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1) Online Smart Class
22nd May,2011Time: 6 pm to 7 pm IST(please go to the link to attend the class
http://connectpro49277231.adobeconnect.com/corpfin1-dec/ )Link and Instructions will also be availableon www.FinBricks.com on 21st May 2011
2) Class @ Mumbai, India
22nd May,2011 from 11 am to 1 pm IST
LocationFinbricks classes, Pearl centre,near sadguru classes, 2nd floor,Krishna jejurkar,Dadar (W) 400028(5 mins walk from Dadar Station)
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Projects identification and Evaluation
Cash Flows (CF) more than a year
Decisions that impact future earnings Examples- Replacement, innovation,
expansion
Impact other decisions such as Workingcapital, Strategic actions
Projects that increase shareholder value
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Idea generation
Analysis of the proposal- Forecasting of
cash flows
Make firm-wide decisions
Monitor and post audit to see if actual
performance is meeting forecasts
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Replacement Projects
Replacement for cost Reduction
Expansion Projects New Products/Market
Mandatory Projects- Government and
Insurance related OtherProjects- Corporate Perks, High risk
Projects, R&D
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Independent & Mutually Exclusive(ME) Independent-Can select multiple independent
projects at the same time
M E- Need to prioritize. You can have only 1
Project Sequencing Project planning. Invest in one today will lead to
another opportunity tomorrow
Fund allocations Unlimited- Take all projects with returns greater
than Required return
Limited- Capital rationing. Projects that providemax value to shareholders
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Make decisions based on CASH FLOWS
Incremental cash flows
After-tax Cash Flows Externalities (impact on existing project cash
flows by taking up this new project)
Negative Cannibalization to be taken into
accountx Positive
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Opportunity Cost Loss incurred as other opportunities/projects are
forgone to take up the project under
consideration Time Value of Money
Cash flow received earlier are worth more thanthose received later ( certainty, discounting,inflation effect)
Cash Flow Patterns Conventional cash flows
Non-conventional cash flows
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Accounting Income
Sunk costs
Costs that are incurred whether you take the
project or not. (feasibility study, Consulting fees,start-up marketing).
Financing costs Reflected in Required rate of return (RoR)x RoR is the minimum return required to take up the
project. This is further adjusted to reflect project riskx It is the firms cost of capital/ discount ratex Only projects that provide a higher return than RoR
should be accepted
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NPV
IRR
Payback Period
Discounted PaybackPeriod
Profitability Index
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Net Present Value (NPV) Sum of PV of INCREMENTAL AFTER-TAX cash
flows
PV
Future cash flows discounted back to showwhat is their value as of today
Discount rates
x Use FIRMs cost of capital /RoR adjusted forrisk level for discounting future incrementalafter-tax cash flows
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NPV of Normal Project
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(-Initial Cash Flow) + CF1+ CF2+ CF3..CFn
(1+k) (1+k)(1+k)(1+k)1 2 3 n
K=Required rate of return for project(RoR may be higher or lower than firms cost of capital to reflectproject risk)
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A B
Initial Inv 2000 2000
Year 1 1000 200
Year 2 800 600
Year 3 600 800
Year 4 200 1200
Cost of capital 10% 12%
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For Independent projects
Accept if NPV is positive
Reject if NPV is negative
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Trail & Error (Guessing game)
Use the Financial Calculator
Decision Rule based on the project RoR
If IRR>ROR then accept
If IRR< ROR then reject
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A B
Initial Inv 2000 2000
Year 1 1000 200
Year 2 800 600
Year 3 600 800
Year 4 200 1200
Cost of capital 10% 12%
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Project A Project B
Initial Inv equal equal
Total Cash Inflows lower higher
Timing of Cash flows earlier later
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Crossover Rate
Cost of Capital
NPV $
5 10 15 20
Project Bs NPV
Project As NPV
Project Bs IRR
Project As IRR
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Discount Rate NPV A NPV B
0% 500 700
5% 350 370
10% 130 90
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NPV & IRR give same accept/reject decisions forindependent projects. Example if A has positive NPV than it will also have an IRR
which is higher than the cost of capital
IRR and NPV can provide different rankings whileselecting Mutually exclusive projects. Example A has higher NPV than B but B has higher IRR than
A
Difference in the projects ranking for IRR and NPV isbecause of Timing of Cash flows- NPV reinvests CFs at Cost of capital,
IRR reinvests CFs at the internal rate of return Project Size- Small investments will have higher IRR but will
not increase the absolute value of the firm as much as aproject with high investments providing higher NPV
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Remember that both give same
accept/reject decisions
Incase of Mutually Exclusive project, NPVand IRR may provide different ranking
Base your decision on NPV as it measures
the expected increase in wealth fromundertaking a project which in turn
directly impacts the firm value
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Non conventional CF When cash flow pattern is non-normal then there
could be No IRR or Multiple IRR
However NPV also works for non conventionalCFs
Reinvestment rate IRR assumes the reinvestment rate of
incremental project CFs at the internal rate ofreturn which is quite unrealistic. It should bereinvested at the cost of capital. NPV takes careof this issue
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You make an investment in new machineforUSD 500 mn and expect CF of 750 mn
Your enterprise is currently worthU
SD50/share with shares outstanding of 100 mnwhich makes your firm value=5 billion
NPV of new project= 750-500=250 mn
Value of company after project=5bn+250mn=5.25bn
New share price= 5.25 bn/100 mn shares=52.5/share
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PaybackPeriod
Breakeven period for investment
In how many years will I recover myinvestment
Drawback- Liquidity measure not profitabilityDoes not consider TVM
Used with NPV and IRR by firms
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Investment 1000
Year 1 cash inflow- 200
Year 2 cash inflow- 400 Year 3 cash inflow- 300
Year 4 cash inflow- 300
Cumulative CFs
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Cumulative Cashflows
Year 1 cash inflow -800
Year 2 cash inflow -400 Year 3 cash inflow -100
Year 4 cash inflow +200
Payback period= 3 yrs +100/300
= unrecovered cost/netcash flow in the last yr
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Considers Time Value
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Investment 1000
Year 1 cash inflow- 200 Year 2 cash inflow- 400
Year 3 cash inflow- 300
Year 4 cash inflow- 300
Cumulative CFs
Cumulative Cashflows(Assumed to be
Discounted at 10%) Year 1 cash inflow -800
Year 2 cash inflow -400 Year 3 cash inflow -100
Year 4 cash inflow +200
Payback period= 3 yrs +100/300
= unrecovered cost/netcash flow in the last yr
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Same as NPV but gives a ratio and not
the absolute value of the project
Greater than 1 accept, less than 1 reject
PI= PV of future CF/ CF0
= 1 + (NPV
/CF0)
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Location Specific Europe uses payback more than or as much as
NPV, IRR
Size Larger companies use DCF techniques like IRR,
NPV
Public vs Private Public cos prefer DCF techniques, Private usePayback
Management Education Higher level of mgmt education, the more the
use of DCF techniques
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