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Evaluating Cash Flows: Annuities

An annuity is a stream or series of identical cash flows occurring at regular intervals through time for a specified number of periods. In Challenge problems A and B, you were asked to solve problems involving annuity cash flows. Challenge A had two separate annuity flows for different time periods. As you will see in the following text, if an annuity cash flow begins after the first period, the present value annuity (PVA) formula discounts the cash flows only to the period when the annuity stream began. It cannot discount all the way back to the present, the end of time period zero, without another present value calculation. Two common examples of annuities are fully amortizing loans, such as mortgages and automobile loans, and the coupon payments on bonds. Can you think of other examples of annuities? The time line below depicts the cash flows for a $100 loan repaid in 12 equal installments of $8.79, based on a 10 percent annual rate of interest. The payments represent an annuity. When do bank customers use annuities? Low bandwith High bandwith

Annuities appeal to and reward the "slow and steady" investor. Read about how an annuity investment compares with a lump-sum investment.

Negative Compounding Annuities are either ordinary or due. Ordinary annuities, the most common form of annuity, have payments that occur at the end of a period. Most loan payments are ordinary annuities, where the first payment includes interest. An annuity due has payments at the beginning of the period. Most leases and rent agreements require payments due at the beginning of the lease or rental contract, and are examples of annuities due. Future Value of Annuities After you have properly characterized a set of cash flows as being either an ordinary annuity or an annuity due, you can find the future value or present value of all the cash flows at a single point in time. How would you find the future value of a whole stream of cash flows? You could use the future value formula for a single cash flow for each cash flow and then sum the results to calculate the future value. How would this look? Using the formula for future value of a single payment, let FVN be the future value at the end of period N of a payment, Ct, made at the end of

time period t. Then Exponents

That is, the future value of a cash flow (payment) at the end of period t is compounded N t times into the future. Use the time line below to verify this. The cash flow at the end of period 1 has three periods to compound (N t is 4 1). Similarly, cash received at the end of period 2 has only two periods to compound (4 2), and so with period 4. A cash flow 4 periods into the future is already at its future value.

By extension, for all N periods, the future value of N cash flows is

To compute the future value of monthly payments for 30 years would require you to calculate 360 exponentiations, multiplications, and additons using this formula. Happily, there is an easier way, the formula for the future value of an annuity. How is FVA derived? Analytical Methods: Summation

That's it. Now for any number of time periods, N, you can compute the future value of a set of equal cash flows, C,at a periodic compound rate of r. Annuities View animation

Notice that with the formula for FVA, if you know the other variables, you can solve for the cash payment, C,or the term, N. Unfortunately, it is difficult to calculate rdirectly. How is r computed? Now, consider the general form of the future value of an annuity due.

Notice that the FVADue equation is just like the FVA equation, except for the extra term (1 + r) on the far right. The term (1 + r) in the future value of an annuity due formula values the cash flow stream of an ordinary annuity one period later. What does this imply?

Present Value of Annuities What if you wanted to find the present value of an annuity stream? As illustrated in the solution to Challenge A, this can be solved by using the PVA formula. The formula for finding the present value of an annuity will let you find the present value of a stream of cash flows simultaneously. Start by considering the present value of an ordinary annuity, stated in general form. As was done above in computing the future value, remember that the present value of a single cash flow tperiods into the future at a discounting interest rate of rpercent is

For a series of N cash flows, the present value is

Recall from Time Value of Money that the negative exponent in the PV equation is equivalent to the reciprocal of the number raised to the positive of the exponent. In other words,

The purpose of the present value formula is to calculate today's value of a future cash payment. Certainly you would pay less than a dollar today for a dollar in the future. To obtain a future value for a current amount, you multiply the current amount by a factor. Similarly, you can divide a future value by a factor to compute the present value. This is represented mathematically as

Using the same procedure used before to obtain the formula for the future value of an annuity, you derive the

following formula for the present value of an annuity.

PVA = present value of an ordinary annuity C = the fixed annuity payment r = the periodic interest rate N = the total number of annuity payments Solving the PVA equation for C would give you the annual cash payment needed to pay a fully amortizing loan over N periods in the amount of PVA at a periodic interest rate of r. Example: Ordinary annuity Your company needs a substantial amount of money today, and your boss has asked you to ascertain how much the company can borrow. You learn that the company's operating cash flow will be sufficient to support quarterly debt service payments of $45,000 for 20 years. The company's bank is willing to offer a 20-year loan requiring quarterly payments and an annual interest rate of 13.5 percent. What is the maximum amount the company can borrow?

Notice this is an annuity, because you plan to make equal periodic debt service payments of $45,000 per quarter for 20 years. For this problem, C is the $45,000 quarterly payment; r is the 13.5 percent annual rate divided by the compounding frequency, m, which is 4, so r = 3.375 percent or .03375. N is equal to the payment frequency, 4, times the number of years, 20, or 80. Construct a time line. Remember that each payment, a cash outflow, occurs at the end of a period. The first payment occurs at the end of period 1, and the last payment occurs at the end of period 80. The time line would show 80 end-of-period payments of $45,000, occurring one per quarter for 20 years. For reference, the end of the first period is at the mark for time period 1, and the end of the last period is at the mark for time period 79.

Substitute the given values in the formula for present value of an ordinary annuity, and solve.

Therefore, assuming that the company can make quarterly payments of $45,000 each over 20 years, it can borrow $1,239,643 at 13.5 percent compounded quarterly. The first payment will occur one quarter after the company borrows $1,239,643. As with the FVA problems, you can solve this problem with Excel. Using either the PVA equation or Excel's built-in PV function, discount all 80 payments to t = 0. Reconsider the above situation with each $45,000 payment being made at the beginning of each period. This is an example of the present value of an annuity due, denoted as PVADue. The general form of PVADue is

Similar to FVADue and FVA, the PVADue equation is just like the PVA equation except for the extra term (1 + r) on the far right. The term (1 + r) in the PVADue equation serves to

value the cash flow stream one period forward, or into the future. Thus, to find the present value of an annuity due, you calculate the present value as if it were an ordinary annuity, then adjust the present value forward one period by the periodic interest rate. Example: annuity due Now find the present value of the $45,000 annuity due.

For this calculation, C is the $45,000 quarterly payment;r is the 13.5 percent annual rate divided by the compounding frequency, m, which is 4, or 3.375 percent; and N is equal to the payment frequency, 4, times the number of years, 20, or 80. All the terms are exactly the same as they were for the ordinary annuity calculation. You may wish to make a time line representing the annuity's cash flows and their timing at the beginning of each period. Note that the first payment is made at the beginning of the first period, which is the same as the end of time period 0. The last payment is made at the beginning of period 80, which is at the mark for the end of time period 79. The time values of the payments, denoted as cash outflows for the company, all need to be discounted to the beginning of the first period, time period 0.

Insert the given values into the formula for the present value of an annuity due, and solve.

Assuming that the company can make quarterly payments of $45,000 starting at the beginning of the first period, over 20 years, it can borrow $1,281,480 at 13.5 percent compounded quarterly over 20 years. Thus, the PVADue equation gives you a lump-sum present value on the date of the first payment. This implies that the first payment is not discounted at all, and that the last payment is discounted back 79 periods. You can solve this problem with the help of an Excel worksheet. Summary Before leaving this section, you may want to review the following essential concepts. When you compute the FV of an ordinary annuity, the result is the equivalent lump-sum payment on the date of the last annuity payment. When you compute the FV of an annuity due, the result is the equivalent lump-sum payment one period after the last annuity payment. When you compute the PV of an ordinary annuity, the result is the equivalent lump-sum payment one period before the first annuity payment. When you compute the PV of an annuity due, the result is the equivalent lump-sum payment on the date of the first annuity payment. Always use an interest rate appropriate for the length of the period between annuity payments. For example, if the payments are annual, use a one-year interest rate; if they are monthly, then use a monthly interest rate. How many decimal places should you use?

