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Chapter 9

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Finance

FNCE 2P91

Clarke Melville

Winter

Description

FNCE 2P91 - Section 05
Winter 2011 - Duration 03
01.03.11
FNCE 2P91: Corporate Finance-Notes-Chapter 9 and Review for Midterm
Notes
MIDTERM
th
Saturday, March 5 at 9:00 am until 12:00 pm
o TH325
Exam covers
o Chapters 1, 5, 6, 7, 8
Format
o 20% Multiple Choice
o 80% Problems
7-8 Problems worth 8-12% each
Mostly the math and calculations but there could be definitions
No midterm posted in the library
As much round as you need for the answer to make sense
o Judgment call for the rounding
o As much needed for the question
No formula supply
Can use a financial calculator
o But remember to put down the steps/formulas
Check off professor’s name on the midterm: Melville
TONIGHT’S CLASS
First half: Chapter 9
Second half: Review
CHAPTER 9
Five Capital Investment Decision Criteria
CHAPTER 9 AND 10
Capital Budget
o Identify projects that produce cash flow (C/F) that exceed the cost of the project
FIVE CAPITAL INVESTMENT DECISION CRITERIA
1. NET PRESENT VALUE (NPV)
∑
Question:
Assume Canadian Tire considers a capita project with investment of $50 000 000 and it is going to be
earning $16 000 000 per year for the next 4 years and $20 000 000 in year 5. Your required return is
10%.
Answer:
( )
( ) ( ) ( ) ( )
( )
So increase shareholder wealth by $13.136 million if you accept the project. FNCE 2P91 - Section 05
Winter 2011 - Duration 03
Rule Applied:
If NPV > 0 accept the project
If MPV < 0 reject the project
2. INTERNAL RATE OF RETURN (IRR)
∑ ( )
Example From Above:
( )
( ) ( ) ( ) ( )
Solve for IRR, Trial and Error or you would have to use a computer or a financial calculator
Try 15%:
Try 20%:
Try 19%:
Try 19.52%:
So IRR = 19.52%
Rule Applied
If IRR > Required Return Accept the Project
If IRR < Required Return Reject the Project
NPV PROFILE
NPV
34
13.136
5.62
0
10 15 19.52
Required Return FNCE 2P91 - Section 05
Winter 2011 - Duration 03
3. PROFITABILITY INDEX (PI)
OR
Rule Applied
IF PI > 1 Accept
IF PI <1 Reject
4. PAYBACK
The number of years to payback the initial investment
Example:
YEAR CASH FLOWS ∑
0 (10 000) (10 000)
1 2 500 (7 500)
2 2 500 (3 000)
3 3 000 (2 000)
4 3 000 1 000
5 3 000 4 0000 FNCE 2P91 - Section 05
Winter 2011 - Duration 03
5. DISCOUNTED PAYBACK
The number of years to pay back the discounted cash flows
Example:
Required Return of 10%
YEAR CASH FLOW DISCOUNT FACTOR DCF ∑
0 (5 000) 1 (5 000) (5 000)
1 1 500 1.12 1 363.64 (3 636.36)
2 1 500 (1.1) 1 239.67 (2 399.69)
3 1 500 (1.1) 1 126.97 (1 269.72)
4
4 1 500 (1.15 1 024.52 (245.20)
5 1 500 (1.1) 931.38 686.18
( )
( ) [ ]
ANALYSIS OF THE 5 MEASURES
NPV
Preferred criteria
o Takes into consideration time value of money
o Gives you the net shareholder wealth
Only as good as the assumptions for cost, cash flow, required return going into it
IRR
If you are doing it right it will give you the same answer as NPV
Cannot use to it to rank mutually exclusive projects
Can give multiple answers for non-conventional cash flows
BUILD GAS BAR BUILD A STORE
IRR 27% 14%
NPV $ 1.5 million $ 20 million
Payback
Easy
Intuitive
No time value of money
Ignores cash flow beyond payback window
PI
Will give you the same answer and the NPV
Cannot use it to rank mutually exclusive projects
Discounted Payback
Includes time value of money
Ignores cash flow beyond payback FNCE 2P91 - Section 05
Winter 2011 - Duration 03
CROSS OVER RATES
At what discount rate are we indifferent between two mutually exclusive projects
Question:
Compare 2 projects
Year Project A C/F Project B C/F Delta (Difference)
0 (50 000) (100 000) 50 000
1 20 000 0 20 000
2 20 000 0 20 000
3 20 000 140 000 (115 000)
IRR 13.8% 11.9%
NPV
Project B
40 000
15 000
Project A
10.9% 11.9% 13.8% Discount Rates
At what rates are we going to be indifferent? That is produce the same NPV?
Crossover Rate?
Find IRR of the delta in C/F
( )
( ) ( )
So when discount rate is 0% 10.9% pick B
At 10.9% Indifferent
From 10.9% to 13.8% Pick A
Greater than 13.8% Pick none! FNCE 2P91 - Section 05
Winter 2011 - Duration 03
MIDTERM REVIEW
APR and EAR
APR

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