Investment Decisions Present Value - PowerPoint PPT Presentation

1 / 38

Investment Decisions Present Value. Assessing investment opportunities Present Value & Net Present Value (NPV) Risk and Present Value Different types of investments To make an investment or not ? Choice between different investments Internal Rate of Return (IRR) Pay-back period (PBP)

Related searches for Investment Decisions Present Value

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

Investment Decisions Present Value

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Investment DecisionsPresent Value

• Assessing investment opportunities

• Present Value & Net Present Value (NPV)

• Risk and Present Value

• Different types of investments

• To make an investment or not ?

• Choice between different investments

• Internal Rate of Return (IRR)

• Pay-back period (PBP)

• Which method is most suited ?

Assessing Investment opportunities

• Is it interesting to make an investment ?

• Example

• I can buy an house for 40.000 US\$ ...

• .. and sell the house after one year for 42.000 US\$

• Apparently the answer is ... YES it is interesting

• I make a profit of 2.000 US\$

• BUT : I had an alternate investment possibility

• to put the money on a saving account

• with an interest rate of 10%

• and make a profit of ... 4.000 US\$

Future Value of Money

• The basic principle is that the Future Value of money is higherthan its Present Value

• if C0is the amount today

• and ifiis the market interest rate

• we can calculate the future value of this amount after one year

• FV1(C0) = C0.(1+i)

• The Future Value of money is equal to

• The initial amount

• Plus the interest on this initial amount

Future Value of money

• We can use the same principle for longer periods

• We can calculate the Future Value of C0 after 2 years

• FV2(C0) = C0.(1+i)2

• be cautious : compounded interest

• it does mean that we calculate the interests on the interests

• or after ... n years

FVn(C0) = C0.(1+i)n

Future Value of money

• Example 1

• The Future Value of 40.000 US\$

• If the market interest rate is equal to 10%

• After 4 years

• FV4(40.000US\$) = 40.000.(1+0,10)4 = 58.564 US\$

• Example 2

• Calculate the Future Value of 1.200 MDong

• If the market interest rate is equal to 18%

• After 3 years

Net Future Value

• We can now define the Net Future Value of an investment

• It is equal to the difference between

• The Future Cash flow generated by the investment

• And the Future Value of the money invested in year 0

• For an initial investment C0

• If C1 is the Cash flow generated after one year

• We can calculate the Net Future Value after 1 year

NFV1(C0) = C1 - C0.(1+i)

Net Future Value

• The Net Future Value

• Can be positive

• it is better to make the investment than to put the money on a saving account

• Can be negative

• do not make this investment

• put your money on a saving account

• Example

• calculate the NFV of the house

• I could buy for 40.000 US\$ and

• Sell after one year for 42.000 US\$

• i=10%

• NFV1(house) = 42.000 - 40.000.(1+0,1) = - 2.000 US\$

Present Value of money

• We can do the reasoning the other way round and calculate the Present Value of future amounts of money

• The basic principle is that the Present Value of money is lower than its Future Value

• If C1is the amount in one year

• And if i is the market interest rate

• We can calculate the Present Value of C1

PV(C1) = C1 / (1+i)

Present Value of money

• We can use the same principle for longer periods

• We can calculate the Present Value of a Cash flow C2 within 2 years

• PV(C2) = C2 / (1+i)2

• ... or the PV of a Cash flow Cn after n years

• PV(Cn) = Cn / (1+i)n

• The interest rate used to calculate the PV is called the discount rate

Net Present Value

• We can now define the Net Present Value of an investment

• It is equal to the difference between

• The Present Value of the Cash flow generated by the investment

• The initial amount of money invested

• For the initial investment C0

• If C1 is the Cash flow generated after one year

• We can calculate the Net Present Value

NPV = C1 / (1+i) - C0

Net Present Value

• The Net Present Value

• can be positive

• it is better to make the investment than to put the money on a saving account

• can be negative

• do not make this investment

• put your money on a saving account : you will earn more

Net Present Value

• We can also extend the calculation to many periods and many Cash flows

• For the initial investment C0

• IfC1is the Cash flow generated after one year, C2after 2 years, ... Cj after j years

• we can calculate the Net Present Value

NPV = C1 / (1+i) + C2 / (1+i)2 + C3 / (1+i)3 + . . . + Cj / (1+i)j + ... - C0

Net Present Value

• Example : Calculate the Net Present Value of

• an investment to buy an house for 40.000 US\$ at t = 0

• generating the following rents

• 3.200 US\$ at t = 1

• 3.700 US\$ at t = 2

• 3.850 US\$ at t = 3

• 4.100 US\$ at t = 4

• 5.000 US\$ at t = 5

• and sold for 57.500 US \$ at t = 6

• if the discount rate i = 9%

• Do you buy the house ?

