QABE Lecture 3 Evaluating Time-Money Choices

School of Economics, UNSW 2011

Contents
1 Introduction 2 Equations of value 2.1 Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.2 Compound Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Net 3.1 3.2 3.3 Present Value The Scenario . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Importance of the Interest Rate . . . . . . . . . . . . . . . . . . . . . 1 2 2 3 3 3 4 5 5 6 7

4 Internal Rate of Return 4.1 Working it out . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Summary

Introduction

We spend a little more time looking at how the value of money is actually dependent on the time at which it is in our hand. That is, as before, we note that there exists a time value of money; would you prefer $100 in your hand today, or $101 tomorrow? There are various explanations for this fact. As you might have reected above Id prefer the money today, since Im not sure what will happen tomorrow, that is the uncertainty of our lives kicking in. Just one of the factors that contribute to the apparent value of money changing through time. We then move on to applying some of our new-found skills in time-value-of-money to one of the most common problems faced in the commercial world, namely, the problem of deciding whether or not to go ahead with a project, or if there is choice between projects, deciding which of the projects to fund. The reason it is so common (if not already obvious) is that in practically every business situation, one has to spend money, to make money that is, make an initial investment (called capital) and after time, begin to yield some kind of income stream from the business. The big competition that then ensues is between that money invested in your project, versus that money invested in the bank at some going rate who gives the best return will decided how you will proceed. However, the question of whether one project is actually worth it on its own, or in comparison to another is not always

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immediately obvious. Not to worry by applying what we have learnt up till now, we have the tools to become experts on these issues! The methods we will develop are two of the most common the net present value of the project on the one hand, and the internal rate of return on the other. The two methods are very connected, but their interpretation requires some care. Agenda 1. Equations of value; (a) Under simple interest; (b) Under compound interest; 2. A campus investment conundrum; 3. Looking at the numbers I (the N P V ); 4. Looking at the numbers II (the IRR); 5. Calculating with a computer; 6. Conclusions.

Equations of value
KZB 1.4, 2.6

Equations of value Scenario You owe your parents some money. At present, you owe them $500 to be paid in 6 months and $350 in 9 months. You dont want to do installments, youd prefer to pay $100 now and the rest in 12 months time. In negotiations, they agree to consider either simple or compounded (quarterly) interest. What will you do?

2.1

Simple Interest

Solution technique: 1. Work out the timings; 2. Using the focal date bring all the payments and debts to it; 3. Set up the equation of value; 4. Solve. Debts: 2 Payments: $100 focal date 4 $500 6 $350 8 10

t (months) 12 focal date

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Example: Using a focal date of now or in 12 months, and simple interest at the nominal value of 7%, what would be the single sum you owe?

Checking the two payments (now = $715.63, 12 months = $766.63), the value of the 12 month payment is, P = 766.63(1 + 0.07)1 = $716.48 !!!

When using simple interest in equations of value, the focal date must be agreed before hand, since it will aect the total value exchanged.

2.2

Compound Interest

1. Try the compound interest version yourself! 2. Check if the value of the future (12 month) payment is the same as the current payment. 3. Which repayment method would you pick?

3
3.1

Net Present Value

The Scenario

Scenario: The Bean House a Micro-coee Roasting House for the Eastern Suburbs Youve recently read about the micro- coee roasting craze that is hitting Sydney. It seems like the perfect business propositon value pricing (as opposed to cost-pricing), a legally addicted market (both to the bean, and to the boutique theme), and with a tiny amount of skill, an easy market to get a foot in (most drinkers dont know the dierence). You and a friend are talking one night and it turns out your friend has already got a plan together. Knowing you are a student of QABE, she turns to you to run the numbers. Will it work out? The numbers ... Upon further inquiry, the numbers (according to your friend) look like this:

