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Presented by
Muhammad Khalid Sohail
Lecture 5
Review:
Present Value
DF = PVIFi,n = 1 / (1+i)n
= C/F (PVIFAi%,n)
= C/F * [(1-1/(1+i)^n) / i ]
1. PV of Single Value.
What will be the PV of $10,000 in 5 years
at a discount rate of 10%.
10%
PV0
6-4
5
$10,000
Year CF-AT
6-5
DF@10%
[Rounding]
PV
0.9091
0.8264
0.7513
0.683
10000
0.6209
6209
6209
2. a. PV of Un-even C/F
300 occurring in 3
years at a discount
rate of 10%.
0
6-6
100
200
300
Year C/F
DF@10 PV
100
0.9091
91
200
0.8264
165
300
0.7513
225
481
Year CF
300 occurring in 3
years at a discount
rate of 10.5%.
6-7
100
200
300
DF@10.5% PV
100
0.905
91
200
0.819
164
300
0.7412
222
477
3. a. What is PV of this
annuity at interest rate 10%
(Ordinary Annuity)
End of
Period 1
1
$1000
Today
6-8
End of
Period 2
End of
Period 3
2
1000
3
1000
PVAn
= C/F (PVIFAi%,n)
n
0.10
DFA
3
2.624316
Year CF-AT DF@10% PV
0
1-3
6-9
1000 2.486852
2487
2487
= C/F (PVIFAi%,n)
= $1,000 (PVIFA10.5%,3)
= $1,000 (2.2465)
= $2,465
Year
CF-AT
0
1-3
6-10
DF@10.5% PV
0
1000
2.465123
2465
2465
PV = CF * DFp
PV = 70 * (1/.10)
= 70 * (10)
= 700
6-11
70
70
70
6-12
100
200
300
1000
1000
1000
70
70
..
.
481
6-13
100
200
300
1000
1000
1000
70
70
100
200
300
1000
1000
1000
70
70
2487
700
..
.
481
2487
Year
CF-AT
700
4
DF@10%
PV
481
481
2487
0.7513
1868
700
0.5645
395
2744
6-14
100
200
300
1000
1000
1000
70
70
Year CF-AT
DF@10% PV
100
0.9091
91
200
0.8264
165
300
0.7513
225
1000
1.8684
1868
70
5.6447
395
4-6
7-inf
2744
Annuity
Ann-diff
6-15
DFA
0.1
4.3553
0.1
2.4869
1.8684
Annuity
0.1
Perp
6
n
0.1 inf
Ann-prep-diff
DFA
4.3553
DFp
10
5.6447
Capital Budgeting
Techniques
6-16
Potential Difficulties
Capital Rationing
Project Monitoring
Post-Completion Audit
Project Evaluation:
Alternative Methods
Average Rate of Return
Payback Period (PBP)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)
Advanced Techniques
Discounted PBP, NTV, MIRR, APV
6-17
Project Types
Independent
A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration. project
do not compete with each other
Dependent
Mutually
6-18
-40
10
2
12
15
10
5
7
-40
(-b) 10
10
12
22
Cumulative
Inflows
6-21
PBP
3 (a)
15
37
(c)
4
10 (d)
47
=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years
5
7
54
In case of annuity
PBP = ICO / [CFi (single)] (years)
PBP = 600 / 200 = 3 years
6-23
-600
200
200
200
200
PBP Strengths
and Weaknesses
Strengths:
Weaknesses:
Can be used as a
measure of
liquidity
Easier to forecast
ST than LT flows
Cutoff period is
subjective
6-24
Lecture 6:
Net Present Value: NPV is the
CF1
NPV =
(1+k)1
6-25
CF2
(1+k)2
CFn
- ICO
+...+
n
(1+k)
NPV0,
NPV+,
NPV-,
6-26
NPV Solution
BW has determined that the appropriate
discount rate (k) for this project is 13%.
-40000
40000
10000
12000
15000
10000
7000
PV of C/Fo ?
PV of C/Fi ?
