Time Valuations 7

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Time Valuations


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2012 BSE Institute LimitedCorporate Finance -1/Capital Budgeting

Session VII - X

At the end of this session, you will be able to:

Review the concept of time value of money

nde!stand the need fo! !is" f!ee !ate in cash #ow valuations

nde!stand va!ious time value concepts such as $et %!esent Value

Inte!nal Rate of Retu!n

&odi'ed Inte!nal Rate of Retu!n

(iscounted )ash *low &ethod

%ay +ac" %e!iod %e!petuity and Annuity

2


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Valuations %lannin.

*inancial fo!ecastin. involves p!edictin. futu!e #ow of cash in and out ofthe company

)apital bud.et can be dissected into two pa!ts /

a0 )apital / !efe!s to ope!atin. assets in p!oduction

b0 +ud.et / is a plan that details p!o1ected cash #ows du!in. some futu!epe!iod

The!efo!e,

)apital bud.etin. is the whole p!ocess of analy2in. the p!o1ects anddecidin. which one to include in the capital bud.et

It is a p!ocess of evaluatin. speci'c investment decisions


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)apital +ud.etin.

$eed fo! capital bud.etin. /

A '!m3s capital bud.etin. decisions must de'ne its st!ate.ic di!ection%lannin. is essential because launchin. of a new p!oducts, se!vices o!ma!"ets is p!eceded by capital e4penditu!e

Results of capital bud.etin. decisions may be achieved in many yea!sto come

%oo! investments can lead to non-optimal utilisation of 'nancial!esou!ces


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)apital +ud.etin.

)apital 54penditu!e / Types, classi'cations and decisions

Replacement: &aintenance of business 6Should we ca!!y on 70

Replacement: )ost !eduction 6)ut cost th!ou.h alte!natives0

54pansion into e4istin. and new ma!"ets 68ow can we 70

54penditu!e on p!oduct 9uality and 9uantity enhancement

Safety ando! 5nvi!onment %!o1ects 6Social !esponsibility0

Resea!ch and (evelopment 6%!oduct enhancement0

;on. te!m cont!acts 6Secu!in. ma!"et deals0


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Recall: Time Value of &oney

TVMis the value of money '.u!in. in a .iven amount of inte!est ea!nedove! a .iven amount of time

The time value of money is the cent!al concept in fnance theory.

The method allows the valuation of a li"ely st!eam of income in the futu!e,in such a way that the annual incomes a!e discounted and then addedto.ethe!, thus p!ovidin. a lump-sum


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sa.e of Time Value of &oney

Techni9ues fo! )apital +ud.etin. /

a0 %aybac" %e!iod

b0 (iscounted %aybac" %e!iod

c0 $et %!esent Value

d0 Inte!nal Rate of Retu!n

e0 &odi'ed Inte!nal Rate of Retu!n


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(iscount Rate, 8ow to )hoose

In#ation Rate

T!easu!y +ill =ield

Annuali2ed Stoc" &a!"et Retu!ns

>-Sec +ond =ield

+an" Rate

*i4ed (eposit


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$et %!esent Value

$et %!esent Value / In p!inciple, simila! to the discounted cash #ow method

%!o1ects with positive $%V should be accepted If not, the p!o1ect must be!e1ected If two p!o1ects have positive $%V, then the one with hi.he! $%Vmust be accepted

;in": $%V
http://net%20present%20value.xls/http://net%20present%20value.xls/


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%ay +ac" &ethod

54pected Afte! / Ta4

$et )ash *low, )*t

=ea! 6t0 %!o1ect S %!o1ect T

? 6I$R @???0 6I$R @???0

@ ?? @??

B C?? D??

D D?? C??

C @?? E??

%!o1ect S has hi.he! cash #ows at the be.innin. of ope!ation

*o! %!o1ect T, hi.he! cash #ows comes as yea!s pass on

Fhich of these two options a!e optimal f!om investment and !evenuepoint of you 7


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%ay +ac" &ethod

%aybac" %e!iod / is the numbe! of yea!s !e9ui!ed to !ecove! the o!i.inal investment

Initial Investment / I$R @???

Net Cash Flow -1000 500 400 300 100Cumulative NCF -1000 -500 -100 200 300

Project S

Net Cash Flow -1000 100 300 400 600

Cumulative NCF -1000 -900 -600 -200 400

Project T


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%ay +ac" &ethod

Techniques or Capital Budgeting

Payback.Discounted Payback.et Present Value.!nternal "ate o "eturn.Modifed !nternal "ate o "eturn.Proftability !nde#.

!recovere" Cost at the

Start o# $ear

Cash #low %uri!& the

$ear

$ear 'e#ore Full (ecover) *Pa) 'ac+ ,erio"

Pa)'ac+ Short Term 2 * .100/300

233 )ears

Pa)'ac+ o!& Term 3 * .200/600

333 )ears


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(iscounted )ash *low

(iscounted %aybac" %e!iod /

8ow !ealistic is the %aybac" %e!iod method 7

(oes it account fo! in#ation facto! time vale of money 7

(%% method allows fo! discountin. of cash #ows The discount !ate used isthe p!o1ect3s cost of capital

The!efo!e, the discounted paybac" pe!iod is de'ned as the numbe! of yea!s

!e9ui!ed to !ecove! the investment f!om the discounted cash #ows


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t )ash *low -@??? ?? C?? D??

