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Finance I

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Finance I

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  1. Finance I October 10 Qinglei Dai for FEUNL, 2006

  2. Topics covered • Capital budgeting: decision-making process for accepting or rejecting projects • Various methods • NPV • Internal rate of return Qinglei Dai for FEUNL, 2006

  3. Net Present Value Net Present Value Opportunity Cost of Capital Qinglei Dai for FEUNL, 2006

  4. Net Present Value Example Q: Suppose we can invest $50 today & receive $60 later today. What is our increase in value? Qinglei Dai for FEUNL, 2006

  5. Net Present Value Example Suppose we can invest $50 today and receive $60 in one year. What is our increase in value given a 10% expected return? Qinglei Dai for FEUNL, 2006

  6. NPV method • The NPV rule: • Value-additivity: Qinglei Dai for FEUNL, 2006

  7. Net Present Value Example You have the opportunity to purchase an office building. You have a tenant lined up that will generate $16,000 per year in cash flows for three years. At the end of three years you anticipate selling the building for $450,000. How much would you be willing to pay for the building? Qinglei Dai for FEUNL, 2006

  8. Net Present Value Example - continued If the building is being offered for sale at a price of $350,000, would you buy the building and what is the added value generated by your purchase and management of the building? Qinglei Dai for FEUNL, 2006

  9. IRR method • Internal Rate of Return (IRR): • Basic IRR rule: Qinglei Dai for FEUNL, 2006

  10. IRR method • Example: suppose a certain project brings a cash flow series of • t=0, c=-200 • t=1, c=100 • t=2, c=100 • t=3, c=100 What is the IRR for the project? Should we accept the project when the discount rate is 20% (30%)? Qinglei Dai for FEUNL, 2006

  11. IRR method • When r=20%, • When r=30% Qinglei Dai for FEUNL, 2006

  12. Problems with IRR • Independent project: • Mutually exclusive projects: • 2 general problems of IRR for both of independent projects and mutually exclusive projects • 2 specific problems of IRR for mutually exclusive projects Qinglei Dai for FEUNL, 2006

  13. Problems with IRR • 1st general problem with IRR: when the cash inflows occur before the cash outflows • Example: • t=0, c=100; t=1, c=-130 Qinglei Dai for FEUNL, 2006

  14. Problems with IRR • investing-type project: • Financing-type project: Qinglei Dai for FEUNL, 2006

  15. Problems with IRR • 2nd general problem with IRR: multiple rates of return with “flip-flop” cash flows • Example: a project with cashflows of (-100, 230, -132) Qinglei Dai for FEUNL, 2006

  16. Problems with IRR • How to solve the above problem? • NPV rule: • Modified IRR (MIRR) Qinglei Dai for FEUNL, 2006

  17. MIRR • Example: cash flow stream (-100, 230, -132), r=14% Qinglei Dai for FEUNL, 2006

  18. Problems with IRR • 1st specific problem with mutually exclusive projects: the scale problem • Example: r=25% Qinglei Dai for FEUNL, 2006

  19. Problems with IRR • How to adjust for this deficiency? • Incremental IRR: Qinglei Dai for FEUNL, 2006

  20. Incremental IRR Qinglei Dai for FEUNL, 2006

  21. Problems with IRR • 2nd specific problem with mutually exclusive projects: timing problem Qinglei Dai for FEUNL, 2006