ADMI 2204: Investment Decisions

Jovelyn Ferrer Garcia

[email protected]
Consultation hours: 10:00 – 12:00 Thursdays or by appointment
La Liga 307 / virtual
Course Description
• This course seeks to equip students with the skills of constructing and interpreting financial criteria
necessary in investment decision making by exposing them to the concepts, tools, and techniques
which management can use in making sound investment decisions that generate value for the
organization.

Justification
• Organization’s limited resources.
• The students will be exposed to the tools, techniques, and concepts that allow a manager to make
sound investment decisions that add value to an organization.
Introduction
What is the organization’s goal in investing?
Introduction
1. What is the organization’s goal in investing?

• To create value for the shareholders/ maximize shareholders wealth

2. How is value created when making financial decisions?

• Value is created when the benefit of investing is greater than the

costs.
Drawbacks of considering profit maximization
as the ultimate goal of the firm
• Change in profit may also represent a change in
risk. A conservative firm that earned $1.25 per
share may be a less desirable investment if its
earnings per share increase to $1.50, but the risk
inherent in the operation increases even more.

• It fails to consider the timing of the benefits.

• It suffers from the almost impossible task of

accurately measuring the key variable in this case:
profit.
Source: Block, S.B.; Hirt, G.A. & Danielsen, B.R. (2017). Foundations of Financial Management. 16th Ed.
New York: McGraw Hill Education
Valuation approach
“The ultimate measure of performance is not what the firm earns, but
how the earnings are valued by the investor.”

Valuation principle
“The value of an asset to the firm is determined by its competitive
market price. The benefit and costs of a decision should be evaluated
using the market prices, and when the value of the benefits exceeds
the value of the costs, the decision will increase the market value of the
firm.”
Time value of money & interest rates
• A dollar today is worth more than a dollar in one year.
• Question: For most financial decisions, do costs and benefits occur at
the same point in time?

Consider the following investment:

T=0 : -$100,000
T=1: $105,000
Time value of money & interest rates
• Interest rate allows the conversion
of money from one point in time to
another.

• An exchange rate across time.

• Tells the market price today of

money in the future.
Time value of money & interest rates
• Consider an annual interest rate of 7%, how much we can exchange in
1 year each $1 today?

• Risk-free rate (rf) = the interest rate at which money can be lent or
borrowed without risk

• 𝟏 + 𝒓𝒇 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑓𝑎𝑐𝑡𝑜𝑟

Time value of money & interest rates
Value of investment in 1 year

• If the interest rate is 7%, the cost is actually

𝐶𝑜𝑠𝑡 = $100,000 𝑡𝑜𝑑𝑎𝑦 𝑥 1 + 7% $ 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 / 𝑑𝑜𝑙𝑙𝑎𝑟 𝑡𝑜𝑑𝑎𝑦

𝐶𝑜𝑠𝑡 = $107,000 𝑖𝑛 1 𝑦𝑒𝑎𝑟 ~ opportunity cost of spending 100,000 today

Going back to the previous investment opportunity, we can compute the investments net value:

= $105,000 − $107,000 = −$2,000 𝑖𝑛 1 𝑦𝑒𝑎𝑟

Question: Accept or reject the investment?

Time value of money & interest rates
Value of investment today

- use the interest rate factor to convert dollars in the future to dollars today

• Given the interest rate of 7%,

what is the value today of the $105,000 (the benefit in 1 yr)

𝐵𝑒𝑛𝑒𝑓𝑖𝑡 = $105,000 𝑖𝑛 1 𝑦𝑟 ÷ 1 + 7% $ 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 / 𝑑𝑜𝑙𝑙𝑎𝑟 𝑡𝑜𝑑𝑎𝑦

1
= $105,000 𝑥 𝑡𝑜𝑑𝑎𝑦
1.07
= $98,130.84 𝑡𝑜𝑑𝑎𝑦
𝑛𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = $98,130.84 − $100,000 = −$1,869.16 𝑡𝑜𝑑𝑎𝑦
Question: Accept or reject the investment?
Time value of money & interest rates
• Present versus future value
• Is the decision to invest the same whether we express the net value in
its present or future value?

= −$1,869.16 𝑡𝑜𝑑𝑎𝑦 𝑥 1.07 $ 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 / $ 𝑡𝑜𝑑𝑎𝑦

= −$2000 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟
Present value – the value of a future benefit expressed in terms of
dollars today
Future value – the value expressed in dollars today
Time value of money & interest rates
• Discount factors and rates

1 1
= = 0.93458 ~ 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑓𝑎𝑐𝑡𝑜𝑟
1 + 𝑟 1.07
Example
• The cost of rebuilding SF bridge to make it earthquake safe was
approximately $3 billion in 2004. Engineers estimated that if the project
were delayed to 2005, the cost would rise by 10%. If the interest rate was
2%, what was the cost of a delay in terms of dollars in 2004?

Solution:
𝑑𝑒𝑙𝑎𝑦𝑒𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑐𝑜𝑠𝑡 = $3𝐵 𝑥 1.10 = $3.3𝐵 𝑖𝑛 2005
2005
$3.3𝐵 𝑖𝑛 2005 ÷ $1.02 𝑖𝑛 𝑖𝑛 2004 = 3.235𝐵 𝑖𝑛 2004
$
𝑐𝑜𝑠𝑡 𝑜𝑓 1 𝑦𝑒𝑎𝑟 𝑑𝑒𝑙𝑎𝑦 = 3.235𝐵 − 3𝐵 = .235𝐵 𝑜𝑟 235 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 𝑖𝑛 2004
Financial instruments
• Intangible assets
• represent legal claims to some future benefit

• Issuer - entity that has agreed to make future cash payments

• Investor - owner of the financial instrument
Asset classes of financial instruments
• Debt instrument
– the claim is for a fixed dollar amount

• Equity instrument
– obligates the issuer of the financial instrument to pay the holder an amount
based on earnings, if any, after the holders of debt instruments have been paid

– Financial asset issued by the firm that confer ownership rights on the investors
who are known as _____________.

Source: Fabozzi, F. J. (Ed.). (2002). Handbook of finance, financial markets and instruments (Vol. 1). John Wiley & Sons.
Basic financial instruments
• Bonds
• a debt security—the issuer owes the holders a debt and, depending on the
terms of the bond, is obliged to pay the coupon (ie the annual interest rate
paid on a bond or similar instrument) and to repay the principal at a specified
maturity date.

• What is a zero-coupon bond?

Basic financial instruments
Commercial papers
• issued by large corporations where the holder contractual right to receive
cash (financial asset) is matched by the issuer’s corresponding obligation to
pay (financial liability)
• Unsecured short term debt instrument
• Paid at the maturity

Treasury bills
• short term obligations of the federal government and considered to be a
popular place to “park funds” because of a large and active market.
Basic financial instruments
Stocks
Common stocks vs preferred
stocks
• Common – an instrument that
represents an ownership interest
in the firm.
• Preferred – usually has
preferential dividend and seniority
in any liquidation and sometimes
special voting rights.
Source: Fabozzi, F. J. (Ed.). (2002). Handbook of finance, financial markets and
instruments (Vol. 1). John Wiley & Sons.
Basic financial instruments
Derivatives - financial instruments that derive their value from an underlying
asset.
• Option – a contract in which the option seller grants the option buyer the right to enter into a transaction
with the seller to either buy or sell an underlying asset at a specified price (strike price) on or before a
specified date (expiration date).

• The option seller grants this right in exchange for a certain amount of money called the option premium or
option price.

• Call option – the right is to purchase the underlying asset.

Call option on stock XYZ that expires in one month and has a strike price of $100. The option price is $3

• Put option – the right is to sell the underlying asset.

• option on one share of stock XYZ with one month to maturity and a strike price of $100. The put option is selling for
$2 and the spot price of stock XYZ is $100.
Source: Fabozzi, F. J. (Ed.). (2002). Handbook of finance, financial markets and instruments (Vol. 1). John Wiley & Sons.
Basic financial instruments
• Futures contract – an agreement between two parties, a buyer and a seller,
where the parties agree to transact with respect to the underlying asset at a
predetermined price at a specified date.
• Both parties are obligated to perform over the life of the contract, and neither party charges
a fee.

