imported>Doug Williamson |
imported>Doug Williamson |
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| ''Project appraisal - discounted cash flow.'' | | 1. ''Credit rating.'' |
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| (NPV).
| | The strongest credit ratings for shorter term obligations. |
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| Net present value is a discounted cash flow technique.
| | Prime represents the strongest credit ratings, for the safest investments. |
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| It expressly recognises that the timing of project cash flows is important, as well as the amounts.
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| It makes future cash flows with different timings directly comparable, by converting them to equivalent ''present values''.
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| | More generally, highly creditworthy. |
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| Net present value is the total present value of all of the cash flows of a proposal - both positive and negative - netting off negative present values against positive ones.
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| For example, the expected future cash inflows from an investment project LESS the initial capital investment outflow at Time 0.
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| | | More broadly still, the highest quality, as assessed by one or more criteria. |
| Each present value (PV) is calculated as:
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| PV = Future value x Discount factor (DF)
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| Where:
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| DF = (1 + r)<sup>-n</sup>
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| :r = cost of capital per period; ''and''
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| :n = number of periods into the future that the cash flow is expected
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| <span style="color:#4B0082">'''Example 1: cost of capital 10%'''</span>
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| A project requires an investment today of $100m, with $120m being receivable one year from now.
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| The cost of capital (r) is 10% per annum.
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| The NPV of the project is calculated as follows:
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| PV of Time 0 outflow $100m
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| = $(100m) negative
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| PV of Time 1 inflow $120m
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| = $120m x 1.1<sup>-1</sup>
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| = $109.09m
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| NPV = -$100m + $109.09m
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| = '''+$9.09m''' (positive)
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| <span style="color:#4B0082">'''''Decision rule'''''</span>
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| In very simple ''Net Present Value analysis'' for investments, the decision rule would be that:
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| (1) All positive NPV investment opportunities should be accepted.
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| (2) All negative NPV investment opportunities should be rejected.
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| So the project in the example above would be accepted (on the basis of this simple form of the NPV decision rule) because its NPV is positive, namely +$9.09m.
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| However this assumes the unlimited availability of further capital with no increase in the cost of capital.
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| A more refined decision rule is that:
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| #All negative NPV investment opportunities should still be rejected; while
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| #All positive NPV investment opportunities remain eligible for further consideration (rather than automatically being accepted).
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| <span style="color:#4B0082">'''''NPV drivers'''''</span>
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| NPV is driven by the amounts of forecast cash flows, their timing, and the cost of capital.
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| <span style="color:#4B0082">'''Example 2: cost of capital rises to 20%'''</span>
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| Taking the same example of a project requiring an investment today of $100m, with $120m being receivable one year from now.
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| The cost of capital (r) rises to 20% per annum.
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| The NPV of the project is now calculated as follows:
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| PV of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $120m
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| = $120m x 1.2<sup>-1</sup>
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| = $100m
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| NPV = -$100m + $100m
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| = '''$NIL'''
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| ''Now the project decision is marginal, following the change in the cost of capital assessment.''
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| <span style="color:#4B0082">'''Example 3: cost of capital rises further to 30%'''</span>
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| Continuing with the same example of a project requiring an investment today of $100m, with $120m receivable one year from now.
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| The cost of capital (r) rises further to 30% per annum.
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| The NPV of the project would now be calculated as follows:
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| PV of Time 0 outflow $100m
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| = $(100m)
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| PV of Time 1 inflow $120m
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| = $120m x 1.3<sup>-1</sup>
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| = $92.31m
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| NPV = -$100m + $92.31m
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| = '''-$7.69m''' (negative)
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| ''Now the project would be rejected, following the further rise in the cost of capital evaluation.''
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| == See also == | | == See also == |
| * [[Capital rationing]] | | * [[Credit]] |
| * [[Cost of capital]] | | * [[Credit rating]] |
| * [[Discounted cash flow]] | | * [[Junk]] |
| * [[Economic value added]]
| | *[[Investment-grade bond]] |
| * [[Future value]]
| | * [[Non-investment grade]] |
| * [[Internal rate of return]]
| | * [[P1]] |
| * [[Investment appraisal]] | | * [[P2]] |
| * [[Payback period]] | | * [[P3]] |
| * [[Present value]] | | * [[Prime]] |
| * [[Profitability index]] | | * [[Sub-prime lending]] |
| * [[Residual theory]] | |
| * [[Time value of money]] | |
| * [[Weighted average cost of capital]] | |
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| [[Category:Corporate_finance]]
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