FINC 3610 Test 4

Net Present Value (NPV)

A measure of how much value is created or added today by undertaking an investment (the difference between the investment’s market value and its cost)

Calculate the present value of future cash flows minus the initial cost

How to find NPV?

Required return

What must be an input to the calculator for NPV problems?

An investment should be accepted if the net present value is positive and rejected if it is negative

What is the NPV rule?

1. Uses all cash flows

2. Adjust for the time value of money

What are the pros of NPV?

1. Need appropriate discount rate

2. Relatively more difficult to communicate

What are the cons of NPV?

Net present value (NPV)

If you have a choice of investment criteria, what should you choose?

Internal Rate of Return (IRR)

The discount rate that makes the net present value of a project equal to zero

Set NPV equal to zero and for solve “r”. (Identical to caclulating YTM of bonds)

How to find IRR?

Interest rate

What is not inputted in the calc for IRR problems?

An investment is acceptable if it exceeds the required rate of return (assume cash flows are reinvested at the IRR)

What is the rule for IRR?

1. Closely rekated to the NPV rule

2. Relatively easier to communicate

What are the pros of IRR?

1. May result in incorrect decisions (mutually exclusive investments)

2. May result in multiple answers (nonconventional cash flows)

What are the cons of IRR?

The discount rate that makes the NPV’s of 2 projects equal

What is the Crossover Rate?

1. Calculate incremental cash flows

2. Calculate IRR based on incremental cash flows

What are the steps to calculate the crossover rate?

Modified Internal Rate of Return (MIRR)

A calculation of IRR on modified cash flows. It is the discount rate that equates the present value of all cash outflows to the future value of all cash inflows

1. Discount all cash outflows to time 0

2. Compound all cash inflows to the end of the project

3. Calculate the discount rate that makes them equal

How to calculate MIRR?

An investment is acceptable if it exceeds the required rate of return (assume cash flows are reinvested at the cost of capital)

What is the rule for MIRR?

1. Closely related to the NPV rule

2. No longer possible to get multiple answers

What are the pros of MIRR?

1. May result in incorrect decisions (mutually exclusive investments)

What are the cons of MIRR?

Profitability Index (PI)

The present value of an investment’s future cash flows divided by the initial cost (absolute value).

The Benefit-Cost Ratio

What is the Profitability Index also called?

Calculate the present value of the future cash flows (PV not NPV) and divide by the initial cost

How to calculate PI?

Greater than 1

If the project has a positive NPV, will the PI be greater or less than 1?

Less than 1

If the project has a negative NPV, will the PI be greater or less than 1?

1. PI = PV of FCFs / Initial cost

2. PI = 1 + NPV / Initial cost

What are the 2 formulas for PI?

Only accept projects with a PI greater than 1, and invest in projects with the largest PI first

What is the rule for PI?

1. Closely related to the NPV rule

2. May be useful when investment funds are limited

What are the pros of PI?

1. May result in incorrect decisions (mutually exclusive investments)

What are the cons of PI?

The Payback Rule

The length of time it takes to recover our initial investment

1. Assume cash flows are received uniformly throughout the year

2. Calculate the number of years it will take for the future cash flows to match the initial cash outflow

How to calculate Payback rule?

An investment is acceptable if its calculated payback period is les than some pre-specified number of years

What is the Payback Rule rule?

1. Simple/easy to do

2. Biased towards liquidity

What are the pros of the Payback Rule?

1. Ignores the time value of money

2. Ignores the cash flows beyond the cutoff

3. Requires an arbitrary cutoff

4. Biased against long-term projects

What are the cons of the Payback Rule?

The Discounted Payback

The length of time it takes for the sum of the discounted cash flows to equal the initial investment, adjusts for time value of money

1. Assume cash flows are received uniformly throughout the year

2. Calculate the number of years it will take for the present value of the future cash flows to match the initial cash outflow

How do you calculate the Discounted Payback?

An investment is acceptable if its discounted payback is less than some pre-specified number of years

What is the Discounted Payback rule?

1. Adjusts for time value of money (doesn’t accept negative NPV projects)

2. Biased towards liquidity

What are the pros of Discounted Payback?

1. Ignores cash flows beyond the cutoff

2. Requires an arbitrary cutoff

3. Biased against long-term projects

What are the cons of Discounted Payback?

The Average Accounting Return (AAR)

The ratio of the average net income of the project to the average book value of the investment

Calculate the average net income and divide it by the average book value

How to calculate the AAR?

An investment is acceptable if its average accounting return is greater than some pre-specified benchmark

What is the AAR rule?

1. Simple/easy to do

What are the pros of the AAR?

1. Very wrong

2. Ignores the time value of money

3. Requires an arbitrary benchmark

4. Accounting numbers and book values

What are the cons of the AAR?

Capital Budgeting

The process of evaluating and deciding whether to invest in long-term projects by analyzing their expected cash flows and profitability

Find the present value of the future cash flows

How do you compute the value of a bond?

Find the present value of the future cash flows

How do you compute the value of a share of stock?

Find the present value of the future cash flows

How you compute the value of a project?

Sunk Costs

Money spent that cannot be recovered

Financing Costs

Costs associated with how a project is funded (ex/ interest on debt or dividends)

Opportunity Costs

The value of the next best alternative that is given up when a project is chosen

Net Working Capital

The difference between current assets and current liabilities, represents short-term investment in operations

NWC = current assets - current liabilities

What is the formula for NWC?

Side Effects

Benefits to other projects due to selecting my project

1. Opportunity Costs

2. Side Effects

3. Net Working Capital

4. Taxes

What cash flows are included in the project cash flows?

1. Sunk Costs

2. Financing Costs

What cash flows are excluded in the project cash flows?

It impacts cash

Why do we include NWC?

Inverse relationship

What is the relationship between NWC and cash?

Recover the net working capital at the end of the project

What is an important part of the NWC calculation?

Book Value

The value of an asset on the balance sheet, equal to its original cost minus accumulated depreciation

Book Value= Initial cost - accumulated cost

What is the formula for book value?

You have a gain and must pay tax

What if we sell an asset for more than book value?

You have a loss and get a benefit (tax credit)

What if we sell an asset for more than book value?

1. Straight-Line Depreciation

2. MACRS

What are the 2 ways to calculate depreciation?

Straight Line Depreciation

Same expense every year

MACRS - Modified-Accelerated Cost Recovery System

Accelerated deprecation that always depreciated to zero and assumes asset is purchased halfway through the first year

Annual depreciation expense = purchase price / number of years

What is the formula for straight-line depreciation?

Net Book Value

What is another name for book value?

Deprectiaion is always a non-cash expense

What type of expense is depreciation?

Cost of Capital

The minimum rate of return the firm must earn overall on its existing assets. If it earns more than, value is created

Weighted average calculation based on methods in which the firm is financed

How do we calculate the cost of capital?

1. The divided growth model

2. CAPM

How do we asses the cost of equity (2 ways)?

Cost of Debt

The return that the firm’s creditors demand on new borrowing

1. Can normally be observed

2. Yield to Maturity (YTM)

How to get the cost of debt?

CAPM = R_e = R_f + B(R_m - R_f)

What is the CAPM formula?

Interest payments are tax deductible

What is one benefit of debt over equity?