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Corporate Finance

Spring Semester 2010

Dr. Isabel Tkatch

Assistant Professor of Finance

1

Time

The

frequency of compounding

Capital

45

60 minutes

Mostly

Bring

amortization only financial calculator!)

Formulas?

2

Learning objectives

Explain

budgeting

Determine

accepted using the following rules:

net present value (NPV)

internal rate of return (IRR)

profitability index (PI)

payback period (PBP)

Explain

maximize shareholder wealth

3

Example

You are contemplating the purchase of a rental

property. The property consists of 12 apartments,

each of which fetches a rent of $600 per month.

The cost of maintaining the entire property is

$1,800 per month.

The effective monthly discount rate is 1%.

The property has an economic life of ten years and

can be sold for $500,000 at the end of its life.

1. What is the maximum that you would pay for this

property?

2. What if the owner is selling for $500,000?

4

Write down the CF stream

cash inflows are positive

cash outflows are negative

Use the risk adjusted cost of capital to calculate

Note: we say net present value because we subtract

the PV of cash outflows (costs, investment) from the

PV of cash inflows (benefits).

5

The goal of capital budgeting:

Find a decision rule that will maximize

shareholder wealth

The NPV rule:

If we accept a project with NPV > 0

increase shareholder wealth

If we accept a project with NPV < 0

decrease shareholder wealth

6

Assumptions

Assumption 1 (magnitude preference):

all else equal, investors prefer to have more money

rather than less

Assumption 2 (timing preference):

all else equal, investors prefer to get the money sooner

(today) rather than later (in the future)

Assumption 3 (risk preference):

all else equal, investors prefer a safe CF to a risky CF

(they are risk-averse)

Assumption 4 (managements goal):

The primary goal of the firms management is to

maximize shareholder wealth

7

Criterion 1:

Does the NPV rule consider ALL CFs?

Criterion 2:

Does the NPV rule consider CFs timing?

Criterion 3:

Does the NPV rule consider CFs riskiness?

Criterion 4:

Is the NPV rule consistent with managements

primary goal - maximizing shareholders wealth?

8

Write down the CF stream

cash inflows

cash outflows (investment)

Use the risk adjusted cost of capital to calculate:

NPV = PV (cash inflows) - PV (cash outflows)

PV (cash inflows)

PI =

PV (cash outflows)

9

PI (ratio) rule intuition: look for projects with

PV(cash inflows) > PV(cash outflows)

PV (cash inflows)

PI =

PV (cash outflows)

If PI = 1 indifference

If PI < 1 Reject project

10

NPV (difference) rule intuition: look for

projects with

PV(cash inflows) > PV(cash outflows)

If NPV > 0 Accept project

If NPV = 0 indifference

If NPV < 0 Reject project

11

You are contemplating the purchase of a rental

property. The property consists of 12 apartments,

each of which fetches a rent of $600 per month.

The cost of maintaining the entire property is

$1,800 per month.

The effective monthly discount rate is 1%.

The property has an economic life of ten years and

can be sold for $500,000 at the end of its life.

1. What is the maximum that you would pay for this

property?

2. What if the owner is selling for $500,000?

12

Example

Consider the mutually exclusive projects A and B

Project

PV(inflows)

PV(outflows)

$110,000

$100,000

$315,000

$300,000

PI

NPV

PI(A) __

13

Criterion 1:

Does the PI rule consider ALL CFs?

Criterion 2:

Does the PI rule consider CFs timing?

Criterion 3:

Does the PI rule consider CFs riskiness?

Criterion 4:

Is the PI rule consistent with managements

primary goal - maximizing shareholders wealth?

14

Write down the CF stream

cash inflows and cash outflows (investment)

Set NPV = 0 and solve for the cost of capital (r):

CFt

CF1

CF2

CFT

NPV CF0

...

...

0

1

2

t

T

(1 IRR ) (1 IRR )

(1 IRR )

(1 IRR)

Note: use a trial-and-error algorithm to find IRR.

If NPV>0 then we used r < IRR

If NPV=0 then we used r = IRR

If NPV<0 then we used r > IRR

15

IRR is a yield what we earn, on average, per year.

Compare the IRR to the required (risk-adjusted) rate

of return

Accept project

If IRR = required risk-adjusted return

Indifference

If IRR < required risk-adjusted return

Reject project

16

You are contemplating the purchase of a rental

property. The property consists of 12 apartments,

each of which fetches a rent of $600 per month.

The cost of maintaining the entire property is

$1,800 per month.

The effective monthly discount rate is 1%.

The property has an economic life of ten years and

can be sold for $500,000 at the end of its life.

1. Calculate IRR if the owner is selling for $500,000

2. Compare IRR to the cost of capital and decide

whether to accept / reject the project.

17

18

A firm considers an investment of $1,200

in a project that yields cash flows of

$500 in the first year, $600 in the

second year and $700 in the third year.

The annual risk adjusted cost of capital is

10%.

Compute the project NPV and IRR and

decide whether to accept or reject.

19

Assume the following CF stream and an annual

risk adjusted cost of capital of 11%.

Compute the NPV, IRR, PI and decide whether

the project should be accepted or rejected.

Date

t=0

t=1

t=2

t=3

t=4

T=5

CF

-1,000

400

400

400

500

500

20

Example

A five-year project, if taken, will require an initial investment of

$120,000. The expected end-of-year cash inflows are as follows:

Date

CF

t=0

t=1

t=2

t=3

t=4

T=5

12,000

the following is a correct decision?

a. Reject the project because NPV = -$30,507, which is less than 0

b. Reject the project because IRR is 10.04%, which is less than the

cost of capital, 11%

c. Both a and b are correct

d. Accept the project because IRR is positive

e. None of the above

21

Textbook Example

The firms cost of capital for the following

project is 12%.

