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  • Chap006

    1. 1. Net Present Value and Other Investment Rules
    2. 2. Chapter Outline <ul><li>6.1 Why Use Net Present Value? </li></ul><ul><li>6.2 The Payback Period Method </li></ul><ul><li>6.3 The Discounted Payback Period Method </li></ul><ul><li>6.4 The Average Accounting Return Method </li></ul><ul><li>6.5 The Internal Rate of Return </li></ul><ul><li>6.6 Problems with the IRR Approach </li></ul><ul><li>6.7 The Profitability Index </li></ul><ul><li>6.8 The Practice of Capital Budgeting </li></ul>
    3. 3. 6.1 Why Use Net Present Value? <ul><li>Accepting positive NPV projects benefits shareholders. </li></ul><ul><li>Forgoing the project today, the value of the firm today is $V + $ 100 </li></ul><ul><li>Accepting the project today, the value of the firm today is $V + $ 100.94 ( 107/1.06 ) </li></ul><ul><li>The difference is $0.94 . </li></ul><ul><li>The value of the firm rises by the NPV of the project . </li></ul>
    4. 4. <ul><li>The discount rate on a risky project is the return that one can expect to earn on a financial asset of comparable risk . </li></ul><ul><li>This discount rate is often referred to as an opportunity cost . </li></ul>
    5. 5. The Net Present Value (NPV) Rule <ul><li>Net Present Value (NPV) = </li></ul><ul><li>- Initial Investment + Total PV of future CF’s </li></ul><ul><li>Estimating NPV: </li></ul><ul><ul><li>1. Estimate future cash flows : how much? and when? </li></ul></ul><ul><ul><li>2. Estimate discount rate </li></ul></ul><ul><ul><li>3. Estimate initial costs </li></ul></ul><ul><li>Minimum Acceptance Criteria: Accept if NPV > 0 </li></ul><ul><li>Ranking Criteria: Choose the highest NPV </li></ul>
    6. 6. Good Attributes of the NPV Rule <ul><li>1. Uses cash flows </li></ul><ul><li>2. Uses ALL cash flows of the project </li></ul><ul><li>3. Discounts ALL cash flows properly </li></ul><ul><li>Reinvestment assumption: the NPV rule assumes that all cash flows can be reinvested at the discount rate . </li></ul>
    7. 7. 6.2 The Payback Period Method <ul><li>How long does it take the project to “ pay back ” its initial investment ? </li></ul><ul><li>Payback Period = number of years to recover initial costs </li></ul><ul><li>Minimum Acceptance Criteria: </li></ul><ul><ul><li>Set by management </li></ul></ul><ul><li>Ranking Criteria: </li></ul><ul><ul><li>Set by management </li></ul></ul>
    8. 8. The Payback Period Method <ul><li>Disadvantages: </li></ul><ul><ul><li>Ignores the time value of money </li></ul></ul><ul><ul><li>Ignores cash flows after the payback period </li></ul></ul><ul><ul><li>Biased against long-term projects </li></ul></ul><ul><ul><li>Requires an arbitrary acceptance criteria </li></ul></ul><ul><ul><li>A project accepted based on the payback criteria may not have a positive NPV </li></ul></ul><ul><li>Advantages: </li></ul><ul><ul><li>Easy to understand </li></ul></ul><ul><ul><li>Biased toward liquidity </li></ul></ul>
    9. 9. <ul><li>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). </li></ul>
    10. 10. 6.3 The Discounted Payback Period <ul><li>How long does it take the project to “pay back” its initial investment, taking the time value of money into account ? </li></ul><ul><li>Decision rule: Accept the project if it pays back on a discounted basis within the specified time. </li></ul><ul><li>By the time you have discounted the cash flows, you might as well calculate the NPV. </li></ul>
    11. 11. 6.4 Average Accounting Return <ul><li>Another attractive, but fatally flawed, approach </li></ul><ul><li>Ranking Criteria and Minimum Acceptance Criteria set by management </li></ul>
