CORPORATE

FINANCE
HOAI NGUYEN
CORPORATE FINANCE DEPARTMENT
FACULTY OF BANKING AND FINANCE
FOREIGN TRADE UNIVERSITY
EMAIL: HOAINT@FTU.EDU.VN
CHAPTER 3:
INVESTMENT
PROJECTS
APPRAISAL
METHOD
4 QUESTIONS INVESTMENT DECISION

THAT
CORPORATE FUNDING DECISION

FINANCE SHORT-TERM FINANCE

MANAGEMENT / WORKING

CAN CAPITAL MANAGEMENT

ANSWER DIVIDEND POLICY

investments

WHAT IF...
You have $10,000

Use it right away!

Put money into saving account
Start new business of your own
Outlines
1. Time Value of Money
2. Capital Budgeting Techniques
Net Present Value
Internal Rate of Return
Payback Period
Discounted Payback Period
Average Accounting Return
Profitability Index
Time Value
of Money
 Time Value of Money

Money earns interest.

This concept illustrates
what economists call an
A dollar today is To evaluate and
opportunity cost of
worth more than a compare investment
passing up the earning
dollar received a year proposals, all the
potential of a dollar
from now. dollar values must be
today. This opportunity
cost is the time value of comparable.
money.
Compound Interest,
Future, and Present
Value
Using Timelines to
Visualize Cash Flows
Simple
Interest
Interest is earned only on principal
Compute simple interest on $100
invested at 6% per year for 3 years.
1st year interest?
2nd year interest?
3rd year interest?
Total interest earned over 3
years?
 Compound
Interest
Compounding is when interest paid on an
investment during the 1st period is added to
the principal; then the second period, interest
is earned on the new sum (that includes the
principal and interest earned so far)
Compute compound interest on $100 invested
at 6% for 3 years with annual compounding.
1st year interest?
2nd year interest?
3rd year interest?
Total interest earned?
Future Value
The value at some time in the future of an investment
One period case: FV = PV x (1 + r)
Multiple period case:

PV is present value
r is the interest rate
t is the number of periods over which the cash is invested
 Exercises

1. What will be the FV of $100 in 2 years at interest rate of 6%

annually?
2. Suppose a stock currently pays a dividend of $1.10, which is
expected to grow at 40% per year for the next 5 years. What
will the dividend be in 5 years?
How to increase the Future Value?

Let’s deposit $500 in bank for 2

years. What is the FV at 2%?

What is the FV if the interest rate is

changed to 6%?
What if we change the time we
invest from 2 years to 10 years?
What is the FV now?
Now, let’s deposit $1,500 instead
of $500. What is the FV now?
Future Value and Compouding
$100 compounded at 6% over 20 years
Future Value and Compouding
$100 deposited and compounded at 0, 5, 10, and 15%
Present Value

What is the value in today’s dollars of

a sum of money to be received in the
future?
Current value of a future payment or
receipt.
If we want to receive $1000 in one
year, how much should we deposit
in the saving account?
Future Value vs. Present Value
Present Future
Compounding

Discounting
Example
The Present Value of $100 to be
Received at a Future Date

PV is lower if:
Time period is longer
Interest rate is higher
Exercise 1

You are currently 20 years old. How

much you should invest today in
order to have one million dollars in
your account by the time you are 65?
You know that you can earn 10%
annually on your money.
Exercise 2

If you deposit $1000 today in your

saving account paying 10% annually,
how long do you have to wait for it to
grow to $1 million?
Exercise 3

Suppose you need to save $5,000 by

the time you graduate college. You
have $2,000 invest today and you
have 3 years until your graduation.
What rate of interest must you earn
on your investment to be able to
achieve your goal?
Annuities

An annuity is a series of equal dollar

payments for a specified number of
years.
Ordinary annuity payments occur at
the end of each period.
Present Value of Annuity
Example
What will be the PV of a 5-year, $500 annuity discounted to the
present at 6%?
 Exercise
If you can afford a $400 monthly car payment, how much car can you afford if
interest rates are 7% on 36-month loans?
Future Value of an Annuity
FV of annuity: depositing or investing an equal some of money at the
end of each year for a certain number of years and allowing it to
grow.
Example
What will be the FV of a 5-year, $500 annuity compounded at 6%?
Growing Annuity
A growing stream of cash flows with a fixed maturity
Perpetuity
A constant stream of cash flows that lasts forever.
Nobel Prize
Scholarship Funds
 Example
What is the value of scholarship fund that promises to pay $150 every
year forever?
The interest rate is 10%.

