ACFI906

CORPORATE FINANCE
AND VALUATION

CAPITAL BUDGETING
Part I
Time value of
Time value of money

• Future Values and Compound Interest

• Present Values
• Multiple Cash Flows
• Level Cash Flows Perpetuities and Annuities
• Effective Annual Interest Rates
• Inflation & Time Value
Future Values

Future Value - Amount to which an investment

will grow after earning interest.

Compound Interest - Interest earned on interest.

Simple Interest - Interest earned only on the

original investment.
Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a principal
balance of $100.

Interest Earned Per Year = 100 x .06 = $ 6

Future Values

Example - Simple Interest

Interest earned at a rate of 6% for five years on a
principal balance of $100.

Today Future Years

1 2 3 4 5
Interest Earned
6 6 6 6 6
Value 100
106 112 118 124 130

Value at the end of Year 5 = $130

Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five years on
the previous year’s balance.

Interest Earned Per Year =

Prior Year Balance x (1 + 0.06)
Future Values

Example - Compound Interest

Interest earned at a rate of 6% for five years on
the previous year’s balance.

Today Future Years

1 2 3 4 5
Interest Earned 6 6.36 6.74 7.15 7.57
Value 100 106 112.36 119.10 126.25 133.82

Value at the end of Year 5 = $133.82

Future Values

Future Value of $100 = FV

t
FV $100 (1  r )
Future Values

t
FV $100 (1  r )

Example - FV

What is the future value of $100 if interest is compounded annually at a rate of 6% for five

years?

5
FV $100 (1  .06) $133.82
Future Values with
Compounding
1800
1600 0%
1400 5%
10%
1200
FV of $100

15%
1000
800
600
Interest Rates
400
200
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
Manhattan Island Sale

Peter Minuit bought Manhattan Island for $24 in 1626. It is now 2021. Assuming a

weighted average interest rate of 8% for the 1626-2020 window, was this purchase a good

deal?
To answer, determine how much $24 is worth in 2021, compounded at 8%.

393
FV = $24 X (1+0.08) = $382,467,607,417,429

FYI - The value of Manhattan Island land is well below this

figure.
Present Values

Present Value = PV

Future Value after t periods

PV = (1+r) t
Present Values

Present Value Discount Factor

Value today of a future Present value of a $1 future

cash flow. payment.

Discount Rate

Interest rate used to compute

present values of future cash

flows.
Present Values

Example
You just bought a new laptop for £600. The payment terms are 2
years same as cash. If you can earn 1% on your money, how
much money should you set aside today in order to make the
payment when due in two years?
Present Values

Discount Factor = DF = PV of $1

DF  1
(1 r ) t

• Discount Factors can be used to compute the

present value of any cash flow.
Time Value of Money
(applications)

• The PV formula has many applications. Given

any variables in the equation, you can solve for
the remaining variable.

PV  FV  1
(1 r ) t
Present Values with
Compounding
120

100
0%Interest Rates

80 5%
PV of $100

10%
60 15%

40

20

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Number of Years
PV of Multiple Cash Flows

Example
Your auto dealer gives you the choice to pay $15,500 cash
now, or make three payments: $8,000 now and $4,000 at
the end of each of the following two years. If your cost of
money is 8%, which do you prefer?
Immediate payment 8,000.00
PV1  (14,.000
08 )1 3,703.70

PV2  (14,.000
08 ) 2
3,429.36
Total PV $15,133.06
Present Values
$8,000

$4,000 $ 4,000

Present Value
Year
0 1 2

Year 0 $8,000

4000/1.08 = $3,703.70

2
4000/1.08 = $3,429.36

Total = $15,133.06
PV of Multiple Cash Flows

• PVs can be added together to evaluate multiple

cash flows.

C1 C2
PV  (1r )1  (1r ) 2 ....
Perpetuities & Annuities

Perpetuity
A stream of level cash payments that
never ends

Annuity
Equally spaced level stream of cash
flows for a limited period of time
Perpetuities & Annuities

PV of Perpetuity Formula

PV  C
r

C = cash payment
r = interest rate
Perpetuities & Annuities

Example - Perpetuity
In order to create an endowment, which pays $100,000
per year, forever, how much money must be set aside
today if the rate of interest is 10%?

