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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 09
METHODS OF PROJECT EVALUATIONS
The following topics will be discussed in this hand out.
Methods of Project evaluations:
NPV
Associated topics that will be covered are:
Weighted Average Cost of Capital
Opportunity cost
Net present value (NPV)
There are two aspects of NPV method of project evaluation. First is the initial investment or upfront cost
and second, is the benefits (like cash flow) emerging from the project.
First aspect is pretty simple. As it is incurred in the current or present time, there are no issues associated
with its measurement. On the other side, benefits shall be reaped in future and involves time value of
money, making the measurement complex and difficult.
NPV measures the NET benefit by which the value of a firm would increase in case the project in
undertaken.
As on overview of this method, the present value of future cash flow is calculated using a discount rate.
And if this PV of future cash flow is greater than the initial investment, the NPV is stated as "positive".
Alternatively, this suggests that project is worth undertaking and financially viable. If the PV of future cash
flow is less than initial investment, then it is better to scrap the project.
The NPV method is used for evaluating the desirability of investments or projects. Net Present Value is
found by subtracting the required investment:
NPV = PV ­ required investment
The building worth Rs. 2,000,000, but this does not mean that you are Rs. 2,000,000 better off. You
committed Rs. 1,900,000, and therefore your net present value is calculated by using the above formula:
NPV = 2,000,000 ­ 1,900,000 = Rs. 100,000
In other words, your office development is worth more than it costs, it makes a net contribution to value.
The formula for calculating NPV can be written as:
NPV = Co + C1 / 1 + r
Where:
Co = the cash flow at time o or investment and therefore cash outflow
r = the discount rate/the required minimum rate of return on investment
The discount factor r can be calculated using:
Examples:
Decision rule:
If NPV is positive (+): accept the project
If NPV is negative (-): reject the project
Weighted Average Cost of Capital:
A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All
capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a
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Corporate Finance ­FIN 622
VU
WACC calculation.
WACC is calculated by multiplying the cost of each capital component by its proportional weight and then
summing:
WACC = E / V * Re + D / V * Rd * ( 1 ­ Tc )
Where:
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
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Broadly speaking, a company's assets are financed by either debt or equity. WACC is the average of the
costs of these sources of financing, each of which is weighted by its respective use in the given situation. By
taking a weighted average, we can see how much interest the company has to pay for every dollar it
finances.
A firm's WACC is the overall required return on the firm as a whole and, as such, it is often used internally
by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is
the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.
Opportunity Cost:
The cost of an alternative that must be forgone in order to pursue a certain action is called opportunity cost.
Put another way, the benefits you could have received by taking an alternative action.
There is a difference in return between a chosen investment and one that is necessarily passed up. Say you
invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up
the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation,
your opportunity costs are 4% (6%-2%).
The opportunity cost of going to college is the money you would have earned if you worked instead. On the
one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more
during your career, thanks to your education, to offset the lost wages.
Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative
crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).
In both cases, a choice between two options must be made. It would be an easy decision if you knew the
end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise)
with another option is the opportunity cost.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk