ch09 Finance

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Net Present Value and OtherInvestment Criteria

Chapter 9


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MBA 819 1

Key Concepts and SkillsBe able to compute payback and discountedpayback and understand their shortcomings

Understand accounting rates of return andtheir shortcomingsBe able to compute the internal rate of returnand understand its strengths and weaknessesBe able to compute the net present value andunderstand why it is the best decisioncriterion


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Chapter OutlineNet Present Value

The Payback RuleThe Discounted PaybackThe A verage A ccounting Return

The Internal Rate of ReturnThe Profitability IndexThe Practice of Capital Budgeting


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Good Decision CriteriaWe need to ask ourselves the followingquestions when evaluating decisioncriteria

Does the decision rule adjust for the timevalue of money?

Does the decision rule adjust for risk?Does the decision rule provide informationon whether we are creating value for thefirm?


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Project Example InformationYou are looking at a new project and youhave estimated the following cash flows:

Year 0: CF = -165,000Year 1: CF = 63,120; NI = 13,620Year 2: CF = 70,800; NI = 3,300Year 3: CF = 91,080; NI = 29,100

A verage Book Value = 82,500Your required return for assets of this risk is12%.


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Net Present ValueThe difference between the market value of aproject and its cost

Value A dditivity PrincipleHow much value is created from undertakingan investment?

The first step is to estimate the expected future

cash flows.The second step is to estimate the required returnfor projects of this risk level.The third step is to find the present value of thecash flows and subtract the initial investment.


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NPV Decision RuleIf the NPV is positive, accept the project A positive NPV means that the project isexpected to add value to the firm and willtherefore increase the wealth of the owners.Since our goal is to increase owner wealth,NPV is a direct measure of how well thisproject will meet our goal.However, you may accept a project with annegative NPV for strategic reasons.


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Computing NPV for the Project Using the formulas:

NPV = 63,120/(1.12) + 70,800/(1.12) 2 +91,080/(1.12) 3 165,000 = 12,627.41

Using the calculator:CF0 = -165,000; CF 1 = 63,120; CF 2 =70,800; CF 3 = 91,080; I/YR = 12; thenyellow NPV = 12,627.41

D o we accept or reject the project?


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Decision Criteria Test - NPVDoes the NPV rule account for the timevalue of money?

A ssumes reinvestment at the required rate of return

Does the NPV rule account for the risk of the cash flows?

Does the NPV rule provide an indicationabout the increase in value?Should we consider the NPV rule for ourprimary decision criteria?


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MBA 819 9

Calculating NPVs with a

Spreadsheet Spreadsheets are an excellent way tocompute NPVs, especially when you have to

compute the cash flows as well.Using the NPV functionThe first component is the required return enteredas a decimalThe second component is the range of cash flowsbeginning with year 1Subtract the initial investment after computing theNPV


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Payback PeriodHow long does it take to get the initial cost back in a nominal sense?Computation

Estimate the cash flowsSubtract the future cash flows from the initial cost until the initial investment has been recovered

Decision Rule A ccept if the payback period is less than some preset limit


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Computing Payback For The

Project A ssume we will accept the project if it paysback within two years.

Year 1: 165,000 63,120 = 101,880 still torecoverYear 2: 101,880 70,800 = 31,080 still to recoverYear 3: 31,080 91,080 = -60,000 project pays

back in year 3A nswer is 2 + .34 years or 2.34 years (assumingcash flows are continuous during the year).



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Decision Criteria Test -

PaybackDoes the payback rule account for the

time value of money?Does the payback rule account for therisk of the cash flows?Does the payback rule provide anindication about the increase in value?Should we consider the payback rule forour primary decision criteria?


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A dvantages and Disadvantages

of PaybackA dvantages

Easy to understandA djusts foruncertainty of latercash flowsB iased towardsliquidity

DisadvantagesIgnores the time valueof moneyRequires an arbitrarycutoff point Ignores cash flowsbeyond the cutoff dateB

iased against long-term projects, such asresearch anddevelopment, and newprojects


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Discounted Payback PeriodCompute the present value of each cashflow and then determine how long it takes to payback on a discounted basisCompare to a specified required periodDecision Rule - A ccept the project if it pays back on a discounted basis within the specified time


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Computing Discounted Payback

for the Project A ssume we will accept the project if it paysback on a discounted basis in 2 years.

