Corporate Finance

Bayes BS

Prof. Paulina Roszkowska

Class 1:
Introduction to Corp Finance
Principles of finance
(repeating for your previous modules)

Decision rules
Our plan

Week 1 Introduction to corporate finance and decision rules

Week 2 Cost of capital
Week 3 Financial planning & cash management
Week 4 Payout policy
Week 5 Reading week
Week 6 Raising capital
Week 7 Midterm Assessment
Week 8 Capital structure & corporate governance
Week 9 Capital budgeting for Valuations
Week 10 Valuation for M&A
Week 11 Review

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Intro to Corporate Finance

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Working in business means…
Should we issue new
stock? Or maybe take a
How should we market loan?
our products? How Should we close one of
much to spend on it? our production plants?

From whom should we

What should we buy materials?
produce? Where?

Should we hire a
Should we acquire firm different CTO? How
X? How much should we much can we spend to
pay? hire a good professional?
Should we export to
India? Should we
hedge currency risk?

Corporate finance (module) is all about making good financial decisions ☺

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 Corporate cash flows & decisions

Firm invests Cash from firm securities issues (A) Financial

in assets (B) markets
Invests
in assets Retained
Current assets cash flows (F) Current liabilities
(B)
Non-current assets Short-term
Non-current debt
Current assets Cash flow Dividends and liabilities
Long-term debt
Fixed assets from firm (C) debt payments (E) Equity shares
Equity shares

Taxes (D)
Total firm value
Total asset value to investors

Ultimately, firm must be a Cash flows from firm

cash generating activity. Government must exceed cash flows
from financial markets.

CASH FLOW: How not to run out of cash? How to generate cash flows?
Managers’ objectives

What is a “good“ decision? How should managers make investment decisions?

• The shareholders are the owners.
• Managers fiduciary duty is to act in their best interest
• So maybe managers should maximize shareholder value

Two questions that follow:

1. Is maximizing shareholder value the “right" objective?
• Arguments for maximizing shareholder value vs. stakeholder value
• Satisfying both – any possible?
2. What guarantees that managers' incentives are aligned with this objective?
• Why managers' incentives might not be aligned with shareholders’ interest?
• What guarantees that managers' incentives are aligned with shareholders’ interest?
(correction mechanisms)

Both these issues are pivotal for the long-term success of any business entity. In our
course, however, we will focus on how to maximize shareholder value. That said, the hope
is that that value will serve some purpose; executed by the company of its shareholders.

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Corporate finance framework
STOCKHOLDERS

hire & fire maximize

managers shareholder wealth

protect bondholder costs can be

interests traced to firm

BONDHOLDERS MANAGERS SOCIETY

lend money minimize
social costs

reveal information markets assess

honestly and timely effect on value

FINANCIAL MARKETS

What happens if managers don’t act in stakeholders’ interests?

Corporate finance framework
STOCKHOLDERS
bad managers put on notice:
activists, hostile takeovers

corporate good citizen constraints:

more laws, investor backlash

BONDHOLDERS MANAGERS SOCIETY

self proctection:
covenants, new types

punishment for misleading market

more sceptical investors, analysts

FINANCIAL MARKETS

What happens if managers don’t act in stakeholders’ interests?

 What is Fintech?
Fintech is an evolution of financial
services driven by technology,
changing customer expectations,
availability of funding, and increasing
support from governments and
regulators. - KPMG

“Fintechs” are firms that use

technology to improve the
competitive advantages of
traditional financial services firms
by:
- improving efficiencies, and
- driving new products and solutions
for customers.
9/22/2023 Corp Fin – Paulina Roszkowska 10
Principles of finance

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Outline

• Valuation and the Time Value of Money

• Tools for comparing cash flows across time
1. Present value
2. Future value
• Rules of time travel
• Shortcuts to PV
1. Perpetuities
2. Annuities
• Compounding
• Arbitrage & Law of one price
• Value additivity

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Purpose & Execution

Core finance begins with understanding the Time Value of Money

• This is a basic ingredient for all valuation—a concept that we will use
extensively.
• And we rely on Excel for carrying out our calculations.

