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Corporate Finance

Corporate Finance. Lecture 4. Topics covered. Inflation in capital budgeting Interest rate and inflation rate Discounting with inflation Investment with unequal lives. Inflation and capital budgeting. Interest rates and inflation

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Corporate Finance

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  1. Corporate Finance Lecture 4

  2. Topics covered • Inflation in capital budgeting • Interest rate and inflation rate • Discounting with inflation • Investment with unequal lives

  3. Inflation and capital budgeting • Interest rates and inflation • The effect of inflation: The time value of money is deflated by inflation. • Real interest rate vs. nominal interest rate

  4. Inflation • Be consistent in how you handle inflation! • Use nominal interest rates to discount nominal cash flows. • Use real interest rates to discount real cash flows. • Notice the treatment of depreciations in the two approaches: Depreciation is a nominal number!

  5. Inflation and capital budgeting • Approximation • Real interest rate ≈ Nominal interest rate – Inflation rate • The approximation is reasonably accurate when the interest rate and the inflation rate are low. • Example. Monarchy of Gerberovia has a norminal interest rate of 300% and inflation rate of 280%. • (1+300%)/(1+280%)-1=5.26% • 300%-280%=20%

  6. Inflation Example You own a lease that will cost you $8,000 this year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease?

  7. Inflation Example - nominal figures

  8. Inflation Example - real figures

  9. Cash flows and Discount rates: An example Inflation rate =10% Norminal rate =15.5%

  10. Discount with the real rate

  11. Discount with the real rate

  12. Discount with the real rate

  13. Discount with the real rate

  14. Discount with the real rate

  15. Discount with the real rate (1+15.5%)/(1+1.10)-1=5% Real rate=

  16. Discount with the real rate

  17. Discount with the real rate

  18. Discount with the nominal rate

  19. Discount with the nominal rate

  20. Discount with the nominal rate

  21. Discount with the nominal rate

  22. Discount with the nominal rate

  23. Discount with the nominal rate

  24. Discount with the nominal rate

  25. Discount with the nominal rate

  26. Investments of unequal lives • So far, the NPV rule has been our rule-of-thumb. • However, there are situations when the NPV rule is not sufficient. • E.g. when investments under decision have different lengths of life.

  27. Investments of unequal lives Discount rate=0.1

  28. Investments of unequal lives

  29. Investments of unequal lives

  30. Investments of unequal lives

  31. Investments of unequal lives

  32. Investments of unequal lives

  33. Investments of unequal lives NPV rule will suggest Machine A because it has a lower NPV of costs……But, is this correct?

  34. Investments of unequal lives • The NPV rule does not consider the time that each machine will last. • Machine A is cheaper but only last for three years. • Machine B is more costly but last for one more year. • Therefore, it is necessary to compare the cost on a per year basis.

  35. Investments of unequal lives

  36. Investments of unequal lives • Annuity • A: 798.42=C1* C1=798/2.4869=321.05 B: 916.99=C2* C2=916.99/3.1699=289.28 C1>C2, it is cheaper to buy machine B

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