Lecture 3

MIN 100
Investment Analysis
Roy Endr Dahl
University of Stavanger

E-mail: roy.e.dahl@uis.no
1
Early dialogue
We need to elect a student representative who will help
organize the early dialogue in this course.
The early dialogue will answer 5 questions:
1. Teaching and assesment methods
2. Curriculum
3. Use of its learning
4. Working conditions
5. Other conditions that could be improved
You will be given 10 minutes during the next lecture to
discuss these questions, and the representative will fill
out a form reporting on the 5 questions.
2
0-3
MIN 100 Investment Analysis
Week / date Chapters / Topic Note
35 29.08.2011
1-3 / Introduction and basic
concepts.
Part 1: Overview
37 12.09.2011
4-5 / Net present value, bonds,
markets
Part 2: Valuation and Capital
budgeting
38 19.09.2011
6-7 / Stocks, NPV and other
investment rules
39 26.09.2011
8-9 / Cash flow and capital
budgeting, decision tree, sensitivity,
Monte Carlo
40 03.10.2011
10-11 / Return and Risk, expected
return, CAPM
Part 3: Risk and Return
41
Mandatory assignment
42 17.10.2011
11-12 / CAPM, Risk, Cost of Capital
43 24.10.2011
13-14 / Financing, capital structure,
Modigliani & Miller
Part 4: Capital Structure and Dividend
Policy
44 31.10.2011
15-16 / Use of debt, leverage,
dividends
45 07.11.2011
17 / Financial and Real Options. Part 5: Special topics
Stock Valuation
Chapter 6
McGraw-
Hill/Irwin
Comprehend that stock prices depend on
future dividends and dividend growth
Compute stock prices using the dividend
growth model
Understand how growth opportunities
affect stock values
Appreciate the PE ratio
Know how stock markets work
Key Concepts and Skills
6.1 The Present Value of Common Stocks
6.2 Estimates of Parameters in the Dividend
Discount Model
6.3 Growth Opportunities
6.4 Price-Earnings Ratio
6.5 Some Features of Common and Preferred
Stock
6.6 The Stock Markets
Chapter Outline
Opening Case
The education dilemma
http://www.tu.no/jobb/article289898.ece
7
Opening Case
Aker Drilling
8
The value of any asset is the present value of its
expected future cash flows.
Stock ownership produces cash flows from:
Dividends
Capital Gains
Valuation of Different Types of Stocks
Zero Growth
Constant Growth
Differential Growth
6.1 The PV of Common Stocks
Assume that dividends will remain at the same level
forever

Since future cash flows are constant, the value of a zero
growth stock is the present value of a perpetuity:
Case 1: Zero Growth
R
P
R R R
P
Div
) 1 (
Div
) 1 (
Div
) 1 (
Div
0
3
3
2
2
1
1
0
=
+
+
+
+
+
+
=
= = =
3 2 1
Div Div Div
Suppose Big Deal Company will pay an annual dividend
of $2.00 per common share that will never increase or
decrease.
The market rate of return is 8.5%.
What is the maximum amount you should be willing pay
for a common share of Big Deal Corporation?

Formula for Zero Growth Model: P = Div / R

Solution: P = $2.00 / .085
P = $23.53

Zero Growth Example
Case 2: Constant Growth
) 1 ( Div Div
0 1
g + =
Since future cash flows grow at a constant rate forever, the
value of a constant growth stock is the present value of a
growing perpetuity:
g R
P
=
1
0
Div
Assume that dividends will grow at a constant rate, g,
forever, i.e.,
2
0 1 2
) 1 ( Div ) 1 ( Div Div g g + = + =
3
0 2 3
) 1 ( Div ) 1 ( Div Div g g + = + =
.
.
.
Suppose Big D, Inc., just paid a dividend of $.50.
It is expected to increase its dividend by 2% per
year. If the market requires a return of 15% on
assets of this risk level, how much should the
stock be selling for?
P
0
= Div / (R g)
P
0
= .50(1+.02) / (.15 - .02) = $3.92
Constant Growth Example
It is critical to understand that in the constant growth
model calculations are based on the next dividend
If a situation only provides information on the last
dividend it must be increased by the growth rate to
arrive at the next dividend
If a situation provides the value of the next dividend,
then the data necessary for the calculation is known and
need not be derived.
An analyst must discriminate whether they have
information about the next or last dividend and proceed
with calculation accordingly
A Word About Dividends in the Constant
Growth Model
Assume that dividends will grow at different
rates in the foreseeable future and then will
grow at a constant rate thereafter.
To value a Differential Growth Stock, we need
to:
Estimate future dividends in the foreseeable
future.
Estimate the future stock price when the stock
becomes a Constant Growth Stock (case 2).
Compute the total present value of the
estimated future dividends and future stock
price at the appropriate discount rate.
Case 3: Differential Growth
This graph demonstrates the dividend profile for a
company with differential growth
Graphic: Differential Dividend Growth
) (1 Div Div
1 0 1
g + =
- Assume that dividends will grow at rate g
1

for N years and grow at rate g
2
thereafter.
2
1 0 1 1 2
) (1 Div ) (1 Div Div g g + = + =
N
N N
g g ) (1 Div ) (1 Div Div
1 0 1 1
+ = + =