Main Goal: Develop a set of tools for making good financial decisions.
To evaluate any economic or financial decision:
• We want to “sum up” all the different elements
• costs and benefits
• Need to convert elements to common denominator
• Usually $ (£, ¥, €, etc.)
• Market prices allow us to do the conversion

Benefits > Costs → Increasing Value ☺

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Example: Using Market Prices to Obtain
Value

A farmer is going to a local farmers market with 1,000 peaches. Another

farmer offers to give him 700 lemons in exchange for his peaches.
Question: Should the farmer accept this trade?

Suppose Plemon = $0.80, Ppeach = $0.50

Value of the transaction = Value of lemons - Value of peaches

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Example: Investment Decision

You can pay $3.5M today to construct a commercial building in 1 year.

The interest rate r to borrow $3.5 M for 1 year is 10%.
The building will be worth $4.0 M next year.
Is it profitable to build this real estate?

First attempt: $4.0M is bigger than $3.5M, so go ahead.

What’s wrong with this answer?
The dates for construction cost and completed value differ - Need to compare
them on a consistent basis:
• Convert the $4.0 M building value at date 1 to a present value, or
• Convert the $3.5 M construction cost at date 0 to a future value.
We get the same investment policy either way.

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Time Value of Money

Many decisions involve trade-offs over time.

A dollar today and a dollar in a future year are not equivalent.

• Which would you prefer: A gift of $100K today or $110K at a later date?
• To answer this, you will have to compare the alternatives to decide which
is worth more. One factor to consider: How long is “later?”

Why do we discount cash flows that happen in the future?

• Time Value of Money: money now is better than money later.
• If you have it now, you can invest it and have more in the future.

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Example: Trade-offs over time
Most business decisions involve inflows and outflows over several years. Costs
(outflows) and benefits (inflows) often occur in different time periods.

A start-up is considering developing new app.

Strategy I: Date 0 1 2 3
Cash Flow -400 200 200 200

Strategy II: Date 0 1 2 3

Cash Flow -400 -100 350 350

Which strategy creates the most value?

• We do not just add up the cash flows - why?
• We need to convert the cash flows to a single common denominator so
that we can add them up.

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2 Questions

1. What common denominator should we use?

• Present value (PV): Converts dollars in the future into dollars today.
• Moving money backward in time (“discounting").
• The units of PV are dollars today.

• Future value (FV): Converts dollars today into dollars at some point in the
future.
• Moving money forward in time (“compounding").
• The units of FV are dollars at some time t.

2. Both PV and FV allow us to convert cash flows into a common

denominator. But we need a price for moving money through time. What is
the price for conversion?
• Interest rate
→ Enter capital markets

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Financial Markets*

• Capital Markets: Allow us to move money through time.

• The cost or benefit of doing so is captured by the interest rate
* © Brett Green.
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Interest rates

Caveat: There are many different interest rates...

• Analogy: many different prices for lemons & peaches, exchange rates,
etc., which depend on supply-demand, time of year, location, etc.
• The trick is to find the ”right" interest rate (we will figure it out later in our
course).
• For now, let's assume we know how to find the relevant interest rate.
• Once we have the interest rate r (discount rate = hurdle rate =
opportunity cost of capital), we can easily convert cash flows to FV or
PV.

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PV – Present Value

Definition:
You have an amount F at some future date. The Present Value (PV) of F is
the amount that one would need to invest today to have F at that future point
in time.

In general, the present value of a cash flow F that arrives n periods from now is:
𝑭𝑽
𝑷𝑽 =
(𝟏 + 𝒓)𝒏

Example
Suppose that you can invest at 5%, how much would you need to invest
today in order to have $100 in one year? in two years?

PV1= 100 /(1 + 0.05)1 = $95.24

PV2= 100 /(1 + 0.05)2 = $90.70

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Multiple cash flows at different dates

Basic principle: To calculate the total PV of a set of cash flows, sum the PVs
of the individual cash flows.
• In other words, once we have converted the cash flows into the same
units, we can just add them up.

Present Value of Multiple Cash Flows (often called NPV – Net Present Value – when we add all
costs and benefits). The PV of a stream of cash flows is given by:
𝐶1 𝐶2 𝐶𝑛
𝑃𝑉 = 𝐶0 + + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛
NPV = PV (All project cash flows)

Three reasons for using PV:

1. If you have cash flows in the future, PV is the amount you could borrow against them
today.
2. If you wanted the cash flows in the future, PV is the amount you would need to invest
in order to get them.
3. In a “competitive" market, PV is the market value or price of the future cash flows.
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Example: Trade-offs over time (start-up cont.)