PV = $150/0.10 = $1,500
Growing Perpetuity
A growing stream of cash flows that lasts forever.
 Annuity: A stream of cash flows that
least for a fixed number of period.
Summarize

Growing Annuity: A stream of cash flows

that grows at a constant rate for a fixed
number of periods.

Perpetuity: A constant stream of cash

flows that lasts forever.

Growing Perpetuity: A stream of cash

flows that grows at a constant rate
forever.
Warming Up!
1. You see an advertisement stating that if you take a sales tour, “you will be
given $100 just for taking the tour”. However, the $100 that you get is in the
form of a savings bond that will not pay you the $100 for 10 years. What is
the present value of $100 to be received 10 years from today if your
discount rate is 6%?

2. How much must we deposit in an 8% savings account at the end of each

year to accumulate $5,000 at the end of 10 years?

3. Corporation X is about to pay a dividend of $3.00 per share. Investors

anticipate that the annual dividend will rise by 6% a year forever. The
applicable discount rate is 11%. What is the price of the stock today?
 Making Interest Rates Comparable
We cannot compare rates with different
compounding periods.
Example: 5% compounded annually vs. 5%
compounded quarterly

How to Compare?

Example Compute the annual percentage yield

(APY) or effective annual rate (EAR)
Deposit $1,000 in bank account with
10% interest rate. Compare future value
between compounding annually and
semiannualy.
 PV = $1,000
Annually Compounding: r = 10%
t = 1 for annually compounding
t = 2 for semiannually
compounding

Semiannually Compounding

10% compounded semiannually is the same as

10.25% compounded annually
 Example
What is the end-of-year wealth if APR (annual percentage rate) of 24% compounded
monthly on $1 investment?

The annual rate of return is 26.82%

This annual rate of return is called either the effective annual rate (EAR) or
the effective annual yield (EAY)
 Annual Percentage Rate (APR)
vs. Effective Annual Rate (EAR)

APR is meaningful only if the compounding interval is given.

For example: APR of 10%. If compounded semiannually, FV will be
$1.1025. If compounded quarterly, FV will be $1.1038.

EAR is meaningful without a compounding interval. An EAR of 10.25%

means that a $1 investment will be worth $1.1025 in one year.
Capital
Budgeting
Techniques
Net Present Value

The Payback Period

What is Capital
The Discounted Payback
Budgeting?
Period Method

Internal Rate of Return The process of decision making with

respect to investments -that is,
Profitability Index should a proposed project be
accepted or rejected.
 Net Present Value (NPV)

What is NPV? Estimating NPV

Acceptance Criteria
Estimate future cash flows:
NPV = Total PV of future CFs + How much, when? Accept if NPV > 0
Initial Investment Estimate discount rate Choose the highest NPV
Estimate initial costs
 NPV Example
Project with an initial cash outlay of $40,000 with following free cash flows for 5
years and a required rate of return of 12%.

Year 0 1 2 3 4 5

Cash Flows -$40,000 $15,000 $14,000 $13,000 $12,000 $11,000

Solution
Solution - Excel

Should we accept this project?

 Benefits
Why Use Considers all cash flows

Net
Recognizes time value of
money

Present
Considers risk

Value? Drawbacks
Requires detailed long-
term forecast of cash flows
Exercise
You have been assigned the task of evaluating two projects with the following
project free cash flows

a. Please calculate each project’s NPV

b. If these are two mutually exclusive projects, which project would you choose and
why?
c. If these are independent projects, which project would you choose and why?
 The Payback Period

What is Payback Period? How to Calculate? Acceptance Criteria

Number of years needed to = # of years just prior to complete Payback period is less than
recover the initial cash outlay recovery of initial outlay + the required payback period.
related to an investment. How (unrecovered amount at beginning Shorter payback periods are
long does it takes to get your of year payback is completed/cash preferred.
money back? flow in year payback is completed)
Example
If a firm’s maximum desired payback period is 3 years, and an investment proposal
requires an initial cash outlay of $10,000 and yields the following set of annual cash
flows, what is its payback period? Should the project be accepted?