) (1 ) (1 Div ) (1 Div Div
2 1 0 2 1
g g g
N
N N
+ + = + =
+
.
.
.
.
.
.
) (1 Div
1 0
g +
Dividends will grow at rate g
1
for N years and
grow at rate g
2
thereafter
2
1 0
) (1 Div g +
N
g ) (1 Div
1 0
+
) (1 ) (1 Div
) (1 Div
2 1 0
2
g g
g
N
N
+ + =
+

0 1 2

N N+1

We can value this as the sum of:
a T-year annuity growing at rate g
1

plus the discounted value of a perpetuity growing at
rate g
2
that starts in year T+1
(
+
+
=
T
T
A
R
g
g R
C
P
) 1 (
) 1 (
1
1
1
T
B
R
g R
P
) 1 (
Div
2
1 T
+
|
|
.
|
\
|
=
+
Consolidating gives:
T T
T
R
g R
R
g
g R
C
P
) 1 (
Div
) 1 (
) 1 (
1
2
1 T
1
1
+
|
|
.
|
\
|
+
(
+
+
=
+
Or, we can cash flow it out.
What is the stock worth? The discount rate is 12%.
A Differential Growth Example
A common stock just paid a dividend of $2. The
dividend is expected to grow at 8% for 3 years,
then it will grow at 4% in perpetuity.

With the Formula
3
3
3
3
) 12 . 1 (
04 . 12 .
) 04 . 1 ( ) 08 . 1 ( 2 $
) 12 . 1 (
) 08 . 1 (
1
08 . 12 .
) 08 . 1 ( 2 $
|
|
.
|
\
|
+
(
= P
| |
( )
3
) 12 . 1 (
75 . 32 $
8966 . 1 54 $ + = P
31 . 23 $ 58 . 5 $ + = P 89 . 28 $ = P
With Cash Flows
08) . 2(1 $
2
08) . 2(1 $

0 1 2 3 4
3
08) . 2(1 $ ) 04 . 1 ( 08) . 2(1 $
3
16 . 2 $
33 . 2 $
0 1 2 3
08 .
62 . 2 $
52 . 2 $ +
89 . 28 $
) 12 . 1 (
75 . 32 $ 52 . 2 $
) 12 . 1 (
33 . 2 $
12 . 1
16 . 2 $
3 2
0
=
+
+ + = P
75 . 32 $
08 .
62 . 2 $
3
= = P
The constant growth
phase beginning in year
4 can be valued as a
growing perpetuity at
time 3.
Where does g come from?

g = Retention ratio Return on retained earnings

Example: Suppose a company has a retention ratio of
70% and earns an ROE of 12%. What is the Growth
Rate, g?

g = .70 X .12
g = .084 = 8.4%

6.2 Estimates of Parameters
The value of a firm depends upon its growth
rate, g, and its discount rate, R.
The discount rate can be broken into two
parts.
The dividend yield
The growth rate (in dividends)
AKA: Capital Gains Yield
In practice, there is a great deal of
estimation error involved in selecting R.
Cases calling for special skepticism:
Stocks not paying dividends
Stocks with g expected to equal or exceed R
Where Does R Come From?
Start with the DGM:

Note that D
1
/P
0
is the dividend yield and g is
the capital gains yield.

Using the DGM to Find R
g
P
D
g
P
g) 1 ( D
R
g - R
D
g - R
g) 1 ( D
P
0
1
0
0
1 0
0
+ = +
+
=
=
+
=
Rearrange and solve for R:
Imagine that a Solar Corp.s last dividend
was $.65 per share. Solars dividends are
growing at a rate of 4% and the current
price per share is $11.25. What is the
market R implicit in Solars price?
R=(D1 / P0) +g
R = [(.65 x 1.04) / 11.25] + .04
R= .10 or 10%
Example: Using DGM to Find R
Dividends may not be a firms only cash
payout
Recently many firms have repurchased
shares, another form of payout
Using the Dividend Growth Model, the
price of a share will be higher if
considering total payout rather than just
dividends
Total Payout
A firm forecasts income of $4.00 per share and will
payout 30% as dividends, 30% as share repurchase and
will retain the rest. Its growth rate is 5% and required
return is 10%. What is the price of a share?
Dividend Growth Model: P
0
= (4.00 X .30) / (.1 - .05) = $24.00
Notice that the price is based on dividend ( 30% of earnings)
growth only
Total Payout Model: P
0
= (4.00 X .60) / (.1 - .05) = $48.00
Notice that the price is based on total payout ( 60% of earnings =
30% for dividends and 30% for share repurchase) growth
Example: Total Payout
Valuation
Growth opportunities are opportunities to
invest in positive NPV projects.
The value of a firm can be conceptualized as the
sum of the value of a firm that pays out 100% of
its earnings as dividends plus the net present
value of the growth opportunities (NPVGO).
6.3 Growth Opportunities
NPVGO
R
EPS
P + =
Two conditions must exist if a company is
to grow:
It must not pay out all of its earnings as
dividends; and,
It must invest in projects with a positive NPV
Prerequisites to Growth
Why dont firms with no dividends have stock price of
$0?
Such firms believe their earnings are better used to
pursue growth opportunities
Investors pay a stock price that conforms to their own
calculus of the NPVGO of the no-payout firm
The dividend growth model does not work in valuing
this firm
The differential growth model can, but evaluating
the timing of changes in growth is tricky
The No-Payout Firm
Opening Case
The education dilemma
33
Many analysts frequently relate earnings per share
to price.
The price-earnings ratio is calculated as the current
stock price divided by annual EPS.
The Wall Street Journal uses last 4 quarters
earnings

