Chap006

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 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

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 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

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) 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

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 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 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

6.8 The Practice of Capital Budgeting Varies by industry: The most frequently used technique for large corporations is IRR or NPV.

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

Chap006

More Related Content

What's hot

Viewers also liked

Similar to Chap006

More from Yuan Kuei Huang

Recently uploaded

Chap006