FINA 351 – Managerial Finance (Ref. 8b)
Note: because I need to be with my mother this weekend (who is on her death bed), I am extending 8b due date to
Monday. However, 10a will also be due Monday so attempt to complete as much of 8b as you can now.
Complete the following questions.
1.
Suppose you hide a $100 bill under your mattress. One year later you pull the $100 bill out and say to
yourself, “Well, at least I broke even . . . I didn’t lose any money.” (This is similar to the servant who
buried his money in the parable of the talents, Matt. 25:24-26)
A. If you could have invested this money safely in a bank at 10% APR, is it true that you didn’t lose
any money? Explain.
B. Even if you had no alternative investment (all banks offered zero percent interest rates), is it true
that you “broke even?” Explain.
C. How much would you need to invest today to have $100 a year from now, if your money could
earn interest at 10% APR? In other words, find the PVSS(1,10%).
D. Compare the present value of your outflow (-$100 invested today) with the present value of your
inflow (letter C above) and then net the two present values against each other and record your
answer. It should be obvious that the resulting figure is called the net present value or NPV.
Why is the NPV a negative figure?
E. What do you suppose the IRR is in this case? (Hint: what interest rate would turn a $100 into
$100?)
F. Find the Profitability Index for this situation. Hint: divide the present value of the cash inflow
(letter C above) by the present value of the cash outflow ($100).
G. Which is the better investment: one with a Profitability Index greater or smaller than 1:1?
2.
Suppose you are an executive who must choose one of three investment options. Each of these
investments will cost $200,000 and have cash inflows that cease after four years, but the cash will occur
at different times for each investment, as shown below. Given the risks, you require a minimum return of
12% (discount rate). In other words, you know you could get 12% return elsewhere so you require at
least 12% on these investments to make them worthwhile.
Investment 1
Investment 2
Investment 3
-$200,000
-$200,000
-$200,000
Estimated cash inflow - Year 1
$70,000
$160,000
$10,000
Estimated cash inflow - Year 2
$70,000
$40,000
$10,000
Estimated cash inflow - Year 3
$70,000
$40,000
$10,000
Estimated cash inflow - Year 4
$70,000
$40,000
$250,000
Initial cost (cash outflow) - Year 0
(A)
If all three investments produce the same total cash inflows, why is one better than the other?
(B)
Complete the table below for the remaining two investments. (For IRR you will either need to
use Excel or a financial calculator -- see Example 8.3 in your text).
(2B) Table
Project 1
Project 2
Project 3
2.86 years
?
?
NPV
$12,614
?
?
IRR
14.96%
?
?
1.06
?
?
Payback
Profitability Index
(C)
3.
Based on the results of the various methods, which project should you pick? Why?
Suppose you want to start a business in SE Washington and are looking at two options. Project 1 is to
open eight different Curves for Women franchises (four in Tri-Cities, one in Pendleton, and two in Walla
Walla). Project 2 is to develop a mini-golf course near Highway 12 in the Walla Walla area. A rich aunt
is willing to provide upfront financing for either investment, but not both. However, she is demanding a
steep 16% return per year, given the risk. You plan on selling either business at the end of 4 years. You
have been able to arrive at the following estimated cash flows:
Project 1 – Curves franchises
Project 2- Mini Golf
-$25,000 x 8 = -$200,000
-$200,000
Estimated cash inflow - Year 1
$12,000 x 8 = $96,000
$25,000
Estimated cash inflow - Year 2
$9,000 x 8 = $72,000
$40,000
Estimated cash inflow - Year 3
$9,000 x 8 = $72,000
$48,000
Estimated cash inflow - Year 4
$25,000 x 8 = $200,000 (from sale)
$365,000 (from sale)
1st Year Cost (cash outflow) - Year 0
(A)
Complete the table below. (For IRR, you will either need to use Excel or a financial calculator).
(3A) Table
Project 1
Project 2
2.44 years
?
NPV
$83,616
?
IRR
28.53%
?
1.42
?
Payback
Profitability Index
(B)
Based on the results recorded in the table, which project should you pick? Why? What
qualitative factors (risks, opportunities, personal interests, etc.) should you consider in arriving at
your conclusion?
4.
The concept of NPV can be used to calculate the value of any income-bearing investment, including a
dental practice or an apartment complex. Suppose you’re looking to buy an apartment complex that
generates net cash flows of $96,000 per year (an annuity). The capitalization rate is 10% (i.e. interest
rate, required rate of return, or IRR). How much should you pay for this real estate investment (i.e. what
is it worth today?). Another way to word this question is: How much would you need in the bank today
to generate interest of $96,000 a year if the interest rate is 10% APR? [Note: no time-value-of-money
calculations are needed for this problem – only common sense.]
5.
6.
T or F: The internal rate of return is the discount rate that makes NPV equal to zero.
T or F: Because finding IRR is mostly a matter of trial and error, performing the calculations by hand can
be very tedious, so spreadsheets or financial calculators are generally used.
T or F: When non-conventional cash flows exist, the IRR method may produce multiple rates of return.
T or F: Despite its weaknesses, the IRR method is even more popular than the NPV method.
