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Name

ID

Kamrun Nahar

18256

Swarna Kundu

18183

Debashis Mondal

18121

Sudipta Das

18150

18261

1.

Payback Period

3. Profitability Index

The amount of time required for a

firm to recover its initial investment

in a project, as calculated from cash

inflows.

Decision Criteria

If the payback period is less than the

maximum acceptable payback

period,

Accept The Project.

If the payback period is greater than

the maximum acceptable period,

Reject The Project.

more projects, then accept the

project with lowest payback period.

Annuity

Mixed stream of cash flows

Annuity

In case of an annuity, where, there is

a series of equal payments at

regular intervals, the payback period

can be found by Dividing the initial investment by

the annual

cash flow.

Example

25000

25000

25000

25000

25000

-100,000

Project A

Payback period = Initial investment / annual cash flow

= 100,000/ 25000

= 4 years

acceptable payback period is 3.5

years, Project A will be Rejected (4

years PB).

Suppose the purchase of a new machine :

which costs 100,000 BDT

After-tax cash inflows :

TK 40,000 in the 1st year

TK 45000 in the 2nd year

TK 60000 in the 3rd year

TK 35000 in the 4th year

The firm has a policy of buying equipment only

if the payback period is 2 years or less.

Whether to buy or not?

1. It ignores all cash flow after the

initial

cash outflow has been recovered.

2. It ignores the time value of money.

Calculates the time it takes to

recover the initial investment in

current or discounted amounts..

Incorporates time value of money by

adding up the discounted cash

inflows up to time 0, using the

appropriate discount rate, and then

measuring the payback period.

discount rate of 10%

Limitations

Like the payback period method, it

also ignores the cash flows after the

recovery of initial investment.

Discounts all the cash flows from a project back to time 0

using an appropriate discount rate, r:

to the firms bottom line and therefore when comparing

projects, the higher the NPV the better.

Financial management Reymond Brooks

investment is TK 10,000 and is likely

to bring in after-tax cash inflows of

TK 4,000 in the first year, TK4,500 in

the second year, TK10,000 in the 3rd

year, and TK8,000 in the 4th year.

Using the cash flows for project, calculate its

NPV and indicate whether the investment should

be undertaken or not.

NPV A = -10,000 + 4,000/(1.10)+ 4,500/(1.10)2 +

10,000/(1.10)3+ 8,000/(1.10)4

= -10,000 + 3636.36 + 3719.01 +

7513.15+ 5,464.11

= 10,332.62

Since the NPV > 0, the project should be accepted.

Independent Projects

NPV approach useful for independent as well as mutually

exclusive projects.

A choice between mutually exclusive projects arises

when:

1. There is a need for only one project, and both projects

can fulfill that need.

2. There is a scarce resource that both projects need, and

by using it in one project, it is not available for the

second.

Higher positive NPVs would be preferred to lower NPVs.

Negative NPV projects are rejected. Decision is clear-cut.

Independent Projects

Example: Calculate NPV for choosing between mutually

exclusive projects.

In either case, assume that the cost of capital will be 10%.

The relevant annual cash flows with each option are listed below:

Year

Project A

Project B

0 -10,000 -12,500

1

4,000

4,400

2

4,500

4,800

3

10,000

11,000

4

8,000

9,500

Which one is the right project to choose?

exclusive projects.

Since these are mutually exclusive options, the one with the

higher NPV would be the best choice.

NPV A = 10,332.62(just calculated)

NPV B = -12,500 + 4,400/(1.10) + 4,800/(1.10)2 +

11,000/(1.10)3 + 9,500/(1.10)4

= -12,500 + 4,000 + 3,966.94 + 8,264.46 + 6,488.63

= 10,220.03

Thus, the less expensive project is A with the higher NPV

(10,332.62 > 10,220.03) is the better option.

What would you rather have, 10,332.62 or 10,220.03?

