Robert Uberman, Financial Management, KA im Frycza Modrzewskiego 7

Session Seven Topics Introducing interrelation between time and money Introducing interrelation between time and money Discounting money streams Discounting money streams Key problems with proper discounting Key problems with proper discounting Brealey, Myers: the chapter titled: “Present Value … “ (pp ) Brealey, Myers: the chapter titled: “Present Value … “ (pp )

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Time Value of Money 1 USD today does not equal 1 USD tomorrow! 1 USD today does not equal 1 USD tomorrow! FV = PV * (1+r) n where: FV = PV * (1+r) n where: r represents a return r represents a return n represents number of periods (quite often years) n represents number of periods (quite often years) PV = FV/ (1+r) n PV = FV/ (1+r) n

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Theoretical fundaments of relation between time and value Risk of a return different from the planned one (Mind you: also bigger !!!) Risk of a return different from the planned one (Mind you: also bigger !!!) Liquidity: investor converts cash, which is the most universal value transponder into less liquid assets (Opportunity Cost of Capital), Liquidity: investor converts cash, which is the most universal value transponder into less liquid assets (Opportunity Cost of Capital), Purchasing Power: universal (inflation, see Brealey, Myers, pp ), individual (ultimate goal in investing) Purchasing Power: universal (inflation, see Brealey, Myers, pp ), individual (ultimate goal in investing) Intrinsic value of money (per se):– J.M. Keynes’ theory. Intrinsic value of money (per se):– J.M. Keynes’ theory.

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Capitalisation FV t – Future Value of a given sum FV t – Future Value of a given sum CF 0 – present value of a given sum CF 0 – present value of a given sum r t – interest rate in period t (most often annual) r t – interest rate in period t (most often annual) t – capitalisation period t – capitalisation period Brealey, Myers pp Brealey, Myers pp

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Capitalisation rate The most common way of expressing a capitalisation rate is an annual one, marked with r letter without index t The most common way of expressing a capitalisation rate is an annual one, marked with r letter without index t However quite often a real capitalisation period is different – interests are added to a capital after each month, quarter or so. Then the previously mentioned equitation is converted into: However quite often a real capitalisation period is different – interests are added to a capital after each month, quarter or so. Then the previously mentioned equitation is converted into:

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Key equations

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Present Value as dependence on a discount rate Discount rate8%10%12%15%20% Discounting PeriodPresent value of USD due at the period’s end PV,25 yrs PV,75 yrs ,400,06 PV, infinity00000

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Present Value as dependence on a discount rate Discount rate8%10%12%15%20% Discounting Period Present value of USD annuity for the given period PV,25 yrs PV,75 yrs PV, infinity

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Various approaches to set an interest (discount) rate There is a huge variety of theories and models covering the issue. The list below indicates a subjective selection of most commonly used ones: There is a huge variety of theories and models covering the issue. The list below indicates a subjective selection of most commonly used ones: Alternative capital cost Alternative capital cost Risk-free alternative Risk-free alternative Debt cost Debt cost WACC WACC Historical rate of return Historical rate of return Risk Adjusted Discount Rate (RADR) Risk Adjusted Discount Rate (RADR) Hurdle rate Hurdle rate Social rate of return Social rate of return Discount rate quite often is presented as: Discount rate quite often is presented as: risk-free rate + risk adjustment

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Concept of risk Financial and insurance meaning of risk Financial and insurance meaning of risk Individual attitudes towards risk: Individual attitudes towards risk: averse, averse, neutral, neutral, Seeker. Seeker.

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Homework If the PV of 150 USD to be paid in one year is 130 USD, what is a discount rate? (Brealey, Myers, Chapter 2, Q 2) You have come to a bank in order to make 1000 PLN deposit for 5 years, with 7% interest and half-year capitalisation (period). An financial advisor has stepped in with an offer of shares which over last 5 years period brought 40 % return. What would be your decision?

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego 8

Session Eight Topics Investment vs Capital Budgeting Decisions Investment vs Capital Budgeting Decisions NPV NPV I(nternal) R(ate of) Return I(nternal) R(ate of) Return PI PI Payback (discounted) Payback (discounted) Brealey, Myers: Chapter titled “Why Net Present Value Leads to Better Investment Decisions …” (pp ) Brealey, Myers: Chapter titled “Why Net Present Value Leads to Better Investment Decisions …” (pp )

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Investment vs. Capital Budgeting Decisions Investment = money committed or property acquired for future income Investment = money committed or property acquired for future income Capital budgeting is planning capital outlays for purchasing new fixed assets to get additional profit thus it means planning investments Capital budgeting is planning capital outlays for purchasing new fixed assets to get additional profit thus it means planning investments Intra-corporate investment process is usually much more complicated ro evaluate than financial investments (share, bonds) since cash flows are not easily defined Intra-corporate investment process is usually much more complicated ro evaluate than financial investments (share, bonds) since cash flows are not easily defined

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Examples of Capital Budgeting Decisions Equipment selection decision. Equipment selection decision. Plant expansion aimed at: Plant expansion aimed at: increase in sales; increase in sales; backward integration. backward integration. Equipment replacement decision caused by aging machine park. Equipment replacement decision caused by aging machine park. New equipment purchase aimed at cost reduction. New equipment purchase aimed at cost reduction.

