Introduction to Finance

Lecture 8
Chapters 9 - 11

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 Chapter 9 – Net Present Value
▪ This is a quick chapter comparing the methods
used by firms to evaluate projects

We’ll focus primarily on NPV and to a lesser extent IRR,

but the catalog includes
– NPV
– IRR
– Payback
– Discounted Payback
– Accounting Rate of Return
– Modified IRR

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 Chapter 9 – 9.1 Net Present Value
▪ The undisputed champion for project evaluation is
NPV
– The key to doing NPV properly is in tracking the cash
flows properly
• If you set up the NPV workbook properly, the assumptions and
cash flows are easy to tweak
Base case - assume no taxes
Time 0 1 2 3 4 5 6 7 8

Build Costs $(30,000.00)

Inflows $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00
Outflows $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $(14,000.00) $ (14,000.00)
Salvage $ 2,000.00

Net Flow $(30,000.00) $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 8,000.00

r 15%
PV factor 1 0.869565217 0.756143667 0.657516232 0.571753246 0.497176735 0.432327596 0.37593704 0.326901774

PV of Flows $(30,000.00) $ 5,217.39 $ 4,536.86 $ 3,945.10 $ 3,430.52 $ 2,983.06 $ 2,593.97 $ 2,255.62 $ 2,615.21

NPV $ (2,422.27)

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 Chapter 9 – 9.1 Net Present Value
▪ Once set up, it is easy to tweak things.
– Take our previous example and assume rates fall to 9%
Base case - assume no taxes
Time 0 1 2 3 4 5 6 7 8

Build Costs $(30,000.00)

Inflows $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00
Outflows $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $(14,000.00) $ (14,000.00)
Salvage $ 2,000.00

Net Flow $(30,000.00) $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 8,000.00

r 9%
PV factor 1 0.917431193 0.841679993 0.77218348 0.708425211 0.649931386 0.596267327 0.54703424 0.50186628

PV of Flows $(30,000.00) $ 5,504.59 $ 5,050.08 $ 4,633.10 $ 4,250.55 $ 3,899.59 $ 3,577.60 $ 3,282.21 $ 4,014.93

NPV $ 4,212.65

One question often asked is for the breakeven rate here

you can see that 12.5673%

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 Chapter 9 – 9.2, 9.3 Payback
▪ Payback is the length of time before an
investment’s cash inflows exceed the net cash
investment
▪ Discounted Payback is the length of time before
an investment’s discounted cash inflows exceed
the net cash investment

– In practice a question about the payback period tends

to be asked as a matter of curiosity, rather than used as
a decision criterion

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 Chapter 9 – 9.4 Accounting Return
▪ A few possibilities for measurement, but the
concept is always to measure some variation of
the investment’s profit relative to the asset base
– Important to keep in mind that similar to the payback
approach, this approach (or a variation) tends to be
meant to provide color and side information rather than
being a decision criterion

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 Chapter 9 – 9.5 IRR
▪ Internal Rate Of Return is a method that’s
commonly encountered, even though it has flaws
– The IRR of a project is the discount rate for which the
project’s NPV = 0
▪ From before: (but now use Excel’s IRR function)
Base case - assume no taxes
Time 0 1 2 3 4 5 6 7 8

Build Costs $(30,000.00)

Inflows $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00 $ 20,000.00
Outflows $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $ (14,000.00) $(14,000.00) $ (14,000.00)
Salvage $ 2,000.00

Net Flow $(30,000.00) $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 6,000.00 $ 8,000.00

r 15%
PV factor 1 0.869565217 0.756143667 0.657516232 0.571753246 0.497176735 0.432327596 0.37593704 0.326901774

PV of Flows $(30,000.00) $ 5,217.39 $ 4,536.86 $ 3,945.10 $ 3,430.52 $ 2,983.06 $ 2,593.97 $ 2,255.62 $ 2,615.21

NPV $ (2,422.27)

IRR function 12.56729%

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 Chapter 9 – 9.5 IRR
▪ Despite flaws. Despite potential for multiple IRRs,
it is a commonly used tool

▪ IRR is most often used in conjunction with NPV to

answer the question “How much higher / lower is
the return on the project than our cost of capital
(or sometimes, hurdle rate)”?

▪ Because of it’s similarity to Yield to Maturity, IRR

retains a place in assisting intuition around project
selection
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 Chapter 9 – 9.5 IRR
▪ Multiple IRRs may occur whenever the cash flows
flip signs more than once.
▪ NPV may be sensitive to discount rates,
particularly for long-dated back-loaded projects

▪ The solution to both of these problems is to

perform sensitivity analysis and graph out the
NPV profile

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 Chapter 9 – 9.6 Profitability Index
▪ In some contexts, the language of cost benefit is
preferred to the language of NPV. However, keep
in mind that Benefit / Cost (or more often called
Cost / Benefit) is simply a re-expression of NPV
as the PV of Benefits / PV of Costs

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Chapter 10 – Capital Investment

Taking a deeper dive on project analysis

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 Chapter 10 – 10.2 Cash Flows
▪ Stand Alone Principle

▪ Incremental cash Flows

– Sunk Costs not to be considered
• No crying over spilt milk
– Opportunity costs should be thought of as alternative
project(s)
– Net working capital – the timing of receivables and
payables may impact working capital
– Financing costs only to extent of fees considered
• Interest payments not considered – that part goes into the cost
of capital

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Chapter 10 – 10.3 Pro Forma Statements
Two-Stage Process:
– Detailed project analysis
• Often a large workbook
• Summary page in front
• Assumptions page
• Followed by multiple pages of the project sales/flows/ etc
• Worksheets for scenarios
– Creating pro-forma financial statements
• Collating the revenue/expense sources with particular care for
accounting rules for revenue/expense recognition
(GAAP/IFRS, tax)
• Calculating pro-forma depreciation
• Creating the (often simplified) project income statement and
balance sheet
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Chapter 10 – 10.3 Pro Forma Statements
▪ Keeping everything simple
– Remember “oroc plus d”
• Operating revenues plus depreciation
• Symbolically (OR-OC+D)
– For capital budgeting remember Only Cash Flows
Matter
– For pro forma statements distinguish between income
and cash flow statements
Income Statement Cash Flow Statement
Sales $200,000.00 EBIT $27,570.00 NOI + D may be a
Variable Costs $125,000.00
Fixed Costs $ 17,430.00
Depreciation $30,000.00 simpler way to think
Depreciation $ 30,000.00 Taxes 21% $ 5,789.70
EBIT $ 27,570.00 OCF $51,780.30 about it, i.e., (OR-OC)(1-
Taxes 21% $ 5,789.70 T)+D
Net Income $ 21,780.30

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 Chapter 10 – 10.4 & 5 Errata
▪ Timing of cash flows may be impacted by the
receivables and payables

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