Corporate Finance- Session 10


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Net Present Value Method

The formula for the net present value canbe written as follows:

n

1t

0t

t

0n

n

3

3

2

21

C

)k1(

CNPV

C)k1(

C

)k1(

C

)k1(

C

)k1(

CNPV


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Why Use Net Present Value?

Accepting positive NPV projectsbenefits shareholders.

NPV uses cash flows

NPV uses all the cash flows of the projectNPV discounts the cash flows properly

Reinvestment assumption: the NPV

rule assumes that all cash flows canbe reinvested at the discount rate.


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The Net Present Value (NPV)Rule

Net Present Value (NPV) =

Total PV of future CFs - Initial Investment

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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Calculating Net Present Value

Assume that Project X costs Rs 2,500 now and isexpected to generate year-end cash inflows of Rs 900,Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through5. The opportunity cost of the capital may be assumed

to be 10 per cent.


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Calculating NPV withSpreadsheets


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The Payback Period Method

How long does it take the project topay 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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Example

Assume that a project requires anoutlay of Rs 50,000 and yields annualcash inflow of Rs 12,500 for 7 years.

The payback period for the project is:

years412,000Rs

50,000RsPB


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Acceptance Rule

The project would be accepted if itspayback period is less than themaximum or standard payback

period set by management. As a ranking method, it gives highest

ranking to the project, which has theshortest payback period and lowest

ranking to the project with highestpayback period.


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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 paybackcriteria may not have a positive NPV

Advantages: Easy to understand

Biased toward liquidity


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The Discounted PaybackPeriod 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 itpays back on a discounted basiswithin the specified time.

By the time you have discounted thecash flows, you might as well calculatethe NPV.


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Average Accounting Return

Another attractive, but fatally flawed,approach

Ranking Criteria and Minimum

Acceptance Criteria set by management

InvestmentofValueBookAverage

IncomeNetAverageAAR


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Example

See page 209.


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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 andmarket values

Advantages:

The accounting information is usuallyavailable

Easy to calculate


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The Internal Rate of Return

IRR: the discount rate that sets NPV tozero

Minimum Acceptance Criteria: Accept if the IRR exceeds the requiredreturn

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 METHOD

The internal rate of return (IRR) is therate that equates the investmentoutlay with the present value of cash

inflow received after one period. Thisalso implies that the rate of return isthe discount rate which makes NPV =

0.


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CALCULATION OF IRR

Uneven Cash Flows: Calculating IRRby Trial and Error


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CALCULATION OF IRR

Level Cash Flows Let us assume that an investment would cost Rs

20,000 and provide annual cash inflow of Rs5,430 for 6 years

The IRR of the investment can be found out asfollows

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

PVAFRs 20,000

Rs 5,430

6,

6,

6,

r

r

r3683.


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NPV Payoff Profile

0% $100.00

4% $73.888% $51.11

12% $31.13

16% $13.52

20% ($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 IRRas 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

NPV


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Calculating IRR withSpreadsheets You start with the cash flows the same

as you did for the NPV.

You use the IRR function:

You first enter your range of cash flows,beginning with the initial cash flow.


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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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Acceptance Rule

Accept the project when IRR > cost ofcapital

Reject the project when IRR < cost ofcapital

May accept the project when IRR = cost ofcapital


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The Profitability Index (PI)

Minimum Acceptance Criteria: Accept if PI > 1

Ranking Criteria: Select alternative with highest PI

InvestentInitial

FlowsCashFutureofPVTotalPI


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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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Lets solve

Q8 and 9 on pg 233


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The Practice of Capital Budgeting

Varies by industry:

Some firms use payback, others use

accounting rate of return. The most frequently used technique for

large corporations is IRR or NPV.


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thankyou

Corporate Finance- Session 10

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Transcript of Corporate Finance- Session 10