6.4 Price-Earnings Ratio
EPS
share per Price
ratio P/E =
Interpreting the P/E ratio
Historically a company has a fair price if the P/E ratio is
between 10 17.
Below 10:
The companys earnings are thought to be in decline, and the
companys future might be in question.
Or, current earnings are substantially above historical earnings
(e.g. through asset sales).
Over 17:
The stock is overvalued or the earnings have increased since
the last earnings figure was published.
Or, the stock is a growth company where earnings are expected
to increase in the future.
Over 25:
High expected future growth in earnings (e.g. Facebook).
May be a speculative bubble.
S&P 500 Average P/E ratio
36
Opening case revisited
Aker Drilling
Is the price paid by Transocean a fair price?
Normally you can find the P/E-ratio of any company by
looking at the qoutes delivered by the stock exchange.
The P/E ratio would then be calculated by using
historical earnings, number of outstanding shares and
the share price:

However, Aker Drilling has only been listed on the Oslo
Stock Exchange since february/march 2011, and the
historical earnings is not available directly in the quotes.
37
Aker Drilling
As a listed company on the stock exchange, Aker Drilling needs to
provide quarterly financial reports.
The latest report is from August 12
th
, and reports an earnings per
share (EPS) equal to 0.10 USD for the first 6 months.
By assuming that the last 6 months will provide the same EPS, the
EPS for Aker Drilling for one year would be 0.20 USD = 1.08 NOK.
Which will provide us with this PE ratio:

PE = 26.50 / 1.08
PE = 24.5

This is relatively high and indicates an optimistic Transocean which
signals high confidence in future revenues.
38
Aker Drilling
The PE ratio is a valuable tool to compare companies.
Aker Drilling: 24.5
Transocean: -2.35 (9.7 in 2010)
Seadrill: 13.0 (9.6)
Songa Offshore: 8.4 (3.5)
Fred Olsen Energy: 9.2 (6.4)
Statoil: 9.0 (6.2)
DNO Int.: 13.6 (10.7)

Technology industry:
Telenor: 14.2 (22.0 in 2011)
Nokia: -2.44 (8.0)
Microsoft: 15.6 (9.9)
Apple: 16.5 (25.5)
Google: 20.9 (19.0)
39
More P/E analysis
The estimates for Transocean
is given in the figure to the
right. How can we explain the
change in P/E ratio?
40
According to the formula, the P/E can increase due to either (1) a decrease in
EPS or (2) an increase in price per share.
- (2) is not plausible in this case, as the price per share must be set as given
in this 3-year scenario due to market equilibrium.
- (1) EPS may decrease by either an increase in number of shares (new
issuing of shares), and since Transocean is not planning to issue new shares,
the only option left is reduced earnings.
Thus, a higher P/E ratio does not necessarily mean that the company is
making more money.
P/E ratio the story of
Renewable Energy Corporation (REC)

41
First public offering
(IPO) sets P/E = 30
Extreme optimism.
P/E > 70
Pessimism.
P/E = 3.8
First public offering
(IPO) sets P/E = 70
Optimism/Realism?
P/E ca. 35
Voting rights (Cumulative vs. Straight)
Proxy voting
Classes of stock
Other rights
Share proportionally in declared dividends
Share proportionally in remaining assets
during liquidation
Preemptive right first shot at new stock
issue to maintain proportional ownership if
desired
6.5 Features of Common Stock
Dividends
Stated dividend must be paid before
dividends can be paid to common
stockholders.
Dividends are not a liability of the firm, and
preferred dividends can be deferred
indefinitely.
Most preferred dividends are cumulative
any missed preferred dividends have to be
paid before common dividends can be paid.
Preferred stock generally does not carry
voting rights.
Features of Preferred Stock
Dealers vs. Brokers
New York Stock Exchange (NYSE)
Largest stock market in the world
License Holders (formerly Members)
Entitled to buy or sell on the exchange floor
Commission brokers
Specialists
Floor brokers
Floor traders
Operations
Floor activity
6.6 The Stock Markets
Not a physical exchange computer-
based quotation system
Multiple market makers
Electronic Communications Networks
Three levels of information
Level 1 median quotes, registered
representatives
Level 2 view quotes, brokers & dealers
Level 3 view and update quotes, dealers
only
Large portion of technology stocks
NASDAQ
46
47
Apple Inc. trades at NASDAQ with the stock ticker AAPL. It traded on September 2
nd
2011 at $374.05,
down 1.83% from the day before.