If the discount rate is 5%, then:

Strategy I:
Date 0 1 2 3
Cash Flow -400 200 200 200
NPV 144.6

Strategy II:
Date 0 1 2 3
Cash Flow -400 -100 350 350
NPV 124.6

NPV means net present value. It's often used instead of PV to indicate that some of the
cash flows are negative.

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FV – Future Value

Definition:
You have an amount P today. The Future Value (FV) of P is the
amount you will have at some point in the future if you invest P today.

In general, the future value, n periods from now, of a cash flow P is:

𝐹𝑉 = 𝑃𝑉 ∗ 1 + 𝑟 ∗ ⋯ ∗ (1 + 𝑟)
𝐹𝑉 = 𝑃𝑉 ∗ (1 + 𝑟)𝑛

Example
A bank pays 3% per year on a 5-year CD (certificate of deposit) and you deposit $1000. What
is the FV of your investment? How much money will you have in 2 years?

FV@t=5 = 1000 * (1 + 0.03)5 = $ 1,159.27

FV@t=2 = 1000 * (1 + 0.03)2 = $ 1,060.90

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What if…

We know how to calculate the present value of a stream of cash flows:

𝐶1 𝐶2 𝐶3
𝑃𝑉 = 𝐶0 + + + +⋯
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)3

This gets very boring when there are 360 cash flows!

• What if there is an infinite number of cash flows???

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Shortcuts to PV calculation

There are two types of cash flows that we will encounter frequently. There
are formulas which make them easy to compute:
1. Perpetuities: payments each period, indefinitely
e.g., dividend payments of a firm
2. Annuities: payments each period, for n periods
e.g., mortgage/loan payments, pension payments

The payments may be constant or growing over time...

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Perpetuity

A (constant) perpetuity is a cash flow stream that provides an identical cash

flow of $C at the end of each period, forever.
𝐶
𝑃𝑉 (𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟

Important: PV (Perpetuity) formula (and the following formulas) gives the

PV as of t=0, even though the first payment arrives at t = 1.
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Example: UK consol bonds

In the 1800's, the UK government consolidated huge debt accumulated

during the Napoleonic wars and replaced it with a single issue of bonds with
no termination date and a coupon rate of 2.5% (UK gov. makes payments of
2.5% of the face value per year to its investors).
These bonds, called consols, are still traded today ☺
Suppose that the current interest rate in the UK is 4%. What is the PV of a
consol with a $1,000 face value?

This is a (constant) perpetuity promising to pay $25 each year.

PV = 25/0.04=625

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Growing perpetuity

A growing perpetuity is a perpetuity in which the cash flow $C grows at a

constant rate g. Provided that r > g,
𝐶
𝑃𝑉 (𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦) =
𝑟−𝑔

• What if g>r?
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Annuity

An annuity provides an identical cash flow of $C each period, starting at the

end of this period and lasting for n periods.
𝐶 1
𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = ∗ (1 − )
𝑟 1+𝑟 𝑛

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Growing Annuity

A growing annuity provides a cash flow of $C at the end of this period, with
subsequent cash flows growing at a rate of g each period and lasting for n
periods.
𝐶 1+𝑔 𝑛
𝑃𝑉 𝐺𝑟𝑜𝑤𝑖𝑛𝑔 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = ∗ (1 − ( ) )
𝑟−𝑔 1+𝑟

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EXCEL

To compute PV or FV for an arbitrary set of cash flows, there are numerous

approaches:

1. Brute force: compute PV (or FV) of each individual cash flow and sum
them up.

2. Use the NPV function for present value

• Multiply result by (1 + r )n to get future value.

3. Type the formula directly into a cell if it is an annuity or perpetuity.

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EXCEL

Excel has canned functions only for constant annuities:

• Not for perpetuities, growing perpetuities, or growing annuities.
• For these, you will need to type the relevant formula into a cell.

