Chap006

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

CHAPTER

6 Net Present Value and Other

Investment Rules

Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

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Chapter Outline

6.1 Why Use Net Present Value?6.2 The Payback Period Method6.3 The Discounted Payback Period Method6.4 The Average Accounting Return Method6.5 The Internal Rate of Return6.6 Problems with the IRR Approach6.7 The Profitability Index6.8 The Practice of Capital Budgeting


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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.


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• 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.


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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


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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.


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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


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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


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• 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).


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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.


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6.4 Average Accounting Return

• Another attractive, but fatally flawed, approach

• Ranking Criteria and Minimum Acceptance Criteria set by management

Investment of ValueBook Average

IncomeNet AverageAAR


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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


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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


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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


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IRR: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(

150$

)1(

100$

)1(

50$2000

IRRIRRIRRNPV


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NPV Payoff Profile

0% $100.004% $73.888% $51.11

12% $31.1316% $13.5220% ($2.08)24% ($15.97)28% ($28.38)32% ($39.51)36% ($49.54)40% ($58.60)44% ($66.82)

If we graph NPV versus the discount rate, we can see the IRR as the x-axis intercept.

IRR = 19.44%

($80.00)($60.00)($40.00)($20.00)

$0.00$20.00$40.00$60.00$80.00

$100.00$120.00

-1% 9% 19% 29% 39%

Discount rate

NP

V


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6.6 Problems with IRR

Multiple IRRs

Are We Borrowing or Lending

The Scale Problem

The Timing Problem


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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


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The Scale Problem (P.175)


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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


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The Timing Problem

($5,000.00)

($4,000.00)

($3,000.00)

($2,000.00)

($1,000.00)

$0.00

$1,000.00

$2,000.00

$3,000.00

$4,000.00

$5,000.00

0% 10% 20% 30% 40%

Discount rate

NP

V

Project A

Project B

10.55% = crossover rate

16.04% = IRRA12.94% = IRRB


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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


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6.7 The Profitability Index (PI)

• Minimum Acceptance Criteria: – Accept if PI > 1

• Ranking Criteria: – Select alternative with highest PI

Investent Initial

FlowsCash Future of PV TotalPI


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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


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6.8 The Practice of Capital Budgeting

• Varies by industry:

• The most frequently used technique for large corporations is IRR or NPV.

27

87


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The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(

150$

)1(

100$

)1(

50$200$0

IRRIRRIRRNPV

Chap006

Economy & Finance

Transcript of Chap006