QABE Lecture 3

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Year ending 0 1 2 3 4 5

Costs 50,000 34,000 34,000 44,000 44,000 44,000

Income 0 25,000 45,000 60,000 70,000 75,000

Cash ow -50,000 -9,000 11,000 16,000 26,000 31,000

Note Set-up costs Two-wages @ $17,000 Third wage @ $10,000

3.2

Working it out

Steps to a decision... 1. Adjusting the cash-flow numbers to turn them into present values (based on the going alternative rate of return); 2. Sum each of the cash-ow values (in todays terms) to get the net present value; 3. Make a decision: If NPV > 0 worthwhile; If NPV < 0 not worth it! Example: Suppose your friend has access to a bank who has a long-term savings account (yearly compounded) oering a nominal rate of 12%. Should The Bean House get o the ground? Year ending 0 1 2 3 4 5 Costs 50,000 34,000 34,000 44,000 44,000 44,000 Income 0 25,000 45,000 60,000 70,000 75,000 I-C -50,000 -9,000 11,000 16,000 26,000 31,000 (1 + 0.12)t PV

NPV

Denition | Net Present Value (NPV) If Ft is the estimated cash ow for a T period project at the end of period t and the yearly compounded rate of interest, the cost of capital is r, then the net present value is the sum of present values, assuming cash ows arrive at the end of the year, N P V = F0 + F1 (1 + r)1 + + FT (1 + r)T . (1)

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Interpretation - what does it mean? As we noted before, if the N P V > 0 then the project is worthwhile; The reason is, that the NPV calculation is really doing an in-built comparison, or play-o, between the project at hand, and the interest rate available at the bank; If you are beating the bank by gaining more value through the project than if your money were invested with the bank alone, then we deem the project to be worthwhile; Challenge: do the same calculation as in the example above, but at 8% cost of capital. Is the project now worthwhile?

3.3

The Importance of the Interest Rate

Suppose we do the calculation of the NPV for a range of interest rates ... 20 16 12 8 IRR 4 r N P V ($ 000) 0 0.05 0.10 0.15 4 8 12 16 20

Internal Rate of Return

The internal rate of return asks the question, What cost of capital would mean an NPV = 0, the break-even point? Which means that if, r = IRR

then the return on the project (over its life) is exactly the same as if we put our money into the bank! (the competition is a dead-heat!) Denition | Internal Rate of Return (IRR) The internal rate of return indicates the equivalent interest rate oered by a nancial institution (compounded yearly) that would give the same outcome for my investment over the project life-time, as my project itself. It is found by setting the N P V to zero, and solving for r, assuming cash ows arrive at the end of the year, N P V = F0 + F1 (1 + r)1 + + FT (1 + r)T = 0 . (2)

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Care with the IRR When interpreting the IRR, notice that it is (by denition) independent of the current cost of capital (what is actually oered by the banks). It is tempting to think that IRR somehow depends on this value. It doesnt! (But we compare to it.)

4.1

Working it out
Example: IRR by hand Suppose a project requires an initial investment of $20,000 and returns $7,000 and $16,000 at the end of the rst and second years respectively. Find the IRR of the project assuming yearly compounding.

There are simple cases (esp. when t 2) that can be solved by hand using the quadratic equation; Obviously, it is dicult to solve for r in most cases (other than trial-and-error approximation), so we often use a software package (such as Microsoft Excel, Open-office or Gnumeric); Be careful how you use the software however... Example: Using a computer program of your choice, nd the IRR and N P V , at 3% interest, of the following stream of net prots: (-45, -25, -2, 12, 27, 30, 31).

The interpretation here needs care! Note that the cost of capital is so-called, since it is the gain fore-gone (given up) when we use the investment money (the capital) in our project. For this reason, if we cant do better than what the bank is oering, we might as well put our backers money in the bank! It is in this sense, that having capital (investment money) outside of the bank is costly unless we are putting it to good use, it is literally costing us in interest we could have been getting! (thats no-risk return too...)
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Summary

Does The Bean House go ahead? Clearly, at cost of capital 12%, the The Bean House isnt worth it wed do better by putting our money in the bank at the oered rate of 12%; However, by calculating the IRR, we could see that for any cost of capital less than 10%, the The Bean House is a good idea! ... wed beat the best interest going at the bank! Finally, suppose that we had two dierent projects the coee roaster being one, the other being a simple bakery, if they both have a positive N P V , we still wouldnt know how to pick between them. However, if you cant do both, choosing the higher N P V project will be the highest returning project.

QABE Lecture 3