100 , 000
PV  .10 $1,000,000
Perpetuities & Annuities

Example - continued
If the first perpetuity payment will not be received until
three years from today, how much money needs to be
set aside today? In other words, how much money do
you have to set aside today, so that its total value after
3 years will be equal to 1 million?

1, 000 , 000
PV  (1.10 ) 3
$751,315
Perpetuity with Growth

C (1  g )
PV 
r g
Where :
c  perpetuity cash flow
g  growth rate
Perpetuities & Annuities

PV of Annuity Formula

PV C  1
r  1
r (1 r ) t 
C = cash payment
r = interest rate
t = Number of years cash payment is received
Perpetuities & Annuities

PV Annuity Factor (PVAF) - The present value of

$1 a year for each of t years.

PVAF    1
r
1
r (1 r ) t 
Perpetuities & Annuities

Example - Annuity
You are purchasing a car. You are scheduled to make
3 annual installments of $4,000 per year. Given a rate
of interest of 10%, what is the price you are paying for
the car (i.e. what is the PV)?

PV 4,000  1
.10  1
.10 (1.10 ) 3 
PV $9,947.41
Perpetuities & Annuities

Applications
• Value of payments
• Implied interest rate for an annuity
• Calculation of periodic payments
– Mortgage payment
– Annual income from an investment payout
– Future Value of annual payments
t
FV  C PVAF  (1  r )
Perpetuities & Annuities

Example - Future Value of annual payments

You plan to save $4,000 every year for 20 years and
then retire. Given a 10% rate of interest, what will be
the FV of your retirement account?

FV 4,000  1
.10  1
.10 (1.10 ) 20  (1.10) 20

FV $229,100
Effective Interest Rates

Effective Annual Interest Rate - Interest rate that is

annualized using compound interest.

Annual Percentage Rate - Interest rate that is

annualized using simple interest.
Effective Interest Rates

12
1+effective annual rate= (1+montly rate)

The effective annual rate is the rate at which

invested funds will grow over the course of a

year. It equals the rate of interest per period

compounded for the number of periods in a

year.
Effective Interest Rates

example
Given a monthly rate of 1%, what is the Effective
Annual Rate(EAR)? What is the Annual Percentage
Rate (APR)?
12
EAR = (1 + .01) - 1 = r
EAR = (1 + .01)12 - 1 = .1268 or 12.68%

APR = .01 x 12 = .12 or 12.00%

Inflation

Inflation - Rate at which prices as a whole are

increasing.

Nominal Interest Rate - Rate at which money

invested grows.

Real Interest Rate - Rate at which the

purchasing power of an investment increases.
Inflation
Inflation

1+nominal interest rate

1  real interest rate = 1+inflation rate

approximation formula

Real int. rate nominal int. rate - inflation rate

Inflation

Example
If the interest rate on one year govt. bonds is 6.0%
and the inflation rate is 2.0%, what is the real
interest rate?
1+.0 6
1  real interest rate = 1+.0 2 Savings

1  real interest rate = 1.039 Bond

real interest rate = .039 or 3.9%

Approximat ion = .06 - .02 = .04 or 4.0%

Although the rates we presented so far (and will
continue presenting) are positive, reality is evolving a
bit differently…

“A Danish bank has launched the world’s first negative interest rate

mortgage – handing out loans to homeowners where the charge is minus

0.5% a year. Negative interest rates effectively mean that a bank pays a

borrower to take money off their hands, so they pay back less than they have

been loaned. Jyske Bank, Denmark’s third largest, has begun offering

borrowers a 10-year deal at -0.5%, while another Danish bank, Nordea, says

it will begin offering 20-year fixed-rate deals at 0% and a 30-year mortgage

at 0.5%. Under its negative mortgage, Jyske said borrowers will make a

monthly repayment as usual – but the amount still outstanding will be

reduced each month by more than the borrower has paid.”

Investment Appraisal Methods
Outline
• Net Present Value
• Internal Rate of Return
• Payback period method
• Accounting Rate of Return
• Profitability index
Net Present Value
Net Present Value - Present value of cash flows minus initial investments.

Opportunity Cost of Capital - Expected rate of return given up by investing in a

project
Net Present Value
Example
Q: Suppose we can invest $50 today & receive $60
later today. What is our increase in value?

A: Profit = - $50 + $60

= $10 $10
Added Value

$50 Initial Investment

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?

