CAPITAL INVESTMENT AND FINANCIAL RISK Chapter 10

Present Value  Present Value: the value today of an amount of money in the future  When we are calculating present value, we are discounting.  PV=FV n ÷(1+r) n where n=number of periods and r=rate of return (discount rate)

Present Value Using Present Value Table  Calculating present value using financial tables  PV=FV n × PV factor  Where the interest rate and the period intersect is the PV factor

Present Value Example What is the present value of a project that is expected to earn a one-time cash flow of $25,400 in 3 years with a discount rate of 9%? PV=FV n ÷(1+r) n =$25,400 ÷ (1+0.09) 3 =$25,400 ÷ (1.295) =$19,614

Present Value of an Annuity  Ordinary Annuity: a continuous stream of equal payments made at specific times over a stated period  Present value of an ordinary annuity is found by calculating the present value of each individual payment and then adding all the results together for the sum present value

Present Value of an Annuity  Can also use a financial table to find the present value  PV A = A × PVAF  Where A=annuity payment per period and PVAF=present value of annuity factor  Use table intersection of interest rate and period as PVAF  This method can also be used with a stream of unequal payments (see p10.8 for example)

Net Present Value (NPV)  The present value of all future cash inflows and outflows at a specified cost of capital minus the initial investment  NPV= -C 0 +(C t ÷(1+r) t )+ … +(C n ÷(1+r) n ) Where C 0 =Initial investment, C t =payment at period t=n, r=discount rate, n=number of periods

Net Present Value  Can also use a financial table to find the NPV such as the one on p10.10  Using the NPV rule, if the calculated NPV is positive, the investment should be made

Net Present Value Example A business is trying to determine today whether to make an $18,000 investment in a 3-year equipment maintenance project. The business requires a 6% return rate. The business projects to save $6,200 at the end of each of the first two years and $8,900 the third year. Should the business make this investment? NPV= -C 0 +(C t ÷(1+r) t )+ … +(C n ÷(1+r) n ) = -$18,000 + [$6,200÷(1+.06) 1 ] + [$6,200÷(1+.06) 2 ] + [$8,900÷(1+.06) 3 ] = -$18,000 + [$5,849] + [5,518] + [7,473] = $840

Capital Budgeting and Expenditures  The planning process a business goes through to determine if projects such as building a new factory or investing in a long-term proposal is worth pursuing  2 Types of Expenditures:  1. Operating expenditures  2. Capital expenditures (focus of capital budgeting)

Using the NPV Method  NPV=PV(sum of future net cash flows) – PV(initial investment)  Info needed to evaluate capital investment proposals:  Initial investment  Acceptable rate of return  Differential annual after-tax net cash flows over useful life  Salvage value if any

Risk Return Tradeoff  Risk-return trade-off: the idea that the potential return rises with an increase in risk  Used for evaluating the after-tax net cash flows that are part of a capital investment project

Cash Flow Analysis  Recognizing any accidental losses in a one-time control cost added to the initial investment and continuously implementing loss control techniques throughout the project  Sensitivity analysis

Risk Financing Techniques  The use of hedging to manage cash flows is typical for businesses that are not able to handle fluctuations in their production results  Forward contracts  Future contracts  Call option contracts