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# Chap006

## by guestc78315 on Nov 10, 2007

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## Chap006Presentation Transcript

• Net Present Value and Other Investment Rules
• Chapter Outline
• 6.1 Why Use Net Present Value?
• 6.2 The Payback Period Method
• 6.3 The Discounted Payback Period Method
• 6.4 The Average Accounting Return Method
• 6.5 The Internal Rate of Return
• 6.6 Problems with the IRR Approach
• 6.7 The Profitability Index
• 6.8 The Practice of Capital Budgeting
• 6.1 Why Use Net Present Value?
• Accepting positive NPV projects benefits shareholders.
• Forgoing the project today, the value of the firm today is \$V + \$ 100
• Accepting the project today, the value of the firm today is \$V + \$ 100.94 ( 107/1.06 )
• The difference is \$0.94 .
• The value of the firm rises by the NPV of the project .
• The discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk .
• This discount rate is often referred to as an opportunity cost .
• The Net Present Value (NPV) Rule
• Net Present Value (NPV) =
• - Initial Investment + Total PV of future CF’s
• Estimating NPV:
• 1. Estimate future cash flows : how much? and when?
• 2. Estimate discount rate
• 3. Estimate initial costs
• Minimum Acceptance Criteria: Accept if NPV > 0
• Ranking Criteria: Choose the highest NPV
• Good Attributes of the NPV Rule
• 1. Uses cash flows
• 2. Uses ALL cash flows of the project
• 3. Discounts ALL cash flows properly
• Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate .
• 6.2 The Payback Period Method
• How long does it take the project to “ pay back ” its initial investment ?
• Payback Period = number of years to recover initial costs
• Minimum Acceptance Criteria:
• Set by management
• Ranking Criteria:
• Set by management
• The Payback Period Method
• Ignores the time value of money
• Ignores cash flows after the payback period
• Biased against long-term projects
• Requires an arbitrary acceptance criteria
• A project accepted based on the payback criteria may not have a positive NPV
• Easy to understand
• Biased toward liquidity
• The payback rule is often used by: large and sophisticated companies when making relatively small decisions , or firms with very good investment opportunities but no available cash (small, privately held firms with good growth prospects but limited access to the capital markets).
• 6.3 The Discounted Payback Period
• How long does it take the project to “pay back” its initial investment, taking the time value of money into account ?
• Decision rule: Accept the project if it pays back on a discounted basis within the specified time.
• By the time you have discounted the cash flows, you might as well calculate the NPV.
• 6.4 Average Accounting Return
• Another attractive, but fatally flawed, approach
• Ranking Criteria and Minimum Acceptance Criteria set by management
•
• Average Accounting Return
• Ignores the time value of money
• Uses an arbitrary benchmark cutoff rate
• Based on book values, not cash flows and market values
• The accounting information is usually available
• Easy to calculate
• 6.5 The Internal Rate of Return
• IRR: the discount rate that sets NPV to zero
• Minimum Acceptance Criteria:
• Accept if the IRR exceeds the required return
• Ranking Criteria:
• Select alternative with the highest IRR
• Reinvestment assumption:
• All future cash flows assumed reinvested at the IRR
• Internal Rate of Return (IRR)
• Does not distinguish between investing and borrowing
• IRR may not exist, or there may be multiple IRRs
• Problems with mutually exclusive investments
• Easy to understand and communicate
• IRR: Example
• Consider the following project:
The internal rate of return for this project is 19.44% 0 1 2 3 \$50 \$100 \$150 -\$200
• NPV Payoff Profile If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44%
• 6.6 Problems with IRR
• Multiple IRRs
• Are We Borrowing or Lending
• The Scale Problem
• The Timing Problem
• Mutually Exclusive vs. Independent
• Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g., acquiring an accounting system.
• RANK all alternatives, and select the best one.
• Independent Projects: accepting or rejecting one project does not affect the decision of the other projects.
• Must exceed a MINIMUM acceptance criteria
• The Scale Problem (P.175)
• The Timing Problem 0 1 2 3 \$10,000 \$1,000 \$1,000 -\$10,000 Project A 0 1 2 3 \$1,000 \$1,000 \$12,000 -\$10,000 Project B
• The Timing Problem 10.55% = crossover rate 16.04% = IRR A 12.94% = IRR B
• NPV versus IRR
• NPV and IRR will generally give the same decision.
• Exceptions:
• Non-conventional cash flows – cash flow signs change more than once
• Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
• 6.7 The Profitability Index (PI)
• Minimum Acceptance Criteria:
• Accept if PI > 1
• Ranking Criteria:
• Select alternative with highest PI
• The Profitability Index