FN2190

Asset Pricing

Chapter 2
Present Value Computations

Reference:
Chapter 2, Section 1– Richard A. Brealey, Stewart C. Myers, and Franklin Allen.
2017 Principles of Corporate Finance, 13th Edition, McGraw-Hill
1
 Learning Objectives

• Use compounding and discounting techniques

to value cashflow streams

• Use the Net Present Value rule to evaluate

investment opportunities

• Explain why the NPV rule is optimal

2
Time-value of Money Concept -
Valuation of Future Cash Flows
and computation of Present
Values

3
 Evaluating Cashflows

$100,000 Which is preferable?

Receiving $100,000
0 1 today
Cashflow A
$100,000 Or

Receiving $100,000
0 1 one year from today
Cashflow B
$100,000 $100,000 (1+ r%) A > B at
A Time 1
0 1
Deposit $100,000 in the bank and earn interest of r%
4
 Outline

• Future value and compounding

• Compound versus Simple interest

• Present value and discounting

• Calculating discount factors and number of

periods

• Future and present value of multiple cash flows

• Opportunity Cost of Capital

5
 Future Value & Compounding

• Future value (FV) refers to the amount of

money an investment will grow to over some
period of time at some given interest rate.

• FV = PV(1+r)

• Investing for a single period:

 E.g.: $100 invested today for 1 year that
pays 10% interest p.a. What is the FV?

6
 Future Value & Compounding

• The process of leaving your investment and

any accumulated interest for more than 1
period, thereby reinvesting the interest, is
called compounding.
• FV = PV(1+r)t
• Investing for more than 1 period:
 E.g.: $100 invested today for 3 years that
pays 6% interest p.a. What is the FV and
the total interest earned?
• Thus, your wealth grows at a compound rate
and the interest earned is called compound
interest. 7
 Power of Compounding

• The higher the frequency of compounding,

the higher the future value.

• With continuous compounding,

FV = PVert
Where r is interest rate expressed in decimal form and t,
time period expressed in years.

8
 Simple Interest

Simple Interest Formula:

I = PRT, where

I = interest earned
P = principle
R = rate of interest
T = time

Unlike compounding interest, simple interest is

only paid ONCE, at the end of the period.
9
 Simple Interest

Example: Simple interest

If I place $100 today with a bank for 3 years
that pays only a simple interest of 6% p.a.
What is the FV?
Answer:
I = PRT = $100*0.06*3 = $18
FV = $100 + $18 = $118

Compare this with compound interest and future

value on slide 7. Compounding results in higher
future values. 10
 Compound versus Simple
interest
The crucial difference between simple and
compound interest is that in the case of
compounding, interest is paid at regular
intervals and interest can be earned on both
the principal amount and interest paid out.

Compound interest is good for savers but bad for

borrowers.

11
Compound versus Simple
interest

12
 Present Value & Discounting

• Another type of question that comes up even

more often is:
 Suppose you need $10,000 in 10 years time
and you can earn 6.5% p.a. How much do
you need to invest today to reach that goal?

• For single period, PV = FV/(1+r)

• Discounting for a single period:

 E.g.: You need $400 next year and can earn
6% interest p.a. How much do you need to
invest today in order to have $400 next
year? 13
 Present Value & Discounting

• Because r is used to discount a future cash flow, it

is often called a discount rate.
• PV = FV/(1+r)t
• Discounting for multiple periods:
 E.g.: You plan to buy a car in 3 years time
which costs $50,000. If you can earn 3%
interest p.a., how much do you need to invest
today?

• Calculating the PV of a future cash flow to

determine its worth today is called discounting.
Present values are discounted cash flows. 14
 Discount Factors

When computing present values, we often make

use of discount factors. A discount factor is just
the present value of $1.

E.g. What is the discount factor when r = 3%

and T = 3 years?

Answer: = 0.91514165

Use this discount factor to compute the answer

in the previous slide. 15
Present Value Table
(Discount Factors)

16 16
 Determining the Discount Rate

• It will turn out that we will frequently need to

determine the discount rate implicit in an
investment.

• Using the basic equation: PV = FV/(1+r)t

• There are 4 parts, namely PV, FV, t and r.

• Given any 3, we can always solve for the 4th.

