Chap006
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  • 1. Net Present Value and Other Investment Rules
  • 2. 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
  • 3. 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 .
  • 4.
    • 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 .
  • 5. 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
  • 6. 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 .
  • 7. 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
  • 8. The Payback Period Method
    • Disadvantages:
      • 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
    • Advantages:
      • Easy to understand
      • Biased toward liquidity
  • 9.
    • 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).
  • 10. 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.
  • 11. 6.4 Average Accounting Return
    • Another attractive, but fatally flawed, approach
    • Ranking Criteria and Minimum Acceptance Criteria set by management
  • 12.  
  • 13. Average Accounting Return
    • Disadvantages:
      • Ignores the time value of money
      • Uses an arbitrary benchmark cutoff rate
      • Based on book values, not cash flows and market values
    • Advantages:
      • The accounting information is usually available
      • Easy to calculate
  • 14. 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
  • 15. Internal Rate of Return (IRR)
    • Disadvantages:
      • Does not distinguish between investing and borrowing
      • IRR may not exist, or there may be multiple IRRs
      • Problems with mutually exclusive investments
    • Advantages:
      • Easy to understand and communicate
  • 16. 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
  • 17. NPV Payoff Profile If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept. IRR = 19.44%
  • 18. 6.6 Problems with IRR
    • Multiple IRRs
    • Are We Borrowing or Lending
    • The Scale Problem
    • The Timing Problem
  • 19. 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
  • 20. The Scale Problem (P.175)
  • 21. 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
  • 22. The Timing Problem 10.55% = crossover rate 16.04% = IRR A 12.94% = IRR B
  • 23. 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
  • 24. 6.7 The Profitability Index (PI)
    • Minimum Acceptance Criteria:
      • Accept if PI > 1
    • Ranking Criteria:
      • Select alternative with highest PI
  • 25. The Profitability Index
    • Disadvantages:
      • Problems with mutually exclusive investments
    • Advantages:
      • May be useful when available investment funds are limited
      • Easy to understand and communicate
      • Correct decision when evaluating independent projects
  • 26. 6.8 The Practice of Capital Budgeting
    • Varies by industry:
    • The most frequently used technique for large corporations is IRR or NPV.
  • 27. 8 7
  • 28.  
  • 29. The Internal Rate of Return: Example
    • Consider the following project:
    The internal rate of return for this project is 19.44% 0 1 2 3 $50 $100 $150 -$200