Fin-Module 12

Discounted Payback Model

1.) Corrects lack of time value. Determine present value of all cash flow and then determine time of payback using those values. 2.) The basic discount rate to determine the discounted values is the firm's cost of capital. But if a project is considered more risky, it doesn't allow for use of adjusted discount rates. Find the PV of each year=N is the number of year, I is the cost of capital and given value is FV. From there, just use payback method.

Risk Adjusted Discount Rates

1.) Risk Adjusted Returns* 2.) Zero Risk Return -Allow return to be adjusted, and then you plug in to different models. -Coefficient of Variation=std/Avg cash flow -Compare Coefficient of Variation for project and company -Compare Disc Rate Chart. If 12% disc rate, then Coeff of Var should be .18 OR -take cost of capital and add 2 or 3% positive and negative to see high risk (positive) or low risk (negative).

Capital Budgeting Under Risk

1.)If uncertainty can be qunatified as a statistical measure, those decisions can be made with greater confidence. 2.) The ability of a financial manager to properly assess and incorporate risk in an analysis is extremely important

Net Present Value

1.)PV of all project inflows and outflows must be determined using cost of capital or appropriate risk-related discount rate. 2.)Determined as net difference between PV of benefits and costs. 3.) When the NPV of a project exceeds zero, it is selected as it is expected to add value to the firm, but if it is less than zero, it reduces value of the firm. 4.) NPV=Present Value of Benefits-Present Value of Costs Cash Flow. Use CF register

Internal Rate of Return

1.)Seeks to determine the rate of return earned from the project, i.e. what rate will make NPV equal to zero. That is rate the project is actually earning. 2.)Once found, it is compared to the firm's cost of capital (min acceptable ror) *Calculation: use CF register

Capital Budgeting Models

1.)The firm which strives to maximize its value should only select assets with positive values 2.)The PV of a firm=sum of PV of all assets 3.)Only the selection of relevant assets with positive values will add value. 4.) Capital budgeting techniques include: payback period, discounted payback period, NPV, Profitability index, IRR, and MIRR

NPV Profile

A graphical plot of NPV values relative various rates.

Project Selection

Additional constraint is funding. If all projects combined exceed budget, you have to look at which to pick.

Discounted Payback Model Decision Criteria Advantages and Disadvantages

Advantage: Uses cash flows not ambigious accounting profits, allows for the use of TVM Disadvantage: Not as easy to implement and may not rank projects in order of the value being added to firm.

Payback Period Advantages/Disadvantages

Advantages: 1.) Easy 2.) Uses cash flows not ambiguous accounting profits Disadvantages: 1.) It ignores additional cash flows after payback 2.) Ignores the time value of money

NPV Advantages and Disadvantages

Advantages: 1.) Uses cash flows 2.) Time value of money 3.) Tells you directly which projects add value to the firm Disadvantages: 1.) It is not easy to implement

IRR Advantages and Disadvantages

Advantages: 1.) Uses cash flows not ambiguous accounting numbers 2.) requires the use of TVM Disadvantages: 1.) IT is not easy to implement or calculate. 2.) Discounting problems assume reinvestment over time, and in the case of IRR cash flows are assumed invested at IRR and IRR is not the minimum return necessary to cover long-term financial costs. 3.) When projects have cash flows that change signs more than once, it is possible for a project to have more than one IRR that yields NPV at zero, making it useless with non-conventional cash flows.

MIRR Advantages and Disadvantages

Advantages: 1.) uses cash flows instead of ambiguous accounting profits 2.) Time Value of money. 3.) Assumes benefit cash flows reinvested at cost of capital, the IRR reinvestment problem is solved. Disadvantage: Doesn't use value added to firm by a project as decision criteria

Profitability Index Advantages and Disadvantages

Advantages: 1.) uses cash flows not ambiguous accounting profits 2.) It utilizes the concept of the time value of money. 3.) Allows for use of adjusted discount rates if risk characteristics differ Disadvantages: 1.) Not easy to implement, 2.) doesn't identify an estimated value to be added because it is a relative number. It tells you how much value relative to the cost.

Financing Decision

Based on financing cost, windows of financing opportunity and minimizing the cost of capital or minimum required return

Assessing Risk level

Done by senstivity anaylsis, simulation analysis, decision trees, risk-adjusted discount rates

Profitability Index (Benefit Cost Ratio)

Extension of NPV method. Tells you the present value of benefits in comparison to value of costs. Present Value of Benefits/Present value of costs cash flow. If your answer is less than one, benefit is less than cost, the PV is negative If your answer is greater than one, benefit is greater than cost, PV is positive Calculate: (NPV on calculator+initial investment)/initial investment

IRR Decision Criteria

If IRR exceeds cost of capital or min req ror, accept project. If positive NPV, then IRR exceeds ror and IRR>0

MIRR Decision Criteria

If MIRR exceeds cost of capital, project is acceptable, if not, it isn't.

Investment Decision

Made on the basis of economic rationale. Does it meet the need/value or not?

NPV Decision Criteria

Only projects with positives NPV's add value and should be selected unless it has to comply with some regulations. For alternative projects, rank from highest NPV

Modified Internal Rate of Return

Rate of discount at which the PV of a project's cost is equal to the PV of its beneficial cash flow terminal value (future value) (beneficial cash flows compounded at reqired cost of capital/risk rate of return) Calculation: Determine Future Value for all positive numbers with N as the number of years to the right, determine the Present Value for all negative numbers with N as the number of years to the left. Add Each-this gives you a terminal value. Use TVM with N as total number of years PV determined and FV determined.

Capital Budgeting Decisions

Selection of projects which meet an organization's needs and which will hopefully make value grow. 2 decisions: 1.) Meets a need 2.) how to finance. They are SEPARATE decisions

Payback Period

Takes the actual cost of an investment and determines number of years/periods necessary for the cash flows from investment in a project to pay back the cost. Even Flows Payback=Investment Cost/Level Cash Flows Uneven Flows Payback=Amount of years where full amount is paid+(Amount from additional year paid/full amount from additional year)=Payback Period.

Discounted Payback Model Decision Criteria

The firm with the fastest time to discounted payback provides fastest return of the investment and is the one taken.

Payback Period Decision Criteria

The project which provides the fastest payback provides the fastest return and should be picked.

NPV vs. IRR

Theoretically, the NPV is the preferred method for capital budgeting decisions. Although they will both indicate an acceptable project, they might not rank them the same. Always take the project NPV tells you to vs. IRR

Risk

Variability of estimated cash flows from the expected cash flow value. 2 Risk components 1.) Market risk 2.) Operating Risk Combined, they equal the total risk factor of the asset

Crossover Rate

What is the point that gives you the same NPV for both projects

Capital Rationing

When more than one project is acceptable, you need to pick numbers based on one of the models. You not only need to look at method number (high IRR NPV or low Payback) but also make sure cost doesn't exceed budget.