 E.g. If you have $100,000 today and plan to
retire in 10 years with $200,000, what return
is required to achieve this? 17
 No. of Periods

Suppose your firm needs to purchase an asset

that costs $50,000. You currently have $25,000.
If this investment can earn 12% return, how long
does your firm need to wait?

Solution:
PV(1+r)t = FV
(1.12) t = 50,000/25,000 = 2
t = ln2/ln1.12 = 6.12 years

18
 Practice Q1

Example: Calculating Future Value

You have just made your first $4,000 contribution
to your retirement account. Assuming you earn an
11% rate of return and make no additional
contributions, what will your account be worth
when you retire in 45 years?

Solution:

FV = 4,000 (1.11)45 = $438,120.97

19
 Practice Q2

Example: Calculating Present Value

You have just received notification that you have
won the $1 million first prize in the Centennial
Lottery. However, the prize will be awarded on
your 100th birthday, which is 80 years from now.
What is the present value of your windfall if the
appropriate discount rate is 10%?

20
 Practice Q3

Example: Calculating Number of Periods

You expect to receive $10,000 at graduation in 2
years. You plan on investing it at 11% until you
have $75,000. How long will you wait from now?

21
 Future Value with Multiple Cash
Flows
• To calculate future value of multiple cash
flows:
 Calculate the FV of each cash flow and add
them at the ending period

• Example:
 Suppose you deposit $100 today in an
account paying 8% p.a. In one year time,
you deposit another $100. How much will
you have in two years?

22
Present Value with Multiple Cash
Flows
• To calculate present value of multiple cash
flows:
 Calculate the PV of each cash flow and add
them up

 Suppose you need $1,000 in one year and

$2,000 more in two years. If you can earn 9%,
how much do you need to put up today?

23
 Cash Flow Timing

• In working with present and future value

problems, cash flow timing is critically
important.

• Unless otherwise stated, cash flows is assumed

to occur at the end of each period.

• On our time line, notice that today is

represented to be t=0 and first cash flow occurs
at the end of first period, etcetera.

24
 Opportunity Cost of Capital

• The opportunity cost of capital is defined as

the rate of return which can be earned from
next best alternative investment
opportunity with similar risk profile.

• The opportunity cost of capital is commonly

used as the discount rate to determine the
present value of future project cash flows.

25
 Opportunity Cost of Capital

Example: Opportunity Cost of Capital

Suppose you own a small company that is
contemplating the construction of an office block. It
costs $700,000 to build and the expected profit from
the sale is $100,000. Thus, the rate of return on this
project is 14.3%. The agent brokering this deal
assures that this is a “risk-free” project.
You can invest in the project or pay cash out to all
shareholders who can invest on their own. They can
earn 7% by investing in government debt securities
(risk-free) or 12% by investing in risky stocks.
What is the opportunity cost of capital, 7% or 12%?
26
 Opportunity Cost of Capital

• The answer is 7%. That is the rate of return

that your company’s shareholders can get by
investing in another investment at the same
level of risk as the proposed project.

27
Making capital investment
decisions

28
 Outline

• The Average Accounting Return

• The Payback Rule

• The Discounted Payback

• Net Present Value

• The Internal Rate of Return

29
 Good Decision Criteria

• What fixed assets should we buy? Which

projects should we undertake?

• We need to ask ourselves the following

questions when evaluating capital budgeting
decision rules:
 Does the decision rule adjust for the time
value of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide information on
whether we are creating value for the firm?
30
Average Accounting Return (AAR)

• There are many different definitions for average

accounting return.
• The more commonly used definition is:
 Average annual operating profit / Average
investment to earn that profit
• Need to determine an arbitrary rate
• Decision Rule: Accept the project if the AAR
is greater than a preset arbitrary rate.

31
 Computing AAR For The Project

Year Operating Cumulative

profit Investment
2025 14,000 125,000
2026 3,300 132,000
2027 21,000 140,000
Average 12,766.67 132,333.33
• Assume we require an average accounting return
of 15%.

• AAR = 12,766.67/132,333.33 =9.65%

• Do we accept or reject the project?

