PowerPoint PresentationTopics CoveredNet Present ValueSlide 4Slide 5Slide 6Slide 7Slide 8Slide 9Slide 10Slide 11Slide 12Payback MethodSlide 14Other Investment CriteriaInternal Rate of ReturnSlide 17Slide 18Slide 19Slide 20Slide 21Slide 22Slide 23Slide 24Project InteractionsMutually Exclusive ProjectsInvestment TimingSlide 28Slide 29Equivalent Annual AnnuitySlide 31Slide 32Capital RationingProfitability IndexCapital Budgeting TechniquesChapter 7Fundamentals of Corporate FinanceFifth EditionSlides byMatthew WillMcGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Net Present Value and Other Investment CriteriaCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 2Topics CoveredNet Present ValueOther Investment CriteriaMutually Exclusive ProjectsCapital RationingCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 3Net Present ValueNet Present Value - Present value of cash flows minus initial investments.Opportunity Cost of Capital - Expected rate of return given up by investing in a projectCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 4Net Present ValueExampleQ: Suppose we can invest $50 today & receive $60 later today. What is our increase in value?Initial InvestmentAdded Value$50$10A: Profit = - $50 + $60 = $10Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 5Net Present ValueExampleSuppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return?This is the definition of NPVProfit = -50 +601.10$4.55Initial InvestmentAdded Value$50$4.55Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 6Net Present ValueNPV = PV - required investmentNPV CCrtt 01( )NPV CCrCrCrtt  011221 1 1( ) ( )...( )Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 7Net Present ValueTerminologyC = Cash Flowt = time period of the investmentr = “opportunity cost of capital”The Cash Flow could be positive or negative at any time period.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 8Net Present ValueNet Present Value RuleNet Present Value RuleManagers increase shareholders’ wealth by accepting all projects that are worth more than they cost. Therefore, they should accept all projects with a positive net present value. If projects are mutually exclusive, managers should select the one with the higher (positive) NPVCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 9Net Present ValueExampleYou have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building?Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 10Net Present Value$16,000$16,000$16,000$450,000$466,0000 1 2 3Present Value 14,953 14,953 380,395$409,323Example - continuedCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 11Net Present ValueExample - continuedIf the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 12Net Present ValueExample - continuedIf the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building?NPVNPV   350 00016 00010716 000107466 0001073231 2 3,,( . ),( . ),( . )$59,Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 13Payback MethodPayback Period - Time until cash flows recover the initial investment of the project.The payback rule specifies that a project be accepted if its payback period is less than the specified cutoff period. The following example will demonstrate the absurdity of this statement.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 14ExampleThe three project below are available. The company accepts all projects with a 2 year or less payback period. Show how this decision will impact our decision.Cash FlowsProject C0 C1 C2 C3 Payback NPV@10%A -2000 +1000 +1000 +10000B -2000 +1000 +1000 0C -2000 0 +2000 0Payback Method+ 7,249- 264- 347222Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 15Other Investment CriteriaInternal Rate of Return (IRR) - Discount rate at which NPV = 0.Rate of Return Rule - Invest in any project offering a rate of return that is higher than the opportunity cost of capital.Rate of Return =C - investmentinvestment1Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 16Internal Rate of ReturnExampleYou can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 17Internal Rate of ReturnExampleYou can purchase a building for $350,000. The investment will generate $16,000 in cash flows (i.e. rent) during the first three years. At the end of three years you will sell the building for $450,000. What is the IRR on this investment?0 350 00016 000116 0001466 00011 2 3 ,,( ),( ),( )IRR IRR IRRIRR = 12.96%Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 18Internal Rate of ReturnCalculating IRR by using a spreadsheetYear Cash Flow Formula0 (350,000.00) IRR = 12.96% =IRR(B3:B7)1 16,000.00 2 16,000.00 3 466,000.00Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin7- 19Internal Rate of ReturnIRR=12.96%Copyright © 2007 by The McGraw-Hill