60
Profit = -50 + $4.55
1.10
$4.55 Added Value

This is the definition of NPV $50 Initial Investment

Example: Valuing an Office
Building
Step 1: Forecast cash flows
Cost of building = C0 = 350,000
Sale price in Year 1 = C1 = 400,000

Step 2: Estimate opportunity cost of capital

If equally risky investments in the capital market
offer a return of 7%, then
Cost of capital = r = 7%
Example: Valuing an Office
Building
Step 3: Discount future cash flows

C1 400 , 000
PV  (1r )
 (1.07 )
373,832
Step 4: Go ahead if PV of payoff exceeds investment

NPV  350,000  373,832

23,832
Risk and Present Value
 Higher risk projects require a higher rate of return
 Higher required rates of return cause lower PVs

PV of C1 $400,000 at 12%
400,000
PV  357,143
1  .12

PV of C1 $400,000 at 7%
400,000
PV  373,832
1  .07
Net Present Value
NPV = PV - required investment
Ct
NPV C0  t
(1  r )

C1 C2 Ct
NPV C0  1
 2
...
(1  r ) (1  r ) (1  r ) t

C = Cash Flow C0 – initial investment, negative

t = time period of the investment

r = “opportunity cost of capital”

Net Present Value
Net Present Value Rule
Managers increase shareholders’ wealth by
accepting all projects that are worth more than they
cost.

Therefore, they should accept all projects with a

positive net present value.

Note: The Cash Flow could be positive or negative at any time period
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?

Assume a 7% opportunity cost of capital

Net Present Value
$466,000
Example - continued
$450,000

$16,000 $16,000 $16,000

0 1 2 3
Present Value

14,953

13,975
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?
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?

16,000 16,000 466,000

NPV  350,000  1
 2
 3
(1.07) (1.07) (1.07)
NPV $59,323
Payback Method
Payback Period - Time until cash flows recover the
initial investment of the project.

• The payback rule specifies that a project be accepted

if its payback period is less than the specified cutoff
period. The following example will demonstrate the
absurdity of this statement.
Payback Method
Example
The three projects below are available. The company accepts
all projects with a 2 year or less payback period. Show how
this decision-rule will impact our decision.

Cash Flows
Project C0 C1 C2 C3 Payback NPV@10%
A -2,000 +1,000 +1,000 +10,000 2 + 7,249
B -2,000 +1,000 +1,000 0 2 - 264
C -2,000 0 +2,000 0
2 - 347
Payback Period: Drawbacks

Drawbacks of the Payback Period method:


It makes no allowance for the time value of money

Receipts beyond the payback period are ignored

Arbitrary selection of the cut-off point

Some of these problems can be avoided by combining the Payback Period method

with the NPV methodology and calculating a Discounted Payback Period.

Reasons for the Continuing
Popularity of Payback Period

Supplements the more sophisticated methods, e.g an early stage

filter

It is simple and easy to use

Projects which return their outlay quickly reduce the exposure

of the firm to risk


If funds are limited, there is an advantage in receiving a return

on projects earlier rather than later

Accounting

Rate Of Return
The accounting rate of return (ARR) method may be known by other names

such as the return on capital employed (ROCE) or return on investment (ROI)


ARR is a ratio of the accounting profit to the investment in the project,

expressed as a percentage

The decision rule is that if the ARR is greater than, or equal to, a hurdle rate

then accept the project

The ARR can be calculated using three (3) alternative methods:

1.Annual Basis

2.Total Investment Basis

ACCOUNTING RATE OF RETURN:
EXAMPLE
Invest £30,000 in machinery: life of three years
ACCOUNTING RATE OF RETURN:
EXAMPLE

Average investment may be calculated

as the sum of the beginning and

ending book value of the project

divided by 2, in this case (30,000 +

(5,000 + 5,000 + 5,000)/3
0) : 2
ARR = –––––––––––––––––––––– × 100 = 33.33%

15,000
DRAWBACKS OF ARR


Wide-open field for selecting profit and asset definitions


Profit figures are very poor substitutes for cash flow


Fails to take account of the time value of money


High degree of arbitrariness in defining the cut-off or hurdle rate


Accounting rate of return can lead to some perverse decisions


Suppose that in the above example the company uses the second version, the total investment ARR, with a

hurdle rate of 15 per cent and the appraisal team discover that the machinery will in fact generate an additional profit
(5,000 + 5,000 + 5,000 + 1,000)/4
of £1,000 in a fourth year. Then we have:
ARR = ––––––––––––––––––––––––––– = 13.33%. Rejected

30,000
ADVANTAGES OF ARR


Far more business people know about accounting than finance. Therefore, in many firms it

is much easier to communicate with other managers in accounting language rather than in finance

language.


