INTRODUCTION TO FINANCE

Lecturer: Tran Thi Minh Tram

Email: [email protected]

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CHAPTER 3: TIME VALUE OF
MONEY
3.1: Time value of money
3.2: Time value of money – Financial table
3.3: Application of time value of money

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CHAPTER 3.3: APPLICATION OF TVM
AND RESOURCE ALLOCATION
Source:
• Bodie, Z, & Merton, R. (2000), Finance, Prentice Hall Inc
• Timothy J.G (2013), Financial Management: Principle
and practices, 6th ed, Freeload Press Publishers
• CFA Program curriculum – Level 1 – Volume 1

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Chapter 3.3: Application of TVM and
resource allocation
INVESTMENT DECISION

DISCOUNTED CASH FLOW METHOD (DCF)

INVESTMENT PROJECT ANALYSIS: NPV, IRR

HOW TO CALCULATE: NPV, IRR

PROBLEMS WITH THE IRR, NPV RULE

 INVESTMENT DECISION

• Expected return vs. Required return

• Price vs. Intrinsic value

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Expected return vs. Required return
• If Expected return = Required return
➢Invest
• If Expected return > Required return
➢Invest
• If Expected return < Required return
➢Don’t invest

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 Price vs. Intrinsic value
• Intrinsic value = Present Value to the
investor
– Based on the investor’s
✓Expected cash flows for the investment
✓Timing of the cash flows
✓Investor’s required return
• Discounted cash flow (DCF) method

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 Price vs. Intrinsic value
• Intrinsic value > Price
➢The investment is underpriced
➢The investment is worth more to you than
what it costs
➢Invest

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 Price vs. Intrinsic value
• Intrinsic value = Price
➢The investment is fairly priced
➢The investment is worth what you pay for it
➢Invest

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 Price vs. Intrinsic value
• Intrinsic value < Price
➢The investment is overpriced
➢Cost you pay for the investment is more than
what it is worth to you
➢Don’t invest

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DISCOUNTED CASH FLOW METHOD
• In finance, discounted cash flow (DCF)
analysis is a method of valuing a project, a
company, or an asset using the concepts
of the time value of money.
• Discounted cash flow analysis is widely
used in investment finance, real estate
development, corporate financial
management and patent valuation…

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 Discounted cash flow (DCF)
• Discounted cash flow (DCF) analysis:
– All Future cash flows are estimated
and discounted to give their Present
Values (PVs).
– These PVs is then used to evaluate the
potential for investment.
✓If the total incoming PVs is greater than the total
outgoing PVs, then the opportunity of investment
may be a good one.
✓The sum of PVs of all future cash flows, both
incoming and outgoing, is the Net Present
Value (NPV), which is taken as the value or price of
the cash flows in question.

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 Discounting and the Prices of
Financial Assets
• Discounting gives us a way of determining the
prices of financial assets
• The price of a financial asset is equal to the
present value of the payments to be received
from owning it

Price= σ𝒏𝒌=𝟎 𝑷𝑽 𝒐𝒇 𝒂𝒍𝒍 𝒕𝒉𝒆 𝒑𝒂𝒚𝒎𝒆𝒏𝒕𝒔

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 NPV & IRR
• Tools for evaluating cash flow streams (choosing among
investment proposals)
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
• NPV and IRR can be used in many contexts, their scope of
application covers all areas of finance.
• Capital budgeting can serve as a representative starting
point:
– Three chief areas of financial decision-making in most businesses:
Capital budgeting, Capital structure, Working capital management.
– Capital budgeting is the allocation of funds to relatively long-range
projects or investments.
✓ Whether to enter a new line of business
✓ Whether to invest in equipment to reduce costs
✓…

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 NET PRESENT VALUE
• Net present value (NPV) of an investment
is the present value of its cash inflows
minus the present value of its cash
outflows (cost).

NPV = PVinflows - PVoutflows

• Assumption: CFs reinvested at required

return

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 Net present value
• The NPV rule:
– If NPV > 0
• Intrinsic value > cost => Invest
– If NPV = 0
• Intrinsic value = cost => Invest
– If NPV < 0
• Intrinsic value < cost => Don’t invest
– If an investor has 2 candidates for investment,
but can only invest in one, the investor should
choose the candidate with the higher positive
NPV.

