Review Session 1

(Finance-2021)

Nazanin Babol
Outline

➢ Capital Budgeting
➢ Net Present Value (NPV)

➢ Payback Methods (i.e. simple and discounted)

➢ Internal Rate of Return (IRR)

➢ Equivalent Annual Cost (EAC)

➢ Real Options

2
What is Financial Management All About?

➢Capital
Structure
Decisions (1)
➢Project
Evaluation
(4a)
➢Distribution
Policies (4b)
3
Which Capital Budgeting Methods Do Managers Apply?
US Evidence

Key question: does the investment add value to firm’s shareholders?

(Institute) 18

4
NPV Method
 Project is a “cash-generating” box!
 Does cash flows recover the initial investment and even make more cash?!
 Future cash-flows need to be discounted.
 Discounting takes into consideration: 1) time-value of Money 2) risk of the project

 NPV= Sum of discounted stream of future cash-flows

 The project should be accepted if NPV>0

CFt CF1 CF2 CFN NPV function in Excel

 NPV = σN
t=0 = CF0 + + + ⋯+
(1+r)t (1+r) (1+r)2 (1+r)N can be used for the
second part of NPV
Initial investment
calculation
PV of Future Cash Flows
(Normally negative)
NPV Method

Aussie Souvenir Exports Pty Ltd imposes a payback cut-off of 3.5 years and 10%
hurdle rate for its international investment projects. Answer Q1 to Q4 if the company
has the following two projects available
Q1. Should the CFO accept either of the projects if she uses the NPV rule?

year 0 1 2 3 4

Cash Flow (A) -75,000 9,000 14,000 18,900 19,600

Cash Flow (B) -61,000 16,500 26,300 17,300 4,900

Solution

1 A B C D E F
NPV
2 year 0 1 2 3 4

3 Cash Flow (A) -75,000 9,000 14,000 18,900 19,600 = B3 + NPV(10%, C3:F3) -27,661

Cash Flow (B) -61,000 16,500 26,300 17,300 4,900 = B4 + NPV(10%, C4:F4) -7,920
4

None of the projects would be accepted using the NPV method, as both NPVs are negative!
 Simple and Discounted Payback Methods
(Speed of recovery)
 Both methods ask the same question
 how long will it take the project to recover (pay back) initial investment?

 break-even analysis (i.e. both methods ignore all cash flows after the cut-off date)
 depending on whether the threshold set by the firm is above or below the cut-off date, the firm will
decide whether to accept or to reject the project!

 Simple vs Discounted Payback Rule

 simple payback rule considers raw cash flows and ignores the time value of money and risk
(accounting break-even)

 discounted payback rule considers discounted cash flows (economic break-even)

Payback methods are typically used in conjunction with other more "sophisticated" methods, such as NPV or IRR
Simple and Discounted Payback Methods

Aussie Souvenir Exports Pty Ltd imposes a payback cut-off of 3.5 years and 10%
hurdle rate for its international investment projects. Answer Q1 to Q4 if the company
has the following two projects available
Q2. If the CFO uses the simple payback rule (no discounting) which project would be
accepted? Answer the same question using a Discounted Payback Rule?

year 0 1 2 3 4

Cash Flow (A) -75,000 9,000 14,000 18,900 19,600

Cash Flow (B) -61,000 16,500 26,300 17,300 4,900

Simple Payback Method
Aussie Souvenir Exports Pty Ltd imposes a payback cut-off of 3.5 years and 10%
hurdle rate for its international investment projects. Q2. If the CFO uses the simple
payback rule (no discounting) which project would be accepted?

A B C D E F
1 year 0 1 2 3 4

2 Cash Flow (A) -75,000 9,000 14,000 18,900 19,600 Project A does not
Cumulative CF (A)/ formula =B2 =sum(B2:C2) =sum(B2:D2) =sum(B2:E2) =sum(B2:F2)
recover the initial
3
investment over the
4 Cumulative CF (A) -75,000 -66,000 -52,000 -33,100 -13,500 first four years !

