...Return (IRR) are two very important tools which can be used in decision making in expanding and investing in overseas projects. Return on Equity (ROE) tells how much profit company is generating with shareholder's money. ROE is calculated as: ROE = Net Income/Shareholder's equity This net income is income after paying tax and preferred stock dividend but before paying common stock dividend.ROE measures profit generating efficiency of the company. (McClure, 2010) Higher the ROE, better the investment opportunity company is offering. Advantage of using ROE for investment decision is, it is easy to calculate and it tells how much profit company is generating for share holders. Ultimate goal of a company is to create value for shareholders. Thus, ROE is the right measure to find out if company is efficient in generating profit on its equity (and asset) or not. However, ROE is not the absolute indicator of investment value. If value of shareholder's equity falls, ROE will go up. Similarly, if company is taking large write-down, ROE will fall sharply. Share buyback also lowers ROE while there is no change in company's operation. (McClure, 2010) Internal Rate of Return (IRR) is an indicator of yield of an investment.IRR is widely used method in capital budgeting decisions. IRR is the discount rate where total present value of all cash inflows is equal to total present value of all cash outflows. i.e. IRR is the discount rate at which NPV is zero. Calculation of IRR is complex...
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...Each statement shows where the money is and how well they are taking care of it. There are income statements, cash flows, net present value (NPV), and Internal Rate of Return (IRR) located in financial statements. To find the NPV and IRR you first need to create an income statement and cash flow statement. These will give you the correct amount. There are steps to take before determining your NPV and IRR. In the capital budgeting case provided for this company to expand the best corporation to choose is corporation A. This corporation seems to be the best to go with by the numbers given. After creating an income statement, cash flow statement, NPV, and IRR for 5 years I have decided to go with A. This corporation will have more money left once all is paid and money is brought in. Starting with the income statement between adding the revenue over 5 years and subtracting the expenses for 5 years the money in corporation a still seems the best. Along with subtracting the tax rate that is given there is still more money in corporation A for the company to work with. Even after 5 years with revenue and expenses this company will still have money left to have over the next couple of years. The cash flow which adds in the depreciation expenses still adds to up to corporation a being the best to go with. Once you have determined your net income and the amounts in the cash flow over the next 5 years you can start figuring out your NPV and IRR. Knowing what your discount rate, initial...
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...Assignment #2 Question 1 (a) How much money will Kevin need at retirement? (12 points) EAR = .10 = [1 + (APR / 12)]12 – 1; EAR = .07 = [1 + (APR / 12)]12 – 1; APR = 12[(1.10)1/12 – 1] = .0957 or 9.57% APR = 12[(1.07)1/12 – 1] = .0678 or 6.78% PVA = $20,000{1 – [1 / (1 + .0678/12)12(25)]} / (.0678/12) = $2,885,496.45 PV = $900,000 / [1 + (.0678/12)]300 = $165,824.26 $2,885,496.45 + 165,824.26 = $3,051,320.71 (b) How much will he have to save each month in years 11 through 30? (20 points) His savings after 10 years: FVA = $2,500[{[ 1 + (.0957/12)]12(10) – 1} / (.0957/12)] = $499,659.64 After he purchases the cabin: $499,659.64 – 380,000 = $119,659.64 When he is ready to retire, this amount will have grown to: FV = $119,659.64[1 + (.0957/12)]12(20) = $805,010.23 When he is ready to retire, based on his current savings, he will be short: $3,051,320.71 – 805,010.23 = $2,246,310.48 This amount is the FV of the monthly savings he must make between years 10 and 30. So, finding the annuity payment using the FVA equation, we find his monthly savings will need to be: FVA = $2,246,310.48 = C[{[ 1 + (.1048/12)]12(20) – 1} / (.1048/12)] C = $3,127.44 Question 2. (18 points) a. The payback period for each project is: A: 3 + ($180,000/$390,000) = 3.46 years B: 2 + ($9,000/$18,000) = 2.50 years The payback criterion implies accepting project B, because it pays back sooner than project A. b. The discounted payback for each project is: A: $20,000/1.15 + $50,000/1.152 + $50,000/1.153 =...
