BA280.

1(Valderrama)

3/9/2012

Capital Budgeting

Review of Time Value of Money Concepts

Opportunity cost of capital Nominal and real interest rates Present value and future value
Single payment Multiple cash flows Level cash flows: perpetuity and annuity Ordinary annuity and annuity due

BA280.1(Valderrama)

3/9/2012

Evaluating Projects
Methods
Return on investment Economic value-added Payback Discounted cash flow analysis: net present value and internal rate of return

NPV and the goal of increasing shareholder value

Time Value of Money

Opportunity cost of capital required rate of return considering the projects level of risk Nominal interest rate rate at which money invested grows Real interest rate rate at which the purchasing power of an investment increases

Real interest rate = [(1+nominal)/(1+inflation)]-1

BA280.1(Valderrama)

3/9/2012

Time Value of Money

How much money will you have after 5 years if you deposited P1000 in a bank account that pays 10% interest p.a.? What is the deposit value if interest is compounded semi-annually? Quarterly? 2. You are planning to get married after graduating from the MBA program (i.e., 2 years from today). How much money must you deposit now at 5% if you want to go on a honeymoon that you estimate will cost P100,000?
1.

Time Value of Money

A rich uncle says he is leaving you with an endowment fund that will pay P100 000 annually in P100,000 perpetuity. How much must your rich uncle deposit in the endowment fund if it is invested at 10%? 4. You borrowed P2M to buy a Porsche and plan to pay for it in equal quarterly installments for the next 5 years. How much is the quarterly payment if the interest rate is 12%? 5. A bank offers a double-your-money-in-5-years investment opportunity. What is the effective interest rate of this investment?
3.

BA280.1(Valderrama)

3/9/2012

Payt.No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Payment 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134,431 134 431 134,431 134,431 134,431 134,431 134,431 134,431

Interest 60,000 57,767 55,467 53,098 50,658 48,145 45,556 42,890 40,144 37,315 34,402 31,401 28,310 25,126 25 126 21,847 18,470 14,991 11,408 7,717 3,916

Principal 74,431 76,664 78,964 81,333 83,773 86,286 88,875 91,541 94,287 97,116 100,029 103,030 106,121 109,305 109 305 112,584 115,961 119,440 123,023 126,714 130,516

CumPrin 74,431 151,095 230,059 311,392 395,165 481,451 570,326 661,867 756,154 853,270 953,299 1,056,330 1,162,451 1,271,755 1 271 755 1,384,339 1,500,301 1,619,741 1,742,764 1,869,478 1,999,994

Balance 2,000,000 1,925,569 1,848,905 1,769,941 1,688,608 1,604,835 1,518,549 1,429,674 1,338,133 1,243,846 1,146,730 1,046,701 943,670 837,549 728,245 728 245 615,661 499,699 380,259 257,236 130,522 6

Time Value of Money

7. What is the price of a 10-year, P5M bond that pays a 10% coupon semi-annually if the market rate of interest is 12% ? 8%? 8. What is the price of a 10-year, P5M zero-coupon bond if the market price of interest is 12%?

BA280.1(Valderrama)

3/9/2012

Time Value of Money

9. What is the price of a stock that pays P10 annually as dividends and whose price is expected to be P200 after 5 years if equally risky stocks have expected rates of return of 15%? 10. What is the price of a stock that is expected to pay annual dividends of P5 in perpetuity if equally risk stocks have a 10% expected rate of return? What is the stock price if said dividends are expected to grow at 5% per year?

Net Present Value

Net present value difference between the present value of future cash flows and the investment outlay.

NPV Rule: Managers increase shareholders wealth by shareholders accepting projects with a positive net present value.

BA280.1(Valderrama)

3/9/2012

NPV Illustration
You are considering 2 types of office networking software, each of which has an expected life of 3 years. Th fi t system i f t (it is expected to The first t is faster i t dt increase cash flows by P350,000/yr due to higher productivity) but is more expensive at P800,000. The other system will increase cash flows by P300,000/yr and costs P700,000. If cost of capital is 7%, which is the better option? What is the NPV of a project that requires an investment of $1000 and has expected inflows of $500, $400, $300, and $100 in the next 4 years if the cost of capital is 10%?

N NPV PROFILE E

BA280.1(Valderrama)

3/9/2012

Internal Rate of Return

Internal rate of return the discount rate that gives a project a zero NPV. IRR rule: Managers increase shareholder value if the projects IRR > opportunity cost of capita.

More on NPV Profiles

BA280.1(Valderrama)

3/9/2012

Exercises

BA280.1(Valderrama)

3/9/2012

Exercises

Challenging Situations
Investment timing Long versus short-lived equipment short lived Replacement decision

BA280.1(Valderrama)

3/9/2012

DCF Guidelines
1. 2.

Discount cash flows, not profits. Discount incremental cash flows (incremental cash flows = cash flows with project less cash flows without project)
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Include all indirect effects. Forget sunk costs but recognize depreciation tax shield. Include opportunity costs. Recognize investment in working capital.

Discount nominal cash flows by the nominal cost of capital. 4. Assume all equity financing. Separate investment and financing decision.
3.

10