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MBA 906: Financial Strategy and Governance

ASSIGNMENT 1: BASIC FINANCIAL CONCEPTS (25% WEIGHT)

Released date: 25th of May, 2022

Submission Date: 29th of May, 2022 (20% plenty for late submission)

Submission: Moodle course site

Financial Management Decisions (10 MARKS)

1. What are the major financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

2. Give five examples of ways in which manager’s goals can differ from those of shareholders.

3. Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your companys management immediately begins fighting off this hostile bid. Is management acting in the shareholders best interests? Why or why not?

Time Value of Money (15 MARKS)

1. You are considering two separate investments. Both investments pay 7 percent interest. Investment A pays simple interest and Investment B pays compound interest. Which investment should you choose, and why, if you plan on investing for a period of 5 years?

2. You would like to retire in 30 years as a millionaire. If you have $15,000 today, what rate of return do you need to earn to achieve your goal?

3. Youve been saving up to buy your dream house. The total cost will be $2 million. You currently have about $0.3 million. If you can earn 4.5 percent on your money, how long will you have to wait?

4. You have 40 years left until retirement and want to retire with $2 million. Your salary is paid annually, and you will receive $40,000 at the end of the current year. Your salary will increase at 3 percent per year, and you can earn an 11 percent return on the money you invest. If you save a constant percentage of your salary, what percentage of your salary must you save each year?

Comparing Investment Criteria (25 MARKS)

Consider the following two mutually exclusive projects:

Year

Cash Flows (A)

Cash Flows (B)

0

-$300,000

-$40000

1

20,000

19,000

2

50,000

12,000

3

50,000

18,000

4

390,000

10,500

Whichever project you choose, if any, you require a 15 percent return on your investment.

1. If you apply the payback criterion, which investment will you choose? Why?

2. If you apply the discounted payback criterion, which investment will you choose? Why?

3. If you apply the NPV criterion, which investment will you choose? Why?

4. If you apply the IRR criterion, which investment will you choose? Why?

5. If you apply the profitability index criterion, which investment will you choose? Why?

6. Based on your answers in (a) through (e), which project will you finally choose? Why?

Capital Budgeting (25 MARKS)

Corporation ABC is considering a four-year project to improve its production efficiency. Buying a new machine press for $560,000 is estimated to result in $210,000 in annual pretax cost savings. The press falls in the MACRS five-year class, and it will have a salvage value at the end of the project of $80,000. The press also requires an initial investment in spare parts inventory of $20,000, along with an additional $3,000 in inventory for each succeeding year of the project. If the companys tax rate is 35 percent and its discount rate is 9 percent, should the company buy and install the machine press? MACRS Rates: 20%, 32%, 19.20%, 11.52%

Risk and Return (25 MARKS)

Explain what CAPM tells us and how to practically use CAPM beta for investment decisions.

Consider the following information about three stocks:

State of Economy

Probability of State of Economy

Expected returns of Stock A

Expected returns of Stock B

Expected returns of Stock C

Boom

35%

24%

36%

55%

Normal

50%

17%

13%

9%

Bust

15%

0%

-28%

-45%

a. If your portfolio is invested, 40 percent each in stock A and stock B and 20 percent in stock C, what is the portfolio expected return and the standard deviation and variance.

b. You own a stock portfolio invested 25 percent in Stock Q, 20 percent in Stock R, 15 percent in Stock S, and 40 percent in Stock T. The betas for these four stocks are .84, 1.17, 1.11, and 1.36, respectively. What is the portfolio beta?

c. A stock has an expected return of 13.5 percent, its beta is 1.17, and the risk-free rate is 5.5 percent. What must the expected return on the market be? 5-1

MBA 906 Financial Strategy and Governance

Dr. Kashif Saleem

E-mail: [emailprotected]

Office: Room 4.18, 4th floor

5-2

FINANCE

Finance : MANAGING MONEY

Trade-off between the present and future

At the personal level:

earnings

savings

investing

In a business context:

raise money

invest money

reinvest profits

distribute them back to investors.

4.2

5-3

WHAT IS CORPORATE FINANCE?

