Session 2, Monday, April 3 rd (11:30-12:30)

Chapters Covered Internal Rate of Return: Part I, Domain B Chapter 6 Payback Period and Discounted Payback Period: Part II, Domain B Chapter 11 Cost of Capital: Part I, Domain B Chapter 6 v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-2

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). v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-3

Internal Rate of Return (IRR) Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. A project is acceptable only if the IRR exceeds the organization s target rate of return or weighted average cost of capital (WACC). v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-4

More on IRR The discount rate that forces the NPV to equal $0 Since an NPV of $0 means that the PV of CFs equals the upfront cost, the IRR is considered to be the yield or rate of return earned $0 = CF 1 1 + IRR 1 + CF 2 1 + IRR 2 +.. CF N 1 + IRR N Upfront Costs Decision Rule: Accept if IRR > WACC Must rely on the spreadsheet to calculate IRR v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-5

IRR Example An investment with an upfront cost of $55,000 will generate the following CFs at the end of the next 5 years: $16,000, $19,000, $18,000, $17,500, $17,500. What is the IRR? v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-6

Problems with the IRR Possibility of multiple IRRs The number of IRRs will equal the number of sign changes in the cash flow stream Reinvestment rate assumption The process used to calculate the IRR assumes that cash flows are reinvested at the IRR The scale problem If two projects/investments are mutually exclusive, the project/investment with the higher NPV may have a lower IRR v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-7

Payback Period The payback period is the number of periods required for the sum of the project s expected cash flows to equal the initial outlay Time needed to recover initial investment Decision rule: Compare the payback period to a standard value E.g., If standard value is 2 years, then a given project with a 3.5 year payback period would be rejected. Projects with longer payback periods may have more risk and are generally less desirable v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-8

Payback Period Example An investment with an upfront cost of $55,000 will generate the following CFs at the end of the next 5 years: $16,000, $19,000, $18,000, $17,500, $17,500. What is the payback period? v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-9

Payback Method Year Cash Inflow Cumulative Cash Inflow Unrecovered Investment at Year End 0 0 $55,000 1 $16,000 $16,000 $39,000 2 $19,000 $35,000 $20,000 3 $18,000 $53,000 $2,000 4 $17,500 $70,500 5 $17,500 $88,000 Payback Period = 3 Years $2, 000 $17, 500 1 Year = 3. 11 Years v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-10

Weaknesses and Strengths of Payback Period Weaknesses Does not account for the timing or risk of cash flows (i.e., no time value of money adjustment) Does not account for cash flows that occur after payback Inherent bias against long-term investments Strengths Simple and easy to apply, providing an efficient screening tool Provides a measure of project liquidity v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-11

Discounted Payback Method Year Cash Inflow Discounted at 8% Cumulative Discounted Cash Inflow Unrecovered Investment at Year End 0 1.0 $55,000 1 $16,000.926 $14,816 $14,816 $40,184 2 $19,000.857 $16,283 $31,099 $23,901 3 $18,000.794 $14,292 $45,391 $9,609 4 $17,500.735 $12,863 $58,254 5 $17,500.681 $11,918 $70,172 Discounted Payback Period = 3 Years $9, 609 $12, 863 1 Year = 3. 75 Years v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-12

More on Discounted Payback Period Accounts for timing and risk of cash flows via adjustment for time value of money Still, it is a limited capital budgeting measure v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-13

Comparison of Analysis Methods Net present value (NPV) Identifies cash flow for each year of the project. Computes PV of cash flow for each period. Add present values of cash flows. An acceptable NPV is greater than Zero. Internal rate of return (IRR) Uses discounted cash flow. Discount rate at which the present value off all cash inflows equals the present value of all cash outflows. Acceptable only if the IRR exceeds target rate of return or WACC. v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-14

Comparison of Analysis Methods Payback and Discounted Payback Determines the time required for an organization to recover its original investment through future cash flows. The longer the period required to recoup the original investment the less certain the projected cash flows are. The payback method is a good screening tool. Does not consider what happens to cash flows after the break-even point. Profitability Index Ratio of a project s returns to the project s required investment. If the ratio is greater than 1, the project is viable. v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-15

WACC The capital budgeting metrics account for the opportunity cost of future cash inflows using the weighted average cost of capital (WACC) WACC = [W D *k D *(1-T)] + [W E *k E ] k D = the annual cost of debt; best proxy is the yield to maturity (YTM) on the firm s most recent bond issue k E = the cost of equity T = Marginal tax rate v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-16

WACC Example from L.S. Capital Capital Structure Rate of Return Weighted Cost of Capital Debt 40% 7% 2.8% Equity 60% 5% 3.0% 5.8% v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-18

More on WACC A firm is trying to determine the best capital structure, and the following options are available. Which capital structure will maximize the value of the firm s cash flows? a. 30% Debt; 70% Equity: Cost of Debt = 5%; Cost of Equity = 9% b. 40% Debt; 60% Equity: Cost of Debt = 6%; Cost of Equity = 10% c. 60% Debt; 40% Equity: Cost of Debt = 6.5%; Cost of Equity = 11% d. 70% Debt; 30% Equity: Cost of Debt = 8.5%; Cost of Equity = 13% v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-19

More on WACC From the Balance Sheet: Assets = $2,000,000 and Equity is $700,000 YTM on bonds = 7% Cost of equity = 12% Tax rate = 35% What is the firm s WACC? v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-20

More on WACC Know the calculation and interpretation Be able to think through the qualitative implications What happens if the tax rate increases? If k D < k E, then why not 100% debt? v2.0 2014 Association for Financial Professionals. All rights reserved. Session 3-22