• Forward contract – an agreement for the future delivery of something at a

specified price at the end of a designated period of time.
• Forward contract differs from futures in that it is usually non-standardized (that is, the terms
of each contract are negotiated individually between buyer and seller), there is no
clearinghouse, and secondary markets are often non-existent or extremely thin.
Interest Capitalization
• Simple versus compound interest
Interest Capitalization
• Compound interest – interest paid on a loan or investment is added
to the principal.
• Interest on interest
𝐹𝑉 = 𝑋0 1 + 𝑟 𝑛

For multiple compounding in a year:

𝑟 𝑚𝑛
𝐹𝑉 = 𝑋0 1 +
𝑚
Where 𝑋0 = initial amount, r = interest rate, m= how many times the interest is
paid in 1 year, n= number of years or the term.
Interest Capitalization

• Simple interest – amount of interest earned without the effect of

compounding, calculated based only on the principal.

𝑆𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑋0 ∗ 𝑟 ∗ 𝑛

𝐹𝑉𝑠𝑖𝑚𝑝𝑙𝑒 = 𝑋0 ∗ 𝑟 ∗ 𝑛 + 𝑋0 = 𝑋0 (1 + rn)
Interest Capitalization: Examples
1. Consider a person who has $100 in an account. If the interest rate is
8% how much will the $100 be worth at the end of a year? (simple
and compounding)
2. How much will the $100 be worth at the end of the 2nd year?
(simple and compounding)
Interest Capitalization: Examples
3. Consider a person who has $100 in an account. If the interest rate is
8% how much will the $100 be worth at the end of the 3rd year
compounding semiannually?

4. How much will the $100 be worth at the end of the 3rd year with
quarterly interest payment?
The 3 rules on time travel
1. “It is only possible to compare or combine values at the same point
in time.”

- To compare or combine cash flows that occur in different points in time, you
first need to convert the cash flows into the same units or move them to the
same point in time.
The 3 rules on time travel
2. “ To move a cash flow forward in time, you must compound it.”
Compounding – process of moving a value or cash flow forward in time.
How much a $1000 is worth in 2 years time given a 10% interest rate?
The 3 rules on time travel
3. “To move a cash flow back in time, you must discount it.”
Discounting – process of moving a value or cash flow backward in time.
– finding the equivalent value today of a future cash flow.

What is the value of $1000 to be received in 2 years from today given a 10%
interest rate?
Opportunity cost and equivalence
• Opportunity cost of using a resource is the value it could have had
provided in its alternative use.

• In the context of time value of money, (investment example), when

you use the $100,000 today for some investment, you are giving up
$107,000 you would have had in 1 year if you deposited the money in
the bank that gives 7% interest rate.

• Concept of equivalence
$100,000 today is equivalent to $107,000 in the future.
Future value of a cash flow

𝐹𝑉1 = 𝐶 + 𝑟𝐶 = 𝐶(1 + 𝑟)

𝐹𝑉2 = 𝐹𝑉1 + 𝑟𝐹𝑉1 = 𝐶 1 + 𝑟 + 𝑟𝐶 1 + 𝑟 = 𝐶(1 + 𝑟)2

𝐹𝑉3 = 𝐹𝑉2 + 𝑟𝐹𝑉2 = 𝐶(1 + 𝑟)2 + 𝑟𝐶(1 + 𝑟)2 = 𝐶(1 + 𝑟)3

Present value of a cash flow
Present value of a stream cash flow
The above formula can be written in summation form as :
Present/future value of a stream of cash flow
Problem
• You have just graduated and need money to buy a new car. Your rich
Uncle Henry will lend you the money so long as you agree to pay him
back within four years, and you offer to pay him the rate of interest
that he would otherwise get by putting his money in a savings
account. Based on your earnings and living expenses, you think you
will be able to pay him $5000 in one year, and then $8000 each year
for the next three years. If Uncle Henry would otherwise earn 6% per
year on his savings, how much can you borrow from him?
Perpetuity
Perpetuity - a stream of equal cash flows that occur at regular intervals
and last forever.

• Examples: Consol (UK government bond), real estate, stocks that pay
dividends
• The oldest perpetuities that are still making interest payments were
issued in 1624 by the Hoogheemraadschap Lekdijk Bovendams, a
seventeenth-century Dutch water board responsible for upkeep of
the local dikes.
Present value of a perpetuity
Timeline for a perpetuity

Note: The first cash flow does not

occur immediately; it arrives at
the end of the first period.

This timing is sometimes referred

to as payment in arrears and is a
standard convention.

The perpetuity formula assumes

that the first payment
occurs at the end of the first
period (at date 1).
Present value of a perpetuity

Question: Is the PV of an infinite series finite?

• Law of one price – the same good must have the same price in every
market.
• The value of the perpetuity must be the same as the cost we would
incur to create it ourselves.
Present value of a perpetuity
Problem:
You want to endow an annual MBA graduation party at your alma
mater. You want the event to be a memorable one, so you budget
$30,000 per year forever for the party. If the university earns 8% per
year on its investments, and if the first party is in one year’s time, how
much will you need to donate to endow the party?
Annuity
Annuity – a stream of N equal cash flows paid at regular intervals. The
difference between an annuity and a perpetuity is that an annuity ends
after some fixed number of payments.

• Examples: car loans, mortgages, and some bonds are annuities.

Present value of an annuity
Annuity – a stream of N equal cash flows paid at regular intervals. The
difference between an annuity and a perpetuity is that an annuity ends
after some fixed number of payments.

• The present value of an N-period annuity with payment C and interest

rate r.
Present value of an annuity
Do-it-yourself approach
• Suppose you buy a Bond with a face value of $100 that pays $5
coupon payment for 20 years. You also get your initial investment at
year 20.
Present value of an annuity

Recall that C = P ∗ 𝑟 ⇒ 𝑃 = 𝐶/𝑟

Present value of an annuity
Problem
• You are the lucky winner of the $30 million state lottery. You can take
your prize money either as (a) 30 payments of $1 million per year
(starting today), or (b) $15 million paid today. If the interest rate is
8%, which option should you take?
Future value of an annuity

Note: same as the formula in Serrano Book

Future value of an annuity
Problems
1. Ellen is 35 years old, and she has decided it is time to plan seriously
for her retirement. At the end of each year until she is 65, she will
save $10,000 in a retirement account. If the account earns 10% per
year, how much will Ellen have saved at age 65?

2. If at the end of each month, a saver deposited $100 into a savings

account that paid 6% compounded monthly, how much would he
have at the end of 10 years?
Present value of an annuity due
Annuity due – an annuity in which the first payment occurs
immediately.

1− 1+𝑟 −𝑛
𝑃𝑉𝐴.𝑑𝑢𝑒 = 𝐶 𝑥 𝑥 (1 + 𝑟)
𝑟
Future value of an annuity due
Annuity due – an annuity in which the first payment occurs
immediately.

1+𝑟 𝑛 −1
𝐹𝑉𝐴.𝑑𝑢𝑒 = 𝐶 𝑥 𝑥 (1 + 𝑟)
𝑟
Future value of an annuity due
Problem:

Suppose you are a beneficiary designated to immediately receive

$1000 each year for 10 years, earning an annual interest rate of 3%.
You want to know how much the stream of payments is worth to you
after receiving the last payment.
Growing cash flows
• Growing perpetuity - stream of cash flows that occur at regular
intervals and grow at a constant rate forever.

• A growing perpetuity with a first payment C and a growth rate g will

have the following cash flows:
Growing cash flows (growing perpetuity)

Assumption: g < r
Why? Because if g is greater than or equal to r, the cash flows grow even faster than they are discounted; each term gets
larger rather than smaller.
Growing cash flows (growing perpetuity)
Problem:
In the previous example, you planned to donate money to your alma mater
to fund an annual $30,000 MBA graduation party. Given an interest rate of
8% per year, the required donation was the present value of

PV = $30,000/0.08 = $375,000 today

Before accepting the money, however, the MBA student association has
asked that you increase the donation to account for the effect of inflation on
the cost of the party in future years. Although $30,000 is adequate for next
year’s party, the students estimate that the party’s cost will rise by 4% per
year thereafter. How much do you need to donate now?
Growing cash flows
• Growing perpetuity example
• Buy stocks of $100 that pays a dividend of $3 at the end of each year.
The dividend grows 2% per year
Growing cash flows (growing annuity)
Growing annuity – stream of N growing cash flows, paid at regular
intervals. It is like a growing perpetuity that eventually comes to an
end.
Growing cash flows (growing annuity)
Problem
Ellen considered saving $10,000 per year for her retirement. Although
$10,000 is the most she can save in the first year, she expects her salary
to increase each year so that she will be able to increase her savings by
5% per year. With this plan, if she earns 10% per year on her savings,
how much (in its present value) will Ellen have saved at age 65?
Problems
Problems
Problems: Solving for cash payments
• Suppose you are opening a business that requires an initial
investment of $100,000. Your bank manager has agreed to lend you
this money. The terms of the loan state that you will make equal
annual payments for the next 10 years and will pay an interest rate of
8% with the first payment due one year from today. What is your
annual payment?
Problems: Solving for cash payments
Interest rates
• Define effective annual rate and annual percentage rate.
• Be able to compute effective annual rate, compute the n-period
effective annual rate.
• Convert an annual percentage rate into an effective annual rate, given
the number of compounding periods.
• Describe the relation between nominal and real rates of interest.
• Be able to compute nominal rate, real rate, and inflation rate.
Interest rate quotes and adjustments
• When evaluating cash flows, we must use a discount rate that matches the
time period of our cash flows; this discount rate should reflect the actual
return we could earn over that time period.