IMAGINE that you were to start your own business. No matter what type you started, you would have to answer the following three questions in some form or another:

What long-term investments should you take on? That is, what lines of business will you be in and what sorts of buildings, machinery, and equipment will you need?

Where will you get the long-term financing to pay for your investment? Will you bring in other owners or will you borrow the money?

How will you manage your everyday financial activities such as collecting from customers and paying suppliers?

4.3

5-4

FINANCIAL MANAGEMENT DECISIONS

4.4

5-5

FINANCIAL MANAGEMENT DECISIONS

CAPITAL BUDGETING – long-term investments.

The process of planning and managing a firms long-term investments is called capital budgeting.

In capital budgeting, the financial manager tries to identify investment opportunities

The types of investment opportunities – depend in part on the nature of the firms business Example: Wal-Mart, Oracle or Microsoft.

Regardless of the specific nature of an opportunity under consideration, financial managers must be concerned:

not only with how much cash they expect to receive

but also with when they expect to receive it and how likely they are to receive it.

Evaluating the size, timing, and risk of future cash flows is the essence of capital budgeting.

4.5

5-6

FINANCIAL MANAGEMENT DECISIONS

CAPITAL STRUCTURE

A firms capital structure (or financial structure) is the specific mixture of long-term debt and equity the firm uses to finance its operations.

The financial manager has two concerns in this area.

First, how much should the firm borrow? That is, what mixture of debt and equity is best? The mixture chosen will affect both the risk and the value of the firm.

Second, what are the least expensive sources of funds for the firm?

Firms have a great deal of flexibility in choosing a financial structure

In addition to deciding on the financing mix, the financial manager has to decide exactly how and where to raise the money.

4.6

5-7

FINANCIAL MANAGEMENT DECISIONS

WORKING CAPITAL MANAGEMENT

The term working capital refers to a firms short-term assets, such as inventory, and its short-term liabilities, such as money owed to suppliers.

Managing the firms working capital is a day-to-day activity

This involves a number of activities related to the firms receipt and disbursement of cash.

How much cash and inventory should we keep on hand?

Should we sell on credit? If so, what terms will we offer

How will we obtain any needed short-term financing? Will we purchase on credit or will we borrow in the short term and pay cash?

If we borrow in the short term, how and where should we do it?

4.7

Examples of Recent Investment and Financing Decisions by Major Public Corporations

5-8

5-9

Forms of Business Organization

SOLE PROPRIETORSHIP

PARTNERSHIP

GENERAL PARTNERSHIP

LIMITED PARTNERSHIP

THE CORPORATION

legal person

articles of incorporation

joint stock companies,

public limited companies,

limited liability companies

4.9

5-10

The Goal of Financial Management

POSSIBLE GOALS

If we were to consider possible financial goals, we might come up with some ideas like the following:

Survive.

Avoid financial distress and bankruptcy.

Beat the competition.

Maximize sales or market share.

Minimize costs.

Maximize profits.

Maintain steady earnings growth.

Each of these possibilities presents problems as a goal for the financial manager

4.10

5-11

THE FINANCIAL MANAGER

owners (the stockholders) are usually not directly involved in making business decisions

corporation employs managers to represent the owners interests and make decisions on their behalf

In a large corporation, the financial manager would be in charge of answering the three questions we raised

4.11

5-12

The Agency Problem

in large corporations ownership can be spread over a huge number of stockholders.

This dispersion of ownership arguably means that management effectively controls the firm.

In this case, will management necessarily act in the best interests of the stockholders? Put another way, might not management pursue its own goals at the stockholders expense?

AGENCY RELATIONSHIPS

The relationship between stockholders and management is called an agency relationship.

Such a relationship exists whenever someone (the principal) hires another (the agent) to represent his or her interests.

4.12

5-13

The Agency Problem

More generally, the term agency costs refers to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct.

An indirect agency cost is a lost opportunity

Direct agency costs come in two forms. The first type is a corporate expenditure that benefits management but costs the stockholders.

The second type of direct agency cost is an expense that arises from the need to monitor management actions. Paying outside auditors to assess the accuracy of financial statement information could be one example.

4.13

5-14

The Agency Problem

Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your companys management immediately begins fighting off this hostile bid.