1. You sell retirement plans. You offer customers a fixed rate of 6.76 percent, compounded monthly, on their monthly contributions. Mr. Smith, a potential new customer, has told you that he can make monthly contributions of $250, starting one month from today for 32 years. How much will he accumulate after 32 years? Assuming that Mr. Smith makes all of his contributions at the end of every month, what will be the future value of

You can use Excel to solve FV. FV Excel Tutorial

his retirement fund after 32 years? Solution 1 2. Your company buys structured settlements or annuities from people who want their money now. If your company requires an annual rate of 28 percent compounded quarterly, how much would it pay for an inheritance that will generate 180 quarterly payments of $15,000 starting today? Solution 2 3. You are an investment attorney, and a new client who just won $60 million in the lottery seeks your advice. Lottery officials have given her two payment options. Under the first option, the lottery would pay your client a one-time payment of $29,888,572.92 today. Under the second option, the lottery would pay your client $250,000 per month for the next 20 years, with the first payment to be made immediately. If your client believes that she can earn a guaranteed 8 percent return, compounded monthly over the next 20 years, which option should she select? Solution 3 4. Having landed a large signing bonus upon completing your MBA and taking a job, you have decided to lease a new car for three years. The dealer offers a 36-month lease that requires you to pay $550 per month and a $2,000 down payment due at lease signing. If you were able to earn 3 percent compounded monthly in a money market account, how much would you have to put in the account today in order to meet your lease obligations? (Include the amounts due today.) Solution 4 You can use Excel to solve PV. PV Excel Tutorial

5. Assume a government bond has a face value of $1,000 (it pays $1,000 at maturity), a coupon of 6 percent (it pays interest at an annual rate of 6 percent), semiannual payments of interest ($30 twice a year), and a five-year maturity. If the market interest rate for such a bond is 5 percent, how much is the bond worth? (Discount the cash

flows at an annual rate of 5 percent, compounded semiannually.) How much is it worth at a market rate of 8 percent? (Discount the cash flows at an annual rate of 8 percent compounded semiannually.) Solution 5 6. Given a mortgage of $100,000 at a 9 percent annual interest rate compounded monthly and 360 monthly payments, how much interest will be charged during the fifth year of the loan? Solution 6 7. A $100,000 mortgage carries a 9 percent annual interest rate compounded monthly and a maximum term of 360 monthly payments. How many payments of $1,000 will pay off the loan? Solution The loan can be paid off in 186 months with a payment of $1,000 per month. Guided Solution From question 6, the payment was determined to be $804.62. A payment of $1,000 should pay off the loan in less than 360 months. Click the "tools" icon, then "Finance Formulas," to find the formula for the solution for the number of periods, N. You can use Excel to solve NPER. NPER Excel Tutorial

Since it does not matter if base 10 logarithms ("log" function) or natural base logarithms ("ln" or "LN" function) are used, use to whatever your calculator uses. The formula can also be stated as

A payment of $1,000 will pay off the loan in 185 months plus a partial payment in month 186. This is just over one half of the original life of the loan of 360 months with a payment of $804.62.

Evaluating Cash Flows: Perpetuities


A perpetuity is an annuity whose payments go on foreveran infinite stream of equal cash flows received at regular intervals over time. A constant growth perpetuity also has payments that never end, but the payments increase at a constant rate over time. Although true perpetuities are rare, some cash flow streams can be treated as a constant growth perpetuity, such as thecash dividend payment stream of dividend-paying companies. A cash dividend payment stream of a dividend-paying company is sometimes treated as a constant growth perpetuity if the payment of dividends is constant and reliable, and if the amount paid in the form of a dividend generally grows over time. Can you think of other examples of perpetuities? Present Value of No-Growth Perpetuities Because a perpetuity is a stream of cash flows that continues forever, you will not be able to find its future value after the last cash flow has occurred; by definition, this will never happen. The future value of a perpetuity at some intermediate future date is the normal future value of an annuity (FVA) for cash flows up to that date. Consider how you would go about computing the present value of an unending stream of constant payments (i.e., a no-growth perpetuity). You could use the formula for present value of an annuity for larger and larger values ofN, the number of periods, until the PVA stopped increasing. As you might recall from the Future Value topic in "Time Value of Money," the marginal increases in payoff diminish as the compounding frequency increases. Sincediscounting is the opposite of compounding, the same holds true. The marginal decrease in the present value of cash flows will diminish as payments extend further and further in the future. Perpetuities View animation

You can test this theory mathematically, using the formula for the present value of an ordinary annuity.

In the PVA formula, C is the payment amount; r is the periodic discount rate; and N is the total number of annuity payments. What happens as N goes to infinity? Examine the term (1 + r)N. Remember that

As N gets larger, the term (1 + r)N gets smaller. As Napproaches infinity, the term (1 + r)-N approaches zero. Subsititute zero for the term (1 + r)-N in the PVA formula to get the present value of a perpetuity (PVP).

This equation can be simplified.

Generally speaking, the present value of a perpetuity is simply the perpetuity's cash flow at the end of period 1,C, divided by the periodic discount rate, r. The formula for the PV of a perpetuity (= C r) implies that the first payment occurs one period from today. Example What would you be willing to pay for an infinite stream of $37 annual payments (cash inflows) beginning one year from today if the interest rate is 8 percent?

You are asked to value a time line that goes on forever with equally spaced cash flows of $37 occurring at the end of each year. Although this problem seems like it will take a lot of work, it is actually quite easy. Use the formula for

the present value of a no-growth perpetuity.

C = the constant payment amount of $37 r = the annual interest rate of 8 percent You may construct a time line to help you visualize the cash flow stream.

Substitute the given values into the formula for the present value of a no-growth perpetuity, and solve.

So you would pay $462.50 today in exchange for an infinite stream of $37 annual cash inflows. Notice that the $37 annual payment is the interest earned on the $462.50 principal over one year: $462.50 x .08 = $37. At the end of each year you receive $37 as a cash inflow. Unlike finite investments, you never get the principal investment back as a cash inflow. More often than not, a perpetuity assumes the first payment occurs at the end of the first period. Unless otherwise specified, you should assume this. However, the first payment can occur immediately. Present Value of a Perpetuity Due Would your answer change if the first $37 payment occurred today (i.e., an annuity-due form of cash flows)? It certainly would, because you now receive one extra

payment today.

To solve this problem, you already know the lump-sum present value of the $37 payments occurring at periods 1 through , so you have only to add to this amount the additional $37 payment already received at 0. Construct a time line.

Substitute the given values into the formula for the present value of a perpetuity, and add one extra payment.

If you received an additional $37 payment today, you would pay $499.50. Here again, you are simply stripping away an 8 percent annual interest payment of $37 each period, starting today. Present Value of a Constant-Growth Perpetuity Company stocks are commonly treated as growth perpetuities. One method used to compute an appropriate value an investor is willing to pay for a company's stock uses the dividend payment stream, which represents real cash flow to the investor and usually does not fluctuate as much as earnings. In addition, investors may assign a growth rate to the dividends, based on an expectation of growth of the company's dividend payments. Why is this necessary? This method of valuing stock (often called the dividend discount model) was extremely popular a number of years ago, when the majority of companies used dividends as a

primary method to return value to shareholders. It remains a popular method used to value traditional dividendpaying stocks issued by banks, utilities, and industrial companies. The formula for the present value of a perpetuity assumes the periodic payment remains constant. But dividends can grow over time with the growth of a company. What is an example of this? If you assume a constant growth rate for dividends, then the formula can be changed to

Here, C is the amount of the first payment at the end of period 1, r is the periodic discount rate, and g is the periodic constant rate of growth. The rate r must be greater than the rate g. Why? Example What would you pay for a share of stock, given arequired annual rate of return of 13 percent compounded quarterly and the following information? The next quarterly dividend will be $1.67, and it is the company's policy to increase the dividend by 3 percent each quarter.

Recognize that this is a constant-growth perpetuity problem, because the dividends continue forever and grow at a constant rate of 3 percent. You can use this equation to decide how much you would pay for the stock.

What is C? Since this a constant-growth perpetuity, the dividends will increase over time, and C is the first dividend to occur in the growth stream. You expect that the next dividend will be $1.67 and that each subsequent dividend will grow 3 percent, so C is $1.67. What does the stream of dividends look like?

and so on until you get to

What would these cash flows look like on a time line? Set up a complete time line.

The values in the PVPg formula are first payment, C = $1.67, the growth rate g = 3 percent, or .03, and the discount rate r = 13 percent 4, or .0325. Use these values in the formula for the present value of a constantgrowth perpetuity.

