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1 Chapter Outline
Chapter 5
Introduction to Valuation: The Time Value of Money Chapter Organization
5.1 Future Value and Compounding
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0 PV
3 ...
t FV
PV is the Present Value, that is, the value today. FV is the Future Value, or the value at a future date. The number of time periods between the Present Value and
FV, r, and t. Given three of them, it is always possible to calculate the fourth.
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Notice that 1. $110 = $100 v (1 + .10) 2. $121 = $110 v (1 + .10) = $100 v 1.10 v 1.10 = $100 v 1.102 3. $133.10 = $121 v (1 + .10) = $100 v 1.10 v 1.10 v 1.10 = $100 v ________
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Notice that 1. $110 = $100 v (1 + .10) 2. $121 = $110 v (1 + .10) = $100 v 1.10 v 1.10 = $100 v 1.102 3. $133.10 = $121 v (1 + .10) = $100 v 1.10 v 1.10 v 1.10 = $100 v (1.10)3 In general, the future value, FVt, of $1 invested today at r%
for t periods is
FVt = $1 v (1 + r)t
The expression (1 + r)t is the future value interest factor.
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Q.
Deposit $5,000 today in an account paying 12%. How much will you have in 6 years? How much is simple interest? How much is compound interest? Multiply the $5000 by the future value interest factor: $5000 v (1 + r )t = $5000 v ___________ = $5000 v 1.9738227 = $9869.11
A.
At 12%, the simple interest is .12 v $5000 = $_____ per year. After 6 years, this is 6 v $600 = $_____ ; the difference between compound and simple interest is thus $_____ - $3600 = $_____
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Q.
Deposit $5,000 today in an account paying 12%. How much will you have in 6 years? How much is simple interest? How much is compound interest? Multiply the $5000 by the future value interest factor: $5000 v (1 + r )t = $5000 v (1.12)6 = $5000 v 1.9738227 = $9869.11
A.
At 12%, the simple interest is .12 v $5000 = $600 per year. After 6 years, this is 6 v $600 = $3600; the difference between compound and simple interest is thus $4869.11 - $3600 = $1269.11
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Q. You have just won a $1 million jackpot in the state lottery. You can buy a ten year certificate of deposit which pays 6% compounded annually. Alternatively, you can give the $1 million to your brother-in-law, who promises to pay you 6% simple interest annually over the ten year period. Which alternative will provide you with more money at the end of ten years?
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T5.5 Interest on Interest Illustration Q. You have just won a $1 million jackpot in the state lottery. You can buy a ten year certificate of deposit which pays 6% compounded annually. Alternatively, you can give the $1 million to your brother-in-law, who promises to pay you 6% simple interest annually over the ten year period. Which alternative will provide you with more money at the end of ten years? A. The future value of the CD is $1 million x (1.06)10 = $1,790,847.70. The future value of the investment with your brother-in-law, on the other hand, is $1 million + $1 million (.06)(10) = $1,600,000. Compounding (or interest on interest), results in incremental wealth of nearly $191,000. (Of course we havent even begun to address the risk of handing your brother-in-law $1 million!)
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Beginning Simple Compound Year Amount Interest Interest 1 2 3 4 5 $100.00 110.00 121.00 133.10 146.41 Totals $10.00 10.00 10.00 10.00 10.00 $50.00 $ 0.00 1.00 2.10 3.31 4.64 $ 11.05
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Suppose you are currently 21 years old, and can earn 10 percent on your money. How much must you invest today in order to accumulate $1 million by the time you reach age 65?
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r = 10 percent
PV = ?
complications, but stay tuned - right now you need to figure out where to get $15,000!
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college tuition. If you can earn 8% on your money, how much do you need today?
A. Here we know the future value is $20,000, the rate (8%),
and the number of periods (3). What is the unknown present amount (i.e., the present value)? From before: FVt = PV v (1 + r )t $20,000 = PV v __________ Rearranging: PV = $20,000/(1.08)3 = $ ________
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college tuition. If you can earn 8% on your money, how much do you need today?
A. Here we know the future value is $20,000, the rate (8%),
and the number of periods (3). What is the unknown present amount (i.e., the present value)? From before: FVt = PV x (1 + r )t $20,000 = PV x (1.08)3 Rearranging: PV = $20,000/(1.08)3 = $15,876.64
T5.9 Present Value of $1 for Different Periods and Rates (Figure 5.3)
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pounds sterling to Massachusetts and the city of Boston. He gave a like amount to Pennsylvania and the city of Philadelphia. The money was paid to Franklin when he held political office, but he believed that politicians should not be paid for their service(!). Franklin originally specified that the money should be paid out 100 years after his death and used to train young people. Later, however, after some legal wrangling, it was agreed that the money would be paid out 200 years after Franklins death in 1990. By that time, the Pennsylvania bequest had grown to about $2 million; the Massachusetts bequest had grown to $4.5 million. The money was used to fund the Franklin Institutes in Boston and Philadelphia.