Bid defines what the highest price the buyers are willing to offer (and at what volume).
Ask specify what the lowest price a seller is willing to sell at (and at what volume).
The difference (Ask Bid) is called the spread.

Days Range tells us todays highest and lowest price.
52wk Range tells us the highest and lowest price during the last year.

Volume specify the number of shares traded the last day.

Market cap gives us the market value of the company (number of shares * price of share)

P/E Ratio is given with regards to the average PE the last twelve months (ttm = trailing twelve months)

Earnings per share, EPS (ttm), is given with earnings reported for the last twelve months.

Dividends specify last dividend paid. For Apple this was 0, and therefore there is no yield to calculate.
Closing Case
Valuating Ragan Engines
East Coast Yachts are considering buying a
supplier in order to make more profit. The
company Ragan Engines is not publicly traded
and is owned by two persons holding 125 000
stocks each.
We know the following about the firm:
EPS = $ 4.20
Dividend = $ 157 500 to each stock holder.
ROE = 20%
Required return = 16%
48
Closing Case
49
Number of shares 250 000
Earnings pr share (EPS) 4,20
Dividend 315 000
Dividend pr share 1,26
Return on Equity (ROE) 20 %
Required return 16 %
1) Calculate value pr share by using company information
Total earnings 1 050 000 =EPS * Number of shares
Payout rate 30 % =Dividend / Total earnings
Retention rate 70 % =1 - Payout rate
Growth rate 14 % =ROE * Retention Rate
Dividends next year 359 100 =Dividend * (1 + Growth Rate)
Equity Value 17 955 000 =Dividends / (Required return - Growth rate)
Value pr share 71,82
Equity value is calculated as a growing
perpetuity, using dividends as the constant
cash flow and required return as discount rate
and growth rate.
According to this valuation, Ragan Engines is
valued at $17 955 000 and East Coast Yachts
should pay $71.82 pr share.
Closing Case
While Ragan Engines have an industry advantage today,
East Coast Yachts believe the industry will catch up
within 5 years and the growth rate will after this be
reduced to industry standard.
In addition, to get a fair valuation, they will use industry
standard as the required return.
Industry numbers follow from the table below:
50
EPS DPS Stock
price
ROE R
Blue Ribband Motors Corp. $ 1,15 $ 0,34 $ 18,25 13,00 % 15,00 %
Bon Voyage Marine, Inc. 1,45 0,42 15,31 16,00 % 18,00 %
Nautilus Marine Engines 1,85 0,60 28,72 N/A 14,00 %
Ragan Engines 4,20 1,26 unknown 20,00 % 16,00 %
Industry average $ 0,80 $ 0,45 $ 20,76 14,50 % 15,67 %
2) Calculate value pr share by using industry information
Industry EPS 1,48 =Average of competitor's EPS
Industry Payout ratio 30,3 % =Industry DPS / Industry EPS
Industry Retention ratio 69,7 % =1-Industry Payout ratio
Industry Growth rate 10,1 % =Industry ROE * Undustry Retention Ratio
Growth rate year 1-5 14 %
Number of shares 250 000
Year Dividends
1 359 100,00
2 409 374,00
3 466 686,36
4 532 022,45
5 606 505,59
6 667 769,47 NOTE: From year 6, use industry growth rate
Stock value in Year 5 11 991 098,82 =Dividends / (Required return - Growth rate)
Total stock value today 7 299 104,48 =NPV of Dividends in year 1-5 + NPV of stock value in year 5
Closing Case
51
Equity value is calculated as a growing
perpetuity, using dividends as the constant
cash flow and required return as discount rate
and growth rate.
EPS DPS Stock $ ROE R
Blue Ribband Motors Corp. $ 1,15 $ 0,34 $ 18,25 13,00 % 15,00 %
Bon Voyage Marine, Inc. 1,45 0,42 15,31 16,00 % 18,00 %
Nautilus Marine Engines 1,85 0,60 28,72 N/A 14,00 %
Ragan Engines 4,20 1,26 unknown 20,00 % 16,00 %
Industry average $ 0,80 $ 0,45 $ 20,76 14,50 % 15,67 %
Total value is the sum of the present value of
all dividends paid in year 1-5, plus the present
value of the stock value in year 5.
Share value is now lowered considerably, and
East Coast Yachts should pay $29.20 pr share.
Closing Case
One more method to valuate Ragan Engines is by using the formula for the
P/E ratio.

