capitalBudgetingChp9

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Chapter

McGraw-Hill/Irwin Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

9

Net Present Value and

Other Investment Criteria

Net Present Value and

Other Investment Criteria

Revised by DBH, January 2006


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9-2

Project Example Information

You are looking at a new project and youhave 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 riskis 12%.


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9-3

Payback Period

How long does it take to get the initial costback in a nominal sense?

Computation

Estimate the cash flows

Subtract the future cash flows from the initialcost until the initial investment has been

recovered Decision Rule Accept if the payback

period is less than some preset limit


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9-4

Computing Payback For TheProject

Assume we will accept the project if it paysback within two years.

Year 1: 165,000 63,120 = 101,880 still torecover

Year 2: 101,880 70,800 = 31,080 still torecover

Year 3: 31,080 91,080 = -60,000projectpays back in year 3

Do we accept or reject the project?


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9-5

Decision Criteria Test - Payback

Does the payback rule account for the timevalue of money? (No)

Does the payback rule account for the riskof the cash flows? (No)

Does the payback rule provide anindication about the increase in value?

(No)

Should we consider the payback rule forour primary decision rule? (No)


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9-6

Advantages and DisadvantagesofPayback

Advantages

Easy to understand

Adjusts for uncertainty

of later cash flows Biased towards

liquidity

Disadvantages

Ignores the time valueof money

Requires an arbitrarycutoff point

Ignores cash flowsbeyond the cutoff date

Biased against long-term projects, such asresearch anddevelopment, and newprojects


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9-7

AAR and Discounted Payback

Discounted paybackis a variation on thepayback rule that does allow for the time value ofmoney, but still requires an arbitrary cutoff.

Average Accounting Return (AAR) doesnt evenmeasure cash flows, but only whether averageaccounting income from the project = a setpercentage of return

Neither effectively measures whether a long-terminvestment has added value to the firm. Forsake of time, we will ignore these methods.


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9-8

Net Present Value

The difference between the market valueof 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 requiredreturn for projects of this risk level.

The third step is to find the present value ofthe cash flows and subtract the initialinvestment.


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9-9

NPV Decision Rule

If the NPV is positive, accept the project

A positive NPV means that the project isexpected to add value to the firm and willtherefore increase the wealth of theowners.

Since our goal is to increase ownerwealth,

NPV is a direct measure of howwell thisproject will meet our goal.


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9-10

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

Many financial calculators also havetemplates for calculating NPV

Easiest to calculate using a computerized

spreadsheet (See Excel, next slide): Do we accept or reject the project?


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9-11

NPV using Excel

e s low

' N P V

O ig in l n es enN e P res en V lue

Since NPV is posi i e we s ould ccep e in es en


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9-12

Decision Criteria Test - NPV

Does the NPV rule account for the timevalue of money? (Yes)

Does the NPV rule account for the risk ofthe cash flows? (Yes)

Does the NPV rule provide an indicationabout the increase in value? (Yes)

Should we consider the NPV rule forourprimary decision rule? (Yes)


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9-13

Internal Rate of Return

This is the most important alternative toNPV

It is often used in practice and is intuitivelyappealing

It is based entirely on the estimated cashflows and is independent of interest rates

found elsewhere


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9-14

IRR Definition and DecisionRule

Definition: IRR is the return that makes theNPV = 0

Decision Rule:Accept the project if theIRR is greater than the required return


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9-15

Computing IRR For The Project

If you do not have a financial calculator,then this becomes a trial and error process

Again many financial calculators havetemplates for estimating IRR

But IRR is most easily estimated using aspreadsheet (See Excel, next slide)

Do we accept or reject the project?


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9-17

Decision Criteria Test - IRR

Does the IRR rule account for the timevalue of money? (Yes)

Does the IRR rule account for the risk ofthe cash flows? (Yes)

Does the IRR rule provide an indicationabout the increase in value? (Yes, by %)

Should we consider the IRR rule forourprimary decision criteria? (Not primary,see following slides)


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9-18

Advantages of IRR

Knowing a return is intuitively appealing

It is a simple way to communicate thevalue of a project to someone who doesntknow all the estimation details

If the IRR is high enough, you may notneed to estimate a required return, which is

often a difficult task


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9-19

Summary of Decisions For TheProject

Summary

Net Present Value Accept

Payback Period Reject

Discounted Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept


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9-20

NPV Vs. IRR

NPV and IRR will generally give us thesame decision

Exceptions

Non-conventional cash flows cash flow signschange more than once

Mutually exclusive projects

Initial investments are substantially different Timing of cash flows is substantially different


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9-21

IRR and Non-conventional CashFlows

When the cash flows change sign morethan once, there is more than one IRR

When you solve for IRR you are solving forthe root of an equation and when you crossthe x-axis more than once, there will bemore than one return that solves the

equation If multiple IRRs are calculated, none are

then reliable.


