Net Present Value and Other Investment Criteria

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Net Present Value And

Other Investment Criteria


Chapter 8
Topics
1. First Look at Capital Budgeting
2. Investment Criteria:
1. Net Present Value √
2. Payback Rule ≈
3. Accounting Rates Of Return ≈
4. Internal Rate Of Return ≈
5. The Profitability Index ≈

2
Financial Management
 Goal Of Financial Management:
 Increasing the value of the equity
 Capital Budgeting:
 Acquire long-term assets
 Because long-term assets:
 Determine the nature of the firm

 Are hard decisions to reverse

 They are the most important decisions for the financial


manager
 Selecting Assets
 Whish assets to invest in?
 There are many options.
 Which do we pick?

3
Good Decision Criteria For
Capital Budgeting
 We need to ask ourselves the
following questions when evaluating
decision criteria
 Does the decision rule adjust for the
time value of money?
 Does the decision rule adjust for risk?
 Does the decision rule provide
information on whether we are creating
value for the firm?
4
Net Present Value = NPV
 The difference between the market value and it’s
cost = Value Added.
 Example:
 Point of View = Asset Buyer
 If:
 Cost = -$200,000
 Market Value (Present Value Future Cash Flows) =
$201,036
 NPV = $201,036 - $200,000 = $1,036

 We examine a potential investment in light of its likely


effect on the price of the firm’s shares
 NPV/(# of shares outstanding)

5
NPV
 If there is a market for assets similar
to the one we are considering investing
in, we use that market and our decision
making is simplified

 When we cannot observe a market


price for at least a roughly comparable
investment, capital budgeting is made
difficult… then we use:
Discounted Cash Flow
Valuation (DCF) to get our NPV
 DCF gives us an estimate of market value.
6
Synonyms
 Discounted Cash Flow
Valuation (DCF)

 Net Present Value (NPV)

7
Synonyms
 Investment = Project =
Asset

8
Rules for DCF or NPV
1. The first step is to estimate the
expected future cash flows (Chapter 9)
2. The second step is to estimate the
required return for projects
(investments) of this risk level
(Chapter 10, 11)

3. The third step is to find the present


value of the cash flows and
subtract the initial investment
(Chapter 8)
9
Net Present Value (NPV) =
Discounted Cash Flow
Valuation (DCF)

Discount Rate = Market Rate = Required Rate Of Return =


RRR

Period Discount Rate

10
NPV/DCF Example 1 & 2:
 Should you invest in a short term project
that will cost us $200,000 to launch and
will yield these cash flows (Required Rate
of Return= 15%):

Cash Flow 0 (Cost) -$200,000.00


Cash Flow 1 $100,000.00
Cash Flow 2 $90,000.00
Cash Flow 3 $70,000.00

11
NPV/DCF Method Used In Earlier
Chapters
Example 1:

12
NPV Excel Function & Formula
NPV Function:
=NPV(rate,value1,value2…)
⃰ rate = Period RRR (Discount) = i/n.
⃰ value1 = Range of cells with cash flows.
⃰ Cash flows must happen at the end of each
period.
⃰ Cash flows start at time 1.
⃰ Never include cash flows at time 0 (zero).
⃰ Cash flows do not have to be equal in amount.
⃰ Time between each cash flow must be the same.

NPV Formula when cost is at time 0:


=NPV(rate,value1,value2…) - Cost
13
NPV/DCF Method Used This Chapter
Example 2:

14
Net Present Value (NPV) =
Discounted Cash Flow Valuation
(DCF)
 The process of valuing an
investment (project) by discounting
its future cash flows
There are no
 Decision Rule: guarantees that
our estimates
 NPV > 0  Accept Project are correct

 NPV < 0  Reject Project


 NPV = 0  Indifferent (RRR = IRR)

Create Search for That yield


value for capital budget positive NPV
stockholder projects value added
15
NPV / DCF Example 3:

16
Annual RRR (Discount) + NPV: Accept
5% 29,576
6% 27,070
Profile of NPV at 7% 24,647
8% 22,303
Different Rates 9%
10%
20,035
17,840
11% 15,714
12% 13,654
13% 11,658
14% 9,723
15% 7,847
16% 6,027
17% 4,260
18% 2,545
19% 880
20% -738
21% -2,310
22% -3,838
23% -5,324
17
Profile of NPV at Different Rates

