FI3300 Corporate FinanceQuiz # 3 - next weekLearning objectivesExampleThe Net Present Value (NPV)The Net Present Value (NPV) ruleAssumptionsGood Capital Budgeting Decision RulesProfitability Index (PI)The Profitability Index (PI) ruleSlide 11Example – apply NPV and PISlide 13Slide 14The Internal Rate of Return (IRR)The Internal Rate of Return (IRR) ruleExample – apply IRRNPV and IRR (conventional projects)Textbook application: NPV & IRRApply the NPV, IRR and PI rulesSlide 21Textbook ExampleIRR technical problems: Example 1IRR technical problems: Example 2NPV and the required rate of returnIRR and Conventional ProjectsIRR and Unconventional ProjectsExample: scale differencesSlide 29The Pay-Back Period (PBP)The Pay-Back Period (PBP) ruleTextbook example: PBPExample: PBP compared with NPVSlide 34The Discounted Pay-Back Period (DPBP)The Discounted Pay-Back Period ruleDiscounted PBP exampleSlide 38Why the PBP criterion exists?Summary 1: DescriptionSummary 2: RulesSummary 2: Rule qualityFI3300Corporate FinanceSpring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance12Quiz # 3 - next week☺Time Value of Money calculations☺The frequency of compounding☺Capital budgeting rules (today)☺45 – 60 minutes☺Mostly multiple choice questions☺Bring your calculators (IRR and loan amortization – only financial calculator!)☺Formulas? – Maybe (one page one side)3Learning objectives☺Explain the purpose and importance of capital budgeting☺Determine whether a new project should be accepted using the following rules: ☺net present value (NPV)☺internal rate of return (IRR)☺profitability index (PI)☺payback period (PBP)☺Explain which decision rule should be used to maximize shareholder wealth4ExampleYou are contemplating the purchase of a rental property. The property consists of 12 apartments, each of which fetches a rent of $600 per month.The cost of maintaining the entire property is $1,800 per month.The effective monthly discount rate is 1%.The property has an economic life of ten years and can be sold for $500,000 at the end of its life.1. What is the maximum that you would pay for this property?2. What if the owner is selling for $500,000?The Net Present Value (NPV)Write down the CF streamcash inflows are positivecash outflows are negativeUse the risk adjusted cost of capital to calculateNPV = PV (CF stream)Note: we say “net” present value because we subtract the PV of cash outflows (costs, investment) from the PV of cash inflows (benefits).5The Net Present Value (NPV) ruleThe goal of capital budgeting: Find a decision rule that will maximize shareholder wealthThe NPV rule:Accept project if NPV > 0If we accept a project with NPV > 0 increase shareholder wealth If we accept a project with NPV < 0  decrease shareholder wealth6AssumptionsAssumption 1 (magnitude preference): all else equal, investors prefer to have more money rather than lessAssumption 2 (timing preference):all else equal, investors prefer to get the money sooner (today) rather than later (in the future)Assumption 3 (risk preference): all else equal, investors prefer a safe CF to a risky CF (they are risk-averse)Assumption 4 (management’s goal): The primary goal of the firm’s management is to maximize shareholder wealth7Good Capital Budgeting Decision RulesCriterion 1:Does the NPV rule consider ALL CFs?Criterion 2:Does the NPV rule consider CFs timing?Criterion 3:Does the NPV rule consider CFs riskiness?Criterion 4:Is the NPV rule consistent with management’s primary goal - maximizing shareholders wealth?8Profitability Index (PI)Write down the CF streamcash inflowscash outflows (investment)Use the risk adjusted cost of capital to calculate:Note that PI is a ratio while NPV is a difference9PV (cash outflows)PV (cash inflows)PV (cash inflows)PVNPV = - (cash outf l PI =ows)The Profitability Index (PI) rulePI (ratio) rule intuition: look for projects withPV(cash inflows) > PV(cash outflows)If PI > 1  Accept project If PI = 1  indifferenceIf PI < 1  Reject project 10PV (cash infloPV (cash wsou PI =tfl )ows)The Net Present Value (NPV) ruleNPV (difference) rule intuition: look for projects withPV(cash inflows) > PV(cash outflows)If NPV > 0  Accept project If NPV = 0  indifferenceIf NPV < 0  Reject project 11PV (cash inflows) PV (cash oNP ut f l V = - ows)12Example – apply NPV and PIYou are contemplating the purchase of a rental property. The property consists of 12 apartments, each of which fetches a rent of $600 per month.The cost of maintaining the entire property is $1,800 per month.The effective monthly discount rate is 1%.The property has an economic life of ten years and can be sold for $500,000 at the end of its life.1. What is the maximum that you would pay for this property?2. What if the owner is selling for $500,000?13ExampleConsider the mutually exclusive projects A and BNPV(A) __ NPV(B)  Choose project ____ PI(A) __ PV(B)  Choose Project ____Which rule should we use?Project PV(inflows)PV(outflows)PI NPVA $110,000 $100,000B $315,000 $300,000Good Capital Budgeting Decision RulesCriterion 1:Does the PI rule consider ALL CFs?Criterion 2:Does the PI rule consider CFs timing?Criterion 3:Does the PI rule consider CFs riskiness?Criterion 4:Is the PI rule consistent with management’s primary goal - maximizing shareholders wealth?14The Internal Rate of Return (IRR)Write down the CF streamcash inflows and cash outflows (investment)Set NPV = 0 and solve for the cost of capital (r):Note: use a trial-and-error algorithm to find IRR.If NPV>0 then we used r < IRRIf NPV=0 then we used r = IRRIf NPV<0 then we used r > IRR151 201 2... ... 0(1 ) (1 ) (1 ) (1 )tTt TCFCF CF CFNPV CFIRR IRR IRR IRR= + + + + + + =+ + + +The Internal Rate of Return (IRR) ruleIRR is a yield – what we earn, on average, per year. Compare the IRR to the required (risk-adjusted) rate of returnIf IRR > required risk-adjusted return  Accept project If IRR = required risk-adjusted return  IndifferenceIf IRR < required risk-adjusted return  Reject project 1617Example – apply IRRYou are contemplating the purchase of a rental property. The property consists of 12 apartments, each of which fetches a rent of $600 per month.The cost of maintaining the entire property is $1,800 per month.The effective monthly discount rate is 1%.The property has an economic life of ten years and can be sold for $500,000 at the end of its life.1. Calculate IRR if the owner is selling for