Every firm has an accounting system. Therefore, the information needed to calculate ARR’s

is readily available. Information on project cash flows is not provided by the firm's accounting

system automatically. Therefore, because the firm's information system is accounting based, it is

easier to use an accounting based method for project evaluation. 


The performance of managers is usually based on some accounting measure, such as return

on capital employed or return on investment. These accounting measures are very similar to ARR.


Naturally no manager will choose to look good under an NPV based performance system
Other Investment Criteria
Internal Rate of Return (IRR) - Discount rate at
which NPV = 0.

Rate of Return Rule - Invest in any project offering a

rate of return that is higher than the opportunity cost
of capital.

C1 - investment
Rate of Return =
investment
Internal Rate of Return
Example
You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows (i.e. rent)
during the first three years. At the end of three years you
will sell the building for $450,000. What is the IRR on
this investment?
16,000 16,000  16,000  450,000
0  350,000  1
 2

(1  IRR ) (1  IRR ) (1  IRR) 3

IRR = 12.96%
Note: Calculating the IRR can be a laborious task.

Fortunately, financial calculators can perform this function easily.

Internal Rate of Return
Calculating IRR by using a spreadsheet

Year Cash Flow Formula

0 (350,000.00) IRR = 12.96% =IRR(B4:B7)
1 16,000.00
2 16,000.00
3 466,000.00
 Internal Rate of Return
200

150

100
NPV (,000s)

50 IRR=12.96%
0
0 5 10 15 20 25 30 35
-50

-100

-150

-200
Discount rate (%)
Rule: accepting a project if the rate of return exceeds the opportunity cost of capital, e.g., this project has a

positive NPV as long as the opportunity cost of capital is lower than 12.96%.
Internal Rate of Return
Pitfall 1 - Lending or Borrowing?
• With some projects the NPV of the project increases as the discount rate increases
• This is contrary to the normal relationship between PV and discount rates.

Pitfall 2 - Multiple Rates of Return

 Certain cash flows can generate NPV=0 at two different discount rates. (The reason for this is the double change in
the sign of the cash flows)

Pitfall 3 - Mutually Exclusive Projects

 IRR sometimes ignores the magnitude of the project.
Lending or borrowing?
Project C0 C1 IRR NPV at 10%
D -100 +150 50% +$36.4
E +100 -150 50% - 36.4

Pitfall 1:

For project E (borrowing money), NPV increases as the discount rate increases. The rate of return

rule will not work in this case.

Multiple Rates of Return
• IRR can result in multiple rates of return if the
estimated cash flows change sign more than once.
• Example: assume a project with cash flows at year 0 =
(£1600); year 1 = £10,000; year 2 = (£10,000).
Determine IRR.
 1600 10,000  10,000
NPV 0   
(1  IRR) (1  IRR) (1  IRR) 2
0 1

• Descarte’s rule of signs: every time the cash flows

change signs, there may be a new (positive, real) root to
the problem solution.
• Solving the quadratic equation: IRR = 25% or 400%

69
Mutually exclusive projects
Example
You have two proposals to choose between. The initial proposal has cash
flows that are different from the revised proposal’s. Using IRR, which do
you prefer?

Project C0 C1 C2 C3 IRR NPV@7%

Initial Proposal -350 400 14.29% $ 24,000
Revised Proposal -350 16 16 466 12.96% $ 59,000

NPV? - Revised Proposal

IRR? - Initial Proposal

Mutually exclusive projects
Example
You have two proposals to choose between. The initial proposal (H) has
a cash flow that is different than the revised proposal (I). Using IRR,
which do you prefer?

16 16 466
NPV   350  1
 2
 3
0
(1  IRR ) (1  IRR ) (1  IRR )
12 .96 %

400
NPV   350  1
0
(1  IRR )
14.29 %
Mutually exclusive projects

50

40 Revised proposal

30
IRR= 12.96%
NPV $, 1,000s

IRR= 14.29%
20

10 Initial proposal

-10
IRR= 12.26%

-20 8 10 12 14 16

Discount rate, %
NPV v IRR: Example

You are a financial analyst for Jeffrey Plc. Your company is

considering investing its surplus funds in one of the following
three projects, A, B or C. The expected cash flows of these three
mutually exclusive projects are given below.