Compute the PV for each cash flow anddetermine the payback period usingdiscounted cash flows

Year 1: 165,000 63,120/1.12 1 = 108,643

Year 2: 108,643

70,800/1.122

= 52,202Year 3: 52,202 91,080/1.12 3 = -12,627 project pays back in year 3The answer is 2.57 years.



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Decision Criteria Test

Discounted PaybackDoes the discounted payback rule account forthe time value of money?Does the discounted payback rule account forthe risk of the cash flows?Does the discounted payback rule provide an

indication about the increase in value?Should we consider the discounted paybackrule for our primary decision criteria?


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A dvantages and Disadvantages of Discounted Payback

A dvantagesIncludes time valueof moneyEasy to understandDoes not accept negative estimatedNPV investmentsB iased towardsliquidity

DisadvantagesM ay reject positive

NPV investmentsRequires an arbitrarycutoff point Ignores cash flowsbeyond the cutoff point B iased against long-term projects, suchas R&D and newproducts


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A verage A ccounting ReturnThere are many different definitions foraverage accounting return

The one used in the book is:A verage net income / average book valueNote that the average book value depends on howthe asset is depreciated.

Need to have a target cutoff rateDecision Rule: Acc ept the proje c t if theAAR is greater than a preset rate.


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Computing AA R For The

Project A ssume we require an average

accounting return of 25%A verage Net Income:(13,620 + 3,300 + 29,100) / 3 = 15,340

AA R = 15,340 / 82,500 = .186 =18.6%



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MBA 819 20

Decision Criteria Test - AA RDoes the AA R rule account for the timevalue of money?Does the AA R rule account for the riskof the cash flows?Does the AA R rule provide an indication

about the increase in value?Should we consider the AA R rule for ourprimary decision criteria?


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A dvantages and

Disadvantages of AA RA dvantages

Easy to calculateNeeded informationwill usually beavailable

DisadvantagesNot a true rate of return; time value of money is ignoredUses an arbitrarybenchmark cutoff rateBased on accounting

net income and bookvalues, not cash flowsand market valuesOvervalues longerprojects


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Internal Rate of Return (IRR)This is the most important alternative toNPV (also it was the first DCF methodused)It is often used in practice and isintuitively appealing

It is based entirely on the estimatedcash flows and is independent of interest rates found elsewhereA ssumes reinvestment at the IRR


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IRR Definition and Decision

RuleDefinition: IRR is the return that makesthe NPV = 0Decision Rule: A ccept the project if the I RR is greater than therequired return


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Computing IRR For The

Project If you did not have a financial calculator,then this calculation becomes a trial anderror processCalculator

Enter the cash flows as you did with NPV

Press yellow IRR/YRIRR = 16.13% > 12% required returnD o we accept or reject the project?


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NPV Profile For The Project

-20,000

-10,000

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

0 0.02 0.04 0.06 0.08 0.1 0.12 0.14 0.16 0.18 0.2 0.22

Discount Rate

NPV

IRR = 16.13%


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Decision Criteria Test - IRRDoes the IRR rule account for the timevalue of money?Does the IRR rule account for the riskof the cash flows?Does the IRR rule provide an indication

about the increase in value?Should we consider the IRR rule for ourprimary decision criteria?


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A dvantages of IRRKnowing a return is intuitively appealing

It is a simple way to communicate thevalue of a project to someone whodoesn t know all the estimation detailsIf the IRR is high enough, you may not need to estimate a required return,which is often a difficult task


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Summary of Decisions For The

Project Summary

Net Present ValueA

ccept Payback Period R eject

Discounted Payback Period R eject

A verage A ccounting Return R eject

Internal Rate of Return A ccept


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Calculating IRRs With A

Spreadsheet You start with the cash flows the same asyou did for the NPVYou use the IRR function

You first enter your range of cash flows, beginningwith the initial cash flowYou can enter a guess, but it is not necessaryThe default format is a whole percent you willnormally want to increase the decimal places toone or two places.


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NPV Vs. IRRNPV and IRR will generally give us thesame decision

ExceptionsNon-conventional cash flows cash flowsigns change more than onceM utually exclusive projects

Initial investments are substantially different (Size of outflow)Timing of cash flows is substantially different


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IRR and Non-conventional

Cash FlowsWhen the cash flows change sign more thanonce, there is more than one IRR

When you solve for IRR you are solving forthe root of an equation and when you crossthe x-axis more than once, there will be morethan one return that solves the equation

If you have more than one IRR, which one doyou use to make your decision?Your financial calculator typically will report not found.