Year
6-27
CF-AT
38577
DF@13%
PV
-40000
-40000
10000
0.885
8850
12000
0.7831
9397
15000
0.6931
10397
10000
0.6133
6133
7000
0.5428
3800
NPV
-1423
NPV Strengths
and Weaknesses
Weaknesses:
Strengths:
Cash flows
assumed to be
reinvested at the
hurdle rate.
Considers all
cash flows.
6-29
$000s
15
10
5
IRR
NPV@13%
0
-4
6-30
Sum of CFs
6
9
12
Discount Rate (%)
15
CF1
PI =
(1+k)1
CF2
CFn
+...+
2
(1+k)
(1+k)n
<< OR >>
Method #2:
6-31
PI = 1 + [ NPV / ICO ]
ICO
PI Acceptance Criterion
PI = $38,577 / $40,000 = .9644 (Method #1)
PI = 1 + (-1423)/ 40,000 = .9644 (Method #2)
Should this project be accepted?
No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
6-32
PI Strengths
and Weaknesses
Strengths:
Weaknesses:
Same as NPV
Same as NPV
Allows
comparison of
different scale
projects
Provides only
relative profitability
Potential Ranking
Problems
6-33
+...+
CFn
(1+IRR)n
IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
6-35
6-36
30000
1
P:6.4
n=
CFi
CFo
IRR
4
30000
10000
0.316074
For Annuity
Calculate DF = CFo / Annuity
ii.
Locate two DFs close to DF in
PVIFA table under year n
iii. Interpolate IRR as:
LDR + (DRs) (LDF DF) / (LDF HDF)
or
HDR - (DRs) (DF HDF) / (LDF HDF)
i.
6-37
5000
5000
5000
5000
PVIFA
LDF
(i) DF
Or
0.3 LDR
2.000
HDF
6-38
2.166
Rate
IRR
1.849
0.4 HDR
IRR
IRR
Now
we Check,
whether NPV
becomes 0, at
35.24%.
Yes
0.
6-39
it is near to
Annuity
Year
0.3524
CF-AT
DFA
4
DF@35.24%
1.9894
PV
-10000
-10000
5000
1.9894
9947
1-4
NPV
-53
i
Annuity
Year
0.349
CF-AT
0
1-4
DFA
4
2.0001
DF@35.24% PV
-10000
-10000
5000
2.0001
10001
NPV
Lecture 7
Annuity
Year
DFA
0.3
CF-AT
0
1-4
4
DF@30%
2.1662
PV
-10000
-10000
5000
2.1662
10831
NPV
i
Annuity
831
n
4
Diff
0.3
Fraction
0.05
IRR
0.98227 0.3491
OR
DFA
0.35
LDR
HDR
1.9969
Diff
0.35
Fraction
0.05
IRR
0.01773 0.3491
Check
Year
CF-AT
0
1-4
DF@35%
-10000
-10000
5000
1.9969
9985
NPV
6-41
PV
-15
Annuity
Year
0.3491
CF-AT
0
1-4
-10000
5000
NPV
DFA
4 1.9998
DF@35.91% PV
1 -10000
1.9998
9999
-1
i.
ii.
iii.
iv.
v.
vi.
vii.
6-42
6-43
-40000
10000
12000
15000
10000
7000
step 1
FA
10800
step 2
DF
3.7037
step 3
in PVIFA
step 4
Adjustment in k= 0
step 5
Find NPV at k=
3.696 Rate=k=
0.11
0.11
step 5
Year
step 6
CF-AT
0.11 PV
Check
0.16 PV
0.1151 PV
-40000
-40000
-40000
-40000
10000
0.9009
9009
0.8621
8621
0.8968
8968
12000
0.8116
9739
0.7432
8918
0.8042
9650
15000
0.7312
10968
0.6407
9611
0.7212
10818
10000
0.6587
6587
0.5523
5523
0.6468
6468
7000
0.5935
4155
0.4761
3333
0.58
4060
NPV
458 NPV
-3994 NPV
-36
step 6
step 7
LDR
0.11 NPV
458
HDR
0.16 NPV
-3994
LDR
6-44
Diff
0.11
Fraction
0.05
0.102875
IRR
0.1151
P:6.3
Year
6-46
Net C/F
- Depr.