We do not know the price of the share, but we do know the earnings pr
share (EPS) = 4.20, and the industry average P/E = $20.76 / $1.48 = 14.00.
This gives us:

Price pr share = P/E * EPS = 14.00 * 4.20 = 58.80

This is between our previous estimates.
Finally, we may compare the industry average P/E with the estimated P/E
in our previous valuations of Ragan Engines:
1: P/E = 71.82 / 4.20 = 17.1
2: P/E = 29.20 / 4.20 = 6.95
52
Extra Case: Statoil
Using DGM to find R
By looking into a companys report we can
find key figures which will help us
estimate the implicit required return R by
shareholders.
This can be valuable information when
valuating the company at a later time or
comparing against other companies in the
same industry. E.g. to compare risk
assesment by shareholders.
53
54
Statoil
Numbers provided by http://www.statoil.com/annualreport2010/en/Pages/frontpage.aspx
Share value as of 31.12.2011 153,50 NOK/Share
Number of shares 3 182 112 843,00
Earnings pr share (EPS) 24,70 NOK/Share
Dividend 20 683 733 479,50 NOK
Dividend pr share 6,50 NOK/Share
Total Equity 285,20 Billion
Net income (return or profit) 78,40 billion
Return on Equity (ROE) 27,5 %
Required return 25,3 %
1) Calculate value pr share by using company information
Total earnings 78 598 187 222 =EPS * #shares
Payout ratio 26,3 % =Dividend / Total earnings
Retention ratio 73,7 % =1 - Payout rate
Growth rate 20,3 % =ROE * Retention Rate
Dividends next year 24 873 307 900 =Dividend * (1 + Growth Rate)
Equity Value 488 454 321 401 =Dividends / (Required return - Growth rate)
When using the number provided
by the annual report, the implied
required return by shareholders is
25.3%. This can be used to
compare risk assesments for
different companies and industries.
Net Present Value and Other Investment
Rules
Chapter 7
McGraw-
Hill/Irwin
Ability to compute and interpret an investments
payback and discounted payback
(Competence in calculating and interpreting
accounting rates of return)
Facility in computation and interpretation of the
internal rate of return and profitability index
Fluency in describing the advantages and
disadvantages of each valuation method specified
above.
Ability to compute and interpret the net present
value and explain why it is the best decision
criterion
Key Concepts and Skills
7.1 Why Use Net Present Value?
7.2 The Payback Period Method
7.3 The Discounted Payback Period Method
7.4 (The Average Accounting Return
Method)
7.5 The Internal Rate of Return
7.6 Problems with the IRR Approach
7.7 The Profitability Index
7.8 The Practice of Capital Budgeting

Chapter Outline
Opening Case
Oil Field
58
Opening case
Oil field investment
59
Revenues Investment Operational cost Tariffs Exploration cost
Reduced
exploration costs
Reduced
investments
Reduced tariffs
Reduced operational costs
Swift decision-making
Fast-track developments
Accelerated ramp-up
of production
Improved regularity and capacity utilisation
Extension of plateau production
Higher prices
Increased recovery
Extended tailend production
Net Present Value (NPV) =
Total PV of future project Cash Flows - the Initial Investment
Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
7.1 Net Present Value & Its Rules
Suppose Big Deal Co. has an opportunity to make an investment of
$100,000 that will return $33,000 in year 1, $38,000 in year 2, $43,000 in
year 3, $48,000 in year 4, and $53,000 in year 5. If the companys required
return is 12% should they make the investment?

Net Present Value: Example
Answer:
YES! The NPV is greater than $0. Therefore, the investment
does return at least the required rate of return.
Year Cash Flow PV of Cash Flow
0 $ -100 000.00 $ -100 000.00
1 $ 33 000.00 $ 29 464.29
2 $ 38 000.00 $ 30 293.37
3 $ 43 000.00 $ 30 606.55
4 $ 48 000.00 $ 30 504.87
5 $ 53 000.00 $ 30 073.62
Net Present Value $ 50 942.69
Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all relevant cash flows of the
project
NPV discounts the cash flows properly
Reinvestment assumption: the NPV rule
assumes that all cash flows can be
reinvested at the discount rate.
Why Use Net Present Value?
How long does it take the project to pay
back its initial investment?
Payback Period = number of years to
recover initial costs
Minimum Acceptance Criteria:
Set by management; a predetermined time
period
Ranking Criteria:
Set by management; often the shortest
payback period is preferred
7.2 The Payback Period Method
Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback
criteria may not have a positive NPV
Advantages:
Easy to understand
Biased toward liquidity
The Payback Period Method
$100,000 that will return $33,000 in year 1, $38,000 in year 2, $43,000 in
year 3, $48,000 in year 4, and $53,000 in year 5. If the company require the
investment to be paid back within 3 years should it take this opportunity?

