RWJ 08

McGraw-Hill/I rwin Copyright 2011 by the McGraw-Hill Companies, I nc. All rights reserved.
Key Concepts and Skills

Understand the payback rule and its
shortcomings
Understand the internal rate of return and its
strengths and weaknesses
Understand the net present value rule and why
it is the best decision criteria
Capital Budgeting
Corporate investing
Analyze potential projects for risk/return
Steps in Capital Budgeting
1. Determine initial investment
2. Estimate the cash flows expected from the
asset
3. Evaluate using a decision rule.
Capital Budgeting Evaluation
Techniques
1. Payback
2. Net present value (NPV)
3. Internal rate of return (IRR)
Payback
Payback period = length of time before the
original cost of an investment is recovered
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year recovery - full
during flow cash Total
year recovery - full of
start at cost d Unrecovere
investment original
of recovery full
before years of Number
Payback
Payback
t 0 1 2 3 4
X -1600 1200 300 400 300

Payback = 2 years + fraction
Fraction = how much needed CF for year
= 100 400 = 0.25
Payback = 2.25 years
Compare to required Payback for accept/reject
Payback
t 0 1 2 3 4
X -1600 1200 300 400 300
Y -1600 300 1200 400 300
Payback Y?

Problem?

Payback
t 0 1 2 3 4
X -1600 1200 300 400 300
Z -1600 1200 300 400 92,000
Payback Z?

Problem?

Payback
Problems:
1. Ignores time value of money
2. Ignores CFs after Payback Period
Average Accounting Return
Many different definitions for average accounting
return (AAR)
In this book:

Note: Average book value depends on how the
asset is depreciated.
Requires a target cutoff rate
Decision Rule: Accept the project if the AAR is
greater than target rate.

Value Book Average
Income Net Average
AAR =
8-11
Net Present Value
Sum of the PVs of all cash flows
Initial cost often is CF
0
and is an outflow.
NPV =

n
t = 0
CF
t
(1 + R)
t
NPV =

n
t = 1
CF
t
(1 + R)
t
- CF
0

NOTE:
t=0
Net Present Value
NPV = present value of net cash flows,
discounted by firms required return
NPV = $ wealth added by project
I f the NPV is positive, accept the project

NPV vs. IRR
NPV
) R 1 (
CF
n
0 t
t
t
=
+
=
IRR: Enter NPV = 0, solve for IRR.
NPV: Enter r, solve for NPV
0
) IRR 1 (
CF
n
0 t
t
t
=
+
=
Internal Rate of Return
Definition: The expected return on the
investment based on projected CFs.
Decision Rule: Accept the project if the I RR is
greater than the required return
Warning: Assumes CFs reinvested at whatever
IRR rate is.

NPV & IRR: Inter-relating Facts
If NPV > 0, IRR > R
If IRR < R, NPV < 0
If NPV = 0, IRR = R
IRR is the return that makes the NPV = 0
If one says accept, the other has to also say
accept, and vice versa
NPV & IRR
t 0 1 2 3 4
X -1600 1200 300 300 300
Y -1600 300 1200 300 300

Calculate NPV@14% & IRR
NPV & IRR
Use CFj button to enter CFs
-1600 CFj
1200 CFj
300 CFj
300 CFj
300 CFj
14 I/YR
<color> NPV
<color> IRR/YR

NPV & IRR
t 0 1 2 3 4
X -1600 1200 300 300 300
Y -1600 300 1200 300 300

X NPV = $63.59 & IRR =
16.66%
Will Ys NPV & IRR be higher? Lower?

Y NPV = -$33.37 & IRR =
12.91%
Project Example Information
You are looking at a new project and you have
estimated the following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: 70,800
Year 3: 91,080
Your required return for assets of this risk is
12%. Find IRR & NPV.
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
N
P
V
IRR = 16.13%
Advantages of IRR
Knowing a return is intuitively appealing
It is a simple way to communicate the value of
a project to someone who doesnt know all the
estimation details
If the IRR is high enough, you may not need to
estimate a required return, which is often a
difficult task
NPV Vs. IRR
NPV and IRR will generally give us 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
Another Example Non-
conventional Cash Flows
Suppose an investment will cost $90,000
initially and will generate the following cash
flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
Summary of Decision Rules
The NPV is positive at a required return of
15%, so you should Accept
If you use the financial calculator for IRR???
Non-conventional CFs -,+,+,-
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 0.3 0.35 0.4 0.45 0.5 0.55
Discount Rate
N
P
V
IRR = 10.11% and 42.66%
IRR and Non-conventional Cash
Flows
When the cash flows change sign more than
once, there is more than one IRR
If you have more than one IRR, which one do
you use to make your decision?
IRR and Mutually Exclusive
Projects
If you choose one, you cant choose the other
Example: You can choose to attend graduate school
next year at either Harvard or Stanford, but not both
Example With Mutually Exclusive
Projects
Period Project A Project B
0 -500 -400
1 325 325
2 325 200
The required return
for both projects is
10%.

Which project
should you accept
and why?
Projects
Period Project A Project B
0 -500 -400
1 325 325
2 325 200
IRR 19.43% 22.17%
NPV 64.05 60.74
Projects
Period Project A Project
B
Project
A B
0 -500 -400 -100
1 325 325 0
2 325 200 125
IRR 19.43% 22.17% 11.80%
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 0.3
Discount Rate
N
P
VA
B
IRR for A = 19.43%
IRR for B = 22.17%
Crossover Point = 11.8%
NPV & IRR
t 0 1 2
Project C -100 0 144
Project D -100 125 0

Calculate NPV@10% and IRR for each.

NPV & IRR
t 0 1 2

IRR NPV@10%
C 20% 19.01
D 25% 13.64

NPV & IRR
t 0 1 2
C D 0 -125 144
IRR(C-D) = Rate where NPVs of C&D are
equal = Crossover rate
IRR(C-D) = 15.2%
Conflicts Between NPV and IRR
NPV directly measures the increase in value to
the firm
Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Capital Budgeting In Practice
We should consider several investment criteria
when making decisions
NPV and IRR are the most commonly used
primary investment criteria
Payback is a commonly used secondary
investment criteria
Quick Quiz
Consider an investment that costs $100,000 and has a
cash inflow of $25,000 every year for 5 years. The
required return is 9% and required payback is 4 years.
What is the payback period?
What is the NPV?
What is the IRR?
Should we accept the project?
What decision rule should be the primary decision
method?
When is the IRR rule unreliable?

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McGraw-Hill/I rwin Copyright 2011 by the McGraw-Hill Companies, I nc. All rights reserved.

Key Concepts and Skills

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