Question: Which is greater an annual rate of 5% or an annual rate of 5%

compounded monthly?

• Effective Annual Rate - indicates the total amount of interest that will
be earned at the end of one year.
– Considers the effect of compounding
• Also referred to as the effective annual yield (EAY) or annual percentage yield (APY
Interest rate quotes and adjustments
• Adjusting the Discount Rate to Different Time Periods
• Earning a 5% return annually is not the same as earning 2.5% every six months.

• General Equation for Discount Rate Period Conversion

Equivalent n-Period Discount Rate = (1 + r ) n − 1
• (1.05)0.5 – 1= 1.0247 – 1 = .0247 = 2.47%
• Note: n = 0.5 since we are solving for the six month
(or 1/2 year) rate
• n can be larger than 1 (to compute a rate over more than one period) or smaller than 1 (to compute a rate over a
fraction of a period).
• Problem
• Suppose an investment pays interest quarterly with the interest rate quoted
as an effective annual rate (EAR) of 9%.
• What amount of interest will you earn each quarter?

• If you have no money in the bank today, how much will you need to save at
the end of each quarter to accumulate $25,000 in 5 years?
• Solution
• 9% EAR is approximately equivalent to earning (1.09)1/4 – 1 = 2.1778% per
quarter.

• To determine the amount to save each quarter to reach the goal of $25,000 in
five years, we must determine the quarterly payment, C:
FV(Annuity)

FV ( Annuity ) $25, 000

C= = = $1, 010.82 per quarter
1 1
[(1 + r ) n − 1] [1.02177820 − 1]
r .021778
Annual percentage rates
• The annual percentage rate (APR), indicates the amount of simple
interest earned in one year.
• Simple interest is the amount of interest earned without the effect of
compounding.

• The APR is typically less than the effective annual rate (EAR).
Annual percentage rates
• The APR itself cannot be used as a discount rate.
• The APR with k compounding periods is a way
of quoting the actual interest earned each
compounding period:

APR
Interest Rate per Compounding Period =
k periods / year
Annual percentage rates
• Converting an APR to an EAR
k
 APR 
1 + EAR = 1 + 
 k 

• The EAR increases with the frequency of compounding.

• Continuous compounding is compounding every instant.
Annual percentage rates
Effective annual rates for a 6% APR with different compounding periods

• A 6% APR with continuous compounding results in an EAR of

approximately 6.1837%.
Guide on problems involving APR
1. Divide the APR by the number of compounding periods per year to
determine the actual interest rate per compounding period.

Then, if the cash flows occur at a different interval than the

compounding period,

2. Compute the appropriate discount rate by compounding (Eq. 5.1).

Once you have completed these steps, you can then use the
discount rate to evaluate the present or future value of a set of cash
flows.
Problem
Solution
The cost of leasing the system can be represented as a 48-month annuity of $4,000. The timeline of the lease
payment is as follows.

First, find the discount rate per month.

𝑠𝑖𝑥 − 𝑚𝑜𝑛𝑡ℎ 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = 5% ÷ 2 = 2.5%
1
𝑜𝑛𝑒 − 𝑚𝑜𝑛𝑡ℎ 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = 1 + 0.025 6 −1 = 0.4124%

Then solve for the PV of the annuity.

Problem
A firm is considering purchasing or leasing a luxury automobile for
the CEO. The vehicle is expected to last three years. You can buy
the car for $65,000 up front , or you can lease it for $1,800 per
month for 36 months. The firm can borrow at an interest rate of 8%
APR with quarterly compounding. Should you purchase the system
outright or pay $1,800 per month?
Solution
• The first step is to compute the discount rate that corresponds to monthly
compounding. To convert an 8% rate compounded quarterly to a monthly
discount rate, compound the quarterly rate using Equations 5.3 and 5.1:

1
.08 4
(1 + ) = 1.082432 → 1.08243212 − 1 = 0.66227% per month
4
• Given a monthly discount rate of 0.66227%, the present value of the 36
monthly payments can be computed:

• Paying $1,800 per month for 36 months is equivalent to paying $57,486 today.

• This is $65,000 - $57,486 = $7,514 lower than the cost of purchasing the
system, so it is better to lease the vehicle rather than buy it.
Application: Discount rates and loans
• Computing Loan Payments
• Payments are made at a set interval, typically monthly.
• Each payment made includes the interest on the loan plus some part of the
loan balance.
• All payments are equal/the same and the loan is fully repaid with the final
payment.
Application: Discount rates and loans
• Computing the Outstanding Loan Balance
• One can compute the outstanding loan balance by calculating the present
value of the remaining loan payments.
• Equate the outstanding with the present value of the loan payments using the
discount rate from the quoted interest rate of the loan, then solve or the loan
payments.
• Amortizing loans – means that each month you pay interest on the loan plus
some part of the loan balance
Application: Discount rates and loans
• Computing Loan Payments
• Consider a $30,000 car loan with 60 equal monthly payments, computed
using a 6.75% APR with monthly compounding.
• 6.75% APR with monthly compounding corresponds to a one-month discount rate of
6.75% / 12 = 0.5625%.

P 30, 000
C = = = $590.50
1  1  1  1 
− −
r  (1 + r ) N  0.005625  (1 + 0.005625) 60 
1 1
Application: Discount rates and loans
• Problem
Determinants of interest rates
• Fundamentally, interest rates are determined in the market based on
individual’s willingness to borrow and lend.
• Some of the factors that may influence interest rates are inflation,
government policy, and expectations of future growth.

• Nominal Interest Rate: The rates quoted by financial institutions and

used for discounting or compounding cash flows

• Real Interest Rate: The rate of growth of your purchasing power,

after adjusting for inflation
 Determinants of interest rates
1 + r Growth of Money
Growth in Purchasing Power = 1 + rr = =
1 + i Growth of Prices
• The Real Interest Rate
r − i
rr =  r − i
1 + i
r= nominal interest rate
i= rate of inflation
Note: The real interest rate should not be used as a discount rate for future cash flows. It can only be used if the cash flows have
been adjusted to remove the effect of inflation (in that case, we say the cash flows are in real terms).
Problem example
Solution

r − i
rr =  r − i Note: The real interest rate was
1 + i negative in 2011, indicating that
interest rates were insufficient to keep
up with inflation.
0.3% − 3% On the other hand, prices actually
𝑟𝑟 = = −2.62%
1 + 3% decreases (deflation) in the year
following May 2014, so the real
0.1% + 0.05% interest rate earned slightly bove the
𝑟𝑟 = = 0.15% nomina interest rate.
1 − 0.05%
Problem example

• On December 31, 2015, the average one-year Treasury Constant

Maturity rate was about 0.65% and the 2015 annual inflation rate
was about 0.70%.

• What was the real interest rate in 2015?

Problem
Solution

• Using Equation 5.5, the real interest rate in 2008 was

• (0.65% − 0.70%) ÷ (1.0070) = -0.05%
• Which is equal to the difference between the nominal rate and
inflation: 0.65% – 0.70% = -0.05%
U.S. interest rates
and inflation rates, 1962–2012
Note: Intuitively,
individual’s willingness to
save depends on the
growth on the purchasing
power they can expect.

Thus, when inflation rate

is high a higher nominal
rate is needed to
encourage saving.
Investment and interest rate policy
• An increase in interest rates will typically reduce the NPV of an
investment.
Consider an investment that requires an initial investment of $10 million and
generates a cash flow of $3 million per year for four years. If the interest rate is
5%, the investment has an NPV of

3 3 3 3
NPV = − 10 + + 2
+ 3
+ 4
= $0.638 million
1.05 1.05 1.05 1.05
Investment and interest rate policy
• If the interest rate rises to 9%, the NPV becomes negative, and the investment is
no longer profitable:
3 3 3 3
𝑁𝑃𝑉 = −10 + + + + = −$0.281 million
1.09 1.092 1.093 1.094
Question: What is then the relationship between interest rates and investment?
- when the costs of an investment precede the benefits, an increase in the interest rate will decrease the investment’s
NPV.

