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Chapter 8 Textbook: Fundamentals of Corporate Finance (Hillier cs) Jan H. Jansen E-mail: [email protected]

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Page 1: Chapter 8HAN

Chapter 8

Textbook:

Fundamentals of Corporate Finance (Hillier cs)

Jan H. Jansen

E-mail: [email protected]

Page 2: Chapter 8HAN

Investment Decision

Nature of an investment decision:

• Investment amount (large amount)

• Expected, Future Cash Flows

– Outflows (Costs)

– Inflows (Revenues)

• Discount factor

– Real interest rate

– Inflation

– Risk

• Economic life vs technical life

• Scrap value / Residual value

Page 3: Chapter 8HAN

Stages in an investment decision

Determine investment

funds available

Identify profitable

project opportunities

Evaluate the proposed

project

Approve the project

Monitor and control the

project

Page 4: Chapter 8HAN

Investment decision criteria

• Payback Period

• Average Accounting Return / ROI

• Net Present Value

• Profitability Index

• Internal Rate of Return / IRR

• Discounted Payback / Break even time

Page 5: Chapter 8HAN

Payback Period

The amount of time required for an

investment to generate cash flows

sufficient to recover its initial cost

Page 6: Chapter 8HAN

Average Accounting Return / ROI

An investment’s average net income

divided by its average book value

Page 7: Chapter 8HAN

Net Present Value (NPV)

Page 8: Chapter 8HAN

NPV

The process of valuing an investment by

discounting its future cash flows

An investment should be accepted if the net

present value is positive and rejected if it is

negative.

Page 9: Chapter 8HAN

Advantages of NPV

Uses Cash Flows

• Cash Flows are better than Earnings (Cash is a fact, profit is an opinion)

Uses all Cash Flows

• Other approaches ignore cash flows beyond a certain date

Discounts Cash Flows

• Fully incorporates the Time Value of Money

Page 10: Chapter 8HAN

Profitability Index

Page 11: Chapter 8HAN

Discounted Payback / Break even time

The length of time required for an

investment’s discounted cash flows

to equal its initial cost

Page 12: Chapter 8HAN

Internal Rate of Return (IRR)

The discount rate (irr) that makes

the NPV of an investment zero

Page 13: Chapter 8HAN

Internal Rate of Return (IRR)

IRR equation: Polynomial (degree of n)

The possibility that more than one

discount rate will make the NPV of an

investment zero

Page 14: Chapter 8HAN

Structure Excel model

Data & Assumptions

Cash Outflows

Cash Inflows

Calculations

Results

Page 15: Chapter 8HAN

How to build an Excel model

– Worksheet 1 (Project name)• Project name

• Version & Date

• Authors

– Worksheet 2 (Results)• Investment amount

• Economic life

• Decision criteria

– Worksheet 3 (Data)• Data

• Assumptions

– Worksheet 4 (COF)• Cash Outflows

– Worksheet 5 (CIF)• Cash Inflows

– Worksheet 6 (NCF)• Net Cash Flows

Page 16: Chapter 8HAN

Investment case

• Investment € 50,000,000

• Scrap value: € 0

• Expected economic life: 10 years

• Expected Real Interest rate: 3%

• Expected Inflation: 2.5%

• Risk mark up: 1.5%

• Annual Revenues: € 10,000,000

• Annual Costs: € 2,000,000

Page 17: Chapter 8HAN

Calculate

• Discount factor

• Payback Period

• Average Accounting Return / ROI

• Net Present Value

• Profitability Index

• Internal Rate of Return / IRR

• Discounted Payback / Break even time

Should we invest or not?

Page 18: Chapter 8HAN

Excel functions

• ^

• COUNTIF

• NPV

• IRR

Page 19: Chapter 8HAN

Results

PBP 7years

ROI 12,0%

NPV € 5.778.955,65

PI 11,56%

IRR 9,6%

BET 9years

Page 20: Chapter 8HAN

Decision criteria: Pro’s & Con’s

• Payback Period

• Average Accounting Return / ROI

• Net Present Value

• Profitability Index

• Internal Rate of Return / IRR

• Discounted Payback / Break even time