Corporate Finance (MAIB FIN 101) Aug 2022

Unit 3
Valuation of future cash flows
Time value of money
Present Value and discounted cash flow
Multiple cash flows
Capital budgeting
Investment criteria
Net Present Value
Payback Period
Average Accounting Return
IRR
Project selection
Annuities and Perpetuities

Corporate Finance (MAIB FIN 101) Aug 2022 1

 Time Value of Money

• A dollar today is worth more than a dollar tomorrow

• Suppose you invest $100 in a bank account that pays interest of r = 7% a year.

• In the first year, you will earn interest of .07 * $100 = $7 and the value of your
investment will grow to $107:
• Value of investment after 1 year = $100 * ​(1 + r) = $100 * 1.07 = $107

• By investing, you give up the opportunity to spend $100 today, but you gain the chance
to spend $107 next year

• If you leave your money in the bank for a second year, you earn interest of .07 . $107 =
$7.49 and your investment will grow to $114.49:
• Value of investment after 2 years = $107 * 1.07 = $100 * ​(1.07)^ 2 = $114.49
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Time Value of Money

• Notice that in the second year you earn interest on both your initial investment ($100)
and the previous year’s interest ($7). Thus, wealth grows at a compound rate and the
interest that you earn is called compound interest.

• If you invest your $100 for t years, your investment will continue to grow at a 7%
compound rate to
$100 * (1.07)^t

For any interest rate r, the future value of your $100 investment will be
• Future value of $100 = $100 *​(1 + r)^ t

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Present Value and Discounted Cash Flow

• How much you need to invest today to produce $114.49 at the end of the second year. In other
words, what is the present value (PV) of the $114.49 payoff?

Present value = PV = = $100

• In general, suppose that you will receive a cash flow of dollars at the end of year t. The present
value of this future payment is

Present value = PV =

• The rate, r, in the formula is called the discount rate, and the present value is the discounted
value of the cash flow,
• The expression 1/(1 + r)^t is called the discount factor. It measures the present value of one
dollar received in year t.
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Multiple Cash Flows
FUTURE VALUE WITH MULTIPLE CASH FLOWS
• Suppose you deposit $100 today in an account paying 8 percent interest. In one year,
you will deposit another $100. How much will you have in two years?
IN ONE YEAR : 100 *(1.08) +100 = $ 208
IN TWO YEARS: 208*(1.08) = $ 224.64

ALTERNATIVELY, WE CAN CALCULATE AS FOLLOWS:

IN TWO YEARS: 100 *(1.08)^2 + 100*(1.08) = $ 224.64
• There are two ways to calculate future values for multiple cash flows:
• (1) Compound the accumulated balance forward one year at a time
• (2) Calculate the future value of each cash flow first and then add them up

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Multiple Cash Flows

PRESENT VALUE WITH MULTIPLE CASH FLOWS

• Suppose you need $1,000 in one year and $2,000 more in two years. If you can earn 9 percent
on your money, how much do you have to put up today to exactly cover these amounts in the
future?
• PRESENT VALUE = = $2600.79

• TO CHECK: $2600.79 invested for one year at 9% interest rate earns $2600.79*(1.09) =
$2834.86

• Take out $1000 dollars, so left with $1834.86 at end of first year

• Invest for another year to get $1834.86*(1.09) = $ 2000

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Multiple Cash Flows

PRESENT VALUE OF AN ANNUITY

Present value of an annuity of C dollars per period for t periods when the
rate of return or interest rate is r is given by:

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Annuities and Perpetuities

• Annuity
•  Financial product that pays out a fixed stream of payments to an individual
• How to value Annuities
• Present value of t-year annuity =
• Annuity Future Value Factor =
• Here C is the annual cash flow and r is the interest rate
• Perpetuity
• A perpetuity is a security that pays for an infinite amount of time.
• How to value Perpetuities
• PV = =

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Capital Budgeting
• Refers to the decision-making process that companies follow with regard
to which capital-intensive projects they should pursue.
• There are 5 major investment criteria for capital budgeting:
• Net Present Value
• Internal Rate of Return
• Profitability Index
• Accounting Rate of Return
• Payback Period

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Net Present Value
• It is the net cash flow that an investment generates in present value terms

• Consider Project X which generates cash flows for the next n periods. Assume
that the cost of project X is $1 million.
• Then NPV =
• Where and r is the opportunity cost of capital, which reflects the discount rate and the risk
of investment

• Assuming everything else is constant, the investment should be undertaken if

NPV > 0 and should not if NPV < 0.
• The procedure to calculate NPV is also called discounted cash flow (DCF)
valuation.
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Net Present Value

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Net Present Value

• 1. NPV rule recognizes that a dollar today is worth more than a dollar
tomorrow

• 2. NPV depends solely on the forecasted cash flows from the project
and the opportunity cost of capital

• 3. Because present values are all measured in today’s dollars, you can
add them up

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Payback period
• The number of years it takes for cumulative cash flows to equal the initial
investment.
• The payback rule states that a project should be accepted if its payback period
is less than some specified cutoff period.

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Payback period

• Consider the example above

• NPV(A) = $ 2624 , NPV(B) = -$58, NPV(C) = $50
• If a firm sets payback rule at 2 years, then Project A is eliminated from consideration even
though it has the highest NPV.

This is because investing in Project A takes more than 2 years to get a return of $2000.

So, in this case, the firm chooses only between B and C

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Payback period

The Discounted Payback

The discounted payback period is the length of time until the sum of the discounted cash
flows is equal to the initial investment

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Payback period
• Why payback rule can be misleading

• The payback rule ignores all cash flows after the cutoff date. If the cutoff
date is two years, the payback rule rejects project A regardless of the size of
the cash inflow in year 3.

• The payback rule gives equal weight to all cash flows before the cutoff date.
The payback rule says that projects B and C are equally attractive, but
because C’s cash inflows occur earlier, C has the higher net present value at
any positive discount rate.

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Average Accounting Return

• ARR =
• A firm sets a target for acceptable ARR, and a project is accepted if it
exceeds that target threshold.
• Problems with ARR:
• It ignores time value of money
• Lack of an objective cutoff period
• Instead of cash flow and market value, it uses net income and book value.
Hence it does not provide a rate of return in any economic sense.

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Internal Rate of Return
• The internal rate of return is defined as the rate of discount that makes NPV = 0.

2000 4000
𝑁𝑃𝑉 =− 4000+ + =0
1+ 𝐼𝑅𝑅 (1+ 𝐼𝑅𝑅 )2

• We can calculate the above by plotting or through Excel

• IRR = 28.08%
• Therefore, if the opportunity cost of capital < 28.08% then NPV > 0.
• Pitfalls of IRR:
• If there is a cash flow stream where NPV rises as discount rate increases then opportunity cost of
capital should be higher than IRR.
• Multiple rates of return or no IRR
• Mutually exclusive projects
• More than one opportunity cost of capital.
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 Project Analysis
• Sensitivity Analysis
• Whenever managers are given a cash-flow forecast, they try to determine what else
may happen and the implications of these possible surprise events. This is called
sensitivity analysis.
• Scenario Analysis
• Managers often find such scenario analysis helpful. It allows them to look at
different, but consistent, combinations of variables. Forecasters generally prefer to
give an estimate of revenues or costs under a particular scenario than to give some
absolute optimistic or pessimistic value.

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SOME PROJECTS CAN HAVE MUTIPLE IRR’s

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• Growing Annuities and Perpetuities
• Growing Annuity PV =
• Growing Perpetuity PV =
• Where g is the growth rate

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