Clearly, a stream of payments that gets larger every quarter is worth more than a stream of constant payments. You are willing to pay $668.00 for this constant-growth perpetuity. How much would you pay for it if it did not grow?

How many decimal places should you use?

1. You are thinking of buying some stock in a company listed on the New York Stock Exchange (NYSE). Before you buy any stock, you should compute a price based on the dividends you expect a stock to pay in the future. This company has paid a $1.15 dividend every quarter for the past 12 years, and you expect this trend to continue to infinity. What do you believe the price of this stock should be if you require a 13 percent quarterly compounded return? Solution 1 2. Since graduating from college, you have grown rich. As a gesture of good will (with a tax benefit), you have decided to endow your alma mater with a research grant in finance. The endowment calls for the grant to be a constant-growth amount paid once a year in perpetuity. The first payment will be $10,000 and is to be made in exactly one year, with subsequent payments growing at a rate of 4.5 percent annually. If you are able to secure a 9 percent annual rate of return on the endowment fund, how much should you put into the endowment fund today? Solution 2 3. A thriving multinational magazine publisher wants to issue some new equity to its stockholders. You have been hired to price its stock based on its current dividend policy and its stockholders' required rate of return. The company has told you that over the last three years, it paid stock dividends of $1.13, $1.16, and $1.19, respectively. The publisher has also assured you that this growth rate in its dividends will continue indefinitely. If the company will pay its next dividend in exactly one year and believes that its stockholders require a 12.85 percent rate of return, what should be the price of its stock? Use an average of the

growth rate of dividend payments over the last three years and the formula for the present value of a constant growth dividend to compute the stock price. Solution 3 4. A major automobile manufacturer wants to ascertain its investors' required rate of return based on the fact that its stock is currently trading for $45. If the company pays a constant dividend of $2.27 semiannually, what is the investors' implied required rate of return, assuming that this situation occurs to infinity? Solution 4

5. Assume a company has total annual revenues of $100 million, and pays $2 million in dividends. Its total market capitalization is $200 million. What is the implied growth rate if the market normally requires a 15 percent return? Solution 5 6. Using the definition of an annuity, add a periodic growth factor, g, after the first period's cash flow, take the number of periods to infinity, and solve for the formula of a constant growth perpetuity. Hint: Use (1 + g)0 on the first period's cash flow. Solution 6 Solution The present value at a periodic discount rate of r, of an infinite number of cash flows starting at C at the end of period 1 and growing by the periodic rate g thereafter, as long asg is less than r, is the present value of a growth perpetuity.

Guided Solution Modify the annuity formula for a constant growth rate, g, and solve for N periods. Then reduce those parts of the formula (terms) that contain N. First, remember the formula for the present value of a stream of equal payments.

This expands into the long form.

If g is the periodic growth rate and the first period has a value of C, then the present value of a growth annuity (PVAg) is

Isolate C and divide both sides by C. Let G = (1 + g). Let R = (1 + r). The above equation becomes

Multiply both sides of the equation by (R G).

Subtract the PVAg equation from the above equation. Notice that all of the terms on the right side of the equal sign cancel except for the first one and the last one.

Isolate PVAg C.

Divide both sides by (R G - 1).

Substitute G with (1 + g) and R with (1 + r).

Simplify the equation by combining terms in the numerator and denominator.

Continue to combine terms.

Reduce and multiply the numerator and denominator by (1 + g) and reduce.

Rearrange the terms and reduce further.

This equation is for the value of a growth annuity.

Find the limit or PVPg as N grows toward infinity for values of r greater than g. For

as

Even though the payments will grow infinitely large over time, the discount rate based on (1 + r) will grow faster, as long as r > g, such that as N goes to infinity, PVA becomes PVP. Substitute infinity for N and rename this from the present value of a growth annuity, PVAg, to the present value of a growth perpetuity, PVPg.

Recognize that the ratio of (1 + g) to (1 + r) as both are being raised to a higher power, becomes zero as long as r is greater that g. Thus

This can be reduced to

Finally, multiply both sides of the equation by C.

The definition of an annuity can be modified to develop the formula for a constant growth perpetuity.

Evaluating Cash Flows: NPV & IRR


How Do Companies Decide Which Projects to Undertake? This discussion of net present value and internal rate of return examines how companies use NPV and IRR as decision tools to evaluate whether investments or projects are worth pursuing. The perpetuities topic introduced the dividend discount model as a way to value a company's stock. Aside from buying stock back from the public, cash dividends are the common way that a company returns cash payments to its equity investors. Where does the company get the cash to pay the dividends? The company generates cash from the projects that it undertakes with the cash that it acquires from investors (both debt and equity investors) and any excess cash generated by its projects. Investors base their required rate of return on the riskiness of the company's projects. The more riskinvestors perceive in the cash flows from the projects, the higher the rate of return investors will require from the company. The combined return required by debt and equity capital is the weighted average cost of capital, or simply the cost of capital. Investment versus financing A key concept of business finance requires separating the investment decision from the financing decision. The liabilities and net worth comprise the source of funds where the company gets its money. The assets represent how those funds are investedthe investment decision. The key point is that it does not matter what the source of funds is when evaluating an investment. For example, suppose an airline wanted to acquire an airplane for a new route. The investment project is the new route. The airplane and crew, ground personnel, fuel, ticketing, airport fees, and so on represent the costs, or cash outflows, of this project. The revenues from ticket sales are the revenues or cash inflows of the project. These aspects of the project will remain the same regardless of how the airline finances the project. The cost of the airplane is considered a cash outflow. The firm could pay for the airplane with cash raised by selling other assets, by using available cash, by borrowing from a bank, issuing bonds, or issuing more stock. Even a lease represents a form of financing. It does not matter what the source of funds is when evaluating an investment. So how does the firm take financing costs into account? Does using returnable containers save a company money? Read about how to evaluate this option using net present value.

Can You Justify Returnables?

Firms use the cost of capital. Cost of capital The cost of capital reflects the minimum amount that a firm must earn on its assets in order for those assets to add value to the firm. Expressed as a percent, the cost of capital is the rate at which assets must provide cash inflows to justify their cost. Therefore, if the rate of return of the net cash flows from a project, including the initial investment and all future net cash flows, exceeds the cost of capital, the project will add to the value of the firm. This was the case in Challenge B. There you found that the assets generated a return of 21.31 percent, while the cost of capital was assumed to be 15 percent. Understanding the derivation of the cost of capital requires a review of how equity markets work, which goes beyond the scope of this course. For the purpose of this topic, assume that the company's financial manager has derived a value for the cost of capital to use in evaluating projects. Value additivity Value additivity is the concept that the present value of a company equals the sum of the present value of independent projects. For projects to be evaluated independently, the cash flows from new projects must include the effects that new projects have on existing projects. This simple concept compels financial managers to go back and reevaluate existing projects and helps managers focus on all of the relevant cash flows attributable to the new project. Relevant cash flows Constructing the relevant cash flows for project evaluation is important and sometimes difficult. Somefinancial instruments, such as bonds and mortgages, present a fairly well-defined set of cash flows. Other financial instruments, such as options, futures, and derivatives, can have complex cash flows dependent on several factors. Most business projects require as much art as science in projecting the cash inflows and cash outflows of a project, including the effects of proposals on existing undertakings. More advanced courses will deal with computing the cost of capital projects and relevant cash flows of the firm's projects. The remainder of this section will consider two methods analysts use to evaluate the cash flows of different projects, regardless of when those cash flows occur. These two methods are the net present value (NPV) and the internal rate of return (IRR). Projects with a Positive NPV Add Value to the Firm The net present value, or NPV, is one of the most common methods used to evaluate investments. At its simplest, How does an entrepreneur use net present value?

NPV is the present value computed by using the firm's cost of capital as the discount rate of cash inflows, minus the present value of cash outflows, including the initial investment.