Unequal Lives of

Projects

Firms often have to decide between

alternatives that are:

mutually exclusive,

cost different amounts,

have different useful lives, and

require replacement once their productive lives run

out.

life analysis) as the evaluation criterion can

lead to incorrect decisions, since the cash

flows will change once replacement occurs.

projects with unequal lives can be analyzed by

using one of the following two modified

approaches:

2. Equivalent Annual Annuity (EAA)

Lets say that there are two machines available,

one lasts for 3 years while the other for 4 years.

The owner realizes that he will have to replace

either of these two machines with new ones when

they are at the end of their productive life, as he

plans on being in the business for a long time.

Using the cash flows listed below, and a cost of

capital is 10%.

which of the two machines he should choose.

First you need determine a point in time where

both choices will be replaced at the same time.

Lowest common denominator here is 12 years

(note you replace the three year machine B in

years 3, 6, 9, and 12 while you replace the four

year machine A in years 4, 8, and 12). Hint: 3 x

4 = 12

Now assume the cash flows for 12 years with a

repetition of the prior machine continuing.

We assume that the annual cash flows are the same for each replication.

Total NPV

10,332.62/(1.10)8

Total NPVA = 10,332.62 + $7,057.32 + 4,820.24

= 22,210.18

Total NPVB

= 8,367.21 + 8,367.21/(1.10)3 +

8,367.21/(1.10)6 + 8,367.21/(1.10)9

Total NPVB = 8,367.21+ 6,286.41+ 4723.07+ 3,548.51

= 22,925.20

Machine Bs NPV = 22,925.20 > Machine As NPV = 22,210.18

Choose Machine B

Profitability Index

If faced with a constrained budget choose projects

that give us the best bang for our buck.

The Profitability Index can be used to calculate the

ratio of the PV of benefits (inflows) to the PV of the

cost of a project as follows:

PI with standard cash flow = (NPV + Cost) /

Cost

In essence, it tells us how much money we are

getting per taka invested.

Year

Project A

Project B

-10,000

-7,000

5,000

9,000

7,000

5,000

9,000

2,000

NPV @ 10%

7,092.41

6,816.68

Example: PI calculation

Using the cash flows listed in our previous example,

and a discount rate of 10%, calculate the PI of each

project. Which one should be accepted, if they are

mutually exclusive? Why?

PIA = (NPV + Cost)/Cost = (17,092.41/10,000) =

1.71

PIB = (NPV + Cost)/Cost = (13,816.68/7,000) =

1.97

Choose Project B, Higher PI.

The IRR of a project is the discount rate which makes its

NPV equal to zero.

In the NPV calculation we assume that the discount rate

is known and determine the NPV.

In the IRR calculation, we set the NPV equal to zero and

determine the discount rate that satisfies this condition.

IRR is the value of r in the following calculation:

Investment =

WHY IRR

used in capital budgeting to measure profitability and investment.

used to evaluate the desirability of investments or projects.

enables firms capacity to manage projects or investment with IRR

that exceed the cost of capital.

It is an indicator of efficiency, quality and yield of an investment.

Acceptability of an investment is dependent if IRR > the minimum

acceptable rate of return.

comparison between different capital projects is the use of IRR.

ILLUSTRATION

To illustrate the calculation of IRR, consider the cash flows of a project being

considered by TECHTRON LTD

Year

30000

30000

40000

45000

100000= (30000/(1+r)^1) + (30000/(1+r)^2) + (40000/(1+r)^3) + (45000/(1+r)^4)

The calculation of r involves a process of trial and error. We try different values of r till we find

that the right hand side of the above equation is equal to 100000. Let us, to begin with, try r

= 15%

(30000/ (1+0.15) ^1) + (30000/ (1+0.15) ^2) + (40000/ (1+0.15) ^3) + (45000/ (1+0.15)

^4) = 100,802.

Since 100802 > 100000, we can increase the value of r from 15 to 16 %. (in general, a higher

r lowers and a smaller r increases the right hand side value). The right hand side becomes:

Continue.

