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Unformatted text preview: Chapter 9 •Net Present Value and Other Investment Criteria McGrawHill/Irwin Capital Budgeting 92 Key Concepts and Skills
• Be able to compute payback and understand their shortcomings • Understand accounting rates of return and their shortcomings • Be able to compute the internal rate of return and understand its strengths and weaknesses • Be able to compute the net present value and understand why it is the best decision criterion
93 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? 94 Project Example Information
• You are looking at a new project and you have estimated the following cash flows:
• • • • • Year 0: CF = 165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 • Your required return for assets of this risk is 12%.
95 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.
96 NPV – Decision Rule
• 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.
97 Computing NPV for the Project
• Using the formulas:
• NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42 • Using the calculator:
• CF0 = 165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I = 12; CPT NPV = 12,627.42 • Do we accept or reject the project? 98 Decision Criteria Test  NPV
• 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?
99 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 • Decision Rule – Accept if the payback period is less than some preset limit
910 Computing Payback For The Project
• 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 • Payback is exactly 2 years + 31,080/91,080= .34 years= 2.34 years if we assume CF’s occur throughout the year. • Payback is 3 years if we assume CF happens at the end. • Do we accept or reject the project? Reject
911 Decision Criteria Test  Payback
• 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? • The answer to all of these questions is no.
912 Advantages and Disadvantages of Payback
• Advantages
• Easy to understand • Adjusts for uncertainty of later cash flows • Biased towards liquidity • Disadvantages
• Ignores the time value of money • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff date • Biased against longterm projects, such as research and development, and new projects
913 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. • Need to have a target cutoff rate • Decision Rule: Accept the project if the AAR is greater than a preset rate.
914 Computing AAR For The Project
• Assume we require an average accounting return of 25% • Average Net Income:
• (13,620 + 3,300 + 29,100) / 3 = 15,340 • AAR = 15,340 / 72,000 = .213 = 21.3% • Do we accept or reject the project? Reject 915 Decision Criteria Test  AAR
• 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? • The answer to all of these questions is no. In fact, this rule is even worse than the payback rule in that it doesn’t even use cash flows for the analysis. It uses net income and book value.
916 Advantages and Disadvantages of AAR
• Advantages
• Easy to calculate • Needed information will usually be available • Disadvantages
• Not a true rate of return; time 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 917 Internal Rate of Return
• 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 918 IRR – Definition and Decision Rule
• Definition: IRR is the return that makes the NPV = 0 • Decision Rule: Accept the project if the IRR is greater than the required return
• • • • Year 0: Year 1: Year 2: Year 3: CF = 165,000 CF = 63,120 CF = 70,800 CF = 91,080 919 Computing IRR For The Project
• If you do not have a financial calculator, then this becomes a trial and error process • Calculator
• Enter the cash flows as you did with NPV • Press IRR and then CPT • IRR = 16.13% > 12% required return • Do we accept or reject the project? Accept
920 NPV Profile For The Project
70,000 60,000 50,000 40,000 NPV 30,000 20,000 10,000 0 10,000 0 20,000 Discount Rate
921 IRR = 16.13% 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22 Decision Criteria Test  IRR
• Does the IRR rule account for the time value of money? The IRR rule accounts for time value because it is finding the rate of return that equates all of the cash flows on a time value basis. Does the IRR rule account for the risk of the cash flows? The IRR rule accounts for the risk of the cash flows because you compare it to the required return, which is determined by the risk of the project. Does the IRR rule provide an indication about the increase in value? The IRR rule provides an indication of value because we will always increase value if we can earn a return greater than our required return. Should we consider the IRR rule for our primary decision criteria? We should consider the IRR rule as our primary decision criteria, but as we will see, it has some problems that the NPV does not have. That is why we end up choosing the NPV as our ultimate decision rule.
922 • • • Advantages of IRR
• Knowing a return is intuitively appealing • It is a simple way to communicate the value of a project to someone who doesn’t 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 923 Summary of Decisions For The Project
Summary
Net Present Value Payback Period Average Accounting Return Internal Rate of Return Accept Reject Reject Accept 924 NPV Vs. IRR
• NPV and IRR will generally give us the same decision • Exceptions
• Nonconventional cash flows – cash flow signs change more than once • Scaling Problem • Mutually exclusive projects 925 IRR and Nonconventional Cash Flows
• 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 xaxis 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?