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Cash inflows and outflows can occur at any time during the project. The NPV of the project is the sum of the present values of the net cash flows for each time periodt, where t takes on the values 0 (the beginning of the project) through N (the end of the project). Analytical Methods: Summation This can be expressed as

Sometimes, for convenience, this can be written with the initial cash flow listed separately as

C0 is negative if there is an initial cash outflow. If the present value of the cash flows, discounted at the cost of capital, exceeds the cost of the investment, then the investment will add to the value of the company. The positive NPVs calculated in Challenges B and C, where the discount rates equaled the costs of capital, indicated that those projects would add value to the firm. Example: Single future cash flow Consider two simple investments, each with only one future net cash flow. Assume that each project costs $900. The net present Exponents

value of each project using different costs of capital are:

The net present value indicates that project B is more valuable at a cost of capital of 10 percent, that project A is slightly more valuable at 15 percent, and that neither project would add to the value of the company at a cost of capital of 20 percent. Which project would you choose? If the projects are independent, you would choose both if the cost of capital is 15 percent or less. Neither project would be acceptable at a cost of capital of 20 percent, since this would lower the present value of the whole firm. If these are mutually exclusive projects, take the one that adds more to the value of the firm. In this case, that answer depends on the actual cost of capital. What happens if the projects have different levels of risk? Bond markets require higher rates of return for bonds from companies in poor financial condition (the so-calledjunk bond market) than the markets do for bonds issued by companies in excellent financial condition (investmentgrade bonds). One way to account for different levels of risk between competing projects is to increase the cost of capital by some amount to reflect the higher risk. If project B is substantially more risky than project A, such that the NPV of project A is computed at 15 percent whereas the NPV of project B is computed at 20 percent, then the investment decision takes on a new dimension. In this case, only project A would be acceptable. As with the cost of capital itself, the process for adjusting projects for risk goes beyond the scope of this topic. Later, in the spreadsheet examples, the NPV of multiple net cash flows is calculated. As the Challenge problems demonstrate, the analysis of net present value is the same whether you have one future cash flow or many. The NPV calculation is one method analysts use to decide whether a potential project, or investment, can add value to the firm. As you may have seen in Challenge A and

Challenge B, the NPV is often calculated assuming a required rate of return on the investment, a rate given in the assumptions of the factual situation. The NPV calculation provides a dollar measure of how much a project is expected to add to a firm's value. Analysts may also want to know what the rate of return on a project is in order to compare it to the cost of capital. This rate is called the internal rate of return, or IRR. Projects with an IRR Greater than the Cost of Capital Add Value to the Firm The IRR is the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows. This is the same as saying that the IRR is the discount rate that makes the net present value equal to zero. What is the IRR for the two projects above, each of which has an initial investment of $900? Project A provides a net cash inflow of $2,000 at the end of five years. Project B provides a net cash inflow of $3,000 at the end of eight years. Unlike projects with multiple future net cash flows, the IRR for a single future net cash flow, and a single initial investment, can be computed with a relatively simple formula. In the "Time Value of Money" section, you learned how to calculate the present value (PV) of a future net cash flow (FV) received N periods from now, discounted at aperiodic interest rate of r.

Solving for r, the rate of return, produces

Let IRRx be the internal rate of return for project x. For project A, FV = $2,000 N=5 PV = $900 Therefore, the IRR is

For project B, FV = $3,000 N=8 PV = $900 Therefore, the IRR is

You will find businesses using both the NPV and IRR calculations to aid in making investment decisions. IRR is a potentially flawed decision tool because it can be easily misapplied. IRR problems include: Lending versus borrowing. For some projects that have cash inflows followed by cash outflows, the NPVrises as the discount rate is increased. In this case, projects in which the IRR is less than the cost of capital are acceptable. Multiple rates of return. If there is more than one change in the sign of the cash flows, the project may have several IRRs, or no IRR. Mutually exclusive projects. The IRR rule may not accurately rank mutually exclusive projects that vary in time or scale. Short-term interest rates may be different from longterm rates. In a single project, the cost of capital for one-year cash flows can differ from the cost of capital for two-year cash flows, and so on. This does not allow you to compare the project's IRR with the cost of capital. In these cases, there is no straightforward method for calculating the project's IRR. The following animation demonstrates how IRR can lead to faulty decision-making. IRR Animation View animation

Evaluating multiple net cash flows The basic approach used for projects with a single net cash inflow after the initial investment also applies to projects with multiple future net cash inflows. Annuity formulas aid computations when all cash flows are equal in amount, but when cash inflows vary over time, computations are more tedious. Example Analyze a project with quarterly net cash flows using a discount rate of 3 percent per quarter. The following table shows the cash flows by quarter. For this project, the investment is the initial cash flow. By convention, outflows appear as negative numbers; net cash inflows are positive.

Obtain the cost of capital, 3 percent per quarter, and generate discount factors. From the present value of a single payment, the discount factor for period t at a periodic interest rate of r is

Compute present values of each net cash flow. Multiply the net cash flow for each period by its discount factor to obtain its present value.

Sum the present values of each cash flow to calculate the NPV.

The NPV for this project is $9.32. Find the IRR, the discount rate, that makes the NPV zero. See the spreadsheet example below. Spreadsheet Examples Net present value Most modern spreadsheets have financial spreadsheet functions that can compute NPV and IRR. Although the exact form may vary, the NPV spreadsheet function typically takes the form NPV (discount rate, net cash flows for t = 1 to N) The discount rate is a value or cell address for the periodic rate. Since the cash flows occur at quarterly intervals, the discount rate must be entered as a decimal quarterly rate. Net cash flows for t = 1 to N means that the cell range for only the future net cash flows must be entered. As a You can use Excel to solve NPV NPV Excel Tutorial

result, the NPV is not NPV as defined here, but the PV of future cash flows. The initial investment must be subtracted from the result of the NPV function to get the actual net present value. (See the cell range for IRR by comparison.) Net Present Value = NPV function + initial investment (as negative number). Using the quarterly cash flows in the example above, enter in a new spreadsheet, in cells A1 through A5, the values: -900, 250, 300, 400, and 20. In cell B6, enter the quarterly discount rate 0.03. In cell A6, enter the formula =NPV(B6,A2:A5)+A1. The result should be $9.32. Internal rate of return Unlike the spreadsheet version of NPV, the IRR function actually uses the values for time periods 0 through N: IRR (net cash flows for t = 0 to N, {optional guess discount rate}). The net cash flows for t = 0 to N are the range of cells with all net cash flows, including the initial investment as a negative number. The optional "guess discount rate" allows the user to enter a value or cell that contains a "guess" as to the value of the IRR in its periodic form, such as .012 annually, .03 for quarterly, and .01 for monthly. Using the same information in the NPV example above, enter in cell A7 the formula =IRR(A1:A5). The answer should be 3.4897 percent. (You may need to increase the number of decimals displayed, or the result may appear to be 3 percent). This is the quarterly IRR. To compute the effective annual rate (EAR) needed to evaluate the annual cost of capital, use the formula presented in Future Value in the "Time Value of Money" section: The effective annual rate is

Here m is the compounding frequency. Notice that this is not the same as multiplying the quarterly rate by 4, which is 13.96 percent. The annual nominal rate is 13.96 percent. Hint: Do not compare the annualized nominal rate to the cost of capital stated at an annual rate. Instead, compare the EAR with the annual cost of capital. Summary The cost of capital is the discount rate companies use to evaluate projects. It will vary from project to project depending on the assessed risk of each project. The investment decision is separate from the financing decision. Value additivity is the theory that the present value of a company is equal to the sum of the present values of all of the company's independent projects. Relevant cash flows include the initial investment, cash inflows, and cash outflows for a new project, plus the changes in cash flow on existing projects. Net present value is the net dollar benefit of a new project discounted at the cost of capital. NPV must be positive to add value to the firm. The internal rate of return is the discount rate that makes the NPV equal to zero. IRR must be greater than the cost of capital for a new project to add value to the firm. How do spreadsheets find the IRR? How many decimal places should you use?