(30000/ (1+0.16) ^1) + (30000/ (1+0.16) ^2) + (40000/ (1+0.16) ^3) + (45000/ (1+0.16)

^4) = 98,641.

Since this value is less than 100000, we conclude that the value of r lies between 15 or 16

%.

If a more refined estimate of r is needed, use of the two closest rate of return.

Step 1.

(NPV/ 15%)

802

(NPV/ 16%)

(1359)

Step 2. find the sum of the absolute values of the net present values obtained in step 1:

802+1359= 2161

Step 3. calculate the ratio of the NPV of the smaller discount rate, identified in step 1, to

the sum obtained in step

2:

802/2161= 0.37

Step 4. add the number obtained in step 3 to the smaller discount rate:

15+0.37= 15.37% (IRR).

of capital.

Reject: if the IRR is less than the cost of

capital.

MODIFIED IRR

TheModified Internal Rate of Return(MIRR) is afinancialmeasure of

aninvestment's attractiveness.It is used incapital budgetingto rank

alternative investments of equal size. As the name implies, MIRR is a

modification of theinternal rate of return(IRR) and as such aims to

resolve some problems with the IRR.

While there are severalproblems with the IRR, MIRR resolves two of them.

Firstly, when the cash flows of the project are not conventional or when

two or more projects are being compared to determine which one is the

best.

Secondly, IRR cannot distinguish between lending and borrowing.

Thirdly, IRR is difficult to apply when short term interest rates differ from

long term interest rates.

finally, more than one IRR can be found for projects with alternating

positive and negative cash flows, which leads to confusion and ambiguity.

MIRR finds only one value.

wherenis the number of equal periods at the end of which the cash

flows occur (not the number of cash flows),PVispresent value(at the

beginning of the first period),FVis future value(at the end of the last

period).

illustration

Year

(4000)

5000

2000

given by:

In this case, the answer is 25.48% (with this conventional pattern of cash flows,

the project has a unique IRR).

To calculate the MIRR, we will assume a finance rate of 10% and a reinvestment

rate of 12%. First, we calculate the present value of the negative cash flows

(discounted at the finance rate):

CONT

Second, we calculate the future value of the positive cash flows (reinvested

at the reinvestment rate):

The calculated MIRR (17.91%) is significantly different from the IRR (25.48%).

EVALUATION

MIRR is superior to the IRR in two ways:

1.MIRR assumes that projects cash flows are reinvested

at the cost of capital whereas IRR assumes that project

cash flows are reinvested at the projects own IRR.

2.The problem of multiple rates does not exist with MIRR.

Thus, MIRR is a distinct improvement over the regular

IRR.

It is as good as NPV in choosing mutually exclusive

projects.

INCREMENTAL ANALYSIS

a technique or approach that can be used with NPW,

EAW and later with IRR and cost/ benefit to determine

if an incremental expenditure should be made.

Incremental analysis can also be used when you

are already incurring an expense.

(e.g; DSL internet service)

and you are trying to determine if it is a good

decision to spend additional funds.(e.g; satellite or

cable)

Assume that an MIRR of 16% per year is required, and $85 000 is available

to invest:

Project A requires $50 000 upfront to obtain an IRR of 35% per year.

Project B requires an $85 000 first cost and returns an IRR of 29% per

year.

000)

= 27.2% per year

Project B returns an IRR of 29% per year on ALL the money available to

invest.

Rank projects from lowest to highest initial cost

Eliminate any projects with IRR < MIRR

Let A & B two projects with IRR and MIRR

Starting from the least expensive project to the next most expensive, justify each

incremental investment

IRR(A) > MIRR(B)

Project

The ARR also referred to as the average rate of return on investment, is a

measure of profitability which relates income to investment, both measured

in accounting terms and is defined as:

profit after tax

book value of the investment

since income and investment can be measured in different ways, there can

be a very large number of measures for ARR.

MEASURES OF ARR

A.Average

B.Average

C.Average

D.Average

income

income

income

income

after

after

after

after

tax/ Average investment.

tax but before interest/ Initial investment.

tax but before interest/ Average investment.