18
We Have Just Talked About NPV
 Investment Criteria:
1. Net Present Value √
2. Payback Rule ≈
3. Accounting Rates Of Return ≈
4. Internal Rate Of Return ≈
5. The Profitability Index ≈

 Let’s
look at one example and
compare all these methods
19
Data For Example 4
 You are looking at a new project and you
have estimated these numbers:
CF0 -160,000.00
CF1 60,000.00
CF2 70,000.00
CF3 90,000.00

Net Income 1 13,000.00


Net Income 2 25,000.00
Net Income 3 20,000.00

Your required return for


assets of this risk 15%
Average Book Value 90,000.00
20
Example 4:
Computing NPV for The Project:

21
Advantages of NPV Rule
 Rule adjusts for the time value of
money
 Rule adjusts for risk (RRR - Discount Rate)
 Rule provides information on
whether we are creating value for
the firm

22
Payback Rule
 Payback Period
 The amount of time required for an investment to
generate cash flows to recover its initial costs
 Computation
 Estimate the cash flows
 Determine # of years Required to get “paid back”.
 Subtract the future cash flows from the initial cost
until the initial investment has been recovered

Pre-specified
Accept
Investment
Payback
Period < # of
Years

23
Data For Example 5
 You are looking at a new project and you
have estimated these numbers:
CF0 -160,000.00
CF1 60,000.00
CF2 70,000.00
CF3 90,000.00

Net Income 1 13,000.00


Net Income 2 25,000.00
Net Income 3 20,000.00

Your required return for


assets of this risk 15%
Average Book Value 90,000.00
24
Computing Payback For The
Project
 Assume we will accept the project if it pays
back within two years.
 Year 1: 160,000 – 60,000 = 100,00 still to
recover
 Year 2: 100,000 – 70,000 = 30,000 still to
recover

 Do we accept or reject the project?


 Reject. The project did not pay back
within 2 years.

25
Example 5 continued:

26
Decision Criteria Test - Payback
 Does the payback rule account for
the time value of money?
 Does the payback rule account for
the risk of the cash flows?
 Does the payback rule provide an
indication about the increase in
value?
 Should we consider the payback rule
for our primary decision criteria?
27
Advantages & Disadvantages of
Payback
 Advantages  Disadvantages
 Easy to understand  Ignores the time value of money
 Cost to do this analysis
 Fails to consider risk differences
 Risky or very risky projects are
is minimal – good for treated the same
small investment  Requires an arbitrary cutoff
decisions point
 Adjusts for uncertainty  Ignores cash flows beyond the
of later cash flows cutoff date
(gets rid of them)  Biased against long-term
projects, such as research and
 Biased towards development, and new projects
liquidity (tends to favor  Does not guarantee a single
investments that free answer
up cash for other uses  Does not ask the right question:
more quickly) Does it increase equity value?
 You have to estimate the cash
flows any way, so why not take
the extra time to calculate NPV?
28
Problems with Payback Rule:
Years Required to Pay Back Investment = 2
Year Pro A Pro B Pro C
0 -$250 $250 -$250
1 100 100 100
2 100 100 200
3 -250 100
4 250 100

Yes, but is it year 2 No. Because only Yes. Because $300


Accept or Reject? or 4? $200 by year 2. Cash In by year 2.
This project has a
negative NPV -
Ignores cash flows ignores time value
Problems: We get 2 answers after year 2. of $.
NPV = $535.50 -$11.81
Required Return: 0.15
29
Average Accounting Return =
AAR
 There are many different definitions for
Average Accounting Return.
Average Net Income
 Here is one: = AAR
Average Book Value

 Here is another:
 Calculate (Return On Assets = ROA) for
each year and then average the ROAs.

30
Average Accounting Return =
AAR
 Steps in calculating AAR:
1. Estimate All Revenue and Expenses over the
life of the asset.
2. Calculate the Net Income for each year.
3. Estimate Book Value over life of asset.
 Note that the average book value depends on how
the asset is depreciated.
4. Decide on target cutoff AAR rate
5. Decision Rule:
Accept the project if the calculated AAR
> cutoff AAR rate.
31
Average Book Value =
 When Straight Line Depreciation is
used:
(Cost + Salvage)/2

 When a Non- Straight Line


Depreciation is used:
(BV0 + BV1 +…BVt)/(t+1)
32
Data For Example 6
 You are looking at a new project and you
have estimated these numbers:
CF0 -160,000.00
CF1 60,000.00
CF2 70,000.00
CF3 90,000.00