32
Advantages and Disadvantages of
AAR
Advantages Disadvantages
 Easy to calculate  Not a true rate of return;
 Needed information time value of money is
will usually be ignored
available  Uses an arbitrary
benchmark cutoff rate

33
 Payback Period

• The payback period is the length of time it

takes to recover our initial investment.
• Approach:
i. Estimate the future cash flows
ii. Subtract the future cash flows from the
initial cost until the initial investment has
been recovered
iii. The fractional year is computed as balance
to be recovered / cash inflow for that period
• Decision Rule – Accept if the payback period
is less than some preset arbitrary limit
34
 Computing Payback Period
for the Project
Example: Payback Period
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
Year 1: 165,000 – 63,120 = 101,880
Year 2: 101,880 – 70,800 = 31,080
Year 3: 31,080 – 91,080 = -60,000
Thus, project pays back in 2.34 years.

• Do we accept or reject the project if the

expected payback period is 2 years or less?
35
 Advantages and Disadvantages
of Payback Period
Advantages Disadvantages
 Easy to  Ignores the time
understand value of money
 Adjusts for  Requires an arbitrary
uncertainty of cutoff point
later cash flows;  Ignores cash flows
focus on near term beyond the cutoff
cash flows rather date
than later cash  Biased against long-
flows term projects, such
 Biased towards as research and
liquidity development, and
36 new projects
 Discounted Payback Period

• A variation of payback period that fixes the

shortcoming on ignoring time value.

• Approach:
 Compute the present value of each cash flow
 Determine how long it takes to payback on a
discounted basis
 Compare to a specified required period

• Decision Rule - Accept the project if it pays

back on a discounted basis within the
specified time

37
 Computing Discounted Payback
for the Project
Example: Discounted Payback Period
Assume required rate of return is 12%.
Year 0: CF = -165,000
Year 1: CF = 63,120/1.12 = 56,357
Year 2: CF = 70,800/1.122 = 56,441
Year 3: CF = 91,080/1.123 = 64,829

Thus, the project pays back in 2.81 years.

Do we accept or reject the project if the expected

payback period is 2 years or less?

38
 Advantages and Disadvantages
of Discounted Payback
Advantages Disadvantages
 Includes time value  Requires an arbitrary
of money cutoff point
 Easy to understand  Ignores cash flows
 Adjusts for beyond the cutoff point
uncertainty of later  Biased against long-term
cash flows; focus on projects, such as R&D
near term cash flows and new products
rather than later cash
flows
 Biased towards
liquidity
39
 Net Present Value

• NPV is a measure of how much value is created

by undertaking an investment today.

• Approach:
 The first step is to estimate the expected
future cash flows.
 The second step is to estimate the required
return for projects of this risk level.
 The third step is to find the present value of
the cash flows and subtract the initial
investment.

40
 NPV – Decision Rule

• If the NPV is positive, accept the project.

• A positive NPV means that the project is

expected to add value to the firm and will
therefore increase the wealth of the owners.

• Since our goal is to increase owners’ wealth,

NPV is a direct measure of how well this project
will meet our goal.

41
 NPV – Decision Rule

Example: NPV Decision Rule

You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120;
Year 2: CF = 70,800;
Year 3: CF = 91,080;

What is the NPV of this project assuming a

required rate of return of 12%?

42
 NPV – Decision Rule

Example: NPV Decision Rule

Solution:
NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = 12,627.42
OR:
Solve in MS Excel. Try it !

Since we have a positive NPV, we should accept

the project.

43
 Relationship between
Risk and PV of Cashflows
• There is a positive relationship between risk &
return.
• A higher required rate of return is required to
compensate an investor for a riskier
investment.
• Higher required rates of return will lower
the PV of projected cash flows.
• Thus, the uncertainty of future projected
cashflow is adjusted for when a higher
discount rate is used.