4.14

The Agency Problem

principalagent problem

how corporations grapple with that problem.

Monitoring

Incentives: Making sure that managers and employees are rewarded appropriately when they add value to the firm.

Performance measurement: firms cant reward value added unless they can measure it.

Top management, including the CFO, must try to ensure that managers and employees have the right incentives to find and invest in positive-NPV projects.

5-15

Agency problem Solution

To solve the agency problem that arises from the conflicting interests of agents and principals, economists have considered various ways to COMPENSATE AGENTS in order to motivate them to work for the benefit of the principals

5-16

Incentive Compensation

The amount of compensation may be less important than how it is structured.

The compensation package should encourage managers to maximize shareholder wealth.

based on input (for example, the managers effort) – How can outside investors observe effort? effort is not observable

or on output (income or value added as a result of the managers decisions). do results always depend just on the managers contribution?

link part of their executive pay to the stock-price performance – Stock options, restricted stock (stock that must be retained for several years), or performance shares (shares awarded only if the company meets an earnings or other target).

Relative performance – industry Equity compensation

5-17

Management Compensation

5-18

Management Compensation

5-19

Incentive Compensation: stock-price performance

CEOs might sacrifice increasing dividends in favor of using the cash to try to increase the stock price

CEOs have a tendency to pick a higher risk business strategy

CEOs may try to time stock price movements to match the time horizons of their own stock options

Disney CEO Michael Eisner Stock options create the possibility that only short-term value will be created, not long-term value

5-20

Disney CEO Michael Eisner

5-21

Example: Xerox Corporation

5-22

Management Compensation

excessive pay – big handouts to departing executives – left behind troubled and underperforming companies

Robert Nardelli (Home Depot) $210 million severance pay

Henry McKinnell (Pfizer) $200 million

Merrill Lynch: The second largest Wall Street bonus of 2008 the year that the financial system melted down was the $39.4 million paid out to Thomas Montag.

Lehman Brothers: CEO Richard Fuld was paid $484 million in salary (2000-2007)

Bear Stearns: CEO James Cayne was paid $163 million from 2003 to 2007

Countrywide Financial: Angelo Mozilo collected $471 million from 2002 to 2007

Bankers whose decisions contributed to the financial crisis were among the highest paid employees on Wall Street.

5-23

5-24

Financial Markets and the Corporation

4.24

5-25

Financial Markets and the Corporation

PRIMARY VERSUS SECONDARY MARKETS

The term primary market refers to the original sale of securities by governments and corporations.

The secondary markets are those in which these securities are bought and sold after the original sale.

Primary Markets:

public offering , private placement

Secondary Markets:

Dealer markets, Auction markets

4.25

5-26

Introduction to Valuation: The Time Value

of Money

5-27

Basic Definitions

Present Value earlier money on a time line

Future Value later money on a time line

Interest rate exchange rate between earlier money and later money

Discount rate

Cost of capital

Opportunity cost of capital

Required return or required rate of return

4.27

5-28

PV and FV

Finance uses compounding as the verb for going into the future and discounting as the verb to bring funds into the present.

Today

1

2

3

4

5

FV

PV

Today

1

2

3

4

5

FV

PV

Compounding

Discounting

28

5-29

Future Values: General Formula

FV = PV(1 + r)t

FV = future value

PV = present value

r = period interest rate, expressed as

a decimal

t = number of periods

29

5-30

Future Values

Today

1 Year

2 Years

$1,000

$1,050

?

Suppose you invest $1,000 for one year at 5% per year.

What is the future value in one year?

Interest = 1,000(.05) = 50

Value in one year = principal + interest = 1,000 + 50 = 1,050

Future Value (FV) = 1,000(1 + .05) = $1,050

4.30

5-31

Future Values

Suppose you leave the money in for another year.

How much will you have two years from now?

FV = 1,000(1.05)(1.05)

= 1,000(1.05)2 = $1,102.50

Today

1 Year

2 Years

$1,000

$1,050

$1,102.60

?