T or F: The profitability index is simply taking the present value of future cash inflows and dividing it by
the present value of the initial cash outflow.
T or F: An investment should be accepted if its profitability index is less than one.
T or F: Based on surveys of corporate executives, the payback method is currently being used more than
other methods, and it has been used more and more every year.
7.
8.
9.
10.
11.
In the chapter, we examined several tools to assist in capital budgeting decisions (payback, NPV, etc.).
One of the biggest capital budgeting decisions in a typical student’s life was the decision to earn a college degree.
For many students, the next major decision is whether to get a graduate degree. Look over the information on the
next few pages and answer these questions:
(A) How well do the top-ranked MBA schools in the U.S. (Harvard, Stanford, Booth, Wharton, Foster, etc.)
perform in terms of payback time? Why do think this is? (Hint: check out the cost at
http://www.economist.com/news/business/21601884-payback-time
(B) T or F, in your opinion: Unless you want to be CEO of a Fortune 500 company, getting an MBA at your
regular state university will likely give you just as much bang for your buck as an Ivy League school.
12.
Top MBA colleges in the world: Payback time
Published by Sameer Kamat at October 24, 2014
http://www.mbacrystalball.com/blog/2014/10/24/top-mba-colleges-in-world/
When you ask the question: ‘Is an MBA worth it?’ the typical answer you’d hear from many friends and
colleagues would sound something like this, ‘Yes, dude, an MBA is worth it…but only if you get it from the
Top MBA colleges in the world’. Some might qualify it further a ‘Top 10 MBA colleges in the world’.
If you aren’t sure about the specific names they have in mind, check out this list of the best MBA programs
in the world. Of course, the list will differ based on how the rankings methodology used to select the top
MBA colleges in the world.
But in a world where everything is relative, such absolute truths seldom hold water.
When you are trying to analyse whether an MBA is worth it, there are several factors that come into play.
You could be looking at a career change, higher earning potential (post MBA salary), the opportunity to
work abroad, the potential to gain new skills. Many of these are difficult to measure, so for the sake of this
post let’s reduce the complexity and focus on one question.
Is an MBA worth it in financial terms?
Again there are various ways in which you might evaluate the financial worthiness of an MBA.
An Investment Banker might suggest using the Discounted Cash Flow (DCF) method to calculate the Net
Present Value (NPV) of your future income. That doesn’t sound like English!
In simpler terms, it means considering the entire post MBA salaries that you’d get till you retire and finding
out how much it would mean in the present day. Still too complex!
Ok, so we simplify it further and use another parameter to answer the question – Is an MBA worth it? We
look at the payback period. Or in other words – how many years does it take MBA students to recoup their
investment (cost of attending the MBA program including fees and other expenses). Much simpler parameter
to understand, right?
Businessweek carried out a survey a few years back (not sure if they have a more recent version) to measure
the payback period for the best MBA colleges. And the results were surprising for most MBA aspirants who
had taken for granted that the best international MBA universities offer the best RoI.
Some of the best business schools (like Harvard, Chicago, Columbia) had the worst RoI in the survey. The
payback period was over 10 years. Whereas for several lower ranked schools, the payback period was over 3
times better than the tier one colleges.
Payback periods for the Top MBA colleges in the world
Here’s a list of the best and the worst performers in the survey.
MBA Colleges with the Longest Payback Periods
School Name
Payback (Yrs)
Chicago (Booth)
14.28
Columbia
12.78
Harvard
10.63
Toronto (Rotman)
10.02
Stanford
9.67
Texas-Austin (McCombs)
9.33
Kellogg
9.12
Wharton
9.09
Washington (Foster)
9.00
London Business School (LBS)
8.91
MIT Sloan
8.87
Georgia (Terry)
8.84
NYU Stern
8.22
Maryland (Smith)
7.99
Georgia Tech
7.89
MBA Colleges with the Fastest Payback Periods
School Name
Payback (Yrs)
SDA Bocconi
2.25
HEC Paris
2.30
Manchester
2.68
Cranfield
2.94
IESE
3.16
Texas A&M (Mays)
3.42
Michigan State (Broad)
3.51
York (Schulich)
3.60
Illinois-Urbana Champaign
3.85
IE Business School
3.90
Penn State (Smeal)
3.98
IMD Switzerland
4.02
Minnesota (Carlson)
4.15
Purdue (Krannert)
4.28
Rochester (Simon)
4.33
Source: Businessweek
A few years ago, we published this article – Is Harvard the best MBA program in the world?
We didn’t have hard data to substantiate it then, but this survey by Businessweek seems to be aligned with
the message in that post as it adds additional insights about selecting business schools.
Payback discussions aside, there might be other reasons for you to consider only the top MBA colleges in the
world. Prestige being one of them. This is important if you have set your eyes on the best strategy consulting
firms or the top bulge-bracket investment banks. Employers like McKinsey, Goldman Sachs, several topnotch private equity funds won’t touch if you aren’t from one of their feeder MBA programs.
However, not all Indian applicants want to get into these companies. Their post MBA goals might be more
modest. For instance, many engineers might only be looking at moving from a pure technical role into a
business oriented role.
In such cases, insisting on sticking only to the Top 10 MBA colleges may not be the best strategy.