Financial Modelling: Module 4 Capital Budgeting

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jordan_hs
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Financial Modelling: Module 4 Capital Budgeting
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2014-10-19 20:32:16
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125 250 M4 Capital Budgeting
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  1. Net Present Value (NPV)
    Present value of all the cash flows relating to aproject including the initial investment which is normally anegative value
  2. NPV equation
    CF0 + [CFt/(1+r)t]
  3. “Yes-No” and NPV
    • • NPV measures the value that will be added to the firm in today’s dollars if the project is undertaken.
    • • When an NPV = 0 the project is providing a risk adjusted return for both debt holders and shareholders. A project with an NPV > 0 is adding wealth to the firm.
    • Accept project if:If NPV 0
  4. Excel’s NPV function
    • • Excel assumes that the first cash flow occurs one period from now.
    • = NPV (rate,value 1,[value 2]...)
    • = NPV (B3, C5:E5) + B5
    •             a       b          c
    • a is the discount rate
    • b is the cash inflows
    • c is the initial investment

    • Excel’s NPV function computes the present value (NOT net present value!) of a series of payments
  5. Excel's NPV function part 2
    Excel’s NPV function computes the present value (NOT net present value!) of a series of payments
  6. PV vs NPV
    • PV function:
    • • Use PV to compute the present value of a single cash flow.
    • • Use PV to compute the present value of an annuity stream—all the cash flows are equal.•

    • The PV function assumes that the payments are made at the end of each time period. If they are made at the beginning of each time period, you should write
    •          = PV(rate, nper, pmt[, fv ] [, 1 ] )
    • • The PV formula produces a negative number.
  7. PV vs NPV
    • NPV function
    • • Use NPV to compute the present value of a stream of cash flows over time (equal or unequal).
    • • Excel assumes that the first cash flow occurs one period from now (at the end of each time period).
  8. Internal Rate of Return (IRR)
    Internal Rate of Return (IRR) is the percentage return that discounts all cash flows from a project, including the initial investment, to zero.
  9. IRR equation


    • Where:
    • CF0 = initial investment, time zero
    • CFt = expected cash flow, time t
    • t = period in which a CF arises
    • n = life of the project
  10. IRR function
    • IRR in Excel doesn’t suffer from the same problem as NPV (how to handle initial investment).

    IRR(values() [, guess ] )

    = IRR (B3:B8)

    a is the series of cash flows
  11. Excel Functions IRR vs RATE
    - Rate Function
    • RATE function
    • • Use RATE to compute the internal rate of return of an annuity stream—all the cash flows are equal.
    • • RATE assumes that payments are made at the end of the period. If they are made at the beginning of each time period, you should write

    =Rate(nper,pmt,pv[,fv] [,1] [,guess ])

    • RATE produces a negative number
  12. Excel Functions IRR vs RATE
    - IRR
    • • IRR can handle cash flows that vary over time.
    • • Each cash flow, specified as a value, occurs at the end of a period.
    • • IRR is more mathematically stable
  13. “Yes-No” and IRR
    • • IRR rule: A project is worthwhile if the IRR ≥discount rate (required rate of return r)
    • • According to the IRR rule:– If IRR ≥ r, then the project is worthwhile– If IRR < r, project should not be undertaken
  14. IRR as a decision criterion
    • Good points
    • – IRR is simple to use
    • – IRR gives information investors want
    •         • What is the rate of return on an investment?
    • Bad points
    • – IRR can represent both the rate of return and the cost of an investment
    •         • You can’t tell without more information
    • – A project can have multiple IRRs
  15. When do multiple IRRs occur?
    • • Project has “conventional cash flows” if cash flows change sign only once:
    • – Initial cash flow is negative
    • – All other cash flows are non-negative
    •                                OR
    • – Initial cash flow is positive
    • – All other cash flows are non-positive

    • Multiple IRRs can occur if project has non-conventional cash flows.
  16. NPV and IRR
    Which to Use?
    • 1. Choosing whether to undertake a single project:
    • NPV: NPV > 0
    • IRR: IRR >= r                       (Yes-No decision)

    • 2. Comparing two mutually exclusive projects:
    • NPV: NPV(A) > NPV(B)
    • IRR: IRR(A) > IRR(B)            (Project Ranking)
  17. NPV and IRR
    • Choosing whether to undertake a single project.
    • For conventional projects, the NPV and IRR Yes-No decisions are the same.
    • • Conventional projects are those that have an initial negative cash flow and the rest of the cash flows are positive.
  18. NPV and IRR
    • For mutually exclusive projects, NPV and IRR can sometimes give conflicting rankings.
    If rankings conflict use the NPV decision rule.
  19. XNPV function
    – Returns the net present value for a schedule of cash flows that is not necessarily periodic
  20. XNPV formula
    • XNPV(rate,values,dates)
    • = XNPV(.15, B25:B30, A25:A30)
    •               a         b             c

    • Where:
    • – a is the cost of capital
    • – b is the range of cash flows
    • – c is the range of dates corresponding to the cash flows
  21. XIRR Function
    – Returns the IRR for a schedule of cash flows that is not necessarily periodic.
  22. XIRR formula
     XIRR(values,dates, guess)

    • = XIRR(B4:B10, A4:A10, 0)

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