Session 1, Monday, April 8 th (9:45-10:45)

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Session 1, Monday, April 8 th (9:45-10:45) Time Value of Money and Capital

2 Chapters Covered Time Value of Money: Part I, Domain B Chapter 6 Net Present Value: Part I, Domain B Chapter 6 Profitability Index: Part II, Domain B Chapter 11 v Association for Financial Professionals. All rights reserved. Session 3-2

Maximizing Shareholder Wealth FP&A helps managers collect, analyze and understand financial data to decide how to: Increase cash flow Speed up cash flow Reduce cash

3 Maximizing Shareholder Wealth FP&A helps managers collect, analyze and understand financial data to decide how to: Increase cash flow Speed up cash flow Reduce cash flow risk Make investment decisions Make financing decisions Operate assets efficiently v Association for Financial Professionals. All rights reserved. Session 3-3

5 Information Gathering Time Periods (duration) Time Intervals Residual Values Revenue & Costs List of assumptions Depreciation/ Amortization & Tax Impact v Association for Financial Professionals. All rights reserved. Session 3-5

6 Miscellaneous Points on Capital Budgeting Types of Capital Investments: New product lines Expansion of existing lines Abandonment of existing lines Cost cutting proposals Only relevant or incremental cash flows matter Marginal benefits vs. Marginal costs When given cash flows on capital budgeting problems, assume that all relevant expenses and revenues have been factored in (unless noted otherwise). However, for future CFs one cost remains to account for.. v Association for Financial Professionals. All rights reserved. Session 3-6

7 Time Value of Money. a dollar in hand is worth more than a dollar to be received in the future because it can either be consumed immediately or put to work to earn a return. A dollar (or any other monetary unit) is worth more today than a dollar received tomorrow because that dollar can be invested today to earn a return. A dollar tomorrow is worth less than a dollar today because of the interest foregone. v Association for Financial Professionals. All rights reserved. Session 3-7

8 Present Values (PV) Key Takeaway on PV calculations: The PV of an investment s expected cash flows is the maximum price that an investor is willing to pay for the investment v Association for Financial Professionals. All rights reserved. Session 3-8

9 Future Value and Present Value: Lump Sum Cash Flows Future Value (FV) Present Value (PV) FV = PV(1 + i) n PV = FV [ 1 ] (1 + i) n Where: FV = Future value PV = Present value or value today i = Periodic (annual) interest rate n = Number of periods (years) v Association for Financial Professionals. All rights reserved. Session 3-9

11 More on Lump Sum PV Alternatively, we can solve for the PV by hand PV = 4, = $3,0000 Depending on the question, you might prefer this method. At a minimum, it serves as a nice check. v Association for Financial Professionals. All rights reserved. Session 3-11

12 More on Lump Sum FV What is the future value of a $2,000 cash flow invested at 5% per year for 3 years? FV = $2,000 ( ) = $2, v Association for Financial Professionals. All rights reserved. Session 3-12

13 More on Time Value of Money With the future value equation, (1+i) N is referred to as the future value interest factor 1/(1+i) N is referred to as the present value interest factor Note the relationships from the equations, as these make for easy opportunities for test question development For example, the PV of a cash flow is inversely related to the opportunity cost of funds Meanwhile, the FV of a cash flow is directly related to the opportunity cost of funds v Association for Financial Professionals. All rights reserved. Session 3-13

14 More on Time Value of Money Simple Interest: Rate multiplied by invested balance $2,000*0.05 = $100 per year in simple interest (from the previous FV example) Compounded Interest: Interest earned on interest Most efficient way to calculate it is to subtract the starting investment balance and the total simple interest from the FV of the investment Compound interest: $2, $2,000 (3 years*$100) = $15.25 v Association for Financial Professionals. All rights reserved. Session 3-14

15 More on Time Value of Money Annuities (both PV and FV) A cash flow stream with a fixed dollar amount, occurring at a fixed frequency for a defined period of time For annuity calculations, it will likely be most efficient to use the worksheet function Present Value of a Constantly Growing Annuity I wouldn t spend much time on Annuities w/ constant growth (page IB-28) v Association for Financial Professionals. All rights reserved. Session 3-15

16 Financial Valuation Methods Discounted Cash Flow (DCF) Discounts the future value of all cash inflows and outflows of an investment back to their present value by factoring in costs of capital debt and equity costs. Required Rate of Return (RRR) The minimum annual percentage earned on invested capital for it to be deemed acceptable. Equal to the weighted average cost of capital (WACC). v Association for Financial Professionals. All rights reserved. Session 3-16

17 Net Present Value (NPV) This metric shows the increase in value created by a project NPV = PV of Cash Inflows PV of Cash Outflows NPV = CF 1 1+WACC 1 + CF 2 1+WACC CF N 1+WACC N Upfront Costs Decision Rule: Accept if NPV > $0 v Association for Financial Professionals. All rights reserved. Session 3-17

19 Net Present Value (NPV) 1. Identify cash flows. 2. Calculate present values. 3. Add values. Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 $(75,000) $18,000 $18,000 $18,000 $18,000 $18,000 $(75,000) 18, = $16,364 18, = $14,876 18, = $13,534 $(75,000) $68,283 $(6,717) 18, = $12,329 18, = $11,180 Function syntax: =NPV(rate,Value1,[Value2],[Value3])+Initial Investment v Association for Financial Professionals. All rights reserved. Session 3-19

20 More on NPV The NPV method accounts for All relevant CFs Timing and riskiness of CFs via discounting Key assumption: constant WACC Sensitivity analysis v Association for Financial Professionals. All rights reserved. Session 3-20

22 More on the PI A project should be accepted if its PI is greater than one and rejected if it is less than one This parallels the NPV rule; if the NPV > $0, then the PI > 1 and vice versa Why is the PI popular? Helps communicate the economic profitability of a project The PI: Adjusts for the timing and risk of cash flows Selects value maximization project, but might lead to a suboptimal selection when comparing two mutually exclusive investments with different initial cash outlays v Association for Financial Professionals. All rights reserved. Session 3-22

23 Required rate of return is 10% PI Example Time CF PV of CFs = = $ PI = = 1.26, which indicates that this investment produces 500 $1.26 in present value cash flow for each $1 invested Note, the NPV for this investment is + and the PI > 1 v Association for Financial Professionals. All rights reserved. Session 3-23

AFP Financial Planning & Analysis Learning System Session 1, Monday, April 3 rd (9:45-10:45) Time Value of Money and Capital Budgeting

AFP Financial Planning & Analysis Learning System Session 1, Monday, April 3 rd (9:45-10:45) Time Value of Money and Capital Budgeting Chapters Covered Time Value of Money: Part I, Domain B Chapter 6 Net