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9-22

Another Example Non-conventional Cash Flows

Suppose an investment will cost 90,000initially and will generate the following cashflows:

Year 1: 132,000

Year 2: 100,000

Year 3: -150,000

The required return is 15%. Should we accept or reject the project?


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9-23

Excel utputExample #2

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ea 2

ea 2

ea

e ec t

P x

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P a t ac c ep t

a t e ec t u t P a t

ac c ep t G t P


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9-24

Summary of Decision Rules

The NPV is positive at a required return of15%, so you shouldAccept

If you use the financial calculatororspreadsheet, you would get an IRR of10.11% which would tell you toReject

You need to recognize when there are

non-conventional cash flows and look atthe NPV profile


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9-25

IRR and Mutually ExclusiveProjects


If you choose one, you cant choose the other

Example: You can choose to attend graduate

school at either Harvard or Stanford, but notboth

Intuitively you would use the following

decision rules: NPV choose the project with the higher NPV

IRR choose the project with the higher IRR


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9-26

Example With Mutually ExclusiveProjects

Period ProjectA

ProjectB

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

The required return

for both projects is

10%.

Which project

should you accept

and why?

Project A has a smaller IRRbut it is a larger project,thus generating greatervalue to the firm

IRR cant measure that, but

NP

V can.


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9-27

Conflicts Between NPV and IRR

NPV directly measures the increase invalue to the firm

Whenever there is a conflict between NPVand another decision rule, you shouldalways use NPV

IRR is unreliable in the following situations

Non-conventional cash flows



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9-28

Profitability Index

Measures the benefit per unit cost, basedon the time value of money

A profitability index of 1.1 implies that forevery 1 of investment, we create anadditional 0.10 in value

This measure can be very useful in

situations in which we have limited capital


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9-29

Advantages and DisadvantagesofProfitability Index

Advantages

Closely related toNPV, generally leadingto identical decisions

Easy to understandand communicate

May be useful whenavailable investment

funds are limited

Disadvantages

May lead to incorrectdecisions incomparisons ofmutually exclusiveinvestments


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9-30

Capital Budgeting In Practice

We should consider several investmentcriteria when making decisions

NPV and IRR are the most commonly usedprimary investment criteria

Payback is a commonly used secondaryinvestment criteria


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9-31

Summary Discounted Cash FlowCriteria

Net present value Difference between market value and cost Take the project if the NPV is positive Has no serious problems Preferred decision criterion

Internal rate of return 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

Profitability Index Benefit-cost ratio Take investment ifPI > 1 Cannot be used to rank mutually exclusive projects May be used to rank projects in the presence of capital rationing


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9-32

Summary Payback Criteria

Payback period

ength of time until initial investment is recovered

Take the project if it pays back in some specified

period Doesnt account for time value of money and there is

an arbitrary cutoff period

Discounted payback period

ength of time until initial investment is recovered on adiscounted basis

Take the project if it pays back in some specifiedperiod

There is an arbitrary cutoff period


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9-33

Quick Quiz

Consider an investment that costs 100,000 andhas a cash inflowof 25,000 every year for 5years. The required return is 9% and requiredpayback is 4 years. What is the payback period? (4 yrs)

What is the NPV? (-2,758.72)

What is the IRR? ( 7.93%)

Should we accept the project? (No)

What decision rule should be the primarydecision method?

When is the IRR rule unreliable?


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9-34

Quiz using Excel

Year 0 - 100,000

Year 1 25,000

Year 2 25,000

Year 3 25,000

Year 4 25,000

Year 5 25,000

IRR 7.93%

NPV at 9% 97,241.28

- riginal Inv. - 100,000

NPV ( 2,758.72)

Reject project!


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9-35

Class Case

Pause here towork in-class NPV / IRR casefor Wallys Widget Works:

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