ZF Wind Power Coimbatore Limited

Time Value of Money

Capital Investment Decisions
Time Value of Money
What do we mean by it ?

For most people consumption todaymore
desirable than consumption tomorrow.

Moreover, money to be received in future is
uncertain than money in hand now.

So people tend to attach a kind of premium
(Interest) or value to money in hand now compared
to money that we are supposed to receive in future
and this brings us to the idea of Time Value of
Money.
4
Time Value of Money
Compounding and Future value of Money
Future Value : The amount an investment is worth after
one or more periods ( after accruing interest)

One period case : if the interest rate is r per year, an
investment of Rs.1 will become (1+r) at the end of 1year

Multiperiod Case: Algebraically, we say that if r is the
interest rate per year, Rs.1 becomes (1 + r ) after 1 yr and
(1+r) X(1+r) i.e (1+r)^
2
after 2 yrs
5
More generally , P Rupees @ r% pa after t years
will become : P(1+r)^t
Time Value of Money
FVIF(r,t) and PVIF(r,t)
The factor ( 1+r)^
t
is called the Future Value Interest
Factor or FVIF(r,t).

The factor is called the discount factor or Present
value Interest Factor --- PVIF(r,t)

The process of finding the future value by multiplying a
sum with FVIF(r,t) is called COMPUNDING while, the
process of finding the present value of a future cash flow, by
multiplying the future cash flows with PVIF(r,t) is called
DISCOUNTING or Discounted Cash Flow (DCF) Valuation

t
r) 1 (
1
+
6
Time Value of Money
Future value of Multiple Cash Flows
Future Value of Multiple cash Flows :
Find the time period for which each cash flow remains invested
at the given rate of interest and find the FV of each.
Add up the FVs to get the future value of the cash flow stream
7
0 1 2 3

4
5
Rs.2000
Rs.2000 Rs.2000 Rs.2000 Rs.2000
Time (yrs)
x 1.1
4

x 1.1
3

x 1.1
2

x 1.1
1

Rs.2200
Rs.2420
Rs.2662
Rs.2928
Total value
Rs.12,210
Time Value of Money
Present values of Multiple Cash Flows
Present value of Future Cash Flows :
Discount each of the future cash flows to the desired point
in time line, to get individual PVs.
Then add the PVs to get the PV of the cash flow stream.
8
0 1 2 3

4
5
Rs.1000 Rs.1000 Rs.1000 Rs.1000 Rs.1000
Time (yrs)
x 1/ 1.06
4

x 1/1.06
3

x 1/ 1.06
2

x 1/1.06
1
Rs.943
Rs.890
Rs.792
Total PV
Rs.839
x 1/ 1.06
5

Rs.747
Rs.4212
Time Value of Money
9
Level cash Flows ..Perpetuities
A perpetuity is a constant stream of cash flows to
infinite time (a very large time for all practical
purposes)



common example -preferred stocks-- the holder
is promised a fixed dividend payment from the
corporation for ever . In UK and Canada, there are
bonds which are called consols which once
purchased assures fixed interest payment from the
Govt. for ever.


C2= C
0 1 2 3
C1= C C3= C
T
Time Value of Money
10
Present Value of a perpetuity :
The PV of the perpetuity is given by :

PV = C/r

where C is the constant cash flow to be received after
every time interval and r is the rate of interest
available for similar investment opportunities

What is FV of Perpetuity ?
Time Value of Money
11
Level cash Flows Annuity
A series of similar cash flows that occur at the end
of each period for a pre specified number of
periods is called an annuity. (Example: EMI paid
against a house loan).


C2= C
0 1
2
3
C1= C C3= C
T
Time Value of Money
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Present and Future values --- Annuity


(
(
(
(

+
r
r) (1
1
- 1
t
PVIFA(r,t)= and FVIFA(r,t)=
(

+
r
r
t
1 ) 1 (
(

+
=
(
(
(
(

=
r
r
C FV
r
r
C PV
t
t
1 ) 1 (
) 1 (
1
1
Time Value of Money
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Annuity Due
It is an annuity where the cash flow occurs at the beginning
of each period ( contrary to the assumption that it occurs at
the end ).