    12. 13. Average Accounting Return <ul><li>Disadvantages: </li></ul><ul><ul><li>Ignores the time value of money </li></ul></ul><ul><ul><li>Uses an arbitrary benchmark cutoff rate </li></ul></ul><ul><ul><li>Based on book values, not cash flows and market values </li></ul></ul><ul><li>Advantages: </li></ul><ul><ul><li>The accounting information is usually available </li></ul></ul><ul><ul><li>Easy to calculate </li></ul></ul>
    13. 14. 6.5 The Internal Rate of Return <ul><li>IRR: the discount rate that sets NPV to zero </li></ul><ul><li>Minimum Acceptance Criteria: </li></ul><ul><ul><li>Accept if the IRR exceeds the required return </li></ul></ul><ul><li>Ranking Criteria: </li></ul><ul><ul><li>Select alternative with the highest IRR </li></ul></ul><ul><li>Reinvestment assumption: </li></ul><ul><ul><li>All future cash flows assumed reinvested at the IRR </li></ul></ul>
    14. 15. Internal Rate of Return (IRR) <ul><li>Disadvantages: </li></ul><ul><ul><li>Does not distinguish between investing and borrowing </li></ul></ul><ul><ul><li>IRR may not exist, or there may be multiple IRRs </li></ul></ul><ul><ul><li>Problems with mutually exclusive investments </li></ul></ul><ul><li>Advantages: </li></ul><ul><ul><li>Easy to understand and communicate </li></ul></ul>
    15. 16. IRR: Example <ul><li>Consider the following project: </li></ul>The internal rate of return for this project is 19.44% 0 1 2 3 $50 $100 $150 -$200
    16. 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%
    17. 18. 6.6 Problems with IRR <ul><li>Multiple IRRs </li></ul><ul><li>Are We Borrowing or Lending </li></ul><ul><li>The Scale Problem </li></ul><ul><li>The Timing Problem </li></ul>
    18. 19. Mutually Exclusive vs. Independent <ul><li>Mutually Exclusive Projects: only ONE of several potential projects can be chosen, e.g., acquiring an accounting system. </li></ul><ul><ul><li>RANK all alternatives, and select the best one. </li></ul></ul><ul><li>Independent Projects: accepting or rejecting one project does not affect the decision of the other projects. </li></ul><ul><ul><li>Must exceed a MINIMUM acceptance criteria </li></ul></ul>
    19. 20. The Scale Problem (P.175)
    20. 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
    21. 22. The Timing Problem 10.55% = crossover rate 16.04% = IRR A 12.94% = IRR B
    22. 23. NPV versus IRR <ul><li>NPV and IRR will generally give the same decision. </li></ul><ul><li>Exceptions: </li></ul><ul><ul><li>Non-conventional cash flows – cash flow signs change more than once </li></ul></ul><ul><ul><li>Mutually exclusive projects </li></ul></ul><ul><ul><ul><li>Initial investments are substantially different </li></ul></ul></ul><ul><ul><ul><li>Timing of cash flows is substantially different </li></ul></ul></ul>
    23. 24. 6.7 The Profitability Index (PI) <ul><li>Minimum Acceptance Criteria: </li></ul><ul><ul><li>Accept if PI > 1 </li></ul></ul><ul><li>Ranking Criteria: </li></ul><ul><ul><li>Select alternative with highest PI </li></ul></ul>
    24. 25. The Profitability Index <ul><li>Disadvantages: </li></ul><ul><ul><li>Problems with mutually exclusive investments </li></ul></ul><ul><li>Advantages: </li></ul><ul><ul><li>May be useful when available investment funds are limited </li></ul></ul><ul><ul><li>Easy to understand and communicate </li></ul></ul><ul><ul><li>Correct decision when evaluating independent projects </li></ul></ul>
    25. 26. 6.8 The Practice of Capital Budgeting <ul><li>Varies by industry: </li></ul><ul><li>The most frequently used technique for large corporations is IRR or NPV. </li></ul>
    26. 27. 8 7
    27. 29. The Internal Rate of Return: Example <ul><li>Consider the following project: </li></ul>The internal rate of return for this project is 19.44% 0 1 2 3 $50 $100 $150 -$200