-Federal Reserve and central banks can raise interest rates to reduce investments if the economy is “overheating” and
inflation is on the rise.
-They can lower interest rates to stimulate investment if the economy is slowing or in recession.
Monetary policy, deflation, and the 2008
financial crisis
• When the 2008 financial crisis struck, the Federal Reserve responded
by cutting its short-term interest rate target to 0%.

• While this use of monetary policy is generally quite effective, because

consumer prices were falling in late 2008, the inflation rate was
negative, and so even with a 0% nominal interest rate, the real
interest rate remained positive.
The yield curve and discount rates
• Term Structure – the relationship between the investment term
(horizon) and the interest rate

• Yield Curve – a graph of the term structure

Term structure of risk-free U.S. interest rates,
November 2006, 2007, and 2008
Term structure
We can use the term structure to compute the present and future values of a risk-
free cash flow over different investment horizons. For example,

$100 invested for one year at the one-year interest rate in November 2008 would
grow to a future value of
$100 * 1.0091 = $100.91 at the end of one year,

$100 invested for ten years at the ten-year interest rate in November 2008 would
grow to
• $100 * (1.0341)10 = $139.84
The yield curve and discount rates (cont'd)
• The term structure can be used to compute the present and future
values of a risk-free cash flow over different investment horizons.
Cn
PV =
(1 + rn ) n

• Present Value of a Cash Flow Stream Using a Term Structure of Discount Rates

N
C1 C2 CN CN
PV =
1 + r1
+
(1 + r2 ) 2
+ +
(1 + rN ) N
= 
n =1 (1 + rn ) n
rn - risk-free interest rate (expressed as an EAR) for an n-year term.
Warning : All of our shortcuts for computing present values
(annuity and perpetuity formulas, the annuity spreadsheet)
are based on discounting all of the cash flows at the same
rate.

They cannot be used in situations in which cash flows need to

be discounted at different rates.
Problem
Problem
Problem
Problem
Compute the present value of a risk-free three-year annuity of $500
per year, given the following yield curve:

Treasury Rates
Term (Years) Rate
1 0.261%
2 0.723%
3 1.244%
Problem
Solution
• Each cash flow must be discounted by the corresponding interest rate:

$500 $500 $500

PV = + +
2
1.00261 1.00723 1.012443

PV = $498.70 + $492.85 + 481.79 = $1, 473.34

Announcement
• Quiz on Wednesday.
• Will cover all topics covered including today
• Difficult formula will be given but the basic ones, you should know
them.
• Bring calculator, cellular phones will not be allowed.
Short-Term Versus Long-Term U.S. Interest
Rates and Recessions
The yield curve and the economy
• Interest Determination
• The Federal Reserve determines very short-term interest rates through its
influence on the federal funds rate, which is the rate at which banks can
borrow cash reserves on an overnight basis.

• All other interest rates on the yield curve are set in the market and are
adjusted until the supply of lending matches the demand for borrowing at
each loan term.
The yield curve and the economy
Questions:

1. Suppose short-term interest rates are equal to long-term interest

rates. If investors expect interest rates to rise in the future, will they
prefer long over short-term investment?

2. Supposed short-term interest rates are equal to long-term interest

rates interest rates and are expected to fall in the future, will
borrowers prefer to borrow on short or long-term basis?
The yield curve and the economy
Answers:

1. They could do better by investing on a short-term basis and then

reinvesting after interest rates rose. Thus, if interest rates are expected to
rise, long-term interest rates will tend to be higher than short-term rates
to attract investors.

1. Similarly, if interest rates are expected to fall in the future, then

borrowers would not wish to borrow at long-term rates that are equal to
short-term rates. They would do better by borrowing on a short-term
basis, and then taking out a new loan after rates fall. So, if interest rates
are expected to fall, long-term rates will tend to be lower than short-
term rates to attract borrowers.
The yield curve and the economy
Interest Rate Expectations
• The shape of the yield curve is influenced by interest rate
expectations.
• An inverted yield curve indicates that interest rates are expected to
decline in the future.
• Because interest rates tend to fall in response to an economic slowdown, an
inverted yield curve is often interpreted as a negative forecast for economic growth.
• Each of the last six recessions in the United States was preceded by a period in
which the yield curve was inverted.
• The yield curve tends to be sharply increasing as the economy comes out of a
recession, and interest rates are expected to rise.
Problem
Arbitrage and law of one price
• Arbitrage - practice of buying and selling equivalent goods in different markets to take advantage of a
price difference.

• Law of One Price

• In a normal market, the price of gold at any point in time will be the same in London and New York. If the
prices in the two markets differ, investors will profit immediately by buying in the market where it is cheap
and selling in the market where it is expensive. In doing so, they will equalize the prices. As a result, prices
will not differ (at least not for long). This important property is the
• Law of One Price:
“If equivalent investment opportunities trade simultaneously in different competitive markets, then they must
trade for the same price in both markets.”

One useful consequence of the Law of One Price is that when evaluating costs and benefits to compute a net
present value, we can use any competitive price to determine a cash value, without checking the price in all
possible markets.
Problem
Suppose the current one-year interest rate is 3%. If it is
known with certainty that the one-year interest rate will be
2% next year and 1% the following year, what will the
interest rates r1, r2, and r3 of the yield curve be today? Is
the yield curve flat, increasing, or inverted?
Problem
Solution
• We are told already that the one-year rate r1 = 3%.
• To find r2, we know that if we invest $1 for one year at the current one-year rate and
then reinvest next year at the new one-year rate, after two years we will earn:
$1 * (1.03) * (1.02) = $1.0506

• We should earn the same payoff if we invest for two years at the current two-year
rate r2:
$1 * (1 + r2)2 = $1.0506
• Otherwise, there would be an arbitrage opportunity
• Solving for r2, we find that:
r2 = (1.0506)1/2 - 1 = 2.499%
Problem
• Solution
• Similarly, investing for three years at the one-year rates should have the same
payoff as investing at the current three-year rate:
(1.03) * (1.02) * (1.01) = 1.0611 = (1 + r3)3
• We can solve for
r3 = (1.0611)1/3 - 1 = 1.997%.
Therefore, the current yield curve has r1 = 3%,
r2 = 2.499%, and r3 = 1.997%.
The yield curve is decreasing as a result of the anticipated lower interest rates
in the future.
Risk and taxes
• Risk and Interest Rates
• U.S. Treasury securities are considered “risk-free.” All other borrowers have
some risk of default, so investors require a higher rate of return.
Source:
FINRA.org.

Figure 5.4 Interest Rates on Five-Year Loans for Various Borrowers, December 2015
Problem
Problem
After-Tax Interest Rates
• Taxes reduce the amount of interest an investor can keep, and we
refer to this reduced amount as the after-tax interest rate.
Problem
Problem
• The yield on a 10-year, AA municipal bond is 1.73%, while a 10-year,
AA corporate bond has a yield of 2.49%. What is the marginal tax rate
that would result in the same after-tax yield?
Problem
• Solution
• Since the municipal security is tax-exempt, its yield is the after-tax yield.
Thus,
1.73% = 2.49% (1 – t). Solving for t,
t = 1 - 1.73%/2.49% = 30.5%
• At a marginal tax rate of 30.5%, an investor would be indifferent between
investing in a taxable security yielding 2.49% and a tax-exempt security
yielding 1.73%
The Opportunity Cost of Capital
• Investor’s Opportunity Cost of Capital: The best available expected
return offered in the market on an investment of comparable risk and
term to the cash flow being discounted
• Also referred to as Cost of Capital
Anticipated/prepaid interest rates
• “tasa anticipada vs tasa vencida”
• Interest rate paid at t=0, not at the end of the period.
• To convert a nominal interest rate paid at the start of the period, convert first this
rate to the equivalent interest rate that is paid at the end of the period. Then use
the conventional EAR formula to get the effective rate.
𝑟𝑎
𝑟=
1 − 𝑟𝑎
𝑟𝑎
𝑛
Per period () rate 𝑟𝑛 = 𝑟
1− 𝑛𝑎
Example
• What is the EAR of a loan whose nominal interest rate is 20% and pre-
paid monthly.
Devaluation, inflation and interest rates
1 + 𝑟𝑒,$ = 1 + 𝑟𝑒,𝑈𝑆$ 1 + 𝐷𝐸𝑉𝑒

