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Financial
FinancialManagement
Management
Financial Management
Financial
FinancialManagement
Management
LECTURE OBJECTIVES
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
4/3/2015
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
UC
Financial
FinancialManagement
Management
Financial Management
Financial
FinancialManagement
Management
CONVENTIONAL OR
UNCONVENTIONAL CASH FLOWS?
4/3/2015
CAPITAL BUDGETING
= Sum of PVs
of future CFs
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
10
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
NPV =
CF2
CF1
CFN
+
+ +
Initial cost
(1 + r )1 (1 + r)2
(1 + r)N
Projects risk-adjusted
cost of capital
(r)
11
4/3/2015
13
Initial outlay
($1100)
2
Revenues $2000
Expenses 1000
Cash flow $1000
Revenues $1000
Expenses
500
Cash flow
500
$1100.00
$500 x
1
1.10
+454.55
$1000 x
+826.45
1
1.102
+$181.00 NPV
NPV Rule:
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Jetty
(1 million)
0.5 mi
0.7 mi
0.8 mi
Port
(3 million)
1.3 mi
1.3 mi
1.3 mi
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
14
15
16
4/3/2015
vs
Medium heating
system
7 years duration
$9,000
17
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
18
19
20
4/3/2015
21
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
CLASS EXERCISE
22
23
Yes
Mutually exclusive
No
Do projects have
equal lives ?
Select project with
highest NPV annual
equivalent
No
Yes
Select projects with
the highest +NPV
PAYBACK METHOD
Financial
FinancialManagement
Management
Financial Management
Financial
FinancialManagement
Management
Are projects
independent ?
4/3/2015
PAYBACK ILLUSTRATION
PAYBACK PERIOD
The payback period is the amount of time required for
the firm to recover its initial investment
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Year
26
PAYBACK ILLUSTRATION
Cash flow
$200
2
3
400
600
Year
Accumulated
Cash flow
1
2
3
Payback period =
$200
600
1200
22/3 years
27
Project
CF0
CF1
CF2
CF3
Payback
-2,000
+1,000
+1,000
+10,000
$7,249
-2,000
+1,000
+1,000
-264
-2,000
+2,000
-347
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Example:
Extremely simple
Helps prevent cash flow problems
Since cash is recovered as quickly as possible
Useful when technology changes rapidly
Cost of machinery is recovered before new model comes out
4/3/2015
Financial
FinancialManagement
Management
Financial Management
Financial
FinancialManagement
Management
400
331
700
526
300
205
1
2
3
4
Accumulated
discounted cash flows
$182
513
1,039
1,244
Advantages
Accumulated Cash Flows
Year
Undiscounted
Discounted
Undiscounted
Discounted
1
2
3
4
5
$ 100
100
100
100
100
$ 89
79
70
62
55
$ 100
200
300
400
500
$89
168
238
300
355
Ordinary payback?
Discounted payback?
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Year
30
31
Disadvantages
-May reject positive NPV
investments
-Arbitrary determination of
acceptable payback period
-Ignores cash flows beyond the cutoff date
-Biased against long-term and new
products
32
4/3/2015
Financial
FinancialManagement
Management
Financial Management
Financial
FinancialManagement
Management
NPV 0 CF0
CF3
CF1
CF2
CFT
....
2
3
(1 IRR) (1 IRR) (1 IRR)
(1 IRR)T
34
35
Discount rates
Cash flow
1
2
3
$ 50
100
150
50
0 = 200 +
100
(1+IRR) 1
50
200 =
(1+IRR) 1
(1+IRR) 2
100
+
150
(1+IRR) 2
(1+IRR) 3
150
+
(1+IRR) 3
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Year
NPV
0%
$100
5%
68
10%
41
15%
18
20%
36
4/3/2015
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Borrowing or lending ?
Multiple IRRs
Mutually exclusive projects
IRR and NPV rankings do not always agree
38
37
39
Project
IRR
NPV at 10%
discount rate
-1,000
1,500
50%
363.64
1,000
-1,500
50%
-363.64
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Year
Cash flows
$252
1431
3035
2850
1000
40
10
4/3/2015
NPV =
at 33.33%:
NPV =
at 42.86%:
NPV =
at 66.67%:
NPV =
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Two questions:
u
u
43
NPV > 0
NPV <0
IRR
NPV
-5,000
8,000
60%
2,273
-5,000
9,800
40%
3,099
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
41
44
Year
IRR
NPV
Small
project
-1
+1.5
50%
0.43
Large
project
-100
+110
10%
4.76
11
4/3/2015
45
Financial
FinancialManagement
Management
IRR says accept the project, then NPV will also say
accept the project.
PROFITABILITY INDEX
PROFITABILITY INDEX
47
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
Present Value ?
CF1
CF2
CFT
...
2
PV of cash flows (1 r ) (1 r )
(1 r ) T
PI
Initial investment
CF0
48
12
4/3/2015
PROFITABILITY INDEX
Financial
FinancialManagement
Management
Financial
FinancialManagement
Management
PROFITABILITY INDEX
49
50
13