4.31

5-32

Effects of Compounding

Simple interest

Compound interest

Consider the previous example:

FV with simple interest = 1,000 + 50 + 50 = $1,100

FV with compound interest = $1,102.50

The extra $2.50 comes from the interest of .05(50) = $2.50 earned on the first interest payment or interest on interest

4.32

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Future Values Example 2

Suppose you invest the $1,000 from the previous example for 5 years.

How much would you have at time 5?

Today

1

2

3

4

5

$1,000

?

4.33

5-34

Future Values Example 2

Suppose you invest the $1,000 from the previous example for 5 years.

How much would you have at time 5?

Today

1

2

3

4

5

$1,000

?

$1,276.28

4.34

5-35

Future Values Example 2

The effect of compounding is small for a small number of periods, but increases as the number of periods increases.

(Simple interest would have a future value of $1,250, for a difference of $26.28.)

4.35

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Future Values-Example 3

Suppose you had a relative deposit $10 at 5.5% 200 years ago.

How much will you have today?

FV = 10(1.055)200

= 10 (44,718.9839) = $447,189.84

200 years ago

Today

$10

$447,189.84

4.36

5-37

Future Value as a General Growth Formula

Suppose your company expects to increase unit sales of widgets by 15% per year for the next 5 years. If you sell 3 million widgets in the current year, how many widgets do you expect to sell in the fifth year?

FV = 6,034,072 units

4.37

6-38

Multiple Cash Flows

Future Value 1

Suppose you have $1,000 now in a savings account that is earning 6%. You want to add $500 one year from now and $700 two years from now.

How much will you have two years from now in your savings account (soon after you make your $700 deposit)?

Today

1 Year

2 Years

$1,000

$500

$700

?

4.38

6-39

Multiple Cash Flows

Future Value 1

Simply look at each payment separately and compute the FV of each as we did in the earlier session.

Today

1 Year

2 Years

$1,000

$ 500

$ 700

$1,124

$ 530

Now just add them up

because they are all

adjusted to be in year 3 value

$2,354

4.39

6-40

Multiple Cash Flows

Future Value 1C

Lets add one more twist to the problem:

What would be the value at year 5 if we made no further deposits into our savings account?

Today

1

2

3

4

5

$1,000

?

500

700

40

6-41

Multiple Cash Flows

Future Value 1C

We could do this two different ways:

2. Bring each of the three original dollars to year 5 and add them all up.

Today

1

2

3

4

5

$2,803

$1,000

?

500

700

$1,338

$ 631

$ 833

41

5-42

Present Values

If we can go forward in time to the future (FV), then why cant we go backward in time to the present (PV)?

We can!

As a matter of fact, finance uses the process of moving future funds back into the present when we value financial instruments like bonds, preferred stock, and common stock. We also use it to evaluate investing in projects.

4.42

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Present Values

If we can go forward in time to the future (FV), then why cant we go backward in time to the present (PV)?

We can! All we need to do is refocus our concept of moving money through time.

Today

1

2

3

4

5

FV

PV

4.43

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Present Values

When we talk about discounting, we mean finding the present value of some future amount.

When we talk about the value of something, we are talking about the present value unless we specifically indicate that we want the future value.

4.44

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Present Values

How much do I have to invest today to have some amount in the future?

FV = PV(1 + r)t

Rearrange to solve for PV:

PV = FV / (1 + r)t

4.45

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Present Value: One Period Example

Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually, how much do you need to invest today?

PV = 10,000 / (1.07)1 = $9,345.79

4.46

5-47

Present Values-Example 1

Suppose you need $10,000 in one year for the down payment on a new car. If you can earn 7% annually.

PV = 10,000 / (1.07)1

= $9,345.79

$9,345.79

$10,000

?

Today

1

i = 7%

How much do you need to invest today?

4.47

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Present Values Example 2

Your Dad want to begin saving for your college education and he estimate that you will need $150,000 in 17 years. If he feel confident that he can earn 8% per year, how much he need to invest today?

N = 17; i = 8;

FV = 150,000

PV = FV /(1+i)^17 = ?

$40,540.34

$150,000

?

Today

17

i = 8%

4.48

6-49

Multiple Cash Flows

Present Value

To compute the present value of multiple cash flows, we again just bring the payments into the present value one year at a time.