1. Calculate the internal rate of return for the following set of cash flows by first using trial and error. The initial cash outflow is $8,145, followed by seven years of semiannual cash inflows of $890. The associated discount rate is 5.6

percent. Hint: There is a concise way to solve by trial and error. Solution 1 2. Your company will invest $5 million to receive payments of $2 million for the next 10 years. Calculate the NPV if the required rate of return is 14 percent per year. Solution 2 Alternate Solution 2 3. After graduation, you landed a job at a large, multinational media corporation. Your firm has been negotiating a license agreement to use a certain documentary film for a term of 2.5 years. You expect that the film will return cash flows of $12.5 million at the end of each six-month period. The company licensing the rights to use the film is asking $50 million. Your company's required rate of return is 17.5 percent. Should you purchase the license to show the film? Solution 3 Alternate Solution 3 4. Consider the following information pertaining to a project that your company is currently evaluating. The project calls for your factory to add a second canning machine that will result in end-of-year cash flows of $3,200, $3,700, $4,100, $4,500, and $4,900 over the next five years. The canning machine will cost $15,000, and your company uses a 13 percent discount rate when evaluating projects. What is the net present value of these cash flows? Solution 4 Alternate Solution 4

5. Take a set of four annual cash flows starting at the end of year 0: -$1,000, +$400, +$600, and +$800. Compute the IRR. Then compute the FV of each cash flow using the IRR as the compounding interest rate. Sum these FVs. What is the net future value? Using the sum of the future

values for the cash inflows in years 1, 2, and 3, what is the IRR of this single future value against the initial investment of $1,000? (Use the formula to compute the IRR of a single future cash flow.) Solution 5 6. Take the same cash flows in the question above. The IRR was fairly high at 31.69 percent. What if the cash flows from the project cannot be reinvested at the IRR? (No other project at that level exists.) Compute the future value of the cash flows at the end of year 3 using a lower interest rate, such as 12 percent. Add the future cash inflows to derive a single sum cash equivalent inflow as of the end of year 3. Now compute the IRR using the formula for a single future cash inflow at the end of year 3. What happens to the IRR? Solution 6 7. A wine lover has decided to start a winery. The initial investment will be $5 million. The winery will require additional investments of $1 million per year at the end of the next five years while the vines mature. Beginning at the end of year 6, the winery is expected to produce net cash inflows of $2 million at the end of each year, growing at 20 percent per year. How long will it take the project to reach a positive net present value, assuming an annually compounded discount rate of 15 percent? Solution 7 8. Using the information about the winery in the previous question, when would the IRR exceed the discount rate of 15 percent if there is an additional $4 million expenditure in year 10, with no change in revenues? Solution 8

Solution The loan can be paid off in 186 months with a payment of $1,000 per month. Guided Solution From question 6, the payment was determined to be $804.62. A payment of $1,000 should pay off the loan in less than 360 months. Click the "tools" icon, then "Finance Formulas," to find the formula for the solution for the number of periods, N.

Since it does not matter if base 10 logarithms ("log" function) or natural base logarithms ("ln" or "LN" function) are used, use to whatever your calculator uses. The formula can also be stated as

A payment of $1,000 will pay off the loan in 185 months plus a partial payment in month 186. This is just over one half of the original life of the loan of 360 months with a payment of $804.62.

Evaluating Cash Flows: Perpetuities


A perpetuity is an annuity whose payments go on foreveran infinite stream of equal cash flows received at regular intervals over time. A constant growth perpetuity also has payments that never end, but the payments increase at a constant rate over time. Although true perpetuities are rare, some cash flow streams can be treated as a constant growth perpetuity, such as thecash dividend payment stream of dividend-paying companies. A cash dividend payment stream of a dividend-paying company is sometimes treated as a constant growth perpetuity if the payment of dividends is constant and reliable, and if the amount paid in the form of a dividend generally grows over time. Can you think of other examples of perpetuities? Present Value of No-Growth Perpetuities Because a perpetuity is a stream of cash flows that continues forever, you will not be able to find its future value after the last cash flow has occurred; by definition, this will never happen. The future value of a perpetuity at some intermediate future date is the normal future value of an annuity (FVA) for cash flows up to that date. Consider how you would go about computing the present value of an unending stream of constant payments (i.e., a no-growth perpetuity). You could use the formula for present value of an annuity for larger and larger values ofN, the number of periods, until the PVA stopped increasing. As you might recall from the Future Value topic in "Time Value of Money," the marginal increases in payoff diminish as the compounding frequency increases. Sincediscounting is the opposite of compounding, the same holds true. The marginal decrease in the present value of cash flows will diminish as payments extend further and further in the future. Perpetuities View animation

You can test this theory mathematically, using the formula for the present value of an ordinary annuity.

In the PVA formula, C is the payment amount; r is the periodic discount rate; and N is the total number of annuity payments. What happens as N goes to infinity? Examine the term (1 + r)N. Remember that

As N gets larger, the term (1 + r)N gets smaller. As Napproaches infinity, the term (1 + r)-N approaches zero. Subsititute zero for the term (1 + r)-N in the PVA formula to get the present value of a perpetuity (PVP).

This equation can be simplified.

Generally speaking, the present value of a perpetuity is simply the perpetuity's cash flow at the end of period 1,C, divided by the periodic discount rate, r. The formula for the PV of a perpetuity (= C r) implies that the first payment occurs one period from today. Example What would you be willing to pay for an infinite stream of $37 annual payments (cash inflows) beginning one year from today if the interest rate is 8 percent?

You are asked to value a time line that goes on forever with equally spaced cash flows of $37 occurring at the end of each year. Although this problem seems like it will take a lot of work, it is actually quite easy. Use the formula for

the present value of a no-growth perpetuity.

C = the constant payment amount of $37 r = the annual interest rate of 8 percent You may construct a time line to help you visualize the cash flow stream.

Substitute the given values into the formula for the present value of a no-growth perpetuity, and solve.

So you would pay $462.50 today in exchange for an infinite stream of $37 annual cash inflows. Notice that the $37 annual payment is the interest earned on the $462.50 principal over one year: $462.50 x .08 = $37. At the end of each year you receive $37 as a cash inflow. Unlike finite investments, you never get the principal investment back as a cash inflow. More often than not, a perpetuity assumes the first payment occurs at the end of the first period. Unless otherwise specified, you should assume this. However, the first payment can occur immediately. Present Value of a Perpetuity Due Would your answer change if the first $37 payment occurred today (i.e., an annuity-due form of cash flows)? It certainly would, because you now receive one extra

payment today.

To solve this problem, you already know the lump-sum present value of the $37 payments occurring at periods 1 through , so you have only to add to this amount the additional $37 payment already received at 0. Construct a time line.

Substitute the given values into the formula for the present value of a perpetuity, and add one extra payment.

If you received an additional $37 payment today, you would pay $499.50. Here again, you are simply stripping away an 8 percent annual interest payment of $37 each period, starting today. Present Value of a Constant-Growth Perpetuity Company stocks are commonly treated as growth perpetuities. One method used to compute an appropriate value an investor is willing to pay for a company's stock uses the dividend payment stream, which represents real cash flow to the investor and usually does not fluctuate as much as earnings. In addition, investors may assign a growth rate to the dividends, based on an expectation of growth of the company's dividend payments. Why is this necessary? This method of valuing stock (often called the dividend discount model) was extremely popular a number of years ago, when the majority of companies used dividends as a

primary method to return value to shareholders. It remains a popular method used to value traditional dividendpaying stocks issued by banks, utilities, and industrial companies. The formula for the present value of a perpetuity assumes the periodic payment remains constant. But dividends can grow over time with the growth of a company. What is an example of this? If you assume a constant growth rate for dividends, then the formula can be changed to

Here, C is the amount of the first payment at the end of period 1, r is the periodic discount rate, and g is the periodic constant rate of growth. The rate r must be greater than the rate g. Why? Example What would you pay for a share of stock, given arequired annual rate of return of 13 percent compounded quarterly and the following information? The next quarterly dividend will be $1.67, and it is the company's policy to increase the dividend by 3 percent each quarter.

Recognize that this is a constant-growth perpetuity problem, because the dividends continue forever and grow at a constant rate of 3 percent. You can use this equation to decide how much you would pay for the stock.

What is C? Since this a constant-growth perpetuity, the dividends will increase over time, and C is the first dividend to occur in the growth stream. You expect that the next dividend will be $1.67 and that each subsequent dividend will grow 3 percent, so C is $1.67. What does the stream of dividends look like?

and so on until you get to

What would these cash flows look like on a time line? Set up a complete time line.

The values in the PVPg formula are first payment, C = $1.67, the growth rate g = 3 percent, or .03, and the discount rate r = 13 percent 4, or .0325. Use these values in the formula for the present value of a constantgrowth perpetuity.

Clearly, a stream of payments that gets larger every quarter is worth more than a stream of constant payments. You are willing to pay $668.00 for this constant-growth perpetuity. How much would you pay for it if it did not grow?

