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Transcript of Week 7 Chapter 9
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
7-1
Chapter Seven
Net Present Value and OtherInvestment Criteria
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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7.1 Net Present Value
7.2 The Payback Rule
7.3 The Discounted Payback Rule
7.4 The Accounting Rate of Return
7.5 The Internal Rate of Return
7.6 The Present Value Index
7.7 The Practice of Capital Budgeting
7.8 Summary and Conclusions
Chapter Organisation
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Chapter Objectives
Discuss the various investment evaluationtechniques, including their advantages anddisadvantages.
Apply these techniques to the evaluation ofprojects.
Interpret the results of the application of thesetechniques in accordance with their respective
decision rules.
Understand the importance of net present value.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Net Present Value (NPV)
Net present value is the difference between aninvestments market value (in todays dollars) and
its cost (also in todays dollars).
Net present value is a measure of how much valueis created by undertaking an investment.
Estimation of the future cash flows and thediscount rate are important in the calculation of theNPV.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Net Present Value
Steps in calculating NPV:
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 the
cash flows and subtract the initial investment.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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NPV Illustrated
0 1 2
Initial outlay($1100)
Revenues $1000Expenses 500
Cash flow $500
Revenues $2000Expenses 1000
Cash flow $1000
$1100.00
+454.55
+826.45
+$181.00
1$500 x
1.10
1$1000 x
1.102
NPV
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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NPV
An investment should be accepted if the NPV ispositive and rejected if it is negative.
NPV is a direct measure of how well theinvestment meets the goal of financialmanagementto increase owners wealth.
A positive NPV means that the investment isexpected to add value to the firm.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Payback Period
The amount of time required for an investment to generatecash flows to recover its initial cost.
Estimate the cash flows.
Accumulate the future cash flows until they equal the initialinvestment.
The length of time for this to happen is the payback period.
An investment is acceptable if its calculated payback is lessthan some prescribed number of years.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Payback Period Illustrated
Initial investment =$1000Year Cash flow
1 $200
2 400
3 600
AccumulatedYear Cash flow
1 $200
2 6003 1200
Payback period = 2 2/3 years
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Advantages of Payback Period
Easy to understand.
Adjusts for uncertainty of later cash flows.
Biased towards liquidity.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Disadvantages of Payback Period
Time value of money and risk ignored.
Arbitrary determination of acceptable payback
period.
Ignores cash flows beyond the cut-off date.
Biased against long-term and new projects.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Discounted Payback Period
The length of time required for an investments
discounted cash flows to equal its initial cost.
Takes into account the time value of money.
More difficult to calculate.
An investment is acceptable if its discountedpayback is less than some prescribed number ofyears.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExampleDiscounted Payback
Initial investment =
$1000R = 10%PV of
Year Cash flow Cash flow
1 $200 $182
2 400 331
3 700 526
4 300 205
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExampleDiscounted Payback(continued)
Accumulated
Year discountedcash flow
1 $182
2 513
3 1039
4 1244
Discounted payback period isjust under three years
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Ordinary and Discounted Payback
Cash Flow Accumulated Cash Flow
Year Undiscounted Discounted Undiscounted Discounted
12345
$ 100100100100100
$ 8979706255
$ 100200300400500
$89168238300355
Initial investment =$300R = 12.5%
Ordinary payback? Discounted payback?
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Advantages and Disadvantages ofDiscounted Payback
Advantages
- Includes time value ofmoney
- Easy to understand
- Does not accept negativeestimated NPV investments
- Biased towards liquidity
Disadvantages
- May reject positive NPVinvestments
- Arbitrary determination ofacceptable payback period
- Ignores cash flows beyondthe cutoff date
- Biased against long-termand new products
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Accounting Rate of Return (ARR)
Measure of an investments profitability.
A project is accepted if ARR > target averageaccounting return.
book valueaverageprofitnetaverageARR
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ExampleARR
Year
1 2 3
Sales $440 $240 $160
Expenses 220 120 80
Gross profit 220 120 80
Depreciation 80 80 80
Taxable income 140 40 0
Taxes (25%) 35 10 0
Net profit $105 $30 $0
Assume initial investment = $240
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExampleARR (continued)
$1202
$0$240
2
valueSalvageinvestmentInitialbook valueAverage
$45
3
$0$30$105profitnetAverage
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExampleARR (continued)
37.5%
$120$45
book valueAverage
profitnetAverageARR
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Disadvantages of ARR
The measure is not a true reflection of return.
Time value is ignored.
Arbitrary determination of target average return.
Uses profit and book value instead of cash flowand market value.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Advantages of ARR
Easy to calculate and understand.