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...Capital Budgeting Techniques Mona School of Business Financial Management Lecturer: Kathya Beckford By the end of this session you will understand: 1. What capital budgeting is How to calculate and interpret a project’s: 2. Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) 3. How to choose projects when capital is rationed What is capital budgeting? Capital budgeting is the process of planning expenditure on assets or projects that can have a long-term impact on an institution. Examples of capital projects Adopting a new enterprise-wide software system Launching a new advertising campaign Replacing factory equipment Expanding sales into a new market Building a road Why is capital budgeting important? Helps firm make smart decisions Capital projects large and expensive- not easy to change course Allows management team to give input and be on same page Capital budgeting techniques include: Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Payback Period- The Concept What is it? The payback period for a project is the expected time it will take to recover the original investment. The decision rule: Accept project if its payback period is less than the maximum allowed. Payback Period- An Example A project requires a $100,000,000 investment...
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...0000 0.8929 0.7972 0.7118 0.6355 0.5674 NPV @ 12% Present Value (4) = (2*3) (100,000) 17,857 23,916 28,471 31,776 17,023 19,043 Sum of Present Value of Cash Inflows = Rs.119,043/- From the Sum of Present Value of Cash Inflows deduct the Initial Investment to get NPV. (b) IRR: In order to find the IRR, we need to find the discount rate at which the NPV at that rate is zero. As the NPV @ 12% is positive, we need to increase the discounting rate, say to 19%. NPV @ 19%: Year 0 1 2 3 4 5 Cash Flows (100,000) 20,000 30,000 40,000 50,000 30,000 NPV @ 19% PVIF @ 19% 1.0000 0.8403 0.7062 0.5934 0.4987 0.4190 Present Value (100,000) 16,807 21,185 23,737 24,933 12,571 (767) 1 At 19%, the NPV is negative, so we need to lower the discount rate slightly, say to 18%. NPV at 18% is as follows: Year 0 1 2 3 4 5 Cash Flows (100,000) 20,000 30,000 40,000 50,000 30,000 NPV @ 18% PVIF @ 18% 1.0000 0.8475 0.7182 0.6086 0.5158 0.4371 Present Value (100,000) 16,949 21,546 24,345 25,789 13,113 1,743 At 18%, the NPV is positive, which means that the IRR falls between 18% and 19%. By interpolation, we can find the IRR as follows: 18% +x 18% + (1743/(1743+767) 18% + (1743/2510) 18%+0.69% = 18.69% The IRR is 18.69% which is greater than the hurdle rate (discount rate), hence we can accept the project. (c) Profitability Index: PV of Cash Inflows PV of Cash Outflows Net Present Value...
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...Chapter 11 The Basics of Capital Budgeting Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 1 2 3 | | | | Project L -100 10 60 80 Project S -100 70 50 20 Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? ...
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...Integrated Case 11-24 Allied Components Company Basics of Capital Budgeting You recently went to work for Allied Components Company, a supplier of auto repair parts used in the after-market with products from Daimler, Chrysler, Ford, and other automakers. Your boss, the chief financial officer (CFO), has just handed you the estimated cash flows for two proposed projects. Project L involves adding a new item to the firm’s ignition system line; it would take some time to build up the market for this product, so the cash inflows would increase over time. Project S involves an add-on to an existing line, and its cash flows would decrease over time. Both projects have 3-year lives, because Allied is planning to introduce entirely new models after 3 years. Here are the projects’ net cash flows (in thousands of dollars): 0 | -100 -100 1 | 10 70 2 | 60 50 3 | 80 20 Project L Project S Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. The CFO also made subjective risk assessments of each project, and he concluded that both projects have risk characteristics that are similar to the firm’s average project. Allied’s WACC is 10%. You must determine whether one or both of the projects should be accepted. A. What is capital budgeting? Are there any similarities between a firm’s capital budgeting decisions and an individual’s investment decisions? Answer: [Show S11-1 through S11-3 here.] Capital budgeting is the...