F. Average income after tax but before interest/ Average investment.

G. (Total income after tax but before dep.- initial investment)/ (Initial

investment2) year.

2.Based on accounting information which

is readily available

3.It considers benefits over the entire life

of the project

SHORTCOMINGS ARE:

1.It is based upon accounting profit, not cash flow

2.It does not take into account the time value of money.

EVALUATION:

the higher the ARR, the better the project.

In general ARR > pre specified cut off rate of return(between

15 & 30%) are accepted, others are rejected.

. The computation of various measures of ARR with

reference to a hypothetical project.

Please see exhibit 8.10, chapter 8, PRASANNA CHANDRA,

PROJECTS.

Economic Analysis

A systematic approachto determining the

optimum use of scarce

resources. It takes

intoaccounttheopportunity costsof

resourcesemployedandattemptstomea

sureinmonetaryterms the private

andsocial costs andbenefits of

aprojectto the community or economy.

Cost benefit

analysis(CBA)

Cost Effective

Analysis(CEA)

Cost Utility

Analysis(CUA)

A cost-benefit analysis (CBA) is a

systematic process for calculating

and comparing benefits and costs of

a project or decision. A CBA helps

predict whether the benefits of a

project or decision outweigh its costs,

and by how much relative to other

alternatives.

Purpose of CBA

A CBA has two purposes:

1. To determine if the project or

decision is a sound.

2. To provide a basis for comparing

projects or decisions. It involves

comparing the total expected cost of

each option against the total

expected benefits.

Principles of CBA

Common unit of measurement

Representation of customers or

producers valuation

Benefit measurement by market

choice

No double counting of benefits or

costs

Some measurement of benefit may

consider human factor

Net benefit

=160000-114000

=46000

= benefit/ cost

=160000/11400

0

=1.40

Cost of capital 12%, initial investment 100,000

Benefits:

year1 - 25000

year2- 40000

year3- 40000

year4- 50000.

Here, the BCR measures for this project got by dividing

present value of benefits by the initial value of

investment. i.e: PV factor: (1+i)^n, then we get BCR

1.145.

And NBCR= BCR-1=0.145.

When BCR

NBCR

RULE IS

Decision rule

>1

>0

ACCEPT

=0

=O

INDIFFERENT

<1

<0

REJECT

Cost-effectiveness analysis(CEA) is a

form ofeconomic analysisthat

compares the relative costs and

outcomes (effects) of two or more

courses of action.

CBA Vs CEA

CBA

CEA

Considers only

monetary value of

output.

Highly used in

industrial or technical

sector.

Focus on monetary

value.

Cost is a denominator

Considers both

monetary and non

monetary value of

output.

Highly used in

Training and personnel

programs.

Focus on no of units.

Cost is a numerator

Math on CEA

Albert healthcare

Intervention

QALY Gained

Net Cost

20

$500

30

$2000

25

$1000

Intervention

QALY Gained

Net Cost

20

$500

25

$1000

30

$2000

CE ratio

Intervention

QALY Gained

Net Cost

per

day(effectiven

ess)

CE ratio

(Net Cost/QALY

Gained)

20

$500

$25

25

$1000

$50

30

$2000

$67

(lowest) cost-effectiveness ratio

ICER

Shipment to new option(From X to Z)

incremental cost = (Cost Z Cost X) = $1000-$500

= $500

incremental benefit = (QALYs Z QALYs X) = 25

QALYs -20 QALYs = 5 QALYs

($1000-$500)/( 25 QALYs -20 QALYs) = $500/5

QALYs = $100/QALY.

This means if we chose to implement

intervention Z in place of intervention X, it would

cost $100 per unit additional health benefit that

Cost-utility

analysis

is

used

to

determine cost in terms of utilities,

especially quantity and quality of life. It

is often used in health appraisals. In a

CUA, costs are expressed in monetary

terms and outcomes/ benefits are

expressed in utility terms e.g.

outcomes are often defined in quality

adjusted life years (QALYs).

