The theory and practice of corporate

The Theory and Practice of Corporate

Some alternative investment rules ,[object Object],[object Object],[object Object]

Some alternative investment rules (contd) ,[object Object]

Some alternative investment rules (contd) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Why use Net Present Value? ,[object Object],[object Object],[object Object]

Why use Net Present Value? (Contd) ,[object Object],[object Object],[object Object],[object Object]

Why use Net Present Value? (Contd) ,[object Object],[object Object],[object Object],[object Object],[object Object]

Why use Net Present Value? (Contd) ,[object Object],[object Object]

Alternative Investment rule ,[object Object],[object Object]

The practice of capital budgeting ,[object Object],% of CFOs who always or almost always use a given technique % of almost always Internal Rate of Return 75.6% NPV 74.9% Payback method 56.7% Discounted payback 29.5% Accounting rate of return 30.3% Profitability index 11.9%

Alternative Investment rule (1): The Payback Period Rule ,[object Object],[object Object],[object Object],[object Object],[object Object]

Payback Period Rule Example ,[object Object],[object Object],[object Object],[object Object],[object Object],Year Cash flow 0 -100 1 20 2 30 3 50 4 60 : :

Example 2 ,[object Object],[object Object],[object Object],[object Object],Year Project A Project B Project C 0 -100 -100 -100 1 20 50 50 2 30 30 30 3 50 20 10 4 60 60 60000 : : : :

The Payback Period Rule (continued) ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Alternative investment rule (2) The Discounted Payback Period Rule ,[object Object],[object Object],[object Object]

Alternative investment rule 3 Average accounting return ,[object Object],[object Object],[object Object]

Average Accounting Return Rule Example ,[object Object],[object Object],[object Object]

Average Accounting Return Rule Example (contd) Then, the average net income is given by Average Net Income =(100,000+150,000+50,000+0-50,000)/5=50,000 Table 1 Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 433,333 450,000 266,667 200,000 133,333 Expense 200,000 150,000 100,000 100,000 100,000 Before tax Cash flow 233,333 300,000 166,667 100,000 33,333 Depreciation 100,000 100,000 100,000 100,000 100,000 Earning before tax 133,333 200,000 66,667 0 -66,667 tax 33,333 50,000 16,667 0 -16,667 Net Income 100,000 150,000 50,000 0 -50,000

Average Accounting Return Rule Example (contd) ,[object Object]

Average Accounting Return Rule Example (contd) We simply take the average of the investment. Notice that investment occurs at date 0. Therefore, there are 6 periods in this table. The average investment is then determined by Average Investment =(500,000+400,000+300,000+200,000+100,000+0)/6=250,000 Table 2 Year 0 Year 1 Year2 Year3 Year4 Year5 Value of the investment $500,000 $400,000 $300,000 $200,000 $100,000 $0

Average Accounting Return Rule Example (contd) ,[object Object],If the company has a target average accounting return smaller than 20% (say 15%), the project will be accepted. If the company had a target AAR greater than 20%, the project will be rejected.

Problems with Average Accounting Return ,[object Object],[object Object],[object Object]

Alternative Investment rule 4 Internal Rate of Return ,[object Object],[object Object]

Internal Rate of Return (IRR) Example ,[object Object]

Internal Rate of Return (IRR) Example, Contd ,[object Object],Solution to y is called the Internal Rate of Return. Internal rate of return for this example is 10%. This means that if the discount rate is lower than 10% (say 8%), it makes sense for the firm to invest in the project; the project provides a higher return than if the firm invests the money elsewhere. Thus, the basic IRR rule of investment is to accept the project if the IRR is greater than the discount rate.

Internal Rate of Return -Decision Rule- ,[object Object],Internal rate of return (IRR) is the solution to the following equation. Decision rule: The decision rule is to accept the project if IRR is greater than discount rate, and reject if IRR is smaller than the discount rate. Period 0 1 2 ··· T Cash flow ‒ C 0 C 1 C 2 ··· C T

Internal Rate of Return: Example ,[object Object],[object Object],[object Object],0 1 2 3 $50 $100 $150 -$200

Exercise ,[object Object],Notice that IRR is the value of y that makes Z equal to zero Use “Internal Rate of Return Exercise”, fill the table, and graph Z against y to find the IRR.

