Académique Documents
Professionnel Documents
Culture Documents
Corporate Finance
Spring Semester 2010
Dr. Isabel Tkatch
Assistant Professor of Finance
1
frequency of compounding
Capital
45
60 minutes
Mostly
Bring
Formulas?
Learning objectives
Explain
Determine
Explain
Example
You are contemplating the purchase of a rental
property. The property consists of 12 apartments,
each of which fetches a rent of $600 per month.
The cost of maintaining the entire property is
$1,800 per month.
The effective monthly discount rate is 1%.
The property has an economic life of ten years and
can be sold for $500,000 at the end of its life.
1. What is the maximum that you would pay for this
property?
2. What if the owner is selling for $500,000?
4
Assumptions
Assumption 1 (magnitude preference):
all else equal, investors prefer to have more money
rather than less
Assumption 2 (timing preference):
all else equal, investors prefer to get the money sooner
(today) rather than later (in the future)
Assumption 3 (risk preference):
all else equal, investors prefer a safe CF to a risky CF
(they are risk-averse)
Assumption 4 (managements goal):
The primary goal of the firms management is to
maximize shareholder wealth
7
PV (cash inflows)
PI =
PV (cash outflows)
Example
Consider the mutually exclusive projects A and B
Project
PV(inflows)
PV(outflows)
$110,000
$100,000
$315,000
$300,000
PI
NPV
CFt
CF1
CF2
CFT
NPV CF0
...
...
0
1
2
t
T
(1 IRR ) (1 IRR )
(1 IRR )
(1 IRR)
Note: use a trial-and-error algorithm to find IRR.
If NPV>0 then we used r < IRR
If NPV=0 then we used r = IRR
If NPV<0 then we used r > IRR
15
18
t=0
t=1
t=2
t=3
t=4
T=5
CF
-1,000
400
400
400
500
500
20
Example
A five-year project, if taken, will require an initial investment of
$120,000. The expected end-of-year cash inflows are as follows:
Date
CF
t=0
t=1
t=2
t=3
t=4
T=5
12,000
Textbook Example
The firms cost of capital for the following
project is 12%.
The project will require an initial investment
of $6 million and generate cash flows of
$750,000 per year for ever.
Compute the NPV, IRR and PI of the project.
22
23
t=0
t=1
t=2
CF
-$400
$2,500
-$3,000
200
NPV
-200
IRR?
-400
-600
-800
-1000
0
100
200
300
400
500
600
Discount rate
25
t=0
t=1
t=2
t=3
CF(A)
-$1,000,000
$400,000
$400,000
$400,000
CF(B)
-$1
$0.4
0.4
0.5
t=1
t=2
t=3
t=4
T=5
CF
30,000
42,000
42,000
28,000
12,000
ACC. CF
30
If PBP < t
Accept project
If PBP = t
Indifference
If PBP > t
Reject project
31
t=0
t=1
t=2
t=3
t=4
T=5
CF(A)
-9,000
2,000
3,000
4,000
5,000
6,000
3,000
4,000
5,000
6,000
32
t=0
t=1
t=2
T=3
CF(A)
-1,000
500
510
10
CF(B)
-1,000
99,000,000
34
t=1
t=2
t=3
t=4
T=5
CF
30,000
42,000
42,000
28,000
12,000
PV(CF)
ACC. PV(CF)
35
Indifference
Reject project
36
Date
t=1
t=2
t=3
t=4
CF
-9,000
3,000
6,000
9,000
PV(CF)
ACC. PV(CF)
37
It
39
Summary 1: Description
Rule
NPV
Description
NPV = PV (CF stream)
= PV(cash inflows) PV(cash outflows)
IRR
PI
D. PBP
40
Summary 2: Rules
Rule
Accept project if
Reject project if
NPV
NPV > 0
NPV < 0
IRR
PI
PI > 1
PI < 1
41
Rule
NPV
IRR
PI
Disc. PDP
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