A B C D E F
1 year 0 1 2 3 4

2 Cash Flow (B) -61,000 16,500 26,300 17,300 4,900

Payback =
3 Cumulative CF (B)/ formula =B2 =sum(B2:C2) =sum(B2:D2) =sum(B2:E2) =sum(B2:F2) 3 + 900/ 4900 = 3.18
4 Cumulative CF (B) -61,000 -44,500 -18,200 -900 4,000 3.18 < 3.5 !
Discounted Payback Method
Aussie Souvenir Exports Pty Ltd imposes a payback cut-off of 3.5 years and 10%
hurdle rate for its international investment projects. Q2. If the CFO uses the discounted
payback rule which project would be accepted?

Project A is rejected by the simple payback rule.

So, it is rejected by the discounted payback too.
Because, the cut-off date estimated by discounted payback rule is always longer than simple one.

A B C D E F
1 year 0 1 2 3 4
Cash Flow (B) -61,000 16,500 26,300 17,300 4,900
2
Discounted CF (B)/
3 =B2 =C2 / (1+10%) ^ C1 =D2 / (1+10%) ^ D1 =E2 / (1+10%) ^ E1 =F2 / (1+10%) ^F1
formula

4 Discounted CF (B) -61,000 15,000.0 21,735.5 12,997.7 3,346.8

Cumulative CF (B) -61,000 -46,000 -24,264 -11,267 -7,920
IRR Method
 Mathematically: Internal Rate of Return
(IRR) is the discount rate that brings NPV
of the project to zero
 IRR method involves two steps
1) estimate IRR of the project (IRR
function in Excel)
2) compare IRR to the discount rate of the
project
 IRR>discount rate! accept the project
 IRR<discount rate! reject the project

 Internal Rate of Return (IRR)= expected

return per $1 of investment
IRR Method

Aussie Souvenir Exports Pty Ltd imposes a payback cut-off of 3.5 years and 10%
hurdle rate for its international investment projects. Q3. Which Project would be
accepted if the IRR rule is applied?

year 0 1 2 3 4

Cash Flow (A) -75,000 9,000 14,000 18,900 19,600

Cash Flow (B) -61,000 16,500 26,300 17,300 4,900

Solution

1 A B C D E F
NPV
2 year 0 1 2 3 4

3 Cash Flow (A) -75,000 9,000 14,000 18,900 19,600 = IRR(B3:F3) -7%
4 Cash Flow (B) -61,000 16,500 26,300 17,300 4,900 = IRR(B4:F4) 3% < 10%

None of the projects would be accepted using the IRR method!

Advantages & Disadvantages of NPV, IRR, and Payback

Q4. Compare all approaches and explain pros and cons for each one.?
NPV IRR Payback
Pros • Good for both • Offers a rate of return • Simple and easy for
conventional and • Lead to the same decision communication!
unconventional cash flows for independent projects
• Good for both with conventional cash flow
independent projects and
mutually exclusive projects
• Preferred technique
Cons • Misleading results for • It is not a sophisticated
projects with approach as it ignores all
unconventional cash flow. cash flows after the cut-off
• Misleading conclusion for date!
mutually exclusive projects
 NPV vs IRR
 Q5. TLC Inc. is considering an investment with an initial cost of $175,000. The firm
has two investment options. The cash inflows generated by the first option are estimated
at $76,000 for the first 2 years, $28,100 and $30,000 for third and fourth year,
respectively. For the second option, cash flows start at $50,000 for the first two years
and then increases to $60,000 for the following 2 years. If the discount rate is 9%,
which project should be chosen by the firm? Which method should be applied? IRR or
NPV?
0 1 2 3 4 Time
OPTION 1

-$175,000 $76,000 $76,000 $28,100 $30,000

0 1 2 3 4 Time
OPTION 2

-$175,000 $50,000 $50,000 $60,000 $60,000

NPV vs IRR
discount rate = 9%

A B C D E F G H
year 0 1 2 3 4 NPV IRR

Cash Flow (Option 1) -$175,000 $76,000 $76,000 $28,100 $30,000 1,644 9.52%

Cash Flow (Option 2) -$175,000 $50,000 $50,000 $60,000 $60,000 1,792 9.45%
 IRR Method (Pitfalls)
 Conventional CFs:
 -, +,+,+,+
 Unconventional CFs:
 -, +,+,+,+,- (e.g. surface mining)
 or -,+,+,-,+,+,- , .. (e.g. hotels, some types of power generation plants)

