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FINE 2000 Lecture Notes - Lecture 1: Payback Period, Opportunity Cost, 0 (Year)

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cerisehorse97
15 Sep 2016
School
York University
Department
Finance
Course
FINE 2000
Professor
Anthony Mayadunne

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Document Summary

Chapter 8 - net present value and other investment criteria. The present value is the only feasible price that satisfies both the buyer and seller: the present value is also its market price or market value. To calculate pv, we discount the expected future payoff by the rate of return, also known as the opportunity cost of capital because it is the return being given up by investing in the project. However, if the same return can be achieved with less risk, investors will rather that option: a risky dollar is worth less than a safe one . Using the npv rule to choose among projects. Rule is simple: calculate the npv of each project and from those options that have a positive. Npv, choose the one whose npbv is highest. A project with a positive npv is worth more than it costs: therefore when a firm invests in such a project it creates value and makes shareholders better off.

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Related Questions

(a) Compare NPV, PI and IRR investment criteria. Describe each investment criteria, detailing their advantages and disadvantages. (9 marks)
(b) In calculating a NPV for a series of cash flows there are two assumptions. Identify and discuss these two assumptions. (2 marks)
(c) Identify whether you agree or disagree with the statements and briefly, in few sentences discuss the reason for your agreement or disagreement: (2 marks each/ 8 marks total)
a. Using the same discount rate to discount all cash flows ignores the fact that less distant cash flows are preferred to more distant ones.
b. The present value of a project is the minimum amount one would have to pay for it to be economically acceptable.
c. A project having a positive NPV should always be chosen.
d. If a project does not recover its initial outlay within three years, it probably is not worth pursuing.

  1. Calculate the present value of a growing perpetuity with thefirst cash flow (occurring in one year) being $10 million and everysubsequent year’s cash flow growing at a constant 6% rate (i.e, thecash flow at the end of two years is $10M(1.06) = $10.6 million,the cash flow at the end of three years is 10M(1.06)^2 = $11.236million, etc.). The cost of capital for this calculation is12%.

  2. The firm has to spend $50 million immediately and $25 millionone year from now to start a new investment project. The firm’scost of capital is 12%. What is the present value of the firm’sexpenditures to start the new investment project?

  3. The firm is considering the investment project in problem 2,where they invest $50 million immediately and $25 millionadditionally one year from now. There are no other cash inflows oroutflows for the project until the end of five years, at which timethe first cash inflow from the project is $10 million. After thisfirst cash inflow, the cash flows grow each year at 6%,indefinitely. The cost of capital for this project is 12%.Calculate the Net Present Value of this investment.

  4. The NPV of the investment in problem 3 depends on the growthrate in perpetuity of the cash inflows. For example, if the growthrate were 4% rather than six percent, the NPV of the project wouldbe lower. For what value of the growth rate is the NPV of theproject zero? (In other words, how high does the growth rate inperpetuity have to be for this project to be positive NPV?)

    The following questions use the Capital Asset Pricing Model. Youhave the following market- wide parameters: the risk-free rate ofinterest in the economy is 3% and the risk premium on the marketportfolio (i.e., the market risk premium) is 6%.

  5. What is the expected return on a stock with a beta of 1.5?

  6. What is the expected return on a stock the return on which isuncorrelated with the return on the market portfolio?

  7. What is the beta of a portfolio where half of the money in theportfolio is invested in the market index and half the money in theportfolio is invested in risk free securities? What is the expectedreturn on such a portfolio?

Scenario Information:
Assume that two gas stations are for sale with the following cash flows; CF1 is the Cash Flow in the first year, and CF2 is the Cash Flow in the second year. This is the time line and data used in calculating the Payback Period, Net Present Value, and Internal Rate of Return. The calculations are done for you. Your task is to select the best project and explain your decision. The methods are presented and the decision each indicates is given below.

Investment Sales Price CF1 CF2
Gas Station A $50,000 $0 $100,000
Gas Station B $50,000 $50,000 $25,000



Three (3) Capital Budgeting Methods are presented:

Payback Period: Gas Station A is paid back in 2 years; CF1 in year 1, and CF2 in year 2. Gas Station B is paid back in one (1) year. According to the payback period, when given the choice between two mutually exclusive projects, the investment paid back in the shortest time is selected.

Net Present Value: Consider the gas station example above under the NPV method, and a discount rate of 10%:
NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644
NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115

Internal Rate of Return: Assuming 10% is the cost of funds; the IRR for Station A is 41.421%.; for Station B, 36.602.

Summary of the Three (3) Methods:

Gas Station B should be selected, as the investment is returned in 1 period rather than 2 periods required for Gas Station A.

Under the NPV criteria, however, the decision favors gas station A, as it has the higher net present value. NPV is a measure of the value of the investment.

The IRR method favors Gas Station A. as it has a higher return, exceeding the cost of funds (10%) by the highest return.