Just something I made to help me remember the course of Corporate Finance more clearly,

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Just something I made to help me remember the course of Corporate Finance more clearly,

Attribution Non-Commercial (BY-NC)

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A little bit of theory at first: After a course of Corporate Finance and I know that some of you are so eager to apply the calculation methods to assess whether your studying is profitable, or not. The same thing might occur to anyone about whether a particular decision will yield enough return to justify the initial investment (which will be treated strictly on the monetary sense). In this small topic, we will try to calculate your studying and then expand it for every decision that you have to make somewhere in the future from the financial point of view. First, lets revise a bit if before you want to calculate the IRR of your studying. Theoretically, calculating the Net Present Value (NPV) and Internal Rate of Return (IRR) are the two popular methods to conduct initial assessment on any investment decision. However, even if you may know how to apply them to your studying, there are some certain inherent problems that we need solving first: Problem 1: A bit of a discussion about NPV. The theory is simple enough, you just project your future cash flows annually (or semiannually or monthly if you really really want to crunch the data), then discount (move back) these future cash flows to the present to find the NPV by the cost of capital. The mathematical expression would look like this:

Where NPV: Net Present Value. : Cash flow at year n. : Cost of Capital at year n.

With NPV > 0, your studying is worthwhile and you should go ahead with your plan. Otherwise, its a no go since the discounting stream of cash flows could not compensate the initial investment. However, problems with this model are 1/ You cannot know exactly how you will earn these cash flows, 2/ You cannot apply the Cost of Capital through each periods of time. To address the problem with the , we could use the Weighted Average Cost of Capital (WACC), which effectively change the mathematical form into something a bit more manageable:

Reasonably, with this model, you best shot is to make some assumptions about the and WACC and with the help of financial modeling and Excel, hopefully you could get a glimpse of what your future looks like. Problem 2: The IRR sounds really itimidating at first, but the principal is somewhat familiar with above. We change the above equation a bit by setting the NPV equal to 0 and with a given set of cash flows, try to figure out the IRR (which replaces the ). The mathematical model will look like this:

With a given set of future cash flows, your assignment will be to find the IRR (by using linear interpolation or Excel) that set the NPV to 0 and then compare that value of IRR to the expected Cost of Capital. If IRR > Cost of Capital, your studying adds value and otherwise, your studying is a waste of time. Simple enough? Not really, please do not be happy just yet. Further assessment with the IRR shows that it is a problematic indicator. For instance, one of the fundamental rule of the IRR is that it could only work if you initiate an investment with negative cash flows precede positive cash flows. Apply to your studying plan or any of your investment, it may lead to: Contradicting information with NPV (IRR > Cost of Capital but NPV < 0). Multiple IRR or no IRR at all.

The conclusion gives a short answer to your question: No, we cannot use IRR alone to assess our studys financial feasibility. The long answer however, is that yes, you can conduct an initial assessment of your studying with the combination of NPV, IRR and other methods at your disposal. Construct a Model for your calculation: Timeline and the effects of Compounding and Discounting: I will not be irresponsible here and let you struggle to figure out how to calculate everything by you own. After all, I am not a CFA Charterholder but this is not exactly rocket science either. First, we need to build a simple time line for your studying plans. Let say that your studying costs $10,000 annually and last for 4 years with the Cost of Capital is 5%: -$10k -$10k -$10k -$10k

A----------------A----------------A----------------A----------------A Simple enough, now suppose the school offer you two methods of payment

You to pay a lump sum of $40k at the start of the first semester for all your studying. Or you pay at the start of each semester for $10k. Or you have the third choice of depositing all the $40k to the bank for 4 years (Bill Gates quit school after all, right?).

For the lump sum of $40k, you pay it right here right now, so immediately you are in the red (that is, you are bleeding cash) of -$40k. After all, some folks just wanna pay the sum right at the start and be done with it. Who are we to judge, its their money, anyway. For the second option, things get really interesting here. You move each $10k payment all the way back to the first period (that is, you move all of your future cash flows back to the present), which we call discounting. So what is the present value of the 4 installments?

You could see that the value of 4 installments is smaller than a lump sum. The reason is the effect of discounting the cash flows which stack up throughout the years. If you decide to study and the school does not change its tuition policy than this option is more desirable for you. For the third option, you decide to deposit all the money to the bank to earn the interest rate of 5%, which may be a good decision anyway. The thing is to find the sum of money at year 4, presumably, you move all the cash flows to the future, which we call compounding. The result is:

At the end, you are without a degree but end up with a slightly larger purse which you could use for any other purposes. This is the alternative (or the next best thing) if you want to compare the opportunity cost of going to college. Notice that with a bigger Cost of Capital, your alternative option looks more attractive. You could verify by assigning a higher Cost of Capital (about 18% more or less if you are in Vietnam). So far, we have constructed a simple timeline for your studying and demonstrate the compounding and discounting effect of the money on the timeline. If we limit our perspective and treat the studying as a stand alone project, apparently, you are bleeding cash from the start to the end of it, thats the beauty of going to school. However, in the next section, by building a layer upon layer of different projects with the appropriate cash flows, you could trace back the NPV value to get the whole picture of your studying.