Assuming that 1,000 pounds sterling was equivalent to 1,000
dollars, what rate did the two states earn? (Note: the dollar didnt become the official U.S. currency until 1792.)
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the present value is $______ . There are 200 years involved, so we need to solve for r in the following: ________ = _____________/(1 + r )200 (1 + r )200 = ________ Solving for r, the Pennsylvania money grew at about 3.87% per year. The Massachusetts money did better; check that the rate of return in this case was 4.3%. Small differences can add up!
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the present value is $ 1,000. There are 200 years involved, so we need to solve for r in the following: $ 1,000 = $ 2 million/(1 + r )200 (1 + r )200 = 2,000.00 Solving for r, the Pennsylvania money grew at about 3.87% per year. The Massachusetts money did better; check that the rate of return in this case was 4.3%. Small differences can add up!
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following: If you earn r % per year, your money will double in about 72/r % years. So, for example, if you invest at 6%, your money will double in 12 years.
Why do we say about? Because at higher-than-normal
rates, the rule breaks down. What if r = 72%? And if r = 36%? FVIF(72,1) = 1.72, not 2.00 FVIF(36,2) = 1.8496
The lesson? The Rule of 72 is a useful rule of thumb, but it is only a rule of thumb!
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percent per year. If you will get $10,000 in 10 years, what rate of return are you being offered?
Set this up as present value equation:
FV = $10,000 PV $5000 = = PV = $ 5,000 t = 10 years
Common stock values increased by 28.59% in 1998 (as proxied by the growth of the S&P 500). How much would the above portfolio be worth at the end of 1998?
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I. Symbols:
PV = Present value, what future cash flows are worth today FVt = Future value, what cash flows are worth in the future r t = Interest rate, rate of return, or discount rate per period = number of periods
C = cash amount
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IV. The basic present value equation giving the relationship between present and future value is:
PV = FVt/(1 + r )t
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2. True or False: For given levels of r and t, PVIF(r,t ) is the reciprocal of FVIF(r,t ). 3. All else equal, the higher the discount rate, the (lower/higher) the present value of a set of cash flows.
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1. Both statements are true. If you use time value tables, use this information to be sure that you are looking at the correct table.
3. The answer is lower - discounting cash flows at higher rates results in lower present values. And compounding cash flows at higher rates results in higher future values.
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$200,000 when your child enters college in 18 years. You have $15,000 to invest. What annual rate of interest must you earn on your investment to cover the cost of your childs college education? Present value = $15,000 Future value t = 18 $200,000 FVIF(r,18) = $200,000 r=? = $15,000 v FVIF(r,18) = $200,000 / $15,000 = 13.333 . . .
million that must be paid in 20 years. To assess the value of the firms stock, financial analysts want to discount this liability back to the present. If the relevant discount rate is 8 percent, what is the present value of this liability? Future value = FV = $425 million t = 20 r = 8 percent Present value = ?
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Chapter 6
Discounted Cash Flow Valuation Chapter Organization
6.1 Future and Present Values of Multiple Cash Flows 6.2 Valuing Level Cash Flows: Annuities and Perpetuities 6.3 Comparing Rates: The Effect of Compounding 6.4 Loan Types and Loan Amortization 6.5 Summary and Conclusions
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Example: Finding C
Q. You want to buy a Mazda Miata to go cruising. It costs $25,000.
With a 10% down payment, the bank will loan you the rest at 12% per year (1% per month) for 60 months. What will your monthly payment be?
A. You will borrow ___ v $25,000 = $______ . This is the amount today, so
its the ___________ . The rate is ___ , and there are __ periods:
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Example: Finding C
Q. You want to buy a Mazda Miata to go cruising. It costs $25,000.
With a 10% down payment, the bank will loan you the rest at 12% per year (1% per month) for 60 months. What will your monthly payment be?
A. You will borrow .90 v $25,000 = $22,500 . This is the amount today, so
its the present value. The rate is 1%, and there are 60 periods: = C v {1 - (1/(1.01)60}/.01 = C v {1 - .55045}/.01 = C v 44.955 = $22,500/44.955 = $500.50 per month
$ 22,500
C C
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PV = C v {1 - [1/(1 + r )t]}/r
PV = C/r
The formulas above are the basis of many of the calculations in
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years to make your tuition payments. Assume you need the first $20,000 in exactly one year. Suppose you can place your money in a savings account yielding 8% compounded annually. How much do you need to have in the account today? (Note: Ignore taxes, and keep in mind that you dont want any funds to be left in the account after the third withdrawal, nor do you want to run short of money.)