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Investment vs. Capital Budgeting Decisions (2) A financial investment decision is usually based on certain one shot outlay and a clear stream of return. A financial investment decision is usually based on certain one shot outlay and a clear stream of return. Most capital budgeting decisions have to consider a complex influence on various items. Most capital budgeting decisions have to consider a complex influence on various items. A typical equipment selection decision may be conditioned by: A typical equipment selection decision may be conditioned by: a cost of an equipment itself (capital expenditure); a cost of an equipment itself (capital expenditure); energy consumption (operating costs); energy consumption (operating costs); personnel requirements (both quality and quantity – operating costs); personnel requirements (both quality and quantity – operating costs); service requirements (inventory of spare parts – NWC). service requirements (inventory of spare parts – NWC).

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Commonly used measures of investment efficiency Payback (straight) Payback (straight) I(nternal) R(ate of) Return I(nternal) R(ate of) Return NPV NPV PI PI Payback (discounted) Payback (discounted)

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Payback (period) The payback period estimates the time required to recover the principal amount of an investment. The payback period estimates the time required to recover the principal amount of an investment. It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Payback (example) A&B Enterprises is trying to select the best investment from among three alternatives. Each alternative involves an initial investment of $100,000. Their cash flows follow: A&B Enterprises is trying to select the best investment from among three alternatives. Each alternative involves an initial investment of $100,000. Their cash flows follow: Which investment will you select using the payback method? Why? (Brealey, Myers) YearABC 1$ 10,000$ 50,000$ 25,000 2$ 20,000$ 40,000$ 25,000 3$ 30,000 $ 25,000 4$ 40,000-$ 25,000 5$ 50,000-$ 25,000

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Payback – key issues What is an investment? What is an investment? Capital expenditure Capital expenditure Increase in NWC Increase in NWC Other Other How one defines a pay back itself? How one defines a pay back itself? Net profit Net profit Net cash flow Net cash flow

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Payback - limitations The payback period method ignores: The payback period method ignores: any benefits that occur after the investment is repaid any benefits that occur after the investment is repaid the time value of money the time value of money risk-free cost of money risk-free cost of money risk risk Therefore payback period: Therefore payback period: is useless for ranking purposes is useless for ranking purposes can be used only in relation to near certain flows can be used only in relation to near certain flows

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego NPV

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego IRR IRR vs Yield to Maturity IRR vs Yield to Maturity IRR algorithm IRR algorithm IRR use IRR use Disadvantages of IRR Disadvantages of IRR

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego IRR - definitions

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego IRR vs NPV IRR: IRR: can be calculated only if a cash flow break even only once – which is typical for many simple investments; can be calculated only if a cash flow break even only once – which is typical for many simple investments; is directly comparable to benchmarks like interests on deposits; is directly comparable to benchmarks like interests on deposits; quite often is calculated simultaneously with NPV quite often is calculated simultaneously with NPV can be used as a ranking tool but with attention to various traps (see Brealey, Myers, pp can be used as a ranking tool but with attention to various traps (see Brealey, Myers, pp NPV NPV in practice it is calculated to get IRR; in practice it is calculated to get IRR; it can be applied to streams not to be assessed using IRR; it can be applied to streams not to be assessed using IRR; it can not be used as a ranking tool (unless all investments are equal) it can not be used as a ranking tool (unless all investments are equal)

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego PI (Profitability Index)

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Discounted Payback (Period) The discounted payback period estimates the time required to recover the principal amount of an investment but applying discounting. The discounted payback period estimates the time required to recover the principal amount of an investment but applying discounting. It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment with consideration of time value of money concept. It is often defined as a length of time needed for an investment's net cash receipts to cover completely the initial outlay expended in acquiring the investment with consideration of time value of money concept. It is quite often used as an indicator of a risk level It is quite often used as an indicator of a risk level

Robert Uberman, Financial Management, KA im Frycza Modrzewskiego Homework An owner of a successful retail business of a traditional handmade wool clothes in Krynica considers opening a new outlet in Warsaw. There are two options as far as location is concerned and they can be characterised as stated below in terms of key economic parameters. Please select the most efficient one using measures presented before. Apply 15 % discount/hurdle rate when needed. An owner of a successful retail business of a traditional handmade wool clothes in Krynica considers opening a new outlet in Warsaw. There are two options as far as location is concerned and they can be characterised as stated below in terms of key economic parameters. Please select the most efficient one using measures presented before. Apply 15 % discount/hurdle rate when needed. Location (PLN) Cost/ month Monthly turnover Mark upDays in stock Days payable Initial investm ent Premium % Subarbian %