Sunday, February 18, 2007
cut-off point
the cut off point refers to the point below which a project would not be accepted. For Example. if 10% is the desired rate of return, the cut-off rate is 10%. The cut-off point may also be in terms of period. For example, if the management desires that the investment in the project should be recouped in 3 years , the period of three years would be taken as the cut-off point. A project, incapable of generating necesaary cash to pay for the initial investment in the project within three years will not be accepted.
time value of money
The time value of money' is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. In other words, the present value of a certain amount of money a is greater than the present value of the right to receive the same amount of money time t in the future. This is because a amount of money could be deposited in an interest-bearing bank account (or otherwise invested) from now to time t and yield interest. Consequently, lenders acting at arm's length demands interest payments for use of their capital.
Additional motivations for demanding interest are to compensate for the risk of borrower default and the risk of inflation (as well as some other more technical factors).
Additional motivations for demanding interest are to compensate for the risk of borrower default and the risk of inflation (as well as some other more technical factors).
finacing decisions
Investment Decision
Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.
The financing decision
Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the "optimal mix" of financing – the capital structure that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)
The sources of financing will, generically, comprise some combination of debt and equity. Financing a project through debt results in a liability that must be serviced - and hence there are cash flow implications regardless of the project's success. Equity financing is less risky in the sense of cash flow commitments, but results in a dilution of ownership and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows.
The dividend decision
In general, management must decide whether to invest in additional projects, reinvest in existing operations, or return free cash as dividends to shareholders. The dividend is calculated mainly on the basis of the company's unappropriated profit and its business prospects for the coming year. If there are no NPV positive opportunities, i.e. where returns exceed the hurdle rate, then management must return excess cash to investors - these free cash flows comprise cash remaining after all business expenses have been met. (This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and Real options.)
Management must also decide on the form of the distribution, generally as cash dividends or via a share buyback. There are various considerations: where shareholders pay tax on dividends, companies may elect to retain earnings, or to perform a stock buyback, in both cases increasing the value of shares outstanding; some companies will pay "dividends" from stock rather than in cash. (See Corporate action.) Today it is generally accepted that dividend policy is value neutral
Management must allocate limited resources between competing opportunities ("projects") in a process known as capital budgeting. Making this capital allocation decision requires estimating the value of each opportunity or project: a function of the size, timing and predictability of future cash flows.
The financing decision
Achieving the goals of corporate finance requires that any corporate investment be financed appropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the firm) will be affected, the financing mix can impact the valuation. Management must therefore identify the "optimal mix" of financing – the capital structure that results in maximum value. (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)
The sources of financing will, generically, comprise some combination of debt and equity. Financing a project through debt results in a liability that must be serviced - and hence there are cash flow implications regardless of the project's success. Equity financing is less risky in the sense of cash flow commitments, but results in a dilution of ownership and earnings. The cost of equity is also typically higher than the cost of debt (see CAPM and WACC), and so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the asset being financed as closely as possible, in terms of both timing and cash flows.
The dividend decision
In general, management must decide whether to invest in additional projects, reinvest in existing operations, or return free cash as dividends to shareholders. The dividend is calculated mainly on the basis of the company's unappropriated profit and its business prospects for the coming year. If there are no NPV positive opportunities, i.e. where returns exceed the hurdle rate, then management must return excess cash to investors - these free cash flows comprise cash remaining after all business expenses have been met. (This is the general case, however there are exceptions. For example, investors in a "Growth stock", expect that the company will, almost by definition, retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative, management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and Real options.)
Management must also decide on the form of the distribution, generally as cash dividends or via a share buyback. There are various considerations: where shareholders pay tax on dividends, companies may elect to retain earnings, or to perform a stock buyback, in both cases increasing the value of shares outstanding; some companies will pay "dividends" from stock rather than in cash. (See Corporate action.) Today it is generally accepted that dividend policy is value neutral
discounted cash flow
In finance, the discounted cash flow (or DCF) approach describes a method to value a project or an entire company using the concepts of the time value of money. The DCF methods determine the present value of future cash flows by discounting them using the appropriate cost of capital. This is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later (put simply: a dollar in your hand today is worth more than a dollar you may receive at some point in the future). The same logic applies to the difference between certain cash flows and uncertain ones, or "a bird in the hand is worth two in the bush". This is due to opportunity cost and risk over time.