Present Value Special Cases

• It can be proved that the Present Value of an infinite series of constant Cash flows (C= C1 = C2 = C3 = ...) is equal to this annual Cash flow divided by the discount rate

PV = C / i

Present Value Special Cases(Gordon-Shapiro formula)

• The Present Value of an infinite series of Cash flows growing at an annual constant rate can also be calculated

• the Cash flow of year 1, C1, is equal to C

• the growth rate is g

• C2 = C.(1+g)

• C3 = C.(1+g)2

• C4 = C.(1+g)3

• . . .

PV = C / (i – g)

Risk and Present Value

• Until now we used as discount rate the market interest rate (i)

• This rate is basically the “risk free” interest rate

• interest rate for Government debt

• But the investments we will analyze are not “risk free”

• Most future Cash flows are uncertain

• We have to consider the risks related to the future Cash flows

• It is logical to use an higher discount rate for an investment in a risky project

• There is a risk to achieve lower Cash flows than expected or even to lose all the Cash flows

• This higher risk must be balanced by an higher discount rate (higher return is needed to compensatepossible losses)

Risk and Present Value

• So to calculate the NPV of a risky project it is logical to use an higher discount rate than the “risk free” interest rate

• r > i

• If the future Cash flows are absolutely safe then the discount rate can be the “risk free” interest rate

• The higher the risk the higher the discount rate

• A more risky dollar within one year is worth less than a safer dollar within one year

Risk and Cost of capital

• For each company or even for each project there is a specific discount rate (Cost of Capital)

• It depends from the risk associated to the company or to the project

• The difference between the discount rate of a project and the “risk free” interest rate is called the risk premium

How high is the risk premium ?

• It can be observed on the financial markets

• 2% to 4% depending on the period of time

• varies from industry to industry

• inside the industry varies from company to company

• between 1% and . . . 20% ... and more

• Each specific project has its own risk premium

• Basically the risk premium of the company

• To be be increased if the risk is higher than average

• high risk of failure (research, oil exploration)

• To be lowered if the risk is lower than average or for strategic reasons

• consolidation of position (market share, eliminate new entrant)

• long-term vision

To make an investment or not ?

• The decision to make or not to make an investment is mainly a financial one . . .

• The investment must bring a return

• NPV > 0

• The company must be able to finance the project

• existing cash

• new debt

• paid-in capital increase

• There will always be money to finance a sound project

To make an investment or not ?

• other aspects must considered with a valuable financial impact

. . . or not

• Strategy

• Opportunities and . . . missed opportunities

• Barriers for new entrants

• Quality

• Image

• Location

• Visibility or presence on the market

• Safety

• Regulations

• Environment, etc.

• Social aspects

• Working conditions

• Loyalty of employees and management

To make an investment or not ?

• The big risk is that other criteria . . .

• . . . may lead to decide to make unprofitable or poorly profitable investments

• It can become dangerous if it happens often or for big amounts

• “the Ego syndrome”

• Sanction by the market or by the shareholders

Choice between different investments

• In most cases there is a choice to do between different projects

• different new products to launch

• different new locations for a new factory

• different new machines for the same process

• The choice must be based on facts and not on impressions

• avoid decision criteria like :

• “I feel that . . .”

• “Believe my experience . . .”

• The best fact is a serious financial assessment

Choice between different investments

• Different types of choice :

• Mutually exclusive investments

• different solutions for the same problem

• machine 1 … or machine 2 … or machine 3

• Ranking of different opportunities

• they can be done simultaneously

• the risks are similar

• there is enough money to do more than one project

• but which one is the most profitable ?

