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Chap006

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  • Transcript

    • 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