How many decimal places should you use?

1. You are thinking of buying some stock in a company listed on the New York Stock Exchange (NYSE). Before you buy any stock, you should compute a price based on the dividends you expect a stock to pay in the future. This company has paid a $1.15 dividend every quarter for the past 12 years, and you expect this trend to continue to infinity. What do you believe the price of this stock should be if you require a 13 percent quarterly compounded return? Solution 1 2. Since graduating from college, you have grown rich. As a gesture of good will (with a tax benefit), you have decided to endow your alma mater with a research grant in finance. The endowment calls for the grant to be a constant-growth amount paid once a year in perpetuity. The first payment will be $10,000 and is to be made in exactly one year, with subsequent payments growing at a rate of 4.5 percent annually. If you are able to secure a 9 percent annual rate of return on the endowment fund, how much should you put into the endowment fund today? Solution 2 3. A thriving multinational magazine publisher wants to issue some new equity to its stockholders. You have been hired to price its stock based on its current dividend policy and its stockholders' required rate of return. The company has told you that over the last three years, it paid stock dividends of $1.13, $1.16, and $1.19, respectively. The publisher has also assured you that this growth rate in its dividends will continue indefinitely. If the company will pay its next dividend in exactly one year and believes that its stockholders require a 12.85 percent rate of return, what should be the price of its stock? Use an average of the

growth rate of dividend payments over the last three years and the formula for the present value of a constant growth dividend to compute the stock price. Solution 3 4. A major automobile manufacturer wants to ascertain its investors' required rate of return based on the fact that its stock is currently trading for $45. If the company pays a constant dividend of $2.27 semiannually, what is the investors' implied required rate of return, assuming that this situation occurs to infinity? Solution 4

5. Assume a company has total annual revenues of $100 million, and pays $2 million in dividends. Its total market capitalization is $200 million. What is the implied growth rate if the market normally requires a 15 percent return? Solution 5 6. Using the definition of an annuity, add a periodic growth factor, g, after the first period's cash flow, take the number of periods to infinity, and solve for the formula of a constant growth perpetuity. Hint: Use (1 + g)0 on the first period's cash flow. Solution 6
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Perpetuities: Solution 6
Solution

The present value at a periodic discount rate of r, of an infinite number of cash flows starting at C at the end of period 1 and growing by the periodic rate g thereafter, as long asg is less than r, is the present value of a growth perpetuity.

Guided Solution Modify the annuity formula for a constant growth rate, g, and solve for N periods. Then reduce those parts of the formula (terms) that contain N. First, remember the formula for the present value of a stream of equal payments.

This expands into the long form.

If g is the periodic growth rate and the first period has a value of C, then the present value of a growth annuity (PVAg) is

Isolate C and divide both sides by C. Let G = (1 + g). Let R = (1 + r). The above equation becomes

Multiply both sides of the equation by (R G).

Subtract the PVAg equation from the above equation. Notice that all of the terms on the right side of the equal sign cancel except for the first one and the last one.

Isolate PVAg C.

Divide both sides by (R G - 1).

Substitute G with (1 + g) and R with (1 + r).

Simplify the equation by combining terms in the numerator and denominator.

Continue to combine terms.

Reduce and multiply the numerator and denominator by (1 + g) and reduce.

Rearrange the terms and reduce further.

This equation is for the value of a growth annuity. Find the limit or PVPg as N grows toward infinity for values of r greater than g. For

as

Even though the payments will grow infinitely large over time, the discount rate based on (1 + r) will grow faster, as long as r > g, such that as N goes to infinity, PVA becomes PVP. Substitute infinity for N and rename this from the present value of a growth annuity, PVAg, to the present value of a growth perpetuity, PVPg.

Recognize that the ratio of (1 + g) to (1 + r) as both are being raised to a higher power, becomes zero as long as r is greater that g. Thus

This can be reduced to

Finally, multiply both sides of the equation by C.

The definition of an annuity can be modified to develop the formula for a constant growth perpetuity.

Evaluating Cash Flows: NPV & IRR


How Do Companies Decide Which Projects to Undertake? This discussion of net present value and internal rate of return examines how companies use NPV and IRR as decision tools to evaluate whether investments or projects are worth pursuing. The perpetuities topic introduced the dividend discount model as a way to value a company's stock. Aside from buying stock back from the public, cash dividends are the common way that a company returns cash payments to its equity investors. Where does the company get the cash to pay the dividends? The company generates cash from the projects that it undertakes with the cash that it acquires from investors (both debt and equity investors) and any excess cash generated by its projects. Investors base their required rate of return on the riskiness of the company's projects. The more riskinvestors perceive in the cash flows from the projects, the higher the rate of return investors will require from the company. The combined return required by debt and equity capital is the weighted average cost of capital, or simply the cost of capital. Investment versus financing A key concept of business finance requires separating the investment decision from the financing decision. The liabilities and net worth comprise the source of funds where the company gets its money. The assets represent how those funds are investedthe investment decision. The key point is that it does not matter what the source of funds is when evaluating an investment. For example, suppose an airline wanted to acquire an airplane for a new route. The investment project is the new route. The airplane and crew, ground personnel, fuel, Does using returnable containers save a company money? Read about how to evaluate this option using net present value.

Can You Justify Returnables?

ticketing, airport fees, and so on represent the costs, or cash outflows, of this project. The revenues from ticket sales are the revenues or cash inflows of the project. These aspects of the project will remain the same regardless of how the airline finances the project. The cost of the airplane is considered a cash outflow. The firm could pay for the airplane with cash raised by selling other assets, by using available cash, by borrowing from a bank, issuing bonds, or issuing more stock. Even a lease represents a form of financing. It does not matter what the source of funds is when evaluating an investment. So how does the firm take financing costs into account? Firms use the cost of capital. Cost of capital The cost of capital reflects the minimum amount that a firm must earn on its assets in order for those assets to add value to the firm. Expressed as a percent, the cost of capital is the rate at which assets must provide cash inflows to justify their cost. Therefore, if the rate of return of the net cash flows from a project, including the initial investment and all future net cash flows, exceeds the cost of capital, the project will add to the value of the firm. This was the case in Challenge B. There you found that the assets generated a return of 21.31 percent, while the cost of capital was assumed to be 15 percent. Understanding the derivation of the cost of capital requires a review of how equity markets work, which goes beyond the scope of this course. For the purpose of this topic, assume that the company's financial manager has derived a value for the cost of capital to use in evaluating projects. Value additivity Value additivity is the concept that the present value of a company equals the sum of the present value of independent projects. For projects to be evaluated independently, the cash flows from new projects must include the effects that new projects have on existing projects. This simple concept compels financial managers to go back and reevaluate existing projects and helps managers focus on all of the relevant cash flows attributable to the new project. Relevant cash flows Constructing the relevant cash flows for project evaluation is important and sometimes difficult. Somefinancial instruments, such as bonds and mortgages, present a fairly well-defined set of cash flows. Other financial instruments, such as options, futures, and derivatives, can have complex cash flows dependent on several factors. Most business projects require as much art as science in projecting the cash inflows and cash outflows of a project, including the effects of proposals on existing undertakings.

More advanced courses will deal with computing the cost of capital projects and relevant cash flows of the firm's projects. The remainder of this section will consider two methods analysts use to evaluate the cash flows of different projects, regardless of when those cash flows occur. These two methods are the net present value (NPV) and the internal rate of return (IRR). Projects with a Positive NPV Add Value to the Firm The net present value, or NPV, is one of the most common methods used to evaluate investments. At its simplest, NPV is the present value computed by using the firm's cost of capital as the discount rate of cash inflows, minus the present value of cash outflows, including the initial investment. How does an entrepreneur use net present value? Low bandwith High bandwith

Cash inflows and outflows can occur at any time during the project. The NPV of the project is the sum of the present values of the net cash flows for each time periodt, where t takes on the values 0 (the beginning of the project) through N (the end of the project). Analytical Methods: Summation This can be expressed as

Sometimes, for convenience, this can be written with the initial cash flow listed separately as

C0 is negative if there is an initial cash outflow.

