Chapter7b+notes

Chapter7b notes - Chapter 7(Cont’d Investment Decision Rules Focusing Question As at HKT Spring 2009 2 Focusing Question Peter bought 10,000

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Unformatted text preview: Chapter 7 (Cont’d) Investment Decision Rules Focusing Question As at HKT 2009/02/20 Spring 2009 2 Focusing Question Peter bought 10,000 shares of Thiz Technology and made a 74% return in one day. John bought 10,000 shares of HKRH and made a 16.8% return in one day. Who is the more successful investor and why? Spring 2009 3 Outline Decision Rules Mutually Exclusive Projects Standalone Projects NPV vs. IRR Delayed Investments Spring 2009 Pay Back Multiple IRRs Differences in Scales Projects w/ Resource Constraints Timing of CF Profitability Index Differences in Lives 4 Learning Objectives 1. Compute the crossover point or incremental IRR for mutually exclusive projects with differences in scales and timing of cash flows. 2. Compute Equivalent Annual Annuity (Equivalent Annual Cost EAC) for mutually exclusive projects with different lives. 3. Compare NPV and IRR in selecting mutually exclusive projects, and tell why NPV always gives the correct decision. 4. Compute profitability index and use it to select projects under resource constraints. Spring 2009 5 Mutually Exclusive Projects When you must choose only one project among several possible projects, the choice is mutually exclusive. Problem: Consider the following two mutually exclusive projects with same initial investment (projects of identical scale): Initial Investment Cash FlowYear 1-3 Cost of Capital Spring 2009 Girlfriend’s Business $10,000 $6,000 12% 2-computer Internet Cafe $10,000 $5,000 12% 6 Projects of Identical Scale Solution: Girlfriend’s Business -$10,000 $6,000 $6,000 $6,000 NPV = $4,411; IRR = 36.3% Internet Cafe -$10,000 $5,000 $5,000 $5,000 NPV = $2,009; IRR = 23.4% Both the NPV rule and the IRR rule indicate the girlfriend’s business is the better alternative. Spring 2009 7 NPV Profiles of Projects w/ Identical Scale Spring 2009 8 Projects with Differences in Scale What if there are 10 computers in the internet cafe? i.e., the internet café investment is 5 times larger? The NPV would be 5 times larger at $2009*5 = $10,046, but the IRR remains the same at 23.4%. The girlfriend’s business has an IRR of 36.3%, but its NPV is only $4,411. Our decision: Use NPV rule The 10-computer internet café makes more money. It has a higher NPV. Spring 2009 9 Return Vs Dollar Impact on Value The IRR is a measure of the average return, but NPV is a measure of the total dollar impact on value. When a project’s size is doubled, its NPV will double. This is not the case with IRR. Thus, the IRR rule cannot be used to compare projects of different scales. Spring 2009 10 NPV Profiles of Projects w/ Different Scale The NPV of the 10computer internet cafe is larger than the NPV of the girlfriend’s business for cost of capital lower than 20%. Spring 2009 11 Crossover Point (Incremental IRR) Problem: How to Compute the crossover point? Solution: Plan: The crossover point is the discount rate that makes the NPV of the two investments equal, i.e., NPV of internet cafe equal NPV of his girlfriend’s business At the crossover point, the difference of the NPVs between internet café and his girlfriend’s business is 0. The difference of the NPVs of two alternatives is the incremental impact of choosing one project over another. Spring 2009 12 Crossover Point for Mutually Exclusive Projects Execute: Find the rate which sets the difference in CF equal to 0 Year Internet Cafe Girlfriend’s business Difference in CF 0 -50,000 -10,000 -40,000 1 25,000 6,000 19,000 2 25,000 6,000 19,000 3 25,000 6,000 19,000 Given: Solve for: 3 -40,000 19,000 0 20.04 Excel Formula: =RATE(NPER, PMT, PV,FV) = RATE(3,19000,-40000,0) Spring 2009 13 Crossover Point for Mutually Exclusive Projects Evaluate: The crossover point is the discount rate at which one would be indifferent between the two investment opportunities because the incremental value of choosing the internet café over girlfriend’s business would be zero. Decision Rules: If cost of capital < crossover point, then you should choose the Internet Cafe. If cost of capital > the crossover point, then you should choose the girlfriend’s business. Since cost of capital < 20.04%, take the internet café. Spring 2009 14 NPV Profiles of Projects w/ Different Scale The NPV of the 10computer internet cafe is larger than the NPV of the girlfriend’s business for cost of capital lower than 20%. Spring 2009 15 Quick Quiz Initial Investment NPV IRR Cost of Capital Project A $1,000 $600 50% 12% Project B $10,000 $1,900 20% 12% 1. Which of the mutually exclusive projects will you prefer? A. Project A B. Project B C. Neither D. Both Spring 2009 16 Outline Decision Rules Mutually Exclusive Projects Standalone Projects NPV vs. IRR Delayed Investments Spring 2009 Pay Back Multiple IRRs Differences in Scales Projects w/ Resource Constraints Timing of CF Profitability Index Differences in Lives 17 Timing of Cash Flows Assume you are offered a maintenance contract on the internet café’s computers which would change the cash flows each year as follows: Year Internet Café w/ contract 0 -50,000 -50,000 1 25,000 30,000 2 25,000 23,000 3 25,000 20,968 NPV $10,046 $10,046 