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 Net present value
• Steps in computing NPV and applying the NPV
rule:
1. Identify all cash inflows and cash outflows of the
investment.
2. Determine the discount rate/required return or
opportunity cost, r for the investment project.
3. Find the present value of each cash flow, using that
discount rate (outflows have a negative sign, inflows
have a positive sign).
4. Sum all present values; this is NPV.
5. Applying the NPV rule.

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 Net present value
• Formula:
n
CFt
NPV = 
t =0 (1 + r ) t (3.15)

• Where:
– CFt is the expected net cash flow at time t
– n is the investment’s projected life
– r is the discount rate or opportunity cost of
capital

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 Net present value
• Example 3.3.1:
• Suppose you are reviewing a proposal
that requires an initial outlay of $2
million. You expect that the proposed
investment will generate net positive cash
flows of $0.50 million at the end of year 1,
$0.75 million at the end of year 2 and
$1.35 million at the end of year 3. Should
you accept the proposal using 10%
discount rate?

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 Net present value
• Example 3.3.2:
• As an analyst covering the RAD Corporation, you
are evaluating its research and development
(R&D) program for the current year. Management
has announced that it intends to invest $1 million
in R&D. Incremental net cash flows are forecasted
to be $150,000 per year in perpetuity. RAD
Corporation’s opportunity cost of capital is 10%.
1. State whether RAD’s R&D program will benefit
shareholders, as judged by the NPV rule.
2. Evaluate whether your answer to part 1 changes
if RAS Corporation's opportunity cost of capital is
15% rather than 10%.
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Calculating NPV
using financial table

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 PVIF table calculation
1. Draw a timeline
2. Set up calculation table
▪ Use 4 columns:
1. Year
2. Cash Flow (+ or -)
3. PVIF
4. PV of cash flow = #2 * #3
3. Calculate NPV
▪ NPV = PV of cash inflow – PV of cash outflow
4. Conclusion

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 PVIF table calculation
• Notes:
– Payment periods could be annual, monthly,
etc.
➢Must adjust required annual return to required
periodic return
– When drawing a timeline:
➢If there are Cash Inlows and Outflows in one year,
net the amounts

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 PVIF table calculation
• Example 3.3.3:
• A company is considering making a real
estate investments. Its initial cost is
$150,000. After 5 years, the company
expects to sell this investment for
$200,000. During the 5 year period, the
company expects annual cash flows of
$7,500; $8,000; $8,500; $9,000 and
$10,000. If the company’s required rate of
return is 10%, should it make this
investment?
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 PVIF table calculation
1. Draw timeline
• Draw timeline
• Write down P/Y
• Write down the required return

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 PVIF table calculation
200,000
10,000

(150,000) 7,500 8,000 8,500 9,000 210,000

0 1 2 3 4 5

P/Y = 1
I/Y = 0.1

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 PVIF table calculation
2. Set up calculation table

Year Cash flow PVIF (2)x(3)

1 7,500 0.9091 6,818
2 8,000 0.8264 6,611
3 8,500 0.7513 6,386
4 9,000 0.6830 6,147
5 210,000 0.6209 130,389
156,351

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 PVIF table calculation
3. Calculate NPV
PV of CFs 156,351
COST (150,000)
NPV 6,351

4. Conclusion
➢Invest

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 INTERNAL RATE OF RETURN
• Internal rate of return (IRR) is the discount
rate that make the Net Present Value equal
to zero.
– It equates the Present Value of the
investment’s costs (outflows) to the Present
Value of the investment’s benefits (inflows).
• Assumption: cash flows are reinvested at
the IRR

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 Internal rate of return
• Formula:
CF1 CF2 CFn
NPV = CF0 + + + ..... + =0
(1 + IRR) (1 + IRR)
1 2
(1 + IRR) n

(3.16)
• Where:
– CFt is the expected net cash flow at time t
– n is the investment’s projected life
– IRR is the internal rate of return

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 Internal rate of return
• The rate is “internal” because it depends
only on the cash flows of the investment;
no external data are needed.
– As a result, we can apply the IRR concept to
any investment that can be represented as a
series of cash flows.
– In the study of bonds, we encounter IRR under
the name of yield to maturity (YTM).