Example: Payback Period
Answer:
YES! According to the payback method, the investment will be paid back
after 3 years, and hence give a profit according to the companys investment
rules.

Year Cash Flow Payback
0 $ -100 000.00 $ -100 000.00
1 $ 33 000.00 $ -67 000.00
2 $ 38 000.00 $ -29 000.00
3 $ 43 000.00 $ 14 000.00
4 $ 48 000.00 $ 62 000.00
5 $ 53 000.00 $ 115 000.00
Payback Period 3 years
Consider a project with an investment of $50,000 and
cash inflows in years 1,2, & 3 of $30,000, $20,000,
$10,000

The timeline above clearly illustrates that payback in
this situation is 2 years. The first two years of return =
$50,000 which exactly pays back the initial investment
Example: Payback Method
How long does it take the project to pay
back its initial investment, taking the
time value of money into account?
Decision rule: Accept the project if it pays
back on a discounted basis within the
specified time.
By the time you have discounted the cash
flows, you might as well calculate the
NPV.

7.3 The Discounted Payback Period
$100,000 that will return $33,000 in year 1, $38,000 in year 2,
$43,000 in year 3, $48,000 in year 4, and $53,000 in year 5. If the
companys required return is 12% and predetermined payback
period is 3 years should they make the investment?

Example: Discounted Payback Period
Answer:
NO! At the end of three years the project has still not broken even or
paid back. Therefore, it must be rejected.
Year Cash Flow PV of Cash Flow Payback
0 $ -100 000.00 $ -100 000.00 $ -100 000.00
1 $ 33 000.00 $ 29 464.29 $ -70 535.71
2 $ 38 000.00 $ 30 293.37 $ -40 242.35
3 $ 43 000.00 $ 30 606.55 $ -9 635.80
4 $ 48 000.00 $ 30 504.87 $ 20 869.07
5 $ 53 000.00 $ 30 073.62 $ 50 942.69
Discounted Payback Period 4 years
Another attractive, but fatally flawed,
approach
Ranking Criteria and Minimum Acceptance
Criteria set by management
7.4 Average Accounting Return
Investment of Value Book Average
Income Net Average
AAR =
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and
market values
Advantages:
The accounting information is usually
available
Easy to calculate

Average Accounting Return
IRR: the discount rate that sets NPV to
zero
Accept if the IRR exceeds the required
return
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested
at the IRR
7.5 The Internal Rate of Return
Disadvantages:
Does not distinguish between investing and
borrowing
IRR may not exist, or there may be multiple
IRRs
Problems with mutually exclusive
investments

Advantages:
Easy to understand and communicate

Internal Rate of Return (IRR)
company require a minimum of 12% return on the investment,
should it take this opportunity?
When calculating Internal Rate of Return (IRR), we want to find the
discount rate that will result in an NPV = 0.

It can be solved in Excel by the IRR-formula, or graphically by
calculating NPV over a series of discount rates.

Example: Internal Rate of Return
company require a minimum of 12% return on the investment,
should it take this opportunity?

Answer:
YES! The projects IRR is 29.3% which is higher than the required rate
of return.
Year Cash Flow
0 $ -100 000.00
1 $ 33 000.00
2 $ 38 000.00
3 $ 43 000.00
4 $ 48 000.00
5 $ 53 000.00
Internal Rate of Return (IRR) 29.3%
75
$-40,000.00
$-20,000.00
$-
$20,000.00
$40,000.00
$60,000.00
$80,000.00
$100,000.00
$120,000.00
$140,000.00
0 % 4 % 8 % 12 % 16 % 20 % 24 % 28 % 32 % 36 % 40 %
Internal Rate of Return
NPV
IRR = 29.3%

7.6 Problems with IRR
Multiple IRRs
Are We Borrowing or Lending
The Scale Problem
The Timing Problem
IRR Pitfall 1 Borrowing or lending?
In this scenario, both projects seems to be ok according to
IRR. However, when discounting at 10% the lender gets a
positive NPV, while the borrower has a negative NPV.

When borrowing money the NPV of the project increases as
the discount rate increases, since money today becomes
increasingly and relatively more valuable.
This is contrary to the normal relationship between NPV and
discount rates.
Cash Flow 1 Cash Flow 2 IRR NPV @10%
Lending -1000 1500 50 % 363,64
Borrowing 1000 -1500 50 % - 363,64
IRR Pitfall 1 Borrowing or lending?
-600.00
-400.00
-200.00
-
200.00
400.00
600.00
0 % 10 % 20 % 30 % 40 % 50 % 60 % 70 % 80 % 90 % 100 %
NPV Lending
NPV Borrowing
IRR Pitfall 2 - Multiple Rates of Return
Certain cash flows can generate NPV=0 at two different discount rates.
The following cash flow generates NPV=$ 0 at both IRR% of (-44%) and
+11.6%.