Excel uses the following equation to work with annuities:

𝑃𝑀𝑇 𝑃𝑀𝑇 𝑃𝑀𝑇 𝐹𝑉

0 = 𝑃𝑉 + + + ⋯ + +
(1 + 𝑟)1 (1 + 𝑟)2 1+𝑟 𝑛 1+𝑟 𝑛

where:
• n - number of payments
• r - interest rate per payment period
• PV - (-) present value (principal)
• FV - future value (face value).
• PMT - constant periodic payment amount.

Relevant functions: PV, FV, PMT, NPER, RATE.

Practice more @ https://www.youtube.com/watch?v=AfWRp1mExQw

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More on interest rates

• To this point, we have dealt with non-compounded or “stated rate”

such as annual percentage rate (APR), annual rate…

• Stated rate is always in annual mode.

• Many rates are “compounded” more frequently than annually – i.e. a

10% annual rate with semi-annual compounding or a 12% rate with
monthly compounding

• The key concept: even though it’s stated as a 10% rate, if it’s
compounded more frequently than annually, £100 invested at the
beginning of the year will be worth more than £110 at the end of the
year.

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Compounding period
An investment pays 10% compounded semiannually.
If you invested £100 at the beginning of the year, what would your balance be at the
end of the year?

Compound semiannually → “Period” is “every 6 months” now There are 2 periods of 6

months in a year → Use 5% every 6 months

Year 0 Period 1 Period 2 1

“Period” 0 1 2

£100
Balance after 6 months: 100 (1+.05) = 105
Balance after 1 year: 105 (1+.05) = 110.25
Other way by moving 2 periods: 100 (1+.05)2 = 110.25

Since £100 has grown to £110.25 in a year’s time, we have earned an effective rate of
10.25% (Effective Annual Rate or EAR)
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APR vs. EAR

APR and EAR are different ways of expressing interest rates. They can be
converted to each other.
Effective annual rate (EAR): The interest rate you actually earn/pay per year, taking account
of interest on interest. When we compound k times per year:
𝑘
𝐴𝑃𝑅
1 + 𝐸𝐴𝑅 = 1 +
𝑘

Let’s fix the APR. What happens as we increase compounding frequency k?

No. of years
k EAR
1 5 10 40
1 6.000% 106.00 133.82 179.08 1028.57
2 6.090% 106.09 134.39 180.61 1064.09
4 6.136% 106.14 134.69 181.40 1082.85
6 6.152% 106.15 134.78 181.67 1089.26
12 6.168% 106.17 134.89 181.94 1095.75
365 6.183% 106.18 134.98 182.20 1102.10

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No Arbitrage & Law of One Price

Arbitrage: The practice of buying and selling equivalent goods in different markets to take
advantage of a price difference. An arbitrage opportunity occurs when it is possible to make a
profit without taking any risk or making any investment.

In equilibrium (in a competitive market)

• If two assets generate the same cash flows, they should sell for the same price.
• You shouldn't be able to make riskless profits simply by trading in financial markets.

We will use this logic (No Arbitrage & Law of One Price) throughout the course.
• The theory underlying this conclusion relies on competitive markets.

No-arbitrage price of a security

• Unless the price of the security equals the present value of the security’s cash flows, an
arbitrage opportunity will appear.

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Value additivity

• The law of one price also has implications for packages of securities.
Consider two securities, A and B. Suppose a third security, C, has the same
cash flows as A and B combined. In this case, security C is equivalent to a
portfolio, or combination, of the securities A and B.

• It is called VALUE ADDITIVITY:

Price(C) = Price(A) + Price(B)

• Value additivity and firm value

• To maximize the value of the entire firm, managers should make
decisions that maximize the present value of the firm’s cash flows.
• The present value of the decision represents its contribution to the
overall value of the firm.
• Values can only be added together when they are measured at the same
point in time.

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Key take-aways

• Time Value of Money - $1 today is not equal to $1 in one year!

• Tools for comparing cash flows across time

1. Present value
2. Future value

• Shortcuts to PV
Annuities, perpetuities and rules of time travel

• Arbitrage and the law of one price: asset price implication

• Value additivity: application for valuation

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Decision Rules

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Financial decisions around investing

When you need to make a financial decision to pick projects that create
value, you are doing nothing else but… capital budgeting. When you are
valuation projects/companies, you are doing nothing else but… estimating
how much value they add/create.