1 + 𝑟𝑒,$ = 1 + 𝑟𝑒,𝑈𝑉𝑅 1 + 𝑖𝑛𝑓𝑒

𝑟𝑒,$ - effective interest rates in COP

𝑟𝑒,𝑈𝑆$ - effective interest rates in USD
𝑟𝑒,𝑈𝑉𝑅 - effective interest rates in “unidad valor real”
𝐷𝐸𝑉𝑒 - projected devaluation rate
𝑖𝑛𝑓𝑒 - projected inflation rate
Example
• What is the effective interest rate in COP of a loan in USD with an
interest rate of 7% and a projected annual devaluation of 3.5%

1 + 𝑟𝑒,$ = 1 + 𝑟𝑒,𝑈𝑆$ 1 + 𝐷𝐸𝑉𝑒

1 + 𝑟𝑒,$ = 1 + 0.07 1 + 0.0035
1 + 𝑟𝑒,$ = 1.1074
𝑟𝑒,$ = 0.1074 𝑜𝑟 10.75%
Net present value and internal rate of return
• Learning objectives
• Calculate NPV and IRR
• Explain why maximizing NPV is always the correct decision rule.
• Know the discrepancy in the usage of NPV and IRR
Present value and the NPV decision rule
• The net present value (NPV) of a project or investment is the
difference between the present value of its benefits and the present
value of its costs.
• Net Present Value

NPV = PV (Benefits) − PV (Costs)

NPV = PV (All project cash flows)
Net present value (NPV)
Suppose your firm is offered the following investment opportunity: In exchange for $500 today, you will receive
$550 in one year with certainty. If the risk-free interest rate is 8% per year then

PV (Benefit) = ($550 in one year) , (1.08 $ in one year/$ today)

= $509.26 today
NPV = $509.26 - $500 = $9.26 today

But what if your firm doesn’t have the $500 needed to cover the initial cost of the project? Does the project
still have the same value?

“As long as the NPV is positive, the decision increases the value of the firm and is a good decision regardless of
your current cash needs or preferences regarding when to spend the money.”
The NPV decision rule

When making an investment decision, take the alternative with the

highest NPV. Choosing this alternative is equivalent to receiving its NPV
in cash today.
• Accepting or Rejecting a Project
• Accept those projects with positive NPV because accepting them is equivalent
to receiving their NPV in cash today.
• Reject those projects with negative NPV because accepting them would
reduce the wealth of investors.
Problem example
Problem
You have saved up $25,000 for a new car. A car dealer is offering car you want
for a price of $25,000 with 0% financing for one year or a cash price of $23,500.

If the applicable interest rate is 4%, which deal is better, the cash deal or the
0% financing deal?
Problem
Solution
• If you take the 0% financing offer, the benefit is that you won’t have to pay
$25,000 for a year. However, if you pay cash, you will save $1,500 today. We
therefore convert the cost in one year to a present value at the 4% interest
rate:
• PVCost of 0% deal today = $25,000/1.04 = $24,038.46
• The cost in today’s dollars is $24,038.46. This is greater than the cash price today. Taking
the cash deal is equivalent to getting:
$24,038.46 - $23,500 = $538.46 today.
Choosing among alternatives
• We can also use the NPV decision rule to choose among projects. To
do so, we must compute the NPV of each alternative, and then select
the one with the highest NPV. This alternative is the one which will
lead to the largest increase in the value of the firm.
Problem
Problem
Problem (follow up question)
Suppose you need $60,000 in cash now to pay for school and other expenses. Would selling the business be a
better choice in that case? (consider an interest rate of 10%)
Problem
You have $10,000 to invest and are considering three one-year risk-free
investment options.
1. Invest up to $10,000 in a T-Bill paying 2%.
2. Invest in a project that cost $6,000 and returns $6,100 in one year.
3. Invest in a project that costs $4,000 and returns $4,100 in one year
How should the $10,000 investment be allocated?
Problem
Solution
• Since all of investment options are for one year and risk-free, the appropriate
discount rate is 2%. The PV of each investment @ 2% is:
1. Investing $10,000 in the T-Bill
• $10,000(1.02)/1.02 - $10,000 = $0.00
2. Investing $6,000 and receiving $6,100
• NPV = $6,100/1.02 - $6,000 = -$19.61
3. Investing $4,000 and receiving $4,100
• NPV = $4,000/1.02 - $4,000 = 19.61
Solution (con’t)
• Given that the #2 investment has a negative NPV, it should not be considered.
However, only investing in #3 uses just $4,000 of the available funds to invest,
yielding a total NPV of
• ($4,100 + $6,000)/1.02 - $10,000 = -$98.04
• The optimal strategy is to invest $4,000 in #3 and $6,000 in the T-Bill. The
NPV of this strategy is
• [$4,100 + $6,000(1.02)]/1.02 - $10,000 = $19.61
• Even though the NPV of the T-Bill investment is $0, it is a better investment
than not investing those funds at all. Thus, the total NPV of investing $4,000
in Project 2 and $6,000 in T-Bills yields an NPV of $19.61 (NPV of Project 2)
plus an NPV of $0 (NPV of T-Bill), yielding a total NPV of $19.61
ADMI 2204: Investment Decisions
Jovelyn Ferrer Garcia
[email protected]
Consultation hours: 10:00 – 12:00 Thursdays or by appointment
La Liga 307 / virtual
Internal rate of return
• In some situations, you know the present value and
cash flows of an investment opportunity but you do not
know the internal rate of return (IRR), the interest
rate that sets the net present value of the cash flows
equal to zero.

• a metric used in financial analysis to estimate the

profitability of potential investments
• suppose that you have an investment opportunity that requires a
$1000 investment today and will have a $2000 payoff in six years.

What interest rate, r, would you need so that the NPV of this investment is zero?
NPV and stand-alone projects
• Consider a take-it-or-leave-it investment decision involving a single,
stand-alone project for Fredrick’s Feed and Farm (FFF).
The project costs $250 million and is expected to generate cash flows of $35
million per year, starting at the end of the first year and lasting forever.
• The NPV of the project is calculated as:
35
NPV = − 250 +
r
• The NPV is dependent on the discount rate.
NPV of Fredrick’s fertilizer project

• If FFF’s cost of capital is 10%,

the NPV is $100 million, and
they should undertake the
investment.
Alternative rules versus the NPV rule
• Sometimes alternative investment rules may give the same answer as
the NPV rule, but at other times they may disagree.
• When the rules conflict, the NPV decision rule should be followed.
Internal rate of return
• Consider the general case in which you invest an amount P today, and
receive FV in N years. Then the IRR satisfies the equation

𝑃𝑥 1 + 𝐼𝑅𝑅 𝑁 = 𝐹𝑉
1
𝐼𝑅𝑅 𝑤𝑖𝑡ℎ 2 𝑐𝑎𝑠ℎ𝑓𝑙𝑜𝑤𝑠 = (𝐹𝑉/𝑃)𝑁 −1

This formula takes the total return of the investment over N years and
converts it to an equivalent 1 year rate.
IRR of a perpetuity
IRR of an annuity
• Suppose your firm needs to purchase a new forklift. The dealer gives
you two options: (1) a price for the forklift if you pay cash and (2) the
annual payments if you take out a loan from the dealer. To evaluate
the loan that the dealer is offering you, you will want to compare the
rate on the loan with the rate that your bank is willing to offer you.
Given the loan payment that the dealer quotes, how do you compute
the interest rate charged by the dealer?
IRR investment rule
• Internal Rate of Return (IRR) Investment Rule
Take any investment where the IRR exceeds the cost of capital. Turn down any
investment whose IRR is less than the cost of capital.
• The IRR Investment Rule will give the same answer as the NPV rule in
many, but not all, situations.
• In general, the IRR rule works for a stand-alone project if all of the
project’s negative cash flows precede its positive cash flows.
Applying the IRR rule
• In other cases, the IRR rule may disagree with the NPV rule and thus
be incorrect.
• Situations where the IRR rule and NPV rule may be in conflict:
• Delayed Investments
• Nonexistent IRR
• Multiple IRRs
Applying the IRR rule
• Pitfall 1: Delayed Investments
• Assume you have just retired as the CEO of a successful company. A major
publisher has offered you a book deal. The publisher will pay you $1 million
upfront if you agree to write a book about your experiences. You estimate
that it will take three years to write the book. The time you spend writing will
cause you to give up speaking engagements amounting to $500,000 per year.
You estimate your opportunity cost to be 10%.
• Pitfall 1: Delayed Investments
• Should you accept the deal?
• Calculate the IRR.