Annuity due value = Ordinary Annuity value x (1+r)
Time Value of Money
Capital Investment Decisions
What long term investments should the firm take on ?
Capital budgeting
Investments like :
Plant and equipment, new projects like CONDOR
A fleet of new Aircrafts for an airlines company
Issues Involved :
1. What are the time, quantum and risk of the cash
flows vis-a vis- cost involved in the projects ?
2. Is it Profitable for the company to go for the project?
3. Whether the investment decision is going to create
value for the company ?

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Problems managers face when
they make investment decisions
1. They have to search out for new opportunities or
projects in the marketplace

2. The expected cash flows from the project need to
be estimated.

3. The projects acceptability has to be decided
according to sound decision rules.
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What is a sound decision rule to
make investment decisions ?
The best technique or decision rule should have the
following properties :
1. All cash flows should be considered
2. The cash flows time value of money should be
considered at a suitable discount rate
3. The technique should be able to select one from a set
of mutually exclusive projects


16
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Commonly used Investment Decision criteria
Following investment decision criteria are primarily
used for taking such decisions:

1. Net Present Value (NPV)
2. The Payback Rule
3. The Discounted Payback
4. The Average Accounting Return (ACR)
5. The Internal Rate of Return (IRR)
6. Modified Internal Rate of Return (MIRR)
7. The Profitability Index (PI)

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Net Present Value ( NPV)
Defined as the difference between the value( PV of the
expected cash flows ) of a project and its cost

How do we find NPV of a project or generally an
investment?

STEP I:
The first step is to estimate the expected future cash flows.( not
earnings or other accounting numbers it is the incremental or net
cash flows that matter for capital budgeting decisions)

STEP II :
The second step is to estimate the required return for projects of
this risk level, i.e the opportunity cost of capital.

NPVcontd..
Opportunity Cost of Capital : This is the discount rate that is
used to discount the expected cash flows from an investment
and to find the NPV.
It is the opportunity cost of taking the project, (Why?)..
This is the return the shareholders would have earned themselves by investing in financial assets, if
the project was not taken and the cash distributed as dividends to shareholders.
STEP III
The third step is to find the present value of the cash flows,
by discounting them by the opportunity cost of capital, and
subtract the initial investment.
So NPV = PV of the expected cash flows from the project (
discounted at Opportunity cost of capital) the PV of the
investment made

19
20
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.

Because the goal of the financial manager is to
increase owners wealth, NPV is a direct measure
of how well this project will meet their goal.

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NPV Decision Rule contd..
Suppose you are looking at a new project and you have
estimated the following cash flows:

1. Year 0: CF = -165,000
2. Year 1: CF = 63,120;
3. Year 2: CF = 70,800;
4. Year 3: CF = 91,080;

Your required return for assets of this risk is 12%.

NPV = 63,120/(1.12) + 70,800/(1.12)
2
+ 91,080/(1.12)
3
165,000 =
12,627.42
So Shall we consider this Project ?
YES


The Payback rule :
The amount of time required for an investment to
generate cash flows sufficient to recover its initial
cost is called the payback period of the
investment.
Example: A project requiring an initial
investment of $500 is expected to generate the
following cash flows over the next three years :
Year 1 $100
Year 2 $200
Year 3 $500

What will be the payback period for this project ?


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The payback rule contd..
Soln :
During the first 2 years cash generated = $300 and
remaining amount of cash to be recovered for full
payback = $200 which should happen sometime
during year 2 and year 3. The exact time ( assuming
uniform inflow of cash during the year 3= 200/500 =
0.4 years.

Thus payback period for this project = 2.4 years or
roughly 2 years and 5 months.

The payback rule says :
An investment is acceptable if its payback period is less
than some pre specified number of years.

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What are the problems with Payback rule?
To find out lets examine the following 3 projects, all
having the same payback of 3 years i.e they should
be equally attractive as per payback rule.
Expected Cash Flows for Projects A through C
Year A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60,000
Payback
Period
3 3 3
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Problems with payback rule.. Contd..
Problem-1Timing of cash flows within the payback period
not considered:

If we compare projects A and B, at 15% discount rate, NPV
of A = 7.26 while that of B =13.62 so B is more attractive
than A although as per payback rule they are equally
attractive. Why does this happen ?

Because, payback method does not take into account any
time value of money .

Project B has larger cash inflows early in its life compared
to A. Payback method completely ignores this.
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Problems with payback rule.. Contd..
Problem 2) Payments after the payback period ignored:
Compare B and C. NPV of B =13.62 while that of C = 34284.51, but they
appear equally attractive by payback method. Why does this happen?
Because payback method completely ignores the cash flows after the
payback period.
Because of short term orientation of Payback method, some valuable
long term projects may be ignored.
Year B C
0 -100 -100
1 50 50
2 30 30
3 20 20
4 60 60,000
Payback Period 3 3
26

Problems with payback rule.. Contd..
Problem 3)
Biggest problem is to select a proper cut off payback period. There is
no objective basis or economic rationale for selection of the same.

So is the payback method not used at all in practice?
Often used by large, sophisticated companies when making
relatively small decisions. The principal advantages of the
payback rule perceived by the practitioners are as follows :

It is easy to understand and interpret
Adjust for uncertainty of later cash flows
Biased towards Liquidity This could be important for
small businesses although less significant for large
businesses
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The Discounted Payback Period Rule
How long does it take the project to pay back its
initial investment taking the time value of money into
account?

Compute the present value of each cash flow and then
determine how long it takes to pay back 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
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Discounted payback period rule example
Assume a project that needs Rs. 165,000 as initial investment
and is expected to generate Rs. 63120, Rs. 70800, and Rs.
91080 in years 1 , 2 and 3. We will accept the project if it pays
back on a discounted basis in 2 years. Use 12% as the
appropriate discount rate.

Do we accept or reject the project?

Compute the PV for each cash flow and determine the payback
period using discounted cash flows
1. Year 1: 165,000 63,120/1.12
1
= 108,643
2. Year 2: 108,643 70,800/1.12
2
= 52,202
3. Year 3: 52,202 91,080/1.12
3
= -12,627 project pays back in
year 3
So we do not accept.
But NPV = + 12,627 still we reject.
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Discounted Payback Period. Contd..
1. But if a project pays back on a discounted basis ever,
with some cash flows still remaining, it is bound to
have a positive NPV( assuming that all the cash flows
from the project are positive)

2. This is because by definition, the NPV is zero when the
sum of the discounted cash flows equals the initial
investment. So if a project pays back on a discounted
basis, then some cash flows may still remain which
must add up to give a positive NPV.

3. This implies that if we use a discounted payback, we
wont be accidentally taking up any projects with a
negative NPV. But we may reject some with positive
NPV like the one we just discussed.
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Advantages and Disadvantages of Discounted Payback :
Advantages
Includes time value of money
Easy to understand
Does not accept negative NPV investments when all future
cash flows are positive
Biased towards liquidity

Disadvantages
May reject positive NPV investments
Requires an arbitrary cutoff point
Ignores cash flows beyond the cutoff point
Biased against long-term projects, such as R&D and new
products
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The Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets NPV to zero

Minimum Acceptance Criteria:
Accept if the IRR exceeds the required
return.

Ranking Criteria:
Select alternative with the highest IRR
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The Internal Rate of Return: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
How ?
3 2
) 1 (
150 $
) 1 (
100 $
) 1 (
50 $
200 0
IRR IRR IRR
NPV
+
+
+
+
+
+ = =
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The NPV Payoff Profile for the previous problem
Discount Rate NPV
0% $100.00
4% $71.04
8% $47.32
12% $27.79
16% $11.65
20% ($1.74)
24% ($12.88)
28% ($22.17)
32% ($29.93)
36% ($36.43)
40% ($41.86)
If we graph NPV versus discount rate, we can see the IRR as the
x-axis intercept the discount rate that makes the NPV=0
IRR = 19.44%
($60.00)
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
Discount rate
N
P
V
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Internal rate of return contd
Example:
A project has a total up front cost of Rs.435.44.The cash
flows are Rs.100 in the first year,Rs.200 in the second
year and Rs.300 in the third year. Whats the IRR of the
project? If we require an 18% return should we take this
investment?

Soln : The IRR can be given by the following equation,
NPV=0= -435.44 + 100/(1+IRR) + 200/(1+IRR)
2
+ 300/(1+IRR)
3
A little trial and error shows that the IRR comes out to be
15%.( CHECK NPV =0 for discount rate = 15%)

So shall we Accept the project ?

NO
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Internal rate of return contd
Problems with IRR rule :
The IRR Investment Rule will give the same answer as the NPV rule
in many, but not all, situations.
Problem 1 ) Non Conventional Cash Flows :
In general, the IRR rule works for a stand-alone project if all of
the projects negative cash flows precede its positive cash
flows.
In other cases, the IRR rule may disagree with the NPV rule and
thus be incorrect.
Situations where the IRR rule and NPV rule may be
in conflict are as follows :
Delayed Investments
Nonexistent IRR
Multiple IRRs
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Problems with IRR.contd..
Multiple IRRs
Assume you have just retired as the CEO of a successful
company. A major publisher has offered you a book deal. The
publisher will pay you $1 million upfront if you agree to write a
book about your experiences. You estimate that it will take 3
years to write the book. The time you spend writing will cause
you to give up speaking engagements amounting to $500,000
per year. ( This is effectively an outflow to you). Take
Opportunity cost as 10%.
Now assume the lecture deal fell through. You inform the
publisher that it needs to increase its offer before you will
accept it. The publisher then agrees to make royalty payments
of $20,000 per year forever, starting once the book is published
in 3 years.
Should you accept or reject the new offer?
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Problems with IRR.contd..
Multiple IRRs contd..
The cash flows would now look like:


The NPV is calculated as:
2 3 4 5
3 3
500, 000 500, 000 20, 000 20, 000 20, 000
1,000, 000
1 (1 ) (1 ) (1 ) (1 )
500, 000 1 1 20, 000
1,000, 000 1
(1 ) (1 )
= + + +
+ + + + +
| |
| |
= +
| |
+ +
\ .
\ .
NPV
r r r r r
r r r r
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By setting the NPV equal to zero and solving for r, we find the
IRR. In this case, there are two IRRs: 4.723 % and 19.619 % .
Problems with IRR.contd..
If the opportunity cost of capital is either below 4.723 % or above 19.619
%, you should accept the deal. Between 4.723 % and19.619 %, the book
deal has a negative NPV. Since your opportunity cost of capital is 10 % ,
you should reject the deal.

39
Problems with IRR.contd..
Multiple IRRs contd
Descartes rule of signs :
The number of IRRs will be the same as the number of
changes of signs in cash flows i.e from negative to
positive or positive to negative( or less than it by a
multiple of 2).
40

Problems with IRR.contd..
Problem 2) Mutually Exclusive Projects:
Mutually exclusive projects If you choose one, you
cant choose the other

Decision rules:
1. NPV Choose the project with the higher NPV
2. IRR Choose the project with the higher IRR but
is that always correct ?
41

Problems with IRR.contd..
Example:
The required return for both projects is 10%.

Which project should you accept and why?


Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
The required return
for both projects is
10%.

Which project should
you accept and why?
42

Problems with IRR.contd..
($40.00)
($20.00)
$0.00
$20.00
$40.00
$60.00
$80.00
$100.00
$120.00
$140.00
$160.00
0 0.05 0.1 0.15 0.2 0.25 0.3
Discount Rate
N
P
V A
B
NPV Profiles
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point = 11.8%
43

Problems with IRR.contd..
A has a higher total cash flow, but it pays back at a
slower rate than B. So its NPV is higher at low
discount rates but as the discount rates increase,
the effect of the distant cash flows is reduced to a
great extent and the NPV of B starts exceeding its
NPV.