Notice that Excel returns the error #NUM! when trying to calculate the IRR of
this cash flow, since the IRR is not unique.
Cash flow 0 Cash flow 1 CF 9 CF 10 IRR NPV @10%
Project 1 -60 12 ... 12 -15 #NUM! -3,33
kr -1,000.00
kr -800.00
kr -600.00
kr -400.00
kr -200.00
kr 0.00
kr 200.00
kr 400.00
kr 600.00
-
5
0

%
-
4
5

%
-
4
0

%
-
3
5

%
-
3
0

%
-
2
5

%
-
2
0

%
-
1
5

%
-
1
0

%
-
5

%
0

%
5

%
1
0

%
1
5

%
2
0

%
2
5

%
3
0

%
3
5

%
4
0

%
4
5

%
5
0

%
NPV Project 1
IRR Pitfall 2 Multiple rates of return
It is possible to have no IRR and a positive NPV.

You can guarantee against multiple IRRs by having only
positive cash flows after the first initial investment.
339 500 , 2 000 , 3 000 , 1
% 10 @ Project
2 1 0
+ + + + None C
NPV IRR C C C
IRR Pitfall 3 - Scale problem
IRR sometimes ignores the magnitude of the project, and the
following example illustrates this.
You have to decide between two film projects.
Due to the high risk in movie industry the discount rate is set to
25%.

According to IRR, the small budget movie will be chosen, since the
IRR is bigger, 300% > 160%.
However, the earnings for the large budget is bigger. How can you
by using IRR, show that the large budget is the best investment?
81
Investment Cash flow 1 NPV @25% IRR
Small
budget
-10 million 40 million 22 million 300 %
Large
budget
-25 million 65 million 27 million 160 %
IRR Pitfall 3 - Scale problem
By using incremental IRR, you can show that the large budget
provides extra return compared to the small budget movie:

We know that this includes the IRR of the first 10 million
investment. In addition we get 66.67% return on the extra 15
million invested, which is higher than the discount rate at 25%.
Therefore the incremented investment should be taken.

82
Investment Cash flow 1 NPV @25% IRR
Small budget -10 million 40 million 22 million 300 %
Large budget -25 million 65 million 27 million 160 %
Incremental
(large small)
-15 million 25 million 5 million 66,67 %

IRR Pitfall 3 - Scale Problem
Would you rather make 100% or
50% on your investments?
What if the 100% return is on a $1
investment, while the 50% return is
on a $1,000 investment?
We have usually assumed independent projects:
accepting or rejecting one project does not affect the
decision of the other projects.
Our concern has been if the project has exceeded a
MINIMUM acceptance criteria.

There might be scenarios where we have Mutually
Exclusive Projects: only ONE of several potential
projects can be chosen, e.g., acquiring an accounting
system.
Then we need to RANK all alternatives, and select the
best one. When using IRR the timing may provide a
problem when comparing two or more projects.

Pitfall 4 Timing problem
Consider the following two projects:

Because of the late payment in project B, this project has the
lowest IRR. However, as seen from the NPVs, project B has the
highest NPV when discounted at a lower rate, and we therefore
need to find out when project A is better than B and vice versa.
The crossover rate will tell us at what discount rate NPV A = NPV B.
NPV
CF 1 CF 2 CF 3 CF 4 IRR @ 0% @ 10% @ 15%
Project A -10000 10000 1000 1000 16,04 % 2 000,00 668,67 109,31
Project B -10000 1000 1000 12000 12,94 % 4 000,00 751,31 -484,10
86
-3,000.00
-2,000.00
-1,000.00
-
1,000.00
2,000.00
3,000.00
4,000.00
5,000.00
NPV Project A
NPV Project B
Crossover rate = 10.55%
IRR B = 12.94%
IRR A = 16.04%
Calculating the Crossover Rate
Compute the IRR for either project A-B or B-A

kr -2,500.00
kr -2,000.00
kr -1,500.00
kr -1,000.00
kr -500.00
kr 0.00
kr 500.00
kr 1,000.00
kr 1,500.00
kr 2,000.00
kr 2,500.00
0
.
0
0

%
1
.
5
0

%
3
.
0
0

%
4
.
5
0

%
6
.
0
0

%
7
.
5
0

%
9
.
0
0

%
1
0
.
5
0

%
1
2
.
0
0

%
1
3
.
5
0

%
1
5
.
0
0

%
1
6
.
5
0

%
1
8
.
0
0

%
1
9
.
5
0

%
2
1
.
0
0

%
2
2
.
5
0

%
2
4
.
0
0

%
NPV Project A - B
NPV Project B - A
10.55% = IRR
Cash Flow 1 Cash Flow 2 Cash Flow 3 Cash Flow 4 IRR
Project A -10000 10000 1000 1000 16,04 %
Project B -10000 1000 1000 12000 12,94 %
Project A - B 0 9000 0 -11000 10,55 %
Project B - A 0 -9000 0 11000 10,55 %
NPV and IRR will generally give the same
decision.
Exceptions:
Non-conventional cash flows cash flow
signs change more than once
Mutually exclusive projects
Initial investments are substantially different
Timing of cash flows is substantially different
NPV versus IRR
Accept if PI > 1