926 Another Example – Nonconventional 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 • The required return is 15%. • Should we accept or reject the project?
927 Another Example – Nonconventional Cash Flows
• What is the NPV of this project? • Now think about IRR, discount rate, and NPV. • Calculator: CF0 = 90,000; C01 = 132,000; F01 = 1; C02 = 100,000; F02 = 1; C03 = 150,000; F03 = 1; I = 15; CPT NPV = 1769.54 Instead of NPV CPT, hit IRR CPT. IRR= 10.11 What’s going on??? Does this make sense? • If you compute the IRR on the calculator, you get 10.11% because it is the first one that you come to. • So, if you just blindly use the calculator without recognizing the uneven cash flows, NPV would say to accept and IRR would say to reject.
928 NPV Profile
$4,000.00 $2,000.00 $0.00 NPV ($2,000.00) ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00) Discount Rate
929 IRR = 10.11% and 42.66% 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55 Summary of Decision Rules
• 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
930 IRR and the Scaling Problem 931 IRR and the Scaling Problem 932 IRR and the Scaling Problem 933 IRR and Mutually Exclusive Projects
• Mutually exclusive projects
• If you choose one, you can’t choose the other • Example: You can choose to attend class or watch basketball games. • Doing one precludes doing the other. • Intuitively you would use the following decision rules:
• NPV – choose the project with the higher NPV • IRR – choose the project with the higher IRR
934 Example With Mutually Exclusive Projects
Period 0 1 2 IRR NPV Project A 500 325 325 Project B 400 325 200 Which project should you accept and why? The required return for both projects is 10%. 19.43% 22.17% 64.05 60.74 935 Example With Mutually Exclusive Projects
• At what point are you “indifferent” between A and B? In other words, at what discount rate are you indifferent? • Find the crossover rate. • Take the largest negative initial outlay and subtract it from the second to largest. • Repeat this pattern. 936 Example With Mutually Exclusive Projects
• Find the “incremental” cash flows • CF0=500(400)= 100 • CF1=325325=0 • CF2=325200=125 • CPT IRR=11.8% • What does 11.8% mean? Period 0 1 2 IRR NPV Project Project A B 500 325 325 400 325 200 19.43% 22.17% 64.05 60.74
937 NPV Profiles
$160.00 $140.00 $120.00 $100.00 $80.00 NPV $60.00 $40.00 $20.00 $0.00 ($20.00) 0 ($40.00) Discount Rate
938 IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8%
A B 0.05 0.1 0.15 0.2 0.25 0.3 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
• Nonconventional cash flows • Mutually exclusive projects 939 Profitability Index
• 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 940 Profitability Index 941 Profitability Index 942 Profitability Index 943 Profitability Index 944 Profitability Index 945 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 • Disadvantages
• May lead to incorrect decisions in comparisons of mutually exclusive investments 946 Capital Budgeting In Practice 947 Capital Budgeting In Practice
• 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 • Why is payback so common if it has problems?
948 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 nonconventional cash flows or mutually exclusive projects Benefitcost 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 • Internal rate of return
• • • • • Profitability Index
• • • • 949 Summary – Payback Criteria
• Payback period • Length of time until initial investment is recovered • Take the project if it pays back in some specified period • Doesn’t account for time value of money and there is an arbitrary cutoff period 950 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 951 Quick Quiz
• 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.
• • • • What is the 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?
952 Quick Quiz
• Payback period is 4 years. • Project pays back 25K in one year, still need 75K more. • Pays back 50K at end of two years. Still need 50K more • Pays back 75K at end of three years. Still need 25K more • Pays back 100K at end of four years. • Based on thisaccept the project.
953 Quick Quiz
• • • • • • • What is the NPV? Use CF worksheet. CF0=100K CF1=25K, FO1=5 I=9, NPV CPT= 2758.72 Based on this, reject the project. Before we go on, what do we know about the IRR?
954 Quick Quiz
• We know the IRR MUST be less than 9%. • Why? The NPV is negative and we require a return of 9%. • In the CF worksheet hit “IRR” then CPT • IRR=7.93% • Based on this, we do not accept the project. 955 Final Thoughts 956 Final Thoughts 957 Chapter 9 •End of Chapter McGrawHill/Irwin ...
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This note was uploaded on 04/08/2011 for the course FINANCE 301 taught by Professor Jimmokim during the Spring '11 term at Rutgers.
 Spring '11
 JimmoKim
 Net Present Value

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