4- 1 © ADMN 3116, Anton Miglo ADMN 3116: Financial Management 1 Lecture 4: Basics of Investments Anton Miglo Fall 2014

4- 2 © ADMN 3116, Anton Miglo Topics  Net present value rule  Internal rate of return  Mutually exclusive projects  Capital rationing  Cash flows vs. profits  NPV and firm’s value  Goals of corporations and agency problems  Excel: NPV, IRR  Additional readings: B ch. 2,4,5

4- 3 © ADMN 3116, Anton Miglo Net Present Value You have an investment project available (for example, the opportunity to purchase an office building). It cost $300,000. It will generate $20,000 per year in cash flows for three years. At the end of three years you anticipate selling the assets (building) for $500,000. Would you invest in the project?

4- 4 © ADMN 3116, Anton Miglo -300,000 Net Present Value 20, ,0000

4- 5 © ADMN 3116, Anton Miglo NPV Example How does Eurotunnel Compare?

4- 6 © ADMN 3116, Anton Miglo YearCash Flow PV at 13% YearCash Flow PV at 13% , , , , Total251

4- 7 © ADMN 3116, Anton Miglo Some concepts  Cash flows vs. profits  Incremental benefits  Sunk Costs  Mutually exclusive projects

4- 8 © ADMN 3116, Anton Miglo Cash Flows vs Profits Year 0Year 1Year 2 Cost2000 Cash Income Cash Flow Cash Income Depreciation-1000 Accounting Income

4- 9 © ADMN 3116, Anton Miglo Internal rate of return  IRR is the discount rate for which the NPV = 0.  The project should be accepted if IRR is greater than the discount rate

4- 10 © ADMN 3116, Anton Miglo Investment criteria in use PrimarySecondaryPrimarySecondary NPV9.8%25.8%21.0%24.0%Total about 75% IRR53.6%14.0%49.0%15.0%Total about 75% Payback8.9%44.0%19.0%35.0%

4- 11 © ADMN 3116, Anton Miglo NPV and Firm’s Value  The NPV of a project shows by how much the firm’s value will change after the project is accepted.

4- 12 © ADMN 3116, Anton Miglo Firm’s Value and The Agency Problem  In 1992, Dennis Koslowski’s (TYCO) announced that.. perks such as country-club memberships and executive dining rooms are taboo  Early 2000s revelations of asset embezzlement  $17,100 traveling toilet box  $15,000 dog umbrella stand  $16.8 million apartment on Fifth Avenue  $3 million in renovations  $11 million in furnishings  $7 million apartment on Park Avenue for his former wife.  A $72,000 fee to Germ á n Frers, a yacht maker  A $6,300 sewing basket  A $6,000 shower curtain  $5,960 for two sets of sheets  A $2,900 set of coat hangers  A $2,200 gilt metal wastebasket  and a $445 pincushion

4- 13 © ADMN 3116, Anton Miglo NPV and IRR in Excel ABCD 1 Discount rate25% 2 3 YearCashflow , NPV of project-$153.43B4+NPV(B1,B5:B10) IRR of project19.71%IRR(B4:B10) Take project?No

4- 14 © ADMN 3116, Anton Miglo Mutually exclusive projects Discount rate11% Investment limit28000 Time ABC NPV$5,579.74$6,806.59$11, NPV (A+B)$12,386.33