1FI3300Corporate Finance 010Spring Semester 2010Dr. Isabel TkatchAssistant Professor of Finance1Quiz # 3 - next week☺ Time Value of Money calculations☺ The frequency of compounding☺ Capital budgeting rules (today)2☺ 45 – 60 minutes☺ Mostly multiple choice questions☺ Bring your calculators (IRR and loan amortization – only financial calculator!)☺ Formulas? – Maybe (one page one side)Learning objectives☺ Explain the purpose and importance of capital budgeting☺ Determine whether a new project should be accepted using the following rules: 3☺ 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 wealthExampleYou 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.4The 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 wealth62AssumptionsAssumption 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:jpNote 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)PV (cash infloPV ( h ws PI =tfl ))If PI > 1  Accept project If PI = 1  indifferenceIf PI < 1  Reject project 10PV (cash outflows)The Net Present Value (NPV) ruleNPV (difference) rule intuition: look for projects withPV(cash inflows) > PV(cash outflows)PV (cash inflows)PV (cash oNPutflV= -ows)If NPV > 0  Accept project If NPV = 0  indifferenceIf NPV < 0  Reject project 11PV (cash inflows)PV (cash oNPut f l V =-ows)Example – 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.12The 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?3ExampleConsider the mutually exclusive projects A and BProject PV(inflows) PV(outflows) PI NPVA $110,000 $100,000B $315,000 $300,00013NPV(A) __ NPV(B)  Choose project ____PI(A) __ PV(B)  Choose Project ____Which rule should we use?Good 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):120... ... 0tTCFCF CF CFNPV CF=+ + ++ ++=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 > IRR15012... ... 0(1 ) (1 ) (1 ) (1 )tTNPV CFIRR IR R IRR IR R+ + ++ ++++ + +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 Accept project If IRR = required risk-adjusted return IndifferenceIf IRR < required risk-adjusted return Reject project 16Example – 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.17The 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 $500,0002. Compare IRR to the cost of capital and decide whether to accept / reject the project.NPV and IRR (conventional projects)400,000500,000600,000700,000NPV ($)NPV = 0 whenr = 1 08%=IRR18-300,000-200,000-100,0000100,000200,000300,0000 0.002 0.004 0.006 0.008 0.01 0.012 0.014 0.016 0.018 0.02requiredreturn (r)r = 1.08%= IRR4Textbook application: NPV & IRR A firm considers an investment of $1,200 in a project that yields cash flows of $500 in the first year, $600 in the second year and $700 in the third 19yyear.The annual risk adjusted cost of capital is 10%.Compute the project NPV and IRR and decide whether to accept or reject. Apply the NPV, IRR and PI rulesAssume the following CF stream and an annual risk adjusted cost of capital of 11%. Compute the NPV, IRR, PI and decide whether the project should be accepted or rejected.20th proj ct shou acc pt or r j ct .Datet=0 t=1 t=2 t=3