Net Income 1 13,000.00


Net Income 2 25,000.00
Net Income 3 20,000.00

Your required return for


assets of this risk 15%
Average Book Value 90,000.00
33
Computing AAR For The Project Revenue
Year 1
$80,000
Year 2
$70,000
Year 3
$65,000
Expenses (including
Depreciation and Tax) $67,000 $45,000 $45,000
Net Income $13,000 $25,000 $20,000
Average Net Income $19,333 =AVERAGE(B4:D4)
Original Cost $180,000
Salvage $0
Years 3
Striaght Line Deprectaion $60,000 =(B8-B9)/B10
Time 0 Time 1 Time 2 Time 3
Book Value = Historical
Example 6:

Cost - Accumulated
Depreication $180,000 $120,000 $60,000 $0
Average Book Value $90,000 =AVERAGE(B14:E14)
Average Book Value $90,000 =B8/2
AAR 0.214814815 =B6/B17
Target AAR 0.25
Decision: Reject Project

34
Decision Criteria Test - AAR
 Does the AAR rule account for the
time value of money?
 Does the AAR rule account for the
risk of the cash flows?
 Does the AAR rule provide an
indication about the increase in
value?
 Should we consider the AAR rule for
our primary decision criteria?
35
Advantages and Disadvantages of
AAR
 Advantages  Disadvantages
 Easy to calculate  Not a true rate of
return; time value of
 Needed money is ignored
information will  Uses an arbitrary
usually be benchmark cutoff rate
available  Based on accounting
net income and book
values, not cash flows
and market values

36
NPV Profile

37
Solve For Rate
 Remember:
 Chapter 5 (Annuities and Multiple Cash Flows)
 Chapter 6 (Bonds)
 We learned that we can solve for rate.

 For Annuities or Bonds we were able to look at cash

flows and determine the rate.


 Chapter 8 (Multiple Cash Flows for Buying Assets)
 Just as YTM was “internal rate” of cash flows for

bonds, IRR will be “internal rate” of cash flows for


capital budgeting.
 We solve for the rate at which the NPV is zero and that

becomes the hurdle rate between + NPV and – NPV.

38
IRR = Internal Rate of Return
 To Understand What IRR means, build a NPV Profile and
look for the rate at which NPV = $0
 This tells you the rate of return for the cash flows from
the project.
Project Cash Flows
CF0 -160,000.00
CF1 60,000.00
0)
CF2 70,000.00
CF3 90,000.00
Required Rate Return 0.15

RRR NPV
14.00% 7,241.74
14.50% 5,750.17
15.00% 4,280.43
15.50% 2,832.09
16.00% 1,404.73
16.50% 0.00
17.00% -1,386.63
17.50% -2,753.47
18.00% -4,100.89
18.50% -5,429.27
19.00% -6,738.96 39
IRR = Internal Rate of Return
IRR = Rate at Which NPV = $0

0)

All RRR above


All RRR below IRR, subtract
IRR, add value value (-NPV)
(+NPV)

40
IRR = Internal Rate of Return =“Break Even Rate”
 Definition: Rate that makes the NPV = $0

 Decision Rule:

Accept
Investment
IRR
> RRR

 Most important alternative to NPV.


 It is often used in practice and is intuitively appealing.
 Calculation based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
 Formula inputs are cash flows only!

41
IRR Excel Function
IRR Function:
=IRR(values,guess)
⃰ values = range of cells with cash flows. Cash out is negative,
cash in is positive. Range of values must contain at least one
positive and one negative value.
⃰ Guess is not required. But if you get a #NUM! error, try different
guesses – ones you think might be close.
⃰ Cash flows must happen at the end of each period.
⃰ Cash flows start at time 0.
⃰ Cash flows do not have to be equal in amount.
⃰ Time between each cash flow must be the same.
⃰ IRR gives you the period rate. If you give it annual cash flows, it
gives you annual rate, if you give it monthly cash flows, it gives
you monthly rate.
⃰ **Don’t use IRR for investments that have non-conventional cash flows (cash flow other than
time 0 is negative) or the investments are mutually exclusive alternatives and initial cash
flows are substantially different or timing are substantially different.

