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Lecture -Chapter 9

Course: MGMT 31000, Fall 2011
School: Purdue
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9 Net Chapter Present Value The Payback Rule The Discounted Payback The Average Accounting Return The Internal Rate of Return The Profitability Index Good decision criteria We need to ask ourselves the following questions when evaluating capital budgeting decision rules Does the decision rule adjust for the time value of money? Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? MGMT 310 2/40 Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. MGMT 310 3/40 NPV Decision rule MGMT 310 If the NPV is positive, accept the project A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal. 4/40 Project example You are looking at a new project and you have estimated the following cash flows: Year 0: Year 1: Year 2: Year 3: CF = -165,000 CF = 63,120 CF = 70,800 CF = 91,080 Your required return for assets of this risk is 12%. Do we accept or reject this project? MGMT 310 5/40 Decision criteria MGMT 310 Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? Should we consider the NPV rule for our primary decision rule? 6/40 Using excel for NPV analysis Spreadsheets are an excellent way to compute NPVs, especially when you have to compute the cash flows as well. Using the NPV function The first component is the required return entered as a decimal The second component is the range of cash flows beginning with year 1 Subtract the initial investment after computing the NPV MGMT 310 7/40 Payback period How long does it take to get the initial cost back in a nominal sense? Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered MGMT 310 Decision Rule Accept if the payback period is less than some preset limit 8/40 Computing payback Assume we will accept the project if it pays back within two years. Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back in year 3 MGMT 310 Do we accept or reject the project? 9/40 Decision criteria Payback period MGMT 310 Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision rule? 10/40 Advantages and disadvantages of payback period Advantages Disadvantages Easy to understand Ignores the time value of money Adjusts for uncertainty Requires an arbitrary cutoff point of later cash flows Biased toward liquidity Ignores cash flows beyond the MGMT 310 cutoff date Biased against long-term projects, such as research and development, and new projects 11/40 Discounted payback period MGMT 310 Compute the present value of each cash flow and then determine how long it takes to pay back on a discounted basis Compare to a specified required period Decision Rule - Accept the project if it pays back on a discounted basis within the specified time 12/40 Computing discounted payback Assume we will accept the project if it pays back on a discounted basis in 2 years. Compute the PV for each cash flow and determine the payback period using discounted cash flows Year 1: Year 2: Year 3: MGMT 310 Do we accept or reject the project? 13/40 Decision criteria discounted payback Does the discounted payback rule account for the time value of money? Does the discounted payback rule account for the risk of the cash flows? Does the discounted payback rule provide an indication about the increase in value? Should we consider the discounted payback rule for our primary decision rule? MGMT 310 14/40 Advantages and Disadvantages of discounted payback Advantages Includes time value of money Easy to understand Does not accept negative estimated NPV investments when all future cash flows are positive Biased towards liquidity MGMT 310 Disadvantages May reject positive NPV investments Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff point Biased against long-term projects, such as R&D and new products 15/40 Average accounting return There are many different definitions for average accounting return The one used in the book is: Average net income / average book value Note that the average book value depends on how the asset is depreciated. MGMT 310 Need to have a target cutoff rate Decision Rule: Accept the project if the AAR is greater than a preset rate. 16/40 Computing AAR Year 1: NI = 13,620 Year 2: NI = 3,300 Year 3: NI = 29,100 Average book value = $72,000 Assume we require an average accounting return of 25% Average Net Income= AAR = Do we accept or reject the project? MGMT 310 17/40 Decision criteria test - AAR MGMT 310 Does the AAR rule account for the time value of money? Does the AAR rule account for the risk of the cash flows? Does the AAR rule provide an indication about the increase in value? Should we consider the AAR rule for our primary decision rule? 18/40 Advantages and disadvantages - AAR Advantages Disadvantages Easy to calculate Not a true rate of return; time Needed information value of money is ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values, not cash flows and market values will usually be available MGMT 310 19/40 Internal Rate of Return MGMT 310 This is the most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere 20/40 IRR decision rule Definition: IRR is the return that makes the NPV = 0 Decision Rule: Accept the project if the IRR is greater than the return MGMT required 310 21/40 Computing IRR for the project If you do not have a financial calculator or excel, then this becomes a trial and error process Is IRR higher or lower than required return for our NPV project? (Recall NPV was positive) Do we accept or reject the project? MGMT 310 22/40 Decision criteria test - IRR MGMT 310 Does the IRR rule account for the time value of money? Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria? 23/40 Advantages of IRR MGMT 310 Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesnt know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task 24/40 Using excel for IRR You start with the cash flows the same as you did for the NPV You use the IRR function You first enter your range of cash flows, beginning with the initial cash flow You can enter a guess, but it is not necessary The default format is a whole percent you will normally want to increase the decimal places to at least two MGMT 310 25/40 NPV vs. IRR NPV and IRR will generally give us 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 MGMT 310 26/40 IRR and non-conventional cash flows MGMT 310 When the cash flows change sign more than once, there is more than one IRR When you solve for IRR you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation If you have more than one IRR, which one do you use to make your decision? 27/40 Example: Non-conventional cash flows Suppose an investment will cost $90,000 initially and will generate the following cash flows: Year 1: 132,000 Year 2: 100,000 Year 3: -150,000 MGMT 310 The required return is 15%. Should we accept or reject the project? 28/40 NPV and IRR decision rules MGMT 310 The NPV is positive at a required return of 15%, so you should Accept If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject You need to recognize that there are nonconventional cash flows and look at the NPV profile 29/40 IRR and mutually exclusive projects Mutually exclusive projects If you choose one, you cant choose the other Example: You can choose to attend graduate school at either Harvard or Stanford, but not both Intuitively you would use the following decision rules: NPV choose the project with the higher NPV IRR choose the project with the higher IRR MGMT 310 30/40 Example: Mutually exclusive projects Period Project A Project B 0 -500 -400 1 325 325 2 325 200 IRR 19.43% 22.17% NPV 64.05 60.74 MGMT 310 The required return for both projects is 10%. Which project should you accept and why? 31/40 Conflicts between NPV and IRR NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule, you should always use NPV IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects MGMT 310 32/40 Profitability Index MGMT 310 Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value This measure can be very useful in situations in which we have limited capital 33/40 Advantages and disadvantages of profitability Index Advantages Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited MGMT 310 Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments 34/40 Capital Budgeting in Practice MGMT 310 We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria 35/40 Summary Discounted Cash Flow Criteria Net present value Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion 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 Internal rate of return Profitability Index MGMT 310 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 36/40 Summary Payback Criteria Payback period Length of time until initial investment is recovered Take the project if it pays back within 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 MGMT 310 37/40 Summary Accounting Criterion Average Accounting Return Measure of accounting profit relative to book value Similar to return on assets measure Take the investment if the AAR exceeds some specified return level Serious problems and should not be used MGMT 310 38/40 In class exercise Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and required payback is 4 years. MGMT 310 What is the payback period? What is the discounted payback period? What is the NPV? What is the IRR? Should we accept the project? What decision rule should be the primary decision method? When is the IRR rule unreliable? 39/40 In class exercise II MGMT 310 An investment project has the following cash flows: CF0 = -1,000,000; CF01 - CF08 = 200,000 each. If the required rate of return is 12%, what decision should be made using NPV? How would the IRR decision rule be used for this project, and what decision would be reached? How are the above two decisions related? 40/40

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