Mathematical Problem

two methods used incapital budgetingto compare

mutually exclusiveprojects with unequal lives.

The equivalent annualannuity(EAA) approach calculates

the constant annualcash flowgenerated by a project

over its lifespan if it was an annuity. Thepresent valueof

the constant annualcash flowsis exactly equal to the

project'snet present value.

compare projects:

1.Calculate each project's NPV over its lifetime.

2.Compute each project's EAA, such that the present

value of the annuities is exactly equal to the project

NPV

3.Compare each project's EAA and select the one with

the highest EAA.

CALCULATION

NET PRESENT VALUE

EAA =

project

discount rate

Decision Rule

preferred

Application

Assessing alternative projects of unequal lives.

Determining the optimum economic life of an asset.

Assessing whether leasing an asset would be more economical than

purchasing it.

change the useful life

of an asset.

achieve a desired result.

APPLICATION

equipment.

asset.

Combustion Systems is engaged in development of car racing games. The company has to

choose between two games: Outback and Accelerate. Outback introduces a revolutionary

technology called SRP and is expected to stay fresh for 5 years. Accelerate is more of a low

cost traditional racing game and is sort of an upgrade to Nitrous, the current best-seller.

Accelerate is expected to generate sales for only 2 years.

Following is the schedule of each project's cash flows:

Year

Outback

0

1

(150000 500000

0)

Accelerate (800000 800000

)

2

600000

3

800000

4

300000

5

200000

200000

optimization and testing of the game, and hence the higher initial investment. Outback has

higher risk which warrants use of a 10% discount rate as compared to a rate of 8%

applicable to Accelerate.

Which project the company should go ahead with?

Solution:

Outback

Accelerate

discount

factor

Present

value

Cash flows 8%

discount

factor

(15,000,00

0)

1.0000

(15,000,00 (8,000,000

0)

)

5000,000

0.9091

4545500

6,000,000

0.8264

8,000,000

3,000,000

2,000,000

0.7513

0.6830

0.6209

NPV

year

Present

value

1.0000

(8,000,000

)

8,000,000

0.9259

7,407,407

4,958,678

2,000,000

0.8573

1,714,678

6,010,518

2,049,040

1,241,843

3,805,534

NPV

1,122,085

3

4

5

The second step involves finding the cash flows occurring at each

year end that would equal the relevant net present value when

discounted at the relevant discount rate.

EAA(Outback)=

3805534

(1-(1+10%)^5)/10%

EAA(Accelerate)=

629231

1003890

1122085

(1-(1+8%)^2/8%

Since Outback has higher equivalent annual annuity, it is the clear winner. The company

should work on Outback.

option

Machine A

Machine B

Investment cost

$50,000

$150,000

Expected lifetime

3 years

8 years

$7,500

150000/A8,5+7500=30708

50000/A3,5+13000= 31360

Cost of capital is 5%

since it has a lower EAC.

annuity factor

=(1-(1+i)^n)/i

Real Options Valuation, also often termedreal options

analysis, (ROV or ROA) appliesoption valuation

techniquestocapital budgeting decisions.

obligation to undertake certain business initiatives,

such as deferring, abandoning, expanding, staging, or

contracting a capital investment project.

EXAMPLE

For example, the opportunity to invest in the

expansion of a firm's factory, or alternatively to sell

the factory, is a realcallorput option, respectively.

Real options analysis, as a discipline, extends from

its application incorporate finance, todecision

making under uncertaintyin general, adapting the

techniques developed for financial optionsto "reallife" decisions.

Investment decision can be treated as the exercising of an option.

Firm has option to invest.

Need not exercise the option now can wait for more

information.

If investment is irreversible (sunk cost), there is an opportunity

cost of investing now rather than waiting.

Opportunity cost (value of option) can be very large.

The greater the uncertainty, the greater the value of the firms

options to invest, and the greater the incentive to keep these

options open.