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A n Example Non-conventional

Cash FlowsSuppose an investment will cost $90,000 initially and will generate the

following cash flows:Year 1: 132,000Year 2: 100,000Year 3: -150,000

The required return is 15%.Should we accept or reject the project?


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NPV Profile

($10 ,000 .00)

($8 ,000 .00)

($6 ,000 .00)

($4 ,000 .00)

($2 ,000 .00)

$0 .00

$2 ,000 .00

$4 ,000 .00

0 0 .05 0 .1 0 .15 0 .2 0 .25 0 . 0 . 5 0 .4 0 .45 0 .5 0 .55

D isc t te

I = 10 .11 % d 42 .66 %


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Summary of Decision RulesThe NPV is positive at a required returnof 15%, so you should A ccept

If you use the HP 10 B II financialcalculator, you would get an IRR of not found.

You need to recognize that there arenon-conventional cash flows and look at the NPV profileUse the Net Present Value for decision


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IRR and M utually Exclusive

ProjectsM utually exclusive projects

If you choose one, you can t choose the other

Example: You can choose to purchase a ToyotaCamry or a Ford Taurus, but not both

Intuitively you would use the followingdecision rules:

NPV choose the project with the higher NPVIRR choose the project with the higher IRR


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Example With M utually ExclusiveProjects

Period Project A

Project B

0 -500 -400

1 325 325

2 325 200

IRR 19.43% 22.17%

NPV 64.05 60.74

The required return

for both projects is10%.

Which projectshould you acceptand why?


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NPV Profiles

($40 .00)

($20 .00)$0 .00

$20 .00

$40 .00

$60 .00

$80 .00

$100 .00

$120 .00

$140 .00

$160 .00

0 0 .05 0 .1 0 .15 0 .2 0 .25 0 .

D isc t te

AB

I f r A = 19 .43 %

I f r B = 22 .17 %

Cr ss ver i t = 11 .8%


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Conflicts Between NPV and

IRRNPV directly measures the increase in valueto the firm (Value A dditivity)

Whenever there is a conflict between NPVand another decision rule, you shouldalways use NPVIRR is unreliable in the following situations

Non-conventional cash flowsM utually exclusive projects


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Profitability IndexM easures the benefit per unit cost, based onthe time value of money ( Bang for theB

uck

)A profitability index of 1.1 implies that forevery $1 of investment, we create anadditional $0.10 in value

This measure can be very useful in situationswhere we have limited capitalThis technique is used in capital rationing.


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A dvantages and Disadvantages of Profitability Index

A dvantagesClosely related to NPV,generally leading toidentical decisionsEasy to understand andcommunicate

M ay be useful whenavailable investment funds are limited

DisadvantagesM ay lead to incorrect decisions incomparisons of mutually exclusiveinvestments


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Summary Discounted Cash

Flow CriteriaNet present value

Difference between market value and cost Take the project if the NPV is positiveHas no serious problemsPreferred decision criterion

Internal rate of returnDiscount rate that makes NPV = 0Take the project if the IRR is greater than required returnSame decision as NPV with conventional cash flowsIRR is unreliable with non-conventional cash flows or mutuallyexclusive projects

Profitability IndexBenefit-cost ratioTake investment if PI > 1Cannot be used to rank mutually exclusive projectsM ay be used to rank projects in the presence of capital rationing


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Summary

Payback CriteriaPayback period

Length of time until initial investment is recoveredTake the project if it pays back in some specifiedperiodDoesn t account for time value of money andthere is an arbitrary cutoff period

Discounted payback period

Length of time until initial investment is recoveredon a discounted basisTake the project if it pays back in some specifiedperiodThere is an arbitrary cutoff period


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Summary A ccounting

CriterionA verage A ccounting ReturnM easure of accounting profit relative to

book valueSimilar to return on assets measureTake the investment if the AA R exceedssome specified return levelSerious problems and should not beused

But it is used in industry, and it may

determine compensation of the manager.


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ConclusionCapital Investment Decision Techniques

Net Present ValuePayback PeriodDiscounted PaybackInternal Rate of ReturnProfitability IndexA ccounting Rate of Return

Industry usage

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