Internal Rate of Return ,[object Object],[object Object],[object Object]

Problems with IRR approach (1) Multiple solutions ,[object Object],Exercise: Use “problem with IRR 1”. Compute Z for each value of y, and graph Z against y. Period 0 1 2 Cash flow -100 230 -132

Answer ,[object Object],[object Object]

Problems with IRR approach (1) Multiple solutions, Contd ,[object Object],[object Object],[object Object],[object Object]

Problems with IRR approach (1) Multiple solutions, (modified IRR, contd) ,[object Object],[object Object],[object Object],[object Object],[object Object]

Problems with IRR approach (1) Multiple solutions, (modified IRR, contd) ,[object Object],[object Object],[object Object]

Problems with IRR approach (2) -Two period cash flow, with negative cash outflow coming in second period- ,[object Object]

Problems with IRR approach (2) -Two period cash flow, with negative cash outflow coming in second period- Contd ,[object Object],Suppose that the cash flow of the project is given by the following. If you compute the IRR of this project, it will be 30% See next page Period 0 1 Cash flow 100 -130

Problems with IRR approach (2) -Two period cash flow, with negative cash outflow coming in second period- Contd ,[object Object],[object Object],[object Object]

Problem with IRR (3) -Scale Problem- ,[object Object],[object Object]

Problem with IRR (3) -Scale Problem- ,[object Object],[object Object],[object Object],[object Object],[object Object]

Problem with IRR (3) -Scale Problem- Example ,[object Object],[object Object],Cash Flow at date 0 Cash flow at date 1 IRR NPV at 25% discount rate Small budget -10 million $40 million Big budget -25 million $65million

Problem with IRR (3) -Scale Problem- Example ,[object Object],[object Object],[object Object]

Problem with IRR (3) -Scale Problem- Example contd ,[object Object],‒ $25m ‒(‒$10m) = ‒$15m $65m ‒ $40m = $25m Incremental IRR= 66.67% Period 0 1 IRR Small budget ‒ $10m $40m 300% Large budget ‒ $25m $65m 160% Incremental cash flow from choosing large budget instead of small budget

Problem with IRR (3) -Scale Problem- Example contd ,[object Object],[object Object]

Alternative Investment Rule 5 -Profitability Index (PI)- ,[object Object],[object Object]

Alternative Investment Rule 5 -Profitability Index Example- ,[object Object],Using this example, the profitability Index is computed in the following ways. See next slides. Period 0 1 2 Cash flow -20 70 10

Alternative Investment Rule 5 -Profitability Index Example- First, you compute the present discount value of cash flows subsequent to the initial investment with discount rate of 12%. This is given by Then, the profitability index is computed by dividing the above number ($70.5) by the initial investment ($20). Therefore, the Profitability Index (PI) for this example is given by

[object Object],[object Object],Alternative Investment Rule 5 -Profitability Index Decision rules-

A problem with the profitability index ,[object Object],[object Object],Period 0 1 2 Project 1 -20 70 10 Project 2 -10 15 40

A problem with the profitability index, Contd ,[object Object],Period 0 1 2 Project 1 -20 70 10 Project 2 -10 15 40

A problem with the profitability index, contd ,[object Object],[object Object],[object Object],[object Object],Period 0 1 2 PI Project 1 -20 70 10 3.53 Project 2 -10 15 40 4.53

A problem with the profitability index, contd ,[object Object],Period 0 1 2 PI Project 1 -20 70 10 3.53 Project 2 -10 15 40 4.53 Incremental cash flow (1-2) PI for the incremental cash flow=

A problem with the profitability index, contd ,[object Object],[object Object]

The practice of capital budgeting ,[object Object],% of CFOs who always or almost always use a given technique % of almost always IRR 75.6% NPV 74.9% Payback method 56.7% Discounted payback 29.5% Accounting rate of return 30.3% Profitability index 11.9%

The theory and practice of corporate

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The theory and practice of corporate