Lesson 7 and 8 THE TIME VALUE OF MONEY. ACTUALIZATION AND CAPITALIZATION. CAPITAL BUDGETING TECHNIQUES

Lesson 7 and 8 THE TIME VALUE OF MONEY. ACTUALIZATION AND CAPITALIZATION. CAPITAL BUDGETING TECHNIQUES

Present value A dollar tomorrow is worth less than a dollar today. Why? 1) Present consumption preferred to future consumption to induce people to give up to present consumption you have to offer them more in the future 2) Monetary inflation the value of currencies decreases over time 3) Uncertainty (risk) if there is a risk associated with an investment in the future, the less the investment will be valued

Discounting and compounding Discount rate: it is a rate at which present and future cash flows are traded off. It incorporates: preference for current consumption expected inflation the uncertainty in the future cash flows Discounting converts future cash flows into present cash flows. Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made. Compounding converts present cash flows into future cash flows.

Definition of investment As investment, we mean a transfer of monetary sources over time, which is characterized by net monetary outflows in the first period and net monetary inflows in a second period.

Investment F (t) t outflows inflows

How to finance investments Self financing Equity Debt It depends on: capital offer/supply company s situation economic effects of the financing operation non-economic effects of the financing operation company s flexibility/rigidity

Principal steps Search and analysis of the most appropriate alternative investments (mutually exclusive) from a strategic point of view Evaluation of alternative investments from a technical point of view Economic and financial evaluation of investments Choice of the most profitable option

Characteristics of relevant cash flows Monetary Consider tax effects Not consider financial negative interests Incremental

Estimating relevant cash flows The estimating relevant cash flows for evaluating a new investment project are the INCREMENTAL CASH FLOWS contributed by the project. Incremental CF = Firm s CFs with Project Firm s cash flow without Project Only incremental cash flows are relevant. But consider: sunk costs: forget! Costs incurred before the analysis of the project allocated overhead costs: forget! Costs are not directly traceable to the product product cannibalization: there should be a negative incremental effect due to the new product. The lost cash flows for the existing product should be treated as costs in analyzing wheter or not to introduce the new product

Computing relevant cash flows Revenues - Operating expenses - Depreciations = Operating income - Taxes = Net Earnings + Depreciations ± Change in Net Working Capital (NWC) = Cash flow from operations - Investments + Divestments = RELEVANT CASH FLOW

Distribution in time of cash flows F (t) F (t) 0 1 2 3 4 Time 0 1 2 3 4 Time Both projects have the same outflows but the distribution in time of inflows is different. The two projects have different values (time value of money).

Capital budgeting Capital budgeting: program for financing long-term outlays, such as plant expansion, R&D, advertising, In order to value an investment project: the amount of cash flows the distribution of cash flows the time value of money

Capital budgeting techniques The main techniques are: Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period (PBP)

The Net Present Value (NPV) The NPV is a method used in evaluating investments whereby the net present value of all cash outflows (such as the cost of the investment) and cash inflows is calculated using a given discount rate. NPV rule: Accept all projects for which NPV > 0 Reject all projects for which NPV < 0 Suppose you have several mutually exclusive projects A,B,C, Choose the project with the highest NPV.

The Net Present Value F 4 F (t) F 1 F 2 F 3 NPV = n F ( ) t= 1 1+ t k t - F 0 Time F 0 Discounting F t = cash inflows in period t n = number of periods k = discount rate F 0 = cash outflow in period 0

The Internal Rate of Return (IRR) IRR: rate of return to project required to obtain an NPV = 0 If IRR > opportunity cost of capital, then accept the project. - F 0 + n t= 1 ( + ) 1 F t IRR t = 0

The Payback Period (PBP) The Payback period requires that the initial outlay of a project should be recovered within a specified period. The PBP is the length of time required to recover the initial investment of the project. If PBP is less than the pre-determined cut-off, accept the project. Ex: