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project_4_1.pptxProject 4: Analyzing Capital Budgets for Organizational Projects
Time Value of Money Calculations
Project 4 Step 1
Effective Annual Interest Rate
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FV and PV of a SINGLE SUM OF MONEY
(1) FV = PV * (1 + r)N
(2) PV = FV * { 1 }
(1 + r)N
Where: FV = future value of a single sum of money,
PV = present value of a single sum of money, R = annual interest rate,
and N = number of years
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Future Value Annuity Factor
Present Value Annuity Factor = (1 - (1 + r)-n /r
Where r = interest rate and N = number of payments
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Valuing Perpetuity
For a series of cash flows C received at the end of each period—often called ordinary perpetuity—the present value of this perpetuity with discount rate r is determined by the following equation:
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Valuing Growing Perpetuity
A special case of perpetuity is growing perpetuity. Growing perpetuity is a series of cash flows which continues forever with each cash flow growing at a constant rate in comparison with the previous one. If cash flow one is $1.00, and the growth rate is 5 percent, then cash flow two is $ 1.05, cash flow three is $1.1025, etc.
The present value of this perpetuity with discount rate r and cash flow growth rate g is determined by the following equation:
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Valuing Annuity
The easiest way to value ordinary annuity is to look at it as a difference between two perpetuities with same cash flows, but different starting points. The first perpetuity would start payments at the end of the first period (time 1), while the second starts at the end of period T (time T+1)
The present value of the first perpetuity is
, while the present value of the second perpetuity needs to be discounted from time T and is equal to
The value of ordinary annuity which pays C for T periods is thus:
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Discounted Cash Flow
A discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity.
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Loan Amortization
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Basic capital budget analysis
Project 4 Step 2
Net Present Value - NPV
The following is the formula for calculating NPV:
where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
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Internal Rate Of Return - IRR
IRR calculations rely on the same formula as NPV does
where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
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Payback Period
Most capital budgeting formulas take the time value of money into consideration. The time value of money (TVM) is the idea that cash in hand today is worth more than it is in the future because it can be invested and make money from that investment. Therefore, if you pay an investor tomorrow, it must include an opportunity cost. The time value of money is a concept that assigns a value to this opportunity cost.
Read more: Payback Period http://www.investopedia.com/terms/p/paybackperiod.asp#ixzz4qcTNJpPY
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Capital budgeting – decide which projects to complete
Project 4 Step 3
Net Present Value - NPV
The following is the formula for calculating NPV:
where
Ct = net cash inflow during the period t
Co = total initial investment costs
r = discount rate, and
t = number of time periods
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Profitability Index
The profitability index is an index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
Cost Of Capital
Weighted Average Cost Of Capital – WACC
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D = total market value of the firm’s financing (equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
COST OF CAPITAL
Project 4 Step 4
Profit Maximization
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Financing options
Project 4 Step 5
Financing Options
Discussion