= CF_BT
- Tax
Inc. C/F
8000
5600
2400
816
7184
8000
8960
-960
-326
8326
8000
5376
2624
892
7108
8000
3226
4774
1623
6377
8000
3226
4774
1623
6377
8000
1612
6388
2172
5828
8000
8000
2720
5280
step 1
FA
6640
step 2
DF
4.2169
step 3
in PVIFA
step 4
Adjustment in k
step 5
Find NPV at k=
0.14
4.288 rate = k =
0.14
step 5
step 6
Year
CF-AT
.14 PV
0.19 PV
0.1581 PV
-28000
-28000
-28000
-28000
7184
0.8772
6302
0.8403
6037
0.8635
6203
8326
0.7695
6407
0.7062
5880
0.7456
6208
7108
0.675
4798
0.5934
4218
0.6438
4576
6377
0.5921
3776
0.4987
3180
0.5559
3545
6377
0.5194
3312
0.419
2672
0.48
3061
5828
0.4556
2655
0.3521
2052
0.4145
2416
5280
0.3996
2110
0.2959
1562
0.3579
1890
NPV
1360 NPV
-2399 NPV
-101
step 6
0.19
step 7
LDR
0.14 NPV
1360
HDR
0.19 NPV
-2399
LDR
6-47
Check
Diff
0.14
Fraction
0.05
0.361798
IRR
0.1581
IRR Strengths
and Weaknesses
Strengths:
6-48
Accounts for
TVM
Considers all
cash flows
Less
subjectivity
Weaknesses:
Assumes all cash
flows reinvested at
the IRR
smaller project may
have higher IRR, but
overall do not change
firm value.
Difficulties with
project rankings and
Multiple IRRs
Evaluation Summary
BW Independent Project
6-49
PBP
3.3
3.5
Accept
IRR
11.51%
13%
Reject
NPV
-$1,423
$0
Reject
PI
.96
1.00
Reject
Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
6-50
A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR
6-51
-$100
-$100,000
$400
$156,250
Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?
6-52
Project
IRR
100%
25%
NPV
PI
231
3.31
$29,132
1.29
6-53
0
1
-$1,200
1,000
-$1,200
100
500
600
100
1,080
6-54
IRR
NPV
PI
23%
$198
1.17
17%
$198
1.17
6-55
0
1
-$1,000
0
-$1,000
2,000
3,375
6-56
Project
IRR
NPV
PI
50%
$1,536
2.54
100%
$ 818
1.82
Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.
6-57
ICO
$
500
5,000
5,000
7,500
12,500
15,000
17,500
25,000
IRR
18%
25
37
20
26
28
19
15
NPV
$
PI
50 1.10
6,500 2.30
5,500 2.10
5,000 1.67
500 1.04
21,000 2.40
7,500 1.43
6,000 1.24
ICO
IRR
NPV
PI
$ 5,000
15,000
12,500
5,000
37%
28
26
25
$ 5,500
21,000
500
6,500
2.10
2.40
1.04
2.30
ICO
$15,000
17,500
5,000
IRR
NPV
PI
28%
19
25
$21,000
7,500
6,500
2.40
1.43
2.30
ICO
IRR
NPV
PI
$15,000
5,000
5,000
7,500
17,500
28%
25
37
20
19
$21,000
6,500
5,500
5,000
7,500
2.40
2.30
2.10
1.67
1.43
Summary of Comparison
Method Projects Accepted
Value Added
PI
F, B, C, and D
$38,000
NPV
F and G
$28,500
IRR
C, F, and E
$27,000
Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.
CF-AT
DF@25%
PV
-800
-800
5000
0.8
4000
-5000
0.64
-3200
NPV
Year
CF-AT
DF@400%
PV
-800
-800
5000
0.2
1000
-5000
0.04
-200
NPV
6-65