• The IRR is greater than the cost of capital. Thus, the IRR rule
indicates you should accept the deal.
Applying the IRR rule

• Pitfall 1: Delayed Investments

• Should you accept the deal?

500, 000 500, 000 500, 000

NPV = 1,000,000 − − 2
− 3
= − $243,426
1.1 1.1 1.1

• Since the NPV is negative, the NPV rule indicates you should
reject the deal.
NPV of Star’s $1M book deal

• When the benefits of an investment occur before the costs, the NPV is an increasing
function of the discount rate.
• Pitfall 2: Multiple IRRs
• Suppose Star informs the publisher that it needs to sweeten the deal before
he will accept it. The publisher offers $550,000 advance and $1,000,000 in
four years when the book is published.
• Should he accept or reject the new offer?
Applying the IRR rule
• Pitfall 2: Multiple IRRs
• The cash flows would now look like

• The NPV is calculated as

500, 000 500, 000 500, 000 1, 000, 000

NPV = 550,000 - - - −
1 + r (1 + r ) 2
(1 + r ) 3
(1 + r ) 4
Applying the IRR rule
• Pitfall 2: Multiple IRRs
• By setting the NPV equal to zero and solving for r, we find the IRR. In this case,
there are two IRRs: 7.164% and 33.673%. Because there is more than one IRR,
the IRR rule cannot be applied.
NPV of Star’s book deal with royalties
Applying the IRR rule
• Pitfall 2: Multiple IRRs
• Between 7.164% and 33.673%, the book deal has a negative NPV. Since your
opportunity cost of capital is 10%, you should reject the deal.
Applying the IRR rule
• Pitfall 3: Nonexistent IRR
• Finally, Star is able to get the publisher to increase his advance to $750,000, in
addition to the $1 million when the book is published in four years. With
these cash flows, no IRR exists; there is no discount rate that makes NPV
equal to zero.
NPV of Star’s final offer
Applying the IRR rule
• IRR Versus the IRR Rule
• While the IRR rule has shortcomings for making investment decisions, the IRR
itself remains useful. IRR measures the average return of the investment and
the sensitivity of the NPV to any estimation error in the cost of capital.
Problem
Problem
 NPV profiles of the problem
While the IRR Rule works for project A, it fails for each of the
other projects.
IRR rule
• Questions

1. Under what conditions do the IRR rule and the NPV rule coincide
for a stand-alone project?

• 2. If the IRR rule and the NPV rule lead to different decisions for a
stand-alone project, which should you follow? Why?
Payback rule
• The payback period is amount of time it takes to
recover or pay back the initial investment. If the
payback period is less than a pre-specified length of
time, you accept the project. Otherwise, you reject
the project.
• The payback rule is used by many companies
because of its simplicity.
Payback rule
• To apply the payback rule

1. Calculate the amount of time it takes to pay back the initial

investment, called the payback period.
2. Then you accept the project if the payback period is less than a
prespecified length of time—usually a few years. Otherwise, you
reject the project.
For example, a firm might adopt any project with a payback period of less than two
years.
Problem

Recall: The project costs $250 million and is expected to generate cash flows of
$35 million per year, starting at the end of the first year and lasting forever.
Problem
• Projects A, B, and C each have an expected life of five years.
• Given the initial cost and annual cash flow information below, what is the
payback period for each project?

A B C
Cost $80 $120 $150
Cash Flow $25 $30 $35
Problem
• Solution
• Payback A
• $80 ÷ $25 = 3.2 years

• Project B
• $120 ÷ $30 = 4.0 years

• Project C
• $150 ÷ $35 = 4.29 years
The payback rule
pitfalls
• Ignores the project’s cost of
capital and time value of
money.
• Ignores cash flows after the
payback period.
• Relies on an ad hoc decision
criterion.
Why do some companies consider the
payback rule?
• Probably due to its simplicity.
• Used for small investment decisions—for example, whether to purchase a
new copy machine or to service the old one. In such cases, the cost of
making an incorrect decision might not be large enough to justify the time
required to calculate the NPV.
• The payback rule also provides budgeting information regarding the length
of time capital will be committed to a project.

Some firms are unwilling to commit capital to long-term investments without greater
scrutiny. Also, if the required payback period is short (one or two years), then most
projects that satisfy the payback rule will have a positive NPV. So firms might save effort by
first applying the payback rule, and only if it fails take the time to compute NPV.
Choosing between projects
• Mutually Exclusive Projects
• When you must choose only one project among several possible projects, the choice
is mutually exclusive.
• NPV Rule
• Select the project with the highest NPV.
• IRR Rule
• Selecting the project with the highest IRR may lead to mistakes.
• Unfortunately, picking one project over another simply because it has a larger IRR can lead to
mistakes. In particular, when projects differ in their
scale of investment,
the timing of their cash flows,
or their riskiness,
then their IRRs cannot be meaningfully compared.
Problem
Problem
• A venture capitalist is considering investing in several projects. You
have researched several possibilities for her and come up with the
following cash flow estimates. Which investment should you
recommend for the venture capitalist to choose?
Initial First-Year Growth Cost of
Project
Investment Cash Flow Rate Capital
Dating App $250,000 $55,000 4% 7%
Green Energy $350,000 $75,000 4% 8%
Water Purification $400,000 $120,000 5% 8%
“Smart” Clothes $500,000 $125,000 8% 12%
Problem
• Assuming each business lasts indefinitely, we can compute the present
value of the cash flows from each as a constant growth perpetuity. The
NPV of each project is
$55,000
NPV (Dating App) = -$250,000 + = $1,583,333
7% − 4%
$75,000
NPV (Green Energy) = -$350,000 + = $1,525, 000
8% − 4%
NPV (Water Purification) = -$400,000 +
$120,000
3,600,000
= $2, 600, 000
8% − 5%
$125,000
NPV ("Smart" Clothes) = -$500,000 + = $2, 625, 000
12% − 8%
• Thus, all of the alternatives have a positive NPV. But because we can only
choose one, the water purification business is the best alternative.
IRR rule and mutually exclusive investments:
Differences in scale
• If a project has a positive NPV, then if we can double its size, its NPV will double.

• By the Law of One Price, doubling the cash flows of an investment opportunity must
make it worth twice as much.

• However, the IRR rule does not have this property—it is unaffected by the scale of the
investment opportunity because the IRR measures the average return of the
investment.

• Thus, the IRR rule cannot be used to compare projects of different scales.
IRR rule and mutually exclusive investments:
Differences in scale
• Consider two of the projects from Example 7.3.

Bookstore Coffee Shop

Initial Investment $300,000 $400,000
Cash FlowYear 1 $63,000 $80,000
Annual Growth Rate 3% 3%
Cost of Capital 8% 8%
IRR 24% 23%
NPV $960,000 $1,200,000
IRR rule and mutually exclusive investments:
Timing of cash flows
• Another problem with the IRR is that it can be affected by changing
the timing of the cash flows, even when the scale is the same.
• IRR is a return, but the dollar value of earning a given return depends on how
long the return is earned.
IRR rule and mutually exclusive investments:
Timing of cash flows
• Consider again the coffee shop and the music store investment in
Example 7.3. Both have the same initial scale and the same horizon.
The coffee shop has a lower IRR, but a higher NPV because of its
higher growth rate.
IRR rule and mutually exclusive investments:
Differences in risk
• An IRR that is attractive for a safe project need not be
attractive for a riskier project.
• Consider the investment in the electronics store. The IRR is
higher than those of the other investment opportunities, yet
the NPV is the lowest.