DCF procedure involves three problems
the forecast of future cash flows,
the incorporation of taxes (firm income taxes as well as personal income taxes),
the determination of the appropriate cost of capital.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
Depending on the financing schedule of the company four different DCF methods are distinguished today. Since the underlying financing assumptions are different they do not need to arrive at the same value of the project or company:
DCF procedure involves three problems
the forecast of future cash flows,
the incorporation of taxes (firm income taxes as well as personal income taxes),
the determination of the appropriate cost of capital.
Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.
Depending on the financing schedule of the company four different DCF methods are distinguished today. Since the underlying financing assumptions are different they do not need to arrive at the same value of the project or company:
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The internal rate of return (IRR) is a capital budgeting method used by firms to decide whether they should make long-term investments.
The IRR is the return rate which can be earned on the invested capital, i.e. the yield on the investment.
A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk premium.
Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cashflows.
In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.
Net present value (NPV) is a standard method for financial evaluation of long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. By definition,
NPV = Present value of cash inflows - Present value of cash outflows. For its expression, see the formula section below.
Formula
Each cash inflow/outflow is discounted back to its PV. Then they are summed. Therefore
Where
t - the time of the cash flow
n - the total time of the project
r - the discount rate
Ct - the net cash flow (the amount of cash) at that point in time.
C0 - the capitial outlay at the begining of the investment time ( t = 0 )
If... It means... Then...
NPV > 0 the investment would add value to the firm the project should be accepted
NPV < 0 the investment would subtract value from the firm the project should be rejected
NPV = 0 the investment would neither gain nor lose value for the firm the project could be accepted as shareholders obtain required rate of return
Payback Period
Payback period in business and economics refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. It is intuitively the measure that describes how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods (all else being equal). Payback period is widely used due to its ease of use despite recognized limitations, described below.
The expression is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described of having a payback period of a certain number of years or operating hours (assuming certain costs); here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing", payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. Alternative measures of "return" preferred by economists are internal rate of return and net present value. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.
The IRR is the return rate which can be earned on the invested capital, i.e. the yield on the investment.
A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk premium.
Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cashflows.
In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.
Net present value (NPV) is a standard method for financial evaluation of long-term projects. Used for capital budgeting, and widely throughout economics, it measures the excess or shortfall of cash flows, in present value (PV) terms, once financing charges are met. By definition,
NPV = Present value of cash inflows - Present value of cash outflows. For its expression, see the formula section below.
Formula
Each cash inflow/outflow is discounted back to its PV. Then they are summed. Therefore
Where
t - the time of the cash flow
n - the total time of the project
r - the discount rate
Ct - the net cash flow (the amount of cash) at that point in time.
C0 - the capitial outlay at the begining of the investment time ( t = 0 )
If... It means... Then...
NPV > 0 the investment would add value to the firm the project should be accepted
NPV < 0 the investment would subtract value from the firm the project should be rejected
NPV = 0 the investment would neither gain nor lose value for the firm the project could be accepted as shareholders obtain required rate of return
Payback Period
Payback period in business and economics refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example, a $1000 investment which returned $500 per year would have a two year payback period. It is intuitively the measure that describes how long something takes to "pay for itself"; shorter payback periods are obviously preferable to longer payback periods (all else being equal). Payback period is widely used due to its ease of use despite recognized limitations, described below.
The expression is also widely used in other types of investment areas, often with respect to energy efficiency technologies, maintenance, upgrades, or other changes. For example, a compact fluorescent light bulb may be described of having a payback period of a certain number of years or operating hours (assuming certain costs); here, the return to the investment consists of reduced operating costs. Although primarily a financial term, the concept of a payback period is occasionally extended to other uses, such as energy payback period (the period of time over which the energy savings of a project equal the amount of energy expended since project inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavour. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing", payback period has no explicit criteria for decision-making (except, perhaps, that the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not properly account for the time value of money, inflation, risk, financing or other important considerations. Alternative measures of "return" preferred by economists are internal rate of return and net present value. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.
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