IRR Spring 2009 Internet Café w/o contract 23.4% 24.2% 18 Timing of Cash Flows The IRR with maintenance contract (24.2%) is larger than the IRR without maintenance contract (23.4%). Is the maintenance contract valuable? Should we take the maintenance contract? Sensitivity to timing of cash flows: This is another problem with the IRR. It can be affected by changing the timing of the cash flows, even when that change in timing does not affect the NPV. It is possible to alter the ranking of projects based on IRR without changing their ranking in terms of NPV. Hence you cannot use the IRR to choose between mutually exclusive investments. Spring 2009 19 Quick Quiz Net present value Year 160 0 1 2 3 4 140 120 Project A: – $350 50 100 150 200 100 Project B: – $250 125 100 75 50 80 60 40 Crossover Point 20 0 – 20 – 40 – 60 – 80 Discount rate – 100 0 Spring 2009 2% 6% 10% 14% 18% 22% 26% 20 Quick Quiz 2. If projects A and B are mutually exclusive, and the cost of capital for your firm is 12%, which project should you accept? A. Project A B. Project B C. neither project A nor B because their IRR are lower than your required rate of return D. both projects A and B because their IRR are higher than your cost of capital Spring 2009 21 Outline Decision Rules Mutually Exclusive Projects Standalone Projects NPV vs. IRR Delayed Investments Spring 2009 Pay Back Multiple IRRs Differences in Scales Projects w/ Resource Constraints Timing of CF Profitability Index Differences in Lives 22 Projects with Different Lives Solution: Plan: Benefits are the same. The objective is to minimize the cost. Put the choices in an equal footing: computing their constant annual cost that is the same as the PV of one lump sum at time zero. Computing an Equivalent Annual Annuity (Equivalent Annual Cost EAC) by 1. Computing its PV at the cost of capital. 2. Computing the equivalent n-year annuity with the same PV as the cash flows of the project. Spring 2009 24 Projects with Different Lives Execute: Given: 3 10 -12.49 Solve for: 0 5.02 Excel Formula: =PMT(RATE,NPER, PV, FV) = PMT(0.08,30,-80000,0) Spring 2009 25 Projects with Different Lives Evaluate: By putting all the costs associated with purchasing and maintaining these two servers into an equivalent annuity, Server A appears to be a less expensive option to run for three years on a per year basis. Additional consideration before making decision: Consider all available options and possible scenarios beyond the existing conditions of these two proposed servers: Required life, either shorter or longer Replacement cost, either higher or lower Spring 2009 26 Outline Decision Rules Mutually Exclusive Projects Standalone Projects NPV vs. IRR Delayed Investments Spring 2009 Pay Back Multiple IRRs Differences in Scales Projects w/ Resource Constraints Timing of CF Profitability Index Differences in Lives 27 Project Selection w/ Resource Constraints Consider three possible projects that require warehouse space. Profitability Index = Spring 2009 Value Created NPV = Resource Consumed Resource Consumed 28 Profitability Index Profitability Index Measures the “bang for your buck” Value created in terms of NPV per unit of resource consumed. The profitability index can be used to identify the optimal combination of projects to undertake. Instead of selecting the project with the highest NPV (Project A), select the projects with the highest PI (Projects C and then Project B) Result: Investments in Projects C and B with total NPV of $150 mil Spring 2009 29 PI Rule with Resource Constraint Example 7.5 Spring 2009 30 PI Rule with Resource Constraint Solution: Plan: Resource constraint: 190 employees at most Goal: maximize the total NPV Steps: Use Engineering Headcount in the denominator for profitability index for each project Sort the projects based on their PI Calculate the cumulative required EHC up to 190 Spring 2009 31 PI Rule with Resource Constraint Execute: Spring 2009 32 PI Rule with Resource Constraint Evaluate: To maximize NPV within the constraint of 190 employees, NetIt should choose the first four projects on the list. No other combination will create more value without using more engineers. This ranking also shows us exactly the costs of the engineering constraint – NetIt has to forgo three otherwise valuable projects (C, D, and B) with a total NPV of $33.6 million. Shortcomings of Profitability Index: In some situations the profitability Index does not give an accurate answer. With multiple resource constraints, the profitability index can break down completely. Spring 2009 33 Quick Quiz Spring 2009 34 Quick Quiz 3. Suppose NetIt has an additional small project with a NPV of $100,000 that requires 3 engineers. This project’s PI is 0.03 and so it is ranked the lowest. Should this project be accepted? A. Yes B. No C. Insufficient information Spring 2009 35 Outline Decision Rules Mutually Exclusive Projects Standalone Projects NPV vs. IRR Delayed Investments Spring 2009 Pay Back Multiple IRRs Differences in Scales Projects w/ Resource Constraints Timing of CF Profitability Index Differences in Lives 36 ...
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This note was uploaded on 04/03/2010 for the course FINA FINA111 taught by Professor Lynnpi during the Spring '09 term at HKUST.

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