 IRR does not work well for

 Unconventional cash flows: .g. negative cash flows in the future.
 Mutually exclusive projects
IRR Method (Pitfalls)
 Q6. A project which requires an initial investment of $60,000, and the cash flows that the
project delivers each year starting one year from the start date, are $155,000 and (minus) -
$100,000. The hurdle rate is 30%. Should we take the project based on IRR rule? NPV?
Explain.

0 1 2 Time

-$60,000 +$155,000 -$100,000

First shift in the Second shift in

project sign the project sign
IRR Method (Pitfalls)

($000s)

➢IRR method doesn’t work here!

➢ NPV = NPV(30%, [155,000, -100,000]) -60,000

= $59.17
Equivalent Annual Cost (EAC)
 The Concept of Mutually Exclusive Projects with different lifespans

 Two-step process
 Step 1: estimate NPV for each of the investment projects
 Step 2: calculate annual cost that would have NPV equal to that estimated in Step 1

 in Excel: PMT(discount rate, lifespan, NPV from step 1)

 Choose investment with the lowest EAC.

 Equivalent Annual Cost (EAC)

Q7. Eagle Manufacturing is considering expanding its business by purchasing a new

machine. There are two available options. Both options are riskier than the existing
business of Eagle Manufacturing, so management uses 10% as the hurdle rate for
such risky projects. Once a machine is chosen, it will be renewed at the end of its life.
According to the manager’s preliminary analysis, should Eagle Manufacturing choose
Machine A or Machine B??

NPV Lifespan
Machine A -$798,000 4 years
Machine B -$916,000 5 years
Equivalent Annual Cost (EAC)
NPV Lifespan
Machine A -$798,000 4 years
Machine B -$916,000 5 years

discount rate =10%

Since these two machines have different lifespans, we cannot compare them by their NPVs.
Instead, we need to calculate the equivalent annual costs (EACs)

Step 1: estimate NPV for each of the two projects : NPVs are given!
Step 2: find an equal annual payment (EAC) with NPV equal to NPV of the project (PMT function
in Excel)
EAC(A): PMT(10%, 4, -$798,000) = $251,745.70 ;
EAC(B): PMT(10%, 5, -$916,000) = $241,638.49
EAC(A) > EAC(B) !choose Project B
Projects with Real Options

 Embedded options add value to the project

 Not considering these options make NPV a conservative
 estimate of value added
 In practice: limited use of real options approach.
 Valuing real options can be a difficult task.
 will not be tested in exam!
 We just need to know the concept behind these projects and how embedded options can add
value to the project!
Projects with Real Options

 Q8. The forecasted cash flows from launching a new R&D project by a firm are given
in a Table below. If the firm discount rate is %5 and given that the firm decided to
take the project, what is the minimum value of the Option to Abandon in this project?
(i.e. Cash flows ($000s)

year 0 1 2 3 4
Cash Flow -600 100 110 180 200
Projects with Real Options

The first few things we need to know

 We’re not expected to be able to calculate the exact value of real options
 We don’t even have enough information to
 However, by saying that the firm accepted the project, the question implies that the
firm was able to calculate the value of real options
 So, the firm knows the exact value of the real options but we don’t. Then what do we
know?
 First, let’s calculate the NPV

year 0 1 2 3 4
Cash Flow -600 100 110 180 200

 NPV = -600 + NPV(5%, [100,110,180,200]) = -$84.96

Projects with Real Options

 NPV = -600 + NPV(5%, [100,110,180,200]) = -$84.96

➢ Their calculation of the expected returns from this project, including the real options,
must have been positive!
➢ We can therefore infer that the value of those options was at least enough to tip the
expected returns into positive territory.

• Value of real options + NPV >= 0

• Value of real options + (-84.96) >= 0
• Value of real options >= 84.96
How to contact the TA!

1. Through Canvas
2. Email: [email protected]