Note that value of a firm is value of its capital in place plus the

value of its growth options.

Valuation Inputs:

The options underlying is the project

in question. It is modelled in terms of

Spot price

volatility: 1) price/Historical

2) implied volatility

Dividends

OPTION CHARACTERISTICS

1)strike price

2)Option term

3)Option style & option exercise:

Option to contract

Option to abandon

Option to extract

EXAMPLES

R&Dmanagers can use Real

Options Valuation to help them

allocate their R&D budget among

diverse projects;

a non business example might

be the decision to join the work

force, or rather, to forgo several

years of income to

attendgraduate school

"Investment

Example"

Consider a firm that has the option to

invest in a new factory. It can invest

this year or next year. The question

is: when should the firm invest? If the

firm invests this year, it has an

income stream earlier. But, if it

invests next year, the firm obtains

further information about the state of

the economy, which can prevent it

from investing with losses.

EXAMPLE CONT

Investment Example

this year: 5M. If it invests next year, the discounted

cash flows are 6M with a 66.7% probability, and 3M

with a 33.3% probability. Assuming a risk neutral rate

of 10%, futurediscounted cash flowsare, in present

terms, 5.45M and 2.73M, respectively. The investment

cost is 4M. If the firm invests next year, the present

value of the investment cost is 3.63M.

Following thenet present valuerule for investment,

the firm should invest this year because

thediscounted cash flows (5M) are greater than the

investment costs (4M) by 1M. Yet, if the firm waits for

next year, it only invests if discounted cash flows do

not decrease. If discounted cash flows decrease to

3M, then investment is no longer profitable. If, they

grow to 6M, then the firm invests. This implies that the

firm invests next year with a 66.7% probability and

earns 5.45M - 3.63M if it does invest. Thus the value to

invest next year is 1.21M. Given that the value to

invest next year exceeds the value to invest this year,

the firm should wait for further information to prevent

losses. This simple example shows

firm to take unnecessary risk, which could

be prevented by real options valuation.

mineral, and oil industries. In this example, it is studied a staged

investment abroad in which a firm decides whether to open one

or two stores in a foreign country. This is adapted from"Staged

Investment Example"

The firm does not know how well its stores are accepted in a

foreign country. If their stores have high demand, the discounted

cash flowsper store is 10M. If their stores have low demand,

thediscounted cash flowsper store is 5M. Assuming that the

probability of both events is 50%, the expecteddiscounted cash

flowsper store is 7.5M. It is also known that if the store's demand

is independent of the store: if one store has high demand, the

other also has high demand. The risk neutral rate is 10%. The

investment cost per store is 8M.

Should the firm invest in one store, two stores, or not invest?

Thenet present valuesuggests the firm should not invest: the

net present value is -0.5M per store. But is it the best alternative?

Following real options valuation, it is not: the firm has the real

option to open one store this year, wait a year to know its

demand, and invest in the new store next year if demand is high.

By opening one store, the firm knows that the probability of high

demand is 50%. The potential value gain to expand next year is

thus 50%*(10M-8M)/1.1 = 0.91M.

The value to open one store this year is 7.5M - 8M = -0.5. Thus

the value of the real option to invest in one store, wait a year,

and invest next year is 0.41M. Given this, the firm should opt by

opening one store. This simple example shows that

Stage investment

the firm should not invest.

SWITCHING VALUE/COST

Switching costs are the negative costs that a consumer incurs as a

result of changing suppliers,brandsor products.

It may be..

Inmutual funds, the process of transferring an investment from one

fund to another.

In securities, the process of liquidating a position in exchange for

other securities with better prospects for growth, yields orcapital

gains.

strategies that incur some sort of high cost in order to

dissuade customers from switching to a competitor's

product, brand or services.

For example, many cellular phone carriers charge very

highcancellationfees for canceling a contract. Cell

phone carriers do this in hopes that the costs involved

with switching to another carrier will be high enough

to prevent their customers from doing so.