• The higher cost of capital means a higher IRR is necessary to

make the project attractive.
When is it reasonable to compare returns
using IRR rule
We can only compare returns if the investments
(1) have the same scale,
(2) have the same timing, and
(3) have the same risk
Incremental IRR rule
• Incremental IRR Investment Rule
• Apply the IRR rule to the difference between the cash flows of the two
mutually exclusive alternatives (the increment to the cash flows of one
investment over the other).
Comparison of minor and major overhauls

In Example7.4, we can see that despite its lower IRR, the major overhaul has a higher NPV at the cost of capital of
12%. Note also that the incremental IRR of 20% determines the crossover point or discount rate at which the optimal
decision changes.
Problem
• Suppose your firm is considering two different projects, one that lasts one
year and another that lasts five years. The cash flows for the two projects
look like this:

What is the IRR of each proposal? What is the incremental IRR? If your firm’s cost of capital is 10%, what
should you do?
Problem
• Solution
• We can compute the IRR of Project L & S using the annuity calculator:
NPER RATE PV PMT FV Excel formula
Given 5 -100 0 200
Solve 14.87% =RATE(5,0,-100,200)
for rate

NPER RATE PV PMT FV Excel formula

Given 1 -100 0 125
Solve 25% =RATE(1,0,-100,125)
for rate
 Problem
• Solution (cont’d)
• We can calculate the incremental IRR this way:
Project 0 1 2 3 4 5 Because the 12.47%
L -100 200 incremental IRR is
bigger than the cost of
S -100 125 capital of 10%, the
Difference 0 -125 200 long-term project is
better than the short-
NPER RATE PV PMT FV Excel formula term project, even
though the short-term
Given 4 -125 0 200
project has a higher
Solve 12.47% =RATE(4,0,-125,200) IRR.
for rate
Shortcomings of the incremental IRR rule
• The incremental IRR may not exist.
• Multiple incremental IRRs could exist.
• The fact that the IRR exceeds the cost of capital for both projects does not
imply that either project has a positive NPV.
• When individual projects have different costs of capital, it is not obvious
which cost of capital the incremental IRR should be compared to.
Project selection with resource constraints
• In principle, the firm should take on all positive-NPV investments it
can identify. In practice, there are often limitations on the number of
projects the firm can undertake.
• Evaluation of projects with different resource constraints
• Consider three possible projects with a $100 million budget constraint:
Profitability Index
• The profitability index can be used to identify the optimal
combination of projects to undertake.

Value Created NPV

Profitability Index = =
Resource Consumed Resource Consumed

From Table 7.1, we can see it is better to take projects II & III together and
forgo project I.
Problem
• Suppose your firm has the following five positive NPV projects to
choose from. However, there is not enough manufacturing space in
your plant to select all of the projects. Use profitability index to
choose among the projects, given that you only have 100,000 square
feet of unused space.
Project NPV Square feet needed
Project 1 100,000 40,000
Project 2 88,000 30,000
Project 3 80,000 38,000
Project 4 50,000 24,000
Project 5 12,000 1,000
Total 330,000 133,000
Problem
• Solution
• Compute the PI for each project.
Project NPV Square feet Profitability Index
needed (NPV/Sq. Ft)
Project 1 100,000 40,000 2.5
Project 2 88,000 30,000 2.93
Project 3 80,000 38,000 2.10
Project 4 50,000 24,000 2.08
Project 5 12,000 1,000
12.0
Total 330,000 133,000
Shortcomings of the profitability index
Although the profitability index is simple to compute and use, for it to
be completely reliable, two conditions must be satisfied:

1. The set of projects taken following the profitability index ranking

completely exhausts the available resource.

2. There is only a single relevant resource constraint.

Shortcomings of the profitability index
• In some situations the profitability index does not give an accurate
answer.
• Suppose in Example 7.4 that NetIt has an additional small project with a NPV
of only $120,000 that requires three engineers. The profitability index in this
case is 0.12 ÷ 3 = 0.04, so this project would appear at the bottom of the
ranking.
• However, three of the 190 employees are not being used after the first four
projects are selected. As a result, it would make sense to take on this project
even though it would be ranked last.

• With multiple resource constraints, the profitability index can break down
completely.
Investment decisions: Summary
• NPV, IRR, and stand-alone projects
• If your objective is to maximize wealth, the NPV rule always gives the
correct answer.

• The difference between the cost of capital and the IRR is the
maximum amount of estimation error that can exist in the cost of
capital estimate without altering the original decision.
Investment decisions: Summary
IRR rule
• IRR investment rule: Take any investment opportunity whose IRR
exceeds the opportunity cost of capital. Turn down any opportunity
whose IRR is less than the opportunity cost of capital.

• Unless all of the negative cash flows of the project precede the
positive ones, the IRR rule may give the wrong answer and should not
be used.

• Furthermore, there may be multiple IRRs or the IRR may not exist.
Investment decisions: Summary
Payback rule
• Payback investment rule: Calculate the amount of time it takes to pay
back the initial investment (the payback period). If the payback period
is less than a prespecified length of time, accept the project.
Otherwise, turn it down.

• The payback rule is simple and favors short-term investments.

Investment decisions: Summary
Choosing between projects
• When choosing among mutually exclusive investment opportunities,
pick the opportunity with the highest NPV.
• We cannot use the IRR to compare investment opportunities unless
the investments have the same scale, timing, and risk.
• Incremental IRR: When comparing two mutually exclusive
opportunities, the incremental IRR is the IRR of the difference
between the cash flows of the two alternatives.
• The incremental IRR indicates the discount rate at which the optimal
project choice changes.
Investment decisions: Summary
Project selection with resource constraints
• When choosing among projects competing for the same resource,
rank the projects by their profitability indices and pick the set of
projects with the highest profitability indices that can still be
undertaken given the limited resource.

• The profitability index is only completely reliable if the set of projects

taken following the profitability index ranking completely exhausts
the available resource and there is only a single relevant resource
constraint.
ADMI 2204: Investment Decisions
Jovelyn Ferrer Garcia
[email protected]
Consultation hours: 10:00 – 12:00 Thursdays or by appointment
La Liga 307 / virtual
Capital budgeting: Learning objectives

1. Given a set of facts, identify relevant cash flows for a capital

budgeting problem.
2. Explain why opportunity costs must be included in cash flows, while
sunk costs and interest expense must not.
3. Calculate taxes that must be paid.
Capital budgeting: Learning objectives
4. Calculate free cash flows for a given project.
5. Illustrate the impact of depreciation expense and tax on cash flows.
6. Describe the appropriate selection of discount rate for a particular
set of circumstances.
7. Use breakeven analysis, sensitivity analysis, or scenario analysis to
evaluate project risk (moved to later session).
Forecasting earnings
Capital budget
• Lists the investments that a company plans to undertake
Capital budgeting
• Process used to analyze alternate investments and decide which ones to
accept
Incremental earnings
• The amount by which the firm’s earnings are expected to change as a result of
the investment decision
Income statement example
Case: HomeNet (Main company, Cisco)
Based on extensive marketing surveys, the sales forecast for HomeNet is 100,000 units per year. Given
the pace of technological change, Linksys expects the product will have a four-year life. It will be sold
through high-end electronics stores for a retail price of $375, with an expected wholesale price of $260.
Developing the new hardware will be relatively inexpensive, as existing technologies can be simply
repackaged in a newly designed, home-friendly box. Industrial design teams will make the box and its
packaging aesthetically pleasing to the residential market. Linksys expects total engineering and design
costs to amount to $5 million. Once the design is finalized, actual production will be outsourced at a cost
(including packaging) of $110 per unit. In addition to the hardware requirements, Linksys must build a
new software application to allow virtual control of the home from the Web. This software development
project requires coordination with each of the Web appliance manufacturers and is expected to take a
dedicated team of 50 software engineers a full year to complete. The cost of a software engineer
(including benefits and related costs) is $200,000 per year.

To verify the compatibility of new consumer Internet-ready appliances with the HomeNet system as
they become available, Linksys must also install new equipment that will require an upfront investment
of $7.5 million. The software and hardware design will be completed, and the new equipment will be
operational, at the end of one year. At that time, HomeNet will be ready to ship. Linksys expects to
spend $2.8 million per year on marketing and support for this product.
Revenue and cost estimates
• Example
• Linksys is considering the development of a wireless home networking
appliance called HomeNet. It has completed a $300,000 feasibility study to
assess the attractiveness of a new product, HomeNet. The project has an
estimated life of four years.

• Revenue Estimates
• Sales = 100,000 units/year
• Per unit price / wholesale price = $260
Revenue and cost estimates
• Example
• Cost estimates
• Up-front R&D = $15,000,000
• Up-front new equipment = $7,500,000
• Expected life of the new equipment is five years.
• Housed in existing lab
• Annual overhead = $2,800,000
• Per unit cost = $110
Incremental earnings forecast
• HomeNet
Capital expenditures and depreciation
• The $7.5 million in new equipment is a cash expense, but it is not
directly listed as an expense when calculating earnings. Instead, the
firm deducts a fraction of the cost of these items each year as
depreciation.
• Straight line depreciation
• The asset’s cost is divided equally over its life.
Annual depreciation = $7.5 million ÷ 5 years = $1.5 million/year
Interest expense
• In capital budgeting decisions, interest expense is typically not
included. The rationale is that the project should be judged on its
own, not on how it will be financed.
Taxes
• Marginal corporate tax rate
• The tax rate on the marginal or incremental dollar of pre-tax income. Note: A
negative tax is equal to a tax credit.