42
Data For Example 7
 You are looking at a new project and you
have estimated these numbers:
CF0 -160,000.00
CF1 60,000.00
CF2 70,000.00
CF3 90,000.00

Net Income 1 13,000.00


Net Income 2 25,000.00
Net Income 3 20,000.00

Your required return for


assets of this risk 15%
Average Book Value 90,000.00
43
Computing IRR For The Project
Example 7:
 Formula Inputs
are cash flows
– that’s it!

 If you do not
have Excel or a
financial
calculator, then
this becomes a
trial and error
process.

44
Trial And Error Process: Build Profile And
“Zero In On” the IRR.
Project Cash Flows
Project Cash Flows CF0 -160,000.00
CF0 -1,000.00 CF1 60,000.00
CF1 1,200.00 CF2 70,000.00
CF3 90,000.00
Solve for directly when Required Rate Return 0.15
exponent is 4 or less (But no Increment 0.005
need to).
NPV = -CF0 + CF1/(1+IRR) RRR (Discount) + NPV
0 = -1,000 + 1,200/(1+IRR) 14.0% 7,241.74
1,000 = 1,200/(1+IRR) 14.5% 5,750.17
1 + IRR = 1,200/1,000 15.0% 4,280.43
IRR = 1,200/1,000 -1 15.5% 2,832.09
IRR = 0.2 16.0% 1,404.73
16.5% -2.05
17.0% -1,388.65
17.5% -2,755.46
18.0% -4,102.85
18.5% -5,431.20
45
Decision Criteria Test - IRR
 Does the IRR rule account for the time
value of money?
 Does the IRR rule account for the risk
of the cash flows?
 Does the IRR rule provide an
indication about the increase in value?
 Should we consider the IRR rule for
our primary decision criteria?
 No! Because of two circumstances…

46
Advantages of IRR
 Knowing a return is intuitively appealing.
 It is a simple way to communicate the
value of a project to someone who
doesn’t 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.

 In the working world, many people use


IRR.

47
Summary of Decisions For The
Project
Summary

Net Present Value Accept

Payback Period Reject

Average Accounting Return Reject

Internal Rate of Return Accept

48
Define
Mutually Exclusive Independent
 A situation were  Taking one project does
taking one project not affect the taking of
prevents you from another project.
taking another  Ex: If you buy machine A,
you can also buy machine
project. B, or not.
 Ex: With the land,  Ex: Cash flows from Project
you can build a farm A do not affect cash flows
or a factory, not for Project B.
both.  Projects that are Not
 Not Both. Mutually Exclusive are
said to be Independent.

49
NPV & IRR
 NPV and IRR will generally give us the same
decision if:
OK to use
IRR or NPV
 Conventional Cash Flows =
Both give
 Cash flow time 0 is negative. same
 Remaining cash flows are positive. answer.

 Projects (investments) Are Independent:


 The decision to accept/reject this project does not
affect the decision to accept/reject any other project.

 Independent = “not mutually exclusive”.

50
DO NOT Use IRR, Instead Use NPV
 DO NOT use IRR for projects that have
non-conventional cash flows

 DO NOT use IRR for projects that are


mutually exclusive.

NOT OK to use IRR

Use NPV instead

51
IRR and Nonconventional Cash
Flows
 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 the x-axis more than once, there
will be more than one return that solves
the equation
 If you have more than one IRR, which
one do you use to make your decision?

52
Example 8: Non-conventional
Cash Flows: You Will Get Two
53

Answers. Which Is Correct?


Summary of Decision Rules
 The NPV is positive at a required
return of 15%, so you should
Accept.
 If you use Excel, you would get an
IRR of 14% which would tell you to
Reject.
 You need to recognize that there are
non-conventional cash flows and use
NPV for decision rule.

54
IRR and Mutually Exclusive Projects
 So far we have only asked the question:
“Should we invest our $ in Project A?”
 But what if we ask: “Should we invest our $
in Project A or B?”

 Mutually exclusive projects


 If you choose one, you can’t choose the
other
 Example: You can choose Investment A or
B, but not both.

55
Example 9: Mutually Exclusive Projects

The required return


Period Cash Flow A Cash Flow B for both projects is
0 -5,500.0 -5,500.0 10%.
1 2,500.0 1,100.0
2 2,200.0 2,200.0
3 2,200.0 2,750.0
4 1,650.0 3,000.0
Which project
should you accept
and why?