Cont..

1.Investors mayswitchtheir assets between funds in

the same family or into a different family entirely.

use the cash received from theliquidationof their

initial securities to purchase new securities.

the best product and assume that the

customers will come.

If you want to be agoodproduct

manager,understand relevant switching costs

and attempt to reduce them as much as possible

to improve customer acquisition and perceived

value.

Switching cost:

the price of the product to purchase.

These switching costs take multiple

different forms:

learning cost

Opportunity cost

implementation cost

conversion cost

Multinational Capital

Budgeting

Like domestic capital budgeting, this focuses

on the cash inflows and outflows associated

with prospective long-term investment projects

Capital budgeting follows same framework as

domestic budgeting

Identify initial capital invested or put at risk

Estimate cash inflows, including a terminal value or

salvage value of investment

Identify appropriate discount rate for PV calculation

Apply traditional NPV or IRR analysis

Budgeting

together with their probability of

occurrence.

Inflation.

Although

price/cost

forecasting

implicitly

considers

inflation, inflation can be quite

volatile from year to year for some

countries.

Capital Budgeting

Financing arrangement. Financing costs

rate. However, many foreign projects are

partially financed by foreign subsidiaries.

Blocked

require that the earnings be reinvested

locally for a certain period of time before

they can be remitted to the parent.

Capital Budgeting

Uncertain

typically has a significant impact on the projects

NPV, and the MNC may want to compute the

break-even salvage value.

business for the same customers.

Host government incentives. These should also

Firms Perspective

One recipe for international decision

makers:

1. Estimate future cash flows in

foreign currency.

2. Convert to the home currency at

the predicted exchange rate.

3. Calculate NPV using the home

currency cost of capital.

Firms Perspective: Example

A U.S.-based MNC is considering a

European opportunity.

To simplify the example

There

There

There

There

is no incremental debt

is no incremental depreciation

are no concessionary loans

are no restricted funds

Firms Perspective: Example

A U.S. MNC is considering a European

opportunity. The size and timing of the

after-tax cash flows are:

600

200

500

300

The inflation rate in dollars is $ = 6%

The business risk of the investment would lead the U.S.based firm to demand a return of Kud = i$ = 15%.

Firms Perspective: Example

600

200

500

300

$1.25

The current exchange rate is S0($/) =

U.S. shareholders?

To address that question, lets convert all of the cash

flows to dollars and then find the NPV at i$ = 15%.

Firms Perspective: Example

$750

600

200

500

300

$1.25 = $750

CF0 = (600) S0($/) =(600)

$1.25

flow is easy; convert at the spot rate: S0($/) =

Firms Perspective: Example

$750

600

$257.28

200

500

300

can be found as:

1 + $

1.06

$1.25

S1($/) = 1 + S0($/) =

= $1.2864/

1.03

Firms Perspective: Example

$750

600

$257.28

200

$661.94

500

300

CF2=

1.06

1.03

1.06

1.03

$1.25

500 = $661.94

Firms Perspective: Example

$750

600

$257.28

200

$661.94

500

CF3=

1.06

1.03

1.06

1.03

1.06

1.03

$408.73

300

$1.25

300 = $408.73

Firms Perspective: Example

$750

$257.28

$661.94

$408.73

Find the NPV using the cash flow @ interest rate i$ = 15%:

CF0 = $750

CF1 = $257.28

CF2 = $661.94

CF3 = $408.73

= 15

NPV = $242.99

Firms Perspective: Alternative

Another recipe for international decision

makers:

1. Estimate future cash flows in foreign

currency.

2. Estimate the foreign currency discount

rate.

3. Calculate the foreign currency NPV using

the foreign cost of capital.

4. Translate the foreign currency NPV into

dollars using the spot exchange rate

Method

600

200

500

300

= 3%

i$ = 15%

cash flows to find the NPV in euros.

$ = 6%

at the spot rate.