If the present value of the cash flows, discounted at the cost of capital, exceeds the cost of the investment, then the investment will add to the value of the company. The positive NPVs calculated in Challenges B and C, where the discount rates equaled the costs of capital, indicated that those projects would add value to the firm. Example: Single future cash flow Consider two simple investments, each with only one future net cash flow. Assume that each project costs $900. The net present value of each project using different costs of capital are:

Exponents

The net present value indicates that project B is more valuable at a cost of capital of 10 percent, that project A is slightly more valuable at 15 percent, and that neither project would add to the value of the company at a cost of capital of 20 percent. Which project would you choose? If the projects are independent, you would choose both if the cost of capital is 15 percent or less. Neither project would be acceptable at a cost of capital of 20 percent, since this would lower the present value of the whole firm. If these are mutually exclusive projects, take the one that adds more to the value of the firm. In this case, that answer depends on the actual cost of capital. What happens if the projects have different levels of risk? Bond markets require higher rates of return for bonds from companies in poor financial condition (the so-calledjunk bond market) than the markets do for bonds issued by companies in excellent financial condition (investmentgrade bonds). One way to account for different levels of risk between competing projects is to increase the cost of capital by some amount to reflect the higher risk. If project B is substantially more risky than project A, such that the NPV of project A is computed at 15 percent whereas the NPV of project B is computed at 20 percent, then the investment decision takes on a new dimension. In this

case, only project A would be acceptable. As with the cost of capital itself, the process for adjusting projects for risk goes beyond the scope of this topic. Later, in the spreadsheet examples, the NPV of multiple net cash flows is calculated. As the Challenge problems demonstrate, the analysis of net present value is the same whether you have one future cash flow or many. The NPV calculation is one method analysts use to decide whether a potential project, or investment, can add value to the firm. As you may have seen in Challenge A and Challenge B, the NPV is often calculated assuming a required rate of return on the investment, a rate given in the assumptions of the factual situation. The NPV calculation provides a dollar measure of how much a project is expected to add to a firm's value. Analysts may also want to know what the rate of return on a project is in order to compare it to the cost of capital. This rate is called the internal rate of return, or IRR. Projects with an IRR Greater than the Cost of Capital Add Value to the Firm The IRR is the discount rate that makes the present value of the cash inflows equal to the present value of the cash outflows. This is the same as saying that the IRR is the discount rate that makes the net present value equal to zero. What is the IRR for the two projects above, each of which has an initial investment of $900? Project A provides a net cash inflow of $2,000 at the end of five years. Project B provides a net cash inflow of $3,000 at the end of eight years. Unlike projects with multiple future net cash flows, the IRR for a single future net cash flow, and a single initial investment, can be computed with a relatively simple formula. In the "Time Value of Money" section, you learned how to calculate the present value (PV) of a future net cash flow (FV) received N periods from now, discounted at aperiodic interest rate of r.

Solving for r, the rate of return, produces

Let IRRx be the internal rate of return for project x. For project A, FV = $2,000 N=5 PV = $900 Therefore, the IRR is

For project B, FV = $3,000 N=8 PV = $900

Therefore, the IRR is

You will find businesses using both the NPV and IRR calculations to aid in making investment decisions. IRR is a potentially flawed decision tool because it can be easily misapplied. IRR problems include: Lending versus borrowing. For some projects that have cash inflows followed by cash outflows, the NPVrises as the discount rate is increased. In this case, projects in which the IRR is less than the cost of capital are acceptable. Multiple rates of return. If there is more than one change in the sign of the cash flows, the project may have several IRRs, or no IRR. Mutually exclusive projects. The IRR rule may not accurately rank mutually exclusive projects that vary in time or scale. Short-term interest rates may be different from longterm rates. In a single project, the cost of capital for one-year cash flows can differ from the cost of capital for two-year cash flows, and so on. This does not allow you to compare the project's IRR with the cost of capital. In these cases, there is no straightforward method for calculating the project's IRR. The following animation demonstrates how IRR can lead to faulty decision-making. IRR Animation View animation

Evaluating multiple net cash flows The basic approach used for projects with a single net cash inflow after the initial investment also applies to projects with multiple future net cash inflows. Annuity formulas aid computations when all cash flows are equal in amount, but when cash inflows vary over time, computations are more

tedious. Example Analyze a project with quarterly net cash flows using a discount rate of 3 percent per quarter. The following table shows the cash flows by quarter. For this project, the investment is the initial cash flow. By convention, outflows appear as negative numbers; net cash inflows are positive.

Obtain the cost of capital, 3 percent per quarter, and generate discount factors. From the present value of a single payment, the discount factor for period t at a periodic interest rate of r is

Compute present values of each net cash flow. Multiply the net cash flow for each period by its discount factor to obtain its present value.

Sum the present values of each cash flow to calculate the NPV.

The NPV for this project is $9.32. Find the IRR, the discount rate, that makes the NPV zero. See the spreadsheet example below. Spreadsheet Examples Net present value Most modern spreadsheets have financial spreadsheet functions that can compute NPV and IRR. Although the exact form may vary, the NPV spreadsheet function typically takes the form NPV (discount rate, net cash flows for t = 1 to N) The discount rate is a value or cell address for the periodic rate. Since the cash flows occur at quarterly intervals, the discount rate must be entered as a decimal quarterly rate. Net cash flows for t = 1 to N means that the cell range for only the future net cash flows must be entered. As a You can use Excel to solve NPV NPV Excel Tutorial

result, the NPV is not NPV as defined here, but the PV of future cash flows. The initial investment must be subtracted from the result of the NPV function to get the actual net present value. (See the cell range for IRR by comparison.) Net Present Value = NPV function + initial investment (as negative number). Using the quarterly cash flows in the example above, enter in a new spreadsheet, in cells A1 through A5, the values: -900, 250, 300, 400, and 20. In cell B6, enter the quarterly discount rate 0.03. In cell A6, enter the formula =NPV(B6,A2:A5)+A1. The result should be $9.32. Internal rate of return Unlike the spreadsheet version of NPV, the IRR function actually uses the values for time periods 0 through N: IRR (net cash flows for t = 0 to N, {optional guess discount rate}). The net cash flows for t = 0 to N are the range of cells with all net cash flows, including the initial investment as a negative number. The optional "guess discount rate" allows the user to enter a value or cell that contains a "guess" as to the value of the IRR in its periodic form, such as .012 annually, .03 for quarterly, and .01 for monthly. Using the same information in the NPV example above, enter in cell A7 the formula =IRR(A1:A5). The answer should be 3.4897 percent. (You may need to increase the number of decimals displayed, or the result may appear to be 3 percent). This is the quarterly IRR. To compute the effective annual rate (EAR) needed to evaluate the annual cost of capital, use the formula presented in Future Value in the "Time Value of Money" section: The effective annual rate is

Here m is the compounding frequency. Notice that this is not the same as multiplying the quarterly rate by 4, which is 13.96 percent. The annual nominal rate is 13.96 percent. Hint: Do not compare the annualized nominal rate to the cost of capital stated at an annual rate. Instead, compare the EAR with the annual cost of capital. Summary The cost of capital is the discount rate companies use to evaluate projects. It will vary from project to project depending on the assessed risk of each project. The investment decision is separate from the financing decision. Value additivity is the theory that the present value of a company is equal to the sum of the present values of all of the company's independent projects. Relevant cash flows include the initial investment, cash inflows, and cash outflows for a new project, plus the changes in cash flow on existing projects. Net present value is the net dollar benefit of a new project discounted at the cost of capital. NPV must be positive to add value to the firm. The internal rate of return is the discount rate that makes the NPV equal to zero. IRR must be greater than the cost of capital for a new project to add value to the firm. How do spreadsheets find the IRR? How many decimal places should you use?

