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# FIN302: Chapter 10 Notes FIN302

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This 6 page Class Notes was uploaded by Giulia Dias Roncoletta on Monday October 19, 2015. The Class Notes belongs to FIN302 at University of Miami taught by Frank Peterson in Summer 2015. Since its upload, it has received 90 views. For similar materials see FIN 302 - Fundamentals of Finance in Finance at University of Miami.

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Date Created: 10/19/15

CHAPTER 10 NOTES Capital Project Analysis to t1 12 t3 t4 t5 tn l l i Invest CF1 CF2 CF3 ca CF5 crn Salvage Value Decision Rules to take a Project Net Present Value Internal Rate of Return Payback Period Profitability Index Discounted Payback Period Modified IRR Various Accounting Criteria IOUU ILOON L Good Decision Criteria consider the time value of money consider risk reflect value created lead to value maximizing decision Net Present Value difference between a projects value and cost Difference between the present value of a project s future cash flows and its initial cost Expected value created from undertaking an investment Best single decision criterion Project Example NPV Discount Rate 12 000 1 0 11 12 3 I l I I I l I PVB 17763 value 1263 Net Present Value NPV 12 The pro jecf is worfh 12630 more rm if costs IF THE NVP is POSITIVE ACCEPT the project it means the project is expected to add value to the firm and increase the wealth of its owners Payback Period How long it will take to get your initial investment back Computation subtract future cashflows from the initial investment until its all recovered the time it takes is the payback period Accept if the period is less than some preset limit Advantages easy to understand adjusts for uncertainty later cash flows biased towards liquidity L Disadvantages 1 ignores the time value of money 2 requires an arbitrary cutoff limit 3 ignores cashflow beyond cutoff time 4 biased against long term projects 5 might give the wrong answer it is a poor decision criterion but we use it to estimate the pay back time Discounted Payback 000 1390 1 1 1392 1139s I I I I I I I I 16500 6312 7080 9108 PV 16500 5636 5644 6483 16500 10864 5220 1263 Extrapolate between years 2 52206483 281 years How long is the in ves39fmenf exposed to N39sr f l Yl RhON Accounting Criteria always looking for change in EPS change in income and change in ROE Internal Rate of ReturnlRR Represents the effective annual rate of return on the investment an EAR Best alternative to NPV Used in practice May result in incorrect decisions under some circumstances Assume cashflow are reinvested at the IRR Definition IRR is the discount rate that makes the NPVO Decision Rule accept the project if the IRR is greater than the required return We Examp39e quot IRR Project Example NPV Discount Rate 12 To 1391 1392 1 3 l t l l to t1 t2 t3 165 65 65 65 g g N z 3 N z 3 16500 6312 7o80 9108 CPT I 8841570 gt I 88415o PVI 5636 PMT 65 PMT 65 We 64 83 1quot FV 0 FV O 3 39 So otodiscoum rate of 88415the PV of the future N31 Present Value 12 cash flows equals the project39s cost so NPV O PLILRSON Project Example IRR to 11 12 3 IRR is the discount rate that makes the NPV 0 l l l l CE CFz CE 16590 312 7980 108 NW O quotCF 1IRR1 1Ii2i2Z quot m 5435 quot 5250 quot 5815 t 000 NPV 1613 IRR Bur how do you calculate if Must solve this equation for IRR gun sn on ms Fl ENTER 1 439 OHIOquot r uw IRR AMORI sun In NH XPIY PIY K v I x1 1Ix 39 HYP SIN 03 MN 7quot BOND BRKLVN PROHT ll WORK Elt NPV PROFILE graph of a project s NPV over a wide range of discount rates discount rate zero NVP is the addition of all cash flows Initial outflow followed by inflows conventional project always downward slope to right IRR and PV will always give you same decision NPV vs IRR won t always give same decision NPV measures increase in firm value NPV always makes the decision Conventional 1 negative first number then all positive IRR wont work if negative unreliable Multiple lRR s since there negative number s DESCARTES RULE OF SIGNS when signs change thats a new IRR Example Problem Suppose you are asked to approve a capital investment proposal that is expected to provide the following stream of cash flows 0 1 2 1150 560 3397039 z3o You determine that this project has two IRRs 20 and 92 Over what range of discount rates is this a viable investment 20 lt r lt 92 NW 2075 92 x 30 NPV Mutually Exclusive Projects Cross Over Rate discount rate where both projects produce the same present value gt Compare the difference between two projects plug in difference numbers and compare cross over rate at IRR EXAMPLE If you are indifferent between Projects A and B Mmtmm be wthV to t 2 1393 4 Project A 40000 14000 18000 22000 26000 Project 8 40000 26000 20000 16000 10000 Difference 0 12000 2000 6000 16000 1917 WV CF CFO 40000 001 14000 002 18000 7 003 22000 004 26000 I 1917 1917 2 mm Profitability Index PV of future cash flows NPV 1 Example Problem Initial Investment CFO You are analyzing a 20 million project PI is an index that measures the benefit per 1 of K 05 0 PI 01 115 Who 5 5 NPV investment based on the time value of money NPV Profitability index of 110 implies that for every 1 of p 1 investment we create an additional 10 in value CFo PI of 9 means for every 1 we loose 10 NPV 115 1 20 NPV 01520 3 million

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