6-50

Multiple Cash Flows

Present Value – 1

Consider receiving the following cash flows:

Year 1 CF = $200

Year 2 CF = $400

Year 3 CF = $600

Year 4 CF = $800

If the discount rate is 12%, what would this cash flow be worth today?

6-51

Multiple Cash Flows

Present Value -1

Find the PV of each cash flow and just add them up!

PV1 = 178.57

PV2 = 318.88

PV3 = 427.07

PV4 = 508.41

Total PV = 178.57 + 318.88 + 427.07 + 508.41 = $1,432.93

5.51

6-52

Multiple Cash Flows

Present Value – 2

You are considering an investment that will pay you $1,000 in one year, $2,000 in two years and $3,000 in three years. If you want to earn 10% on your money, how much would you be willing to pay?

PV (CF1) = 909.09

PV (CF2) = 1,652.89

PV (CF3) = 2,253.94

PV = 909.09 + 1,652.89 + 2,253.94 = 4,815.93

5.52

5-53

Discount Rate

Often we will want to know what the implied interest rate is on an investment

Rearrange the basic PV equation and solve for r:

FV = PV(1 + r)t

r = (FV / PV)1/t 1

53

5-54

Discount Rate Example 1

You are looking at an investment that will pay $1,200 in 5 years if you invest $1,000 today. What is the implied rate of interest?

r = (1,200 / 1,000)1/5 1 = .03714 = 3.714%

Calculator note the sign convention matters (for the PV)!

N = 5

PV = 1,000 (you pay 1,000 today)

FV = 1,200 (you receive 1,200 in 5 years)

R = 3.714%

4.54

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Discount Rate Example 2

Suppose you are offered an investment that will allow you to double your money in 6 years. You have $10,000 to invest. What is the implied rate of interest?

N = 6

PV = 10,000

FV = 20,000

R= 12.25%

4.55

5-56

Discount Rate Example 3

Suppose you have a 1-year old son and you want to provide $75,000 in 17 years towards his college education. You currently have $5,000 to invest. What interest rate must you earn to have the $75,000 when you need it?

N = 17; PV = 5,000; FV = 75,000

R = 17.27%

4.56

5-57

Finding the Number of Periods

Start with the basic equation and solve for t (remember your logs)

FV = PV(1 + r)t

t = ln(FV / PV) / ln(1 + r)

You can use the financial keys on the calculator as well; just remember the sign convention.

4.57

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Number of Periods: Example 1

You want to purchase a new car, and you are willing to pay $20,000. If you can invest at 10% per year and you currently have $15,000, how long will it be before you have enough money to pay cash for the car?

R = 10%; PV = 15,000; FV = 20,000

N = 3.02 years

4.58

5-59

Number of Periods: Example 2

Suppose you want to buy a new house. You currently have $15,000, and you figure you need to have a 10% down payment plus an additional 5% of the loan amount for closing costs. Assume the type of house you want will cost about $150,000 and you can earn 7.5% per year. How long will it be before you have enough money for the down payment and closing costs?

5-60

Number of Periods: Example 2 (Continued)

How much do you need to have in the future?

Down payment = .1(150,000) = 15,000

Closing costs = .05(150,000 15,000) = 6,750

FV=Total needed = 15,000 + 6,750 = 21,750

Compute the number of periods

PV = 15,000; FV = 21,750; R = 7.5%

N = 5.14 years

Using the formula

t = ln(21,750 / 15,000) / ln(1.075) = 5.14 years

4.60

6-61

Annuities and Perpetuities Definitions

Annuity finite series of equal payments that occur at regular intervals

If the first payment occurs at the end of the period, it is called an ordinary annuity

If the first payment occurs at the beginning of the period, it is called an annuity due

Most problems are ordinary annuities

Perpetuity infinite series of equal payments

6-62

Annuities and Perpetuities Basic Formulas

Perpetuity: PV = C / r

Annuity:

5.62

6-63

Annuity: Saving for a Car

After carefully going over your budget, you have determined you can afford to pay $632 per month towards a new sports car. You call up your local bank and find out that the going rate is 1% per month for 48 months. How much can you borrow?