The project will require an initial investment

of $6 million and generate cash flows of

$750,000 per year for ever.

Compute the NPV, IRR and PI of the project.

22

Consider a project that yields (pays) a cash

flow of $120 on date t=0 and requires an

outflow (investment) of $100 to be paid on

date t=1. The discount rate is 10%.

Calculate the NPV and IRR and decide

whether to accept / reject.

23

Consider the following project cash flows:

Date

t=0

t=1

t=2

CF

-$400

$2,500

-$3,000

NPV = $32.53

What about the IRR?

24

Figure 11.3: Project NPV profile.

Cash flows at t = 0, 1, 2 are -$400, $2,500, -$3,000.

200

NPV

-200

IRR?

-400

-600

-800

-1000

0

100

200

300

400

500

600

Discount rate

25

Conventional project:

1. Starts with an investment: outflows, one or

more negative CFs

2. Ends with inflows, positive CFs

3. There is only one sign change only one

transition from negative to positive CFs

USE the IRR rule only for conventional

projects!

26

Unconventional project:

1. May start with a positive CF rather than an

investment (outflow, negative CF)

2. May end with negative CFs - outflows, not

inflows

3. There may be more than one sign change more

than one transition from negative to positive CFs

or positive to negative CFs

If the project is not conventional the IRR rule

has to be modified. Use the NPV rule!

27

Consider the mutually exclusive projects A and B

and assume an annual cost of capital of 5%

Date

t=0

t=1

t=2

t=3

CF(A)

-$1,000,000

$400,000

$400,000

$400,000

CF(B)

-$1

$0.4

0.4

0.5

IRR(A) __ IRR(B) Choose Project ____

PI(A) __

28

Criterion 1:

Does the IRR rule consider ALL CFs?

Criterion 2:

Does the IRR rule consider CFs timing?

Criterion 3:

Does the IRR rule consider CFs riskiness?

Criterion 4:

Is the IRR rule consistent with managements primary

goal - maximizing shareholders wealth?

+ technical problems if the project is not conventional

29

The payback period for a project is the length of time

it take to get your initial investment back. It is the

time from the initial cash outflow to the time when the

projects cash inflows add up to the initial cash outflow.

Example: if the initial investment is $100,000 and the

projects CF stream is as follows, PBP = _____

Date

t=1

t=2

t=3

t=4

T=5

CF

30,000

42,000

42,000

28,000

12,000

ACC. CF

30

Firms usually specify an arbitrary number of periods (t)

as the maximum time-to-payback. The PBP decision rule

is:

If PBP < t

Accept project

If PBP = t

Indifference

If PBP > t

Reject project

31

Calculate the payback period for the following

projects, which project will you accept if you require a

maximum of 3 years to payback?

Date

t=0

t=1

t=2

t=3

t=4

T=5

CF(A)

-9,000

2,000

3,000

4,000

5,000

6,000

3,000

4,000

5,000

6,000

32

Assume the firm uses two years as the critical number of

periods to payback and the cost of capital is 10%.

Calculate the NPV and PBP for the two projects.

Date

t=0

t=1

t=2

T=3

CF(A)

-1,000

500

510

10

CF(B)

-1,000

99,000,000

PBP(A) __ PBP(B) Choose Project ____

Which rule should we use?

33

Criterion 1:

Does the PBP rule consider ALL CFs?

Criterion 2:

Does the PBP rule consider CFs timing?

Criterion 3:

Does the PBP rule consider CFs riskiness?

Criterion 4:

Is the PBP rule consistent with managements primary

goal - maximizing shareholders wealth?

34

The discounted payback period for a project is the

length of time it take to get your initial investment

back in terms of discounted future CFs.

Example: if the initial investment is $100,000, the cost

of capital is 2% and the projects CF stream is as

follows, DPBP = _____

Date

t=1

t=2

t=3

t=4

T=5

CF

30,000

42,000

42,000

28,000

12,000

PV(CF)

ACC. PV(CF)

35

Firm usually specify an arbitrary number of periods (t)

as the maximum time-to-discounted-payback. The

Discounted PBP decision rule they is:

If Discounted PBP = t

Indifference

Reject project

36

Suppose that the discount rate is 10%. Project A has

the following cash flows. Find As discounted PBP.

Date

t=1

t=2

t=3

t=4

CF

-9,000

3,000

6,000

9,000

PV(CF)

ACC. PV(CF)

37

Criterion 1:

Does the Discounted PBP rule consider ALL CFs?

Criterion 2:

Does the Discounted PBP rule consider CFs timing?

Criterion 3:

Does the Discounted PBP rule consider CFs riskiness?

Criterion 4:

Is the Discounted PBP rule consistent with

managements primary goal - maximizing shareholders

wealth?

38

PBP

It

criterion

Example: the firm may require a project to have

(1) positive NPV first and also

(2) satisfy some payback criterion.

39

Summary 1: Description

Rule

NPV

Description

NPV = PV (CF stream)

= PV(cash inflows) PV(cash outflows)

IRR

PI

D. PBP

back, in terms of discounted future CFs

40

Summary 2: Rules

Rule

Accept project if

Reject project if

NPV

NPV > 0

NPV < 0

IRR

PI

PI > 1

PI < 1

(arbitrary number)

(arbitrary number)

41

Criterion

Rule

NPV

IRR

PI

Disc. PDP

ALL CFs?

CFs timing?

CFs riskiness?

with maximizing

shareholders wealth?

42

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