44
 Advantages of NPV

Advantages Disadvantages
 Includes time value of  Requires an estimate for
money required return/discount
 Easy to understand rate
 Directly measures the  Does not differentiate
value created between projects of
different size; uses NPV
 Factors the risk
measure as an absolute
inherent in the project
measure.
through the discount
rate
 Adjusts for uncertainty
of later cash flows
(smaller PV) 45
 NPV

Example: Net Present Value

A factory costs $800,000. You reckon that it will produce
an inflow after operating costs of $170,000 a year for 10
years. If the opportunity cost of capital is 14%, what is
the net present value of the factory? What will the factory
be worth at the end of the 5 years?
Solution:
in $ Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Net cashflows (800,000) 170,000 170,000 170,000 170,000 170,000 170,000 170,000 170,000 170,000 170,000

NPV 86,739.66
PV (5th year) 583,623.76

46
 NPV

Example: PV and Opportunity cost of capital

Halcyon Lines is considering the purchase of a new bulk
carrier for $8 million. The forecasted revenues are $5
million a year and operating costs are $4 million. A major
refit costing $2 million will be required both in the 5th and
10th year. After 15 years, the ship is expected to be sold
for scrap at $1.5 million.

a) What is the NPV if the opportunity cost of capital is

8%?
b) Halcyon could finance the ship by borrowing the entire
investment at an interest rate of 4.5%. How does this
borrowing opportunity affect your calculation of NPV?
47
 NPV

Example: PV and Opportunity cost of capital

Solution:
a)
in millions Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15
Initial investment -8
Revenues 5 5 5 5 5 5 5 5 5 5 5 5 5 5 5
Opex -4 -4 -4 -4 -4 -4 -4 -4 -4 -4 -4 -4 -4 -4 -4
Retrofit -2 -2
Scap value 1.5
Net cashflows -8 1 1 1 1 -1 1 1 1 1 -1 1 1 1 1 2.5

NPV -1.255

b) The cost of borrowing does not affect the NPV

because the opportunity cost of capital depends on
the use of the funds, not the source.

48
 Internal Rate of Return (IRR)

• This is the most important alternative to NPV.

It is closely related to NPV.

• It is often used in practice and is intuitively

appealing.

• It is based entirely on the estimated cash flows

of a particular investment and is independent of
interest rates found elsewhere.

49
IRR – Definition and Decision Rule

• The IRR solves for the expected rate of return on

the project.

• The PV of future cash flows discounted by the IRR

is exactly the same as the initial investment.
Thus, it represents the rate of return.

• Definition: IRR is the rate of return that makes

the NPV zero

• Decision Rule: Accept the project if the IRR is

greater than the required
50
return
 Computing IRR for the Project

Example: IRR Decision Rule

You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120;
Year 2: CF = 70,800;
Year 3: CF = 91,080;

Would you accept the project if the required rate

of return is 12%?

51
 Computing IRR for the Project

Example: IRR Decision Rule

Solution:
To solve for IRR, we need to use MS Excel:
Year 0 1 2 3
Cash flows -165,000 63,120 70,800 91,080
IRR 16.13%

IRR = 16.13 > 12%

Hence, we should accept the project as the
expected rate of return exceeds required rate of
return.
52
NPV Profile For The Project

53
 Computing IRR using
Algebraic Approach
Solving for IRR using algebraic approach
To solve for the IRR, basically we are looking for
the discount rate such that the present value of
future cash flows exactly equals the initial
investment. In other words:

PV(future cash flows) – initial investment = 0

This is solving for the IRR where NPV = 0

54
 Computing IRR using
Algebraic Approach
Example: IRR using Algebraic Approach
Consider the following cash flows:
Year 0: CF = -97.55;
Year 1: CF = 5;
Year 2: CF = 5;
Year 3: CF = 105;

Solve for the IRR of the above cash flows.

55
 Computing IRR using
Algebraic Approach
Example: IRR using Algebraic Approach
Solution using algebraic approach
Try y = 7%,
NPV = (1.07) (1.07) (1.07) - 97.55
=4.6729+4.3672+85.7113- 97.55
=-2.7986
Try y = 5%,
NPV = (1.05) (1.05) (1.05) - 97.55
=4.7619+4.535147+90.7029 – 97.55
=2.4499
56
 Computing IRR using
Algebraic Approach
Example: IRR using Algebraic Approach
Solution using algebraic approach
2.4499

5% 7%
-2.7986

2.4499 (2%)
IRR = 5% +
(2.4499 + 2.7986 )
= 5.93%
57
 Advantages of IRR

• Closely related to NPV, often leading to

identical decisions.

• Easy to understand and communicate. People

in general prefer to talk about rates of return.

• If the IRR is high enough, you may not need to

estimate a required return, which is often a
difficult task.