5.63

6-64

Annuity: Saving for a Car

You borrow money TODAY so you need to compute the present value.

Formula:

5.64

6-65

Annuity: Buying a House

You are ready to buy a house, and you have $20,000 for a down payment and closing costs. Closing costs are estimated to be 4% of the loan value. You have an annual salary of $36,000, and the bank is willing to allow your monthly mortgage payment to be equal to 28% of your monthly income.

The interest rate on the loan is 6% per year with monthly compounding (.5% per month) for a 30-year fixed rate loan.

How much money will the bank loan you?

How much can you offer for the house?

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6-66

Annuity: Buying a House – Continued

Bank loan

Monthly income = 36,000 / 12 = 3,000

Maximum payment = .28(3,000) = 840

30*12 = 360 N

r = 0.5

C = 840/ month

PV = $140,105

Total Price

Closing costs = .04(140,105) = 5,604

Down payment = 20,000 5,604 = 14,396

Total Price = 140,105 + 14,396 = $154,501

5.66

6-67

Finding the Payment

Suppose you want to borrow $20,000 for a new car. You can borrow at 8% per year, compounded monthly

(8/12 = .66667% per month).

If you take a 4-year loan, what is your monthly payment?

20,000 = C[1 1 / 1.006666748] / .0066667

C = 488.26

5.67

6-68

Future Values for Annuities

Suppose you begin saving for your retirement by depositing $2,000 per year in a fund. If the interest rate is 7.5%, how much will you have in 40 years?

FV = $454,513.04

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6-69

Annuity Due

You are saving for a new house and you need 20% down to get a loan. You put $10,000 per year in an account paying 8%. The first payment is made today.

How much will you have at the end of 3 years

(you make a total of three $10,000 payments)?

FV = $35,061.12

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6-70

Perpetuity Example

Suppose the Fellini Company wants to sell preferred stock at $100 per share. A similar issue of preferred stock already outstanding has a price of $40 per share and offers a dividend of $1 every quarter.

What dividend will Fellini have to offer if the preferred stock is going to sell?

6-71

Perpetuity

Perpetuity formula: PV = C / r

Current required return:

40 = 1 / r

r = .025 or 2.5% per quarter

Dividend for new preferred:

100 = C / .025

C = 2.50 per quarter

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6-72

Growing Annuity

A growing stream of cash flows with a fixed maturity

6-73

Growing Annuity: Example

A defined-benefit retirement plan offers to pay $20,000 per year for 40 years and increase the annual payment by three-percent each year.

What is the present value at retirement if the discount rate is 10 percent?

6-74

Growing Perpetuity

A growing stream of cash flows that lasts forever

5.74

6-75

Growing Perpetuity Example

The expected dividend next year is $1.30, and dividends are expected to grow at 5% forever.

If the discount rate is 10%, what is the value of this promised dividend stream?

5.75 5-1

MBA 906 Financial Strategy and Governance

Dr. Kashif Saleem

E-mail: [emailprotected]

Office: Room 4.18, 4th floor

9-2

Net Present Value and Other

Investment Criteria

2

9-3

Replace Expand

Maintenance

or

Obsolescence

Current Product

or

Current Service

Cost

Reduction

New Product or

New Service

Uses of Capital Budgeting

3

9-4

Our Task:

To determine if we should invest in/purchase the project.

HOW?

9-5

Good Decision Criteria

For each of the criteria listed above, we need to ask following questions when evaluating capital budgeting decision rules:

Does the decision rule adjust for the time value of money?

Does the decision rule adjust for risk?

Does the decision rule provide information about wealth creation, that is, whether we are creating value for the firm?

5

9-6

Payback Period

Definition: How long does it take to get the initial cost back in a nominal sense?

Computation:

Estimate the cash flows

Subtract the future cash flows from the initial cost until the initial investment has been recovered

9-7

Project Example Information

You are reviewing a new project and have estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk level is 12%.

8.7

9-8

Project Example – Visual

R = 12%

$ -165,000

1

2

3

CF1 = 63,120

CF2 = 70,800

CF3 = 91,080

The required return for assets of this risk level is 12% (as determined by the firm).