Accounting information almost always available.
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Internal Rate of Return (IRR)
The discount rate that equates the present value ofthe future cash flows with the initial cost.
Generally found by trial and error.
A project is accepted if its IRR is > the requiredrate of return.
The IRR on an investment is the required returnthat results in a zero NPV when it is used as thediscount rate.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExampleIRR
Initial investment =$200
Year Cash flow
1 $ 50
2 100
3 150
n Find the IRR such that NPV = 0
50 100 1500 =200 + + +
(1+IRR)1 (1+IRR)2 (1+IRR)3
50
100 150
200 = + +(1+IRR)1 (1+IRR)2 (1+IRR)3
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ExampleIRR (continued)
Trial and Error
Discount rates NPV
0% $100
5% 68
10% 41
15% 18
20% 2
IRR is just under 20%about 19.44%
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NPV Profile
Year Cash flow
0 $2751 1002 1003 1004 100
Discount rate
2% 6% 10% 14% 18%
120
100
80
60
40
20
Net present value
0
20
40
22%
IRR
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
7-27
Problems with IRR
More than one negative cash flow multiple ratesof return.
Project is not independent mutually exclusive
investments. Highest IRR does not indicate thebest project.
Advantages of IRR Popular in practice
Does not require a discount rate
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Multiple Rates of Return
Assume you are considering a project forwhich the cash flows are as follows:
Year Cash flows
0 $252
1 1431
2 3035
3 2850
4 1000
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Multiple Rates of Return
n Whats the IRR? Find the rate at whichthe computed NPV = 0:
at 25.00%: NPV = 0
at 33.33%: NPV = 0
at 42.86%: NPV = 0
at 66.67%: NPV = 0
n Two questions:u 1. Whats going on here?
u 2. How many IRRs can there be?
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Multiple Rates of Return
$0.06
$0.04
$0.02
$0.00
($0.02)
NPV
($0.04)
($0.06)
($0.08)
0.2 0.28 0.36 0.44 0.52 0.6 0.68
IRR = 25%
IRR = 33.33%
IRR = 42.86%
IRR = 66.67%
Discount rate
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
7-31
IRR and Non-conventional CashFlows
When the cash flows change sign more than once,there is more than one IRR.
When you solve for IRR you are solving for the root
of an equation and when you cross thexaxis morethan once, there will be more than one return thatsolves the equation.
If you have more than one IRR, you cannot use
any of them to make your decision.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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IRR, NPV and Mutually-exclusiveProjects
Discount rate
2% 6% 10% 14% 18%
6040
20
0
20
40
Net present value
60
80
100
22%
IRRA IRRB
0
140
120100
80
160
Year
0 1 2 3 4
Project A: $350 50 100 150 200
Project B: $250 125 100 75 50
26%
Crossover Point
Present Value Index (PVI)
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Present Value Index (PVI)(Profitability Index)
Expresses a projects benefits relative to its initial
cost.
costInitialinflowsofPVPVI
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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Present Value Index (PVI)
Expresses a projects benefits relative to its
initial cost.
Accept a project with a PVI > 1.0.
costInitialinflowsofPVPVI
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExamplePVI
Assume you have the following information on Project X:
Initial investment =$1100 Required return = 10%
Annual cash revenues and expenses are as follows:
Year Revenues Expenses
1 $1000 $500
2 2000 1000
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExamplePVI (continued)
1.16451001
1001181PVI
$181
10011.10
0001
1.10
500NPV
2
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Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExamplePVI (continued)
1.1645
1001
1001181PVI
$181
10011.10
0001
1.10
500NP V
2
Net Present Value Index
= 181
1100
= 0.1645
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExamplePVI (continued)
Is this a good project? If so, why?
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
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ExamplePVI (continued)
Is this a good project? If so, why?
This is a good project because the present value of
the inflows exceeds the outlay.
Each dollar invested generates $1.1645 in value or$0.1645 in NPV.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
Ross, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
7-40
Advantages and Disadvantages ofPVI (and NPVI)
Advantages
- Closely related toNPV, generally leadingto identical decisions.
- Easy to understand.
- May be useful whenavailable investmentfunds are limited.
Disadvantages
- May lead to incorrectdecisions in
comparisons ofmutually exclusiveinvestments.
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Copyright 2004 McGraw-Hill Australia Pty LtdPPTs t/a Fundamentals of Corporate Finance 3e
C f
Capital Budgeting in Practice
We should consider several investment criteriawhen making decisions.
NPV and IRR are the most commonly used primaryinvestment criteria.
Payback is a commonly used secondary
investment criteria.