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Annuity Present Value - Solution Here we know the periodic cash flows are $20,000 each. Using the most basic approach: PV = $20,000/1.08 + $20,000/1.082 + $20,000/1.083 = $18,518.52 + $_______ + $15,876.65 = $51,541.94 Heres a shortcut method for solving the problem using the annuity present value factor: PV = $20,000 [____________]/__________ = $20,000 2.577097 = $________________
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Annuity Present Value - Solution Here we know the periodic cash flows are $20,000 each. Using the most basic approach: PV = $20,000/1.08 + $20,000/1.082 + $20,000/1.083 = $18,518.52 + $17,146.77 + $15,876.65 = $51,541.94 Heres a shortcut method for solving the problem using the annuity present value factor: PV = $20,000 v [1 - 1/(1.08)3]/.08 = $20,000 v 2.577097 = $51,541.94
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Assume the same facts apply, but that you can only earn 4% compounded annually. Now how much do you need to have in the account today?
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Annuity Present Value - Solution Again we know the periodic cash flows are $20,000 each. Using the basic approach: PV = $20,000/1.04 + $20,000/1.042 + $20,000/1.043 = $19,230.77 + $18,491.12 + $17,779.93 = $55,501.82 Heres a shortcut method for solving the problem using the annuity present value factor: PV = $20,000 v [1 - 1/(1.04)3]/.04 = $20,000 v 2.775091 = $55,501.82
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Example 1: Finding t
Q.
Suppose you owe $2000 on a Visa card, and the interest rate is 2% per month. If you make the minimum monthly payments of $50, how long will it take you to pay off the debt? (Assume you quit charging stuff immediately!)
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Example 1: Finding t
Q.
Suppose you owe $2000 on a Visa card, and the interest rate is 2% per month. If you make the minimum monthly payments of $50, how long will it take you to pay off the debt? (Assume you quit charging stuff immediately!)
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Example 2: Finding C
Previously we determined that a 21-year old could accumulate $1
million by age 65 by investing $15,091 today and letting it earn interest (at 10%compounded annually) for 44 years. Now, rather than plunking down $15,091 in one chunk, suppose she would rather invest smaller amounts annually to accumulate the million. If the first deposit is made in one year, and deposits will continue through age 65, how large must they be?
Set this up as a FV problem:
$1,000,000 = C v [(1.10)44 - 1]/.10 C = $1,000,000/652.6408 = $1,532.24 Becoming a millionaire just got easier!
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accumulating $1 million by age 65 requires saving only $1,532.24 per year. Unfortunately, most people dont start saving for retirement that early in life. (Many dont start at all!) Suppose Bill just turned 40 and has decided its time to get serious about saving. Assuming that he wishes to accumulate $1 million by age 65, he can earn 10% compounded annually, and will begin making equal annual deposits in one year and make the last one at age 65, how much must each deposit be?
Setup:
Solve for C: C = $1 million/98.34706 = $10,168.07 By waiting, Bill has to set aside over six times as much money each year!
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Again assume he just turned 40, but, recognizing that he has a lot of time to make up for, he decides to invest in some high-risk ventures that may yield 20% annually. (Or he may lose his money completely!) Anyway, assuming that Bill still wishes to accumulate $1 million by age 65, and will begin making equal annual deposits in one year and make the last one at age 65, now how much must each deposit be?
Setup:
Solve for C: C = $1 million/471.98108 = $2,118.73 So Bill can catch up, but only if he can earn a much higher return (which will probably require taking a lot more risk!).
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II. FV of C per period for t periods at r percent per period: FVt = C v {[(1 + r )t - 1]/r} III. PV of C per period for t periods at r percent per period: PV = C v {1 - [1/(1 + r )t]}/r IV. PV of a perpetuity of C per period: PV = C/r
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next 5 years. Our opportunity rate is 6%. What is the value today of this set of cash flows? PV = $1000 v {1 - 1/(1.06)5}/.06 = $1000 v {1 - .74726}/.06 = $1000 v 4.212364 = $4212.36
Now suppose the cash flow is $1000 per year forever. This is
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(as long as the discount rate, r, is greater than 0). Heres a question for you: How can an infinite number of cash payments have a finite value?