Moral of the example is when we have mutually
exclusive projects we should not rank them based
on their IRRs. Instead we need to look at relative
NPVs and the required rate of return.
44
Advantages and Disadvantages of IRR:
Advantages
Closely Related to NPV, Often Leading to
Identical decisions
Easy to understand and communicate

Disadvantages
May result in multiple answers
Not Deal with non conventional cash flows
May Lead to incorrect decisions in comparison
to mutually exclusive investments
45
Modified Internal rate of Return ( MIRR)
To address some of the problems with conventional
IRR ( like multiple IRRs) sometimes a modified IRR
is used.


46
0 1 2


-$ 60 +$ 155 - $ 100
IRR = 25% and
IRR = 33.33%
Modified Internal rate of Return ( MIRR)
Approach 1 : The discounting approach :

1. Discount all negative cash flows at the required rate of
return and add them to the initial cost. ..
2. Calculate the IRR.
3. The discount rate used might be the required return.

In this example , if the projects required rate of return is
20%, then the modified cash flows look as follows :
Time 0 : -$60 + (-$100/1.22)=-$129.44
Time 1 : +$155
Time 2 : +$0
If you calculate the IRR now, you should get IRR =
19.71%
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MIRR contd..
Approach 2 : The Reinvestment approach :

1. Compound all cash flows (positive and negative) except the
first one, to the end of the projects life at the required rate of
return.
2. Calculate the IRR.

In this example , if the projects required rate of return is 20%,
then the modified cash flows look as follows :
Time 0 : -$60
Time 1 : 0
Time 2 : +$155*1.2 -$100= $86
If you calculate the IRR now, you should get IRR = 19.72%

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MIRR contd..
Approach 3.. Combination
1. Discount all the negative cash flows back to the
present
2. Compound all the positive cash flows to the end.
3. Calculate IRR

For our example modified cash flows become :
At time 0 : -$60+(-$100/1.22)=-$129.44
Time 1 : +$0
Time 2 : $155x 1.2 = $186
Calculate the MIRR = 19.87%
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MIRR problems
MIRRs are controversial. Detractors say its Meaningless IRR

Many analysts claim that MIRRs are superior to IRRs,. For example by design
they clearly do not suffer from the multiple rate of return problem.

One problem with MIRRs is however there are different ways to calculate it
and we get different results with each and there is no clear reason which one
is better.

Because MIRR depends on an externally supplied discount rate, the answer
that one gets is not truly internal which by definition should depend only
on the projects cash flows and nothing else.

If we have the discounting rate, why not calculate the NPV and be done with
it ?
50

Average Accounting Return Rule
The average accounting return is interpreted as an
average measure of the accounting performance of a
project over time, computed as some average profit
measure attributable to the project divided by some
average balance sheet value for the project.

Expression : Average net income / average book value

Need to have a target cutoff rate of return. ( which is a
problem)

Decision Rule: Accept the project if the AAR is greater
than a preset rate.
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Example AAR
You are looking at a three year project with a
projected net income of $2000 in year 1, $4000 in
year 2, and $6000 in year 3. The cost is $12000
and that will be depreciated over the three year life
of the project. What is the AAR for the project?
Solution :
Average net income for the project is =(2000
+4000 +6000)/3 =4000
Average book value of the project = (12000 +8000
+4000 +0)/4 = 6000 ( or =12000/2 =6000)
AAR = 4000/6000 = 66.67%

52

Advantages and Disadvantages of AAR
Advantages
Easy to calculate and understand

Disadvantages
Not a true rate of return; time value of money is
ignored completely.
Uses an arbitrary benchmark cutoff rate
Based on accounting net income and book values,
not real cash flows and market values

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The Profitability Index (PI) Rule
Example : if a project costs Rs. 200 crores and the present
value of the future cash flows discounted at a suitable
opportunity cost is Rs. 220 crores then, the PI is 220/200 =
1.1.

If a project has a PI > 1 it implies that the PV of the future
cash flows > the initial cost i.e the project has a positive
NPV.

Thus , Minimum Acceptance Criteria: Accept if PI > 1
Investent Initial
Flows Cash Future of PV Total
PI =
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The Profitability Index (PI) Rule contd..
Advantages
Closely related to NPV, generally leading to identical
decisions
Easy to understand and communicate

Disadvantages
May lead to incorrect decisions in comparisons of
mutually exclusive investments of different scale.
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