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

2. 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

3. 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- 4 © ADMN 3116, Anton Miglo -300,000 Net Present Value 20,000 520,0000

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

6. 4- 6 © ADMN 3116, Anton Miglo YearCash Flow PV at 13% YearCash Flow PV at 13% 1986-457 1999636130 1987-476-4212000594107 1988-497-3892001689110 1989-522-3622002729103 1990-551-3382003796100 1991-584-317200485995 1992-619-297200592390 199321190200698386 199448918420071,05081 199545515220081,11376 199650214820091,17771 1997530138201017,781946 1998544126Total251

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

8. 4- 8 © ADMN 3116, Anton Miglo Cash Flows vs Profits Year 0Year 1Year 2 Cost2000 Cash Income1500500 Cash Flow1500500 Cash Income1500500 Depreciation-1000 Accounting Income 500-500

9. 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

10. 4- 10 © ADMN 3116, Anton Miglo Investment criteria in use 197619862001 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%

11. 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.

12. 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

13. 4- 13 © ADMN 3116, Anton Miglo NPV and IRR in Excel ABCD 1 Discount rate25% 2 3 YearCashflow 4 0 -1,000 5 1100 6 2200 7 3300 8 4400 9 5500 10 6600 11 12 13 NPV of project-$153.43B4+NPV(B1,B5:B10) 14 15 IRR of project19.71%IRR(B4:B10) 16 17 Take project?No

14. 4- 14 © ADMN 3116, Anton Miglo Mutually exclusive projects Discount rate11% Investment limit28000 Time ABC 0-12000-16000-28000 160001000030000 2150001700015000 NPV$5,579.74$6,806.59$11,201.36 NPV (A+B)$12,386.33