58
 Problems with IRR

• NPV and IRR will generally give us the same

decision

• Exceptions
 Non-conventional cash flows – cash flow
signs change more than once or cash inflow
comes first before cash outflows

 IRR measure is sensitive to timing and size

of cash flows. It may give an incorrect
decision when choosing between mutually
exclusive projects.
59
 IRR and Non-conventional
Cash Flows
• When the cash flows change sign more than
once, there is more than one IRR.
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
(100,000) 20,000 30,000 40,000 (15,000) 10,000 35,000
1st sign change 2nd sign change

• When you solve for IRR you are solving for the
root of an equation and when you cross the x-
axis more than once, there will be more than
one return that solves the equation.
• If you have more than one IRR, which one do
you use to make your decision?
60
 IRR and Non-conventional
Cash Flows
• Suppose an investment will cost $90,000
initially and will generate the following cash
flows:
 Year 1: 132,000
 Year 2: 100,000
 Year 3: -150,000
• The required return is 15%.
• What is the NPV and IRR?
• Should we accept or reject the project?

61
 IRR and Non-conventional
Cash Flows

Year 0 1 2 3
Cash flows -90,000 132,000 100,000 (150,000)
IRR 10.11%

• NPV=1,769.54
• If you compute the IRR on MS Excel, you get
10.11% because it is the first one that you come
to.

• However, we know that there will be multiple

solutions as there is more than 1 sign change.
62
 NPV Profile

You should accept the project if the required return is

between 10.11% and 42.66% 63
 IRR and Mutually
Exclusive Projects
• Note that when choosing between mutually
exclusive projects, the IRR measure is sensitive
to timing and size of cash flows.

• IRR and NPV may give conflicting results when

choosing between projects with different size
and timing of cash flows

• Initial investments are substantially different

• Timing of cash flows is substantially different

• The IRR measure is sensitive to both timing

and size of cash flows. 64
 Example With Mutually
Exclusive Projects

Period Project Project The required return

A B for both projects is
10%.
0 -500 -500

Which project should

1 325 400 you accept and why?

2 325 240

65
 Example With Mutually
Exclusive Projects
Project A: NPV = $64.05, IRR = 19.43%

Project B: NPV = $61.98, IRR = 20.00%

Choose Project A because it yields a higher NPV.

Decision should not be based on IRR.

66
 NPV Profiles

If the required NPV Profile

return is less 160.0000

than the 140.0000

crossover IRR for A = 19.43%
point of 120.0000
IRR for B = 20.00%
13.33%, then 100.0000

you should Crossover = 13.33%

80.0000
choose A.
Project A
NPV

60.0000
Project B
If the required 40.0000
return is
20.0000
greater than
the crossover 0.0000
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24%
point of 13.33, -20.0000
then you
should Crossover rate
-40.0000

choose B. https://www.youtube.com/watch?v=t_Bv5R_wSvY
67
 Conflicts Between NPV and IRR

• NPV directly measures the increase in value to

the firm.
• Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
• IRR is unreliable in the following situations
 Non-conventional cash flows - results in
multiple answers, thus cannot deal with such
situations
 Choosing between mutually exclusive
projects with different size and timing of
cash flows. 68
 Capital Budgeting In Practice

• Firms will typically consider several investment

criteria for evaluating an investment and
consequently make a decision.

• NPV and IRR are the most commonly used

primary investment criteria

• Payback and AAR are commonly used as

secondary investment criteria

69
 Practice Question

Example: NPV versus IRR

Mapletree Inc. has identified the following 2
mutually exclusive projects:
Year Cash Flow (A) Cash Flow (B)
0 -43,000 -43,000
1 23,000 7,000
2 17,900 13,800
3 12,400 24,000
4 9,400 26,000

Assume a required rate of return of 11%. What is

the NPV and IRR for each project? Which project
should the company accept? 70
 Practice Question

Example: NPV versus IRR

Mapletree Inc. has identified the following 2
mutually exclusive projects:
Year Cash Flow (A) Cash Flow (B)
0 -43,000 -43,000
1 23,000 7,000
2 17,900 13,800
3 12,400 24,000
4 9,400 26,000
NPV 7,507.61 9,182.29
IRR 20.44% 18.84%

Project B should be selected as it has a higher

NPV. 71