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 Internal rate of return
• The IRR rule:
– If IRR > required return
➢Expected return > required return
➢Invest
– If IRR = required return
➢Expected return = required return
➢Invest
– If IRR < required return
➢Expected return < required return
➢Don’t invest

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 Internal rate of return
• Example 3.3.4:
• In the previous RAD Corporation
example, the initial outlay is $1 million
and the program’s cash flows are
$150,000 in perpetuity. Now you are
interested in determining the program’s
IRR. Address the following:
– Write the equation for determining the
internal rate of return of this R&D program?
– Calculate the IRR?

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Internal rate of return

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Calculating IRR
using financial table

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 PVIF table calculation
1. Interactive process:
– Select discount rate
– Calculate NPV
– Adjust to new discount rate
– Calculate NPV
2. When NPV = 0 => discount rate = IRR

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 PVIF table calculation
• Notes:
– If timing of cash flows is more frequent than
annual
➢Must adjust IRR
➢Discount rate * P/Y
– When drawing a timeline:
➢If there are Cash Inflows and Outflows in one
year, net the amounts

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 PVIF table calculation
• Interactive process:
– Draw a timeline
– Set up calculation table
✓Use 4 columns:
1. Year
2. Cash Flow (+ or -)
3. PVIF
4. PV of cash flow = #2 * #3
– Calculate NPV
✓NPV = PV of cash inflow – PV of cash outflow

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 PVIF table calculation
• If NPV > 0
➢Select higher discount rate
➢Recalculate NPV

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 PVIF table calculation
• If NPV < 0
➢Select lower discount rate
➢Recalculate NPV

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 PVIF table calculation
• If NPV = 0
➢Discount rate = IRR

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 PVIF table calculation
• Example 3.3.5:
• A company is considering making a real
estate investments. Its initial cost is
$150,000. After 5 years, the company
expects to sell this investment for
$200,000. During the 5 year period, the
company expects annual cash flows of
$7,500; $8,000; $8,500; $9,000 and
$10,000. Calculate IRR of the project?

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 PVIF table calculation
1. Draw timeline
• Draw timeline
• Write down P/Y
• Write down the required return

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 PVIF table calculation
200,000
10,000

(150,000) 7,500 8,000 8,500 9,000 210,000

0 1 2 3 4 5

P/Y = 1
I/Y = 0.1

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 PVIF table calculation
2. Set up calculation table

Year Cash flow PVIF (2)x(3)

1 7,500 0.9091 6,818
2 8,000 0.8264 6,611
3 8,500 0.7513 6,386
4 9,000 0.6830 6,147
5 210,000 0.6209 130,389
156,351

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 PVIF table calculation
3. Calculate NPV
PV of CFs 156,351
COST (150,000)
NPV 6,351

Current discount rate 0.1

Select higher discount rate
New discount rate 0.12

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 PVIF table calculation
2. (again) Set up calculation table

Year Cash flow PVIF (2)x(3)

1 7,500 0.8929 6,697
2 8,000 0.7972 6,378
3 8,500 0,7118 6,050
4 9,000 0.6355 5,720
5 210,000 0.5674 119,154
143,999

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 PVIF table calculation
3. (again) Calculate NPV
PV of CFs 143,999
COST (150,000)
NPV (6,001)

Current discount rate 0.12

Select lower discount rate
New discount rate 0.11

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 PVIF table calculation
• With discount rate = 0.11
➢ NPV = 0
➢ IRR = 0.11

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Uneven cash flow computation
• Be very careful about:
– The initial investment
– The signs of the cash flows
– The last year’s cash flows
– Any year that has multiple cash flows

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 NPV & IRR
• The NPV, IRR rule helps companies
decide whether or not to proceed
with a project.
• For a given opportunity cost, the IRR
and the NPV rule lead to the same
decision in almost cases.
• A company may not rigidly follow the
rule if the project has other, less
tangible, benefits.

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 NPV & IRR
• When:
• IRR > Required return  NPV>0
• IRR = Required return  NPV=0
• IRR < Required return  NPV<0

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 HOW TO CALCULATE NPV, IRR?

• Using Financial table (tables of Future

value factors, Present value factors for
various interest rates and numbers of
periods)
• Using Financial calculators
• Using Excel

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 PROBLEMS WITH IRR, NPV

• Multiple IRRs
• Mutually exclusive projects (when a
company cannot finance all the projects
it would like to undertake).