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...CHAPTER 4 DISCOUNTED CASH FLOW VALUATION Solutions to Questions and Problems 10. To find the future value with continuous compounding, we use the equation: FV = PVeRt a. b. c. d. FV = $1,000e.12(5) FV = $1,000e.10(3) FV = $1,000e.05(10) FV = $1,000e.07(8) = $1,822.12 = $1,349.86 = $1,648.72 = $1,750.67 23. We need to find the annuity payment in retirement. Our retirement savings ends at the same time the retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the retirement savings. So, we find the FV of the stock account and the FV of the bond account and add the two FVs. (Monthly installment and so monthly compounding: 30 years time 12 months equal to 360months) Stock account: FVA = Rs.700[{[1 + (.11/12) ]360 – 1} / (.11/12)] = Rs.1,963,163.82 Bond account: FVA = Rs.300[{[1 + (.07/12) ]360 – 1} / (.07/12)] = Rs.365,991.30 So, the total amount saved at retirement is: Rs.1,963,163.82 + 365,991.30 = Rs.2,329,155.11 Solving for the withdrawal amount in retirement using the PVA equation gives us: PVA = Rs.2,329,155.11 = C[1 – {1 / [1 + (.09/12)]300} / (.09/12)] C = Rs.2,329,155.11 / 119.1616 = Rs.19,546.19 withdrawal per month 26. This is a growing perpetuity. The present value of a growing perpetuity is: PV = C / (r – g) PV = Rs.200,000 / (.10 – .05) PV = Rs.4,000,000 39. We are given the total PV of all four cash flows. If we find the PV of the three cash flows we know, and subtract them from the total PV, the amount left over must be the PV...
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...CHAPTER 10 The Fundamentals of Capital Budgeting Learning Objectives 1. Discuss why capital budgeting decisions are the most important decisions made by a firm’s management. 2. Explain the benefits of using the net present value (NPV) method to analyze capital expenditure decisions, and be able to calculate the NPV for a capital project. 3. Describe the strengths and weaknesses of the payback period as a capital expenditure decision-making tool, and be able to compute the payback period for a capital project. 4. Explain why the accounting rate of return (ARR) is not recommended for use as a capital expenditure decision-making tool. 5. Be able to compute the internal rate of return (IRR) for a capital project, and discuss the conditions under which the IRR technique and the NPV technique produce different results. 6. Explain the benefits of a postaudit review of a capital project. I. Chapter Outline 10.1 An Introduction to Capital Budgeting A. The Importance of Capital Budgeting • Capital budgeting decisions are the most important investment decisions made by management. • The goal of these decisions is to select capital projects that will increase the value of the firm. • Capital investments are important because they involve substantial cash outlays and, once made, are not easily reversed. • Capital budgeting techniques help management to systematically analyze potential business opportunities...
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...Key differences between the most popular methods, the NPV Method and IRR Method, include: * NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; * Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; * The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); * However, the IRR Method does have one significant advantage – managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, * While both the NPV Method and the IRR Method are both discounted cash flow models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash. * Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation. (Wilkinson 2013) It makes this adjustment using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital -- either interest paid...
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...in cash flows from negative to positive. LG1 2. Derive an accept/reject rule for IRR similar to 13-8 that would make the correct decision on cash flows that are non-normal, but which always have one large positive cash flow at time zero followed by a series of negative cash flows: |Time |0 |1 |2 |3 |4 |5 | |Cash Flow Sign |+ |- |- |- |- |- | With one positive at the beginning and all future cash flows negative, this type of project would be worth more if rates were higher, implying that the NPV profile would be upward-sloping. So the appropriate accept/reject decision rule would look like Accept Project if IRR ≤ Cost of Capital Reject Project if IRR > Cost of Capital LG1 3. Is it possible for a company to initiate two products that target the same market and are not mutually exclusive? Sure, as long as the market has room for both products. LG2 4. Suppose that your company used “APV”, or “All-the-Present Value-Except-CF0”, to analyze capital budgeting projects. What would this rule’s benchmark value be? Accept Project if APV ≥ -CF0 Reject Project if APV < -CF0 LG3 5. Under what circumstances could Payback and Discounted Payback be equal? They would be equal if i = 0. LG5 6. Could a project’s MIRR ever exceed its IRR? MIRR would be greater than IRR if a project with normal cash flows had a negative NPV. LG6 7. If you had two mutually...
