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Principles of Finance

16.4 Alternative Methods

Principles of Finance16.4 Alternative Methods

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Calculate profitability index.
  • Calculate discounted payback period.
  • Calculate modified internal rate of return.

Profitability Index (PI)

The profitability index (PI) uses the same inputs as the NPV calculation, but it converts the results to a ratio. The numerator is the present value of the benefits of doing a project. The denominator is the present value of the cost of doing the project. The formula for calculating PI is

PI=PV(CashInflows)PV(CashOutflows)PI=PV(CashInflows)PV(CashOutflows)

For the embroidery machine project that Sam’s Sporting Goods is considering, the PI would be calculated as

PI=$18,836$16,000=1.18PI=$18,836$16,000=1.18

The numerator of the PI formula is the benefit of the project, and the denominator is the cost of the project. Thus, the PI is the benefit relative to the cost. When NPV is greater than zero, PI will be greater than 1. When NPV is less than zero, PI will be less than 1. Therefore, the decision criterion using the PI method is to accept a project if the PI is greater than 1 and reject a project if the PI is less than 1.

Note that the NPV method and the PI method of project evaluation will always provide the same answer to the accept-or-reject question. The advantage of using the PI method is that it is helpful in ranking projects from best to worst. Issues that arise when ranking projects are discussed later in this chapter.

Discounted Payback Period

The payback period method provides a fast, simple approach to evaluating a project, but it suffers from the fact that it ignores the time value of money. The discounted payback period method addresses this flaw by discounting cash flows using the company’s cost of funds and then using these discounted values to determine the payback period.

Consider Sam’s Sporting Goods’ decision regarding whether to purchase an embroidery machine. The expected cash flows and their values when discounted using the company’s 9% cost of funds are shown in Table 16.9. Earlier, we calculated the project’s payback period as four years; that is how long it would take the company to recover all of the cash that it would spend on the project. Remember, however, that the payback period does not consider the company’s cost of funds, so it underestimates the true breakeven time period.

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000.00) 2,000.00 4,000.00 5,000.00 5,000.00 5,000.00 5,000.00
Discounted Cash Flow ($) (16,000) 1,834.86 3,366.72 3,860.92 3,542.13 3,249.66 2,981.34
Cumulative Discounted
Cash Flow ($)
(16,000.00) (14,165.14) (10,798.42) (6,937.50) (3,395.37) (145.72) 2,835.62
Table 16.9

When the cash flows are appropriately discounted, the project still has not broken even by the end of year 5. The discounted payback period would be 5+145.722,981.34=5.055+145.722,981.34=5.05 years. This adjusted calculation addresses the payback period method’s flaw of not considering the time value of money, but managers are still confronted with the other disadvantages. No objective criterion for acceptance or rejection exists because of the lack of a theoretical underpinning for what is an acceptable payback period length. The discounted payback period ignores any cash flows after breakeven occurs; this is a serious drawback, especially when comparing mutually exclusive projects.

Modified Internal Rate of Return (MIRR)

Financial analysts have developed an alternative evaluation technique that is similar to the IRR but modified in an attempt to address some of the weakness of the IRR method. This modified internal rate of return (MIRR) is calculated using the following steps:

  1. Find the present value of all of the cash outflows using the firm’s cost of attracting capital as the discount rate.
  2. Find the future value of all cash inflows using the firm’s cost of attracting capital as the discount rate. All cash inflows are compounded to the point in time at which the last cash inflow will be received. The sum of the future value of cash inflows is known as the project terminal value.
  3. Compute the yield that sets the future value of the inflows equal to the present value of the outflows. This yield is the modified internal rate of return.

For our embroidery machine project, the MIRR would be calculated as shown in Table 16.10:

Year 0 1 2 3 4 5 6
Cash Flow ($) (16,000.00) 2,000.00 4,000.00 5,000.00 5,000.00 5,000.00 5,000.00
              3,077.25
              5,646.33
              6,475.15
              5,940.50
              5,450.00
            Terminal Value $31,595.22
Table 16.10
  1. The only cash outflow is the $16,000 at time period 0.
  2. The future value of each of the six expected cash inflows is calculated using the company’s 9% cost of attracting capital. Each of the cash flows is translated to its value in time period 6, the time period of the final cash inflow. The sum of the future value of these six cash flows is $31,595.22. Thus, the terminal value is $31,595.22
  3. The interest rate that equates the present value of the outflows, $16,000, to the terminal value of $31,595.22 six years later is found using the formula
$16,0001 + i6 = $31,595.221 + i6 = 1.97i = 0.12=12%$16,0001 + i6 = $31,595.221 + i6 = 1.97i = 0.12=12%

The MIRR solves the reinvestment rate assumption problem of the IRR method because all cash flows are compounded at the cost of capital. In addition, solving for MIRR will result in only one solution, unlike the IRR, which may have multiple mathematical solutions. However, the MIRR method, like the IRR method, suffers from the limitation that it does not distinguish between large-scale and small-scale projects. Because of this limitation, the MIRR cannot be used to rank projects; it can only be used to make accept-or-reject decisions.

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