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 Multiple IRRs
• Example 3.3.6:
• Company A is considering a project to
strip-mine coal. The project requires an
investment of $22 million and is expected
to produce a cash inflow of $15 million in
each of years 1 through 4. However, the
company is obliged in year 5 to reclaim the
land at a cost of $40 million.
• Calculate IRR and/or NPV of the project,
with 10% opportunity cost of capital, and
give comments?
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 Multiple IRRs
• Reason: Double change in the sign of cash
flow.
• Solution: Using modified IRR
– Combine cash flows in several years to
become 1 PV at a specific year, choose which
PV eliminate the double change in the sign of
the cash flows.
– Then find the IRR of newly created cash flow.
– This will be the modified IRR

➢If a project has multiple IRRs, use NPV

method for project accept/reject decisions

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 Mutually exclusive projects
• Project A NPV = $1,090 IRR = 14,96%
• Project B NPV = $1,154 IRR = 13,50%

What is your decision???

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 Mutually exclusive projects
• If project A & B are independent then we
accept BOTH projects.
• If project A & B are mutually exclusive,
there is a ranking conflict.
➢Use NPV as the decision maker

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 Mutually exclusive projects
• Problem:
– When making investment decision, sometimes we
face 2 projects with:
✓NPV1>NPV2 but
✓IRR1<IRR2 so how can we choose the effective project?
– When a company need to choose 1 project from a
short-list feasible projects, it must rank the
projects from the most profitable to least.
– Rankings of projects according to IRR and NPV
may not be the same. The IRR and NPV rules rank
projects differently when:
✓The size or scale of the projects differs (measuring size
by the investment needed to undertake the project).
✓The timing of the projects’ cash flows differs.
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 Mutually exclusive projects
• Example 3.3.7: IRR and NPV for mutually exclusive
projects of different size
• To illustrate the preference for the NPV rule, consider the
case of projects that differ in size. Suppose that a company
has only $30,000 available to invest, while it has 2 available
investment project A and B.

Project Investment Cash flow IRR (%) NPV at 8%

at t=0 at t=1
A -$10,000 $15,000 50 $3,888.89
B -$30,000 $42,000 40 $8,888.89

• In the case of limited resources:

– According to IRR rule: choose project A
– According to NPV rule: choose project B
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 Mutually exclusive projects
• Example 3.3.8: IRR and NPV for mutually exclusive
projects with different timing of cash flows
• IRR and NPV can also rank projects of the same scale
differently when the timing of cash flows differs

Project CF0 ($) CF1 ($) CF2 ($) CF3 ($) IRR NPV at
(%) 8%
A -10,000 15,000 0 0 50,0 $3,888.89
D -10,000 0 0 21,220 28.5 $6,845.12

• In the case of limited resources:

– According to IRR rule: choose project A
– According to NPV rule: choose project D
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 Mutually exclusive projects
• Solution:
– When the IRR and NPV rules conflict in ranking
projects, we should take directions from the
NPV rule.

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 Mutually exclusive projects
• Why that preference?
• The NPV of an investment represents the
expected addition to shareholder wealth
from an investment, and we take the
maximization of shareholder wealth to be
a basic financial objective of a company.

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 Ranking conflicts for NPV/IRR

• Best decision rule for all projects:

CHOOSE THE HIGHER NPV!

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 Summary
• We can have many investment projects, but our
resources are limited, so we need to compare and
choose among them.
• In order to compare among investment projects, we
need to compare expected future cash flow.
• In order to compare expected future cash flow, we use
the concept “time value of money” to calculate money
to the same time basis.
• Net Present Value (NPV) and Internal Rate of Return
(IRR) are 2 methods applied the concept “time value of
money”, which we can use to evaluate and choose
among different investment projects.

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 END OF CHAPTER QUESTIONS
1. What is NPV? How to calculate NPV?
2. What is IRR? How to calculate IRR?
3. What does NPV and IRR tell you?
4. What is the difference between NPV and IRR?
5. Why do NPV or IRR disagree?
6. Why do we use NPV over IRR?
7. Can IRR be positive if NPV negative?
8. Is higher IRR better?
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Practice

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 ASSIGNMENT OF CHAPTER 3
1. SELF-TEST
2. REVIEW QUESTIONS
3. PROBLEMS

➢ DO IT BY YOURSELF FIRST
➢ ASK IN LATER CLASS IF YOU COULD NOT FINISH

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 PREPARE FOR CHAPTER 4
1. Read documents

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