56
Example 9: NPV and IRR Can Give Different Answers.
For These Cash Flows, When RRR = 10%, We Get
Different Answers.
Mutually Exclusive Projects (Investements)
RRR 10%

Period Cash Flow A Cash Flow B


0 -5,500.0 -5,500.0
1 2,500.0 1,100.0 Total cash flows are
2 2,200.0 2,200.0 larger, but payback
more slowly, so
3 2,200.0 2,750.0 higher NPV at low
4 1,650.0 3,000.0 RRR
IRR 0.2183 0.1986
NPV 1,370.8 1,433.3

At RRR = 10%, we use NPV as criteria and accept B.


57
Example 9: NPV and IRR
NPV Profile shows that NPV depends on RRR.
IRR is the same no matter what the RRR is.
Mutually Exclusive Projects (Investements)
RRR 17%
Bigger cash flows in
early years means
they are less affected Period Cash Flow A Cash Flow B
by large RRR (cash 0 -5,500.0 -5,500.0
flows closer to time
zero are less affected
1 2,500.0 1,100.0
by discounting (less 2 2,200.0 2,200.0
time to compound)) 3 2,200.0 2,750.0
Payback is quicker,
so higher NPV at 4 1,650.0 3,000.0
high RRR. IRR 0.2183 0.1986
NPV 498.0 365.3

At RRR = 17%, we use NPV as criteria and accept A. 58


NPV B > NPV A,
When Discount Example 9: NPV Profile shows
Rate < 12%
Ranking conflict:
that NPV depends on RRR.
IRR & NPV give
different answers ME – Don’t Use IRR, use NPV.

NPV B
NPV A > NPV B,
When Discount
Rate > 12%
No ranking conflict:
IRR and NPV
NPV A give same answer

59
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
 Mutually exclusive projects

60
Modified Internal Rate of Return (MIRR)
Example 10:

61
Modified Internal Rate of Return (MIRR)
 3 different methods
 Controversial:
 Not one way to calculate MIRR (different results that with
large values and long time frames can lead to large
differences).
 Is it really a rate if it comes from modified cash flows?
 Why not just use NPV?
 If you use a discount rate to get modified cash flows, you
can not get a true IRR.
 Cash reinvested may be unrealistic because, who knows if
the rate that you are using for discounting is the same
rate that would be applied to a cash flow that might be
used for any number of things.

62
Profitability Index (Benefit Cost Ratio)
 PI Formula= PVFCF/Initial Cost
 PI > 1, accept project
 PI < 1, reject project

 Measures the benefit per unit cost, based on the


time value of money
 A profitability index of 1.1 implies that for every $1
of investment, we create an additional $0.10 in
value
 Use this PI Formula = PVFCF/Initial Cost – 1

 This measure can be very useful in situations


where we have limited capital (can’t do all projects,
then select greater PI)

63
PI
Example 11:
Advantages and Disadvantages of
Profitability Index
 Advantages  Disadvantages
 Closely related to  May lead to
NPV, generally incorrect decisions
leading to identical in comparisons of
decisions mutually exclusive
 Easy to understand investments
and communicate  Scale is not
 May be useful revealed
when available  10/5 = 1000/500
investment funds
are limited
65
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
 Why so many? Because they are all only
estimates!
 The financial manager acts in the
stockholder’s best interest by identifying
and taking positive NPV projects

66
67
Quick Quiz
 Consider an investment that costs $150,000 and
has a cash inflow of $38,500 every year for 6 years
and in 7th year the cash flow is $2,000. The required
return is 15% and required payback is 3 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?

68
Following slides are from Author.
Multiple IRRs
 Descartes Rule of Signs
n
CFt

t  0 (1  IRR )
t
 0

 Polynomial of degree n→n roots


 When you solve for IRR you are solving for
the root of an equation
 One positive ?? real root per sign change
 Remaining are imaginary (i2 = -1)
Two Reasons NPV Profiles Cross
 Size (scale) differences.
 Smaller project frees up funds sooner for
investment.
 The higher the opportunity cost, the more
valuable these funds, so high discount rate
favors small projects.
 Timing differences.
 Project with faster payback provides more
CF in early years for reinvestment.
 If discount rate is high, early CF especially
good
Reinvestment Rate Assumption
 IRR assumes reinvestment at IRR
 NPV assumes reinvestment at the
firm’s weighted average cost of
capital (opportunity cost of capital)
 More realistic
 NPV method is best

 NPV should be used to choose


between mutually exclusive
projects

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