Constructing your life, financially: Lets use the above example and assume that you have to pay the first installments today. We then add a little bit extra of variables to your life by presuming that you are currently have a part time job of flipping burgers at MessyJoe fast food restaurant. We keep things simple at first and gradually introduce some new elements to your life later.

Please notice that the cash flows in the future have been discounting to the present values (at Year 1). Good luck flipping burgers, dude, youre still swimming in the red, hard. Now, on the bright side, your family agrees to finance the studying plan with an additional positive cash flow of $3000 at year 1 plus 10% more every year to compensate for the inflation. Normally, we can compute this by applying the equation of growing annuity but we only calculate for 4 years and dont want things to be complicated, just yet. So, you dads generosity will translate into $3,000; $3,300; $3,630 and $3,993 respectively in Year 1, 2, 3 and 4 which results in:

PV ($37,232.4 8) 18616.240 15 $12,884.68 ($5,731.56 ) Year 1 ($10,000.0 0) 5000 3000 Year 2 ($9,523.8 1) $4,761.9 0 $3,142.8 6 Year 3 ($9,070.2 9) $4,535.1 5 $3,292.5 2 Year 4 ($8,638.3 8) $4,319.1 9 $3,449.3 0

Please notice that the cash flows in the future have been discounting to the present values (at Year 1). Your dad saves the day by making the table seems much more breathable. Notice that the Part time 1 cash flows are declining due to the effect of discounting (5% every year) while the other cash flows appreciate more value in the future since your dad offers an additional 10% (versus 5% of the Cost of Capital) every year which compensate the discounting effect and grows gradually in the future.

From now and you have many options to select regarding your future cash flows. You could try to solidify your cash flows by taking another job with a better paying, or you could kiss your dads shoes for additional cash flows in the future. The idea here is that every time you detect there is an opportunity, you could use a spreadsheet to have an overall perspective to see how your NPV is affected, positively or negatively. Additionally, you could try to conduct different models such as IRR (for stand alone investment), time needed for cumulative cash flows and peak funding requirements or even Profitability index, which are complimentary to one another just to be sure about your investment. Using the IRR appropriately: You decide to go to college and find another part time job with a reasonable salary of $12,000 per year at your college as an assistant. By default, we could treat this whole shebang as a single investment and because you decide to pay $40,000 lump sum, you could get $12,000 per year at your own pace. Please be reminded that your payment will comes at the end of the first year (the start of the second year). The timeline will be like this: -$40K A----------------A----------------A----------------A----------------A $12k $12k $12k $12k

We have already calculated the PV of the tuition fees to be -$40k. Now we need to figure out the PV of the annual salaries of $12K to see how this amount of money could stack up against the PV of the tuition. The following table shows the result as:

PV ($40,000.0 0) $42,551.41 $2,551.41 Year 1 ($40,000.0 0) $11,428.5 7 Year 2 $10,884.3 5 Year 3 $10,366.0 5 Year 4 $9,872.4 3

School TA NPV

After a bunch of excruciatingly torturous time crunching the IRR using the infamous linear interpolationJust kidding, I am using Excel with the IRR = 7.71% (versus Cost of Capital of 5%) so the decision is take the offer because its profitable (in term of NPV and IRR). The margin here is 7.71% - 5% = 2.71% indicates the maximum

estimation error in the cost of capital that can exist without changing the initial decision. However, this assignment loosens the constraints by treating two different aspects as one investment (that is, by combining the tuitions and the payment into one project). In practice however, please refrain from using this practice and apply IRR for stand alone project with the specified constraints only. Conclusion: So that is, this is the simplest way to model your life through Excel financially. You could do it on your own and modify it to suit your business preferences and characteristics. These methods are not really sophisticated and can be reasonably model on an Excel spreadsheet provided that you know how to construct an appropriate timeline and objectively utilize your data instead of being overly optimistic (like a simpleton). We will try to cover some more sophisticated models like a decision of marrying another person or a mortgage for 30 years (currently a bad idea) somewhere in the future, hopefully. P/S: The elements introduce in the timeline are compute via discounting and compounding each value, which are the simple but not very convenient ways of calculation. You could try and introduce the equations of Annuity, Perpetuity, Growing Annuity and Growing Perpetuity into the models to see how it reacts toward the NPV. For the formulas, they are all over the net at your convenience. My apologize for any mistake I made in this note. If you detect one, please notify me and Ill fix it right away and giving you credits for it, I swear.

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