• To make or not to make small capex proposed by the production manager

Mutually exclusive investments

• The company has the choice between different solutions to solve one problem

• There is no budget constraint

• But you want to choose the best solution

• Depending on the Cost of Capital of the company

 Use tne NPV of each project and choose the highest NPV

Saigon hotel : an example of investment choice

• To renovate the 130 rooms there are 3 alternatives

• « Light Solution »

• Capex of 3.000 US\$/room (total 0,39 Mio US\$)

• Same amount to be reinvested every 5 years

• Unit rate increase of 6 US\$ (from 80 US\$)

• No change in occupancy : 30.000 nights/year

• « Medium Solution »

• Capex of 20.000 US\$/room + 0,4 Mio US\$ for lobby (total 3 Mio US\$)

• Valid for 10 years

• Unit rate increase of 12 US\$ (from US\$)

• Higher occupancy : 33.000 nights/year

• Additional margin per night 72 US\$ (60 initial + 12 unit rate increase)

• « Heavy Solution »

• Capex of 30.000 US\$/room + 2,1 Mio US\$ (lobby & pool) (6 Mio US\$)

• Valid for 10 years + Terminal value of 1 Mio US\$ (pool)

• Luxury hotel : unit rate increase of 24 US\$

• Higher occupancy : 33.000 nights/year

Saigon Hotel : Cash flow analysis (000 US\$)

DCFsaigonhotel.xls - DATA!A1

Saigon Hotel : the decision

• By using the NPV method which alternative will you choose ?

• if the Cost of capital is 10 % ?

• if the business is more risky and the Cost of capital is 15 % ?

• if the business is less risky and the Cost of capital is 8 % ?

• Calculation of NPV (Excel formula NPV)

• NPV(discount rate;data)

• Be careful

• In the formula the 1st data is after 12 months

• The data of Y1 should not be discounted

• The data of Y0 must be out of the formula

• NPV = -C0 + NPV(discount rate;C1:C10)

DCFsaigonhotel.xls - NPV1!A1

Saigon Hotel : the decisionInvestment Table (000 US\$)

DCFsaigonhotel.xls - NPV2!A1

Internal rate of return (IRR)

• NPV is useful but

• Uncomplete if you want to rank different projects in competition when your budget is limited

• The NPV says : GO or DO NOT GO (NPV>0)

• The NPV says : This project gives the highest result for each Cost of Capital independently of the size

• But you do not know which project gives the best ROCE

• Introducing the Internal Rate of Return (IRR)

• It is the value of the Cost of Capital bringing the NPV of the project to exactly zero

• 0 = C1/(1+IRR) + C2/(1+IRR)2 + ... + Cj/(1+IRR)j + ... - C0

Internal rate of return (IRR)

• How to calculate the IRR ?

• Iterative process

• is it higher than 0 % and lower than 20% ?

• is it higher than 1% . . . 2% . . . 3% . . . ?

• is it lower than 19% . . . 18% . . . 17% . . . ?

• On most calculators a standard formula

• Excel

• Goal seek : NPV = 0

• function IRR

Saigon Hotel : IRR calculation

DCFsaigonhotel.xls - IRR!A1

Use of IRR to decide on investments

• All projects with IRR higher than Cost of Capital are financially interesting

• If different projects are in competition and if the budget is limited, the most interesting projects are the projects with the highest IRR’s

• They can be ranked

• All projects with IRR lower than the Cost of Capital are financially uninteresting

if IRR < r : DO NOT INVEST IN THE PROJECT

Pay-back period

• The Pay Back Period is the number of years necessary to have a positive NPV for an investment

• The PBP is the lowest value of N so that

C1/(1+r) + C2/(1+r)2 + ... + CN/(1+r)N - C0 > 0

• The Pay Back Period is a very useful tool to decide rapidly if it is worth to do a small investment proposed by a local manager

• If Pay Back Period is short (max 4 years) : OK

Conclusions of the Lesson

• The Future Value of money is equal to

• The initial amount

• Plus the compounded interest on this initial amount

• The Present Value of a future Cash Flow is calculated using a discount rate r

• PV(Cn) = Cn / (1+r)n

• The Net Present Value is equal to

• The PV of the Cash Flows generated by the investment

• Less the initial amount of money invested

Conclusions of the Lesson

• Investments must be decided on the base of

• Financial criteria

• If justified other criteria

• Long term Strategy

• Quality (not always with direct financial return)

• Safety

• Regulations (environment, social protection, etc.)

• Choice must be based in any case on factsnot on impressions

• It is logical to use an higher discount rate for an investment in a more risky project

• The difference between the discount rate of a project and the “risk free” interest rate is called the risk premium

• The risk related to one project can vary from person to person

• The lower the discount rate the more interesting are the capital intensive projects

Conclusions of the LessonWhich method is most suited ?

• To decide not to invest in a project

• NPV < 0

• IRR < r

• To make a choice between mutually exclusive projects

• highest NPV

• To make a ranking of competing projects if the budget is limited

• Ranking by IRR (1st = higher IRR)

• To decide on small marginal capex

• Short Pay-Back Period (4 years)

• Never forget the residual value of the investments !