True or False: Present Worth Analysis is done to maximize the NPV

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ENGM 401 & 620 X1 Fundamentals of Engineering Finance Fall 2010 Lecture 24: Present Worth Analysis (2) It takes a lot of money to make these dreams come true. - Walt Disney M.G. Lipsett University of Alberta http://www.

1 ENGM 401 & 620 X1 Fundamentals of Engineering Finance Fall 2010 Lecture 24: Present Worth Analysis (2) It takes a lot of money to make these dreams come true. - Walt Disney M.G. Lipsett University of Alberta Present Worth (Review) Which statement is false about Present Worth? a) Present Worth is the comparable equivalent value at the present time of a future sum, or a set of future sums. b) Present worth analysis compares the net present value of multiple mutually exclusive options. c) Present worth includes all the incomes and expenditures, including costs before the present time. Sunk costs are ignored d) Financing and investment activities are considered separate activities and then their NPVs are combined. True or False: Present Worth Analysis is done to maximize the NPV of a combination of financing and investment activities. True or False: In an Excel spreadsheet, Cell $C$7 would have the expression =B7*(1+$A$2)^(A7) A B C 1 2 Present value i = 3% 3 n FV PV 4 0 $0.00 $ $ $ $ $ $ $ NPV $ MG Lipsett,

2 Problem 7.3(a) from Course Text You are contemplating the purchase of a company that has a $600,000 balloon payment on a new 4-year loan with 8.5% interest. As part of your plan to purchase this company, you are contemplating paying off the debt early (i.e., today) in order to take out a larger long term debt with longer repayment provisions, at the current long-term interest rate of 7.5% Questions: What payment would be a fair offer to repay the balloon payment, assuming that you are going to refinance the new long term debt from the same financial institution at current rates? What if the company had an equivalent 4-year loan with uniform annual payments? MG Lipsett, Problem 7.3(a) from Course Text (2) The first step in solving this problem: is to determine the present value of the future debt (the market value of the bond with 4 years remaining) using the market rate of 7.5%. Payments for the loan are: $600k x 8.5% = $51k per year on the $600k principal. 7.5% is the current value of money, and the lending institution will re-lend the money at this rate. Thus, we will want to value the repayment and new loan at the same rate. A A A A+F MG Lipsett,

Problem 7.3(a) from Course Text (2) A A A A+F Now we set up the cash flow series from today to the end of the loan and determine net present value @ 7.5%. Coupon rate A = 600,000 x 0.

3 Problem 7.3(a) from Course Text (2) A A A A+F Now we set up the cash flow series from today to the end of the loan and determine net present 7.5%. Coupon rate A = 600,000 x = $51,000 Coupon + principal MG Lipsett, Problem 7.3(a) from Course Text (2) A A A A+F From the cash flow series, determine net present 7.5%. Coupon rate A = $51,000 Coupon + principal MG Lipsett,

4 Problem 7.3(a) from Course Text (3) Alternatively, we find the solution for a set of future uniform payments: FV: $600k(A/P, 8.5%,4) = $183,173 payment in each period But, the PV is discounted by the market discount rate of 7.5% MG Lipsett, Problem 7.3(a) from Course Text (3) Now, we find the solution for a set of uniform payments: FV: $600k(A/P, 8.5%,4) = $183,173 payment in each period But, the PV is discounted by the market discount rate of 7.5% MG Lipsett,

5 Another Spreadsheet Example Personal transportation: bus vs. car bus pass used to cost $75 per term. Was that a good deal for a new first-year student? Or should he/she get a car? What assumptions should be made to define the problem? How would we set up a spreadsheet to compare the options? (see posted spreadsheet) Other suggested examples to do in class? MG Lipsett, Choosing a Value of i Many broad factors affect choice of i : Inflation Supply and demand of money Specific funds availability ( flavour of the month ) Risk and liquidity of investment Alternative investment opportunities For many projects, companies often identify a hurdle rate, also known as the minimum acceptable rate of return (MARR) Risk: What if payment is from Govt of Alberta? Mike Lipsett? Fellow student? Person you met in the bar? Does your need for cash influence the outcome, i.e., Might my answer be different from yours? Why? When do I need the cash? When might you need the cash? MARR is the lowest return you are willing to earn on an investment For large projects, hurdle rates are too simplistic to be applied blindly MG Lipsett,

6 Weighted Average Cost of Capital Most large publicly traded companies have a blend of financing: Short term debt Long term debt Preferred shares (dividend is paid after tax ) Capital (market has some expectation of return based on dividend and capital gains) The weighted average cost of capital (WACC) takes the mix of financing and factors in the cost Many companies use WACC as the MARR for an investment that adds no more risk to the company Then, they apply a project-specific risk premium to investments that have a higher level of risk MG Lipsett, Fiscal Policy and Economic Activity High interest rates make capital more expensive, and reduce the likelihood of investment If you can save $1000 per year over a 25 year period, you will be willing to invest $8422 at 11% interest/return If your interest/return is 16%, you re only willing to invest $6097 Government policy affects interest rates Fiscally irresponsible governments create high rates, which stifles investment. Capital investment and business acquisition shrinks at such times, damaging the prosperity of a nation Lower capital investment Higher interest rates MG Lipsett,

An Interesting News Item

An Interesting News Item ENGM 401 & 620 X1 Fundamentals of Engineering Finance Fall 2010 Lecture 26: Other Analysis Techniques If you work just for money, you'll never make it, but if you love what you're doing and you always