Answer: Payback period = 3 + 1/3 = 3.33 years

Discussions
Going back to our previous exercise of calculating NPV.

a. Calculate payback period of project A and B.

b. Using payback period, which project should you choose?
c. Using NPV method, which project should you choose?
Discussions 2
Consider another projects!

a. Calculate payback period of project A and B.

b. Calculate NPV of project A and B if discount rate is 10%.
c. What do you think about these 2 projects?
 Benefits
Payback Simple to compute & easy to understand

Period
Allow quick evaluation
User cash flows rather than accounting

Trade-Offs profits
Biased toward liquidity

Drawbacks

Ignores the time value of money

Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
 Discounted Payback Period

What is Discounted How to Calculate? Acceptance Criteria

Payback Period?
Is similar to the traditional payback Same as the payback period
Number of years needed to
period except that it uses
recover the initial cash outlay
discounted free cash flows.
from the discounted free cash
flows.
Example
Calculate discounted payback period for project A with discounted rate at 17%.

Compare between payback period and discounted payback period.

Discounted Benefits

Payback
Consider time value of money and risk

Period Drawbacks
Trade-Offs
Ignores cash flows after the discounted
payback period
Too much work! Should have calculated NPV
 The Internal Rate of Return (IRR)

What is IRR? Assumption Acceptance Criteria

The discount rate that sets NPV All future cash flows are assumed Accept if the IRR > required
to zero to be reinvested at the IRR return
Select the highest IRR
Example
Consider a project with cashflows as below. The discount rate is 10%.
Calculate IRR.

What should you do to make

NPV = 0?
This calculation process will
involve trial & error.
1. Try the discount rate = 10% & calculate NPV

We want NPV = 0, therefore the IRR must be higher than 10%.

Let’s try another rate!
2. Try the discount rate = 15% & calculate NPV

We want NPV = 0, therefore the IRR must be higher than 15%.

Let’s try another rate!
3. Try the discount rate = 20% & calculate NPV

With discount rate of 20%, NPV is less than 0. It means that IRR
lies between 15% and 20% (so that NPV will equal to 0).
Conclusion
At 15%, NPV = + 224
At 20%, NPV = - 208
An increase of 5% (from 15% to 20%) in the discount rate causes a fall of $432
(from $224 to -$208) in NPV
For the NPV to fall by only 224 (to zero) the discount rate would have to
increase by [224/432] x 5% = 2.59%

The discount rate of 15% + 2.59% = 17.59% would give a zero NPV for the
investment.

Use Excel, IRR = 17.50%

Multiple IRRs

2 IRRs? How many IRRs

should we have?
Multiple IRRs
A normal cash flow pattern for project is negative initial outlay
followed by positive cash flows (-, +, +, +, ...)

However, if the cash flow pattern is not normal (such as -, +, -) there

can be more than one IRR

Projects may have as many IRRs as there are changes in the signs of
the cash flows
 Benefits

IRR Trade-
Easy to understand and communicate
Considers the time value of money and risk

Offs Consider all cash flows

Drawbacks

Does not distinguish between investing and

borrowing
IRR may not exist, or there maybe multiple
IRRs
Problems with mutually exclusive investments
 The Profitability Index (PI)
(Benefit-Cost Ratio)

What is PI? Formula Acceptance Criteria

Is the ratio of the present value Accept if PI 1

of the future cash flows to the Reject if PI < 1
initial outlay When consider single
project, PI gives the same
accept/reject decision as
NPV
 Example
Project with an initial cash outlay of $40,000 with following free cash flows for 5
years and a required rate of return of 12%.

PI = (13,392.86 + 11,160.71 + 9,253.14 + 7,626.22 + 6,241.70)/40,000 = 1.19

Should we accept this project?
Does it give the same result as NPV?
Exercise
There are 2 projects X and Y with cash flows as below. Discount rate is 10%.

Project X 0 1

Cash Flows $(100.00) $250.00

Project Y 0 1

Cash Flows $(10,000.00) $20,000.00

a. Calculate NPV of each project.

b. Calculate PI of each project.
 Benefits

PI Trade-
Easy to understand and communicate
Correct decision when evaluating

Offs independent projects

Drawback

Problems with mutually exclusive investment

Which method
should we use?

Varies by industry, company,

and project complexity

The most frequently used

technique for large corporation
is either NPV or IRR

Payback method is used widely

in initial face
Thank You