3 steps to do that:
1. Project cash flows – class 9
2. Estimate the cost of capital (the “right” discount rate) – class 2
3. Employ a decision rule - class 1 today
• NPV, IRR, MIRR, PI, PP, best-case analysis

Similar procedure is done for firm valuations using a DCF approach.

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How does NPV work?

The NPV is:

𝐸(𝐶1 ) 𝐸(𝐶2 ) 𝐸(𝐶𝑛 )
𝑁𝑃𝑉 = 𝐸(𝐶0 ) + + + ⋯ +
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛

where E(Ct) is the expected cash flow

• Match up all inflows from project with outflows to providers of capital.

• Residual accrues to the shareholders of the firm.
• Discount back the residual at the shareholders (firm) cost of capital (r).
• That is the NPV of the project ☺

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NPV rule

The correct and primary criterion for evaluating projects is NPV

• When NPV > 0, take the project
• When NPV < 0, reject the project

How projects relate to each other

• If projects are independent, accept projects with NPV>0
• If projects are mutually exclusive, accept the project(s) with the highest NPV
• When choosing among projects, start with highest NPV

Intuition: NPV reflects the value added to the firm when the project is taken
• Value added to the firm (added market value) = value that accrues to the
equity holders
• Value of all benefits minus value of all costs

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How does NPV work?

• Imagine that each project was financed separately (like project finance)

• Outside investors would put up all the money required for the investment
in exchange for some promise of future cash flows

• Outside investors had no recourse to other assets of the firm

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Projects at Google: Example 1

Suppose you are at a Google (Alphabet) shareholders meeting. Two funds

– biggest shareholders are advocating what the firm should do.
• One fund would like to consume today: they want Google to develop new
features for online advertising (positioning advs in their search browser),
which would yield an immediate profit.
• Another fund calls for money in the future: they want Google to invest in
developing driverless cars.

What should the Google managers do?

Does the NPV rule assume all shareholders are the same (their needs are
equally valid)?

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Projects at Google: Example 2

Suppose Google has 100M shares outstanding trading for $50/share.

Google announces that it will undertake a new project with novel browser
features with NPV of $200M.

What should happen to the stock price upon the announcement?

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Decision rules in practice

https://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdf

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Alternative evaluation tools

Supplements to the basic NPV rule:

IRR and MIRR:
• Tells us how much estimation error in the cost of capital can exist without
changing the initial (NPV based) decision.
• A good communication tool!

Profitability index:
• Maximizes overall NPV from a set of projects when you face a constraint.
Better than just picking projects in order of decreasing NPV.

APV (adjusted PV): NPV where you account for the tax benefits of debt.
Real options theory: Allows us to maximize NPV when the project has embedded options, e.g., the option to shut down
early if bad news arrives. It is a way to value flexibility.

Note: Any method producing results that differ from NPV is WRONG. Use such
methods with great care.

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Internal Rate of Return

• IRR rule is the most popular alternative method, since it is intuitive and usually gives the right
result.

A project’s IRR = the interest rate that sets the NPV of cash flows equal to zero:
𝐶1 𝐶2 𝐶𝑛
0 = 𝐶0 + + +⋯+
(1+𝐼𝑅𝑅)1 (1+𝐼𝑅𝑅)2 (1+𝐼𝑅𝑅)𝑛

• IRR ~ how much you earn per $1 invested

• If projects are independent, accept a project if the IRR is greater than the opportunity cost of
capital (IRR>r).

• If projects are mutually exclusive, accept the one with the highest IRR, provided it is greater
than the opportunity cost of capital.

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IRR: Example
Company ABC considers an investment decision involving a single, stand-
alone project. The project costs $250M 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!

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IRR: Example EXCEL
If ABC’s cost of capital is 10%, then the NPV is $100 million, and they should
undertake the investment.

At 14%, the NPV=0, so the project’s IRR is 14%. For ABC, if its cost of capital
estimate is more than 14%, the NPV will be negative.
The difference between the cost of capital and the IRR is the maximum
amount of estimation error in the cost of capital estimate that can exist
without altering the original decision.

