FL04 - Net Present Value, Expected Value & Capital Asset Pricing Model

FL04 – Capital Budgeting 15/10/15 Prof. Michael Shillig


CAPITAL BUDGETING: NET PRESENT VALUE/EXPECTED VALUE/CAPM

CAPITAL BUDGETING
 Methods to decide which projects to invest in and which to reject
o NPV rule
o Internal Rate of Return
o Other methods – Ivo Welch, Chapter 4

NPV rule
 Present value of all future cash flows of a project – present value of costs
 Sum of present value of all future positive and negative cash flows
o Discount future cash flows to PV
F1 F FT
NPV  F0   2  .... 
1  r0,1 1  r1, 2 1  rT 1,T

 E.g. you buy a project today for 100, next year it will generate return of
20, following year of 50, year three when project ends, 75. Constant
interest rate = 10%
o NPV = 100 – PV of 20 – PV of 50 – PV of 75 = 15.85
20 50 75
NPV  100     15.85
1  0.1 (1  0.1) 2
(1  0.1) 3
 Only accept (invest in) projects with NPV > 0
 Accepting projects with positive NPV increases firm value
o Reject projects with negative NPV decreasing firm value
 Present (market) value of future cash flow – cost = profit/loss from project
 Positive NPV projects mean ‘free’ money
 Application (see paper)

IRR (ALTERNATIVE METHOD)
 IRR = rate of return like number for NPV = 0
F1 F2 FT
0  F0    .... 
1  r (1  r ) 2
(1  r )T
 Solve for r by making NPV = 0  not really possible by hand
 Invest if IRR > required rate of return
 Advantages
o Single number easy to understand
o All you need is cash flows
 Disadvantages – largely with the fact that equation might be difficult to
solve
o Sometimes there are multiple IRRs  depending on how cash flows
are structured
o Sometimes IRR is not defined
o Comparison problems as it does not adjust for project scale
 OVERALL = NPV more reliable

VALUING RISK – IN PRESENCE OF UNCERTAINTY
 NPV formula is easy