Ranking Criteria:
Select alternative with highest PI
7.7 The Profitability Index (PI)
Investent Initial
Flows Cash Future of PV Total
PI =
90
Capital rationing
So far we have assumed that the company may pursue all
investment projects with a positive NPV
In real life, however, the company may face restrictions
on capital access
Capital rationing
Capital rationing may arise from imperfect capital
markets
e.g., special demands from investors and analysts
The problem is then to design a portfolio of projects
which maximises total NPV
91
Project ranking with capital
rationing
Consider the following three projects

Assume a capital budget of NOK 10 M
Project I has the highest NPV at a 10% discount rate, but not larger
than the sum of projects J and K
We therefore need a tool which secure maximum NPV per NOK
invested.

Initial investment Cash Flow 1 Cash Flow 2 NPV @10%
Project I -10 30 5 21.4
Project J -4 5 20 17.1
Project K -6 5 15 10.9
92
An NPV index for capital
rationing
The Profitability Index (PI) is calculated by:

This yields for our projects I, J, and K

We should therefore chose projects J and K which would
provide a combined PI = 2.80 > PI Project I = 2.14
I
0
NPV @10% PI
Project I 10 21.4 2.14
Project J 4 17.1 4.27
Project K 6 10.9 1.82
Disadvantages:
Problems with mutually exclusive
investments
Advantages:
May be useful when available investment
funds are limited
Easy to understand and communicate
Correct decision when evaluating
independent projects

The Profitability Index
Varies by industry:
Some firms use payback, others use accounting rate of return.
The most frequently used technique for large
corporations is IRR or NPV.

7.8 The Practice of Capital
Budgeting
Net present value
Difference between market value and cost
Accept the project if the NPV is positive
Has no serious problems
Preferred decision criterion
Internal rate of return
Discount rate that makes NPV = 0
Take the project if the IRR is greater than the required return
Same decision as NPV with conventional cash flows
IRR is unreliable with non-conventional cash flows or mutually
exclusive projects
Profitability Index
Benefit-cost ratio
Take investment if PI > 1
Cannot be used to rank mutually exclusive projects
May be used to rank projects in the presence of capital rationing
Summary Discounted Cash Flow
Payback period
Length of time until initial investment is recovered
Take the project if it pays back in some specified period
Doesnt account for time value of money, and there is
an arbitrary cutoff period
Discounted payback period
Length of time until initial investment is recovered on a
discounted basis
Take the project if it pays back in some specified period
There is an arbitrary cutoff period
Summary Payback Criteria
97
Should the oil field be developed?
Calculate the following:
Payback Period
Discounted Payback Period
Net Present Value
Profitability Index
Decision rule #1 - Net Present Value
NPV 1 360,51
Decision rule #2 - Payback period
Years to payback 11
Desicion rule #2 version 2 - Discounted Payback period
Years to payback 14
Decision rule #3 - Internal rate of return
IRR 14,5 %
Decision rule #4 - Profitability Index
Initial investment -5 086,75
Total PV 6 447,26
Profitability index 1,27
98
NPV > 0. The field should be developed.
If the decision rule is to accept investments
with more than 11 years (or 14 years for
discounted payback), then the investment
should be started.
If the decision rule is to accept investments
with more than 11 years (or 14 years for
discounted payback), then the investment
should be started.
If the alternative cost at the company is below
14.5% the investment will provide a bigger
return than other projects.
PI > 1. The field should be developed.
99
Reduced
exploration costs
Reduced
investments
Reduced tariffs
Reduced operational costs
Swift decision-making
Fast-track developments
Accelerated ramp-up
of production
Improved regularity and capacity utilisation
Extension of plateau production
Higher prices
Increased recovery
Extended tailend production

There are a lot of uncertainties when estimating the value of an investment.
And the longer the horizon, the higher the uncertainty is.

So far we have only used certain outcomes,
but in our next lecture we will introduce probability
as we do sensitivity analysis, decision trees
and monte carlo analysis.

How much can the oil price increase or decrease within 20 years?
How big or small is the real size of the oil field?
How much can we increase the efficiency ratio by improved technology?

And how will this effect the valuation of our project?

Lecture summary
Chapter 6 Stock Valuation
Present Value of Common Stocks
Dividend Growth Model (DGM)
P/E Ratio
Common vs. Preferred Stock
Stock Markets
Chapter 7 NPV and other Investment Rules
Net Present Value
(Discounted) Payback Method
Profitability Index 100

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