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NPV vs. IRR

Calculation Investment Decision

Taking discount rate as given (r), Accept project if NPV >
NPV calculate NPV hurdle (zero)
Taking NPV as given (zero), Accept project if
IRR calculate IRR. IRR > hurdle (r)

• The IRR is useful to know even if you use the NPV decision rule.
• It tells you how high the cost of capital can be before the NPV goes
negative.
• Most of the time, these rules are equivalent
• But not always…
→ Pitfalls of IRR ☺

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IRR Pitfalls

• IRR Pitfalls 1: Lending or Borrowing, Delayed investments

• In business projects, IRR rule doesn't work if cash flows are positive and then negative

• IRR Pitfall 2: Multiple IRR Values

• This can occur if cash flows change sign more than once
• Comes up a lot in real estate when doing large renovations

• IRR Pitfall 3: No Real Solutions Exists

• This can occur with certain cash flows (e.g., check the situation of CFs: +4, -8, +102)

• IRR Pitfall 4: Mutually Exclusive Projects

The project with the higher IRR may not be the one with the higher NPV because:
• Timing of the cash flows differ
• Scale of the cash flows differ

• IRR Pitfall 5: Time Varying Interest Rates (Non-Flat yield curve)

• The IRR rule: accept project if IRR > discount rate (cost of capital).
• What if a 3-year IRR = 10.0%, but discount rates are: r1 = 7%; r2 = 10%; r3 = 13%?

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 IRR Pitfalls 1: Lending or Borrowing, Delayed
investments

• In a “normal” project, outflows (costs) occur before inflows. For a delayed

investment, inflows occur before outflows.

• Example: You’ve just retired as a 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 3 years to write the book and the time you spend writing the
book will cause you to give up speaking engagement amounting to
$500,000 per year, and that your opportunity is 10%.

$1,000,000 -$500,000 -$500,000 -$500,000

0 1 2 3

Find IRR: Excel =rate(3,-500000,1000000,0)=23% > 10% → accept?

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IRR Pitfalls 1: Lending or Borrowing, Delayed
investments

$1,000,000 -$500,000 -$500,000 -$500,000

0 1 2 3
IRR = 23% > 10% → accept
→ reject?

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 IRR Pitfall 2: Multiple IRR Values

• In a “normal” project, outflows (costs) occur before inflows. If the project

has cash flows that change directions more than once (i.e., outflow-inflow-
outflow), the NPV profile may have a “curve” and therefore may have more
than one possible IRR.

• Each change of direction results in another possible IRR (i.e., two

directional changes may result in two IRRs).

• All projects (even “abnormal” ones) have one and only one NPV.

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 IRR Pitfall 2: Multiple IRR Values

• Suppose you inform the publisher that it needs to sweeten the deal before
you will accept it. The publisher offers $550,000 in advance and $1,000,000 in
4 years when the book is published. Should you accept the new offer?
0 1 2 3 4

$550,000 -$500,000 -$500,000 -$500,000 $1,000,000

• Find IRR:
0 = 550,000 - 500,000/(1+IRR) – 500,000/(1+IRR)2 – 500,000/(1+IRR)3
+ 1,000,000/(1+IRR)4
→ IRR = 7.16% or 33.67% (trial and error)

• <0 with r =10%

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IRR Pitfall 2: Multiple IRR Values

▪ Which IRR should you use? 7.16% or 33.67%?

▪ You need to recognize that there are non-conventional cash flows and
look at the NPV profile!

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 IRR Pitfall 3: No Real Solutions Exists
• Finally, you’re able to get the publisher to increase his advance to
$1,750,000 (instead of $1,000,000) in 4 years when the book is published.
How much is your IRR and what should you do?
0 1 2 3 4

$550,000 -$500,000 -$500,000 -$500,000 $1,750,000

• Find IRR:
0 = 550,000 - 500,000/(1+IRR) – 500,000/(1+IRR)2 – 500,000/(1+IRR)3
+ 1,750,000/(1+IRR)4
→ IRR = #NUM (from Excel)

• >0 with r=10%

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IRR Pitfall 3: No Real Solutions Exists

▪ You need to recognize that there are non-conventional cash flows and
look at the NPV profile!
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IRR Pitfall 4: Mutually Exclusive Projects

Summary of IRR problems so far:

▪ When cash flows are not conventional, we may have some IRR
problems: Delayed investment, Multiple IRRs, or Non-existent IRR.

▪ In these situation, do not use the IRR rule, use NPV rule instead.