1. Calculate the internal rate of return for the following set of cash flows by first using trial and error. The initial cash outflow is $8,145, followed by seven years of semiannual cash inflows of $890. The associated discount rate is 5.6

percent. Hint: There is a concise way to solve by trial and error. Solution 1 2. Your company will invest $5 million to receive payments of $2 million for the next 10 years. Calculate the NPV if the required rate of return is 14 percent per year. Solution 2 Alternate Solution 2 3. After graduation, you landed a job at a large, multinational media corporation. Your firm has been negotiating a license agreement to use a certain documentary film for a term of 2.5 years. You expect that the film will return cash flows of $12.5 million at the end of each six-month period. The company licensing the rights to use the film is asking $50 million. Your company's required rate of return is 17.5 percent. Should you purchase the license to show the film? Solution 3 Alternate Solution 3 4. Consider the following information pertaining to a project that your company is currently evaluating. The project calls for your factory to add a second canning machine that will result in end-of-year cash flows of $3,200, $3,700, $4,100, $4,500, and $4,900 over the next five years. The canning machine will cost $15,000, and your company uses a 13 percent discount rate when evaluating projects. What is the net present value of these cash flows? Solution 4 Alternate Solution 4

5. Take a set of four annual cash flows starting at the end of year 0: -$1,000, +$400, +$600, and +$800. Compute the IRR. Then compute the FV of each cash flow using the IRR as the compounding interest rate. Sum these FVs. What is the net future value? Using the sum of the future

values for the cash inflows in years 1, 2, and 3, what is the IRR of this single future value against the initial investment of $1,000? (Use the formula to compute the IRR of a single future cash flow.) Solution 5 6. Take the same cash flows in the question above. The IRR was fairly high at 31.69 percent. What if the cash flows from the project cannot be reinvested at the IRR? (No other project at that level exists.) Compute the future value of the cash flows at the end of year 3 using a lower interest rate, such as 12 percent. Add the future cash inflows to derive a single sum cash equivalent inflow as of the end of year 3. Now compute the IRR using the formula for a single future cash inflow at the end of year 3. What happens to the IRR? Solution 6 7. A wine lover has decided to start a winery. The initial investment will be $5 million. The winery will require additional investments of $1 million per year at the end of the next five years while the vines mature. Beginning at the end of year 6, the winery is expected to produce net cash inflows of $2 million at the end of each year, growing at 20 percent per year. How long will it take the project to reach a positive net present value, assuming an annually compounded discount rate of 15 percent? Solution 7 8. Using the information about the winery in the previous question, when would the IRR exceed the discount rate of 15 percent if there is an additional $4 million expenditure in year 10, with no change in revenues? Solution 8

NPV & IRR: Solution 8


Solution The IRR will exceed the 15 percent discount rate in year 15. Guided Solution

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Add three extra columns to the spreadsheet you developed for the solution to the preceding problem, and find where the IRR exceeds the cost of capital of 15 percent. (See the table below for an example. The resulting spreadsheet follows after that table.) Add a new column, D, which contains the new cash flows for each time period (there is only one, the

$4 million outflow in year 10). Add another new column, E, which contains the new net cash flows minus the sum of the cash flow in columns B and D The third new column will contain a running measure of the IRR (internal rate of return) starting in year 6. (It could start as early as year 0, if you wish.) Be sure to enter the range as IRR(E$10:E16), where the "$" sign is known as an absolute reference. Don't worry if the result is "#NUM!"that just means that the IRR cannot find an answer. Copy the formula down the column to the remaining years. Make sure that the range starts with row 10 and ends with the row containing the IRR. Note the year in which the IRR exceeds 15 percent. Result: The IRR exceeds 15 percent in year 15. A 1 2 3 4 5 6 7 8 9 Yea Ct (Cash Flow r Year t) -$5,000,000 (Name: $B$10 or Investment -$1,000,000 (Name: $B$11 or Year1 -$1,000,000 -$1,000,000 -$1,000,000 -$1,000,000 $2,000,000 =NPV($C$5, $B$11:B16) +$B$10 or =NPV(Discount, Year1:B16) +Investment =IRR($B$10:E16 ) {Copy above on Net Present Value New Cas Net Flow h Flow =B10+D1 0 {copy above on down} IRR Revenue Growth Rate Discount Rate 20% (Name: Growth) 15% (Name: Discount) B C D E F

1 0 1 1 1 2 1 3 1 4 1 5 1 6 1

1 2 3 4 5 6 7

=B16*(1+Growth =NPV(Discount,Year1:B17)+Investme

7 1 8 8

) {Copy B17 on down}

nt {Copy C17 on down}

down}

Resulting Spreadsheet The information above was used to produce the spreadsheet below. Notice that the IRR exceeds 15 percent in the 15th year. Winery Problem Revenue Growth Rate 20% Discount Rate Year Cash Flow 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 ($5,000,000) ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) $2,000,000 $ 2,400,000 $ 2,880,000 $ 3,456,000 $ 4,147,200 $ 4,976,640 $ 5,971,968 $ 7,166,362 $ 8,599,634 $ 10,319,561 $ 12,383,473 $ 14,860,167 $ 17,832,201 $ 21,398,641 $ 25,678,369 ($7,487,500) ($6,585,251) ($5,643,774) ($4,661,363) ($3,636,239) ($4,000,000) ($2,566,544) ($1,450,340) ($285,606) $929,769 $2,197,986 $3,521,343 $4,902,237 $6,343,170 $7,846,753 $9,415,708 15% NPV New Cash Flow Net Cash Flow IRR ($5,000,000) ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) ($1,000,000) $2,000,000 $2,400,000 $2,880,000 $3,456,000 $147,200 $4,976,640 $5,971,968 $7,166,362 $8,599,634 $10,319,561 $12,383,473 $14,860,167 $17,832,201 $21,398,641 $25,678,369 #NUM! #NUM! -5.6% 1.1% 1.4% 6.5% 10.1% 12.8% 14.9% 16.6% 18.0% 19.1% 20.1% 20.9% 21.6%

Risk and Return: Introduction


Why, as an investor, do you receive only a 3 percent return on your deposits in an insured savings account, and at times a double-digit return on money invested in technology-based mutual funds? How do these two investments differ other than the returns they provide? The technology-based mutual fund is much riskier than the insured savings account. Perhaps the most fundamental relationship in finance is the tradeoff between riskand return. On the one hand, if this tradeoff did not exist and the market viewed all investments as having equal risk, no one would invest in the low-return insured savings account if they could invest in the high-return mutual fund. On the other hand, if investors were not compensated for taking risks, no one would be willing to invest in the technology-based mutual fund. As an investor, a financial manager, an entrepreneur, or a person in any other position that requires making investment decisions, the relation between risk and return raises three basic questions:

How do I estimate the percentage return that I will receive on an investment? How much risk does an asset add to a portfolio? What can I do to eliminate some of that risk?

Expected Return The expected return is the market's, or an investor's, best guess as to the return on an asset. Any technique can be used to arrive at the guess. This section will review two common techniques. One uses a simple average of historical returns. Another technique uses the returns from possible outcomes and the probabilities of those outcomes to arrive at an expected return. Variance and Standard Deviation Risk is the possibility that actual returns might differ, or vary, from expected returns. In fact, actual returns will likely differ from expected returns. It is important for decision-makers to estimate the magnitude and likelihood of the difference between actual and estimated returns. After all, there is a big difference if your predictions result in an error of only $100 versus an error of $1 million. By using the concepts of variance and standard deviation, investors can judge not only how wrong their estimates might be, but also estimate the

likelihood, or probability, of favorable or unfavorable outcomes. With the tools of expected return and standard deviation, financial decision-makers are better able to evaluate alternative investments based on risk-return tradeoffs, and their own risk preferences. Diversification The Diversification topic answers the third question regarding what one can do to minimize risk of a group, or portfolio, of investments. By selecting investments that perform differently under the same market conditions, one can create a portfolio that has less risk for the same level of expected return. The concepts of covariance and correlation are used to measure how the returns on assets relate to each other and the market in general and how they can be used to reduce the overall risk to the investor. Once you answer these basic questions, you may then consider more advanced question: If it is possible to diversify away some risks by holding a portfolio of assets, for what risks should investors receive compensation? Should investors who don't diversify be rewarded with higher returns? The answers to these questions rest in understanding different types of risk such as "market" or "non-diversifiable risk" versus "firm-specific" or "diversifiable" risk. The concept of beta, or how an asset moves relative to the market, helps investors quantify the level of diversifiable risk. Using "Risk and Return" concepts, you should be able to

compute the expected return of an individual security compute the expected return of a portfolio of securities compute a confidence interval around an expected return using standard deviation compute the variance and standard deviation of an individual security compute the variance and standard deviation of a portfolio compute beta, a measure of market risk

With a solid understanding of these finance basics, you will be well prepared to venture into more advanced aspects of financial theory and practice.

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