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Week 2 Time Value of Money & Capital Budgeting (Time Value of Money,…
Week 2
Time Value of Money
& Capital Budgeting
Time Value of Money
Capital Budgeting principles:
Net Present Value
: marginal benefit versus marginal cost comparison
NPV = -(Initial Investment) + the PV of Cash Flow for each Period(NPV):
NPV=−C0*C1/(1+r)+C2/(1+r)2+...+CT/(1+r)T
it measures the magnitude, timing, and risk associated with future cash flows, which further illustrates its link to the firm’s stock price.
Internal Rate of Return (IRR)
Interest Rate to cause NPV=0
compared to management’s required rate of return
cannot be used to compare, or rank, mutually exclusive projects or to compare projects of different durations
When the “normal case” (an initial negative outflow, followed by positive inflows) of cash flows is reversed, , the IRR decision rule must be reversed
Scale problems exist with IRR. Often, small projects will show a higher IRR over large projects, even though the latter will have a higher NPV. In these cases incremental IRR analysis must be employed
One method for eliminating multiple IRRs is to use the Modified Internal Rate of Return (MIRR). Discount all cash outflows to the present, and compound all cash inflows to the last period of the project. Then, find the rate that equates the values. The discounting and compounding can be done at borrowing and investment rates, respectively.
Payback Period
Payback Period: a measure of how long it takes to recover the amount of the investment. Initial investment/Cash Savings or Increase of Cash Flow. Ignores Time value of Money
Discounted Payback Period: Time to recover cost of investment using discounted future Cash Flow
Considers Time value of Money
Accounting Rate of Return:
Average Net Income/ Average Investment
Indicator of Profitability
Ignores Time value of Money
Profitability Index
PV Cash Flows/ Investment
Consider Time Value of Money
Capital Rationing
:when a firm must choose between projects due to restrictions on the number of new projects that can be undertaken
However, while other measures (profitability index, IRR, etc.) provide helpful information to capital budgeting decision-making, NPV remains an all-purpose measure to evaluate projects.
Calculation of
Present Value : PV= FVn / (1 + i)n
Future Value (FVn =PV x (1 + i)n
Cost of Capital
when they raise financing by selling securities like Debt, Preferred Stock and Equity.
pricing of ownership claims
identifying the optimal Capital Structure.
Perpetuities & Annuities
Perpetuities :a never-ending, constant stream of cash flows
PV of a perpetuity: PV = C/r Growing perpetuity PV = C/(r-g)
Growing Annuities
PV of Growing Annuity Equation
Types of Projects
Independent projects
Mutually exclusive investment decisions