T Pr1 (£000) Pr2 (£000) Pr3 (£000)

0 -2,000 -1,500 -2,000
1 500 400 1,000
2 250 400 200
3 750 400 300
4 600 400 800
5 850 400 1000

Jeffrey’s cost of capital (k) is 12 per cent.

The NPV solution

T 0 1 2 3 4 5
Pr1 (£000) -2,000 500 250 750 600 850

500
1.12

250
1.12 2

750
1.12 3
650
1.12 4
850
1.12 5
The NPV solution

T 0 1 2 3 4 5
Pr1 (£000) -2,000 500 250 750 600 850

Pr2 (£000) -1,500 400 400 400 400 400

Pr3 (£000) -2,000 1,000 200 300 800 1000

k 1 0.893 0.797 0.712 0.636 0.567

1
1  k  n
NPVPr1 -2000 446.5 199.3 533.9 381.3 482.3 43.2
NPVPr2 -1500 357.2 318.9 284.7 254.2 227.0 -58.1
NPVPr3 -2000 892.9 159.4 213.5 508.4 567.4 341.7
The Internal rate of Return Solution

k12%
NPVPr1 -2000 446.5 199.3 533.9 381.3 482.3 43.2
NPVPr2 -1500 357.2 318.9 284.7 254.2 227.0 -58.1
NPVPr3 -2000 892.9 159.4 213.5 508.4 567.4 341.7
k13% NPVPr1 -2000 442.5 195.8 519.8 368.0 461.3 -12.6
k10% NPVPr2 -1500 363.6 330.6 300.5 273.2 248.4 16.3
k19% NPVPr3 -2000 840.3 141.2 178.0 398.9 419.0 -22.4
 Cr   43.2 
IRRPr 1 r   *  rB  rA   12%   13%  12%  
 Cr  Cr   43.2  ( 12.6) 
12%   0.77419 1% 12.7742%
 16.3 
IRRPr 2 10%   12%  10%   10.43817%
 16.3  ( 58.1) 
 341.7 
IRRPr 3 12%   19%  12%   18.5693% 18.511%
 341.7  ( 22.4) 
Investment Timing

Sometimes you have the ability to defer an

investment and select a time that is more ideal
at which to make the investment decision. A
common example involves a tree farm. You
may defer the harvesting of trees. By doing
so, you defer the receipt of the cash flow, yet
increase the cash flow.
Investment Timing

Example
You may purchase a computer anytime within the
next five years. While the computer will save your
company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the
data listed below, when should you purchase the
computer?
Investment Timing
Example
You may purchase a computer anytime within the next five years. While the
computer will save your company money, the cost of computers continues to
decline. If your cost of capital is 10% and given the data listed below, when
should you purchase the computer?
Year Cost PV Savings NPV at Purchase NPV Today
0 50 70 20 20.0
1 45 70 25 22.7 = 25/(1+0.1)^1
2 40 70 30 24.8 = 30/(1+0.1)^2
3 36 70 34 Optimal purchase date 25.5 = 34/(1+0.1)^3
4 33 70 37 25.3 = 37/(1+0.1)^4
5 31 70 39 24.2 = 39/(1+0.1)^5

Rule: choose the investment date that results in the highest NPV today
Profitability Index
PV of the project

Profitability Index = ---------------------------------

Initial Investment
Profitability Index: Ratio of present value to initial investment. The projects with

highest PI are picked.

Project PV Investment NPV Index
J 4 3 1 1.3
K 6 5 1 1.2
L 10 7 3 1.4
M 8 6 2 1.3
N 5 4 1 1.3
A comparison of investment
decision rules
Capital Budgeting
Techniques
Essential reading

• Brealey, Myers, and Allen, 2019, Principles of

Corporate Finance, 13th Edition, McGraw Hill.,
Chapters 2, 5, 6, 7, 9 and 11
• Richard Pike, Bill Neale, Philip Linsley (2012),
‘Corporate Finance and Investment: Decisions
& Strategies’, 7th Edition, FT Prentice Hall,
Chapters 3, 4, 5, 6, 10 and 11