Year 1: $165,000 63,120 = 101,880

We need to get to zero so keep going

Year 2: $101,880 70,800 = 31,080

We need to get to zero so keep going

Year 3: $31,080 91,080 = -60,000

We passed zero so payback is achieved

8

9-9

Payback Decision

We need to know a managements number. What does the firm use for the evaluation of its projects when they use payback?

Most companies use either 3 or 4 years.

Lets use 3 in our numerical example

9-10

Payback Decision

Our computed payback was 3 years

The firms uses 4 years as its criteria, so

YES, we Accept this project as we recover our cost of the project early.

9-11

Discounted Payback Period

Definition: How long does it take to get the initial cost back after you bring all of the cash flows to the present value.

Computation:

Estimate the present value of the cash flows

Subtract the future cash flows from the initial cost until the initial investment has been recovered

9-12

Discounted Payback Computation

56,357

56,441

64,829

R = 12%

$ -165,000

1

2

3

CF1 = 63,120

CF2 = 70,800

CF3 = 91,080

Year 1: 165,000 56,357 = 108,643; continue

Year 2: 108,643 56,441 = 52,202; continue

Year 3: 52,202 64,829 = -12,627; finished

9-13

Net Present Value

Definition: The difference between the market value of a project and its cost

Computation:

Estimate the future cash flows

Estimate the required return for projects of this risk level.

3. Find the present value of the cash flows and subtract the initial investment.

13

9-14

NPV Decision Rule

A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal, as measured in dollar terms.

14

9-15

Project Example – NPV

R = 12%

$ -165,000

1

2

3

CF1 = 63,120

CF2 = 70,800

CF3 = 91,080

15

9-16

Discounted Payback Computation

56,357

56,441

64,829

R = 12%

$ -165,000

1

2

3

CF1 = 63,120

CF2 = 70,800

CF3 = 91,080

177,627 = PV of all cash flows

NPV =$177,627 – $165,000 = $12,627

9-17

Net Present Value Decision

If the NPV is positive

(NPV > $0), then we ACCEPT the project. Conversely, if the NPV is negative, then we REJECT the project.

Thus in our case, the NPV is $12,627 so we ACCEPT the project.

9-18

Profitability Index

Definition: The PI measures the benefit per unit cost of a project, based on the time value of money. It is very useful in situations where you have multiple projects of hugely different costs and/or limited capital (capital rationing).

Computation: PI = PV of Inflows

PV of Outflows

18

9-19

Profitability Index Example

PI = PV of Inflows

PV of Outflows

$177,627 = 1.0765

$165,000

A Profitability Index of 1.076 implies that for every $1 of investment, we create an additional $0.0765 in value. A PI >1 means the firm is increasing in value.

19

9-20

Average Accounting Return

Definition: The AAR is a measure of the average accounting profit compared to some measure of average accounting value of a project. The AAR is then compared to a required return by the company.

Computation: AAR = Average Net Income

Average Book Value

20

9-21

Project Example Information

You are reviewing a new project and have estimated the following cash flows:

Year 0: CF = -165,000

Year 1: CF = 63,120; NI = 13,620

Year 2: CF = 70,800; NI = 3,300

Year 3: CF = 91,080; NI = 29,100

Average Book Value = 72,000

Your required return for assets of this risk level is 25%.

8.21

9-22

Average Accounting Return

Using the figures of our previous example:

1. ($13,620 + 3,300 + 29,100) / 3

46,020/ 3 = $15,340

AAR = 15,340 /72,000 = .2131 or 21%

If we compare this to our firms requirement of 25%, then we would Reject this project as the AAR < 25% 22 9-23 Internal Rate of Return This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere 23 9-24 Internal Rate of Return Definition: It is the discount rate (or required return) that will bring all of the cash flows into present value time and total the exact value of the cost of the project. Said another way, IRR is the return that will yield a NPV = $0. 24 9-25 Computing IRR for the Project If no Excel, then Trial & Error with linear interpolation Step1: Start off with an initial guess and compute NPV. Step2: If NPV >0, take a second guess that would give a negative NPV (if NPV<0, second guess should h

August 19, 2022

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August 19, 2022