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... DO NOT TURN THIS PAGE UNTIL YOU ARE TOLD TO DO SO. QUESTION ONE a) Assume the total cost of a university education will be $185632.5 when your child enters college in 18 years. You presently have $15000 to invest. What annual rate of interest must you earn on your investment to cover the cost of your child’s university education? ( 6 Marks) FV = PV (FIVIF r,t) $185632.5 = $15000(FIVIF r,18) (FIVIF r, 18) = $185632.5/$15000 (FIVIF r, 18) = 12.3755 Therefore Check the value 12.3755 in the period of 18 years in the future value factor tables r= 15% b) A student requires K11, 000,000 to clear an outstanding balance before graduating in two (2) years time. How much should he invest now at 9% compounded quarterly for him to have the required amount to pay the school at the end of the two years? ( 4 Marks) PV = FV (PVIF r,t) PV = 11000000 (PVIF 9/4, 2(4)) PV = 11000000 (PVIF 9/4, 8) PV = K9, 206,321.81 c) Prepare an amortization schedule for a K1000 loan to be paid in 3 equal...
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...b. What is the IRR of the asset? Exercício 2 • You just took a $10,000, five-year loan. • Payments at the end of each year are flat (equal in every year) at an interest rate of 15 percent. Calculate the appropriate loan table, showing the breakdown in each year between principal and interest. Exercício 3 • You are offered an investment with the following conditions: • The cost of the investment is $1,000. • The investment pays out a sum X at the end of the first year; this payout grows at the rate of 10 percent per year for 11 years. If your discount rate is 15 percent, calculate the smallest X that would entice youto purchase the asset. For example, as you can see in the following display, X = $100 is too small—the NPV is negative. Exercício 4 • The following cash-flow pattern has two IRRs. • Use Excel to draw a graph of the NPV of these cash flows as a function of the discount rate. Then use the IRR function to identify the two IRRs. • Would you invest in this project if the opportunitycost were 20 percent? Exercício 5 • In this exercise we solve iteratively for the internal rate of return. Consider an investment that costs 800 and has cash flows of 300, 200, 150, 122, 133 in years 1–5 (see cells A8:B13 in the following spreadsheet). • Setting up the loan table shows that 10 percent is greater than the IRR (since the return of principal at the end of year 5 is less than the principal at the beginning of the year). Exercício 5 • Setting the IRR? cell equal to...
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...Case 19 Target Corporation 1. Why does Target use different hurdle rates for the store and the credit cards (9% and 4%)? -----This is because they want to get or make as much revenue as they could. You find that with low credit card rate they actually get a lot of customers who sign for the credit card since the interest rates are considerably low. What process would you use to estimate these discount rates to see if they are reasonable? - I would choose the IRR, NPV and the discount payback method to estimate 2. What is Targets Capital-budgeting process? -The Capital Expenditure committee said that the budgeting process would be to annually build 100 more stores while still maintaining an appealing image to the customers. This means that the loyal satisfied base would be retained and the company improving on its operating profits of 26%. The Targets operating earnings would also see an improvement and thus be integrated with the company’s overall strategy by focusing only on customers who visited Targets stores. Is it consistent with the company business and financial objectives? The Capital budgeting method is in line with the company’s business and financial objectives 3. Which of the five CPRs did you accept? Which project attributes did you consider as part of your decision? * I chose the Whalen court Capital Project request. This is because the location had the largest percentage of college educated people compared to other projects after carefully...
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...inputs. Cash flows, Project Life, and Discounting Factor The effectiveness of the decision rule depends on how these three factors have been properly assessed. Estimation of cash flows requires immense understanding of the project before it is implemented; particularly macro and micro view of the economy, polity and the company. Project life is very important; otherwise it will change the entire perspective of the project. So, great care is required to be observed for estimating the project life. Cost of capital is being considered as discounting factor which has undergone a change over the years. Cost of capital has different connotations in different economic philosophies. Hence, determination of cost of capital would carry greatest impact on the investment evaluation. A number of capital budgeting techniques are used in practice. They may be grouped in the following two categories: - I. Capital budgeting techniques under certainty; and II. Capital budgeting techniques under uncertainty 2. Capital budgeting techniques under certainty Capital budgeting techniques (Investment appraisal criteria) under certainty can also be divided into following two groups: 2.1 Non-Discounted Cash Flow Criteria: - (a) Pay Back Period (PBP) (b) Return On Investment (ROI) 2.2 Discounted Cash Flow Criteria: - (a) Net Present Value (NPV) (b) Internal Rate of Return (IRR) 3. Non-Discounted Cash Flow Criteria: These are also known as traditional techniques: 3.1 Pay Back...
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