BUS601 Study Guide

Unit 3: Financial Management

3a. Calculate the value of a dollar today, and at some time in the future

  • What is the purpose of preparing a capital budget?
  • What is the importance of a firm's rate of return target?
  • What is the difference between present value and future value? How is each used when considering an investment?

One of the fundamental activities of business is the requirement to make investments. This process begins with the investment to start a new business and continues as that business invests in products, services, plants, and equipment to support and grow. Let's consider an established manufacturing company. As this company grows, it will need to invest in new equipment as the demand for its products increases. In fact, most companies plan for this type of growth by developing an annual capital budget. This budget allows the firm to plan for the cost of new equipment and to consider their alternatives for funding this investment.

Of critical importance for all investments made by the business is a focus on the rate of return. Simply stated, the rate of return measures the profit or loss that results from an investment over some period. The simple rate of return equals the current value of the investment, minus the initial cost of the investment, divided by the initial value. To express this as a percentage, you will multiply this result by 100. For example, an investment that costs $10,000 is valued at $12,000 in two years. The simple rate of return is ($12,000 -$10,000 / $10,000) × 100 = 20.0%, or a 20% return on this investment.

However, the firm will have to consider more than the simple rate of return. Obviously, the company will include more criteria when deciding to invest in a particular project. For example, there may be more than one investment opportunity, and depending on the availability of funds, the company may have to choose one over the other. For this discussion, the firm will look at the impact of time on the investment, referred to as the time value of money (TVM). This principle recognizes that money received in the future is worth less than money in hand today. Why? By investing now, you are giving up the interest that could be earned while waiting for future payments. Going back to our earlier example, suppose that the $10,000 used for the investment could be placed into an account that would earn 25% over the next two years. Was this a good use of the firm's money?

This concept forces the company to evaluate two fundamental investment principles: the present value (PV) and future value (FV) of a potential investment. The present value of an investment is stated in today's dollars. For our example, the present value is $10,000. If nothing is done with this money, it will erode in value over time. Putting it in a savings account will at least earn interest over the time the funds stay in the account. The future value is a calculation of how much this account will be worth at some point in the future, which can be as simple as calculating the compound interest on the account.

Some general rules for investing will include:

  1. Money not allocated should be invested to earn interest.
  2. Ensure that the expected returns on an investment will meet or exceed the target return.
  3. Given a choice among investments, select the one that represents the greatest rate of return over the target rate.

To review, see Capital Budgeting Decisions.

 

3b. Calculate the internal rate of return (IRR) for an investment

  • What is the discounted cash flow model, and how is it used?
  • Why is it important for a firm to calculate the internal rate of return on investments?

When evaluating potential investments, a common practice is to forecast the projected cash flows that will come to the firm in the future. As previously discussed, money that will be received in the future must be evaluated against the present values of the investment. Given that the firm can put the present value in a risk-free investment that pays interest, such as a treasury bill, we must discount the future earnings by the interest we are giving up. This is known as the discounted cash flow model (DCF).

To calculate the value of an investment to the firm, the investment (present value), the interest rate that the firm can currently earn, the forecasted future cash flows, and the time involved to receive the return. The investment amount is already known. The discounted cash flow model takes the future cash flows and discounts them, using the identified interest rate, back to the present value. The difference between the present value of the investment and the discounted future cash flows results in the net present value (NPV).

If the net present value is '0', the investment will cover the initial cost but no additional return. If the NPV is positive, it will cover the initial cost and earn a return. If the NPV is a negative value, the investment will not cover the initial cost or generate a return. Looking at the NPV as a percentage, which is how most firms will report the rate of return, it is necessary to calculate the internal rate of return (IRR). This requires that the company determine the expected rate of return and use this in the NPV formula to get to an NPV of '0'.

To review, see Use Discounted Cash Flow Models to Make Capital Investment Decisions.

 

3c. Explain how the TVM impacts investment decisions faced by the firm

  • What are the importance of the payback period, net present value, and internal rate of return in evaluating investment decisions?

From our review of the issues facing a firm considering investment opportunities, we have looked at different approaches for conducting an analysis. Each methodology has some advantages and disadvantages. The payback method provides a quick view of how long it will take the firm to recover its investment. An investment of $5,000 today that will return $1,000 per year has a payback period of 5 years. This does not include the loss of potential interest earnings or the effects of time on the investment. To incorporate the principles of the time value of money, we should calculate the present value (investment) and the future value (cash flows) of the project. The net present value (NPV) is the difference between the two, and we would be willing to invest in projects with an NPV that is zero or a positive number. Usually, the firm will have a target rate of return for investments calculated to cover the company's cost of capital and generate a return that will be acceptable to its shareholders. This is known as the hurdle rate, and the firm will accept projects that have a return equal to or greater than this rate. This is used in determining the internal rate of return, or the rate that will generate an NPV of zero.

To review, see Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions.

 

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • capital budget
  • discounted cash flows
  • future value
  • hurdle rate
  • internal rate of return
  • net present value
  • payback period
  • present value
  • rate of return
  • simple rate of return
  • time value of money