_4 NPV & Other Techniques - Lecture 4 NPV & Other...

Lecture 4
NPV & Other Techniques

Major Topics
•
The following topics will be discussed in this
lecture :
–
Concepts of Capital Budgeting.
–
Major investment criteria, including :
•
Net Present Value
•
Payback Rule
•
Average Accounting Return Rule
•
Internal Rate of Return
•
Profitability Index
–
Non-conventional Cash Flows & Mutually Exclusive
Projects
–
Modified Internal Rate of Return
2

Capital Budgeting
•
It is the process of decision making with respect
to investments in fixed assets.
•
It helps to consider whether we should accept or
reject a proposed project.
•
Projects may originate from :
–
Within the firm
–
Other sources
3

Capital Budgeting
•
Within the firm :
–
Research & Development (R&D)
Department of a firm will search for ways of
improving existing products or finding new
projects.
•
Other Sources :
–
Projects may come from the needs to tackle
competitions, from demand of suppliers, or
usually from the pressure from customers.
4

Capital Budgeting Decision Criteria
•
Capital budgeting focuses on free cash flows,
which are the benefits generated from accepting
a capital-budgeting proposal.
•
Based on these free cash flows, we have some
commonly used criteria for determining the
acceptability of investment proposals or projects.
–
Net Present Value (NPV)
–
Payback Rule
–
Average Accounting Return (AAR)
–
Profitability Index
–
Internal Rate of Return (IRR)
5

Capital Budgeting Decision Criteria
•
Before we discuss the details, please
note that when we are evaluating these
decision criteria, we need to consider a
number of factors :
–
Adjustments for Time Value of Money.
–
Adjustments for Risk.
–
Value Creation for the firm.
6

Background Information
•
Before illustrating different decision criteria,
here are the background information of a new
project.
•
Your required return for projects of similar risk
is 12% p.a.
7
Year Cash Flow $ Net Income $
0 -165,000
1 63,120 13,620
2 70,800 3,300
3 91,080 29,100
Average Book Value = $72,000

8
Net Present Value (NPV)
•
Recall from previous lecture about NPV, it can be
described as the difference between the market
value of a project (How to determine ?) and its
cost.
•
It is also a measure of the value created from
undertaking an investment / a project.
•
To find the NPV of an investment / a project :
–
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 minus the initial investment .

9
NPV Decision Rule
•
If the NPV is positive , we should 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
because the sum of the discounted future
cash flows is greater than the initial
investment.
•
Since our goal is to increase owner wealth,
NPV is a direct measure of how well this
project will meet our goal.

Net Present Value (NPV)
NPV = PV – Required Investment
NPV C
C
r
t
t
= +
+
0
1 ( )
NPV C
C
r
C
r
C
r
t
t
= +
+
+
+
+ +
+
0
1
1
2
2
1 1 1 ( ) ( )
...
( )
10

Net Present Value (NPV)
Terminology
C
0
, C
1
…..C
t
= Cash Flow at period t