Other IRR problems:

SCALE PROBLEM:
Would you rather make 100% or 50% on your investments?
What if the 100% return is on a $1 investment, while the 50% return is on a
$1,000 investment?
→ IRR ignores scale!

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IRR Pitfall 4: Mutually Exclusive Projects
TIMING PROBLEM:
-10,000 10,000 1,000 1,000
Project A
0 1 2 3
-10,000 1,000 1,000 12,000
Project B
0 1 2 3
NPV
@0% @10% @15% IRR
Project A 2,000 669 109 16.04%
Project B 4,000 751 −484 12.94%

• Project A always has a higher IRR.

• A common mistake to make is choose A regardless of the discount rate.

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Additionally: IRR is not the actual return!!!

A project yields 41% IRR and requires a $10 million initial investment. Investors
think that it means that after 5 years, they will have $10M *1.415 = $56M

This is only true if you can reinvest intermediate cash flows at a 41% return.
• McKinsey article: “IRR: A Cautionary Tale."
It is more realistic to assume reinvestment rate equal to the cost of capital.
• To compute the actual return, you can then use Modified IRR (or CAGR).

1
𝐹𝑉 𝑜𝑓 𝑓𝑢𝑡𝑢𝑟𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑎𝑡 𝑑𝑎𝑡𝑒 𝑛 𝑔𝑖𝑣𝑒𝑛 𝑟𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 𝑛
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐼𝑅𝑅 = −1
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑎𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Excel: =MIRR(CFs,CoC,CoC)

To apply in your mini case...

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IRR is not the actual return!

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IRR Summary

• Why use IRR at all?

• Lots of other people use it.
• It works (it exists, is unique, and gives right decision) as long as:
• One discount rate for all periods
• One negative cash flow in period 0 followed by positive cash
flows.
• We are only looking at one investment
• It provides an intuitive measure of a project’s rate of return.

• However, given a choice, you should always use NPV (or PI if

resource constrained)

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The 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.

• However, the payback rule does not always give a reliable decision since it
ignores: (i) the time value of money, (ii) cash flows after payback, and (iii) risk.

Example: Project A maximizes NPV but fails to meet a payback rule of 2 years.

Date Project A Project B Project C

0 -2000 -2000 -2000
1 500 500 1800
2 500 1800 500
3 5000 0 0
Payback 3 years 2 years 2 years
NPV (10%) $2,624 ($58) $50

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Resource Constraints & Profitability Index

In theory: Firm should take on all positive NPV projects.

In practice: Firms face resource constraints.
• Capital, workers, engineers, programmers, factories etc.

The profitability index of a project is the ratio of the present value to the resource
consumed:
𝑁𝑃𝑉
𝑃𝐼 =
𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝐶𝑜𝑛𝑠𝑢𝑚𝑒𝑑

You still want to maximize the NPV of the set of projects you choose.
• Need to consider both NPV and resource constraints requirements.
• You do not necessarily want to pick projects in order of decreasing NPV.

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Example: PI

As an entrepreneur you have $1,000,000 in available venture capital. You

cannot raise more capital. You can choose any combination of the following
projects:

Project Cost at t = 0 PV of C1; C2; … NPV as of t=0 PI

A 200,000 300,000 100,000 0.50
B 500,000 620,000 120,000 0.24
C 400,000 700,000 300,000 0.75
D 200,000 275,000 75,000 0.38
E 100,000 130,000 30,000 0.30
F 100,000 140,000 40,000 0.40

If you incorrectly pick projects in order of decreasing NPV, what's your total
NPV?
If you instead pick projects in order of decreasing PI, what's your total NPV?
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Best-case cash flows

You have project with two possible scenarios.

• Best case, (50%): Cash flow at t=1: $100M
• Downside case, (50%): Cash flow at t=1: $60M

How to compute Project Value?

• Weight each of the two scenarios by their probability and compute the
expected net present value.

• Further reading: McKinsey article: “Avoiding a risk premium..."

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Key take-aways

Given a choice, you should always use NPV! The NPV decision rule:
• Captures how much value the project adds
• Does not require manager to account for shareholder's time preferences
Useful supplements:
• Internal Rate of Return (communication device, less useful for decision-
taking; fixes: incremental & modified IRR)
• Profitability Index (when dealing with resource constraints)

Payback Period (Less useful metric which you should know but not rely
upon)

Best-case cash flows & decision-taking

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