Income Tax = EBIT  tc

• Unlevered net income calculation

Unlevered Net Income = EBIT  (1 − tc )

= (Revenues − Costs − Depreciation)  (1 − tc )
Problem
Problem
Problem
• NRG, Inc. plans to launch a new line of energy drinks.
• The marketing expenses associated with launching the new product will
generate operating losses of $500 million next year for the product.
• NRG expects to earn pre-tax income of $7 billion from operations other than
the new energy drinks next year.
• NRG pays a 39% tax rate on its pre-tax income.
• What will NRG owe in taxes next year without the new energy drinks?
• What will it owe with the new energy drinks?
Problem
Solution
– Without the new energy drinks, NRG will owe corporate taxes next year in the
amount of:
• $7 billion × 39% = $2.730 billion

– With the new energy drinks, NRG will owe corporate taxes next year in the amount
of:
• $6.5 billion × 39% = $2.535 billion
– Pre-Tax Income = $7 billion - $500 million = $6.5 billion

– Launching the new product reduces NRG’s taxes next year by:
• $2.730 billion − $2.535 billion = $195 million.
Indirect effects on incremental earnings
Opportunity cost
• The value a resource could have provided in its best alternative use

• In the HomeNet project example, space will be required for the investment.
Even though the equipment will be housed in an existing lab, the opportunity
cost of not using the space in an alternative way (e.g., renting it out) must be
considered.
Problem
Problem
• Suppose NRG’s new energy drink line will be housed in a factory that the
company could have otherwise rented out for $900 million per year.
• How would this opportunity cost affect NRG’s incremental earnings next year?

Solution
The opportunity cost of the factory is the forgone rent.
The opportunity cost would reduce NRG’s incremental earnings next year
by:
$900 million × (1 − .39) = $549 million.
Indirect effects on incremental earnings
• Project Externalities
• Indirect effects of the project that may affect the profits of other business activities
of the firm.
• Cannibalization is when sales of a new product displaces sales of an existing product.

• In the HomeNet project example, 25% of sales come from customers who
would have purchased an existing Linksys wireless router if HomeNet were
not available. Because this reduction in sales of the existing wireless router
is a consequence of the decision to develop HomeNet, we must include it
when calculating HomeNet’s incremental earnings.
Indirect effects on incremental earnings
• HomeNets incremental earnings forecast including cannibalization
and lost rent.
• Assume that the wholesale price of the router is $100, per unit cost is
$60 and 25% of Homenet’s sale is cannibalized from that of the
router.
Sunk costs and incremental earnings
Sunk costs are costs that have been or will be paid regardless of the decision
whether or not the investment is undertaken.
“If our decision does not affect the cash flow, then the cash flow should not
affect our decision.”
Sunk costs should not be included in the incremental earnings analysis.
• Fixed overhead expenses - typically overhead costs are fixed and not
incremental to the project and should not be included in the calculation of
incremental earnings.
Sunk costs and incremental earnings
• Past research and development expenditures
• Money that has already been spent on R&D is a
sunk cost and therefore irrelevant. The decision to continue or abandon a project
should be based only on the incremental costs and benefits of the product going
forward.
• Unavoidable competitive effects
• When developing a new product, firms may be concerned about the cannibalization
of existing products.
• However, if sales are likely to decline in any case as a result of new products
introduced by competitors, then these lost sales should be considered a sunk cost.
Real-world complexities

• sales will change from year to year.

• the average selling price will vary over time.
• the average cost per unit will change over time.
Problem
 • Sale price and
manufacturing cost
are expected to
decline by 10%

• SGA to rise with

inflation by 4%

Updated incremental earnings forecast after considering some changes

Determining free cash flow and NPV
• The incremental effect of a project on a firm’s available cash is its free
cash flow.
• Capital expenditures and depreciation
• Capital expenditures are the actual cash outflows when an asset is
purchased. These cash outflows are included in calculating free cash flow.
• Depreciation is a non-cash expense. The free cash flow estimate is adjusted
for this non-cash expense.
Calculating the free cash flow from earnings
Table 8.3 Spreadsheet Calculation of HomeNet’s Free Cash Flow (Including
Cannibalization and Lost Rent)
Calculating the free cash flow from earnings
• Net working capital (NWC)
Net Working Capital = Current Assets − Current Liabilities
= Cash + Inventory + Receivables − Payables

• Most projects will require an investment in net working capital.

• Trade credit is the difference between receivables
and payables.
• The increase in net working capital is defined as

NWCt = NWCt − NWCt − 1

Calculating the free cash flow from earnings
• Table 8.4 Spreadsheet HomeNet’s Net Working
Capital Requirements
Problem
Problem
Problem
Problem
• Rising Star Inc is forecasting that their sales will increase by $250,000 next
year, $275,000 the following year, and $300,000 in the third year. The
company estimates that additional cash requirements will be 5% of the
change in sales, inventory will increase by 7% of the change in sales,
receivables will increase by 10% of the change in sales, and payables will
increase by 8% of the increase in sales. Forecast the increase in net working
capital for Rising Star over the next three years.
Calculating free cash flow directly
Free Cash Flow
Unlevered Net Income

Free Cash Flow = (Revenues − Costs − Depreciation)  (1 − tc )

+ Depreciation − CapEx − NWC

Free Cash Flow = (Revenues − Costs)  (1 − tc ) − CapEx − NWC

+ tc  Depreciation
tc × Depreciation is called the depreciation tax shield
- tax savings that results from the ability to deduct depreciation from
earnings.
 Calculating the NPV
FCFt 1
PV ( FCFt ) = = FCFt 
(1 + r ) t
(1 + r )t
t = year discount factor

Assumption: HomeNet NPV (WACC = 12%)

NPV = − 16,500 + 4554 + 5740 + 5125 + 4576 + 1532
= 5027
Terminal or continuation value
• This amount represents the market value of the free cash flow from the
project at all future dates.
• Applies when the FCF forecast horizon is shorter than the full horizon of the
project
Problem
• Problem
• Now assume Plentix is considering a new project that costs $200 million and
will generate free cash flows in its first three years of $10 million, $15 million,
and $20 million, respectively.
• After the third year, free cash flows are expected to grow at an annual rate of
7%.
• Plentix’s has determined that the appropriate cost of capital for this project is
16%.
• What is the year 3 continuation value?
What is the NPV of the project?
Problem

• Solution
• The year 3 continuation value is calculated as:

FCFYear3  (1+g )
Year 3 Continuation Value =
r−g
 $20  1.07 
Year 3 Continuation Value =   = $237.78 million
 .16 − .07 
 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑟𝐸
• an implied cost or an opportunity cost of capital
• rate of return shareholders require, in theory, in order to compensate
them for the risk of investing in the stock

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝑟𝐷 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑/𝐷𝑒𝑏𝑡

• rate of interest on debt
Weighted Average Cost of Capital (WACC)
• Computed cost of capital obtained by multiplying the cost of each
item in the capital structure by its weighted representation in the
overall capital structure and summing up the results (BHD, pp G-17)
• average cost of capital the firm must pay to all of its investors, both
debt and equity holders.
Aproximation of cost of equity
Capital asset pricing model (CAPM)
𝑟𝑖 = stock return
𝑟𝑓 = risk free rate
𝐶𝑜𝑣𝑎𝑟 (𝑟𝑚 ,𝑟𝑖 )
𝛽𝑖 = = a measure of risk
𝑉𝑎𝑟𝑟𝑚

𝑟𝑚 − 𝑟𝑓 = risk premium reward investors expect to earn for holding a portfolio given the be

𝑟𝑖 = 𝑟𝑓 + 𝛽𝑖 𝑟𝑚 − 𝑟𝑓
𝑟𝑖 = 3.5% + 0.5(4.7% − 3.5%)

𝑟𝑖 = 6.45%
Cost of equity
Cost of preferred stocks
• similar to the cost of debt in that a constant annual payment is made, but dissimilar in
that there is no maturity date on which a principal payment must be made.

• Flotation costs – costs incurred by publicly traded company when it issues preferred
stocks (underwriting costs, registration fees, etc)
Cost of equity
Cost of common equity
• Valuation approach using the constant growth dividend valuation
model
Solution to RISING STAR problem
• The required increase in net working capital is shown below:
Year
0 1 2 3
Sales Forecast (increase) $250,000 $275,000 $300,000
Net Working Capital Forecast
Cash Requirements (5% of sales) $12,500 $13,750 $15,000
Inventory (7% of sales) $17,500 $19,250 $21,000
Receivables (10% of sales) $25,000 $27,500 $30,000
Payables (8% of sales) $20,000 $22,000 $24,000
Net Working Capital $35,000 $38,500 $42,000