16,000 Third wage @ $10,000
4 44,000 70,000 26,000
5 44,000 75,000 31,000

3.2 Working it out


Steps to a decision...

1. Adjusting the cash-flow numbers to turn them into present values (based on
the going alternative rate of return);

2. Sum each of the cash-flow values (in today’s terms) to get the net present value;

3. Make a decision:

• If NPV > 0 −→ worthwhile;


• If NPV < 0 −→ not worth it!

Problem: Suppose your friend has access to a bank who has a long-term savings
account (yearly compounded) offering a nominal rate of 12%. Should The Bean House
get off the ground?

Year ending Costs Income I-C (1 + 0.12)−t PV


0 50,000 0 -50,000
1 34,000 25,000 -9,000
2 34,000 45,000 11,000
3 44,000 60,000 16,000
4 44,000 70,000 26,000
5 44,000 75,000 31,000
NPV

P V = S(1 + r)−t = (I − C)(1 + 0.12)−t

Year ending Costs Income I-C (1 + 0.12)−t


0 50,000 0 -50,000 1.000
1 34,000 25,000 -9,000 0.893
2 34,000 45,000 11,000 0.797
3 44,000 60,000 16,000 0.712
4 44,000 70,000 26,000 0.636
5 44,000 75,000 31,000 0.567
Year Costs Income I-C (1 + 0.12)−t PV
end
0 50,000 0 -50,000 1.000 −50, 000
1 34,000 25,000 -9,000 0.893 −8, 036
2 34,000 45,000 11,000 0.797 8, 769
3 44,000 60,000 16,000 0.712 11, 388
4 44,000 70,000 26,000 0.636 16, 523
5 44,000 75,000 31,000 0.567 17, 590
NPV −3, 764
—————————————————————-

QABE Lecture 3 4
ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

Definition | Net Present Value (NPV)


If Ft is the estimated cash flow for a T period project at the end of period t and
the yearly compounded rate of interest, the cost of capital is r, then the net
present value is the sum of present values, assuming cash flows arrive at the
end of the year,

N P V = F0 + F1 (1 + r)−1 + · · · + FT (1 + r)−T . (1)

Interpretation - what does it mean?

• As we noted before, if the N P V > 0 then the project is worthwhile;

• The reason is, that the NPV calculation is really doing an in-built comparison, or
play-off, between the project at hand, and the interest rate available at the bank;

• If you are ‘beating the bank’ by gaining more value through the project than if
your money were invested with the bank alone, then we deem the project to be
‘worthwhile’;

Challenge: do the same calculation as in the example above, but at 8% cost of capital.
Is the project now worthwhile?

3.3 The Importance of the Interest Rate


Suppose we do the calculation of the NPV for a range of interest rates ...
20
16
b

12
b
8
4 IRR b


N P V ($ 000) 0 b
r
−4 0.05 0.10 0.15 b

b
−8 b

−12 b

−16
−20

4 Internal Rate of Return


• The internal rate of return asks the question,

What cost of capital would mean an NPV = 0, the break-even point?

• Which means that if,


r = IRR
then the return on the project (over its life) is exactly the same as if we put our
money into the bank! (the competition is a dead-heat!)

QABE Lecture 3 5
ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

Definition | Internal Rate of Return (IRR)


The internal rate of return indicates the equivalent interest rate offered by a
financial institution (compounded yearly) that would give the same outcome for
my investment over the project life-time, as my project itself.
It is found by setting the N P V to zero, and solving for r, assuming cash flows
arrive at the end of the year,

N P V = F0 + F1 (1 + r)−1 + · · · + FT (1 + r)−T = 0 . (2)

Care with the IRR When interpreting the IRR, notice that it is (by
definition) independent of the current cost of capital (what is actu-
ally offered by the banks). It is tempting to think that IRR somehow
depends on this value. It doesn’t! (But we compare to it.)

4.1 Working it out


Example: IRR by hand
Suppose a project requires an initial investment of $20,000 and returns $7,000
and $16,000 at the end of the first and second years respectively. Find the IRR
of the project assuming yearly compounding.

• There are simple cases (esp. when t ≤ 2) that can be solved by hand using the
quadratic equation;

• Obviously, it is difficult to solve for r in most cases (other than trial-and-error


approximation), so we often use a software package (such as Microsoft Excel,
Open-office or Gnumeric);

• Be careful how you use the software however...

QABE Lecture 3 6
ECON 1202/ECON 2291: QABE c
School of Economics, UNSW

Example:
Using a computer program of your choice, find the IRR and N P V , at 3%
interest, of the following stream of net profits: (-45, -25, -2, 12, 27, 30, 31).

The interpretation here needs care! Note that the cost of capital is so-called, since
it is the gain fore-gone (given up) when we use the investment money (the capital) in
our project. For this reason, if we can’t do better than what the bank is offering, we
might as well put our backer’s money in the bank!
It is in this sense, that having capital (investment money) outside of the bank is
costly – unless we are putting it to good use, it is literally costing us in interest we
could have been getting! (that’s no-risk return too...)

5 Summary
Does The Bean House go ahead?

• Clearly, at cost of capital 12%, the The Bean House isn’t worth it – we’d do better
by putting our money in the bank at the offered rate of 12%;

• However, by calculating the IRR, we could see that for any cost of capital less
than 10%, the The Bean House is a good idea! ... we’d beat the best interest going
at the bank!

• Finally, suppose that we had two different projects – the coffee roaster being
one, the other being a simple bakery, if they both have a positive N P V , we still
wouldn’t know how to pick between them.

– However, if you can’t do both, choosing the higher N P V project will be the
highest returning project.

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