HMP607 F08 Lecture05 NetPresentValue

7/30/2019 HMP607 F08 Lecture05 NetPresentValue

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Net Present ValueBMA Ch 6

NPV and PV

NPV Rule

Internal Rate of Return (IRR) NPV and IRR

NPV and PMT

Payback Period


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NPV and PV

PV = sum of discounted future cash flows

T

t

tr

CPVt

1 )1(

T

T

r

C

r

C

r

CPV

)1()1()1(

....22

1

1


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NPV and PV

NPV = sum of current + disc. future cash flows

NPV = C0 + PV

NPV = initial investment (negative) + futureinvestment returns (positive)

T

t

tr

NPVCt

0)1(

T

t

tr

NPVCt

0)1(


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NPV Rule

NPV Rule - Accept investments (or financingmethods) that have positive NPVs

Such investments generate enough cash to

Cover their operating costs

Cover their financing costs

Add value to the firm (=NPV)

Ex: What is the NPV of a business opportunity that costs$300 and generates the following stream of cash flows:

yr 1: 100yr 2: 150

yr 3: 165, if r=.07?


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Internal Rate of Return (IRR) An investment generates a rate of return that

can be compared to the discount rate

0

)1(0

T

tt

IRR

Ct

Ex: What is the rate of return on a business opportunity that costs $300 andgenerates the following stream of cash flows:

yr 1: 100yr 2: 150

yr 3: 165

IRR Rule: Accept investments that offer rates ofreturn in excess of the discount rate (cost of

financing)


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NPV and IRR

If NPV > 0 IRR > r

If NPV < 0 IRR < r

If NPV = 0 IRR = r Investment with highest NPV not always

the one with the highest IRR


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NPV and IRR

Example

Red Hen Proteins can purchase a turbopowered egg carton machine for $4,000. The

investment will generate cash flows of $2,000 inyear 1 and $4,000 in year two. What is the IRRon this investment?


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NPV and IRR

IRR=28%


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NPV and IRR

Evaluating independent investmentsNPV and IRR will generally imply samedecision

Comparing two (or more) mutuallyexclusive investments NPV and IRR canproduce different ranking


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NPV and IRRmutually exclusive projects (same lives)

Ex: Argus Enterprises is comparing two retailoutlets in the same market, one on Corky St. andone on Beanie Ave.

Best investment depends on what is appropriatediscount rate (i.e., true cost of financing)

NPV assumes cash flows can be reinvested at r

IRR assumes cash flows can be reinvested at IRR

Investors care about cash (i.e., NPV), not interestrates (i.e., IRR)


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NPV and IRR

Projects with no positive cash flows Often involves comparison of competing

technologies

Minimize net present value of costs

Tax effects


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NPV and PMTmutually exclusive projects (different lives)

In comparing two or more projects with differenteconomic lives, you must account for the time ittakes to achieve a given NPV

Ex (simple): Wahoo Products is considering twonew brands:

TippyNPV=100

T=4r=.06

CaseyNPV=200

T=10r=.06

To compare, calculate the NPV created per year Annualized NPV = NPV/Annuity Factor


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Payback Period

The payback period of a project is the number ofyears it takes before the cumulative forecastedcash flow equals the initial outlay.

The payback rule says only accept projects thatpay back in the desired time frame.

This method is flawed, primarily because itignores later year cash flows and the presentvalue of future cash flows.


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Payback Period

Example

Examine the three projects and note the mistake

we would make if we insisted on only taking

projects with a payback period of 2 years or less.

050018002000-C

018005002000-B50005005002000-A

10%@NPVPeriod

PaybackCCCCProject 3210


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Payback Period

Example

Examine the three projects and note the mistake

we would make if we insisted on only taking

projects with a payback period of 2 years or less.

502050018002000-C

58-2018005002000-B2,624350005005002000-A

10%@NPVPeriod

PaybackCCCCProject 3210


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Payback Period

Sometimes used as supplementarydecision criterion to NPV or IRR

We will invest in new business opportunities

with positive NPVs and PPs of 5 years orshorter.

Risk reduction criterion (more later)

PP in present value terms

Ex: How many years does project generating $200,000 per year in cash flowtake to return an initial investment of $1,000,000, in PV terms, if r=.08?


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CFO Decision ToolsSurvey Data on CFO Use of Investment Evaluation Techniques

SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field,

Journal of Financial Economics 61 (2001), pp. 187-243.

HMP607 F08 Lecture05 NetPresentValue

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