Heres an example related to the question above. Suppose you are
considering the purchase of a perpetual bond. The issuer of the bond promises to pay the holder $100 per year forever. If your opportunity rate is 10%, what is the most you would pay for the bond today?
One more question: Assume you are offered a bond identical to the
one described above, but with a life of 50 years. What is the difference in value between the 50-year bond and the perpetual bond?
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value is because the present values of the cash flows in the distant future become infinitesimally small.
The value today of the perpetual bond = $100/.10 = $1,000. Using Table A.3, the value of the 50-year bond equals
$100 v 9.9148 = $991.48 So what is the present value of payments 51 through infinity (also an infinite stream)? Since the perpetual bond has a PV of $1,000 and the otherwise identical 50-year bond has a PV of $991.48, the value today of payments 51 through infinity must be $1,000 - 991.48 = $8.52 (!)
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Compounding period
Year Quarter Month Week Day Hour Minute
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Effective annual rate 10.00000% 10.38129 10.47131 10.50648 10.51558 10.51703 10.51709
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then the actual rate is 8% per six months. Is 8% per six months the same as 16% per year?
A. If you invest $1000 for one year at 16%, then youll
have $1160 at the end of the year. If you invest at 8% per period for two periods, youll have
FV = = =
or $6.40 more. Why? What rate per year is the same as 8% per six months?
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compounded semiannually is the quoted or stated rate, not the effective rate.
By law, in consumer lending, the rate that must be quoted
on a loan agreement is equal to the rate per period multiplied by the number of periods. This rate is called the _________________ (____).
Q. A bank charges 1% per month on car loans. What is the
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compounded semiannually is the quoted or stated rate, not the effective rate.
By law, in consumer lending, the rate that must be quoted
on a loan agreement is equal to the rate per period multiplied by the number of periods. This rate is called the Annual Percentage Rate (APR).
Q. A bank charges 1% per month on car loans. What is the
EAR = (1.01)12 - 1 = 1.126825 - 1 = 12.6825% The APR is thus a quoted rate, not an effective rate!
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Year 1 2 3 4 5 Totals
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Year 1 2 3 4 5 Totals
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RIPOV RETAILING Going out for business sale! $1,000 instant credit! 12% simple interest! Three years to pay! Low, low monthly payments!
Assume you buy $1,000 worth of furniture from this store and agree to the above credit terms. What is the APR of this loan? The EAR?
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1. Borrow $1,000 today at 12% per year for three years, you will owe $1,000 + $1000(.12)(3) = $1,360. 2. To make it easy on you, make 36 low, low payments of $1,360/36 = $37.78. 3. Is this a 12% loan? $1,000 r APR EAR = $37.78 x (1 - 1/(1 + r )36)/r = 1.767% per month = 12(1.767%) = 21.204% = 1.0176712 - 1 = 23.39% (!)
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investment policy that will pay you and your heirs $1,000 per year forever. If the required return on this investment is 12 percent, how much will you pay for the policy?
The present value of a perpetuity equals C/r. So, the most a
rational buyer would pay for the promised cash flows is C/r = $1,000/.12 = $8,333.33
Notice: $8,333.33 is the amount which, invested at 12%,
would throw off cash flows of $1,000 per year forever. (That is, $8,333.33 v .12 = $1,000.)
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sell you an investment policy that will pay you and your heirs $1,000 per year forever. Seinfeld told you the policy costs $10,000. At what interest rate would this be a fair deal?
Again, the present value of a perpetuity equals C/r. Now solve the
deal for you; but if you can earn more than 10.00%, you can do better by investing the $10,000 yourself!
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the Subscriptions R Us Sweepstakes. Unfortunately, the sweepstakes will actually give you the $20 million in $500,000 annual installments over the next 40 years, beginning next year. If your appropriate discount rate is 12 percent per year, how much money did you really win?
How much money did you really win? translates to, What is
the value today of your winnings? So, this is a present value problem. PV = $ 500,000 v [1 - 1/(1.12)40]/.12 = $ 500,000 v [1 - .0107468]/.12 = $ 500,000 v 8.243776 = $4,121,888.34 (Not quite $20 million, eh?)
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Chapter 9
Net Present Value and Other Investment Criteria Chapter Organization
9.1 Net Present Value 9.2 The Payback Rule 9.3 The Discounted Payback 9.4 The Average Accounting Return 9.5 The Internal Rate of Return 9.6 The Profitability Index 9.7 The Practice of Capital Budgeting 9.8 Summary and Conclusions
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Assume you have the following information on Project X: Initial outlay -$1,100 Required return = 10%
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0 Initial outlay ($1,100) Revenues Expenses Cash flow $1,100.00 $500 x +454.55 +826.45 +$181.00 NPV 1 1.10
2 $2,000 1,000
$1,000 x
1 1.10 2
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Why does the NPV rule work? And what does work mean?