$1.25

The current exchange rate is S0($/) =

Capital: i

Recall that the Fisher Effect holds that

(1 + e) (1 + $) = (1 + i$)

real

rate

inflation

rate

nominal

rate

(1 + e) =

(1 + i$)

(1 + $)

Capital: i

If Fisher Effect holds here and abroad then

(1 + e$) =

(1 + i$)

(1 + $)

and

(1 + e) =

(1 + i)

(1 + )

If the real rates are the same in dollars and euros (e = e$)

(1 + i$)

(1 + $)

(1 + i)

(1 + )

Capital: i

If we have any three of these variables, we can find the fourth:

(1 + i$)

(1 + $)

(1 + i)

(1 + )

(1 + i) =

i =

(1.15) (1.03)

(1.06)

(1 + i$) (1 + )

(1 + $)

1

i = 0.1175

Example

600

200

500

300

Find the NPV using the cash flow menu and i = 11.75%:

CF0 = 600

CF1 = 200

CF2 = 500

CF3 = 300

= 11.75

NPV = 194.39

$1.25 = $242.99

194.39

600

200

500

300

1

3

2

200

500

300

=

194.39

+

+

NPV = 600 +

1.1175

(1.1175)2

(1.1175)3

$750

$257.28

194.39

$1.25 = $242.99

$661.94

$408.73

1

3

2

$257.28 $661.94

$408.73

= $242.99

+

+

NPV = $750 +

2

3

1.15

(1.15)

(1.15)

International Capital

Budgeting

We have two equally valid approaches:

Change the foreign cash flows into dollars at

the exchange. Find the $NPV using the

dollar cost of capital.

Find the foreign currency NPV using the

foreign currency cost of capital. Translate

that into dollars at the spot exchange rate.

exactly the same answer either way.

Which method you prefer is your choice.

18-112

Computing IRR

Recall that a projects Internal Rate of

Return (IRR) is the discount rate that

gives a project a zero NPV.

NPV = 600 +

200

1+IRR

IRR = 28.48%

NPV = $750 +

$257.28

1+IRR$

IRR$ = 32.23%

18-113

500

(1+IRR)

$661.94

(1+IRR$)

300

(1+IRR)

$408.73

(1+IRR$)

= 0

= $0

Computing IRR

Easily done with the IRR key

NPV = 600 +

CF0 = 600

200

1+IRR

500

(1+IRR)

300

(1+IRR)

CF2 = 500

18-114

= 0

IRR = 28.48%

CF1 = 200

CF3 = 300

IRR = 28.48%

Computing IRR

Easily done with the IRR key

NPV = $750 +

$257.28

1+IRR$

CF0 = $750

$661.94

(1+IRR$)

$408.73

(1+IRR$)

CF2 = $661.94

18-115

= $0

IRR$ = 24.85%

CF1 = $257.28

CF3 = $408.73

IRR = 32.23%

Use the same IRP and PPP conditions

that we used to convert from one

discount rate to another.

1+IRR$

(1 + $)

(1+IRR$) =

1+IRR

(1 + )

Finding IRR$ without converting all cash

flows into dollars is straightforward:

(1+IRR)(1 + $)

(1 + )

= 3%, $ = 6%

18-116

i =

(1.2848)(1.06)

(1.03)

IRR$ = 32.23%

Use the same IRP and PPP conditions

that we used to convert from one

discount rate to another.

1+IRR$

(1 + $)

(1+IRR$) =

1+IRR

(1 + )

Finding IRR$ without converting all cash

flows into dollars is straightforward:

(1+IRR)(1 + $)

(1 + )

= 3%, $ = 6%

18-117

i =

(1.2848)(1.06)

(1.03)

IRR$ = 32.23%

INVESTOPEDIA

SEE PRASANNA CHANDRA, PROJECTS,

8TH EDITION

SEE GITMAN, MANAGERIAL FINANCE,

8TH EDITION

SEE ROSS, WESTERFIELD, JEFFE,

CORPORATE FINANCE, 7TH EDITION

Q&A

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