)umulative $)* @?G -@??? C DD@BB EH

0 1 2 3 4

Project S

(iscounted $)* -@??? C -B@C @@

(iscounted %aybac" %e!iod K B L 6B@CBB0

K BJ yea!s


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t )ash *low -@??? @?? D?? C??

)umulative $)* @?G -@??? J@ BCHD?@ C@?

0 1 2 3 4

%!o1ect T

(iscounted $)* -@??? -J?J -EE@ -DE?

(iscounted %aybac" %e!iod K D L 6DE?C@?0

K DH yea!s


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Inte!nal Rate of Retu!n

Inte!nal Rate of Retu!n / is the discount !ate that e9uates the p!esent valueof the p!o1ects cash in#ows to the p!esent value of the p!o1ects costs

Si.ni'cance of IRR /

The IRR on a p!o1ect is its e4pected !ate of !etu!n

If the IRR e4ceeds the cost of the funds used to 'nance the p!o1ect, asu!plus will !emain afte! payin. fo! the capital

A su!plus indicates that the!e is an inc!ease in sha!eholde! wealth


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&odi'ed Inte!nal Rate of Retu!n

&odi'ed Inte!nal Rate of Retu!n /

In &IRR, the cash #ows f!om each p!o1ects a!e !einvested at the cost ofcapital

&IRR is the !ate at which all the futu!e cash #ows a!e !einvested

;in": &IRR

CIFt( 1 + r )n - t

t = 0

n

( 1 + MIRR )

n

=COFt

( 1 + r )t

t = 0

n

. 1 * r t

CFt. 1 * r ! - t

t 0

!

. 1 * (( !

CFtt 0

!

M K
http://mirr.xls/http://mirr.xls/


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$et %!esent Value, In detail

)alculatin. $%V based on /

%e!petuities

neven )ash *low %e!petuity

Annuities

a0 N!dina!y Annuities

b0 Annuities (ue


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%e!petuities and Annuities

%e!petuities is the constant st!eam of cash #ows without end

In cont!ast to 'nite numbe! of cash #ows called annuities, pe!petuitiesp!ovide fo! an in'nite unendin. st!eam of cash #ows ove! an un-measu!able pe!iod of time

)an this happen 7

)onsol +onds issued in the O entitles the owne! to !eceive yea!ly inte!estf!om the +!itish .ove!nment Pfo!eve!Q


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%e!petuities and Annuities

Tal"in. of annuities, the te!m constant payment is always !efe!!ed to Inothe! wo!ds, annuities involve payments that a!e the same in eve!ype!iod

A!e the!e any scope of uneven cash #ow 7

If yes, could you thin" of any asset that will .ene!ate, hypothetically, ava!iable cash #ow 77

)ommon Stoc"s and its uneven cash #ow / dividends


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>!owin. %e!petuities

>!owin. %e!petuities / Simila! to pe!petuities in te!ms of its application , in.!owin. pe!petuities, the cash #ows a!e e4pected to .!ow at someconstant !ate P.Q

) / cash #ow !eceived one pe!iod

! / discount !ate

. / !ate of .!owth pe! pe!iod

%V K ) L ) 6@ L .0 L )6@ L .0B L )6@ L .0$ / @

6@ L !0 6@ L !0B 6@ L !0D 6@ L !0$


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Annuities and *VA3s

An annuity is a level st!eam of !e.ula! payments that lasts fo! a P'4edQnumbe! of pe!iods

54amples:

@0 %ensions

B0 nspeci'ed time based leases

In othe! wo!ds, an annuity is a se!ies of e9ual payments made at '4edinte!vals fo! a speci'ed numbe! of pe!iod

Receipts Received %ayments made at the end of one accountin. pe!iod /

N!dina!y o! (efe!!ed Annuity

Receipts Received %ayments made typically on the @st day of theaccountin. pe!iod / Annuity (ue


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Annuities: %ension

Amount: I$R ?,???

Inte!est Rate: HG

Time: @? y!s

%!esent Value of Annuities: I$R CJ?J?C

;in": %e!petuities and Annuities
http://perpetuity%20and%20annuity%20notes.xls/http://perpetuity%20and%20annuity%20notes.xls/


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>!owin. Annuities: %ension

Amount: I$R ?,???

Inte!est Rate: HG

Time: @? y!s

%!esent Value of >!owin. Annuities: I$R CJ?J?C

;in": %e!petuities and Annuities

6@ L i0
http://perpetuity%20and%20annuity%20notes.xls/http://perpetuity%20and%20annuity%20notes.xls/


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Than" =ou

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Time Valuations 7

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