Look at it this way: A firm is created when securityholders supply the funds to acquire assets that will be used to produce and sell a good or a service; The market value of the firm is based on the present value of the cash flows it is expected to generate; Additional investments are good if the present value of the incremental expected cash flows exceeds their cost; Thus, good projects are those which increase firm value - or, put another way, good projects are those projects that have positive NPVs! Moral of the story: Invest only in projects with positive NPVs.
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Initial outlay -$1,000 Year 1 2 3 Year 1 2 3 Cash flow $200 400 600 Accumulated Cash flow $200 600 1,200
T9.5 Discounted Payback Illustrated Initial outlay -$1,000 R = 10% PV of Cash flow Cash flow $ 200 400 700 300 $ 182 331 526 205 Accumulated discounted cash flow $ 182 513 1,039 1,244
Year 1 2 3 4 Year 1 2 3 4
Cash Flow Year 1 2 3 4 5 Undiscounted Discounted $100 100 100 100 100 $89 79 70 62 55
Accumulated Cash Flow Undiscounted $100 200 300 400 500 Discounted $89 168 238 300 355
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Year 1 Sales Costs Gross profit Depreciation Earnings before taxes Taxes (25%) Net income $440 220 220 80 140 35 $105 2 $240 120 120 80 40 10 $30 3 $160 80 80 80 0 0 $0
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50 0 = -200 + (1+IRR)1 + +
100 (1+IRR)2 + +
150 (1+IRR)3
50 200 = (1+IRR)1
100 (1+IRR)2
150 (1+IRR)3
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NPV $100 68 41 18 -2
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which the cash flows are as follows: Year 0 1 2 3 4 Cash flows -$252 1,431 -3,035 2,850 -1,000
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0 0 0 0
Two questions:
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$0.02 $0.00
($0.02)
IRR = 1/3
($0.04)
($0.06)
($0.08) 0.2 0.28 0.36 0.44 0.52 Discount rate 0.6 0.68
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Net present value 160 140 120 100 80 60 40 20 0 20 40 60 80 100 0 2% 6% 10% 14% IRR A 18% IRR B 0 Project A: Project B: $350 $250 1 50 125
Crossover Point
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Now lets go back to the initial example - we assumed the following information on Project X: Initial outlay -$1,100Required return = 10% Annual cash benefits: Year 1 2 Cash flows $ 500 1,000
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why? Its a good project because the present value of the inflows exceeds the outlay.
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T9.14 Chapter 9 Quick Quiz 1. Which of the capital budgeting techniques do account for both the time value of money and risk?
2. The change in firm value associated with investment in a project is measured by the projects _____________ . a. Payback period b. Discounted payback period c. Net present value d. Internal rate of return 3. Why might one use several evaluation techniques to assess a given project?
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T9.14 Chapter 9 Quick Quiz 1. Which of the capital budgeting techniques do account for both the time value of money and risk? Discounted payback period, NPV, IRR, and PI 2. The change in firm value associated with investment in a project is measured by the projects Net present value.
3. Why might one use several evaluation techniques to assess a given project? To measure different aspects of the project; e.g., the payback period measures liquidity, the NPV measures the change in firm value, and the IRR measures the rate of return on the initial outlay.
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years for its international investment projects. If the company has the following two projects available, should they accept either of them? Year 0 1 2 3 4 Cash Flows A -$30,000 15,000 10,000 10,000 5,000 Cash Flows B -$45,000 5,000 10,000 20,000 250,000
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Project A:
Payback period
Project B:
Payback period
payback period is 3.04 years. Since the maximum acceptable payback period is 3 years, the firm should accept project A and reject project B.
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rule. If the required return is 18 percent, should the firm accept the following project? Year 0 1 2 3 Cash Flow -$30,000 25,000 0 15,000
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To find the IRR, set the NPV equal to 0 and solve for the
discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR) 2 +$15,000/(1 + IRR)3
At 18 percent, the computed NPV is ____. So the IRR must be (greater/less) than 18 percent. How did
you know?
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To find the IRR, set the NPV equal to 0 and solve for the
discount rate: NPV = 0 = -$30,000 + $25,000/(1 + IRR)1 + $0/(1 + IRR)2 +$15,000/(1 + IRR)3
At 18 percent, the computed NPV is $316. So the IRR must be greater than 18 percent. We know this
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